Partners Paul Brehony, Abdulali Jiwaji, Head of Knowledge and Legal Services Johnny Shearman, and Associate Ligia Bob examine in PLC Magazine the transition from LIBOR to alternatives and how businesses must act now to reduce risks and exposure in relation to potential LIBOR-related litigation.
This article was first published in PLC, 25 February 2021. A link to the article on the PLC Magazine website can be found here.
|The Financial Conduct Authority announced in July 2017 that, after 2021, it would no longer expect panel banks to submit the rates required to calculate the London Interbank Offered Rate (LIBOR), in anticipation of transitioning to an alternative system. Beyond this date, LIBOR, which exists in five currencies and seven borrowing periods, and is used in calculating floating or adjustable interest rates for numerous financial products, is likely to be consigned to the history books. Various alternative reference rates, also called risk-free rates (RFRs), have been identified as replacements for LIBOR. The Working Group on Sterling RiskFree Reference Rates, which was convened by the Bank of England to identify the preferred risk-free rate for sterling markets, recommended the Sterling Overnight Index Average (SONIA) benchmark as its preferred RFR. While great strides have been taken to ensure that RFRs provide a real alternative to LIBOR, the LIBOR transition still represents one of the greatest and most complex challenges for financial institutions in recent years.
Legacy contracts are those that reference LIBOR but are due to expire after the 2021 cessation date. These contracts may not perform as expected both when LIBOR ends, and potentially before that, because liquidity in LIBOR-referenced instruments is likely to decline and there may not be sufficient transaction-based submissions to LIBOR in the future for the rate to remain representative of the underlying market.
For the large part, legacy contracts were entered into at a time when the parties did not foresee a permanent discontinuation of LIBOR and the drafting of these contracts reflects that. Therefore, converting legacy contracts is not simple and, while conversion may be possible, it is likely to give rise to a number of financial and legal implications for the contracting parties. A company may have thousands of contracts that need to be assessed, which may be found across numerous electronic file systems and hard copy records. Technology solutions, such as electronic discovery software and artificial intelligence, can help tackle some of the problems that organisations face when trying to get to grips with the scale of the challenge before them.
There will be many companies that are already deep into a LIBOR transition programme. However, for those companies that are not, the time to act is now. The first step is to run a comprehensive impact assessment considering how and where LIBOR is used in the business. This will be highly business-specific and depend on the financial products in use. The assessment should identify relevant counterparties and include a review of: the expiry date of the relevant contracts; cessation triggers and fallback provisions; economic and litigation risks of existing fallbacks; exposure to different triggers and timings; and exposure to differing currencies and regulatory regimes. From this assessment, companies should not only determine the financial exposure that the business faces, but also take into account other considerations, such as accounting and tax issues.
Some say only two things in life are guaranteed: death and taxes. But there are actually three: death, taxes and the end of LIBOR (the London Interbank Offered Rate). This phrase, coined by John Williams, President and Chief Executive Officer of the Federal Reserve Bank of New York, illustrates the inevitability of the end of LIBOR, irrespective of the significant upheaval that this will cause.
The Financial Conduct Authority (FCA) announced in July 2017 that, after 2021, it would no longer expect panel banks to submit the rates required to calculate LIBOR, in anticipation of transitioning to an alternative system (www.fca.org.uk/news/speeches/the-future-of-libor). Beyond this date, LIBOR, which exists in five currencies and seven borrowing periods (from overnight to one year), and is used in calculating floating or adjustable interest rates for numerous financial products, is likely to be consigned to the history books.
While LIBOR is a benchmark rate that is administered and regulated in the UK, it is used globally and therefore its replacement is set to have a global impact. The value of outstanding contracts that use LIBOR is potentially huge and is widely estimated to be in excess of $350 trillion.
This article discusses:
- The LIBOR manipulation scandal that underlies the LIBOR transition.
- Alternatives to LIBOR, such as risk-free rates (RFRs).
- The problem of legacy LIBOR contracts.
- Possible technology solutions, such as the use of electronic disclosure software and contract management tools.
- The actions that companies should be taking to reduce the risk of LIBOR-related litigation.
