Amending legacy LIBOR contracts: how to cater for near risk-free rates

Herbert Smith Freehills LLP has published an article in Butterworths Journal of International Banking and Financial Law on amending legacy loan agreements to replace LIBOR with near risk-free rates.

Following the Financial Conduct Authority’s announcement on 5 March 2021 that all LIBOR settings will either cease to be provided by an administrator or no longer be representative on 31 December 2021 (in the case of all but the most commonly used USD LIBOR tenors), market participants have focused in earnest on the amendment of legacy facility agreements to cater for near risk-free rates (RFRs). The Working Group on Sterling RFRs imposed an interim milestone of 30 September 2021 for conversion of all legacy sterling LIBOR facility agreements to RFRs where possible, and the Loan Market Association (LMA) has published recommended documentation using compounded RFRs which effect the Working Group’s Best Practice Guide for GBP Loans. However, there are a significant number of legacy loans which still refer to LIBOR, so there will be substantial pressure on resources in Q4.

In our article, we examine the various approaches being taken to amending legacy finance documents in the loans market in the context of a market-driven, rather than borrower-requested amendment, and the areas where practice has not yet settled.

The article can be found here: Amending legacy contracts: how to cater for near risk-free rates. This article first appeared in the October 2021 edition of JIBFL.

Emily Barry
Emily Barry
Professional Support Consultant
+44 20 7466 2546

The UK’s LIBOR safe harbour legislation: a missed opportunity?

The Critical Benchmarks (References and Administrators’ Liability) Bill (Bill) was today introduced to the UK Parliament and the first reading took place.

The Bill introduces a legal “safe harbour” within the primary legislative framework for the UK’s LIBOR legislative solution, the Financial Services Act 2021 (FSA 2021). It follows a consultation paper published by HMT earlier this year: Supporting the wind-down of critical benchmarks (see our blog post: LIBOR transition: What is a “safe harbour” and why does the UK’s legislative toolkit need one?).

In this blog post, we set out our initial thoughts on the impact of the new Bill on LIBOR transition, in particular: (i) the broad parameters of the contractual continuity provision; (ii) the notable absence of protection from claims; (iii) its application to non-financial contracts; (iv) its interaction with contractual fall-backs; and (v) the likely impact on the litigation risks of LIBOR transition.

Background

The FSA 2021 provides an overarching legal framework giving the FCA new and enhanced powers to manage the wind-down of a critical benchmark (i.e. LIBOR), as discussed in our blog post: LIBOR transition measures in the new Financial Services Bill: the legal framework, market impact and risks. While the legislation is drafted in general terms as to the wind-down of a critical benchmark, this blog post will focus on its impact on LIBOR transition.

The FSA 2021 makes amendments to the UK Benchmarks Regulation (UK BMR), which forms part of retained EU law: The Benchmarks (Amendment and Transitional Provision) (EU Exit) Regulations 2019. References to Articles in the FSA 2021, are to Articles of the UK BMR.

In a nutshell, the FCA has the power to designate LIBOR as an “Article 23A” benchmark, resulting in a general prohibition on the use of LIBOR by supervised entities. The FCA will be able to invoke its Article 23A power immediately after 31 December 2021, following its announcement earlier this year that LIBOR (save for certain USD tenors) will either cease to be provided by any administrator or will no longer be representative after this date (see our blog post: LIBOR Discontinuation: FCA non-representativeness announcement).

Although the use of LIBOR by supervised entities will be prohibited after 31 December 2021, the FCA has the power to exempt certain contracts from the general prohibition (Article 23C) and to change the methodology by which LIBOR is set in those contracts (Article 23D). Not all LIBOR currency tenor pairs will be converted to a new methodology and in its proposed decision released in June 2021 (CP21/19), the FCA confirmed its intention to restrict the use of its Article 23D powers to change the methodology for 1-month, 3-month and 6-month sterling and Japanese yen LIBOR settings only. Accordingly, publication of other LIBOR settings will cease permanently at the end of 2021 (save for the USD tenors continuing to end-June 2023).

These powers will have the effect of switching automatically the reference rate in “tough legacy” contracts from the relevant LIBOR setting to so-called “synthetic LIBOR”. The breadth of the “tough legacy” definition is, therefore, critical to understanding which legacy LIBOR contracts will be converted to synthetic LIBOR. The market is awaiting clarity on this question following the FCA’s consultation on its Article 23C powers (see our blog post: LIBOR transition: critical FCA consultation on “tough legacy” definition).

HMT consultation and outcome

While the LIBOR legislative fix has been broadly welcomed by the market, there are concerns that the mechanism adopted in the FSA 2021, namely the conversion of LIBOR contracts to synthetic LIBOR contracts, could give rise to contractual uncertainty and disputes.

In response to approaches made to HMT by a number of stakeholders, articulating the need for a legal safe harbour in the legislation to reduce these risks, HMT published a consultation paper in February 2021: Supporting the wind-down of critical benchmarks (see our blog post: LIBOR transition: What is a “safe harbour” and why does the UK’s legislative toolkit need one?).

In its consultation paper, HMT set out two features proposed by stakeholders for inclusion in the safe harbour, to reduce such risks:

(1) Contractual continuity

Express legal certainty as to the continuity of legacy LIBOR contracts that are automatically transitioned to synthetic LIBOR by the FSA 2021, to prevent parties from refusing to perform contractual obligations, frustrating the contract or triggering a force majeure clause on the basis that LIBOR no longer exists once it has been converted to the synthetic LIBOR rate.

(2) Protection from claims

Protection from claims based on either: (a) the designation of LIBOR as an Article 23A benchmark; or (b) the change its methodology under Article 23D (i.e. claims based on the change in interest rate payable under the contract when legacy LIBOR contracts are converted automatically to the synthetic LIBOR rate).

HMT published a very brief summary of the outcome of the consultation, confirming that it intended to bring forward further legislation.

Critical Benchmarks (References and Administrators’ Liability) Bill

Following on from the consultation, the Critical Benchmarks (References and Administrators’ Liability) Bill has been introduced. The key features of the Bill that are likely to be of most interest to financial institutions are considered in further detail below (the provisions dealing with the liability of benchmark administrators are not covered in this blog post).

(i) Express contractual continuity

The Bill aims directly to address any legal uncertainty by clarifying the way in which a reference to LIBOR should be interpreted in a contract or other arrangement after the exercise of the FCA’s powers. The express contractual continuity provision has the following key pillars:

  • LIBOR = synthetic LIBOR. Article 23FA paragraph 1 confirms that references to LIBOR should be treated as references to synthetic LIBOR, once it has been designated as an Article 23A benchmark by the FCA and the new synthetic LIBOR methodology has kicked in. This continuity applies however references to LIBOR are expressed, including where LIBOR is described, rather than being named expressly (paragraph 2).
  • Synthetic LIBOR deemed from inception. Article 23FA paragraph 5 seeks to prevent parties from arguing that it was not their intention to use synthetic LIBOR in the contract. It does this by stating that once synthetic LIBOR is deemed to be the reference rate, the contract will be treated as if it always referenced synthetic LIBOR.
  • Retrospective application. The express contractual continuity provisions apply regardless of when the contract was formed, i.e. the Bill will have retrospective application, and apply to contracts formed before it comes into full force and effect.

(ii) No express protection from claims

Most significantly, while the Bill addresses the question of contractual continuity, it fails to provide express protection from claims.

Although HMT’s consultation paper noted the possibility of the safe harbour including only one of the two features suggested (i.e. either contractual continuity or protection from claims), undoubtedly this omission will be met by disappointment and frustration by many market participants, given the broad industry consensus on the need for such protections in the UK’s LIBOR legislative solution. This is considered further in the section looking at litigation risk below.

The UK’s final form of safe harbour stands in stark contrast to the broad form of safe harbour provided by the New York legislative solution for contracts that are switched to the “recommended benchmark replacement”, which is intended to provide comfort to market participants in adopting that benchmark proactively and reduce the risk of speculative litigation following the transition event (see our blog post: New York legislative solution for LIBOR passed: Impact on transition of legacy LIBOR contracts).

