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

LIBOR Discontinuation: FCA non-representativeness announcement

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

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

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

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

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

Market impact

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

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

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

Operational Resilience: respond, enhance, thrive

Operational resilience is the next phase in the evolution of financial services regulatory policy.

Regulators’ expectations are increasing – but it’s an evolution rather than a revolution; firms – more specifically firms’ senior managers – must “join the dots” across a range of practical risk management and governance activities.

Increased regulatory scrutiny can lead to increased litigation risks for financial services institutions, and so to help keep you up to date on the upcoming regulatory expectations, we are pleased to announce the launch of our new #OperationalResilience hub.

The hub features an interactive timeline which currently covers the UK, EU, Hong Kong and Singapore, and output from global standard setters such as the Basel Committee on Banking Supervision, the Financial Stability Board, and the International Organisation of Securities Commissions. We are adding more major financial services centres and will be regularly updating the timeline to provide a “one stop shop” for #OperationalResilience.

Navigate the legal and regulatory milestones here and engage with our experts across the world for global and local insights.

Hannah Cassidy
Hannah Cassidy
Partner
+852 2101 4133
Cat Dankos
Cat Dankos
Regulatory Consultant
+44 20 7466 7484
Andrew Procter
Andrew Procter
Partner
+44 20 7466 7560
Natalie Curtis
Natalie Curtis
Partner
+65 6868 9805
Luke Hastings
Luke Hastings
Partner
+61 2 9225 5903
Charlotte Henry
Charlotte Henry
Partner
+61 2 9322 4444
John O'Donnell
John O'Donnell
Partner, New York
+1 917 542 7809
Leopoldo Gonzalez-Echenique
Leopoldo Gonzalez-Echenique
Partner
+34 91 423 41 17
Jenny Stainsby
Jenny Stainsby
Partner
+44 20 7466 2995
Clive Cunningham
Clive Cunningham
Partner
+44 20 7466 2278
Martin Le Touze
Martin Le Touze
Partner
+33 1 53 57 73 72
Nick Pantlin
Nick Pantlin
Partner
+44 20 7466 2570
Miriam Everett
Miriam Everett
Partner
+44 20 7466 2378
Mark Robinson
Mark Robinson
Partner
+65 6868 9808
Andrew Moir
Andrew Moir
Partner
+44 20 7466 2773
Kate Macmillan
Kate Macmillan
Consultant
+44 20 7466 3737

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

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

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

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

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

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

Background to the FS Bill

The FS Bill provides an overarching legal framework which gives the FCA new and enhanced powers to manage the wind-down of a critical benchmark (i.e. LIBOR), as discussed in our previous blog post: LIBOR transition measures in the new Financial Services Bill: the legal framework, market impact and risks. The FS Bill amends the Benchmarks Regulation 2016/1011 (EU BMR), as amended by The Benchmarks (Amendment and Transitional Provision) (EU Exit) Regulations 2019 (UK BMR). While the legislation is drafted by reference to the wind-down of any “critical benchmark”, for ease of reference in this blog post we refer only to the impact on LIBOR transition.

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

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

Purpose of the safe harbour

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

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

  1. Contractual continuity

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

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

  1. Protection from claims

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

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

Comparison with EU/US position on safe harbour

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

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

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

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

Impact on LIBOR transition risk

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

1. Rationale for a safe harbour

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

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

2. Scope of the safe harbour

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

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

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

3. Effect on active transition efforts

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

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

4. Risk of forum shopping

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

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

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

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

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

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

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

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

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

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

New framework for the EU legislative solution

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

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

Mechanism

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

Scope

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

Impact on LIBOR transition risk

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

1. Potential for winners and losers

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

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

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

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

2. Narrow safe harbour

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

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

3. Narrowed extraterritorial scope

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

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

This seems to be a neat solution to the conflicts issue. However, it will be interesting to see what (if any) changes/clarifications are made to the UK and US legislative solutions to complement this approach, as currently both of these jurisdictions have solutions that seek to have wide extraterritorial effect. For example, the draft Financial Services Bill is not limited to contracts governed by UK law and applies to all UK supervised entities. This is tempered by express requirements for the FCA to have regard to the likely effect outside the UK when exercising its various powers delegated under the draft Bill. In particular, this applies to the FCA exercising its power of prohibition (Article 21A), exemption (Article 23C) and change of methodology (Article 23D).

