This week, the Critical Benchmarks (References and Administrators’ Liability) Act 2021 received Royal Assent and will now pass into UK law.

The Critical Benchmarks Act represents the final part of the UK’s legislative framework to deal with LIBOR cessation and its passage is welcome news, particularly with the hard deadline for most currencies of LIBOR (save for certain USD tenors) fast approaching at the end of this year.

In this blog post, we explain the overarching mechanism of the UK legislative regime, some key takeaways from the Critical Benchmarks Act, and the likely impact on litigation risk.

UK legislative mechanism: a two-stage process

The UK legislative solution has been enacted via two separate pieces of legislation, both of which make amendments to the retained EU law version of the Benchmarks Regulation (EU) 2016/1011 (UK BMR):

1. Firstly, amendments have been introduced by the Financial Services Act 2021 (FSA 2021) to grant the FCA new and enhanced powers to manage the wind-down of a critical benchmark (i.e. LIBOR, which is the benchmark we will focus upon in this blog post).
2. Secondly, amendments have been introduced by the Critical Benchmarks Act 2021 to clarify the way in which a reference to LIBOR should be interpreted in individual contracts after the exercise of the FCA’s powers granted under the FSA 2021.

We consider each element of the legislative solution in turn below.

The Financial Services Act 2021

The FSA 2021 gives the FCA new and enhanced powers to manage the wind-down of 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 outcome of the FCA using its new regulatory powers will be the publication, from 4 January 2022, of so-called “synthetic” LIBOR for 1-month, 3-month and 6-month sterling LIBOR and all yen LIBOR tenors, by ICE Benchmark Administration.

The effect of publication of synthetic LIBOR on individual contracts is not expressly catered for within the FSA 2021, which deals only with the powers granted to the regulator. For this reason the Critical Benchmarks Act has been introduced, 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 Critical Benchmarks Act 2021

The key features of the Critical Benchmarks Act, which are likely to be of interest to financial institutions, are as follows:

Express contractual continuity

The express contractual continuity provisions in the Critical Benchmarks Act have the following key pillars:

• LIBOR = synthetic LIBOR. Article 23FA paragraph 1 confirms that references to LIBOR in a contract or arrangement 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. Accordingly, from 4 January 2022, synthetic LIBOR will be “deemed” into each contract or arrangement that references one of the six exempt LIBOR settings. This applies regardless of how 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 the introduction of synthetic LIBOR into the contract on 4 January 2022 constitutes a change in the contract. It does this by stating that once synthetic LIBOR is deemed to be the reference rate in the contract, the contract will be treated for all purposes as if it always referenced synthetic LIBOR.
• Retrospective application. Article 23FA paragraph 4 ensures that the deeming of synthetic LIBOR into a contract or arrangement will apply regardless of when the contract was formed, i.e. the Critical Benchmarks Act will have retrospective application, and apply to contracts formed before it came into full force and effect.

Protection from claims

Paragraph 5 of Article 23FA may address arguments that the change to synthetic LIBOR amounts to a frustration/force majeure event or breach of contract. As noted above, once synthetic LIBOR is deemed into the contract, the contract is to be treated for all purposes as having always referenced the synthetic rate.

Further protection from claims is provided by paragraph 6(a) and 6(b) of Article 23FA:

• Paragraph 6(a) provides that nothing in “this Article” (i.e. Article 23FA) creates any liability in relation to an act or omission relevant to the formation or variation of a contract which took place before the introduction of synthetic LIBOR. Paragraph 61 of the Explanatory Notes to the legislation confirms that any claims based on alleged misrepresentations made before the introduction of synthetic LIBOR are to be considered according to the actual reality at the relevant time the representations were made.
• Paragraph 6(b) provides that nothing in “this Article” creates any liability in relation to the operation of the contract prior to the introduction of synthetic LIBOR.

It remains to be seen how these paragraphs will be interpreted, but we expect firms to seek to rely upon paragraph 6 as part of their armoury of defences to any LIBOR transition claims.

Impact on non-financial contracts and non-BMR supervised entities

The Critical Benchmarks Act is not limited to contracts/parties in scope of UK BMR. Accordingly, the contractual continuity provisions outlined above apply equally to non-financial contracts and where neither of the counterparties are “supervised entities” for the purposes of UK BMR. See in particular paragraphs 1, 2 and 9 of Article 23FA, which confirm that references to LIBOR should be treated 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. This is also confirmed by paragraphs 42-43 and 65 of the Explanatory Notes.

Interaction with transitioned contract provisions

The Critical Benchmarks Act 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).

Impact on 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 may be a real economic incentive to bring claims, and this may provide fertile ground for litigation.

The contractual continuity provisions in the Critical Benchmarks Act should help to deter arguments based on refusal to perform contractual obligations, alleged frustration or force majeure.

