On 21 October 2020, the UK government introduced the Financial Services Bill (FS Bill) to Parliament, which has been described by HM Treasury (HMT) as a new Bill “designed to ensure the UK’s world-leading financial services sector continues to thrive and grasp new opportunities on the global stage”.
The focus of this blog post is on the LIBOR transition measures included in the FS Bill, which are consistent with the Chancellor’s announcement of the legislative fix mechanism on 23 June 2020, as considered in our previous blog post: UK Government announces LIBOR legislative fix: summary of proposals and our initial observations.
This blog post explains the legal framework of the measures included in the FS Bill, and explores the potential market impact and legal risks.
The FS Bill amends the Benchmarks Regulation 2016/1011 (EU BMR), as amended by The Benchmarks (Amendment and Transitional Provision) (EU Exit) Regulations 2019 (UK BMR). It provides an overarching legal framework which gives the FCA new and enhanced powers to manage the wind-down of a critical benchmark, i.e. LIBOR.
The draft legislation seeks to reduce the risk of litigation arising from disputes about the continuity of so-called “tough legacy” LIBOR contracts. In simple terms, it does this by providing new and enhanced powers for the FCA where it has determined that a critical benchmark is at risk of becoming unrepresentative, or has become unrepresentative, and that its representativeness cannot reasonably be maintained or restored. In such circumstances, the FCA will have the power to designate a change to the methodology by which LIBOR is set so that references in “tough legacy” contracts to LIBOR will effectively be treated as a reference to the new methodology (the synthetic LIBOR rate), rather than a rate which no longer exists.
The key points to note on the legal framework are as follows:
- The FCA will have the power to give notice to a relevant benchmark administrator (under Article 21(3B)(a) or Article 22B(3)(a)) that the critical benchmark is unrepresentative (of the market or economic reality that the benchmark is intended to measure) or its representativeness is at risk.
- Where the FCA has given notice under Article 21 or 22B, it may designate a critical benchmark as an “Article 23A benchmark”.
- Use of an Article 23A benchmark by UK supervised entities will be prohibited under Article 23B.
- However, in order to ensure an orderly wind-down of the benchmark for “tough legacy” contracts, the FCA will have discretion to determine specific categories of contracts which will be exempt from this prohibition on use. The exception from the prohibition against using an Article 23A benchmark appears at Article 23C, under which the FCA may publish a notice permitting “some or all legacy use of the benchmark by supervised entities”.
- While an Article 23A benchmark can continue to be used (where exempt from the prohibition by Article 23C), the FCA will be able to direct a change in the methodology of the benchmark and extend its publication for a limited time period for the benefit of “tough legacy” contracts. Article 23D allows the FCA to impose requirements on the administrator of the Article 23A benchmark, including as to the way in which the benchmark is determined and the input data. Article 23D(6) says that the FCA will not be restricted in its exercise of this power by having to replicate the market or economic reality that was intended to be measured by the benchmark immediately before it became an Article 23A benchmark (although the FCA may have regard to that when exercising the powers).
- Before exercising its new powers, the FCA will be required to issue statements of policy to inform the market about how it intends to exercise these powers (Article 23F). The FCA will be able to engage with industry stakeholders and international counterparts as appropriate through this process. In particular, the FCA must prepare and publish a statement of policy with respect to:
- The designation of benchmarks under Article 23A;
- The exercise of its powers under Article 23C and Article 23D;
- The exercise of its power under Article 21A (which relates to the “new use” of a critical benchmark that is to be ceased).
The framework provides for a UK legislative solution to the cessation of LIBOR by way of primary legislation, so that the market has comfort that a cliff-edge scenario will be avoided, but leaves the policy detail to be worked out by the FCA at a later stage. The likely market impact of this approach and effect on the risk profile are considered further below.
The policy statement accompanying the FS Bill notes the government’s recognition of the existence of “tough legacy” LIBOR contracts, which face “insurmountable barriers” in transitioning away from LIBOR. There is no doubt that the legislative fix is a helpful and significant step forward, and the market will welcome the introduction of a mechanism to address tough legacy LIBOR (as we noted in response to the Chancellor’s statement in June 2020). However, key questions remain about the approach and scope of the protections offered by the FS Bill (considered further in the section below on litigation risks) and this continued lack of clarity at this late stage in LIBOR transition will be a source of frustration for many.
