What Happens After LIBOR? The Impact on Legacy Instruments

Marc Gottridge Ashley Hutto-Schultz

By Marc Gottridge and Ashley Hutto-Schultz

Marc Gottridge is a New York-based partner and head of the U.S. Financial Services Litigation practice at global law firm Hogan Lovells. Ashley Hutto-Schultz is a senior associate in Hogan Lovells’ Washington office.

On July 27, 2017, the U.K.’s Financial Conduct Authority (FCA), which has regulated the London Interbank Offered Rate (LIBOR) since 2013, announced that after 2021 it would neither compel nor try to persuade contributor banks to make LIBOR submissions. Although those banks are free to continue to sustain the world’s most widely used benchmark rate voluntarily, without the FCA’s imprimatur, most observers believe that they are unlikely to do so. Central banks and industry groups have already done substantial work developing alternatives to LIBOR. So it is safe to assume that in little more than four years, LIBOR will cease to be published. It is not too early to consider what that will mean for participants in financial markets, including financial institutions, commercial parties and consumers.

Because LIBOR is used in such a wide range of contracts, including “legacy instruments” that have reset and/or maturity dates beyond 2021, the prospect that it will no longer be published, combined with the lack of an off-the-shelf replacement likely to win widespread acceptance across diverse markets, raises a number of questions.

After providing some background about LIBOR, its phase-out and the ongoing efforts to develop replacement benchmark rates and amend instruments to include fallbacks that can be used when LIBOR is no longer available, we will explore legal issues—including potential litigation risks—that may affect legacy instruments in the U.S. We will focus particularly on legacy instruments lacking sufficiently robust fallback rates (or mechanisms to generate them), and those which permit one party to substitute another rate if LIBOR is no longer available. How will American courts enforce such contracts once LIBOR is no longer being published? Does the common law furnish courts with tools to reform or adjust legacy instruments so that ongoing financial relationships may continue even though LIBOR doesn’t? And how will courts assess claims that a lender has abused its discretion in replacing LIBOR with what might be a higher rate?

LIBOR: The $350 Trillion Benchmark

LIBOR is indicative of the average rate at which the designated contributor banks can obtain unsecured funding in the London interbank market. It is calculated for five currencies—the U.S. dollar, British pound, Japanese yen, Euro and Swiss franc—and seven maturities, from overnight to 12 months. From 1986 until February 2014, LIBOR was administered by the British Bankers Association. Since then, it has been administered by the Intercontinental Exchange Benchmark Administration Limited.

The variety of uses to which financial markets in the U.S. and around the world have put LIBOR is impressive. LIBOR is incorporated into, among others: futures contracts and options—most notably Eurodollar futures, the CME’s most actively traded contract; interest rate swaps; cross-currency swaps; forward rate agreements; floating rate notes, bonds and preferred stock; credit agreements governing syndicated and other commercial loans; consumer loans, including an estimated 40 percent of U.S. adjustable rate mortgages (ARMs) as well as student and auto loans; and structured finance products, including RMBS, CMBS, ABS and CLO notes.

The FCA’s Announcement and the Development of LIBOR Substitutes

In a July 2017 speech, FCA chief executive Andrew Bailey stated that his agency would cease supporting LIBOR after 2021, because “the underlying market that LIBOR seeks to measure—the market for unsecured wholesale term lending to banks—is no longer sufficiently active.” Mr. Bailey warned that “market participants must take responsibility for their individual transition plans” over the next four-plus years.

There is no ready-made alternative to LIBOR that has broad market acceptance. But years before the FCA’s announcement, the Federal Reserve and Bank of England had instructed committees to develop “risk free” benchmarks for dollars and sterling, respectively. These rates—the new Broad Treasuries Repo Finance (BTRF) and a reformed Sterling Overnight Index Average (SONIA)—are still under development; both are scheduled to be launched in 2018. Each will represent an average of rates paid by banks for a specified type of overnight borrowing. Both are poised to win acceptance as benchmark overnight interest rates, and markets requiring term reference rates (e.g., one, three or twelve month rates) are likely to develop “spreads” interpolated from the new overnight benchmarks to engineer term rates that may more or less approximate LIBOR for various maturities or tenors. But it is far from clear who will calculate and publish those term rates, how widely they will be accepted and whether a single standard will emerge; it may take years for the dust to settle. This uncertainty poses a challenge to those drafting or amending contracts today.