It is important to highlight the inclusion of Article 23FA paragraphs 6 and 7, which seek to preserve the status quo in terms of claims and causes of action that exist prior to the date on which LIBOR is converted to synthetic LIBOR. Unfortunately, it is likely that the real impact and importance of these paragraphs will only be determined in due course by the court, as a matter of statutory interpretation.

(iii) Impact on non-financial contracts

There are a wide variety of non-financial contracts, which reference LIBOR and are unlikely to be amended before the cessation of the benchmark at the end of this year. This section considers the impact of the Bill on such contracts.

The prohibition on continuing to use LIBOR after the end of this year (under Article 23B of the FSA 2021) applies only to financial contracts within the scope of the UK BMR, to which a supervised entity is a party. However, parties to non-financial contracts will be prevented at an operational level from continuing to use the benchmark, given the announcement made by ICE of its intention to cease the publication of LIBOR settings (other than certain USD tenors) at the end of 2021.

The critical question is whether those non-financial contracts can rely upon synthetic LIBOR calculated in accordance with the new methodology under Article 23D, even though they do not fall within the Article 23C exemption (which applies only to “use” of a benchmark within the scope of the UK BMR in financial contracts to which a supervised entity is a party).

This question is answered by Article 23FA, in particular at paragraphs 1, 2 and 9, which confirm that parties will be able to treat references to LIBOR as references to synthetic LIBOR in: (a) any “contract or other arrangement”; and (b) even where LIBOR is not “used” as a benchmark within the scope of the UK BMR. In consequence, parties to non-regulated arrangements should be able to rely upon the contractual continuity provisions in the Bill.

This approach should help to mitigate the risk of creating gaps in coverage between equivalent provisions in the US and EU legislative solutions.

Interestingly, there is no threshold requirement for non-financial contracts to be able to rely upon the contractual continuity provisions and therefore access synthetic LIBOR, i.e. they do not need to satisfy any definition of “tough legacy” as per the requirement for financial contracts seeking to take advantage of the primary legislative mechanism of exemption and change of methodology under the FSA 2021.

(iv) Interaction with transitioned contract provisions

The Bill seeks to avoid inadvertently overriding the fall-backs or replacement rates which have been agreed between contractual counterparties through active transition (Article 23FB paragraphs 2-5). This accords with the regulatory emphasis that firms should continue to prioritise active transition away from LIBOR to alternative benchmarks, and that the legislative fix is not intended to divert attention from active transition efforts. It is also possible for parties to contract out of the safe harbour provisions (Article 23FB paragraph 1).

(v) Effect on the litigation risk

As explained in our previous blog posts on this topic, the UK’s legislative solution is a blunt tool, which will change automatically the interest rate payable under the contract when the relevant trigger is activated and LIBOR switches to synthetic LIBOR. For those parties who lose out financially, there will be a real economic incentive to bring claims, and this will provide fertile ground for litigation.

The contractual continuity provisions in the Bill should deter arguments based on refusal to perform contractual obligations, alleged frustration or force majeure. However, there remains the risk of potential litigation and market disruption as a result of speculative mis-selling type claims. The omission from the Bill of protection from claims is, therefore, regrettable, although firms may take some comfort from paragraph 6 of Article 23FA.

In better news, the wide safety net afforded to non-financial contracts, enabling parties to such contracts to rely upon the contractual continuity provisions in the Bill and therefore access synthetic LIBOR, is likely to be welcomed broadly by supervised and unsupervised entities alike.

Jenny Stainsby
Jenny Stainsby
Partner
+44 20 7466 2995
Rupert Lewis
Rupert Lewis
Partner
+44 20 7466 2517
Harry Edwards
Harry Edwards
Partner
+61 3 9288 1821
Nick May
Nick May
Partner
+44 20 7466 2617
Ceri Morgan
Ceri Morgan
Professional Support Consultant
+44 20 7466 2948

UK post-Brexit reform: Financial Services Act 2021

On 29 April 2021, the Financial Services Act 2021 received royal assent. The Act is a milestone in implementing the UK Government’s wider Future Regulatory Framework initiative and represents the first major step towards HM Government’s objective of maintaining the competitive position of the UK financial services industry whilst capitalising on new opportunities following the end of the Brexit transition period.

This is the first significant piece of UK primary legislation in the financial services sector following the end of the Brexit transition period; it introduces wide-ranging reforms to the current UK regulatory regime which include significant amendments to the Financial Services and Markets Act 2000 and various other ‘onshored’ EU financial services regulation. Many of these provisions are designed to recalibrate the UK regulatory architecture towards a more regulator-led approach and to correct various functional issues with rules introduced under former EU regimes.

For more a detailed overview of the Act and its substantive reforms, please see our briefing.

 

LIBOR transition: critical FCA consultation on “tough legacy” definition

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.

Background

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.

FCA consultations

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.

The consultations on designation (Article 23A) and methodology (Article 23D) closed in January 2021, and the FCA’s Statements of Policy are here and here, respectively.

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:

  1. The scale and nature of legacy contracts that do not have adequate provisions to deal with a prohibition on use.
  2. Whether and to what degree it is feasible for parties to amend these contracts in a way that delivers fair outcomes.
  3. 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.
  4. 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.

Jenny Stainsby
Jenny Stainsby
Partner
+44 20 7466 2995
Rupert Lewis
Rupert Lewis
Partner
+44 20 7466 2517
Harry Edwards
Harry Edwards
Partner
+61 3 9288 1821
Nick May
Nick May
Partner
+44 20 7466 2617
Ceri Morgan
Ceri Morgan
Professional Support Consultant
+44 20 7466 2948

New York legislative solution for LIBOR passed: Impact on transition of legacy LIBOR contracts

The New York (NY) State Legislature has passed a statutory solution to tackle so-called “tough legacy” LIBOR contracts, to reduce the risks associated with the transition away from USD LIBOR: Senate Bill 297B/Assembly Bill 164B. This is very welcome news given the widespread use of NY law in financial contracts.

In this blog post, we continue to highlight the global progress of the legislative fixes in each of the key LIBOR jurisdictions (the UK, US and EU), consider the effect and scope of the NY legislation, look its safe harbour provisions in more detail and highlight the potential jurisdictional issues which may arise from the interaction between the different solutions.

The final form of the NY legislation is based on the draft proposal by the Alternative Reference Rates Committee, see our previous blog posts: LIBOR transition: What does the US regulator’s proposed legislative fix mean for UK financial markets? and LIBOR Transition: Is ARRC’s Proposed Legislative Fix Constitutional? Similar Federal level legislation seems to be a possibility as well.

LIBOR legislative solutions: global progress comparison

As regular readers of our updates will know, legislative solutions have been proposed in each of the key jurisdictions to convert legacy LIBOR contracts to a replacement benchmark, where the parties have been unable or unwilling to amend the contract and move to a new rate.

The EU’s legislation is already in force (see our blog post: Final EU legislative fix for legacy LIBOR: impact on transition risk for UK entities). The UK is yet to pass a statutory solution, although primary legislation to address “tough legacy” LIBOR contracts has been introduced to Parliament in the form of the Financial Services Bill (FS Bill) (see our blog post: LIBOR transition measures in the new Financial Services Bill: the legal framework, market impact and risks). Uncertainty in significant areas of that proposal remain, however.

New York has progressed its statutory fix notwithstanding the expected extension to end-June 2023 of the continued publication of certain USD LIBOR tenors (following the ICE Benchmark Administration Consultation on Potential Cessation published in December 2020). This makes the contrast with the position in the UK, where cessation of sterling LIBOR will take place at the end of this year, more stark.

Furthermore, even if the LIBOR provisions in the FS Bill are passed into law in their current form, parties will need to wait for the FCA to provide crucial clarity as to which contracts fall within the definition of “tough legacy” LIBOR and therefore within the scope of the legislative fix, as well as gaining important further clarity on what “synthetic LIBOR” will look like. The breadth of the definition of “tough legacy” will be considered as part of the FCA’s forthcoming consultation on its enhanced powers under the FS Bill (specifically its powers under Article 23C), which has not yet been published.

