It is widely recognised that despite best efforts, there will be a pool of ‘tough legacy’ LIBOR contracts and instruments that are impossible to transition to alternative rates in the required time frame, or at all.
As a result, working groups in the US, the UK and the EU have concluded that legislation is necessary to preserve the continuity of those LIBOR contracts that are impossible to transition to alternative rates by consensual means.
Legislative attempts to minimise disruption are welcome in principle, but should not invite complacency from LIBOR users. The circumstances in which the law will solve the tough legacy problem and how it will do so have not yet been finalised, but it is clear that legislation will come to the rescue only in limited and carefully defined circumstances.
This article outlines the legislative measures currently in train and the reasons why regulators and working groups continue to emphasise that parties to LIBOR-referencing contracts must not rely on the availability of a statutory ‘emergency backstop’, and take active steps to transition their contracts to alternative rates.
The Financial Conduct Authority (FCA) confirmed in March that while most USD LIBOR tenors will continue to be published until June 2023, all other LIBOR rates will either cease to be published or lose representativeness (‘pre-cessation’) at the end of this year.
Many contracts referencing LIBOR do not contain suitable fallback provisions, or contain no fallback provisions at all.
If such contracts are not amended to replace LIBOR with a suitable alternative in advance of the cessation or pre-cessation of the relevant LIBOR rates, the likely result is at best, disruption and confusion, and at worst, disputes leading to litigation.
LIBOR users are being urged to ensure all references to LIBOR that require replacement are amended in advance of the cessation or loss of representativeness of the relevant rates (and in the context of financial products, the financial sector is under significant pressure from regulators to get the job done).
In most cases, replacing LIBOR is not under the control of a single party, meaning effective transition arrangements are reliant on obtaining the required consents. This has been a concern, for example, in relation to LIBOR-linked floating-rate notes, where amendments may require majority or even unanimous noteholder consent.
Noteholders may not engage with consent solicitation requests or may withhold their consent, possibly with a view to obtaining better economic terms. There will also be a certain rump of LIBOR-referencing contracts that are not amended because the parties simply run out of time.
The policy objective behind legislating for LIBOR transition is to avoid the market disruption and disputes that might arise out of legacy LIBOR contracts that have not been updated with replacement rates.
However, it has proved challenging to define exactly which LIBOR references should be replaced by law, and exactly what should happen to them.
Faced with LIBOR references in many different contexts that might be replaced in many different ways, the policy objective of minimising disruption must be balanced against the risk of unintended or undesirable consequences.
The difficulties of legislating for LIBOR transition are quite apparent in UK, EU and US legislation, in that the primary legislation empowers regulators to develop and implement the solution, rather than prescribing replacement rates and related drafting for particular contracts and products.
This is why even now – when we know how each jurisdiction will, or plans to, legislate (see further below) – we cannot be certain yet precisely which contracts these laws will assist or precisely how they will do so.
Further, while the policy objectives are the same in each jurisdiction and the authorities have been coordinating, the legislative frameworks are inevitably somewhat different in terms of approach, giving rise to questions as to the interplay and interaction between them.
The UK’s proposal takes the form of amendments to the UK Benchmarks Regulation, contained in the Financial Services Bill currently before Parliament.
These amendments, in summary, empower the FCA to direct the continued publication of LIBOR currency/tenor pairs on a non-representative ‘synthetic’ basis for a specified period, yet to be determined.
The FCA has indicated that ‘synthetic LIBOR’ is likely to comprise a forward-looking term-rate version of the RFR in the relevant currency (for example, Term SONIA) plus a fixed credit-adjustment spread calculated on the five-year historic median basis.
Its availability is the subject of consultation, but as the FCA’s ability to exercise this power, among other things, depends on the availability of a robust methodology, synthetic LIBOR is only consideration for certain LIBOR settings.
Even where made available, the use of synthetic LIBOR in financial products will be controlled. FCA-regulated institutions will only be allowed to use synthetic LIBOR for the purposes of legacy products (not new business), where specifically permitted by the FCA.
The FCA will consult on the availability of, and uses for, synthetic LIBOR in the coming months.
While the use of synthetic LIBOR by financial institutions within the FCA’s remit will be restricted, the FCA does not have the ability to restrict its use between non-regulated parties, for example, for the purposes of a commercial contract that has not been updated to replace LIBOR.
This begs the question of how synthetic LIBOR might be used by such parties. Absent further legislation, in legacy contracts, the application of synthetic LIBOR would most likely be a matter of contractual interpretation on a case-by-case basis – ie, can the reference to LIBOR be read to refer to synthetic LIBOR?