The policy statement emphasises that firms should continue to prioritise active transition away from LIBOR to alternative benchmarks. It says it is in the interests of financial markets and their customers that the pool of contracts referencing LIBOR is shrunk to an irreducible core ahead of LIBOR’s expected cessation after end-2021. Our expectation is that the market will not take its foot of the pedal of transition efforts as a result of the legislative solution. This is not just because of this warning from HMT, but (in particular) because of the likely narrow scope of the legislative fix and the desire to retain control over the economic effect of any switch.
The key risk areas arising from the drafting of the FS Bill are as follows:
1. Definition of “tough legacy” LIBOR contracts
The FS Bill does not define “tough legacy” LIBOR contracts, i.e. which contracts will fall within the Article 23C exemption. However the policy statement confirms that HMT and the FCA are of the view that this exemption is intended for those contracts that genuinely have no realistic ability to be renegotiated or amended to transition to an alternative benchmark.
This is therefore a legislative fix that is somewhat more narrow in scope than the approaches which have been suggested by the European Commission (see here) and in the US by the Alternative Reference Rates Committee (see here). The suggestion that the solution will apply only to “tough legacy” contracts indicates that there may be some legacy LIBOR contracts, which are not swept up by the proposed legislative solution, even if they have not been actively amended bilaterally or by consent solicitation, or amended via market protocol.
It is possible that the legal framework and supporting communications from HMT and the FCA have been deliberately positioned to avoid giving the market the comfort of a broad and certain legislative solution, to ensure transition efforts are not slowed. However, we will need to wait for the FCA’s policy statements to confirm the scope, and market participants would be wise not to rely on any expansion.
2. Methodology changes to LIBOR
Another aspect of the legislative solution, which has been left to the FCA’s policy statements, is the selection of the methodology for calculating synthetic LIBOR.
The FCA has given some general guidance to the market already. In particular, we note the comments of Edwin Schooling Latter (Director of Markets and Wholesale Policy at the FCA) in a webinar on 18 September 2020 hosted by the UK’s Working Group on Sterling Risk-Free Reference Rates (RFRWG), the FCA and others. Mr Schooling Latter suggested that the FCA would use the same adjustment spread as ISDA, but with the adjusted risk-free rate (RFR) being based on a forward-looking approach. This issue was foreshadowed at the time of the Chancellor’s announcement, in a statement made by ISDA’s CEO, Scott O’Malia:
“For one thing, derivatives markets have opted to use overnight RFRs compounded in arrears, which require amendments to contractual terms in addition to referencing a different rate. Given tough legacy contracts currently reference a forward-looking term IBOR and cannot be amended, it indicates a ‘synthetic LIBOR’ will be a forward-looking term rate based on the RFRs plus a spread adjustment. Indeed, the FCA says that use of overnight RFRs compounded in arrears ‘may not be possible to replicate within the restrictions of the existing LIBOR framework’.”
As a result, there are two critical points on the value of synthetic LIBOR to be aware of:
- When the legislative solution is triggered, because conversion of LIBOR to synthetic LIBOR will not be present value neutral, there will be an immediate and obvious change in the interest paid under the relevant contract, over which none of the parties to the contract will have control (having been unable to amend the relevant contract before the trigger); and
- Where one contract is converted to synthetic LIBOR via the legislative solution (e.g. an unamended loan), but its associated hedge is converted via ISDA’s 2020 IBOR Fallbacks Protocol, the hedge will no longer exactly match the cash product (see our banking litigation blog post on the ISDA Protocol).
3. Extraterritorial scope
The FS Bill purports to have extra-territorial effect, as it is not limited to contracts governed by UK law and applies to all UK supervised entities. This is tempered by express requirements for the FCA to have regard to the likely effect outside the UK when exercising its various powers delegated under the draft Bill. In particular, this applies to the FCA exercising its power of prohibition (Article 21A), exemption (Article 23C) and change of methodology (Article 23D).