The UK’s delay in providing the market with confirmation as to the precise scope of its legislative solution is the source of significant frustration for participants. It is hoped that the good progress made in other jurisdictions will be followed closely by greater certainty in the UK.

Effect of the New York legislation

Turning to the effect of the NY legislative solution, any contracts caught within its scope will be transitioned automatically (“by operation of law”) from the relevant USD LIBOR rate to the “recommended benchmark replacement” rate. This is defined in the legislation as the appropriate adjusted SOFR plus a spread adjustment to be selected by the US regulators.

The trigger for transition has already been activated by the FCA’s announcement that all USD LIBOR settings will cease to be provided by any administrator or will no longer be representative immediately after 31 December 2021 (in the case of 1-week and 2-month USD settings) and immediately after 30 June 2023, in the case of the remaining USD settings (see our blog post: LIBOR Discontinuation: FCA non-representativeness announcement).

Parties have the right to opt out of the operation of the statute to instead switch to a reference rate of their own choice at any time (but this must be mutually agreed).

Scope of the New York solution

On its face, the NY legislation seeks to apply to USD LIBOR referencing “contracts, securities or instruments”, which is widely defined and likely to cover contracts relating to most financial products as well as general corporate/commercial contracts. The scope of the NY legislation is likely to be welcome, as it will capture the potentially vast numbers of non-financial contracts which use LIBOR in some way (such as late payment clauses). This is similar to the approach adopted in the EU and is to be contrasted with the likely scope of the UK legislative solution, where the focus (currently) remains on financial contracts only.

Having cast the net wide in respect of the types of contract to which it theoretically applies, the NY legislation controls which contracts will be caught by applying a filter based on the nature of the fallback.  This is (again) similar to the EU mechanism and can be contrasted with the approach in the UK, where the FS Bill will apply based on the definition given to “tough legacy” (which the regulators have indicted will depend upon an ability/inability to actively transition).

To understand which contracts will in fact be caught by the NY legislation, it is critical to look at sections 18-401(1) and 18-401(2) (the mandatory provisions) and 18-401(3) (the discretionary provisions).

Mandatory provisions

The first pillar of the legislation specifies the type of fallbacks that will result in the mandatory replacement of LIBOR, as follows:

  • Where there is no fallback (18-401(1)(a));
  • Where the fallback is itself based on LIBOR (18-401(1)(b));
  • Where the fallback is based on a poll, survey, inquiries for quotes or information concerning interbank lending rates or any interest rate or dividend rate based on LIBOR. In this scenario, the effect of the legislation is that these fallbacks will be ignored, so that the contract will instead fall back to the next option in the waterfall. If, following the application of this provision, there are no remaining fallbacks, the contract will be deemed to contain no fallback (18-401(2)).

Discretionary provisions

The second pillar of the legislation caters for contracts that give a party the right to exercise contractual discretion or judgment regarding the fallback (i.e. which do not specify a replacement rate but instead permit or require the determining party to select a benchmark replacement). In this scenario, the determining party is expressly given the option to exercise that discretion to select the “recommended benchmark replacement” under section 18-401(3).

Accordingly, the impact of the NY legislation solution on legacy USD LIBOR contracts will depend ultimately on the type of fallback used, which may lead to different results according to market type.

Market impact

Take the example of a derivative contract where the parties have not adhered to the ISDA IBOR Fallbacks Protocol. Under both 1992 and 2002 ISDA incorporating the 2006 ISDA Definitions, the legacy fallback provisions require the calculation of an arithmetic mean of quotations which are obtained from certain specific Reference Banks, under what is described as the “dealer poll” method. This would appear to fall squarely within what is meant by a fallback being based on a poll, survey, or inquiry for quotes and so would seem likely to fall within section 18-401(2). On this basis, the NY legislation would apply to such USD LIBOR derivative contracts, subject to arguments based on the governing law of the contract (see forum shopping discussion below).

By way of further example, one could consider a typical waterfall in legacy standard LMA documentation, which could include an interpolated LIBOR rate, a historic LIBOR rate fallback (essentially, the last published LIBOR rate), a provision which is similar to the ISDA dealer poll method, and a “cost of funds” fallback. The interpolated LIBOR rate fallback and the historic LIBOR rate would arguably both fall within section 18-401(1)(b) because it is a rate based itself on LIBOR. The analysis in respect of the equivalent to a dealer poll method would be similar to that which would apply to the derivative contract considered above. Most interesting, perhaps, is the “cost of funds” fallback. It is not immediately obvious that this would fall within one of the categories contained in the NY legislation, given that it is based on the lender’s own cost of funding the loan in question. It therefore does not necessarily require a “poll, survey, inquiries for quotes or information concerning interbank lending rates”. Arguments may arise, however, as to whether the cost of funds calculation consists of “information concerning interbank lending rates”, perhaps depending on the source of the funds that a bank chooses to base its costs of funds calculation on.

While legacy USD LIBOR syndicated loans governed by NY law are more likely to be based on the standard documentation produced by the Loan Syndications and Trading Association (which did not contain a cost of funds fallback historically), there are many legacy USD LIBOR LMA-based and APLMA-based loans (often not governed by NY law), which would fall back to cost of funds. These legacy loan agreements may only fall under the NY legislation if cost of funds is interpreted as falling within one of the types of fallback at section 18-401 (again, subject to arguments based on the governing law of the contract).

Safe harbour and other key protections

The NY legislative solution is, like all of the legislative fixes which have been considered or introduced, inevitably somewhat of a blunt tool. It will change automatically the interest rate payable under any contract to which it applies when the relevant trigger is activated such that USD LIBOR is replaced by SOFR plus a spread adjustment. For those parties who lose out financially, there will be a real economic incentive to bring claims, and this could provide fertile ground for litigation.

However, the NY legislation provides for a package of safety nets, including express continuity of contract provisions, a broad form of safe harbour from potential litigation and a statement to guard against negative inference or negative presumption for contracts/events falling outside of the legislation:

  • Continuity of contract. The NY legislation states that neither the discontinuation of USD LIBOR nor the selection/use of the “recommended benchmark replacement” (or related conforming changes) will affect the continuity of any contracts referencing LIBOR. This usefully means that the effect of the NY legislation cannot be relied upon as impacting contractual rights, to discharge or excuse performance, to terminate/suspend performance, to constitute a breach, or to void/nullify the contract in question.
  • Safe harbour. The NY legislation includes a broad form of safe harbour from other claims for those whose contracts are switched to the “recommended benchmark replacement” (whether as a result of the mandatory or discretionary provisions of the legislation), which is intended to provide comfort to market participants in adopting that benchmark proactively and reduce the risk of speculative litigation following the transition event. The wording of the safe harbour from claims is broad and includes the following:

“…no person shall have any liability for damage to any person or be subject to any claim or request for equitable relief arising out of or related to the selection or use of [the recommended benchmark replacement]…and such selection or use of [the recommended benchmark replacement] shall not give rise to any claim or cause of action by any person in law or in equity.”

  • No negative inference/presumption. The legislation also states that its provision should not be interpreted as creating any negative inference or negative presumption regarding the validity or enforceability of: (a) replacements for USD LIBOR that are not the “recommended benchmark replacement”; (b) other ways of calculating the spread adjustment; or (c) “any changes, alterations or modifications to or in respect of a contract, security or instrument that are not benchmark replacement confirming changes”.

By contrast, the EU’s legislative solution provides only for contractual continuity, with no express protection from civil claims. In the UK, the FS Bill does not currently contain a safe harbour, although HMT recently conducted a consultation to consider the case for including such provisions to reduce the potential risk of contractual uncertainty and disputes in respect of legacy LIBOR contracts that are caught by the mechanism (see our blog post: LIBOR transition: What is a “safe harbour” and why does the UK’s legislative toolkit need one?).

