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

UK post-Brexit reform: Financial Services Act 2021

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

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

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

 

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

The FCA has published an important consultation in respect of its enhanced powers under the UK’s legislative solution for the transition of so-called “tough legacy” LIBOR contracts, including the all-important question as to which legacy LIBOR contracts will be within the scope of the legislative fix: Benchmarks Regulation: how we propose to use our powers over use of critical benchmarks.

The breadth of the definition of “tough legacy” will have a direct impact on the risks associated with LIBOR transition, because a narrow solution will result in a greater volume of legacy LIBOR contracts being exposed to contractual continuity issues if those contracts are not actively amended bilaterally or by consent solicitation, or amended via market protocol.

The consultation itself provides very limited insight as to the approach likely to be taken by the FCA to the use of its powers in this context, as discussed further below. The consultation closes on 17 June 2021, after which the FCA will need to consider the responses before publishing its Statement of Policy.

It now seems inevitable that much-needed clarity as to which legacy LIBOR contracts will be caught by the UK’s legislative fix will not be forthcoming until Q3 2021 at the earliest. It is possible that this delay is a deliberate strategy by the regulators, to avoid giving the market the comfort of a broad and certain legislative solution and risk any slowdown in proactive transition efforts. However, given that LIBOR as we know it will cease at the end of this year (save for certain USD tenors), this continued uncertainty will no doubt be a source of significant frustration to many market participants, and is markedly different to the approach taken in other key LIBOR jurisdictions, such as the EU and New York.

Background

The UK’s legislative fix for LIBOR is contained within the Financial Services Act 2021 (FSA 2021). The FSA 2021 provides an overarching legal framework that gives the FCA new and enhanced powers to manage the wind-down of a critical benchmark (i.e. LIBOR), as discussed in our previous blog post: LIBOR transition measures in the new Financial Services Bill: the legal framework, market impact and risks.

Historically, the FCA has regulated LIBOR under the EU Benchmarks
Regulation (EU BMR), which forms part of retained EU law: The Benchmarks (Amendment and Transitional Provision) (EU Exit) Regulations 2019 (UK BMR). The FSA 2021 makes amendments to the UK BMR, and references to “Articles” in this blog post are to the new Articles of the UK BMR.

The amendments to the UK BMR seek to reduce the risk of litigation arising from disputes about the continuity of so-called “tough legacy” LIBOR contracts. In simple terms, the amendments provide new and enhanced powers for the FCA where it has determined that a critical benchmark is at risk of becoming unrepresentative, or has become unrepresentative, and that its representativeness cannot reasonably be maintained or restored. In such circumstances, the FCA will have the power to designate a change to the methodology by which LIBOR is set so that references in “tough legacy” contracts to LIBOR will be treated effectively as a reference to the new methodology (the synthetic LIBOR rate), rather than a rate which no longer exists.

FCA consultations

Before exercising its new powers, the FCA is required to issue “Statements of Policy” to inform the market about how it intends to exercise these powers (Article 23F). The FCA has, therefore, engaged in a consultation process with respect to the exercise of its powers, as follows:

  • Designation (Article 23A): FCA’s designation of a critical benchmark as unrepresentative or where its representativeness is at risk (such designation would result in a general prohibition on use of the benchmark under Article 23B);
  • Exemption (Article 23C): FCA’s exemption of certain legacy contracts from prohibition;
  • Methodology (Article 23D): proposed methodology change to the way in which that benchmark is determined; and
  • New use (Article 21A): prohibition on “new use” of a critical benchmark that is to be ceased.

The most recent consultation published by the FCA considers the FCA’s power to exempt certain legacy contracts from prohibition, i.e. which contracts will fall within the definition of “tough legacy” (Article 23C) and prohibition on new use (Article 21A).  This consultation is considered in more detail below.

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

Exemption (Article 23C) – definition of “tough legacy”

Chapter 2 of the consultation sets out the FCA’s proposed policy for how it will consider whether and how to exercise its legacy use power (under new Article 23C(2) of the UK BMR) to permit legacy use of an Article 23A benchmark, i.e. the outcome of the consultation will determine the scope of “tough legacy” LIBOR contracts able to take advantage of the legislative solution.

The consultation states that the FCA may only exercise this power where it considers it would advance either or both of its consumer protection and integrity objectives. The consultation sets out four key considerations to take into account when reaching a view on whether to exercise its legacy use power, as follows:

  1. The scale and nature of legacy contracts that do not have adequate provisions to deal with a prohibition on use.
  2. Whether and to what degree it is feasible for parties to amend these contracts in a way that delivers fair outcomes.
  3. Whether permitting only a limited form of use might enable the parties to remove reliance on the Article 23A benchmark – such as permitting legacy use for a time limited period after the prohibition takes effect, or permitting legacy use to calculate a final termination payment.
  4. Additional factors, such as international consistency, or the degree to which clear and practicable criteria can be provided for contracts for which the FCA proposes to permit continued legacy use.

In discussing the first of these considerations, the consultation asks the key question: What kinds of provisions do you consider would lead to unintended, unfair or disruptive outcomes, or prove inoperable in practice, if a critical benchmark could no longer be used? (Question 1).

