Reform of the UK prospectus regime – update on securities litigation risk

HM Treasury (HMT) has published a response setting out its policy approach to reforming the UK’s prospectus regime, in the biggest shake up since 2005. The response follows the initial consultation published in July 2021.

HMT’s intention is to proceed with the reforms broadly as proposed in its initial consultation. The next step is for HMT to make the necessary legislative changes to the Financial Services and Markets Act 2000 (FSMA), to create the framework for the new regime when parliamentary time allows.

The idea behind these changes is to simplify regulation in this area, as well as facilitating wider participation in the ownership of public companies and improving the quality of information investors receive. As part of this, HMT will delegate a greater degree of responsibility to the Financial Conduct Authority (FCA) to set out the detail of the new regime through rules. The full suite of reforms will take effect after the FCA has consulted on, and is ready to implement, new rules under its expanded responsibilities. HMT is keen to return responsibility for designing and implementing financial services regulatory requirements to regulators. For more information on the reforms themselves, please see this detailed briefing produced by our Capital Markets team.

From a securities litigation perspective, in light of the ever-evolving statutory and regulatory landscape, it is important issuers continue to monitor the impact of any changes to their disclosure requirements. HMT’s reforms of the UK’s prospectus regime are likely to have a potential impact on claims under s.90 FSMA for liability for prospectuses and listing particulars. For more information on this impact, please see our previous blog post: HMT reform of prospectus regime: the potential impact on securities litigation.

Ceri Morgan
Ceri Morgan
Professional Support Consultant
+44 20 7466 2948
Nihar Lovell
Nihar Lovell
Professional Support Lawyer
+44 20 7466 2529

Regulation in Focus Podcast – Operational Resilience

Our FSR colleagues’ latest Regulation in Focus podcast features two former regulators in conversation about operational resilience – Andrew Procter from Herbert Smith Freehills and Michael Sicsic from Sicsic Advisory.

The discussion focuses on the implementation of operational resilience requirements for the upcoming UK regulatory deadline of 31 March 2022, including a discussion of the regulatory and litigation risks for financial institutions.

To listen to the podcast and for more details, please see our FSR Notes blog post.

Final part of UK LIBOR legislative solution receives Royal Assent

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.

Ceri Morgan
Ceri Morgan
Professional Support Consultant
+44 20 7466 2948
Rupert Lewis
Rupert Lewis
Partner
+44 20 7466 2517
Jenny Stainsby
Jenny Stainsby
Partner
+44 20 7466 2995

Global Bank Review: Greenwashing Litigation Podcast

Join Mark Smyth, Jojo Fan, Benjamin Rubinstein and Sousan Gorji as they discuss global greenwashing issues in the banking sector. You can read more insights in our Global Bank Review.

You can also listen on Apple, Spotify and SoundCloud.

Please subscribe to our Financial Services Disputes & Regulation podcast channel here to listen to our regular bite-sized broadcasts covering both litigation and regulatory developments for banks and other financial institutions.

Jojo Fan
Jojo Fan
Partner
+852 21014254
Benjamin Rubinstein
Benjamin Rubinstein
Partner
+1 917 542 7818
Mark Smyth
Mark Smyth
Partner
+61 2 9225 5440
Sousan Gorji
Sousan Gorji
Senior Associate
+44 20 7466 2750

FCA consults on the new Consumer Duty

Our Financial Services Regulatory colleagues have published a blog post on the FCA’s Consultation Paper 21/36 (CP 21/36) which includes proposed new rules and guidance setting out a Consumer Duty which it considers will “fundamentally shift the mindset of firms” and establish an appropriate level of care to consumers. The consultation is open until 15 February 2022 and the FCA expects to confirm any final rules by the end of July 2022.

The proposals from the FCA will add to the range of regulatory tools to address the poor customer outcomes it has identified in retail markets. They would therefore give the FCA a greater ability to hold firms and senior management to account if poor outcomes are identified in the future, and they are intended to raise industry standards by putting the emphasis on firms to get products and services right in the first place. Although the new proposed Consumer Duty will create a further burden on firms, the Handbook rules and guidance and non-Handbook guidance should provide greater clarity on the FCA’s expectations of the outcomes that should be achieved.

From a disputes perspective, firms are likely to welcome the fact that there will be no private right of action for breaches of any part of the Consumer Duty at this time. Firms will still be accountable for any breach of the Consumer Duty through the Financial Ombudsman Service framework, which has had a recent increase in the value of award limits within its jurisdiction. However, the consultation paper notes that the possibility of a private right of action is being kept under review.

For a more detailed analysis, please see our FSR Notes blog post.

LIBOR transition risks – November 2021 update

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.

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
Ben Goodman
Ben Goodman
Of Counsel
+44 20 7466 2862
Ceri Morgan
Ceri Morgan
Professional Support Consultant
+44 20 7466 2948

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

SPACs in the City: the emerging litigation and regulatory risks in England & Wales

Herbert Smith Freehills LLP have published an article in Butterworths Journal of International Banking and Financial Law on the litigation and regulatory risks for special purpose acquisition companies (SPACs) in England & Wales.

SPACs scorched the US stock markets last year, with the UK left out in the cold. While the recent crackdown by the Securities and Exchange Commission (SEC) is cooling investor interest in the US, the UK regulators are hoping that changes to the regulatory framework will bring some SPAC sunshine to this side of the Atlantic.

Given the limited number of London-listed SPACs to date, the litigation and regulatory risks for SPACs in the UK remain broadly untested. However, some cautionary tales are emerging from the US, where increasingly SPACs are the subject of litigation and regulatory scrutiny.

The article considers the changes to the UK’s regulatory framework applying to SPACs, before exploring some of the key anticipated regulatory and litigation risks for SPACs in this jurisdiction.

The article can be found here: SPACs in the City: the emerging litigation and regulatory risks in England & Wales. This article first appeared in the October 2021 edition of JIBFL.

Karen Anderson
Karen Anderson
Partner
+44 20 7466 2404
Emma Deas
Emma Deas
Partner
+44 20 7466 2613
Sarah Hawes
Sarah Hawes
Head of Corporate Knowledge, UK
+44 20 7466 2953
Ceri Morgan
Ceri Morgan
Professional Support Consultant
+44 20 7466 2948
Eleanor Dole Sheaf
Eleanor Dole Sheaf
Associate
+44 20 7466 7612

Article published on collective assurance activities and the risk management of outsourcing arrangements

Our Financial Services Regulatory team have published an article in the September 2021 edition of Butterworths Journal of International Banking and Financial Law, making the case for more guidance from sectoral regulators and competition authorities to allow banks and their service providers to get comfortable with the option to participate in collective assurance activities, as part of their outsourcing arrangements.

The risk management of outsourcing and third party arrangements is a challenge facing financial services firms, and therefore accommodations in regulatory policies on the assurance or audit mechanisms which can be used, will likely be of interest and welcomed by firms and their service providers. However, the article emphasises that it is important for regulators to take a further step and provide specific guidance for firms.

To read the article in full, see our FSR blog post.

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