The outcome of HMT’s consultation is awaited, but it considered the inclusion of one or both of the following features in order to reduce such risks: (1) express wording as to the continuity of contracts that are automatically transitioned by the FS Bill; and/or (2) protection from claims relying on the effect of automatic transition under the FS Bill (e.g. a change in interest rate payable under the contract) as a cause of action, liability or grounds for litigation between parties to contracts. It is the second feature of the proposed UK safe harbour that may have the greatest impact on potential litigation and market disruption as a result of LIBOR transition. It raises the possibility of a broad immunity from the use of LIBOR (and then synthetic LIBOR), arising as a result of the operation of the FS Bill.

The inclusion in the NY legislation of an express provision to combat the potential for negative inference/presumption as a result of the legislation is interesting. One of the challenges for the market in relation to LIBOR transition is the risk of claims following active transition away from LIBOR. For example, if active transition leads to a customer being put in a position that ultimately turns out to be worse than if the same customer had been transitioned to an alternative rate (through the operation of the legislative fix or otherwise). This element of the NY legislation is designed to at least partially address this concern, and will arguably help to support active transition efforts, by seeking to avoid a presumption that active transition to any replacement rate other than the recommended replacement rate would give rise to the suggestion of invalidity or unenforceability.

Risk of forum shopping

The text of the NY legislation is not strictly confined to NY (or even US) law contracts. The only express relevant limitation on its scope is that it will apply only to contracts referencing USD LIBOR rates.

However, the legislation inserts the LIBOR transition law as a new section in New York’s General Obligation Law. Given that express choice of law clauses are generally recognised by NY courts (see N.Y. Gen. Oblig. Law § 5-1401), this could mean that the NY legislative solution will apply only to contracts containing an express choice of law clause in favour of NY law or, in the absence of such a clause, a strong connection to NY. If the jurisdictional reach of the NY legislative fix is limited to NY law contracts, then the fix is still likely to have wide application to a very substantial number of US and international contracts outside of NY, given the popularity of selecting NY law for commercial transactions.

It is possible that NY courts may apply the NY legislative solution even where the contract contains an express choice of law clause in favour of the law of another jurisdiction. Under rare circumstances, NY courts will disregard a foreign choice law clause where the application of the foreign law would offend a fundamental public policy of NY (see Welsbach Elec. Corp. v. MasTec N. Am., Inc., 7 N.Y.3d 624, 632 (2006)).

There is also a risk that other US states may decline to recognise a NY choice of law clause after applying their own choice of law analysis. For example, California could adopt similar LIBOR transition legislation but set a different replacement rate for certain types of consumer contracts. A California borrower could then argue that California courts should disregard NY law because California’s public policy interest in protecting California consumers outweighs NY’s interest in having NY choice of law provisions enforced.

By way of reminder of the approach taken in other jurisdictions, the FS Bill is not limited to contracts governed by UK law and purports to apply to all UK supervised entities (the extra-territorial effect of which is tempered by express requirements on the FCA to have regard to the likely effect outside of the UK when exercising its powers). However, the FS Bill is not limited to sterling LIBOR. The EU has taken a different approach, so that the EU solution will only apply to EU law contracts, unless the applicable law is of a third country which does not have its own legislative fix (and one of the parties to the contract is established in the EU).

The interaction between the different jurisdictional regimes has the potential for some very complicated issues of conflicts of laws, in relation to which it is too early to provide proper commentary. However, if a party stands to lose out financially, then there is a clear potential for forum shopping by that party to bring its claim in a jurisdiction where a more advantageous replacement rate applies or where the parameters of any safe harbour are different.

UK contacts:

Jenny Stainsby
Jenny Stainsby
Partner
+44 20 7466 2995
Rupert Lewis
Rupert Lewis
Partner
+44 20 7466 2517
Harry Edwards
Harry Edwards
Partner
+61 3 9288 1821

Nick May
Nick May
Partner
+44 20 7466 2617
Ceri Morgan
Ceri Morgan
Professional Support Consultant
+44 20 7466 2948
Emily Barry
Emily Barry
Professional Support Lawyer
+44 20 7466 2546



US contacts:
Peter Behmke
Peter Behmke
Partner
+1 917 542 7611
John O'Donnell
John O'Donnell
Partner
+1 917 542 7809
Alex Hokenson
Alex Hokenson
Associate
+1 917 542 7836

Navigating “the final and critical phase” of LIBOR – Senior Managers take heed

At the end of 2020, we identified the following key issues to have in mind as we entered the LIBOR “endgame”:

  • Readiness, meeting the milestones set by relevant industry groups
  • Right time, the need to communicate with customers in a timely way
  • Right information, communicating in a way that’s clear, fair and not misleading
  • Right rate, using a fair replacement rate
  • Remaining contracts, managing “tough legacy”
  • Record keeping, the importance, not least for senior managers, of having a record of decisions and their rationale

The PRA and FCA have reinforced all these points in a Dear CEO letter published on 26 March 2021.

The issues raised in this Dear CEO letter are not unexpected. But that does not mean they are straightforward to manage. LIBOR transition remains a key challenge for financial institutions and a key area of regulatory scrutiny, and risk, throughout 2021.

While this guidance has been promulgated in a Dear CEO letter, it is impossible to miss that accountability for orderly transition is being placed on relevant Senior Managers, and the letter refers to a separate letter being sent to the senior managers at firms with the largest and most complex LIBOR exposures. The regulators have made it clear that failure to take appropriate steps in the remaining time will have consequences, highlighting that “As a key regulatory priority, we expect that this transition forms part of the performance criteria for determining their variable remuneration.”

For a more detailed analysis of the latest Dear CEO letter, see our FSR blog post.

Jenny Stainsby
Jenny Stainsby
Partner
+44 20 7466 2995
Rupert Lewis
Rupert Lewis
Partner
+44 20 7466 2517
Harry Edwards
Harry Edwards
Partner
+61 3 9288 1821
Nick May
Nick May
Partner
+44 20 7466 2617
Ceri Morgan
Ceri Morgan
Professional Support Consultant
+44 20 7466 2948

High Court finds that a claimant’s “awareness” of a representation is an essential prerequisite to a claim for misrepresentation

In an important decision for financial institutions, the High Court has confirmed that a claimant’s awareness of a representation is an essential prerequisite to a claim for misrepresentation, by striking out implied fraudulent misrepresentation claims in relation to LIBOR against a defendant bank. The claimants had failed to plead that the alleged representations were actively present in their mind when entering into the products in question and therefore the claim stood no realistic prospect of success: Leeds City Council and others v Barclays Bank plc and another [2021] EWHC 363 (Comm).

The decision is particularly helpful in several respects:

  • Requirement for awareness. The court’s detailed consideration of the “awareness” requirement in the context of misrepresentation claims provides important, binding clarity on the topic. This prerequisite means that a representee must have had some appreciation that a representation in the sense alleged was being made, and is a necessary part of the reliance or inducement analysis in misrepresentation claims. Without it, a claim must fail.
  • Satisfying the awareness requirement. What is required to satisfy the awareness requirement will depend upon the precise circumstances. The answer may be one which requires conscious thought, or for the representation to have be “actively present” in the representee’s mind, or some less stringent element of awareness (depending on the facts).
  • Assumptions based on conduct. The court rejected the notion that mere assumption based on the representor’s conduct is sufficient. In the simplest representation by conduct cases, the element of awareness may be very similar to an assumption (e.g. where a bidder at auction represents their willingness and ability to pay a certain sum by raising a paddle). However, this principle should not be inferred in more complex cases where the conduct does not “speak for itself” in the same way so as to permit the quasi-automatic understanding which may look like assumption.

Considering the awareness requirement in the context of the present case, the court commented that the present claim was not being considered in a vacuum and referred to two previous cases based on similar LIBOR-related representations: Property Alliance Group Ltd v The Royal Bank of Scotland plc [2016] EWHC 3342 (Ch) (see our blog post on the Court of Appeal decision) and Marme Inversiones 2007 v Natwest Markets [2019] EWHC 366 (Comm) (see our blog post here). These decisions pointed towards an established position that, in misrepresentation cases of this type, there is a relatively stringent awareness requirement. In the present case, this required each claimant to prove that the alleged representations were “actively present” in their mind. As the claimants failed to plead awareness in the sense required, the claims were struck out.