Incorporating Fallbacks Into LIBOR-linked Instruments: A Mixed Bag

Many instruments that reference LIBOR—from swaps to ARMs—do not mature until after 2021 and/or provide for reset dates beyond that year. Some, but not all, of these legacy instruments provide fallbacks for LIBOR, or mechanisms for determining a fallback to use if LIBOR is no longer available. But not all of those fallback mechanisms are sufficiently robust or practical to be useful in the long term. For example, ISDA’s 2006 documentation and the forms of many instruments used in various markets specify an average of the costs of funds reported by a designated group of “reference banks” if LIBOR is unavailable. But this is plainly intended as a backstop for the benchmark’s temporary unavailability, rather than a permanent replacement if (as now appears probable) LIBOR ceases to be published altogether. Nor is it clear that the designated “reference banks” would voluntarily contribute to a LIBOR-like rate after LIBOR’s demise; they would have little incentive to do so, yet might risk lawsuits from those unhappy with their “submissions.”

Other instruments contain a different kind of fallback provision that also plainly wasn’t designed for use in case LIBOR was no longer published at all: they provide for the continued use of the designated LIBOR rate as fixed on the most recent date for which it was available, which could unwittingly lock in December 31, 2021 LIBOR as the benchmark governing such instrument for years to come. In contrast, some ARM notes and other instruments provide for the issuing bank’s own cost of funds to replace LIBOR if that benchmark is no longer available. Others grant the lender discretion to select a rate as a substitute for LIBOR in that situation. And still others say nothing at all about what happens if LIBOR is no longer available. In short, the practice as to fallbacks varies widely from market to market and instrument to instrument.

In the wake of the FCA’s July 2017 announcement, industry groups are pushing to amend legacy instruments where possible to incorporate fallbacks or fallback mechanisms that will be sufficiently robust to function smoothly after 2021. ISDA, the LMA and other organizations are working on recommendations to promote the amendment of legacy instruments, including “protocols” to facilitate multilateral amendments. Although the path ahead isn’t entirely clear and much work remains to be done, it is likely that by 2021 many legacy instruments will incorporate reasonably workable fallback provisions. Nevertheless, the parties to other instruments (including those involving multiple parties) may not be able to agree on a fallback mechanism. In other cases, lenders may be content to rely on their discretion to designate a substitute.

We now consider some of the issues that courts in the U.S. may have to grapple with in dealing with these legacy instruments after LIBOR is no longer published—and the resulting risks to the parties, in particular lenders.

Contractual Interpretation

If LIBOR ceases to be published after December 31, 2021, parties to agreements specifying LIBOR in a certain tenor as the governing reference rate (e.g., a note requiring periodic payments at the rate of 3% plus then-prevailing 3 month U.S. dollar LIBOR) and containing no fallback provision should not assume that courts in the U.S. will interpret the contractual reference to LIBOR as permitting them to switch, over the counterparty’s objection, to a new reference rate—even if the new rate has by then achieved widespread acceptance in the relevant market. The alternatives to LIBOR that remain to be developed are almost certain to be materially different in nature and methodology from LIBOR, and inevitably will produce rates that parties can argue are either higher or lower than LIBOR would have been.

U.S. courts, when called upon to interpret contracts, often explain (as the New York Court of Appeals has often done, at least since Morlee Sales Corp. v. Manufacturers Hanover Trust Co., 9 N.Y.2d 16, 19 (1961)), that their task is to “give effect to the intentions of the parties as expressed in the unequivocal language employed” and that they “may not by construction add or excise terms, nor distort the meaning of those used and thereby make a new contract for the parties under the guise of interpreting the agreement.” Courts across the U.S. have repeatedly applied these principles in cases involving contracts which failed to provide for various contingencies. They generally do not construe such an omission as creating an ambiguity that would justify them in inserting a provision (such as a fallback rate for LIBOR) for which the parties did not bargain. It is therefore unlikely that a plea for contractual interpretation will aid a party that failed to obtain an amendment incorporating a LIBOR fallback mechanism but now argues that the court should designate another rate as a post-2021 substitute.

