The Financial Stability Board (FSB) has published its long-awaited report to the G20 on supervisory issues related to LIBOR transition. It follows a survey of the state of preparedness of regulators around the globe and presents its recommendations. Continue reading
In a recent decision, the Court of Appeal has confirmed that the terms of an English law facility agreement in respect of Tier 2 Capital, allowed the borrower to withhold payment of interest instalments where there was a risk of secondary sanctions being imposed on the borrower under US law. In the view of the Court of Appeal, this result effectively balanced the competing interests of the lender to be paid timeously against the borrower’s ability to delay making a payment where it would be illegal (in a broad sense of the word, and under a different system of law to the facility agreement) and therefore affect the borrower’s ability to conduct its ordinary business: Lamesa Investments Limited v Cynergy Bank Limited  EWCA Civ 821. Continue reading
The latest development in the Bank of England’s (BoE) attempts to support the adoption of SONIA in cash products – and to speed up the transition away from LIBOR-linked products – is the publication of its response to the consultation it conducted into the publication of a SONIA index: Supporting Risk-Free Rate transition through the provision of compounded SONIA: summary and response to market feedback (June 2020). Continue reading
The FCA and PRA yesterday published a joint statement setting out their key observations from the responses of major banks and insurers in the UK to the Dear CEO letters published in September 2018, which asked for details of the preparations and actions being taken by those firms to manage transition from LIBOR to alternative interest rate benchmarks (SONIA in the UK).
The statement confirms that the FCA and PRA have reviewed responses from those firms and provided feedback directly. In addition, given the market-wide nature of the issue, they have decided to publish a number of market-wide observations which they have made in the course of reviewing the responses to the Dear CEO letters. The FCA and PRA identify a number of critical elements which were present in “stronger responses” to the Dear CEO letters, which are summarised below and provide some helpful guidance for other firms affected by LIBOR discontinuation.
As repeatedly emphasised by the FCA and PRA, given the widespread use of and reliance on LIBOR, there are significant risks associated with transitioning from LIBOR to alternative risk free rates. We considered in some detail the potential litigation risks in our article published in the Journal of International Banking Law and Regulation: LIBOR is being overtaken: Will it be a car crash? (2019) 34 J.I.B.L.R..
The stated purpose of the Dear CEO letter was to seek assurance that firms’ senior managers and relevant governance committee(s) understand the risks and are taking appropriate action now. It is clear from the joint statement that there is real divergence across the market in terms of preparedness for LIBOR discontinuation. This latest communication is a further call to action from the FCA and PRA to ensure firms are properly prepared for the transition.
Good practice identified by the FCA and PRA for LIBOR transition
- Identifying reliance on and use of LIBOR beyond a firm’s balance sheet exposure and assessing (for example) whether LIBOR is present in the pricing, valuation, risk management and booking infrastructure firms use.
- Quantification of LIBOR exposures using a range of quantitative and qualitative tools and metrics, keeping the metrics up to date.
- Nominating a senior executive covered by the Senior Manager Regime as the responsible executive for transition, with clarity on the senior manager’s role in transition work.
- Developing a project plan for transition with sufficient granularity of detail, including key milestones and deadlines to ensure delivery by end-2021.
- Carrying out a detailed prudential risk assessment (subject to appropriate review and challenge), taking a broad view and considering all risks that could be relevant to a firm’s operations. Aligning identified risks with appropriate mitigating actions.
- Identifying a range of conduct risks, including management of potential asymmetries of information and the potential for conflicts of interest, when forming and reviewing transition plans. Again, aligning identified risks with appropriate mitigating actions.
- Planning and managing risks on the basis of LIBOR discontinuation at the end of 2021, rather than assuming that it will continue in some form thereafter.
- Demonstrating a good understanding of and involvement in with relevant industry initiatives.
- Proactively transacting using new risk free rates or taking steps to incorporate robust fallback language.
In a speech given on the same date this feedback was published, Dave Ramsden (Deputy Governor for Markets and Banking at the Bank of England) made clear that regulatory scrutiny in relation to LIBOR transition will continue:
“More generally, I only see the level of supervisory engagement on this topic intensifying to make sure firms are ready for end 2021. The response to the Dear CEO letter provides a basis for this engagement to continue.”
