Pub. 13 2018-2019 Issue 6

WWW.NEBANKERS.ORG 14 For more information, contact Jeff Makovicka at Kutak Rock LLP: (402) 346-6000 or jeff.makovicka@kutakrock. com. Mr. Makovicka is a member of Kutak Rock LLP’s banking practice group where he concentrates on bank matters. Counselor’s Corner — continued from page 13 Spreads Most legacy contracts that provide for a fallback rate do not also provide for a change to the spread added to the index rate. Whatever alternative rate is ultimately selected to replace LIBOR, such rate will likely be higher or lower than LIBOR, so any spreads that are currently in the contracts (for instance, to set an effective interest rate of LIBOR plus or minus some percentage) may need to be adjusted. New LIBOR-Based Contracts While new LIBOR-based contracts which mature prior to the end of 2021 likely would not be significantly affected by the LIBOR phase-out, using LIBOR for new contracts with short terms might not be the best course. As we get closer to the phase-out date, there is a significant possibility that LIBOR could become extremely volatile. Any contract with a maturity beyond 2021 should absolutely have LIBOR alternative provisions. The New York Fed suggests that “what market participants must do right now is stop writ- ing new contracts on LIBOR and start using … another robust alternative. And, especially if you need to keep using LIBOR, make sure your new contracts have strong and workable fallback language.” 5 Structuring and negotiating such newLIBOR-based contracts should include trigger and fallback provisions tailored to account for the phase-out of LIBOR after 2021. As discussed below, banks must consider many issues and it may not be pos- sible to eliminate all commercial and legal risk. 6 Legal Considerations for LIBOR Phase-out • Breach of contract. Any ambiguity can raise a question of contract interpretation and, therefore potentially, support a claim for breach of contract. • Implied covenant of good faith and fair dealing. A doc- trine that prevents one party fromdenying the other the benefit of the contract or from seizing an unanticipated windfall. Courts could use the doctrine to evaluate general fairness in light of changed circumstances. 7 Banks may find themselves on both sides of some of these legal issues as parties to a range of financial contracts, and in various settings in roles including lender, servicer, borrower, trustee, and more. What’s the Replacement for LIBOR? In 2014 the Federal Reserve convened the ARRC to plan the transition away fromLIBOR. 8 The ARRC conducted two public roundtables, published a written consultation, and created an advisory group of end users across market sectors. The ARRC’s criteria for LIBOR’s replacement includedmethodological qual- ity, accountability, governance, and ease of implementation. In the end, the ARRC recommended the Secured Overnight Financing Rate (“SOFR”) as a potential replacement for LIBOR. 9 According to the New York Fed, SOFR is a much more resilient rate than LIBOR for several reasons, all of which center on how it’s produced and the depth and liquidity of the markets that underlie it. 10 Since SOFR is an overnight borrowing rate and since SOFR transactions are collateralized by Treasury securities, it is generally a lower rate than LIBOR and it is not yet considered a truly comparable substitute for LIBOR. Nevertheless, the creation of SOFR and its publication are important steps in establishing an alternative to LIBOR. There is some momen- tum via ARRC and other industry sources to accept SOFR as a replacement index for LIBOR. And with passage of time, it’s expected that the market will arrive at a consensus toward using an index such as SOFR as the replacement for LIBOR. Until that consensus is achieved, and to avoid compounding the LIBOR cessation problem, banks and their counsel will likely rely on the broad approaches and draft replacement rate provisions to (1) not to designate a specific alternative index rate yet and (2) to provide that the bank may in its reasonable judgment select a substitute rate and spread from another recognized source so long as the substitute rate and spread produce an interest rate comparable to the LIBOR rate and spread in the current documents and the substitute rate is readily verifiable from a published source. What to Do Now As mentioned above, the first thing that can be done now is to take inventory of your bank’s LIBOR-based contracts and as- sets. Banks should scrutinize the relevant contractual language and consider possible trouble spots (as described above) as they consider entering into and/or amending LIBOR-based contracts. Perhaps most important, banks should maintain a list of any LIBOR affected contracts, so that if there is any opportunity to amend these agreements (requests for extension, renewals, etc.), banks should strongly consider using that opportunity to incorporate robust LIBOR fallback language. 1 LIBOR: Origins, Economics, Crisis, Scandal, and Reform, New York Federal Reserve (2014). 2 5 Things You Should Know About LIBOR, ARRC, and SOFR, New York Federal Reserve (2018). 3 See note 2. 4 Note that individual amendment of every contract that refers to LIBOR, however, is likely not possible given how widespread LIBOR has become. 5 SOFR and the Transition from LIBOR, New York Federal Reserve (February 26, 2019). 6 The Alternative Reference Rates Committee (“ARRC”) has released LIBOR fallback consultations for syndicated business loans, for floating rate notes, for bilateral business loans and for securitizations. These consultations outline draft language for new LIBOR-based contracts. The ARRC intends to publish additional consultations and final recommendations in the near future. Banks should review these draft fallback provisions. 7 Other legal considerations include force majeure and certain unexpected-circumstances doctrines (e.g. impossibility, frustration of purpose, and mutual mistake of fact). 8 Information on the ARRC, including its announcements and publications, can be found at https://www.newyorkfed.org/arrc. 9 The ARRC Selects a Broad Repo Rate as its Preferred Alternative Reference Rate (June 2017). 10 See note 2.