In 2012, following a large-scale global investigation, it was found that bankers at major financial institutions had colluded with each other to manipulate LIBOR for profit during the global collapse of the financial markets in 2008 and, in some instances, before then (see box “LIBOR manipulation”). Many leading banks were implicated in the scandal, such as Deutsche Bank, Barclays, Citigroup, JPMorgan Chase and The Royal Bank of Scotland (see News briefs “RBS, LIBOR and another fine: the FSA broadens its approach”; and “LIBOR conviction: a watershed in the saga?”). In the UK alone, the FCA fined nine financial institutions over £757 million collectively for LIBOR-related misconduct. The global probe into the banking industry’s alleged interest rate manipulation kicked off with the investigation of Barclays by the FCA’s predecessor, the Financial Services Authority (FSA), in 2010. Following that investigation, Barclays became the first bank in the UK to be fined. In total, Barclays was fined £290 million by UK and US authorities collectively over rate-rigging activity. Subsequently, other major banks in the UK were also penalised by the regulators. As a result, questions were raised as to LIBOR’s viability as a credible benchmark rate. In response, the government asked Martin Wheatley, then managing director of the FSA, to review LIBOR and, in September 2012, he delivered his independent review and recommendations (www.practicallaw.com/8-521-9513).
Mr Wheatley’s suggestions for reform included scrapping LIBOR altogether and replacing it with a borrowing rate based on actual trades that should be overseen by a new independent body rather than the British Bankers Association (BBA). He also recommended criminal sanctions specifically for the manipulation of benchmark interest rates. The government accepted his recommendations, which were later implemented through legislation (www.practicallaw.com/8-526-6482). The FCA took away responsibility for LIBOR supervision from the BBA and turned it over to the Intercontinental Exchange’s Benchmark Administration (IBA), an independent UK subsidiary of the private US-based exchange operator.
As well as the fines, regulatory reviews and reforms that followed in the aftermath of the LIBOR scandal, civil claims against participating banks were not far behind. Predominantly, these claims were based on allegations relating to the sale of LIBOR referenced derivatives. Recent cases, such as Property Alliance Group Limited v The Royal Bank of Scotland PLC, have involved allegations of fraudulent misrepresentation and dishonesty on the part of banks ( EWCA Civ 355; see News brief “Mis-selling and LIBOR: Court of Appeal test case”).
The courts have, in those cases that have not settled, generally ruled in favour of the banks. However, in doing so, the courts have clarified that banks may still be liable for statements made when selling financial products. For example, in Property Alliance Group, the Court of Appeal held that when a bank enters into a LIBOR-related product with a customer, there is an implied representation on behalf of the bank that it is not manipulating LIBOR at the same time.
Limitation periods are likely to prevent many similar claims from now being pursued but there may be some circumstances where this issue can be overcome. However, even if limitation can be addressed, these cases are highly fact-specific and, as demonstrated by the court rulings to date, there is only a narrow scope for claimants to successfully argue that the banks have breached their obligations.
Despite the LIBOR scandal, the fines, the civil claims, and the fact that the underlying market LIBOR measure is no longer as liquid as it was previously, LIBOR has remained the dominant interest rate benchmark, underpinning trillions of dollars of financial contracts.
Various alternative reference rates, also called RFRs, have been identified as replacements for LIBOR. The Working Group on Sterling Risk-Free Reference Rates (the working group), which was convened by the Bank of England to identify the preferred risk-free rate for sterling markets, recommended the Sterling Overnight Index Average (SONIA) benchmark, which is administrated by the Bank of England, as its preferred RFR.
Since the announcement to transition away from LIBOR, the FCA and the Bank of England have been working with financial institutions, through the working group, to support the switch to suitable RFRs. In a short time, great strides have been taken to ensure that RFRs provide a real alternative to LIBOR. There have been several measures introduced that firms have been encouraged to follow to ensure that they remove any dependencies on LIBOR by the end of 2021.
For example, on 28 September 2020, the Bank of England and the FCA issued a statement encouraging market makers and interdealer brokers to switch from quoting LIBOR to SONIA as a default price for sterling swaps as of 27 October 2021 (www.bankofengland.co.uk/news/2020/september/fca-and-boe-joint-statement-on-sonia-interest-rate-swap). More recently, in January 2021, the working group indicated that by the end of the first quarter of 2021 banks should cease the initiation of new LIBOR-linked loans, bonds, securitisations and linear derivatives that expire after the end of 2021 (www.bankofengland.co.uk/-/media/boe/files/markets/ benchmarks/rfr/rfr-working-group-roadmap.pdf).