Firms (whether recipient of the original Dear CEO letter or not) should therefore reflect carefully on the published feedback. No doubt it will also be of interest to firms considering benchmark transition issues in other jurisdictions, notably in Hong Kong and Australia where the regulators have similarly asked firms to confirm their preparedness.
The Working Group on Sterling Risk-Free Reference Rates (RFRWG) has published a further statement on the impact of COVID-19 for firms’ LIBOR transition plans.
The latest statement follows the earlier joint statement made by the FCA, Bank of England and RFRWG on 25 March 2020, in which the regulators set out their initial response to the impact of COVID-19 on transition plans.
In this blog post we consider the specific delays to interim LIBOR transition milestones that have been announced, the likely effect such delay is likely to have on loan market LIBOR transition and how this may impact the profile of the associated litigation risks.
Overarching theme of the regulators’ COVID-19 impact statements
Both of the statements published by the regulators/working group, emphasise that the deadline for LIBOR cessation remains fixed for end-2021 and firms cannot rely on LIBOR being published after that date, notwithstanding the impact of COVID-19 on firms’ steps to prepare for that event. The regulators are working with the RFRWG and its sub-groups and task forces to consider how all firms’ LIBOR transition plans may be impacted.
However, recognising the reality at least in the short term, it is clear that some interim transition milestones may be delayed. The most recent communication announces the first key date to be affected.
Delay to key interim milestone in the loan market
The first key interim LIBOR transition milestone to be affected by COVID-19 is the deadline by which the cash market is recommended to stop issuing LIBOR linked loans. That deadline was originally the end of Q3 2020 but has now been pushed back to the end of Q1 2021.
The RFRWG’s current timetable as to the use of LIBOR-linked loan products is now as follows:
- By the end of Q3 2020 lenders should be in a position to offer non-LIBOR linked products to their customers;
- After the end of Q3 2020 lenders, working with their borrowers, should include clear contractual arrangements in all new and re-financed LIBOR-referencing loan products to facilitate conversion ahead of end-2021, through pre-agreed conversion terms or an agreed process for renegotiation, to SONIA or other alternatives; and
- All new issuance of sterling LIBOR-referencing loan products that expire after the end of 2021 should cease by the end of Q1 2021.
The regulators have repeatedly acknowledged that the loan market has made less progress in transitioning away from LIBOR than other markets. This led to various initiatives earlier this year to accelerate change, with an emphasis on steps to alleviate some of the difficulties which were faced in the cash markets: The Bank of England’s attempts to “turbo-charge” LIBOR transition in the cash markets: will these increase or decrease the litigation risks? In particular, the Bank of England announced the publication of a SONIA-linked index from July 2020 to support market participants to cease issuing LIBOR-based cash products (maturing beyond 2021). It is therefore perhaps not surprising that the first interim milestone to be relaxed is in that market.
Impact on loan market LIBOR transition
Given that one of the most important drivers to move the cash market to new risk free rates (RFRs) is to stop writing new loans linked to LIBOR, the RFRWG’s decision to delay this particular milestone is significant, though not surprising given the pressures that both lenders and corporates find themselves under as a result of COVID-19.
While there was significant impetus from both lenders and corporates behind a movement to RFRs in the loan markets in Q1 of 2020 (for example British American Tobacco signed a USD 6bn revolving credit facility linked to both SONIA and SOFR in March – see this press release), which will be further boosted by the publication of central bank indices, there has been an understandable hiatus as the impact of COVID-19 has been felt. The issues around market conventions for compounding, and the development of new loan and treasury management systems to support RFR loans, have not yet been resolved, nor has the calculation been fully settled of the credit spread above the RFRs to ensure that the transfer is value neutral. Once the immediate impact of COVID-19 has abated, attention will need to be turned to these once again.
During the extension period (i.e. the six-month period from the original deadline of end-Q3 2020 to end-Q1 2021), the RFRWG’s guidelines state that all new and re-financed LIBOR-linked loans should include a robust fallback mechanisms to enable transition to SONIA (or other alternatives) when LIBOR ceases. For example, through pre-agreed conversion terms or an agreed process for renegotiation.
Profile of litigation risks: impact of delay
Most loans currently being issued include more robust fallbacks of the kind envisaged by the RFRWG’s guidelines (i.e. including an agreed process for renegotiation when LIBOR ceases). However – importantly – the deadline relaxation will mean a further six months’ worth of facilities being written in LIBOR, which will increase the overall volume of LIBOR-linked loans in the market when the benchmark ceases.
