The LIBOR Transition – What a Legacy!: Legislative Solutions/ Constitutional Law Considerations

Orrick, Herrington & Sutcliffe LLP

As noted in our Financial Industry Alert published on January 17, 2020, one of the most daunting challenges for the forthcoming transition from LIBOR to an alternative reference rate has to be the impact of the prospective transition on outstanding financings and other contracts (legacy instruments). In the prior Alert, we discussed some of the issues that may arise for legacy instruments once LIBOR is no longer available and said that some are intractable, many may be insolvable, and that some, although not all, may be addressed by prospective legislation that has been the subject of discussion within the Alternative Reference Rates Committee (the “ARRC”) and elsewhere. Below we discuss legislative solutions under consideration, as well as certain U.S. Constitutional law challenges such legislation may face.

New York State Legislation Under Consideration

The ARRC announced through the publication of its November 2019 meeting minutes that it had “reached a basic consensus . . . to begin exploring a potential legislative solution to address the trillions of dollars of existing LIBOR-linked contracts that either lack contractual provisions to deal with the end of LIBOR or have contractual provisions that do not effectively address a permanent cessation of LIBOR.” Additionally, the ARRC and its Legal working group have “agreed that it [is] appropriate to discuss a potential legislative solution with relevant New York State authorities and to begin engaging more publicly on the issue.”

According to the November meeting minutes, the legislative solution would insert the ARRC-recommended secured overnight financing rate (“SOFR”) and the related recommended spread adjustment into certain LIBOR contracts governed by New York law across all asset classes, as described in greater detail below. The ARRC is focused on New York law because, as stated in the November meeting minutes, “a significant portion of financial products and agreements that use LIBOR are governed by New York law, [and] a New York legislative solution would mitigate adverse economic outcomes and minimize disputes that would burden New York courts.”

The legislation under consideration would apply the ARRC-recommended SOFR rate, spread adjustment and related provisions as follows:

  • Silent Contracts. With respect to “silent contracts” (i.e., contracts that have no fallback provision), the legislation would apply on a mandatory basis. For a loan agreement that provides simply that the borrower’s interest rate is based on LIBOR, and does not include any fallback provision, the legislation would, upon the occurrence of a specified statutory trigger event, insert the ARRC-recommended SOFR fallback rate and spread adjustment into the terms of the loan.
  • LIBOR-based Fallbacks. With respect to contracts with LIBOR-based fallbacks (e.g., floating rate bonds and securitizations that provide for a fallback to the last available LIBOR, or call for conducting a dealer poll to request quotes for LIBOR), the legislation also would apply on a mandatory basis. For example, if a floating rate bond provides that (i) in the event of the unavailability of LIBOR, the calculation agent shall conduct a dealer poll to request quotes for LIBOR and, if the dealer poll fails, (ii) the interest rate on the bond will be fixed based on the last available LIBOR rate, then under the proposed legislation, upon the occurrence of the specified statutory trigger event, the calculation agent would not be required to conduct the dealer poll, and the ARRC-recommended SOFR fallback rate and spread adjustment for bonds would be inserted into the terms of the bond and would override the contractual LIBOR-based fallback provision.
  • Contracts with Discretion. With respect to contracts providing discretion, the legislation would apply on an optional basis. For example, a loan agreement might include fallback provisions whereby the administrative agent has the right to choose the replacement benchmark in its discretion when LIBOR is “unavailable”. The legislation would provide a safe harbor that would protect an election by the administrative agent to use the ARRC-recommended SOFR fallback rate and spread adjustment. The safe harbor would be available to all persons (including the lender and the borrower) and not just to the administrative agent. If the administrative agent elected to use a different replacement benchmark, however, there would be no safe harbor protection, but also no negative inference with respect to the administrative agent’s election. For the safe harbor to be available, the decision to use the ARRC-recommended provisions would have to be made within a specified timeframe and could not be changed.
  • Non-LIBOR-based Fallbacks. With respect to contracts with fallbacks to rates other than LIBOR (e.g., prime), such fallbacks would remain in place and would not be affected by the legislation.
  • Trigger Events. The legislation would use the same trigger events recommended by the ARRC for the cash markets and adopted by the International Swaps and Derivatives Association, Inc. (ISDA) for the derivatives markets. (Presumably, the legislation will provide for the ARRC triggers to apply to cash instruments and the ISDA triggers to apply to derivatives. It is not yet certain that these triggers will be entirely the same.)
  • Opt Out. Parties to a contract would be permitted mutually to opt-out of the application of the legislation at any time before or after the occurrence of a statutory trigger event.
  • Conforming Changes. Safe-harbor protection under the legislation would be available for parties that add conforming changes to their documents to accommodate administrative/operational adjustments for the statutory endorsed benchmark rate.