At first blush, it may appear obvious that a party saying that it has relied upon a representation must also be able to say that it was aware of the representation being made. However, the healthy debate in this case and others demonstrates that the requirement for awareness has caused controversy. Leeds v Barclays provides welcome clarity and certainty on the issue. The approach taken by the court in finding that the alleged representations were not understood in the sense alleged and therefore not relied upon demonstrates a welcome degree of scepticism, particularly given how intricate and complex the alleged representations at issue in the claims have been. It is also noteworthy that to date, no claim relating to LIBOR representations has been successful at full trial.

Background

The claimant local authorities entered into 60 to 70 year term Lender Option – Borrower Option loans (or LOBO loans) with Barclays (the Bank) between 2006 and 2008. The interest rate payable under the loans referenced LIBOR. As is well known, in 2012, it was discovered that several banks on the LIBOR survey panel were engaged in LIBOR manipulation (including the Bank).

The claimants brought an action alleging that fraudulent implied representations in relation to LIBOR were made by the Bank prior to their entry into the loans. In particular, the claimants alleged that the Bank had made implied fraudulent representations to the effect that LIBOR was set honestly and properly and the Bank was not (and had no intention of) engaging in any improper conduct in connection with its participation in the LIBOR panel. The alleged representations were similar in nature to those which have been considered and rejected by the court in the cases of PAG and Marme. The claimants sought rescission of the loans, damages, interest and costs on that basis.

The Bank sought to strike out the claims on the basis that: (1) the claimants could not show that they relied on the representations alleged; and (2) even if the claimants were successful in proving misrepresentation, they had affirmed the relevant contracts. For the purpose of the Bank’s application, the court assumed that the LIBOR representations had been made, were false and had been made by the Bank fraudulently.

Decision

On the question of reliance, the court found in favour of the Bank and struck out all of the claims. Given this outcome, it was not necessary for the court to determine the question of affirmation, but the court considered the alternative application briefly and found that the case on affirmation would not have been suitable for summary determination (and this aspect of the application is not considered further in this blog post).

In relation to the reliance requirement which forms part of misrepresentation claims, the Bank asserted that a necessary building block of reliance in a misrepresentation claim is awareness by the claimant of the representation being made. As none of the claimants had pleaded awareness of the alleged representation, the Bank argued that their claim should be struck out.

The claimants focused only on inducement, pointing to their pleading that, had they known the truth, they would not have entered into the contracts. They argued that awareness cannot be separated from inducement and is not an independent precondition that must be satisfied in its own right before the court can move on to the analysis of inducement.

The court conducted a useful and detailed analysis of the authorities in which the question of reliance has been considered, in particular, the extent to which the relevant representation must operate on a claimant’s mind. The key points of general application are considered below.

Is there an awareness requirement for misrepresentation claims?

The court confirmed that misrepresentation involves some requirement of awareness. In reaching this conclusion, the court considered a number of authorities generally and those specifically in the context of LIBOR manipulation, which indicated that for a misrepresentation to be actionable, the representee must be aware of it. In particular, so far as relevant in a financial services context, the court cited: Raiffeisen Zentralbank Osterreich AG v The Royal Bank of Scotland plc [2010] EWHC 1392, Cassa Di Risparmio Della Republica Di San Marino SpA v Barclays Bank Plc [2011] EWHC 484 (Comm), Property Alliance Group Ltd v The Royal Bank of Scotland plc [2016] EWHC 3342 (Ch), Marme Inversiones 2007 v Natwest Markets plc [2019] EWHC 366 (Comm).

Importantly, the court rejected the claimants’ submission that in the case of a representation by conduct, there is no requirement of awareness. The court confirmed that the existence of the awareness requirement is the same in cases involving representations by conduct and those involving representations by express words (rejecting the argument that the authorities could be divided into separate categories based on cases about representations by conduct vs express words, because most of them concerned representations compounded out of words and conduct). Representation by conduct is discussed in more detail in the next section.

The court also noted that often the requirement for awareness will not be in issue; but that does not mean it is not a requirement. It is just that in some cases, the fact that the claimant was aware of the representation is so obvious that the parties do not bother to argue about it. In contrast, the court said that the existence of the awareness requirement is of particular importance when considering implied representations.

What is required to satisfy the awareness element?

Where awareness is in issue, the court noted that in some cases the question will be what the claimant consciously thought, while in others it may be better expressed by a focus on whether the representation is “actively present” in the representee’s mind (see Marme and PAG).

The court considered expressly the question of assumption, and whether or not an assumption by a claimant (in combination with proof of what the claimant would have done if told the truth) could ever be sufficient. It said that where there is an issue as to whether the representation was ever actively present in the representee’s mind, the authorities indicate there is no scope for reliance on an assumption.

In particular, the court rejected the claimants’ argument that assumption suffices in the case of representations by conduct, so that there is no requirement for awareness in such cases. The claimants’ arguments here were based on the criminal appeal in DPP v Ray [1974] AC 370. In this case, the House of Lords held that by entering the Wing Wah restaurant and placing an order for prawn chop suey and rice, Mr Ray represented that he intended to pay the 47 pence that the meal cost. The court in the present case said that comparisons with DPP v Ray were “overstretched”. Such comparison ignored a number of “not unimportant” facts, including that it was a criminal case; that it focused on the fact that the representation was true when it was made but became untrue (when Mr Ray changed his mind about paying for the meal and absconded after eating); and that it did not deal with the question of an awareness requirement.

In the court’s opinion, there may be cases “where the element of awareness will come close to something which might loosely (and without careful analysis) be characterised as assumption and which is most obviously derived from conduct”. This may be the position for the simplest of representation by conduct cases, where specific conduct may precisely and inevitably equate to a representation, without any room for ambiguity (for example, in the case of a bidder at an auction raising a paddle, implicitly representing by that conduct a willingness and ability to pay the relevant bid amount). In such a case a requirement for separate or distinct understanding or thought to the representations would be artificial.

However, the court recognised that this principle should not be inferred in more complex cases where the conduct does not “speak for itself” in the same way so as to permit the quasi-automatic understanding which may look like assumption.

Accordingly, what is required to satisfy the awareness requirement will depend upon the precise circumstances, and the answer may be one which requires conscious thought or some less stringent element of awareness (depending on the facts). In this context, the court emphasised throughout the judgment that misrepresentation is capable of occurring in a huge range of factual circumstances of varying complexity; and the difference in complexity of different representations may have an impact both on how the representation is spelled out and how it is received (and understood).

The court recognised that the above analysis could lead the issues in the present application to be unsuitable for determination at the strike out/summary judgment stage. However, the court was conscious of previous case law which had considered the issue on essentially the same facts (see the section on reliance in the context of interest reference rate manipulation cases below).

Awareness in the context of interest reference rate manipulation cases

As mentioned when discussing the test for awareness, the court found that what is required to satisfy the awareness requirement will depend upon the precise facts as to the representation.

Looking at the facts of the present case, the court commented that it did not operate in a vacuum and referred to two previous cases based on similar LIBOR-related representations as this one, where the court found that awareness was required:

  • PAG: this case concerned LIBOR representations and, at first instance, the court considered the question obiter. It found that the claimants had no understanding of what were extremely complex and intricate representations, and concluded that they did not cross the relevant principals’ minds. As a result, they could not have understood the representations to have been made and therefore did not rely on them.
  • Marme: this case concerned EURIBOR representations and, although also obiter, the court commented that there would need to be “some contemporaneous conscious thought” given to the fact that some representations were being impliedly made.

The court was clear that PAG and Marme pointed towards an established position that, in misrepresentation cases involving interest reference rate manipulation, there is a relatively stringent awareness requirement. In the present case, this required each claimant to prove that the alleged representations were “actively present” in their mind.

In contrast, the claimants failed to plead that the representations were “actively present” in their mind. Their pleaded cases relied on their assumption that LIBOR was honest and not being manipulated rather than anything more, which was not sufficient. As a result, the LIBOR misrepresentation claims were struck out.

