The FCA has published an important consultation in respect of its enhanced powers under the UK’s legislative solution for the transition of so-called “tough legacy” LIBOR contracts, including the all-important question as to which legacy LIBOR contracts will be within the scope of the legislative fix: Benchmarks Regulation: how we propose to use our powers over use of critical benchmarks.
The breadth of the definition of “tough legacy” will have a direct impact on the risks associated with LIBOR transition, because a narrow solution will result in a greater volume of legacy LIBOR contracts being exposed to contractual continuity issues if those contracts are not actively amended bilaterally or by consent solicitation, or amended via market protocol.
The consultation itself provides very limited insight as to the approach likely to be taken by the FCA to the use of its powers in this context, as discussed further below. The consultation closes on 17 June 2021, after which the FCA will need to consider the responses before publishing its Statement of Policy.
It now seems inevitable that much-needed clarity as to which legacy LIBOR contracts will be caught by the UK’s legislative fix will not be forthcoming until Q3 2021 at the earliest. It is possible that this delay is a deliberate strategy by the regulators, to avoid giving the market the comfort of a broad and certain legislative solution and risk any slowdown in proactive transition efforts. However, given that LIBOR as we know it will cease at the end of this year (save for certain USD tenors), this continued uncertainty will no doubt be a source of significant frustration to many market participants, and is markedly different to the approach taken in other key LIBOR jurisdictions, such as the EU and New York.
The UK’s legislative fix for LIBOR is contained within the Financial Services Act 2021 (FSA 2021). The FSA 2021 provides an overarching legal framework that gives the FCA new and enhanced powers to manage the wind-down of a critical benchmark (i.e. LIBOR), as discussed in our previous blog post: LIBOR transition measures in the new Financial Services Bill: the legal framework, market impact and risks.
Historically, the FCA has regulated LIBOR under the EU Benchmarks
Regulation (EU BMR), which forms part of retained EU law: The Benchmarks (Amendment and Transitional Provision) (EU Exit) Regulations 2019 (UK BMR). The FSA 2021 makes amendments to the UK BMR, and references to “Articles” in this blog post are to the new Articles of the UK BMR.
The amendments to the UK BMR seek to reduce the risk of litigation arising from disputes about the continuity of so-called “tough legacy” LIBOR contracts. In simple terms, the amendments provide 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 be treated effectively as a reference to the new methodology (the synthetic LIBOR rate), rather than a rate which no longer exists.
Before exercising its new powers, the FCA is required to issue “Statements of Policy” to inform the market about how it intends to exercise these powers (Article 23F). The FCA has, therefore, engaged in a consultation process with respect to the exercise of its powers, as follows:
- Designation (Article 23A): FCA’s designation of a critical benchmark as unrepresentative or where its representativeness is at risk (such designation would result in a general prohibition on use of the benchmark under Article 23B);
- Exemption (Article 23C): FCA’s exemption of certain legacy contracts from prohibition;
- Methodology (Article 23D): proposed methodology change to the way in which that benchmark is determined; and
- New use (Article 21A): prohibition on “new use” of a critical benchmark that is to be ceased.
The most recent consultation published by the FCA considers the FCA’s power to exempt certain legacy contracts from prohibition, i.e. which contracts will fall within the definition of “tough legacy” (Article 23C) and prohibition on new use (Article 21A). This consultation is considered in more detail below.
Exemption (Article 23C) – definition of “tough legacy”
Chapter 2 of the consultation sets out the FCA’s proposed policy for how it will consider whether and how to exercise its legacy use power (under new Article 23C(2) of the UK BMR) to permit legacy use of an Article 23A benchmark, i.e. the outcome of the consultation will determine the scope of “tough legacy” LIBOR contracts able to take advantage of the legislative solution.
The consultation states that the FCA may only exercise this power where it considers it would advance either or both of its consumer protection and integrity objectives. The consultation sets out four key considerations to take into account when reaching a view on whether to exercise its legacy use power, as follows:
- The scale and nature of legacy contracts that do not have adequate provisions to deal with a prohibition on use.
- Whether and to what degree it is feasible for parties to amend these contracts in a way that delivers fair outcomes.
- Whether permitting only a limited form of use might enable the parties to remove reliance on the Article 23A benchmark – such as permitting legacy use for a time limited period after the prohibition takes effect, or permitting legacy use to calculate a final termination payment.
- Additional factors, such as international consistency, or the degree to which clear and practicable criteria can be provided for contracts for which the FCA proposes to permit continued legacy use.
In discussing the first of these considerations, the consultation asks the key question: What kinds of provisions do you consider would lead to unintended, unfair or disruptive outcomes, or prove inoperable in practice, if a critical benchmark could no longer be used? (Question 1).
In the context of LIBOR, the crux of this question is the volume and variety of legacy LIBOR contracts with inappropriate legacy fall-backs. For example, if there is a prohibition on the use of LIBOR and the relevant fall-back kicks in, would the effect of that fall-back lead to unintended/unfair/disruptive outcomes or would it simply not work?
It is difficult to glean any insights from the FCA’s articulation of this question as to the likely scope of “tough legacy”, other than to note that this presents an opportunity for the market to explain the very real and varied issues with historic fall-back provisions, and the complexity caused by the sheer variety of circumstances in which these questions arise. The more examples that can be given of contracts without adequate fall-back provisions, the better the illustration of the risk to consumer protection and financial stability, supporting the need for a wide definition of “tough legacy”.
There is an interesting comparison to the scope of the legislative solutions enacted in New York (New York legislative solution for LIBOR passed: Impact on transition of legacy LIBOR contracts) and in the EU (Final EU legislative fix for legacy LIBOR: impact on transition risk for UK entities). In both of these jurisdictions, the legislation takes a broad approach to potentially “unsuitable” fall-backs, and in consequence this is likely to lead to a greater volume of contracts being moved off LIBOR to the statutory replacement rate.
New use (Article 21A) – prohibition on new use of a critical benchmark
The consultation also considers the FCA’s power under new Article 21A of the UK BMR, which gives the FCA the ability to prohibit some or all new use of a critical benchmark when it has been notified by its administrator that it will cease to be provided (the new use restriction power).
The idea behind this power is to restrict the new use of a ceasing critical benchmark during a wind-down period. This is relevant most obviously to the USD tenors of LIBOR that will cease at the end of June 2023 (with the expectation that these rates will continue to be representative until then). Chapter 3 of the consultation sets out the FCA’s proposed policy for considering whether and how to exercise its new use restriction power.