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):
- 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).
- 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.