LIBOR Transition: Is ARRC’s proposed legislative fix constitutional?
In early March, 2020, the Alternative Reference Rates Committee (ARRC) in the US published a proposal for New York legislation to assist the transition of financial contracts away from US dollar (USD) LIBOR.
In a blog post in March, HSF provided an overview of this proposal and its specific provisions. LIBOR transition: What does the US regulator’s proposed legislative fix mean for UK financial markets? In this blog post we will discuss potential constitutional objections to ARRC’s proposed legislative fix, and discuss the viability of such arguments in US courts.
If New York enacts the legislation as proposed, certain provisions that retroactively affect the terms of existing contracts could be struck down if New York state or federal courts determine that they violate the US Constitution. Two constitutional provisions, the Contract Clause of Article 1 and the Due Process Clause of the Fourteenth Amendment, provide a potential basis to challenge the validity of state legislation which imposes retroactive effects on existing contracts. The likelihood of success or failure of such a challenge to the proposed legislation would depend on a number of factors, discussed below.
1. Overview of Retroactive Provisions in ARRC’s Proposed Legislation
There are several key provisions in ARRC’s proposed legislative fix that would affect existing contracts whose terms reference LIBOR-linked rates. These provisions include:
- Any contracts that do not contain fallback language or fall back to a LIBOR-linked rate will automatically transition from LIBOR to the “recommended benchmark replacement” (e., the Secured Overnight Financing Rate (SOFR) plus a spread adjustment, both of which will be selected by the US regulators).
- On April 8, the ARRC recommended a spread adjustment based on a historical median over a five-year lookback period calculating the difference between USD LIBOR and SOFR.
- Any legacy language that includes a fallback to polling for LIBOR or other interbank funding rate will effectively be ignored.
- Providing a safe harbor from litigation for using the recommended benchmark replacement.
- The discontinuation of LIBOR will not affect the continuity of any contracts referencing LIBOR, e., it cannot be relied upon to discharge or excuse performance of the contract in question.
As a general principle of statutory construction in both federal and New York State courts, there is a presumption against interpreting laws to have retroactive effects. This presumption does not apply, however, where the legislative language and history shows a clear intent to have retroactive effects. ARRC’s proposed legislation will clearly have a retroactive effect on contracts, as it must in order to achieve ARRC’s stated goals of guaranteeing continuity of contracts and preventing uncertainty, harm to consumers, and unnecessary litigation.
2. Potential Impact of the ARRC’s Proposed Legislation on Existing Contracts
Central to any constitutional challenge to retroactive legislation will be the degree of harm or impairment on contracts caused. The scope of the legislation is extremely wide: LIBOR is used as a financial benchmark linked to more than US $350 trillion in financial instruments, a significant percentage of which are governed by New York law. Although the ARRC is attempting to create a replacement rate methodology designed to account for the differences between SOFR and LIBOR, such a rate will never be able to perfectly match LIBOR under all market conditions. The lack of credit risk being priced into overnight rates such as SOFR means that, even with a spread adjustment, the replacement rate will not respond to credit conditions in the same way that LIBOR would. This pricing differential between the replacement rate and LIBOR, whether it is higher or lower, will inevitably create winners and losers. As the LIBOR scandal demonstrated, a change of even a small number of basis points in multibillion dollar interest rate swaps can potentially amount to millions of dollars in profits or losses to a party.
Some of the potential impacts from the replacement rate set by the proposed legislation could include:
- A replacement rate that is set higher than LIBOR could hurt borrowers. A higher rate could negatively impact consumer loans and increase the risk of defaults and foreclosures for vulnerable consumers.
- A replacement rate that is set lower than LIBOR could lower the profitability of loans for lenders. This could fundamentally change the profitability of certain contracts and upset the expectations of parties that relied on them.
- The limited accounting for credit risk in SOFR could expose certain contracting parties to a potentially greater level of risk than they had negotiated.
Regardless of the pricing differential between LIBOR and the replacement rate that is ultimately used, the proposed legislation may cause other effects on contracting parties, including:
- Increased compliance costs associated with the transition to a new rate and implementing the required changes.
- Increased risk of regulatory enforcement for financial institutions that fail to transition to the recommended rate or apply a rate using an incorrect methodology.
- Increased costs associated with renegotiation of contracts.