Other potential claims may include mis-selling type claims (whether in contract, tort or under statute) on the basis of allegedly negligent statements and/or advice in relation to the LIBOR-referencing product at the original point of sale, where parties feel they have lost out financially as a result of conversion to synthetic LIBOR vs the original rate. Mis-selling claims may also arise in relation to products that contractual counterparties have actively transitioned away from LIBOR, on the basis that a customer is put in a position that turns out to be worse than if the same customer had not been actively transitioned, and the contract had been amended by the legislative solution.

Such claims are likely to be highly speculative, but regardless of their merits, there is a risk of disruption for firms because of the time and cost of defending them on a large scale. The UK’s final form of safe harbour does not give the clarity of the protections offered by the federal and New York legislative solutions 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). However, the protections included in the Critical Benchmarks Act are welcome additions and clearly the intention of the legislators was to avoid market disruption.

The safety net afforded to non-financial contracts, enabling parties to such contracts to rely upon the contractual continuity provisions in the Critical Benchmarks Act and therefore access synthetic LIBOR, is likely to be welcomed broadly by supervised and unsupervised entities alike.

With three months to go before the end of LIBOR as we know it (save for certain USD tenors), regulators around the globe continue to emphasise the importance of active transition away from the benchmark. In the UK, the FCA is simultaneously affirming this message while clarifying the scope of the UK legislative solution for legacy LIBOR contracts that fail to transition by 31 December 2021. The result has been a flurry of new notices, consultations and guidance published by the FCA over the past month.

The key developments during this period, and their impact on transition risk, are summarised below.

1. Update on the UK legislative framework

By way of reminder, the UK legislative solution operates via amendments to the retained EU law version of the Benchmarks Regulation (EU) 2016/1011 (UK BMR), which have been introduced by the Financial Services Act 2021 (FSA 2021) (see our blog post). The FSA 2021 amends the BMR to enable the FCA to designate a benchmark (such as LIBOR) that is unrepresentative or is at risk of becoming unrepresentative under Article 23A, with the result that its use (as defined in the BMR) is prohibited by virtue of Article 23B, except where legacy use is permitted by the FCA under Article 23C. The Article 23A benchmark may be published under a changed methodology using powers under Article 23D, so-called “synthetic” LIBOR.

The FSA 2021 is complemented by the Critical Benchmarks (References and Administrators’ Liability) Bill (see our blog post), which aims to reduce the potential risk of contractual uncertainty arising from the introduction of synthetic LIBOR, by clarifying the way in which a reference to LIBOR should be interpreted in a contract after the exercise of the FCA’s powers to change the methodology for calculating LIBOR. Following the introduction of the Critical Benchmarks Bill to Parliament, the Committee Stage passed through the House of Lords last week with no amendments tabled, and there was a third reading on Tuesday 2 November. The Bill will now pass to the House of Commons for its first reading and it is hoped that that it will receive receive Royal Assent before the end of the year.

2. Article 23A Benchmarks Regulation – notice of designation

On 29 September, the FCA issued a notice designating 1-month, 3-month and 6-month sterling LIBOR and all yen LIBOR tenors (the 6 LIBOR Versions), as “Article 23A” benchmarks. The designation will take effect on 1 January 2022.

The notice provides a summary of the FCA’s reasons for the designation, explaining that the panel bank contributors to the 6 LIBOR Versions will no longer make submissions to IBA after 31 December 2021, and consequently these 6 LIBOR Versions cannot continue to be published on a representative basis after the contributors’ departure. The FCA has concluded that none of the 6 LIBOR Versions could be ceased in an orderly fashion at end-2021 due to significant legacy exposures, and so there is adequate justification to designate these settings under Article 23A, in order to access powers to permit legacy use and change the methodology to a synthetic one under Article 23D.

In practical terms, this means that BMR supervised entities will be prohibited from using the 6 LIBOR Versions from 1 January 2022 under the automatic prohibition on use in Article 23B. However, these entities will be able to continue to use the benchmark under the synthetic methodology, where the FCA makes exemptions under Article 23C. In this way, the FCA’s notice of designation is linked intrinsically to the update below, which confirms the FCA’s proposed decision on the scope of the Article 23C exemption.

It is worth noting that once LIBOR has been designated as an Article 23A benchmark by the FCA, all UK law governed contracts (whether or not in scope of UK BMR) will treat references to LIBOR as references to synthetic LIBOR under the Critical Benchmarks Bill, i.e. the ability to access the synthetic benchmark is not limited to financial contracts of BMR supervised entities or a defined class of exempted contracts for non-supervised entities and in respect of non-financial contracts.