4. Wide range of contracts falling within scope

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

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

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

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

Jenny Stainsby
Jenny Stainsby
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

FSR Outlook 2021: Paving the Way Forward

Our Financial Services Regulatory team have announced the launch of FSR Outlook 2021: Paving the Way Forward.

In this annual publication, the team survey the regulatory landscape in 2021 and identify some themes expected to be at the core of regulatory priorities globally in the next 12 months.

2020 has been dominated by Covid-19, political uncertainty, and the preparations for Brexit – which are likely to continue to cast a long shadow over 2021. Although some second-guessing of crisis-driven responses is probably inevitable (“2020 hindsight”), the hope is that regulators will also focus on the benefits and opportunities furnished by the adoption of digital solutions in response to the pandemic, and how the financial system can best help support the global economic recovery.

Global Outlook for 2021 looks at nine different areas, ranging from doing something useful about culture and tackling the “alphabet soup” of ESG standards, to maintaining market integrity in the time of Covid-19, and the final countdown for LIBOR. Protecting investors through a focus on end outcomes, managing innovation in payments, and ensuring digital operational resilience are of course high on the list. Perhaps unsurprisingly, part of the regulatory response to 2020’s pandemic has been a trend towards increased regulatory intervention, and we expect the number of investigations against individuals to continue to grow, not least given continuing regulatory focus on making senior managers accountable.

View the FSR Outlook 2021 here.

LIBOR transition measures in the new Financial Services Bill: the legal framework, market impact and risks

On 21 October 2020, the UK government introduced the Financial Services Bill (FS Bill) to Parliament, which has been described by HM Treasury (HMT) as a new Bill “designed to ensure the UK’s world-leading financial services sector continues to thrive and grasp new opportunities on the global stage”.

The focus of this blog post is on the LIBOR transition measures included in the FS Bill, which are consistent with the Chancellor’s announcement of the legislative fix mechanism on 23 June 2020, as considered in our previous blog post: UK Government announces LIBOR legislative fix: summary of proposals and our initial observations.

This blog post explains the legal framework of the measures included in the FS Bill, and explores the potential market impact and legal risks.

Legal framework

The FS Bill amends the Benchmarks Regulation 2016/1011 (EU BMR), as amended by The Benchmarks (Amendment and Transitional Provision) (EU Exit) Regulations 2019 (UK BMR). It provides an overarching legal framework which gives the FCA new and enhanced powers to manage the wind-down of a critical benchmark, i.e. LIBOR.

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

The key points to note on the legal framework are as follows:

  1. The FCA will have the power to give notice to a relevant benchmark administrator (under Article 21(3B)(a) or Article 22B(3)(a)) that the critical benchmark is unrepresentative (of the market or economic reality that the benchmark is intended to measure) or its representativeness is at risk.
  2. Where the FCA has given notice under Article 21 or 22B, it may designate a critical benchmark as an “Article 23A benchmark”.
  3. Use of an Article 23A benchmark by UK supervised entities will be prohibited under Article 23B.
  4. However, in order to ensure an orderly wind-down of the benchmark for “tough legacy” contracts, the FCA will have discretion to determine specific categories of contracts which will be exempt from this prohibition on use. The exception from the prohibition against using an Article 23A benchmark appears at Article 23C, under which the FCA may publish a notice permitting “some or all legacy use of the benchmark by supervised entities”.
  5. While an Article 23A benchmark can continue to be used (where exempt from the prohibition by Article 23C), the FCA will be able to direct a change in the methodology of the benchmark and extend its publication for a limited time period for the benefit of “tough legacy” contracts. Article 23D allows the FCA to impose requirements on the administrator of the Article 23A benchmark, including as to the way in which the benchmark is determined and the input data. Article 23D(6) says that the FCA will not be restricted in its exercise of this power by having to replicate the market or economic reality that was intended to be measured by the benchmark immediately before it became an Article 23A benchmark (although the FCA may have regard to that when exercising the powers).
  6. Before exercising its new powers, the FCA will be required to issue statements of policy to inform the market about how it intends to exercise these powers (Article 23F). The FCA will be able to engage with industry stakeholders and international counterparts as appropriate through this process. In particular, the FCA must prepare and publish a statement of policy with respect to:
    • The designation of benchmarks under Article 23A;
    • The exercise of its powers under Article 23C and Article 23D;
    • The exercise of its power under Article 21A (which relates to the “new use” of a critical benchmark that is to be ceased).