3. Overview of the Contract’s Clause’s Blaisdell Test
The Contract Clause of the US Constitution states that “[n]o State shall . . . pass any . . . Law impairing the Obligation of Contracts.” In Home Building & Loan Association v. Blaisdell, 290 U.S. 398 (1934), the Supreme Court adopted its current approach to the Contract Clause, which balances the Contract Clause’s prohibition of contract impairments against countervailing state interests. Under the “Blaisdell test,” the Contract Clause invalidates any state law which constitutes a “substantial impairment” of a contractual relationship unless the law satisfies certain conditions. If a state law does impose a substantial impairment, the law must (a) advance a “legitimate public purpose” and (b) be appropriately tailored to serve that purpose.
The proposed ARRC legislative fix has some precedents, and it is partly based on earlier “continuity of contracts” legislation enacted by New York in 1998 to address the discontinuance of national currencies then-scheduled to be replaced by the euro (Illinois, California and several other US states enacted similar legislation). That legislation, which had similar retroactive effects on existing contracts denominated in certain national currencies, was not formally challenged on constitutional grounds in a US court. Unlike the conversion of a discontinued national currency to the euro, however, ARRC’s proposal to replace LIBOR with a fundamentally different overnight rate like SOFR could potentially result in a greater change to the value of a contract.
a. Does the ARRC’s Proposed Legislation Constitute a “Substantial Impairment” on Existing Contracts?
The first inquiry under the Blaisdell test is whether the state law at issue imposes a “substantial impairment” on an existing contractual relationship. A state law which has no effect or only a minimal effect on a contract will not violate the Contract Clause, regardless of its purpose. The Supreme Court recently applied the Blaisdell test in upholding a Minnesota statute (which automatically removed an ex-spouse as an insurance beneficiary following divorce) because they determined that the statute did not constitute a substantial impairment. Sveen v. Melin, 138 S. Ct. 1815 (2018). The Sveen decision identified several relevant factors in determining that there was no substantial impairment: the statute was intended to further a “typical” insurance policyholder’s intent, the statute was unlikely to upset the policyholder’s reasonable expectations, and the policyholder could reinstate the ex-spouse with a simple form. In another Contract Clause case, Energy Reserves Grp., Inc. v. Kansas Power & Light Co., 459 U.S. 400 (1983), the Supreme Court held that a state legislative intervention to place price limits on existing natural gas contracts following federal price deregulation was not a substantial impairment where all parties entering into such contracts had expected regulated prices.
At this stage, it is difficult to determine whether the ARRC’s proposed legislation would rise to the level of substantial impairment before the terms are finalized and the degree of harm to a party becomes clear. The proposal does contain several measures which are ostensibly designed to honor the expectations and intent of the contracting parties by attempting to provide an alternative to LIBOR. The proposed legislation includes a “spread adjustment” in order to reflect the difference between LIBOR and SOFR to which contracts will transition. Despite this spread adjustment, however, the ultimate rate used will not match LIBOR exactly and the difference could disadvantage a contracting party, perhaps substantially. The availability of an opt-out provision, which was cited as weighing against substantial impairment in Sveen, will have more limited significance for existing contracts where two or more parties with conflicting interests must mutually consent to opt-out.
b. Does the Proposed Legislative Fix Have a “Legitimate Public Purpose”?
State laws which are found to impose a substantial impairment on one of the contracting parties must serve a “legitimate public purpose.” The Supreme Court has recognized the need to allow states to sometimes impair contracts in order to exercise legitimate police powers, rather than benefitting a legislatively favored special interest. Courts will generally defer to a state legislature’s judgment to determine whether a law serves a legitimate public purpose (unless the state itself is a party to the contract affected).
Legislation that aims to remedy a “broad and general social or economic problem” will meet this standard, while legislation that provides a benefit to special interests will not. Energy Reserves Group, Inc. v. Kansas Power & Light Co., 459 U.S. 400, 411 (1983) The Supreme Court has found a legitimate public purpose in legislation aimed at preventing increased litigation and uncertainty surrounding land titles, City of El Paso v. Simmons, 379 U.S. 497 (1965), and in legislation intended to address and control “serious economic dislocations.” Kansas Power & Light Co., 459 U.S. at 409.