Nevertheless, the transition away from LIBOR arguably represents one of the greatest and most complex challenges for financial institutions in recent years. At its most basic, this is because, since the 1970s, banking systems have been built around LIBOR and this alone creates difficulties when switching to alternative RFRs, which are calculated in a fundamentally different way. Undoubtedly, the LIBOR transition gives rise to numerous challenges for all stakeholders, from banks and multinational organisations to SMEs.
For example, market infrastructure remains geared towards LIBOR and therefore accounting techniques and software are underdeveloped for use with RFRs. In addition, liquidity in the RFR market is likely to be a restraining factor on the move away from LIBOR, especially early on after the end of the transition. However, what represents perhaps one of the most significant complications is that the vast majority of contracts that reference LIBOR have not been drafted with any fallback provisions to deal with the permanent discontinuation of the rate (see “The legacy problem” below).
It is clear that the COVID-19 pandemic has had an impact on the LIBOR transition, which the FCA acknowledged during the course of 2020, and especially so in the case of the loan market (www.fca.org.uk/news/statements/further-statement-rfrwg-impact-coronavirus-timeline-firms-libor-transition-plans). However, despite the additional challenges presented by the pandemic, the UK regulators remain steadfast that there will be no change in the timetable and that LIBOR will cease at the end of 2021.
The picture around the globe is more opaque. The IBA, as the authorised and regulated administrator of LIBOR, has announced that it intends to delay, until June 2023, ceasing to publish the most widely used tenors of US dollar LIBOR. This delay has been welcomed in the Middle East and some parts of Asia due to the close links these regions have to the US dollar. In addition, while the proposed RFR for US dollar LIBOR is the Secured Overnight Financing Rate (SOFR), concerns have now been raised as to its adequacy, partly due to sudden fluctuations in value. As a result, there is now some dissent among market participants using US dollar LIBOR, with many championing the American Interbank Offering Rate (AMERIBOR) as an alternative.
The Legacy Problem
On 15 July 2019, Andrew Bailey, then Chief Executive of the FCA, delivered a speech at the LIBOR transition briefing in New York, saying that the LIBOR transition is not just about new business but about converting outstanding, or legacy, LIBOR contracts (www.fca.org.uk/news/speeches/libor-preparing-end). Legacy contracts are those that reference LIBOR but are due to expire after the 2021 cessation date (see box “Tough legacy contracts”). This messaging was critical then, and it remains so now, as contracts relying on LIBOR may not perform as expected both when LIBOR ends and potentially before that because:
- Liquidity in LIBOR-referenced instruments is likely to decline.
- There may not be sufficient transaction-based submissions to LIBOR in the future for the rate to remain representative of the underlying market.
For the large part, legacy contracts were entered into at a time when the parties did not foresee a permanent discontinuation of LIBOR or the above risks, and the drafting of these contracts reflects that. Therefore, converting legacy contracts is not simple and, while conversion may be possible, it is likely to give rise to a number of financial and legal implications for the contracting parties.
There may be instances where legacy contracts contain fallback provisions that provide for circumstances where LIBOR is unavailable. To be robust, these provisions will need to specify:
- The trigger event to prompt transition to a replacement.
- The replacement rate.
- The spread adjustment, or pricing gap, to align the replacement rate with the benchmark LIBOR rate that it replaces.
To ensure a smooth transition, the language used in the contract must be unambiguous and provide a clear and workable way to transition to an alternative rate.
However, it is unlikely that fallback provisions will exist in contracts drafted without LIBOR cessation in mind: for the most part, those executed before the FCA’s announcement in 2017. Even if these contracts contain fallback provisions, they are unlikely to have been drafted to accommodate a permanent cessation, but rather an interim solution that was typically intended to apply over a short period of time should LIBOR be temporarily unavailable, such as, for example, because of a technology outage. Therefore, relying on these provisions to navigate permanent LIBOR cessation may well have unintended consequences. For example, a rate may default to a historic screen rate, effectively turning a variable rate to fixed one. The result may be particularly economically undesirable for one party when applied in the long term.
Where the contractual fallback provisions leave the position unclear, open to interpretation or plainly more advantageous to one party in circumstances where it is clear that this had not been the parties’ intention or even an accepted risk when drafting, the risk of a dispute arising is a real one, should the parties fail to pre-emptively address these uncertainties in a constructive manner.