The framework provides for a UK legislative solution to the cessation of LIBOR by way of primary legislation, so that the market has comfort that a cliff-edge scenario will be avoided, but leaves the policy detail to be worked out by the FCA at a later stage. The likely market impact of this approach and effect on the risk profile are considered further below.

Market impact

The policy statement accompanying the FS Bill notes the government’s recognition of the existence of “tough legacy” LIBOR contracts, which face “insurmountable barriers” in transitioning away from LIBOR. There is no doubt that the legislative fix is a helpful and significant step forward, and the market will welcome the introduction of a mechanism to address tough legacy LIBOR (as we noted in response to the Chancellor’s statement in June 2020). However, key questions remain about the approach and scope of the protections offered by the FS Bill (considered further in the section below on litigation risks) and this continued lack of clarity at this late stage in LIBOR transition will be a source of frustration for many.

The policy statement emphasises that firms should continue to prioritise active transition away from LIBOR to alternative benchmarks. It says it is in the interests of financial markets and their customers that the pool of contracts referencing LIBOR is shrunk to an irreducible core ahead of LIBOR’s expected cessation after end-2021. Our expectation is that the market will not take its foot of the pedal of transition efforts as a result of the legislative solution. This is not just because of this warning from HMT, but (in particular) because of the likely narrow scope of the legislative fix and the desire to retain control over the economic effect of any switch.

Risk profile

The key risk areas arising from the drafting of the FS Bill are as follows:

1. Definition of “tough legacy” LIBOR contracts

The FS Bill does not define “tough legacy” LIBOR contracts, i.e. which contracts will fall within the Article 23C exemption. However the policy statement confirms that HMT and the FCA are of the view that this exemption is intended for those contracts that genuinely have no realistic ability to be renegotiated or amended to transition to an alternative benchmark.

This is therefore a legislative fix that is somewhat more narrow in scope than the approaches which have been suggested by the European Commission (see here) and in the US by the Alternative Reference Rates Committee (see here). The suggestion that the solution will apply only to “tough legacy” contracts indicates that there may be some legacy LIBOR contracts, which are not swept up by the proposed legislative solution, even if they have not been actively amended bilaterally or by consent solicitation, or amended via market protocol.

It is possible that the legal framework and supporting communications from HMT and the FCA have been deliberately positioned to avoid giving the market the comfort of a broad and certain legislative solution, to ensure transition efforts are not slowed. However, we will need to wait for the FCA’s policy statements to confirm the scope, and market participants would be wise not to rely on any expansion.

2. Methodology changes to LIBOR

Another aspect of the legislative solution, which has been left to the FCA’s policy statements, is the selection of the methodology for calculating synthetic LIBOR.