The particular risks associated with fallbacks based on a requirement to renegotiate at the time of LIBOR cessation fall broadly within two categories:
- Commercial difficulties. An agreed process for renegotiation will only take participants so far: each transaction will still need to be amended on a deal-by-deal basis, though the LMA hopes that its exposure draft form of reference rate selection agreement will smooth this process in some cases. Accordingly, the way in which negotiations unfold on a loan by loan basis will reflect the relative bargaining strengths of the parties at that time.
- Practical difficulties. Continuing to increase the volume of loans which will subsequently require renegotiation upon the cessation of LIBOR (on top of legacy loans) will increase the practical challenges firms will face, and the time and cost burden, particularly for those with large books of bilateral loan facilities.
In summary, while pushing this interim milestone back by six months may provide some welcome breathing space in the cash market in the short term, it is not without cost. It will almost certainly increase the challenges firms face in the next stage of the process to achieve LIBOR transition in this market by the fixed deadline of end-2021. It is unlikely that this is the last adjustment to that timetable which will need to be made.
The past week has been important for developments in LIBOR transition, particularly for the cash markets where progress has hitherto been less advanced than other markets.
On 26 February 2020, the International Swaps and Derivatives Association (ISDA) and Securities Industry and Financial Markets Association (SIFMA) hosted a joint conference on benchmark reform in London. One of the most important speeches at this event was given on behalf of the Bank of England (BoE) by Andrew Hauser: Turbo-charging sterling LIBOR transition: why 2020 is the year for action – and what the Bank of England is doing to help.
So what is the BoE doing to accelerate the transition? It seems the answer is to offer both “carrots” and “sticks” to encourage the transition of financial products from LIBOR to SONIA. In a nutshell, the BoE has announced measures:
- Supporting the adoption of SONIA in cash products by simplifying the calculation of compounded interest rates by agents through the publication of a SONIA-linked index from July 2020;
- Acknowledging the market’s desire to go a step further by agreeing to consult the potential publication of daily “screen rates” for specific period averages of compounded SONIA which would avoid agents having to perform any calculation at all; and
- Penalising firms which continue to hold LIBOR assets by October 2020, by increasing haircuts on LIBOR linked collateral when using the BoE’s funding window, if that collateral remains LIBOR-linked.
These measures are explained further below, together with a discussion as to how these developments are likely to be received by the market, and how they might alter the profile of the litigation risk faced by financial institutions and other corporates given the impact on ease, certainty and necessity of transition.
1. BoE to publish compounded SONIA-linked index from July 2020
The BoE intends to publish a compounded SONIA-linked index from July 2020. It has said that this will complement its existing publication of the overnight SONIA rate and the index will provide a flexible tool to help market participants construct compounded SONIA rates in an easy, consistent and flexible way. The stated intention of the BoE is to support market participants to cease issuing GBP LIBOR-based cash products (maturing beyond 2021) by Q3 of 2020. This is the deadline set by the UK Risk Free Rate (RFR) Working Group in its roadmap for 2020 – see our banking litigation blog post for further discussion of the 2020 roadmap and the accompanying suite of documents published by the regulators and working groups at the beginning of this year.
The BoE has celebrated the speed with which SONIA has become the default reference rate of choice for floating-rate notes and securitisations (which are predominantly wholesale transactions), but recognises that replicating this success in the bilateral and syndicated loan market is a different challenge. It is understood that one of the challenges to widespread adoption is the practical difficulty of calculating compounded SONIA rates in a simple and consistent way that can easily reconcile with the overnight SONIA rate published by the BoE. For example, to calculate the compounded interest rate for a three month period requires approximately 60 data inputs (the overnight SONIA rates for each working day of the interest period) and there are a number of different ways in which the precise calculation can be performed that might create difficulties without universal acceptance of established conventions.
It is to overcome this (primarily operational) challenge, that the BoE plans to publish a “golden source” SONIA-linked index from which bespoke rates can more readily be calculated.