Transfers to RFRs
Where legacy contracts can be transferred to an RFR, either through an appropriate fallback provision or a renegotiation, issues may still arise as a result of the differing methodologies used for calculating LIBOR as compared with RFRs. In short, LIBOR is a forward-looking rate, which means that the amount of interest payable is known from the start of the interest period. SONIA, by comparison, is an overnight backward-looking rate, which means that the interest payable will not be known until the last day of the interest period. This means that parties lose cash flow certainty. Therefore, as the working group has acknowledged, there are many products for which RFRs may not be appropriate. These include export finance, mid-corporate, private banking, retail and working capital products.
In addition, the spread between LIBOR and RFRs will vary, with LIBOR generally exceeding RFRs. Unfortunately, there is no magic formula to identify what constitutes the extra spread. To address this, the FCA has indicated that a fair way to approximate the expected future difference between LIBOR and RFRs from the point of LIBOR cessation, is to take a historical median of that difference (www.fca.org.uk/publication/policy/consultation-exercise-fca-powers-new-article-23d.pdf). The median will sometimes be below or above the actual market prices on any given day before LIBOR cessation. However, in times of market turbulence, LIBOR and RFRs can behave very differently and the extra spread can fluctuate significantly.
In spring 2020, for example, as financial markets reacted to the impact of COVID-19, the spread between LIBOR and SONIA moved substantially above the then five-year historical median. Shortly after, the spread then moved below the five-year historical median due to various market factors. An alternative approach is to transfer to the Bank of England’s monetary policy rate, known as Bank Rate, plus a spread.
An obvious solution would be to adopt forward-looking term RFRs. These are rates that use an overnight RFR as the basis for a term rate that is set for a predetermined period, such as three months. One way in which this may be done is by using the prices of derivative instruments that reference the RFR to infer the market’s expectation of the average value of the RFR over a particular period of time.
While transitioning to RFRs is the overall aim, regulators have recognised that some stakeholders in the cash markets may need term RFRs. This is because they afford greater certainty of cash flow, particularly for retail and corporate end users, which will include many SMEs. However, there remains a lack of liquidity across term RFRs and, while several companies have proposed term RFRs, each is calculated differently. Therefore, as matters stand, there is still some way to go before there is a range of market-accepted term RFRs.
Ultimately, in the UK at least, it is up to market participants to determine when and how to transition ahead of the LIBOR cessation date. Parties to contracts linked to LIBOR will have to tackle the issue of unpredictable transfers of value, which may mean that converting a legacy contract proves to be more financially advantageous for one party.
The FCA has stressed that the LIBOR transition should not be used to move customers with continuing contracts to replacement rates that are expected to be higher than LIBOR would have been, or otherwise introduce inferior terms. However, equally, firms receiving LIBOR-linked interest are also not expected to give up the difference between LIBOR and SONIA (or other RFRs), which results from the term credit risk premium that is built into the LIBOR rate but not into SONIA. Accordingly, in determining when and how to transition, parties should factor in the costs, risks and benefits of any options, and the information available to them at the time.
In addition, in order to transfer legacy contracts, there must be meaningful volumes and liquidity in the alternative rate markets. For some products, such as swaps and bonds, the alternative rate market is maturing and will likely provide a viable alternative to LIBOR by the end of 2021. For other products, such as forward contracts and loans, there is, presently, limited liquidity across the RFRs.
Banks and other financial institutions must have their regulatory obligations in sharp focus when dealing with customers in relation to the LIBOR transition (see box “Senior managers and certification regime”). The FCA has said that, when dealing with customers with legacy contracts that need to be amended, firms should communicate in good time to ensure that customers can consider all of the options available and respond well before the end of 2021 (www.fca.org.uk/news/press-releases/final-countdown-completing-sterling-libor-transition-end-2021). Where firms continue to market and sell LIBOR products, to avoid the risk that customers may not understand the changes caused by LIBOR cessation, firms are encouraged to offer alternative products that do not reference LIBOR.
Firms must ensure that all client communications linked to LIBOR transition and legacy issues are clear, fair and not misleading. This includes taking account of the knowledge and experience of the intended audience. For example, firms should assume that retail mortgage borrowers have a lower level of knowledge and understanding of LIBOR compared with large companies.
Client-facing staff are also expected to have adequate knowledge to understand the implications of LIBOR cessation in order to respond appropriately to client queries. Any additional training to achieve this level of competence should already be in place. Staff should also understand the boundary between providing information and giving advice.