3. CP21/29: Proposed decisions on the use of LIBOR (Articles 23C and 21A BMR)

The FCA published this consultation to seek views on how to use its Article 23C powers under the UK BMR, confirming its proposal to permit legacy use of the 6 LIBOR Versions in all in scope BMR contracts except cleared derivatives (whether directly or indirectly cleared). It also consulted on the use of its Article 21A power to prohibit new use of overnight, 1 month, 3 month, 6 month and 12 month USD LIBOR.

This provides a very wide “tough legacy” definition. It would be an understatement to say that this announcement took many market participants by surprise. The breadth of the “tough legacy” definition is critical to understanding which legacy LIBOR contracts will be converted to synthetic LIBOR, and the market has been awaiting clarity on this question since the UK Government first announced its intention to introduce a legislative solution in June 2020 (see our blog post). It was widely assumed that “tough legacy” contracts would be defined using some specific parameters (e.g. date of formation of the contract, financial product, nature of counterparties etc.), and would not be so wide as to capture all unamended legacy LIBOR contracts.

However, the only limitations on the definition appear to be the relevant legacy LIBOR setting (i.e. whether a synthetic version will be published), and the exclusion of cleared derivatives. Accordingly, the market has been offered broad comfort that a cliff-edge scenario will be avoided for legacy contracts referencing the 6 LIBOR Versions. The breadth of the exemption is presumably one of the factors driving the late clarification of the FCA’s Article 23C powers, in order to ensure that market participants did not take their foot off the pedal of LIBOR transition.

4. LIBOR and the FCA’s new powers under the UK Benchmarks Regulation: questions and answers

The FCA has also published questions and answers for firms related to the use of its powers under UK BMR. In this blog post, we are highlighting two important points arising from the Q&As, which firms should be aware of:

(i) Synthetic LIBOR is a “bridging” solution only

One of the key messages permeating the Q&As is the fact that availability of synthetic LIBOR rates will be subject to annual review, and that ongoing availability cannot be assured beyond 2022. The FCA is unequivocal that the legislative fix is a “bridging” solution for tough legacy contracts that have not been able to convert by year-end and that synthetic LIBOR is not a permanent solution.

From a risk perspective, this highlights the fact that many tough legacy LIBOR contracts may still face a cliff-edge scenario at a later date, if active amendment during the “bridging” period proves to be impossible.

On a more positive note, this message from the regulator is useful from a conduct perspective, as it recognises that firms should continue to amend their contracts wherever practicable to remove reliance on LIBOR, regardless of the FCA’s decision to require publication of certain synthetic LIBOR settings. What would be more helpful still, is some guidance from the FCA as to how the availability of synthetic LIBOR should be communicated to customers who are considering active transition.

(ii) Use of synthetic LIBOR outside the UK’s statutory framework

Outside of the strict parameters of the UK statutory framework, there is an important question mark as to whether synthetic LIBOR can be imported for use in a contract as a matter of contractual construction. For example, in contracts that are not governed by UK law; or contracts out of scope of UK BMR (although since the Critical Benchmarks Bill applies to a broader scope of contracts than those within the BMR, references to LIBOR in non-BMR contracts should be read as synthetic LIBOR provided the contract is governed by the laws of England and Wales, Scotland or Northern Ireland).

The Q&As confirm the FCA’s expectation that the change of methodology imposed through LIBOR’s administrator should “flow through” to global users of existing LIBOR contracts continuing to reference the rate. The FCA has not expressed a view on the legal basis for adopting synthetic LIBOR in contracts that are not within scope of UK BMR (and so will not be affected by the FCA’s “legacy use” decision) or UK law (and so will not be caught by the wider provisions of the Critical Benchmarks Bill).

The Q&As simply state that firms will need to take legal advice about how synthetic LIBOR will interact with their contract provisions. This is likely to turn on how LIBOR is described within each individual contract, and may present problems for firms with large portfolios of legacy contracts where references to LIBOR are not uniform.

The FCA also states that this “flowing through” of synthetic LIBOR to global users of existing LIBOR contracts is subject to the legislative frameworks of other jurisdictions dealing with legacy contracts, and that the EU/US/UK authorities all agree that contractual governing law clauses should prevail. Note that this expectation appears expressly in the EU legislative framework (see our blog post), but not in the amendments to UK BMR.

While the recent FCA announcements help to provide some further clarity on the scope of the UK’s LIBOR legislative framework, a number of key questions remain unanswered.

The next major development is likely to be publication by the FCA of its decisions in respect of Articles 23C and 21A UK BMR, following the closure of the consultation period. Unfortunately, this is unlikely to provide the certainty the market is looking for on the outstanding issues outlined above, and may be a source of frustration for many at this late stage in the LIBOR end-game.

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.

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.

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.

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