2. BoE consultation on publication of daily “screen rates” for specific period averages of compounded SONIA rates
The BoE recognises that some market participants are calling for it to go a step further and publish daily “screen rates” for one or more specific period averages – for example 6-month, 3-month or 1-month compounded SONIA rates – so that the agent need perform no calculation at all; it can simply use the relevant screen rate. It is therefore consulting on whether there is sufficient market consensus on which set of period averages it should publish as screen rates, or whether the number of different screen rates which would need to be published to meet the market’s needs would create the risk of confusion and undermine the very certainty which the BoE is seeking to achieve.
In our view, while the index is helpful, it is the BoE’s second initiative to consult on publishing a daily “screen rates” for specific period averages which is what the market really wants and needs. The need for a term replacement remains as strong in the market as ever, and the comments from the BoE underline the regulatory commitment to force the transition, irrespective of the state of market readiness, and so the development of a term replacement will continue to rest with the market.
Even if ultimately the BoE decides only to publish a SONIA-linked index, this represents a step forward in terms of helping the bilateral and syndicated loans market move to using RFRs. A number of the barriers to the Loan Market Association (LMA) producing a RFR facility agreement, or even a hard-wired fallback to RFR document, stem from the fact that the market has not yet agreed on the method of calculation of the compounded average RFR. This proposal from the BoE largely dispenses with these concerns, aids standardisation and provides a screen rate for agents to use, assuming the market is willing to accept a single standardised source calculated on this basis.
In terms of litigation risk, the simple point is that if publication of the SONIA-linked index (or daily screen rates for specific period averages) reduce the volume of new cash products written in LIBOR, then that will mean a reduction in the volume of risky LIBOR-linked products in existence on cessation of LIBOR.
However, a number of questions still remain. In particular, even if the operational challenges are removed by publication of a SONIA-linked index (or daily screen rate) in order for parties to transition legacy LIBOR-linked contracts to SONIA, they will have to agree the quantum of the spread adjustment which mitigates or eliminates the value transfer between them. As discussed in our article in the Journal of International Banking Law and Regulation on the types of litigation which may arise on LIBOR discontinuation, there is no procedure to amend legacy loan facilities on an industry-wide basis and there are clear obstacles for achieving effective adoption of revised fallbacks on a bilateral basis. As such there still remains a risk of significant volumes of legacy loan facilities which are not amended before LIBOR cessation takes place, notwithstanding this development.
3. BoE to increase haircuts on LIBOR-linked collateral it lends against from October 2020
And so to the stick. The BoE currently makes funding available to firms as part of its normal market operations against a wide set of eligible collateral, but applies a “haircut” to that collateral to protect against possible falls in its value in the period between a counterparty default and collateral sale.
The current average haircut is just under 25%, but from Q3 2020 the BoE will progressively increase the haircuts on LIBOR-linked collateral – increasing to 35% in October 2020, to 65% in June 2021 and, at the end of 2021, to 100% (i.e. effectively rendering such collateral ineligible). In addition, LIBOR-linked collateral issued after October 2020 will be ineligible for use.
The BoE says this graduated approach will give firms the time they need to replace that collateral with RFR alternatives, ensuring their borrowing capacity is maintained while also protecting public funds. The intended effect is clear, the higher the haircuts the less attractive the collateral, and so this step is likely to further wean firms from holding stocks of LIBOR linked assets and continue the evolution towards RFRs.
This development presents an interesting and novel litigation risk in relation to LIBOR discontinuation for market participants. If firms are unable to transition a sufficient amount of their book of LIBOR-linked products to SONIA in time, then it will affect their borrowing capacity at the BoE. Given that the BoE’s lending operations are designed to provide liquidity support to market participants experiencing either a predictable liquidity need or responding to an idiosyncratic or market wide liquidity shock, impairing the availability of effective liquidity at a possibly critical moment for firms could be significant.
The International Swaps and Derivatives Association (“ISDA”) announced yesterday that it will re-consult on how to implement pre-cessation fallbacks in derivatives contracts. This is an important development for financial institutions with large books of legacy LIBOR-linked products. Continue reading
A suite of documents relating to LIBOR transition were published recently by the regulators and various working groups. In their recent blog post, our FSR colleagues have helpfully summarised the key milestones for transition and regulatory expectations noted in these papers, highlighting comments from the FCA and PRA that they intend to make use of their supervisory powers if firms are seen to be falling short of their expectations on transition.