Impracticability of Performance

Nevertheless, it’s clear that the parties to our hypothetical note could not, as a practical matter, perform that agreement as written once LIBOR is no longer published. Such a case fits the paradigm for the doctrine of impracticability (or as older case law called it, impossibility) of performance. Section 261 of the Restatement (Second) of Contracts explains that where, “after a contract is made, a party’s performance is made impracticable without his fault by the occurrence of an event” whose non-occurrence “was a basic assumption on which the contract was made,” that party’s duty is “discharged, unless the language or the circumstances indicate the contrary.” Section 263 clarifies that “if the existence of a specific thing is necessary for the performance of a duty”—as the existence of published LIBOR is in many agreements—its “destruction” qualifies as an event “whose non-occurrence was a basic assumption on which the contract was made.” The doctrine is a “gap filler,” which courts may in their discretion invoke when the parties have failed to address, at the time of contracting, the possibility of a future event that would disrupt their ability to perform.

But it is unclear that the impracticability doctrine will in practice permit the parties to our hypothetical note to continue their relationship. In the first place, many courts have been reluctant to apply the doctrine at all. And some have insisted that the non-occurrence of the event have been unforeseeable when the parties entered into their contract. Given much-publicized concerns about LIBOR and the lack of a vibrant market for interbank borrowing since at least 2008, some courts might find that the disappearance of LIBOR has been foreseeable for several years and hold the impracticability doctrine inapplicable on that basis.

More importantly, in nearly every reported case applying the impracticability doctrine, it has been used as an equitable defense to terminate one party’s obligations— i.e., to excuse a party from performing a contract that it could not continue to perform at all (or only with great difficulty). For example, in Florida Power & Light Co. v. Westinghouse Electric Corp., 826 F.2d 239 (4th Cir. 1987), impracticability excused the defendant contractor’s breach of its obligation to remove and dispose of spent nuclear fuel because the U.S. government had unforeseeably made it practically impossible for the contractor to perform by discontinuing its reprocessing of such fuel for commercial nuclear plants. Similarly, in Centex Corp. v. Dalton, 840 S.W.2d 952 (Tex. 1992), a consultant sued the prospective purchaser of a number of thrift institutions to recover an agreed fee but the court held that the purchaser was justified in refusing to pay because the federal Office of Thrift Supervision had entered a cease-and-desist order prohibiting payment of fees to the plaintiff.

In contrast to such cases, both parties to financial instruments incorporating LIBOR are likely to prefer that their relationship continue even after the occurrence of the supervening event; the problem is that they just haven’t agreed on how to replace LIBOR in their legacy instruments or failed to specify a workable fallback. Will courts, after finding performance impracticable, reform or adjust the parties’ obligations so as to permit the relationship to continue with a judicially-imposed rate substituting for LIBOR?

Even where courts have found impracticability or frustration of purpose (discussed briefly below) based on developments subsequent to contracting, American judges have generally been reluctant to reform the price or rate-calculation terms of contracts. There are a number of stated reasons for not exercising their equitable powers in such cases, including that: making such adjustments would tend to undermine the principles of predictability, certainty and finality are seen as central to the common law of contracts; it is not the judiciary’s function to rewrite contracts to adjust the allocation of costs and risks between the parties; and the judiciary is ill-equipped to engage in the kind of economic analysis necessary to reform the parties’ agreement and achieve a result consistent with their original intentions.

One of the few reported cases in which a court reformed or equitably adjusted the price term of a contract is Aluminum Co. of America v. Essex Group, Inc., 499 F. Supp. 53 (W.D. Pa. 1980). There, the district court found that the purposes of a 21-year service contract had been frustrated because the actual rate of cost inflation had unexpectedly deviated from the agreed price-escalation index. The judge adopted a “remedial scheme” which essentially rewrote the price term of the parties’ contract. The ALCOA/Essex decision, however, has been widely criticized by other courts and most commentators, and has rarely been followed. Nevertheless, although the case law is sparse, some courts (such as the Pennsylvania Superior Court earlier this year in Murray v. Willistown Township, 2017 WL 3528695) have been willing to reform contracts that had become impracticable to perform where both parties requested such relief “to restore an essential term of their agreement,” even if they disagreed on exactly how the contract should be modified.