Based on previous Supreme Court decisions, ARRC’s proposed legislation likely satisfies the requirement for a legitimate public purpose. ARRC’s proposal outlines an ominous litany of potential negative that could result if legislation is not enacted, including: increased litigation between parties, uncertainty for mortgages, student loans and borrowers, credit rating downgrades, and “extreme volatility.” Although this is no doubt in part to provide New York lawmakers with a political rationale to enact the legislation, it also articulates a number of legitimate public purposes that could be cited to support the legislation’s validity in a Contract Clause challenge.
c. Is ARRC’s Proposed Legislative Fix Appropriately Tailored?
If a state law is found to have a legitimate public purpose, any adjustment of the rights and responsibilities of contracting parties still must be based upon “reasonable conditions” and be “of a character appropriate to the public purpose” which justified its adoption. Keystone Bituminous Coal Ass’n v. DeBenedictis, 480 U.S. 470, 505 (1987). The Supreme Court has noted that this is not a significant burden to overcome and that courts should generally defer to legislative judgment on the reasonableness or necessity of a particular measure. Id.
If the ARRC’s proposed legislation is found to have a legitimate public purpose that justifies a substantial impairment of contracts, the measures it proposes to achieve that purpose should be able to satisfy this test. It is difficult to conceive how the legislative fix could guarantee the continuity of contracts or prevent uncertainty and unnecessary litigation without mandating an automatic transition away from LIBOR. The proposed legislation includes several measures designed to minimize the level of disruption for existing contracts to the extent that it is possible while still achieving its goals. These measures include delaying the mandatory transition to the recommended replacement rate until LIBOR is discontinued, including provisions for parties to opt-out, and providing for a spread adjustment. Still, the implementation of a particular measure by a regulatory agency could potentially run afoul of the Contract Clause (a regulation is considered a state law for Contract Clause purposes).
4. The Proposed Legislative Fix Raises Minimal Due Process Clause Concerns
The Due Process Clause of the Fourteenth Amendment prohibits states from “depriv[ing] any person of life, liberty, or property, without due process of law.” The Supreme Court has held that the Due Process Clause can prohibit retroactive state laws under limited circumstances where the consequences are particularly “harsh and oppressive.” U.S. Tr. Co. of New York v. New Jersey, 431 U.S. 1, 17 (1977). The level of scrutiny imposed by the Due Process Clause on retrospective legislation is, however, much lower than the scrutiny required by the Blaisdell test. For economic legislation such as the ARRC’s proposed legislative fix, a state law is subject only to “rational basis” scrutiny; the law only needs to have a “legitimate legislative purpose furthered by rational means.” General Motors Corp v. Romein, 503 U.S. 181, 190 (1992). The New York State Constitution also contains a due process clause that would apply to retrospective New York state legislation, but this due process clause has similar terms and is generally coextensive with the Fourteenth Amendment’s due process requirements. N.Y. CONST. art I, § 6.
If the legislation meets the stricter Blaisdell test required by the Contract Clause, then it will very likely satisfy the more lenient rational basis test required by the Due Process Clause.
5. Key Takeaways
Given the large number of existing contracts that will be affected by ARRC’s proposed legislation and the potential scale of the impact (ARRC estimates the value of these contracts to be around $2.5 trillion in value), aggrieved parties may seek to invalidate retroactive provisions of the legislation on Contract Clause grounds. In order to prevail in such a challenge, a party would need to show that the relevant provision did not satisfy the elements of the Blaisdell test. First, a party would need to show that the legislation substantially impaired a contractual relationship. After substantial impairment is established, the party would then need to show there was either no legitimate public purpose or that the legislation was not appropriately tailored to serve an otherwise legitimate public purpose.
Such a challenge may be difficult under existing Contract Clause case law—the measures proposed by ARRC appear relatively modest when compared with state laws that have been upheld in previous cases, and courts will generally show deference to state legislatures in economic matters. Still, open questions remain that could make a Contract Clause challenge more viable. The draft legislation has not yet been introduced into the New York state legislature and it may still be amended or implemented in a way that creates a more onerous or unreasonable burden on existing contractual relationships. The legislation will be at greater risk of a challenge if it alters contracts more than is necessary to address LIBOR discontinuation concerns—particularly if this is done to benefit a legislatively favored group.
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