The latest publications build on the warning given by the FCA at the end of 2019 about conduct risks during LIBOR transition and proposed next steps, as discussed in our banking litigation blog post. The momentum of the regulators has clearly been building over recent weeks, ramping up efforts to engage both the sell-side and the buy-side on preparedness for LIBOR transition.
In this blog post, we set out our observations on the recent documents which have been released, offering some insight into the approach the regulators are taking on key issues such as so-called “tough” legacy contracts, term SONIA and the level of engagement expected from banks.
Tough legacy contracts / legislative fix
We commented in our December 2019 blog post that there has been some degree of variance between the various speeches from the regulators on what assistance (if any) the market can expect in relation to tough legacy contracts, particularly in relation to some form of legislative fix. The FCA has previously hinted that there would be a consultation on the possibility of legislation, but to date there has been no sign of anything in the pipeline.
However, seemingly buried in the large volume of documents published by the regulators and working groups is confirmation that a formal paper is due to be published which looks specifically at this issue.
The UK Working Group on Sterling Risk Free Reference Rates (RFRWG) has published a roadmap for 2020. One of the deliverables for the RFRWG which is identified in this roadmap is a paper to be published on tough legacy contracts in the second half of Q1 2020. We are hopeful that this will contain some more details as to how the regulators and working groups suggest the market should deal with tough legacy contracts, including the possibility of primary legislation. While the RFRWG notes that its views and outputs do not constitute guidance or legal advice from the regulators, the Bank of England and the FCA are each ex-officio members of the working group and so this paper is likely to indicate the desired approach to tough legacy contracts from the regulators’ perspective.
The regulators have repeatedly emphasised that the market (particularly the loan market) should not hold out for a term SONIA rate in order to transition away from LIBOR. This message is reiterated in the latest suite of publications.
However, there seems to be some acceptance of the reluctance/refusal of some market participants to move from a forward-looking term rate to a compounded in arrears rate. This can be found in the RFRWG road map, which has prioritised the publication of the live term rate for SONIA in the early part of Q3 2020, ahead of the target to cease issuance of GBP LIBOR-based cash products (maturing beyond 2021) by the close of the same quarter.
Level of engagement expected from banks
One of the key messages from the recent publications is that firms should engage proactively with their clients. However, what the regulators mean by “engagement” is not entirely clear. Presumably it means making sure that clients are aware of the risks of new/existing LIBOR-linked contracts, but the expectations of the regulators are not clear. An interesting example of this can be seen in the decision tree on page 11 of the RFRWG paper on Use Cases of Benchmark Rates: Compounded in Arrears, Term Rate and Further Alternatives (again, although the decision tree was published by the working group, it is likely to give an indication of the regulators’ stance).
The decision tree suggests that – where the use of compounded SONIA in arrears is not appropriate – all customers should explore alternatives (such as SONIA term rate, BoE base rates or fixed rates) with bank “advisers” to find a replacement to LIBOR which meets the customer’s needs. This excludes large corporates where the transaction size is £25 million or greater (for which the decision tree suggests the compounded rate would be appropriate), but appears to apply to all other customers (including mid/large corporates).
It is unclear what is meant by reference to bank “advisers” in the decision tree and this loose language may be problematic from a litigation risk perspective. This issue is not limited to a question of language or terminology – the role that the banks are being asked to fulfil by finding a LIBOR replacement to meet the “customer’s needs” reflects a similar mindset.
In a civil litigation context, there is an important distinction between a bank which sells a financial product on an execution-only basis, and one which enters into an advisory relationship with a customer. In an execution-only relationship, the bank will usually only owe a duty not to negligently misstate (i.e. not to provide incorrect information about the product), whereas the duties imposed on a bank in an advisory relationship will be broader (e.g. they may extend to whether or not the product is suitable for the client). The type of loss recoverable by a customer will also depend upon whether the bank simply provided information or advice (applying the SAAMCO principle from the case of South Australia Asset Management Corpn v York Montague Ltd  AC 191).
For LIBOR-linked products which were sold on an execution-only basis, any suggestion that the process of switching such products away from LIBOR could result in the bank acting in an advisory capacity, assuming a wider scope of duties and potentially exposing the bank to greater recoverable losses, is likely to be met with significant resistance by financial institutions.
Over the past couple of weeks, the FCA has released two important communications in the context of the discontinuation of LIBOR, which is expected to cease after end-2021. Continue reading