Harry Edwards
Harry Edwards
Partner
+61 3 9288 1821
Chris Bushell
Chris Bushell
Partner
+44 20 7466 2187
Ceri Morgan
Ceri Morgan
Professional Support Consultant
+44 20 7466 2948
Nic Patmore
Nic Patmore
Senior Associate
+44 20 7466 2298

LIBOR Discontinuation: FCA non-representativeness announcement

The FCA today made its much anticipated announcement that all LIBOR settings will either cease to be provided by any administrator or will no longer be representative:

  • immediately after 31 December 2021, in the case of all sterling, euro, Swiss franc and Japanese yen settings, and the 1-week and 2-month US dollar settings; and
  • immediately after 30 June 2023, in the case of the remaining US dollar settings.

The FCA has said that, based on undertakings received from the panel banks, it does not expect that any LIBOR settings will become unrepresentative before the relevant dates set out above. Representative LIBOR rates will not, however, be available beyond the dates set out above.

The FCA expressly state that they “make this statement in awareness that it will engage certain contractual triggers for the calculation and future application of fallbacks that are activated by pre-cessation or cessation announcements made by the FCA (howsoever described) in contracts…” as they had said that they would.

Publication of most of the LIBOR settings will cease immediately after the dates above, though the FCA will consult on requiring the IBA to continue to publish certain tenors of Sterling, Yen and potentially USD on a synthetic basis, using changed methodology, under its new proposed powers in the Financial Services Bill 2020 which we have previously analysed here.  Today the FCA also published their statements of policy in relation to these proposed new powers.

Market impact

ISDA has announced that this is an Index Cessation Event under the Supplement and the Protocol and will fix the spread adjustment published by Bloomberg (which will then be capable of being used by the loans market).

There may also be contractual consequences in loan agreements which include a non-representativeness trigger for screen rate replacement, and in bond programme documents which include the new style fallback language catering for a pre-cessation or cessation trigger.

Jenny Stainsby
Jenny Stainsby
Partner
+44 20 7466 2995
Rupert Lewis
Rupert Lewis
Partner
+44 20 7466 2517
Harry Edwards
Harry Edwards
Partner
+61 3 9288 1821
Nick May
Nick May
Partner
+44 20 7466 2617
Ceri Morgan
Ceri Morgan
Professional Support Consultant
+44 20 7466 2948
Emily Barry
Emily Barry
Professional Support Lawyer
+44 20 7466 2546

LIBOR transition: What is a “safe harbour” and why does the UK’s legislative toolkit need one?

In the context of the UK’s legislative solution for the transition of so-called “tough legacy” LIBOR contracts, contained within the Financial Services Bill (FS Bill), HM Treasury (HMT) has recently published a consultation paper: Supporting the wind-down of critical benchmarks.

The consultation considers the case for incorporating a legal “safe harbour” in the legislation, to reduce the potential risk of contractual uncertainty and disputes in respect of legacy LIBOR contracts that are automatically transitioned by the statute. In essence, the proposed safe harbour may include one or both of the following features in order to reduce such risks: (1) express wording as to the continuity of contracts that are automatically transitioned by the FS Bill; and/or (2) protection from claims relying on the effect of automatic transition under the FS Bill (e.g. a change in interest rate payable under the contract) as a cause of action, liability or grounds for litigation between parties to contracts. The consultation was published in response to approaches made to HMT by a number of stakeholders, articulating the need for such a provision.

The significance of the legal safe harbour will depend ultimately on the all-important question as to which legacy LIBOR contracts will be able to take advantage of the legislative fix, on which the market does not yet have clarity, nor is it likely to in the near future. The breadth of the definition of “tough legacy” LIBOR contracts will be considered as part of the FCA’s forthcoming consultation on its enhanced powers under the FS Bill (specifically its powers under Article 23C), which has not yet been published. If “tough legacy” is defined broadly, it could contradict the regulator’s policy for parties to proactively transition. If the definition is too narrow, it will limit the impact of the legislative fix on the problematic cliff-edge scenario when publication of LIBOR ceases. Equally, greater clarity on the definition of “tough legacy” at an earlier stage may impact negatively on proactive transition efforts; but if the regulators wait too long, then the legislative solution may cause more disruption than it is trying to fix.

The dynamic between the scope of the safe harbour vs the scope of the definition of “tough legacy” is important and illustrates the difficult balance the regulators are trying to achieve. The wider the definition of “tough legacy”, the greater the volume of legacy LIBOR contracts caught by the legislative fix, increasing the potential risk of contractual uncertainty and disputes in respect of legacy LIBOR contracts that are automatically transitioned by the statute, and emphasising the need for a robust safe harbour in the legislation.

“Safe harbour” is not a term of art and the precise effect of a safe harbour in the context of the FS Bill will be defined following the receipt of responses from stakeholders to the consultation, which closes on 15 March 2021. However, the wording of the consultation itself provides some insight as to the operation and parameters of the safe harbour that HMT is considering, as discussed below. We also give an overview of how the UK proposal compares with other jurisdictions and the likely impact of the safe harbour provision on the risks of LIBOR transition.

Background to the FS Bill

The FS Bill 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), as discussed in our previous blog post: LIBOR transition measures in the new Financial Services Bill: the legal framework, market impact and 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). While the legislation is drafted by reference to the wind-down of any “critical benchmark”, for ease of reference in this blog post we refer only to the impact on LIBOR transition.

The FS Bill 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 FCA’s powers of designation arise under Article 23A and its powers to change the methodology are provided for at Article 23D of the UK BMR.

Purpose of the safe harbour

The overarching purpose for the safe harbour is set out at Chapter 1 of the consultation paper. In summary, while firms should continue to prioritise active transition away from LIBOR, HMT recognises that legislation is necessary to support orderly cessation and wishes to minimise (as far as is reasonably possible) the potential for litigation and/or market disruption arising as a direct result of the powers provided for under the legislation.

The consultation identifies two distinct features of a potential safe harbour aimed at minimising litigation/market disruption:

  1. Contractual continuity

This feature of the proposed safe harbour would provide express legal certainty that references to LIBOR in “tough legacy” contracts caught by the FS Bill should continue to be read as such following transition to the synthetic LIBOR rate (i.e. after designation of LIBOR as an Article 23A benchmark and any changes made to its methodology under Article 23D).

The purpose of this feature is to prevent parties to legacy contracts from refusing to perform contractual obligations, frustrating the contract or triggering a force majeure clause on the basis that LIBOR no longer exists after designation and the change in methodology. The mechanism contained in the existing FS Bill ought to be effective in providing parties with the legal basis to resist such arguments, through the operation of synthetic LIBOR as the applicable contract rate. However, this express safe harbour would nevertheless be valuable.

  1. Protection from claims

This feature of the safe harbour would prevent parties from relying on the automatic switch from existing LIBOR to synthetic LIBOR under the FS Bill as a cause of action, liability or grounds for litigation between parties to contracts. This has the potential to provide parties with a broader protection from litigation, not only from claims relating to frustration and force majeure, but extending to claims for breach of contract or mis-selling claims for losses suffered as a result of the change in interest rate.

As explained in the introduction, the precise scope of the safe harbour will be influenced by stakeholder responses to the consultation. HMT has indicated that the legislation may include both or only one of the features identified above.

Comparison with EU/US position on safe harbour

The EU’s legislative solution for the transition of legacy LIBOR contracts is now in force (see our blog post: Final EU legislative fix for legacy LIBOR: impact on transition risk for UK entities). The safe harbour provided by the EU legislation is limited to providing contractual continuity, with no express protection from civil claims. The wording of the initial proposal from the EU suggested that the legislation might provide for a broader form of safe harbour (for example to provide immunity from counterparty claims brought as a result of the automatic change in the interest rate when the legislative fall-back is imposed). However, the European Commission ultimately opted for a narrow safe harbour. It is also important to note that the final EU legislative fix clarifies that it will only apply to contracts governed by Member State laws (or third country laws where that jurisdiction has not introduced a legislative fix).