The FCA has given some general guidance to the market already. In particular, we note the comments of Edwin Schooling Latter (Director of Markets and Wholesale Policy at the FCA) in a webinar on 18 September 2020 hosted by the UK’s Working Group on Sterling Risk-Free Reference Rates (RFRWG), the FCA and others. Mr Schooling Latter suggested that the FCA would use the same adjustment spread as ISDA, but with the adjusted risk-free rate (RFR) being based on a forward-looking approach. This issue was foreshadowed at the time of the Chancellor’s announcement, in a statement made by ISDA’s CEO, Scott O’Malia:

“For one thing, derivatives markets have opted to use overnight RFRs compounded in arrears, which require amendments to contractual terms in addition to referencing a different rate. Given tough legacy contracts currently reference a forward-looking term IBOR and cannot be amended, it indicates a ‘synthetic LIBOR’ will be a forward-looking term rate based on the RFRs plus a spread adjustment. Indeed, the FCA says that use of overnight RFRs compounded in arrears ‘may not be possible to replicate within the restrictions of the existing LIBOR framework’.”

As a result, there are two critical points on the value of synthetic LIBOR to be aware of:

  • When the legislative solution is triggered, because conversion of LIBOR to synthetic LIBOR will not be present value neutral, there will be an immediate and obvious change in the interest paid under the relevant contract, over which none of the parties to the contract will have control (having been unable to amend the relevant contract before the trigger); and
  • Where one contract is converted to synthetic LIBOR via the legislative solution (e.g. an unamended loan), but its associated hedge is converted via ISDA’s 2020 IBOR Fallbacks Protocol, the hedge will no longer exactly match the cash product (see our banking litigation blog post on the ISDA Protocol).

3. Extraterritorial scope

The FS Bill purports to have extra-territorial effect, as it is not limited to contracts governed by UK law and applies to all UK supervised entities. This is tempered by express requirements for the FCA to have regard to the likely effect outside the UK when exercising its various powers delegated under the draft Bill. In particular, this applies to the FCA exercising its power of prohibition (Article 21A), exemption (Article 23C) and change of methodology (Article 23D).

There is an interesting question about the inter-relationship between the UK, EU and ARRC proposals (see our blog post: Legislating for LIBOR transition: UK/EU jurisdictional battle or complementary regimes?).  All three legislative solutions currently seek to have extraterritorial effect, not limiting themselves to contracts governed by their respective laws. This is of course subject to change; it is worth noting that the EU Council has responded to the draft legislation published by the European Commission with the suggestion that it should only apply to EU law contracts (or certain third country contracts, but only where the third country has not sorted out its own fix). Indeed, in circumstances where it is not clear what legislation will ultimately get passed, it is difficult for market participants at this stage to assess whether extra-territoriality is a good thing or not.

It is possible that the regime applicable to a particular contract will not ultimately change the new rate that is applicable on the cessation of LIBOR, if the successor rates adopted for each currency of LIBOR are consistent (e.g. that the UK, EU and ARRC transition a USD LIBOR contract to SOFR plus a spread adjustment). However, it is entirely possible that the successor rates adopted will not be the same, particularly taking into account differing approaches to the calculation of the successor rate (e.g. whether it is a compounded RFR in arrears rate plus a spread, or a forward looking rate plus a spread). Of course, the calculation of the credit spread adjustment may also be different, although currently this appears less likely.

4. Safe harbour

The debate surrounding the inclusion of “safe harbours” in the legislative solutions for LIBOR cessation provided by the different jurisdictions, is complicated by a lack of clarity as to what is meant by these words. The phrase “safe harbour” is generally used to mean that a party affected by the legislation in question is protected from a particular type of civil claim. In the context of LIBOR cessation, the spectrum of potential claims is broad, as set out in our first article on the risks of LIBOR cessation, dating back to early 2019.

The FS Bill in and of itself seeks to prevent claims as to the continuity of LIBOR-linked contracts, by securing the continued publication of a rate which meets the contractual definition of LIBOR. However, it is noteworthy that ARRC’s legislative solution contains an express and very widely drafted safe harbour provision, which is intended to encourage market participants to adopt the ARRC recommended rate, by offering protection from claims as a result of adopted the legislative fix. The European Commission has confirmed that it intends to include a safe harbour, but has not yet provided detail on the drafting.