U.S. Constitutional Law Considerations

Any state legislation that purports to effect a change in an outstanding contract could possibly be subject to challenge under the “Contracts Clause” of the United State Constitution (Article I, section 10, clause 1). That Clause prohibits states from passing any “Law impairing the Obligation of Contracts.” Despite the categorical terms of the Contracts Clause, U.S. Supreme Court opinions have generally tended to be forgiving toward state legislation with retroactive effects on contracts.

When evaluating whether to uphold state legislation under the Contracts Clause, the basic test, as expressed by the U.S. Supreme Court most recently in Sveen v. Melin (2018), essentially involves three steps: (1) whether the statute effects a “substantial impairment” of contracts; (2) if the statute does impose a substantial impairment, whether the statute advances a legitimate public purpose; and (3) in satisfying the preceding step, whether the means-ends fit is reasonable. See also the decisions in Energy Reserves Group, Inc. v. Kan. Power & Light Co. (1983), United States Trust Co. v. New Jersey (1977), and Home Building & Loan Ass'n v. Blaisdell (1934).

“Substantial Impairment”. On the question whether the legislation under consideration would result in a “substantial impairment” of contractual rights, those defending the law are likely to try to minimize claims of impairment by arguing that the objective of the ARRC in choosing an alternative reference rate and a rate adjustment is to minimize value transfer between the parties to a contract.[1] The ARRC has explained, “LIBOR and SOFR are different rates and thus the transition from LIBOR to SOFR will require a spread adjustment to make the rate levels more comparable.”

“Legitimate Public Purpose”. If a substantial impairment is shown, a court would next look to whether the impairment is supported by “a significant and legitimate purpose,” and whether it does so in an “appropriate” and “reasonable” way. Sveen v. Melin (2018) (citing Energy Reserves Grp., Inc. v. Kan. Power & Light Co. (1983)). Advocates seeking to support the New York State legislation under consideration could argue that it serves important public purposes in providing uniformity and avoiding “likely adverse economic and financial impacts on consumers, businesses, and other market participants that would materialize” absent a legislative fix (as suggested by the ARRC November 2019 meeting minutes). Challengers could argue that the proposed legislation is an improper means to serve those ends. Such efforts will be stronger if the challengers identify an alternative approach that would provide stability and uniformity.

The Sveen case concerned a Minnesota statute providing that, where a life insurance policy designates a spouse as beneficiary, a divorce has the automatic presumptive effect of revoking that beneficiary designation. Sveen represents the Court’s most recent extended treatment of the Contracts Clause and, as such, it provides the best indication of how the Court, as currently composed, may receive a constitutional challenge to a legislative LIBOR fix.

Sveen upheld the Minnesota statute at the first step of the analysis, concluding that the law did not substantially impair contracts. Writing for the Court, Justice Kagan focused on three aspects of the Minnesota law in question: (1) that the law is “designed to reflect a policyholder’s intent”; (2) the law is “unlikely to disturb any policyholder's expectations” at the time of contracting; and (3) that it “supplies a mere default rule” that the policyholder can undo. (The Court also deemed its ruling to be in accord with earlier precedent upholding legislation that conditioned an existing contractual right on compliance with “minimal paperwork burdens”.)

Justice Gorsuch filed a solo dissent in Sveen, which articulated a robust conception of the constitutional limits on retroactive legislation. His dissent opened by questioning the Court’s premise that the Contracts Clause (which is phrased in unqualified terms) permits impairments that are “insubstantial,” or even substantial impairments as long as they are “reasonable”. He also addressed New Deal-era cases where the Court had upheld laws against Contracts Clause challenges, including Home Building & Loan Ass’n v. Blaisdell (1934), which sustained a moratorium on residential mortgage foreclosures. Those cases, in Justice Gorsuch’s view, “involved statutes altering contractual remedies”, and should thus be distinguished from legislation involving substantive rights.

Applicability of Sveen. Justice Kagan’s reasoning can be considered in the context of each of the types of contracts that would be impacted by the New York State legislation under consideration. A party seeking to support the legislation against a Contracts Clause challenge may argue that the parties intended that, unless the parties agreed to an alternative in the contract, there is a need for the legislation because otherwise there would be no interest rate provided in the contract if LIBOR were not available. Such a party may also argue that the expectation at the time of contracting was that LIBOR would remain in existence, and now that LIBOR is no longer in existence the use of the ARRC recommended reference rate and spread adjustment, which are intended to “minimize value transfer”, to set the interest rate on the contract is consistent with such expectations.

Similarly, with respect to contracts with discretion - those that leave to an administrative agent or other party the right to implement the ARRC recommended reference rate and spread adjustment to set the interest rate on the contract - a party seeking to sustain the legislation against a Contracts Clause challenge might argue that the parties intended that there be an interest rate and that the provision of a safe harbor for the use of the ARRC recommended reference rate and spread adjustment is consistent with the expectations of the parties at the time of contracting.

