This article was originally published on Banking Litigation Notes.
The UK’s Tough Legacy Taskforce (Taskforce) has issued a paper on “tough legacy” issues in the transition from LIBOR. In an important intervention, it has recommended a legislative fix for all asset classes and possibly all LIBOR currencies. The scope of the recommendation from the Taskforce is wider than many will have expected, but will be broadly supported by the market.
However, while the Taskforce has indicated its preference for a legislative solution of some kind, it is of course not within the gift of the Taskforce, or indeed the regulators, to provide this fix. Moreover, the Taskforce is at pains to point out that any legislative fix is not a solution that will achieve economic neutrality for the parties. By its nature, it would trigger a blunt amendment to contracts, which may not necessarily accord with the parties’ intentions and may not be appropriate. In this blog post we summarise the key conclusions of the Taskforce, discuss what this might mean in the context of litigation risk for LIBOR transition and consider the probable next steps.
What are “tough legacy” contracts?
The Taskforce is keen to emphasise that tough legacy contracts are those that do not have robust fallbacks and “cannot be dealt with in any other way”. The Taskforce has considered whether tough legacy contracts are likely to exist across the different asset classes in the UK affected by LIBOR transition, including: derivatives, bonds, loans (syndicated and bilateral) and mortgages.
Context and status of the tough legacy paper
To put the status of the paper in context, the Taskforce was set up by the Working Group on Sterling Risk-Free References Rate (RFRWG), to focus on tough legacy LIBOR issues. The RFRWG’s membership consists of a number of representatives from large financial institutions and buy-side market participants. Personnel from the Bank of England and the FCA are also ex-officio members. Accordingly, while the paper notes that the views and outputs of the Taskforce do not constitute guidance or legal advice from the regulators, this paper provides a very useful indication of the latest thinking on the status of preparations for LIBOR transition from both the regulators’ and the market’s perspective.
Publication of this paper has been eagerly anticipated since the beginning of the year, having been foreshadowed in the RFRWG’s roadmap for 2020 (see our blog post: LIBOR transition: litigation risk observations on suite of documents published by the regulators in January 2020). The paper on tough legacy contracts was one of the deliverables for the RFRWG identified in the roadmap. It was originally due in the second half of Q1 2020, but publication was delayed, primarily due to the COVID-19 pandemic.
Summary of conclusions
Case for action
The Taskforce has concluded that there is a “case for action” to consider how to address tough legacy contracts which extends to all asset classes and possibly all LIBOR currencies.
The Taskforce considered each asset class separately, noting that the strength of the case for action differs between them, depending on the contracts involved and the ability to amend the terms. However, while many contracts within certain asset classes will be able to successfully transition, this may be more difficult where:
- Contracts form part of complex transactions or arrangements, so there are linkages across different asset classes.
- Distribution of the product is broad (e.g. syndicated loans and bonds with a wide investor base) and there may be additional complications with obtaining the necessary consent.
- Retail counterparties are involved (particularly retail holders of mortgages or bonds).
The Taskforce explains that it has focused primarily on sterling LIBOR exposures. However, the group notes that exposures to US dollar LIBOR exceed the exposures to sterling LIBOR for UK market participants, and that English law is used extensively to govern financial contracts denominated in different LIBOR currencies. The paper therefore advocates for action to address English law tough legacy contracts denominated in any LIBOR currency.
The paper notes that the case for action has been strengthened by the market impact of the COVID-19 pandemic. While the deadline for the market to be ready for the cessation of LIBOR by the end of 2021 remains the same, there is less time available in practice to meet it.
Having found that there is a case for action for all asset classes, the paper proceeds to recommend that the UK Government considers legislation to address tough legacy exposures. However, the Taskforce recognises that there is no guarantee that such a solution will materialise, that it will materialise across all relevant legal jurisdictions, or that it would be available for all products and circumstances.
Further, it is important to bear in mind that a legislative fix will automatically determine the amendments that will be made to those contracts that are caught, whatever the economic consequences for the parties. This will have a significant impact on litigation risk (see below).
Alternative solution: synthetic LIBOR
The paper briefly, but interestingly, notes that an alternative solution of LIBOR being stabilised via a so-called “synthetic methodology”, at least for a wind down period following the end of 2021 or until primary legislation is enacted. This would require either an administrator willing to modify the methodology for LIBOR and/or potentially official sector intervention to modify it.
Impact on litigation risk
While the proposed legislative fix should have the effect of reducing the litigation risk for those contracts that are caught by a definition of “tough legacy” contracts, neither the working groups nor the regulators have the power to automatically transition tough legacy exposures. Primary legislation is required to be enacted by the UK Government. The Taskforce recognises the challenge of the Government legislating in the time available, particularly given the obvious need to cooperate across jurisdictions because of the global use of LIBOR. There also remain risks of significant divergence between the legislative measures introduced in different jurisdictions (notwithstanding attempts to cooperate, given local differences across products).
Further, even if legislation is forthcoming, much will depend on the drafting of the provisions to identify those contracts within particular asset classes that will be transitioned in this way and what the economic consequences will be. Even with a spread adjustment to account for the value transfer that arises from the automatic transition to the new reference rate (which would need to be carefully drafted in any legislation), a legislative fix is a blunt tool and the possibility of “winners” and “losers” is inevitable. This will provide a clear incentive for parties seeking to find loopholes in the legislation and challenge the power of the UK Government to effect such changes to private contracts. It is far from certain, at this stage, how this will play out. However, given the clear potential for any legislative fix to operate in a way that is not economically neutral, the risk of disputes arising as a result will not necessarily diminish with the introduction of primary legislation (even if contractual continuity is assured for some contracts).
The message from the Taskforce therefore remains very clear: LIBOR transition should primarily be achieved by active amendment, as this is the only way for parties to have certainty over their contracts and their economic effects. While this is sensible advice, it grates against the genesis and purpose of the paper – that there are some legacy contracts that do not have robust fallbacks and where it will simply not be possible to amend them ahead of LIBOR discontinuation. This highlights the very difficult line which is being trodden between encouraging proactive transition efforts and a safety net. In the absence of a legislative fix as that safety net, however, there is little doubt that the litigation risks remain very real (see our blog post: LIBOR is being overtaken: Will it be a car crash?).
The suggestion of synthetic LIBOR poses separate risks. First, in order for this solution to be effective, the existing reference rate provisions in legacy contracts would need to be capable of being interpreted to include synthetic LIBOR (without amendment). This will depend upon the contractual interpretation of individual contracts, in particular as to how LIBOR is defined. Second, the continued publication of a synthetic LIBOR (which does not sound dissimilar to the so-called “zombie LIBOR” concept) has the potential to increase litigation risk by making the value transfer occasioned by transitioning a given contract more transparent (i.e. more clearly identifying the winners and losers).
It will be critical to see if and when the UK Government takes up the recommendations from the Taskforce. This will be challenging given the many competing demands for its attention: in particular the COVID-19 pandemic and Brexit.
To date, no draft legislation has been published. If the UK is to follow the approach of the US, it is possible that a first draft will emanate from the Taskforce itself. In the US, the equivalent body to the RFRWG – the Alternative Reference Rates Committee (ARRC) – published the proposal for New York legislation to assist the transition of financial contracts away from US dollar LIBOR (see our blog post: LIBOR transition: What does the US regulator’s proposed legislative fix mean for UK financial markets?). While this would not be the usual procedure for development of primary legislation in this jurisdiction, against the current backdrop and with time moving on, the UK may choose to adopt a similar approach