A broader form of safe harbour has, however, been proposed by the ARRC in the legislative solution for contracts governed by New York law (and largely tracked in a Senate Bill introduced in the New York State legislature on 28 October 2020). Progress in the US has stalled since the expected extension to end-June 2023 of the continued publication of certain USD LIBOR tenors (following the ICE Benchmark Administration Consultation on Potential Cessation published in December 2020). However, the wording of ARRC’s proposed safe harbour is broad and includes the following:

“…no person shall have any liability for damage to any person or be subject to any claim or request for equitable relief arising out of or relating to the use of [the recommended benchmark replacement to which legacy LIBOR contracts will automatically transition]…and the use of such [recommended benchmark] shall not give rise to any claim or cause of action by any person in law or in equity.”

Given the drafting of HMT’s consultation, the scope of the UK’s safe harbour could be as broad as that of the ARRC. Even if the UK adopts the same approach, there is clearly going to be variation in the comparative protection from claims offered by the regimes of different jurisdictions (in particular the EU), and forum shopping remains a possibility, as discussed below.

Impact on LIBOR transition risk

We consider below the likely impact of the proposed safe harbour on LIBOR transition.

1. Rationale for a safe harbour

The legislative solution is a blunt tool, which will change automatically the interest rate payable under the contract when the relevant trigger is activated and LIBOR switches to synthetic LIBOR. For those parties who lose out financially, there will be a real economic incentive to bring claims, and this will provide fertile ground for litigation. This will lead to inevitable market disruption, not only because of uncertainty for individual contracts as to the effect of arguments that there has been an event of frustration, a breach of contract or breach of duty etc., but also in terms of the time and cost for financial services institutions in dealing with such litigation on a potentially very large scale.

To the extent the safe harbour can reduce these risks, then it will be welcomed by the financial services sector, but it will ultimately benefit end users of financial services as well.

2. Scope of the safe harbour

The scope of the safe harbour will have a clear impact on the extent to which the risk of LIBOR transition is reduced.

In terms of the first feature of the proposed safe harbour, an express provision for legal certainty and contractual continuity will provide welcome incremental certainty, notwithstanding the fact that the mechanism contained in the FS Bill ought to be effective in providing parties with the legal basis to resist attempts to refuse to perform contractual obligations, frustrate contracts or trigger force majeure clauses as a result of the operation of synthetic LIBOR.

The second feature of the proposed safe harbour may have the greatest impact on the potential for litigation and market disruption because it raises the possibility of a broad immunity from the sorts of mis-selling claims which we have long flagged as one of the key risks of LIBOR transition (at least for the sub-set of “tough legacy” contracts). However, it is not clear how comprehensive that immunity will be because although tortious claims, for example, certainly fall within HMT’s broad description of the second feature of the safe harbour, the categories of claim specifically listed in the examples at paragraph 1.9 of the consultation is far from comprehensive. Whether or not the ultimate form of the safe harbour is sufficiently broad to include the typical causes of action for mis-selling claims (including tortious claims and breaches of statutory duty) will have an enormous impact on the potential for mis-selling claims as a result of the legislative fix.

3. Effect on active transition efforts

The regulatory authorities continue to emphasise that the legislative fix is not intended to divert attention from active transition efforts. Indeed it is possible to characterise a safe harbour as entirely consistent with the continued encouragement of transition. There will be some parties to legacy LIBOR contracts who have not engaged with outreach communications from the banks, in the hope that they will be able to take advantage of uncertainties at the time of LIBOR cessation to negotiate a better contractual bargain.

Removal of the theoretical opportunity to bring claims simply as a result of the rate changing under the legislation may remove one obstacle to proactive transition. There will be no upside to a “wait and see” approach; and by contrast there will remain a clear downside to having no control over privately negotiating the future rate. This may bring parties to the negotiating table who have, to date, been hesitant.

4. Risk of forum shopping

The first iteration of the various legislative fixes of the UK, EU and US all sought to have extraterritorial effect, regardless of the law applicable to the legacy contract.

Since then, the European Commission has confirmed that the EU solution will only apply to EU law contracts, unless the law of the third country does not have its own legislative fix (and the parties to the contract are established in the EU). The FS Bill is not limited to contracts governed by UK law and applies to all UK supervised entities (this is tempered by express requirements on the FCA to have regard to the likely effect outside of the UK when exercising its powers). However, the consultation states that the UK can only provide a possible legal safe harbour for contracts governed by UK law. The US legislative solution (including its broad form of safe harbour) seeks to have wide extraterritorial effect and is not limited to contracts governed by US law.

The matrix described above has the potential for some very complicated issues of conflicts of laws, in relation to which it is too early to provide proper commentary. However, if a party stands to lose out financially as a result of transition (regardless of which regime applies), then there is a clear risk of forum shopping by that party to bring its claim in a jurisdiction where there is no (or a more narrow form of) safe harbour (e.g. the EU). The EU solution would not apply if the contract in question was subject to English law and the UK’s legislative fix applied to the contract. However, this could lead to a dispute as to whether or not the contract was a “tough legacy” contract within the scope of the exemption at Article 23C of the UK BMR. We do not yet know how broad the Article 23C exemption will be (the FCA’s consultation on this aspect of its powers is awaited), but anything short of a blanket exemption for all legacy contracts referencing LIBOR is likely to lead to technical statutory interpretation arguments as to whether the UK legislative solution applies.

By contrast, the UK and US legislative solutions are more likely to be relied upon by parties who have financially benefitted as a result of transition and wish to have protection from civil claims, or who wish to avoid the time and cost of such claims, regardless of the economic outcome, such as financial institutions.

Jenny Stainsby
Jenny Stainsby
Partner
+44 20 7466 2995
Rupert Lewis
Rupert Lewis
Partner
+44 20 7466 2517
Harry Edwards
Harry Edwards
Partner
+61 3 9288 1821
Nick May
Nick May
Partner
+44 20 7466 2617
Ceri Morgan
Ceri Morgan
Professional Support Consultant
+44 20 7466 2948

Final EU legislative fix for legacy LIBOR: impact on transition risk for UK entities

On 2 February 2021, the European Council paved the way for the EU’s legislative solution for the transition of legacy LIBOR contracts to become law, by adopting amendments to the Benchmark Regulation (EU) 2016/1011 (BMR), which will now enter into force and apply from 13 February 2021.

The final version of the EU’s legislative fix contains some welcome improvements on the European Commission’s initial proposal, most notably in the reduced scope for potential conflict with the LIBOR legislative solutions proposed by other jurisdictions (see our blog post considering the original EU proposal here: Legislating for LIBOR transition: UK/EU jurisdictional battle or complementary regimes?).

In this blog post, we summarise the EU’s new framework for the legislation, highlight the key changes that have been made since publication of the initial proposal and discuss the likely impact on LIBOR transition risk.

In the context of comparing global legislative proposals for LIBOR cessation, the expected extension to end-June 2023 of the continued publication of certain USD LIBOR tenors is relevant (following the ICE Benchmark Administration Consultation on Potential Cessation published in December 2020). The consultation confirms that ICE intends to cease publication of all other LIBOR settings (including all tenors of GBP LIBOR and EUR LIBOR), as planned, at the end of 2021. It is worth noting that the legislation enacted now will (unless amended) still apply to legacy USD LIBOR contracts caught within the relevant framework at that later date. It remains important, therefore, to understand how all of the different legislative solutions fit together, complement one another or potentially overlap.

New framework for the EU legislative solution

The EU’s chosen mechanism for introducing a legislative fall-back for certain benchmarks in cessation (including LIBOR) remains the same as its original proposal: to amend the BMR to enable the Commission to select replacement rates. However, the final drafting of the legislation departs from the initial proposal in a number of material respects. These changes largely follow the negotiating mandate published by the European Council on 6 October 2020.

