MODIFICATION OF LIBOR CONTRACTS 4 April 2024

LIBOR has been one of the main interest rate benchmarks used in financial markets and called “the most important number” of the world. However, in order to ensure the stability and credibility of the global financial system, financial regulators in the United States, United Kingdom, European Union, Switzerland, and Japan have, respectively, transitioned away from the LIBOR to the Secured Overnight Financing Rate (SOFR), the Sterling Overnight Index Average (SONIA), the Euro Short-Term Rate (€STR), the Swiss Average Rate Overnight (SARON), and the and the Tokyo Overnight Average Rate (TONA) due to scandals alleging that banks manipulate the LIBOR to make greater profits from trade or appear more trustworthy than they are.

That said, even if financial regulators and central banks have created a safe environment for international banks to provide a smooth transition period from LIBOR to alternative reference rates, there are, even rare, contracts not modified their provisions under the strict guidance thereof and still utilizing LIBOR as a benchmark interest rate. This article examines the regulatory frameworks in the European Union, the United Kingdom, and the United States, addressing specific contractual possibilities for transition away from LIBOR and creating a sustainable contractual relationship between banking institutions in their financial transactions.

1. European Union and the United Kingdom Benchmarks Regulation

First off, some banking institutions may be legally required to craft contractual stipulations as regards applicable procedures to modify the contract in the mere possibility that the contractual benchmark is put to an end since some jurisdictions have specific rules applicable to the transition period from LIBOR to other alternative rates. Art. 28(2) of the European Union and the United Kingdom Benchmarks Regulation obliges supervised entities to insert fallback provisions in their contracts addressing which alternative benchmark rate would take LIBOR’s place in the event that a benchmark which they are using materially changes or ceases to be provided.

If banking institutions must comply with this specific regulation, they are expected to have a fallback provision addressing the replacement of LIBOR with alternative benchmark rates in their contract. These contracts automatically shift to the specified alternative rate upon LIBOR's cessation, such as the Secured Overnight Financing Rate (SOFR) in the United States or the Sterling Overnight Index Average (SONIA) in the United Kingdom. However, to ensure continuity of terms and reducing the risk of disputes, even banking institutions with no legal obligation to craft contracts with fallback provisions are strongly encouraged to insert appropriate mechanisms by which alternative benchmark rates of their contract can automatically replace the previous benchmark no longer used.

2. The Adjustable Interest Rate (LIBOR) Act of the United States

The LIBOR Act clearly differentiates between three kinds of LIBOR contracts, each with distinct fallback provisions. According to the Act, a "LIBOR contract" is defined in broad terms to encompass any financial obligation or asset that references the overnight, one-month, three-month, six-month, or 12-month USD LIBOR rates as a benchmark.

The first group of LIBOR contracts includes those with fallback clauses that specify a clear alternative benchmark not derived from any USD LIBOR values, aside from adjustments made to bridge the gap between LIBOR and the new benchmark. These contracts do not require any individual (apart from a benchmark administrator) to engage in polling, surveying, or requesting quotes or information regarding interbank lending or deposit rates.

Such contracts are generally expected to shift to the alternative benchmark outlined in their fallback clauses by or before the designated date for replacing LIBOR. This date is set as the first banking day in London following June 30, 2023, unless it is determined that any specific LIBOR tenor will stop being published or recognized as representative on a different date.

The second category of LIBOR contracts includes (i) those without any fallback clauses and (ii) those with fallback clauses that neither designate a specific person to determine the benchmark replacement nor do they (A) specify an alternative benchmark that relies in any way on USD LIBOR values (besides adjustments for the difference between LIBOR and the replacement benchmark), or (B) mandate that an individual (excluding a benchmark administrator) carry out polls, surveys, or requests for quotes or information related to interbank lending or deposit rates.

As regards the second category of LIBOR contracts, the LIBOR Act mandates that the benchmark replacement, effective on the LIBOR transition date, will be the alternative benchmark chosen by the Board. This selected benchmark must be based on the Secured Overnight Financing Rate (SOFR) and incorporate the necessary tenor spread adjustments as required by the LIBOR Act.

Therefore, any mention of USD LIBOR in contracts within this second group will automatically be substituted by the benchmark chosen by the Board on the designated date for transitioning away from LIBOR, as per the legal stipulations.

The third category includes LIBOR contracts that have fallback clauses granting the authority to a designated individual, referred to as the determining person, to choose an alternative benchmark.

The relevance of the LIBOR Act to contracts within this third group hinges on the choice made by the determining person, if any. In cases where the determining person fails to choose an alternative benchmark by either the designated date for LIBOR's replacement or the contract's own deadline for making such a choice (whichever comes first), the Act stipulates that the alternative benchmark for the contract will automatically become the benchmark chosen by the Board from that date forward.

If the determining person opts for the Board's chosen benchmark as the replacement, the Act specifies that this decision is (i) final and cannot be reversed, (ii) must be made no later than the sooner of the date set for LIBOR's replacement or the contract's last permissible date for selecting an alternative, and (iii) will apply to all subsequent benchmark determinations for the contract from the LIBOR replacement date onwards.

CONCLUSION

In sum, the shift from LIBOR to alternative benchmarks is a pivotal moment for the financial world, driven by the imperative of market stability and credibility. Regulatory frameworks across the EU, UK, and US have laid out directives to navigate this transition, categorizing LIBOR contracts by their fallback scenarios. These guidelines aim to ensure a smooth shift to stable benchmarks like SOFR, SONIA, €STR, SARON, and TONA, accommodating contracts both with and without predetermined fallbacks. As we near LIBOR's cessation deadline, it's crucial for financial market participants to align their contracts with these new standards, securing the seamless continuation of financial activities in a post-LIBOR environment.