A suite of documents relating to LIBOR transition were published recently by the regulators and various working groups. In their recent blog post, our FSR colleagues have helpfully summarised the key milestones for transition and regulatory expectations noted in these papers, highlighting comments from the FCA and PRA that they intend to make use of their supervisory powers if firms are seen to be falling short of their expectations on transition.
The latest publications build on the warning given by the FCA at the end of 2019 about conduct risks during LIBOR transition and proposed next steps, as discussed in our banking litigation blog post. The momentum of the regulators has clearly been building over recent weeks, ramping up efforts to engage both the sell-side and the buy-side on preparedness for LIBOR transition.
In this blog post, we set out our observations on the recent documents which have been released, offering some insight into the approach the regulators are taking on key issues such as so-called “tough” legacy contracts, term SONIA and the level of engagement expected from banks.
Tough legacy contracts / legislative fix
We commented in our December 2019 blog post that there has been some degree of variance between the various speeches from the regulators on what assistance (if any) the market can expect in relation to tough legacy contracts, particularly in relation to some form of legislative fix. The FCA has previously hinted that there would be a consultation on the possibility of legislation, but to date there has been no sign of anything in the pipeline.
However, seemingly buried in the large volume of documents published by the regulators and working groups is confirmation that a formal paper is due to be published which looks specifically at this issue.
The UK Working Group on Sterling Risk Free Reference Rates (RFRWG) has published a roadmap for 2020. One of the deliverables for the RFRWG which is identified in this roadmap is a paper to be published on tough legacy contracts in the second half of Q1 2020. We are hopeful that this will contain some more details as to how the regulators and working groups suggest the market should deal with tough legacy contracts, including the possibility of primary legislation. While the RFRWG notes that its views and outputs do not constitute guidance or legal advice from the regulators, the Bank of England and the FCA are each ex-officio members of the working group and so this paper is likely to indicate the desired approach to tough legacy contracts from the regulators’ perspective.
The regulators have repeatedly emphasised that the market (particularly the loan market) should not hold out for a term SONIA rate in order to transition away from LIBOR. This message is reiterated in the latest suite of publications.
However, there seems to be some acceptance of the reluctance/refusal of some market participants to move from a forward-looking term rate to a compounded in arrears rate. This can be found in the RFRWG road map, which has prioritised the publication of the live term rate for SONIA in the early part of Q3 2020, ahead of the target to cease issuance of GBP LIBOR-based cash products (maturing beyond 2021) by the close of the same quarter.
Level of engagement expected from banks
One of the key messages from the recent publications is that firms should engage proactively with their clients. However, what the regulators mean by “engagement” is not entirely clear. Presumably it means making sure that clients are aware of the risks of new/existing LIBOR-linked contracts, but the expectations of the regulators are not clear. An interesting example of this can be seen in the decision tree on page 11 of the RFRWG paper on Use Cases of Benchmark Rates: Compounded in Arrears, Term Rate and Further Alternatives (again, although the decision tree was published by the working group, it is likely to give an indication of the regulators’ stance).
The decision tree suggests that – where the use of compounded SONIA in arrears is not appropriate – all customers should explore alternatives (such as SONIA term rate, BoE base rates or fixed rates) with bank “advisers” to find a replacement to LIBOR which meets the customer’s needs. This excludes large corporates where the transaction size is £25 million or greater (for which the decision tree suggests the compounded rate would be appropriate), but appears to apply to all other customers (including mid/large corporates).
It is unclear what is meant by reference to bank “advisers” in the decision tree and this loose language may be problematic from a litigation risk perspective. This issue is not limited to a question of language or terminology – the role that the banks are being asked to fulfil by finding a LIBOR replacement to meet the “customer’s needs” reflects a similar mindset.
In a civil litigation context, there is an important distinction between a bank which sells a financial product on an execution-only basis, and one which enters into an advisory relationship with a customer. In an execution-only relationship, the bank will usually only owe a duty not to negligently misstate (i.e. not to provide incorrect information about the product), whereas the duties imposed on a bank in an advisory relationship will be broader (e.g. they may extend to whether or not the product is suitable for the client). The type of loss recoverable by a customer will also depend upon whether the bank simply provided information or advice (applying the SAAMCO principle from the case of South Australia Asset Management Corpn v York Montague Ltd  AC 191).
For LIBOR-linked products which were sold on an execution-only basis, any suggestion that the process of switching such products away from LIBOR could result in the bank acting in an advisory capacity, assuming a wider scope of duties and potentially exposing the bank to greater recoverable losses, is likely to be met with significant resistance by financial institutions.