In the context of LIBOR, the crux of this question is the volume and variety of legacy LIBOR contracts with inappropriate legacy fall-backs. For example, if there is a prohibition on the use of LIBOR and the relevant fall-back kicks in, would the effect of that fall-back lead to unintended/unfair/disruptive outcomes or would it simply not work?

It is difficult to glean any insights from the FCA’s articulation of this question as to the likely scope of “tough legacy”, other than to note that this presents an opportunity for the market to explain the very real and varied issues with historic fall-back provisions, and the complexity caused by the sheer variety of circumstances in which these questions arise. The more examples that can be given of contracts without adequate fall-back provisions, the better the illustration of the risk to consumer protection and financial stability, supporting the need for a wide definition of “tough legacy”.

There is an interesting comparison to the scope of the legislative solutions enacted in New York (New York legislative solution for LIBOR passed: Impact on transition of legacy LIBOR contracts) and in the EU (Final EU legislative fix for legacy LIBOR: impact on transition risk for UK entities). In both of these jurisdictions, the legislation takes a broad approach to potentially “unsuitable” fall-backs, and in consequence this is likely to lead to a greater volume of contracts being moved off LIBOR to the statutory replacement rate.

New use (Article 21A) – prohibition on new use of a critical benchmark

The consultation also considers the FCA’s power under new Article 21A of the UK BMR, which gives the FCA the ability to prohibit some or all new use of a critical benchmark when it has been notified by its administrator that it will cease to be provided (the new use restriction power).

The idea behind this power is to restrict the new use of a ceasing critical benchmark during a wind-down period. This is relevant most obviously to the USD tenors of LIBOR that will cease at the end of June 2023 (with the expectation that these rates will continue to be representative until then). Chapter 3 of the consultation sets out the FCA’s proposed policy for considering whether and how to exercise its new use restriction power.

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

The FCA’s proposed new “Consumer Duty” – what does it mean?

The FCA has published its long-awaited consultation on “duty of care” which has morphed into a proposed package of measures intended to deliver better outcomes for consumers – together a new “Consumer Duty”.

The consultation, which is open until 31 July 2021, proposes:

  • a new Consumer Principle that provides an overarching standard of conduct; and
  • a set of Cross‑cutting Rules and four Outcomes that support the Consumer Principle.

The proposals apply to regulated products and services sold to “retail clients” which would include SMEs.

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. The FCA has not made any specific proposals on a private right of action. It has, however, said that it would welcome stakeholders’ further views on how a private right of action could support or hinder the success of the proposals and their intended impact on firms, consumers and markets.

It is good to see that a private right of action for Principles breaches is not the focus of the Consultation Paper. In this regard, it is questionable whether a private right of action for Principles breaches would be of real benefit to consumers who already have access to the Financial Ombudsman Service (FOS), which is better suited to dealing with claims from a speed and cost perspective.

For a more detailed analysis of the FCA’s case for change, the proposals and our thoughts on what this may mean for firms, please see our FSR and Corporate Crime blog post.

Redemption periods and liquidity mismatch in authorised open-ended property funds: regulatory update and litigation risks

The FCA has recently published a feedback statement to its consultation into liquidity mismatch in authorised open-ended property funds (CP20/15) (considered in our previous banking litigation blog post).

The FCA consultation considered whether property funds should be required to have notice periods before an investment can be redeemed, suggesting a notice period of between 90 and 180 days for these funds. The recent statement sets out the feedback received by the FCA, with many respondents defending the utility of open-ended property funds as a component of an investment portfolio. The statement confirms that only a small number of respondents agreed with the proposal of notice periods as consulted on, but just over half of respondents supported the proposals in principle (subject to conditions). The FCA will not take a final decision on its policy position until Q3 2021 at the earliest, primarily due to uncertainty over the operational hurdles to overcome to support notice periods.

The latest regulatory development follows the suspension of numerous open-ended property funds last year, when lockdown measures were announced in response to the COVID-19 pandemic. Some funds have since re-opened, but a number remain gated. It is a reminder that, in times of stressed market conditions, there is likely to be an increase in investors seeking to cash in or transfer assets held in such funds, which may lead to a liquidity crisis.

This has once again cast a spotlight on the risks arising from mismatches between the redemption periods offered by investment funds and the liquidity of the underlying assets, which we considered in our article published in the Journal of International Banking & Financial Law: Redemption periods and liquidity mismatch in the investment funds market: the litigation risks.

Simon Clarke
Simon Clarke
Partner
+44 20 7466 2508
Ceri Morgan
Ceri Morgan
Professional Support Consultant
+44 20 7466 2948

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

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

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

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

LIBOR legislative solutions: global progress comparison

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

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

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

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

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

Effect of the New York legislation

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

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

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

Scope of the New York solution

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

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

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

Mandatory provisions

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

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

Discretionary provisions

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

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

Market impact

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

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

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

Safe harbour and other key protections

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

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

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

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

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

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

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

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

Risk of forum shopping

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

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

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

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

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

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

UK contacts:

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

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



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

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

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

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

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

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

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

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

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