The FCA will challenge firms as to whether they are treating their customers fairly where:
- Contracts contain small print resulting in higher costs for the customer; for example, by replacing LIBOR with a higher rate.
- Conversations with customers affected by LIBOR are delayed, meaning that the client is left with insufficient time to make informed decisions.
- Alternative products are not presented to customers due to unfounded fears of straying into a personal recommendation or investment advice.
Asset managers and those firms investing on the behalf of customers are also on the FCA’s radar when it comes to LIBOR transition. These firms should be assessing and working to manage their customers’ exposure to LIBOR in a way that protects their customers’ interests, whether that is within a fund or through a firm’s portfolio of activities.
Other Global Approaches
LIBOR cessation is a challenge that is affecting financial hubs across the globe and, while the UK’s regulatory bodies are focused on the transition away from sterling-linked LIBOR, other regulatory bodies are having to grapple with the transition of LIBOR linked to other currencies and operating under different governing laws (see box “Language issues”).
On 27 March 2020, the Alternative Reference Rates Committee (ARRC) released a legislative proposal to address legacy contracts that are linked to US dollar LIBOR and governed by New York law (the ARRC proposal) (www.newyorkfed.org/medialibrary/Microsites/arrc/files/2020/ARRC-VRPSL-consultation03272020.pdf). In short, the ARRC proposal will mean that any contracts that do not contain an appropriate fallback provision will automatically transition from LIBOR to the recommended benchmark replacement (that is, SOFR) plus a spread adjustment. Any legacy language that includes a fallback linked to LIBOR will effectively be ignored. In addition, the ARRC proposal will mean that the discontinuation of LIBOR will not affect the continuity of any contracts referencing LIBOR, so the cessation of LIBOR cannot be relied on to discharge or excuse the performance of any contractual obligations.
Underpinning these provisions is the central purpose of the ARRC proposal, which is to minimise costly and disruptive litigation. In effect, the legislative fix will provide immunity from litigation if the recommended substitute to LIBOR is used. The ARRC proposal was included in the US executive budget on 19 January 2021, which is an important step toward having it passed and signed into US law.
In addition to the ARRC proposal, the IBA announced on 30 November 2020 that it intends to delay the cessation of US dollar LIBOR until June 2023 (https://s2.q4cdn.com/154085107/files/doc_news/ICE-Benchmark-Administration-to-Consult-on-Its-Intention-to-Cease-the-Publication-of-One-Weekand-Two-Month-USD-LIBOR-Settings-at-End-ELPZZ.pdf). The 2021 deadline, however, remains firmly in place for other LIBORs, including sterling-linked LIBOR.
Broadly, the concern arising from the IBA’s announcement is that the transition to RFRs will stall. However, there was already mounting criticism by many market participants using US dollar LIBOR that SOFR, the ARRC’s proposed RFR, is inadequate. There have been sudden fluctuations to SOFR and therefore AMERIBOR is quickly becoming the goto alternative rate as it is perceived as less volatile.
Nevertheless, this news will likely be welcomed in regions offering Islamic finance where US dollar LIBOR is widely used with no meaningful alternative as yet identified. This is because RFRs are backward-looking, meaning the rate is determined on the basis of historical data and is unknown at the outset. These transactions are inconsistent with Sharia principles in Islamic financing, where the pricing must be determined at the start of the relevant period.
In Europe, the European Commission proposes to amend the EU Benchmark Regulation (2016/1011/EU) to accommodate the cessation of critical benchmarks, such as LIBOR. In effect, the European Commission’s proposal will enable it to designate a replacement benchmark that covers all references to LIBOR when it is necessary to do so to avoid disruption of the financial markets in the EU. The statutory replacement rate will be available only for contracts that reference LIBOR at the time it ceases to be published. As the statutory replacement will be a matter of law, this will reduce the scope for contractual disputes.
Meanwhile, the International Swaps and Derivatives Association (ISDA) has launched its own protocol to incorporate fallback provisions to financing, which uses ISDA’s standard documents for interest rate derivatives (www.isda.org/2020/10/23/isda-launches-ibor-fallbacks-supplement-and-protocol). The protocol and supplement to ISDA’s 2006 definitions will facilitate large-scale amendments of legacy contracts by adhering parties. However, careful consideration should be given as to whether the protocol is the appropriate course to take given that it is optional and may not provide an effective fallback in all instances. A wait-and-see approach for some market participants may be the sensible option at this time.