We set out below the key elements of the planned amendments to the BMR, highlighting the aspects that are most likely to have an impact on transition risk:

Mechanism

  • Statutory successor to LIBOR to be decided by the Commission. The BMR will grant powers for the Commission to designate statutory successors for affected benchmarks. This will include the replacement for the benchmark itself, a spread adjustment and any corresponding essential confirming changes.
  • Industry-agreed replacement rates. In selecting the statutory successors to LIBOR (and other benchmark) rates, the Commission will take into account recommendations made by the central bank responsible for the currency area in which the relevant benchmark is being wound down, or by the alternative reference rate working group (for example, the US’s Alternative Reference Rates Committee (ARRC) and the Sterling Risk-Free Rate Working Group in the UK). The Commission will also conduct a public consultation and take into account the recommendations of other relevant stakeholders, including the regulator of the benchmark administrator and the European Securities and Markets Authority (ESMA).
  • Trigger events. The statutory replacement rates will become applicable upon the occurrence of certain trigger events, including a statement of non-representativeness from the regulator with responsibility for the benchmark administrator.

Scope

  • Which benchmarks are affected? The legislative solution is not limited to critical benchmarks under the BMR, but extends to any benchmarks based on the contribution of input data and any third-country benchmarks where cessation/wind-down would significantly disrupt the functioning of financial markets in the EU or pose a systemic risk to the financial system in the EU (the latter for third-country benchmarks only). It is clear, therefore, that the scope of the legislative solution still includes LIBOR, notwithstanding the fact that LIBOR no longer qualifies as a critical benchmark under the BMR since the UK’s departure from the EU.
  • Which legacy LIBOR contracts are affected? The scope of the initial proposal by the Commission covered only “financial instruments, financial contracts and measurements of the performance of an investment fund”. In the final draft, the scope has extended significantly to apply to any contract or financial instrument referencing an affected benchmark, provided the contract in question falls within the territorial scope of the legislation (see below). The final version of the EU’s legislative fix therefore extends to a broader range of contracts and financial instruments than originally envisaged.
  • What about legacy contracts with existing fall-backs? The EU legislative fall-back will only be engaged by contracts where there is no, or ”no suitable”, fall-back provision. The legislation now includes some detail as to what will constitute an “unsuitable” fall-back, following concerns raised by ISDA and other market bodies (see ISDA’s response to the Commission’s initial proposal). Importantly, the legislation will not cut across any previous amendments by parties to include a more robust fall-back (which was ISDA’s concern). As to what will classify as an “unsuitable” fall-back the legislation provides that this will include fall-backs: (a) that do not provide a permanent replacement; (b) where third party consent is required and has been denied; and (c) where it provides for a replacement for a benchmark that no longer reflects the market/economic reality that the benchmark in cessation was intended to measure and could adversely impact financial stability. In terms of assessing whether a fall-back falls foul of the final category, the legislation provides for a protocol to be followed, involving the relevant national authority, the Commission and ESMA. This provides a mechanism for the EU’s legislative solution to apply widely to contracts that include some form of existing fall-back, but where one of the parties objects to the contractually agreed fall-back provision.
  • Extraterritorial scope. The EU’s legislative solution is only applicable to EU law contracts, with the exception of non-EU law contracts where the relevant jurisdiction does not provide for its own legislative solution (provided all parties to the contract are “established” in the EU). The extraterritorial scope has therefore materially narrowed since publication of the initial proposals (see below for a discussion of how this is likely to impact transition risk).
  • Safe harbour. The safe harbour provided by the legislation is limited to addressing the permanent cessation of the benchmark by providing contractual continuity. While the ambit of the proposed safe harbour was not articulated in the initial proposal published by the Commission, it was expected that the legislation would provide for a broader form of safe harbour (for example, in ICMA’s reaction to the initial proposal).

Impact on LIBOR transition risk

We identify below the key elements of the EU legislative solution that are likely to have an impact on LIBOR transition risk.

1. Potential for winners and losers

Consistent with the point we have made in previous blog posts on the legislative solutions of various jurisdictions, the inherent risk of the EU legislation is that it is a blunt tool. It will automatically change the interest rate payable under the contract when the relevant trigger is activated and the Commission designates replacement benchmarks. The replacement rates are unlikely to represent the bargains that the parties would have struck had they been able to/chosen to amend their contracts.

This means that the interest rate payable under LIBOR contracts will change overnight – it will be both immediate and obvious – and will inevitably give rise to the possibility of “winners” and “losers”. From a litigation perspective, this heightens the risk of mis-selling claims either by those who agree to transition to alternative rates or those whose contracts are transitioned to the statutory successor rate. In this context, it is significant that the EU legislation does not provide for a broader form of safe harbour (see below).

As ever, there is the risk of creating mismatches between different parts of a portfolio, where some products move to the statutory successor rate, but others are amended via bilateral agreement or (for example, in the case of hedging products) the ISDA Protocol.

Moreover, the EU has left the key question – what the statutory successor rate will be – open. As with the UK and US approaches, that rate will be determined at some, unspecified, point in the future. This makes it very difficult for firms to assess currently the extent of the risk that falling back to any of the statutory successor rates entails.

2. Narrow safe harbour

The Commission could have included a broader form of safe harbour; for example, to provide immunity from counterparty claims brought as a result of the automatic change in the interest rate when the legislative fall-back is imposed. A broader form of safe harbour of this sort has been proposed by the ARRC in the legislative solution for contracts governed by New York law (and largely tracked in a Senate Bill bill introduced in the New York State legislature on 28 October 2020). However, the Commission has chosen not to follow suit with the EU solution.

We have identified above the risk of winners and losers under the legislative solution and it seems inevitable that counterparty claims will follow. By failing to include a broader form of safe harbour/immunity, there is a very real risk of speculative litigation and consequent market disruption.

3. Narrowed extraterritorial scope

One of the most helpful changes to the EU legislative fix since the initial proposal, is to narrow its extraterritorial effect and reduce the likelihood of conflict between the legislative solutions of different jurisdictions.

There was a real risk that the original proposal would have resulted in the EU solution competing with (for example) the UK solution, with the EU successor rate applying to English law legacy contracts if one of the parties was an EU supervised firm. Rather than treading on the toes of non-EU law contracts, the final version of the EU legislation clearly divides up the pie of legacy contracts, so that the EU solution will only apply to EU law contracts, unless the law of the third country does not have its own legislative fix (and the parties to the contract are established in the EU).

This seems to be a neat solution to the conflicts issue. However, it will be interesting to see what (if any) changes/clarifications are made to the UK and US legislative solutions to complement this approach, as currently both of these jurisdictions have solutions that seek to have wide extraterritorial effect. For example, the draft Financial Services Bill 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).

4. Wide range of contracts falling within scope

The EU’s legislative solution has the potential to apply to a very wide range of legacy LIBOR contracts.

The Commission has deliberately extended its powers to a broader range of contracts and financial instruments, no doubt driven by the EU Council’s negotiating mandate seeking such changes. However, this is coupled with a very inclusive approach to contracts with existing fall-backs. In particular, the mechanism by which the relevant national authority, the Commission and ESMA determine whether an existing fall-back can be ousted because it “fails to reflect market/economic reality”, has the potential to be interpreted widely and therefore increase the application of the EU’s legislative solution.

The combined effect of these changes could, for contracts falling within the territorial application of the EU legislative solution, significantly reduce the rump of tough legacy LIBOR contracts.

It is as yet unclear how this will compare with the solution in the UK, pending the final version of the Financial Services Bill and the outcome of the FCA’s consultations into its powers derived from the legislation. No doubt the UK Government and the FCA will be mindful of future comparisons as to the relative success of the different legislative solutions. This has the potential to drive a more generous approach to the scope of the UK’s legislation, particularly in the context of how “tough legacy” LIBOR contracts are defined. This question is to be considered in the context of the FCA’s consultation on Article 23C, which is due to be carried out in the first half of this year.

Jenny Stainsby
Jenny Stainsby
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Rupert Lewis
Rupert Lewis
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Harry Edwards
Harry Edwards
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Nick May
Nick May
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Ceri Morgan
Ceri Morgan
Professional Support Consultant
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