Federal Reserve implements statutory replacement rates for US dollar LIBOR contracts

On 16 December 2022, the Board of Governors of the Federal Reserve System (Board) adopted final rule 12 CFR Part 253, "Regulation Implementing the Adjustable Interest Rate (LIBOR) Act" (Final Rule). The Final Rule supplements the US Adjustable Interest Rate (LIBOR) Act (US Act) and establishes the statutory replacement rates that will apply under certain US law contracts and instruments once the remaining US dollar LIBOR tenors are discontinued or cease to be representative on 30 June 2023. The Board requested feedback on its proposed replacement rates in July this year.

Replacement Rates

The US Act provides that a "board-selected benchmark replacement" will replace overnight, one-month, three-month, six-month and twelve-month US dollar LIBOR in certain contracts and instruments that do not contain effective fallbacks, or in respect of which the relevant "determining person" has not determined a replacement rate. However, the US Act leaves it to the Board to specify what the replacement benchmark will be. In the Final Rule, the Board officially adopts the replacement rates proposed in July. These are:

1. for derivative transactions, ISDA's Fallback Rate (SOFR), being SOFR compounded in arrears plus the applicable Bloomberg spread (each such spread being specified in the Final Rule); and
2. for transactions that are not derivative transactions and are neither consumer loans nor contracts to which government sponsored enterprises are party:
   
   (i) for contracts referencing overnight US dollar LIBOR, SOFR plus the applicable Bloomberg spread; and
   
   (ii) for contracts referencing one-month, three-month, six-month or twelve-month US dollar LIBOR, CME Term SOFR plus the applicable Bloomberg spread.

In its accompanying guidance, the Board notes that basis risk may arise due to the differing replacement rates for cash products and related derivative hedging transactions. However, the Board considers that the parties typically involved in these types of transactions are experienced in managing hedging risk and notes that the US Act does not prevent parties from agreeing a more suitable replacement rate.

Benchmark replacement conforming changes

The US Act authorises the Board to implement conforming changes to affected contracts, to address any issues with the implementation, administration or calculation of a replacement rate. The original proposed rules did not include any such conforming changes, as the Board considered these to be unnecessary. However, the Board reconsidered its position in light of concerns raised by commenters, and the Final Rule implements a number of changes to affected contracts to clarify the interpretation of various provisions relating to the replacement rate.

Firstly, the Final Rule replaces any reference to a specified LIBOR source (such as a screen page) with a reference to the publication of the replacement rate by the benchmark administrator or an authorised third party. A related provision replaces references to a particular time of day for determining LIBOR (such as 11:00 a.m. London time) with the standard publication time for the replacement rate. These are common sense clarifications that will be welcomed by market participants.

Secondly, the Final Rule modifies contractual provisions that require the use of a combination (such as an average) of LIBOR values over a period of time spanning the LIBOR replacement date, so that the appropriate LIBOR rate will be used prior to such date and the replacement rate will be used on or after such date. This is a helpful clarification, particularly for certain structured derivative and cash products; for example, a range accrual product where the amount of interest payable depends on the number of days during a period on which the relevant rate is above a specified threshold.

Finally, the conforming changes clarify that, if the board-selected benchmark is not available on the contractual determination date, the most recently published rate is to be used, irrespective of the original contractual provisions.

Contractual fallbacks without a pre-cessation trigger

In the proposed rules the Board sought feedback as to whether guidance should be issued to the effect that contracts with viable cessation fallbacks but without a pre-cessation trigger should fall back to the contractually agreed rate, despite the lack of an applicable trigger. As discussed here, guidance to this effect would avoid the potentially undesirable outcome of a contract falling back to a non-representative rate despite more appropriate fallbacks having been agreed by the parties, and would reduce the risk of disputes. However, the Board declined to address this point in the Final Rule, as it considers that contracts and instruments that identify a specific replacement rate are outside of the scope of the US Act, even if those provisions lack an express pre-cessation trigger.

Determining person

The US Act contains a definition of "Determining Person", being a person with the authority to identify a benchmark replacement under an affected contract. The Final Rule expands this to include any such person with a contingent right to do so. This addresses commenters' concerns that, without such reference to a contingent (or future) right, the determining person would need to wait until the LIBOR replacement date to effect any such change, which was clearly not the intended effect of the US Act.

Importantly from a practical perspective, the Board elected not to impose any particular notice requirements on any such determining person, again based on commenters' feedback.

Scope of US Act

The Final Rule also states that the US Act applies only to existing contracts governed by federal law or the law of a US state, confirming that it is not intended to extend to non-US law contracts or instruments.

Next steps

Given that there are now multiple legislative solutions applicable in respect of USD LIBOR contracts and instruments governed by different governing laws, and in light of the likely publication of synthetic USD LIBOR for certain tenors after 30 June 2023, affected market participants who have not already started their contractual due diligence should do so now.

Authors: Tim Edmonds; Kirsty McAllister-Jones