While contracts with non-LIBOR fallbacks (such as a fallback to the prime rate) are not covered by the legislation under consideration, an argument can be made, certainly in cases where there would be a very significant change in the contract interest rate (as of February 3, 2020 the WSJ Prime Rate was 4.75% and USD LIBOR was 1.57% for overnight, up to 1.77% for 1-year LIBOR, about a 300 basis point increase in the rate to be paid by a borrower whose LIBOR referenced contract switches to prime), that the parties clearly intended LIBOR to be the contract interest rate. Further, that the fallback rate was included to address temporary unavailability of LIBOR (which is widely understood, although admittedly generally not so stated in contracts), that no one expected LIBOR to no longer be available on a permanent basis, that the parties did not expect or intend for the borrower’s interest obligation to increase so dramatically, and that the use of the ARRC recommended reference rate and spread adjustment is consistent with the intentions and expectations of the parties at the time of contracting.

We note that there of course have been cases upholding Contract Clause challenges to legislation, including these. The U.S. Trust case from 1977 invalidated a New Jersey statute that retroactively repealed a statutory covenant, which had the effect of impairing Port Authority bondholders’ interests. The Court held that the repeal eliminated an important security provision and was not reasonable or necessary to serve an important public purpose (encouraging the use of public transportation), since less drastic measures were available. Also, the following year, in Allied Structural Steel Co. v. Spannus, the Court invalidated an application of a Minnesota pension law that would have retroactively imposed additional pension obligations on certain large employers who had previously established voluntary pension plans but later closed their Minnesota offices. The Court held that the impairment was severe and that it did not serve a public purpose in that it seemed to be aimed at punishing a narrow set of employers rather than protecting a broad social interest. All of these decisions are, of course, heavily dependent on the facts of a particular case.

Challengers to the legislation might argue for a broad reconsideration of the Supreme Court’s modern Contracts Clause doctrine, along the lines suggested in Justice Gorsuch’s Sveen dissent. For example, challengers could argue against limiting the Clause’s protections to “substantial” impairments, noting that the text of the Clause does not contain that qualifier, but rather proscribes “any” law that impairs contractual obligations, even if the impairment is minimal. Similarly, the text of the Clause does not call for the balancing approach that the Supreme Court has applied in measuring the fit between the challenged legislation and a legitimate public purpose, which has led the Court to uphold legislation that substantially impairs contractual obligations as long as the impairment is “reasonable”. Note, however, that Justice Gorsuch’s dissent did not attract the vote of Justice Thomas, who has not been hesitant in calling for the Court to depart from its constitutional precedent when, in his view, that doctrine deviates from the original meaning of the provisions at issue. Justice Thomas’ vote with the majority in Sveen may therefore be an ominous sign for challengers who seek a major overhaul of modern Contracts Clause doctrine.

Additional U.S. Constitutional Law Considerations

It should be noted that constitutional challenges to LIBOR legislation would not necessarily be limited to the Contracts Clause. The Due Process Clause of the U.S. Constitution may also be relevant in a constitutional challenge by a litigant and might be added to any Contracts Clause claim, although the Court in PBGC v. RA Gray & Co. (1984) said that scrutiny of retroactive economic legislation under the Due Process Clause is “less searching” than the analysis under the Contracts Clause. Additionally, the New Deal era’s Gold Clause Cases may offer further grist for constitutional argument. The Gold Clause Cases[2] concerned, among other issues, the validity of a 1933 Joint Resolution of the Congress that cancelled “gold clauses” (allowing a party the option to receive payment in gold) in private and public contracts. The Supreme Court narrowly upheld the cancellation of gold clauses under the Joint Resolution, but its analysis turned in large part on Congress’s enumerated power to regulate money.

* * *

The ARRC noted in its October 2019 meeting minutes that “exploring potential legislative options would be challenging.” The challenges of such a legislative solution surely include the constitutional issues described above. Although there are reasons to believe that such legislation would survive constitutional challenges, such litigation could take several years (or longer) to culminate in a definitive resolution. Challenges would first need to be brought in federal or state courts of first instance, likely in the form of an action seeking injunction or declaratory relief. Any trial-court ruling could then be appealed to a federal court of appeals, or a state intermediate appellate or supreme court. The U.S. Supreme Court, for its part, may well refrain from accepting review of the issue unless a clear split of authority develops among various federal courts of appeals or state courts of last resort that consider the issue. Given the amounts potentially at stake, borrowers or lenders adversely affected by this legislation may have every incentive to litigate to a conclusion.


[1] “In determining recommended fallbacks for LIBOR in consumer products, the choice of the replacement index, spread adjustment to the replacement index, succession timing, and mechanics . . . should seek to minimize expected value transfer based on observable, objective rules determined in advance.”

[2] Norman v. Baltimore & Ohio Railroad Co. (1935); United States v. Bankers Trust Co. (1935); Nortz v. United States (1935); and Perry v. United States (1935).

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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