While a global fix is not on the agenda, the issue that arises with these varied approaches is that inconsistencies will lead to uncertainty, meaning a greater risk of litigation and considerable scope for regulatory arbitrage. For example, it is not clear how the UK’s proposal for a synthetic LIBOR for tough legacy contracts will interact with the EU’s proposal to designate a statutory alternative rate.
The issues arising from LIBOR cessation cannot be fixed by a single technological magic bullet. However, technology can help and is helping to tackle some of the problems that organisations face when trying to get to grips with the scale of the challenge before them. For example, larger organisations may find it difficult to locate, collate and review all of the relevant documents that are needed to fully understand the legal position.
A company may have thousands of contracts that need to be assessed, which may be found across numerous electronic file systems and hard copy records. For example, a loan document may be saved to a local hard drive but a side letter amending the terms of the loan may simply be stored in the finance director’s email account. Both the underlying loan document and the side letter will be needed, and this is where the litigator’s friends, electronic discovery software and artificial intelligence, can be deployed to assist (see Briefing “Using technology in litigation: costs savings and competitive advantages”; and feature article “The disclosure pilot scheme: views from the ground”).
Following an explosion of data over the past 20 years, electronic disclosure software is used by litigators to tame the number of potentially disclosable electronic documents that are relevant to a claim. Once data have been collected, the software enables litigators to run machine learning across the electronic documents. This makes it possible to deduplicate files, cluster similar records together and prioritise the review of similar documents. In essence, the software enables litigators to quickly collate, filter and review electronic documents. These processes can equally be applied to help organisations manage the review of their financial instruments that contain LIBOR provisions.
Looking ahead, following the upheaval caused by LIBOR cessation, the use of contract management tools is likely to increase in the future. These tools enable teams to create, negotiate, sign, renew and analyse contracts at scale and in one shared workspace.
There will be many companies that are already deep into a LIBOR transition programme. However, for those companies that are not, the time to act is now. The first step is to run a comprehensive impact assessment considering how and where LIBOR is used in the business. This will be highly business-specific and depend on the financial products in use.
The assessment should identify relevant counterparties and include a review of:
- The expiry date of the relevant contracts.
- Cessation triggers and fallback provisions.
- Economic and litigation risks of existing fallbacks.
- Exposure to different triggers and timings.
- Exposure to differing currencies and regulatory regimes.
From this assessment, companies should not only determine the financial exposure that the business faces, but also take into account other considerations, such as accounting and tax issues.
In terms of accounting considerations, parties may need to assess whether replacing LIBOR with an RFR in a financial arrangement constitutes a substantial modification and, therefore, derecognition for the purposes of accounting under the International Financial Reporting Standards. If amendments are considered material, this may constitute a disposal of the existing contract and entering into a new product, which may also attract different tax considerations.
In addition, a possible tax implication may arise where one party makes a payment to the other to accommodate a shift from LIBOR to an RFR. If that payment is recognised in a company’s income statement it will likely be brought into account for tax purposes.
Where it is identified that existing contractual terms do not adequately deal with LIBOR cessation, there will need to be a renegotiation. Sufficient time needs to be allowed for this process so that new commercial terms can be agreed and documented before the end of 2021.
Where contracts do need renegotiating and amending, it will be important to record those amendments formally. This may need to be undertaken in line with whatever variation provisions exist in the contract, including any consent and notice requirements, and with the appropriate authorisations. Failure to follow these steps may lead to questions as to the validity of the variation. This in itself presents a risk for a dispute arising if the parties are not careful.
This can readily be achieved for a single contract but, for multiple products across different businesses, the challenge is compounded exponentially. What may be commercially acceptable to one counterparty or one transaction may not be for others.
Failure to agree a way forward may lead to parties deploying, or contemplating deploying, a range of legal arguments to allege that LIBOR’s demise means that they are discharged from future obligations under an unfavourable contract; for example, by reason of frustration or because LIBOR cessation constitutes a force majeure event (see feature article “Force majeure in a changing world: predicting the unpredictable”). Where one party is left at a disadvantage, even following a consensual restructuring, one can expect to see fresh claims going through the courts. This may again raise allegations of misselling, depending on the underlying facts. It is therefore critical that parties face headon, constructively, and responsibly, the issues arising from the LIBOR transition and, in particular, legacy issues.
