Professional Support Lawyer, Johnny Shearman, and Barrister at Outer Temple Chambers, Justina Stewart, discuss how the fallout from the Covid-19 pandemic is heaping pressure on market participants to resolve the legal issues regarding the transition from Libor to alternative risk-free rates.
Johnny and Justina’s article was published in Global Risk Regulator, 8 June 2020, and can be found here.
Covid-19 has caused a dramatically increased need for credit, as well as significant uncertainty about the value of a huge range of assets. LIBOR is the world’s most widely used interest rate benchmark. Market behaviour, in light of Covid-19, has only served to confirm the lack of LIBOR’s representativeness. Therefore, the FCA and the Bank of England have not changed their core message – firms cannot rely on LIBOR being published after the end of 2021.
However, as matters stand, it remains for the market to effect the transition.
Without legislative intervention or urgent action by, and cooperation between, parties to legacy contracts (LIBOR-linked contracts outstanding post-2021), the litigation risk arising from these contracts is, for many companies, real if not significant.
That risk is exacerbated by Covid-19.
Numerous legacy contracts were entered at a time when the parties did not foresee a permanent cessation of LIBOR.
As a result, many contracts have no fallbacks covering unavailability of LIBOR. Many others contain fallbacks that were intended to apply in a scenario of temporary LIBOR unavailability, and so have unintended consequences upon permanent cessation, e.g. rates default to the ‘Historic Screen Rate’, thus converting a variable to fixed rate, or to a ‘Reference Bank Rate’. Even if banks submit such rates (questionable), the rates are likely to be far more volatile than LIBOR. This is not what the parties typically bargained for.
Absent a unilateral right by parties to amend rates or a statutory solution, the parties must agree to any variation.
The proposed alternatives are risk free rates (RFRs) (SONIA for Sterling LIBOR). There are at least two issues with RFRs.
Firstly, while LIBOR generally exceeds RFRs, there is no magic number/formula telling parties what constitutes the extra spread over the RFR. Further, as illustrated by the behaviour of LIBOR relative to SOFR and SONIA with the onset of Covid-19, in times of market turbulence, LIBOR and RFRs can behave very differently and the extra spread can fluctuate significantly. On any analysis, if parties agree to an extra spread, they face unpredictable transfers in value that will inevitably prove to be more financially advantageous for one party.
Secondly, the proposed RFRs are backward, not forward looking, so the interest payable is not known until after the end of interest period. This means that parties lose cashflow certainty. Therefore, as acknowledged in a report in January by the Working Group on Sterling Risk-Free Reference Rates (RFRWG), there are many categories of products for which RFRs are unlikely to be appropriate – from export finance, mid-corporate, private banking and retail to working capital products.
An obvious solution would be forward-looking term RFRs (TSRRs for SONIA). However, due to current lack of liquidity, these are easily manipulated. Moreover, while several companies have proposed term TSRRs, each is calculated differently. Therefore, as matters stand, we are some way from market accepted TSRRs.
Many agreements have ‘cost of funds’ fallbacks. These are unlikely to provide a solution, due to practical difficulties in calculating the cost of funds. Further, such clauses, like fallback clauses giving one party a discretion to determine a replacement rate, also cast the shadow of a fertile area of litigation – concerning the limits of exercise of a party’s discretion.
Therefore, even before Covid-19, parties were deploying, or contemplating deploying a range of legal arguments to allege that LIBOR’s demise means they are discharged from future obligations under an unfavourable contract, even if simply to negotiate better terms, e.g. by reason of ‘frustration’, or because LIBOR’s demise constitutes a force majeure event. Others, in order to obtain better terms, were deploying arguments relying on an illegitimate exercise of contractual discretion.
Given these factors, and the FCA making it clear that it will take action against firms that do not manage the conduct risk – the risk of adverse client outcomes – associated with LIBOR transition, it is no surprise that the rate of transition for tougher legacy contracts has been glacial.
Impact of Covid-19
The economic devastation wreaked by Covid-19 increases the probability that an unfavourable replacement rate will tip a company in distress into default, and of further and widespread restructuring and renegotiation of companies’ financial obligations.
These factors are likely to cause an increased focus on replacement rates, and so may increase the pace of transition to alternative rates, and even the development and further liquidity of alternative products. Arguably positive developments.
However, as companies battle for survival, there is also an increased likelihood of deployment of legal arguments like frustration as a negotiating tool, and associated litigation. At present there is considerable good will in the market but as the economic crisis unfolds this will likely evaporate. Naturally, this will be viewed in less positive terms in many quarters.
Increasing calls for UK statutory intervention
Given the economic crisis that is unfolding, and the obvious need to focus on saving businesses and livelihoods, it is unsurprising that calls for UK legislative intervention are increasing.
In March, the Alternative Reference Rates Committee (ARRC) released a legislative proposal to address legacy contracts governed by New York law. This would, among other things, provide immunity from litigation if a recommended substitute is used. The proposal has attracted some criticism. However, if enacted, the proposal is likely to reduce litigation by, at the very least, indicating how settlement should be approached.
Shortly afterwards, at the end of May, the RFRWG’s Tough Legacy Taskforce proposed that the UK Government considers legislation similar to ARRC’s proposal to address tough legacy exposures in English law contracts that reference sterling LIBOR, and ideally other LIBOR currencies.
However, as the Taskforce recognises, there is no guarantee that such a solution will materialise, nor that it would necessarily deliver the desired economic basis of the contract.
Therefore, it is more important than ever that parties face head-on, constructively, responsibly and urgently the issues arising from LIBOR transition and legacy contracts.