Frustration of Purpose

A cousin to the impracticability doctrine is frustration of purpose, which applies where, although performance is still possible, a change in circumstances makes one party’s performance virtually worthless to the other, frustrating the latter’s principal purpose in making the contract. This doctrine, as applied by American courts, is not likely to apply to legacy instruments that incorporate LIBOR but fail to provide a fallback. After all, the difficulty created when LIBOR ceases to be published is not that the underlying purpose of parties to (for example) an ARM has been frustrated— the parties still wish to finance the borrower’s purchase of a home—but rather that it is impossible or at least impracticable to perform the instrument as written. Impracticability is therefore a better fit for this scenario than frustration. But even if frustration were found, U.S. courts, as explained above, have generally been reluctant to reform price terms of contracts (as opposed to excusing further performance or terminating the parties’ obligations), whether supervening events have frustrated the contract’s purpose or rendered continued performance impracticable.

Unilateral Modification — Express and Implied Limitations

As mentioned above, some legacy instruments provide that if LIBOR is no longer available, one party (often the lender) can select a replacement rate; this discretion may in some instruments be subject to a contractual limitation – e.g., that the replacement rate be “comparable” to LIBOR. For example, in the case of an ARM, the lender may decide that after LIBOR is no longer published, it will reset to a rate that it considers a reasonable substitute for LIBOR, such as a “spread rate” extrapolated from the Fed’s new BRTF or perhaps the bank’s own cost of term funding. What are the litigation risks associated with such provisions?

If the instrument provides that the substitute rate must be “comparable” to LIBOR (or the like), one obvious ground for litigation is whether the rate selected comports with that express limitation. LIBOR is a cost-of-funding based index rate. A lawsuit may arise, for example, if a lender chooses to implement a rate based on different considerations which the borrower believes is higher than a LIBOR-based rate would have been. And particularly in the consumer finance space, where a lender’s decision applies to a large number of borrowers, class actions are a distinct possibility, unless the instruments contain class action waivers that are enforceable under the law of the relevant jurisdiction and have not been invalidated by one of the federal or state regulations prohibiting lenders from requiring consumers to agree not to participate in class actions (e.g., the Dodd-Frank Act’s amendment to the Truth in Lending Act, and the later amended Regulation Z, prohibiting mandatory arbitration agreements in residential mortgage loans for which an application was received on or after June 1, 2013). And in the context of a class action, a difference of just a few basis points can result in a substantial damages award against the lender.

Even if a legacy instrument lacks any express limitations and grants the lender broad discretion to select a substitute rate, its exercise of that discretion will be subject, under the common law of nearly every U.S. state, to the implied covenant of good faith and fair dealing. Courts have held that a party exercising its discretionary authority in setting a “price under a contract breaches its duty of good faith and fair dealing” if it acts “arbitrarily, unreasonably, or capriciously, with the objective of preventing the other party from receiving its reasonably expected fruits under the contract.” Wilson v. Amerada Hess Corp., 773 A.2d 1121, 1130 (N.J. 2001). Although this standard is a malleable one, if a lender selects an index yielding rates significantly higher than what LIBOR would have produced, it risks litigation under this theory, including (again subject to the possibility of enforceable contractual waivers) class actions.


Following the anticipated end of published LIBOR after 2021, legacy instruments lacking fallbacks will be subject to considerable uncertainty. Courts in the U.S. are unlikely to construe the references to LIBOR in such instruments as also encompassing various LIBOR substitutes that are not expressly incorporated in those contracts. They may also be reluctant to reform or adjust contractual provisions by imposing a new rate in place of LIBOR even if impracticability of performance is apparent, although courts may be more receptive if both parties make clear their desire for such equitable relief. Lenders with the contractual authority to specify another rate if LIBOR is unavailable will need to take care to minimize the risk of litigation, including potentially class actions, based on express or implied contractual terms. All this uncertainty and risk, although four years down the road, reinforces the importance of reviewing instruments incorporating LIBOR and working to amend them wherever possible.

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