There is an interesting question about the inter-relationship between the UK, EU and ARRC proposals (see our blog post: Legislating for LIBOR transition: UK/EU jurisdictional battle or complementary regimes?). All three legislative solutions currently seek to have extraterritorial effect, not limiting themselves to contracts governed by their respective laws. This is of course subject to change; it is worth noting that the EU Council has responded to the draft legislation published by the European Commission with the suggestion that it should only apply to EU law contracts (or certain third country contracts, but only where the third country has not sorted out its own fix). Indeed, in circumstances where it is not clear what legislation will ultimately get passed, it is difficult for market participants at this stage to assess whether extra-territoriality is a good thing or not.
It is possible that the regime applicable to a particular contract will not ultimately change the new rate that is applicable on the cessation of LIBOR, if the successor rates adopted for each currency of LIBOR are consistent (e.g. that the UK, EU and ARRC transition a USD LIBOR contract to SOFR plus a spread adjustment). However, it is entirely possible that the successor rates adopted will not be the same, particularly taking into account differing approaches to the calculation of the successor rate (e.g. whether it is a compounded RFR in arrears rate plus a spread, or a forward looking rate plus a spread). Of course, the calculation of the credit spread adjustment may also be different, although currently this appears less likely.
4. Safe harbour
The debate surrounding the inclusion of “safe harbours” in the legislative solutions for LIBOR cessation provided by the different jurisdictions, is complicated by a lack of clarity as to what is meant by these words. The phrase “safe harbour” is generally used to mean that a party affected by the legislation in question is protected from a particular type of civil claim. In the context of LIBOR cessation, the spectrum of potential claims is broad, as set out in our first article on the risks of LIBOR cessation, dating back to early 2019.
The FS Bill in and of itself seeks to prevent claims as to the continuity of LIBOR-linked contracts, by securing the continued publication of a rate which meets the contractual definition of LIBOR. However, it is noteworthy that ARRC’s legislative solution contains an express and very widely drafted safe harbour provision, which is intended to encourage market participants to adopt the ARRC recommended rate, by offering protection from claims as a result of adopted the legislative fix. The European Commission has confirmed that it intends to include a safe harbour, but has not yet provided detail on the drafting.
As things stand, “forum shopping” between proposed legislative solutions seems a real possibility (in view of the differing approaches taken to the applicability, and potentially the substantive outcome, of the proposed regimes). Material inconsistency between the safe harbours offered by the regimes must surely also increase the risk of disputes arising in relation to the appropriate regime to choose.
5. Risk of challenge by way of judicial review
There is greater risk of challenge (for example by way of irrationality or other public law grounds) to delegated legislation, than primary legislation. It is therefore noteworthy that much of the detail of the UK’s legislative fix has been left to subsequent FCA policy. While this is unsurprising given the time pressures involved, it is potentially significant, because of the greater risk of challenge to the FCA’s policy statements which articulate the detail of the provisions.
There are a number of references to the fact that the FCA may only exercise its powers under the FS Bill where it is desirable in order to advance the FCA consumer protection objective or integrity objective (e.g. the FCA’s power to permit legacy use of the benchmark under Article 23C). This is of course derived from the FCA’s statutory operational objectives. However, the effect of the pre-condition in the UK’s legislative solution is to introduce a further discretionary exercise for the FCA to assess whether action is necessary to protect consumers and/or ensure market integrity. In turn, this could increase the risk for judicial review of the FCA’s exercise of its powers (as it provides an additional layer of decision/determination by the FCA that is subject to challenge).
6. Consistency with proactive transition
It is clearly not the intention of the authorities that the methodology change brought about by the legislative fix contained in the FS Bill should extend to legacy LIBOR contracts that have been actively amended bilaterally or by consent solicitation, or amended via market protocol. However this is not spelt out at present in the FS Bill, which is potentially unhelpful and contrary to the spirit of ongoing transition efforts.
Ensuring that this is ultimately avoided will need careful and precise drafting to define “tough legacy” in the FCA’s exercise of its regulatory powers.