The London Interbank Offered Rate (LIBOR) is formed using reference interest rates submitted by participating banks and is designed to capture the rate at which banks borrow in the wholesale markets. In addition, LIBOR is used to calculate the interest rate for many different financial products including loans, mortgages, bonds, securitisations, derivatives and other non-financial services contracts. During the LIBOR manipulation scandal, it was found that traders at some banks had colluded to submit artificially low or high interest rates to force the LIBOR higher or lower, in an attempt to support their own institutions’ derivative positions and trading activities.
The scandal was so significant because of the central role that LIBOR plays in the global finance market. It is used to determine everything from the interest rates that financial institutions pay for loans, to the rates that individual consumers pay for mortgages and personal finance, as well as for the pricing of derivatives. Therefore, by manipulating LIBOR, the traders in question were causing the mispricing of financial assets across the globe.
|Tough Legacy Contracts
In addition to legacy contracts, there is a pool of contracts referred to as tough legacy contracts. The Tough Legacy Taskforce, set up by the Working Group on Sterling Risk- Free Reference Rates, identifies these as contracts that do not have robust fallback provisions and cannot be converted to a risk-free rate ahead of the cessation of the London Interbank Offered Rate (LIBOR) at the end of 2021.
The question of how to handle tough legacy contracts has proved to be a conundrum. However, in June 2020, the UK announced its solution to the problem (www.fca.org.uk/markets/transition-libor/benchmarks-regulation-proposed-new-powers). The Financial Conduct Authority (FCA) will be given powers, set out in the Financial Services Bill 2019-21, to impose a change in LIBOR’s methodology, if it is no longer representative, in order to allow a synthetic LIBOR-based methodology to be deployed in tough legacy contracts up until maturity. The Financial Services Bill 2019-21 is currently before Parliament and, in addition to granting the FCA these conditional powers, will amend the UK Benchmark Regulation, which is essentially the retained law version of the EU Benchmark Regulation (2016/1011/EU) that has applied in the UK from the end of the Brexit transition period on 31 December 2020 (see News brief “Financial Services Bill 2019-21: shaping regulation outside of the EU”).
The use of a synthetic LIBOR by the FCA is limited to circumstances where:
- The FCA considers this is necessary to ensure that the cessation of LIBOR takes place in an orderly fashion.
- This is required in order to enhance the integrity of the UK financial system.
- This will provide appropriate protection for consumers. Specifically, it is meant to reduce disruption to holders of tough legacy contracts, where renegotiation and contractual amendment is not an option.
Since the announcement of these conditional powers, the FCA has stressed that the continuation of a synthetic LIBOR using a revised methodology should not be viewed as an alternative to transition or contractual fallbacks. Accordingly, stakeholders should continue to focus on the practicalities of transitioning to a risk-free rate or implementing industry-agreed fallbacks wherever possible.
|Senior Managers and Certification Regime
Individual senior managers have responsibilities under the senior managers and certification regime (SMCR) to oversee the implementation of the London Interbank Offered Rate (LIBOR) transition and to ensure that they take reasonable steps to prevent regulatory breaches from occurring in respect of the transition (see Briefing “Senior managers and certification regime: another year on”). The working group has emphasised the need for senior manager involvement and an expectation that supervisory engagement will increase. As a minimum, the Financial Conduct Authority (FCA) expects firms to have:
- Identified the senior manager responsible for overseeing the transition away from LIBOR.
- Detailed those responsibilities in the relevant senior manager’s statement of responsibilities.
Given the murky history of LIBOR, senior managers can expect the FCA to take a robust approach when dealing with failings in this regard. This represents a contrast to the fact that senior management largely escaped censure for the LIBOR manipulation scandal, something the regulators have been criticised for in the years since.
Given the concentration of London Interbank Offered Rate (LIBOR) transactions in London and New York, English will be the dominant language of much of the underlying documents. Nevertheless, the LIBOR transition will penetrate finance industries across the globe and considerable amounts of documents may need to be translated where companies operate in multiple regions.
In addition, the translation of LIBOR-related documents means interpreting content that may be specific, complex and, in many cases, regulated. In these instances, a word-for-word translation may be of little use if the context and purpose of the content is lost. Instead, contracts should be translated not only by a linguist but by one with specific legal subject matter expertise and, if possible, knowledge and understanding of the regulatory framework within which the translation is taking place. While these services are available, they are a limited resource and, again, require careful planning to avoid the unnecessary costs that are often incurred when there is a finite resource and a limited timeframe.