In contrast to the US and EU proposals (see below), the Financial Services Bill does not contain a contractual continuity provision (whereby references to LIBOR in certain legacy contracts should be read, so are to refer to synthetic LIBOR) or a safe harbour provision (whereby the use of synthetic LIBOR would not of itself be a basis for a cause of action, liability or grounds for litigation).
This is in part due to the traditional reluctance of English law to disturb freedom of contract, but in this context is also linked to concerns that such protections might dis-incentivise active transition work.
However, having listened to market participants’ concerns and following consultation, the UK Government has recently indicated that legislation will be brought forward separately for this purpose, to protect parties to English law contracts.
The detail remains to be seen, but this will be an important issue for corporates to monitor, given the potential impact on English law LIBOR referencing contracts across the business, should they not be amended.
The EU has also chosen to deal with the tough legacy problem through amendments to the EU Benchmarks Regulation (on which the UK Benchmarks Regulation is based), although the amendments are different to those proposed to the UK version.
In February, the EU benchmarks were amended, essentially empowering the European Commission to designate a statutory successor to LIBOR in in-scope contracts via implementing acts.
The Commission is also left to designate conforming changes that are associated with, and reasonably necessary for, the use or application of the replacement rates. The Commission is obligated to take into account, and is expected to designate, replacement rates and credit adjustment spreads in line with relevant currency regulators and working groups.
The EU legislation is capable of applying to LIBOR rates in any currency.
All contracts referencing LIBOR without fallbacks or with unsuitable fallbacks (which is further defined in some detail) that are governed by the laws of an EU member state are potentially within scope.
The EU proposals are not limited to financial contracts that are regulated by the EU Benchmarks Regulation. The EU provisions can also apply to contracts governed by the laws of other jurisdictions, if both the parties are established in the EU and the relevant governing law does not have its own legislative solution.
Amendments to the EU legislation include a safe harbour, which provides for contractual continuity where the designated successor rates apply. This is less extensive than the safe harbour provisions under consideration in the UK, and which have been implemented in New York (see below).
Legislation designed by the Alternative Reference Rates Committee (ARRC) was signed into New York state law in April (the NY law). The NY law is relevant only to USD LIBOR contracts without effective fallbacks.
Although the New York legislation is not, on its face, limited to contracts governed by New York law, it is widely accepted that USD LIBOR contracts governed by another governing law (for example, English law or the law of another US state) would not fall within its scope.
However, the NY law may serve as a model for other state legislation or US federal legislation in due course.
The NY law requires the use of the benchmark replacement recommended by the Federal Reserve, the New York Fed or the ARRC where (i) the contract language uses LIBOR as a benchmark and contains no fallback provisions or is silent; or (ii) the contract’s fallback provisions prescribe the use of LIBOR (including by way of a poll or survey of lending rates).
The legislation does not, however, override existing contractual language that specifies a non-LIBOR based rate as a fallback to LIBOR (for example, the prime rate).
The NY law prohibits parties from refusing to perform contractual obligations or declaring a breach of contract as a result of the discontinuance of LIBOR or the use of a replacement, and establishes that the recommended benchmark replacement shall constitute a commercially reasonable substitute for, and a commercially substantial equivalent to, LIBOR.
It also provides a safe harbour from litigation for those that use the recommended benchmark replacement. Parties may, however, mutually opt out of any mandatory application of the proposed legislation at any time.
While it is anticipated that the recommended replacement rates and associated drafting will be in line with the ARRC’s various recommendations for certain products, the full shape of what is proposed is yet to be revealed.
As will be apparent from the above, the New York and EU approaches are different from each other and from the UK’s Financial Services Bill, and currently there remains significant uncertainty, pending further consultation by regulators.
An important question is whether the same replacement rates will be recommended by the authorities under each regime.
The key point for now is that even once all the details are ironed out, which may not be until quite late in the day, all three legislative solutions are limited in their scope. Their existence does not suggest that all relevant legacy contracts will be supported and they are not a substitute for active steps towards LIBOR transition.
The legislative solutions are best viewed as an emergency backstop that may be available (subject to a case-by-case consideration of their legal scope) to contracts that cannot be transitioned in time, or conceivably, that may have been overlooked.
LIBOR users are strongly encouraged to maintain control over the economics of their LIBOR-referencing contracts by pursuing negotiated amendments. The initial focus for many treasurers will be their LIBOR-referencing loans.
The recently published Association of Corporate Treasurers’ Borrower’s Guide to The LMA’s Recommended Forms of Facility Agreement for Loans Referencing Risk-Free Rates provides detailed guidance on the approach to LIBOR transition in the loan market and the replacement rates and contracts terms that are being put forward.
You can read about the US cash fallbacks position here
Kathrine Meloni is a special adviser and Eric Phillips is a professional support lawyer at Slaughter and May
Further ACT resources on the LIBOR transition can be found here: treasurers.org/hub/technical/libor.