As things stand, “forum shopping” between proposed legislative solutions seems a real possibility (in view of the differing approaches taken to the applicability, and potentially the substantive outcome, of the proposed regimes). Material inconsistency between the safe harbours offered by the regimes must surely also increase the risk of disputes arising in relation to the appropriate regime to choose.

5. Risk of challenge by way of judicial review

There is greater risk of challenge (for example by way of irrationality or other public law grounds) to delegated legislation, than primary legislation. It is therefore noteworthy that much of the detail of the UK’s legislative fix has been left to subsequent FCA policy. While this is unsurprising given the time pressures involved, it is potentially significant, because of the greater risk of challenge to the FCA’s policy statements which articulate the detail of the provisions.

There are a number of references to the fact that the FCA may only exercise its powers under the FS Bill where it is desirable in order to advance the FCA consumer protection objective or integrity objective (e.g. the FCA’s power to permit legacy use of the benchmark under Article 23C). This is of course derived from the FCA’s statutory operational objectives. However, the effect of the pre-condition in the UK’s legislative solution is to introduce a further discretionary exercise for the FCA to assess whether action is necessary to protect consumers and/or ensure market integrity. In turn, this could increase the risk for judicial review of the FCA’s exercise of its powers (as it provides an additional layer of decision/determination by the FCA that is subject to challenge).

6. Consistency with proactive transition

It is clearly not the intention of the authorities that the methodology change brought about by the legislative fix contained in the FS Bill should extend to legacy LIBOR contracts that have been actively amended bilaterally or by consent solicitation, or amended via market protocol. However this is not spelt out at present in the FS Bill, which is potentially unhelpful and contrary to the spirit of ongoing transition efforts.

Ensuring that this is ultimately avoided will need careful and precise drafting to define “tough legacy” in the FCA’s exercise of its regulatory powers.

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

Leaving LIBOR – the ISDA Protocol and Supplement

With LIBOR due to disappear by end-2021, work has been underway to facilitate the transition from LIBOR and other IBORs to alternative risk free rates (RFRs). The derivatives market has been at the forefront of the transition and is some distance further ahead than other financial markets. In particular, ISDA has recently published the 2020 IBOR Fallbacks Protocol and IBOR Fallbacks Supplement, which introduce hardwired fallbacks from IBORs to relevant RFRs for new products and legacy products.

Publication of these documents is a key milestone in the transition journey from IBORs to RFRs, and amounts to the starting gun being fired on what is expected to be a mass market wide repapering and amendment exercise as the market says goodbye to the old world of IBORs and welcomes the new world of RFRs. We expect clients will wish to enter into the IBOR Fallbacks Protocol to amend existing transactions, and to include the IBOR Fallbacks Supplement in new trades. In agreeing to do so, hardwired fallbacks from LIBOR to RFRs will be included in the transactions, which will clearly have a significant impact on those transactions and beyond. Clients are therefore well advised to give careful thought to the issues raised by these documents.

Our briefing (which can be found here) provides a detailed analysis of the two publications, including the issues they raise and how adherence to these documents will affect clients’ existing and future transactions.

Nick May
Nick May
Partner
+44 20 7466 2617
Harry Edwards
Harry Edwards
Partner
+61 3 9288 1821
Rupert Lewis
Rupert Lewis
Partner
+44 20 7466 2517
Clive Cunningham
Clive Cunningham
Partner
+44 20 7466 2278
Ceri Morgan
Ceri Morgan
Professional Support Consultant
+44 20 7466 2948

LIBOR Transition Status Update – October 2020

The cessation of the London Inter-bank Offered Rate (LIBOR) at the end of 2021 has long been an issue vexing the global financial services industry given the scale and geographic spread of exposures to the affected benchmarks across the currencies and terms in which it is published. As we reach what Andrew Bailey, Governor of the Bank of England, has called the “endgame”, we thought it would be useful to publish an update on the status of this transition. In our LIBOR Transition Status Update – October 2020, we draw together key recent developments in this transition and summarise the current status in the most impacted product markets at this critical juncture.

The publication can be accessed here: LIBOR Transition Status Update – October 2020.