Federal legislation to mitigate risks related to legacy contracts that use a soon-to-be discontinued reference rate is needed, a top Federal Reserve official will tell a congressional hearing Thursday, according to testimony released Wednesday.
In the written text of his testimony, Federal Reserve Board General Counsel Mark Van Der Weide will say that federal legislation “would establish a clear and uniform framework, on a nationwide basis, for replacing LIBOR (London Interbank Offered Rate) in legacy contracts that do not provide for an appropriate fallback rate.” In the testimony, Van Der Weide will tell the investor protection subcommittee of the House Financial Services Committee that those “fallback rates” include such vehicles as the prime rate.
LIBOR is widely used by financial institutions as a reference rate for adjustable-rate mortgages and other loan contracts. The rate is being phased out because the transactions it is based on don’t occur as often as they did in prior years.
The rate is scheduled to be phased out at the end of this year (meaning, no new loans or contracts are supposed to be written that use the rate). Additionally, existing “legacy contracts” (or those that are in force now and using the reference rate) have until June 2023 to phase out the reference rate.
Van Der Weide will tell the subcommittee that that phase-out in two years will inevitably lead to some lawsuits. “For example, if a legacy contract converts to a fixed rate when LIBOR ends, a party disadvantaged by that conversion might request that a court reform the contract by substituting an alternative floating rate for LIBOR,” according to the testimony. “Parties also might request that a court reform or void a legacy contract that lacks any fallback language if the parties cannot agree bilaterally on a successor rate.
“Similarly, in instances where a legacy contract allows a person to select a replacement rate when LIBOR ends, a party disadvantaged by the replacement rate might argue that the manner in which another person – for example, a bond trustee – selected the replacement rate violates the implied covenant of good faith and fair dealing,” the testimony states.
Van Der Weide will also tell the subcommittee that federal legislation should be targeted narrowly to address legacy contracts that have no fallback language, that have fallback language referring to LIBOR or to a poll of banks, or that convert to fixed-rate instruments. He will also say that federal legislation should not affect legacy contracts with fallbacks to another floating rate, nor should it dictate that market participants must use any particular benchmark rate in future contracts.
“Finally, to avoid conflict of laws problems, federal legislation should pre-empt any outstanding state legislation on legacy LIBOR contracts,” according to the testimony.
Van Der Weide is scheduled to testify at 2 p.m. ET Thursday before the subcommittee.