Final Rule Implementing Libor Act Confirms Use of CME Term SOFR Plus CSA for Tough Legacy Contracts

Final Rule

On December 16, 2022, the Federal Reserve Board adopted the final rule (the “Final Rule”)¹ implementing the Adjustable Interest Rate (LIBOR) Act (the “Libor Act”), which establishes benchmark replacements for contracts governed by U.S. law that reference Libor but do not have terms that provide for the use of a replacement benchmark rate following the cessation of Libor on June 30, 2023. Under the Final Rule, such “tough legacy” contracts will migrate to Term Secured Overnight Financing Rate (SOFR)-based rates, with applicable credit spread adjustments (CSAs). This outcome provides certainty for the CLO market with respect to legacy CLO indentures with interest rate setting mechanisms that would revert to “last known Libor” unless the CLO manager were able to obtain the requisite noteholder consents to effect a benchmark replacement.  

Background

Subsequent to the announcement that Libor would cease after June 30, 2023, Congress took action to provide a national legislative solution to the problem of tough legacy contracts, passing the Libor Act into law on March 15, 2022.² The Libor Act instructed the Federal Reserve Board to issue such regulations as may be necessary or appropriate to carry out the purposes of the Libor Act.³The Federal Reserve Board responded with a proposed rule on July 28, 2022.⁴ Although the Proposed Rule included certain concepts such as “covered contracts” and “non-covered contracts” that have not been incorporated in the Final Rule, the Final Rule does not differ substantially from the Proposed Rule, as both provide for SOFR-based replacement rates and benchmark replacement conforming changes.

Questions answered by the Final Rule

Does the Final Rule require credit spread adjustments to be added to the Term SOFR benchmark rates? What are the implications?

• Yes. As mandated by the Libor Act, the Final Rule provides that static credit spread adjustments must be included as part of the benchmark replacements and are based on the tenor of LIBOR referenced in the contract. Of relevance to CLOs, the credit spread adjustment for three-month Term SOFR is 0.26161 percent⁵. Although there is value in this certainty about the CSA, to the extent a CLO’s underlying loans use a lower spread (as do many loans being issued in the market today), the CLO’s equity returns could suffer as a result of the mismatch.

Can the “determining person” (the collateral manager in a CLO) implement benchmark replacement conforming changes?

• Yes, the Final Rule gives a determining person authority to implement benchmark replacement conforming changes along with the switch from Libor to Term SOFR.⁶

Can I keep my Libor floor?

• Yes, contracts that include a benchmark rate floor will keep the floor; provided that it will now be a Term SOFR floor.⁷

Does the Final Rule require a determining person to notify contract parties or stakeholders of the transition to Term SOFR?

• No, the Final Rule does not impose any notice requirements. However, determining persons should evaluate in each case whether notice is required or would be prudent under each relevant contract, even if not required pursuant to the Libor Act.

Will agreements that have a fallback to the last available Libor still be subject to the Libor Act?

• Yes. Under the Final Rule, language specifying that Libor will be the “last published Libor” is disregarded. Such contracts would therefore fall into the category of “tough legacy” contracts subject to the Libor Act if they do not otherwise have Libor replacement mechanics.⁸

Does the Libor Act protect a “determining person” from liability for replacing Libor with Term SOFR plus the credit spread adjustment?

• Yes, section 5(c) of the Libor Act protects determining persons from liability for selecting a Board-Selected Benchmark Replacement (i.e., Term SOFR plus the applicable credit spread adjustment).

Application of the Final Rule to CLO Indentures

Generally, CLO indentures will fall into one of three categories:

• First, some indentures for older CLOs that have not been reset do not include any mechanism for replacing Libor with a successor benchmark rate. Such indentures would qualify as “tough legacy contracts” and the Libor Act would apply, meaning that the CLO would transition to three-month Term SOFR plus the credit spread adjustment pursuant to the terms of the Libor Act.
• Second, some indentures require a supplemental indenture in order to replace Libor with another benchmark rate. The Libor Act will not apply to such indentures, unless the parties fail to enter into a supplemental indenture. In such case, the collateral manager as a “determining person” would be deemed to have failed to choose a benchmark replacement rate, and the Libor Act would apply, meaning the deal would transition to three-month Term SOFR plus the credit spread adjustment.
• Third, indentures with “hardwired” Libor replacement mechanics are not subject to the Libor Act. Under such indentures, the collateral manager is authorized to select a replacement benchmark rate provided that certain triggers have occurred. The collateral manager need only notify the noteholders of such change. No supplemental indenture is required and no consents are required. Such indentures are outside the scope of the Libor Act.

Readers should note that the analysis above applies to ordinary cash flow transactions and the Final Rule differs with respect to derivatives, consumer loans and certain transactions related to the Federal Housing Finance Agency and Federal Family Education Loan programs. Please contact the authors or your usual Akin Gump advisor for more information and questions about specific contracts.

Akin Gump’s global CLO practice represents collateral managers, issuers and investors. Our signature approach combines current market insights, deep industry knowledge, continuous extensive experience dating back to the “CLO 1.0” era and a commercial approach to addressing evolving regulatory and compliance matters. Bringing all this to bear, we help collateral managers increase assets under management while staying ahead of rapidly changing regulation in multiple jurisdictions.

¹ Federal Register notice: Regulation Implementing the Adjustable Interest Rate (LIBOR) Act (federalreserve.gov).

² The text of the Libor Act is available at PUBL103.PS (govinfo.gov), at p.777-786.

³ See Section 8 of the Libor Act.

⁴ See Federal Register :: Regulation Implementing the Adjustable Interest Rate (LIBOR) Act.

⁵ See § 253.4(c) of the Final Rule.

⁶The determining person may make such changes as would “be necessary or appropriate to permit the implementation, administration, and calculation of the Board-selected benchmark replacement… without any requirement to obtain consent from any other person prior to the adoption of such benchmark replacement conforming changes” (Final Rule at § 253.5(a)(3)).

⁷ See § 253.3(d)(4) of the Final Rule.

⁸ See preamble to the Final Rule at 20.