Head of Knowledge and Legal Services Johnny Shearman examines the legal implications for the transition away from Libor and whether its replacement will provide a fertile ground for litigation.
Following amendments to the Benchmark Regulation (EU) 2016/1011 made by the Financial Services Act 2021, from January 1, 2022, the Financial Conduct Authority (FCA) will have the power impose a change in the London Interbank Offered Rate (Libor)’s methodology to allow a synthetic Libor-based methodology to be deployed in Libor-linked legacy contracts.
The FCA has indicated that one-month, three-month and six-month sterling Libor and yen Libor tenors will continue under the synthetic methodology, and is consulting on a similar strategy for overnight, one-month, three-month, six-month and 12-month dollar Libor.
To support the use of synthetic Libor, the critical benchmarks (References and Administrators’ Liability) Bill has been introduced and should receive royal assent imminently. It aims to clarify how contractual references to Libor should be interpreted with references to Libor being treated as synthetic Libor. These provisions will have retrospective effect, meaning contracts will be treated as though they had always referenced synthetic Libor. However, importantly, the bill does not include express protection from claims, meaning the courts will be left to interpret contractual uncertainties.
Tough legacy contracts are those that do not have robust fallback provisions and cannot be converted to an alternative risk-free rate, such as the Sterling Overnight Index Average. How to handle these contracts has proven problematic. However, the FCA is consulting on the use of synthetic Libor for all contracts captured by the Benchmark Regulation (except cleared derivatives). This broad interpretation could include any unamended legacy contract, provided that a synthetic Libor alternative is available.
This means a cliff-edge scenario now seems unlikely for most tough legacy contracts. However, the FCA has emphasised that synthetic Libor is a temporary, bridging solution. Synthetic Libor rates will be subject to annual review: availability beyond 2022 is not guaranteed. Therefore, market participants must continue to remove reliance on Libor during the bridging period, otherwise tough legacy issues will resurface.
Libor cessation has created international divergence. In New York, the Alternative Reference Rates Committee has introduced a legislative fix to address legacy contracts linked to dollar Libor. Contracts that do not contain an appropriate fallback provision will automatically transition from Libor to the Secured Overnight Financing Rate, the proposed dollar-linked alternative rate. Local regimes are also being implemented for contracts governed by other US state laws.
The EU Benchmarks Regulation was amended this year, meaning the European Commission is empowered to replace Libor references in contracts governed by the law of a member state. These powers extend to contracts governed by the laws of any other country where all parties are established in the EU, and the other country has not put in place its own legislative solution.
Presently, it remains unclear whether the UK’s synthetic Libor can be deployed in a contract not governed by English law. The FCA has indicated that it expects synthetic Libor to flow through to global users of existing contracts continuing to reference the rate. However, legislative frameworks of other jurisdictions will prevail.
The interaction of these global solutions will likely create areas of uncertainty and a conflict of laws is possible. Arguably, the diverging approach is already resulting in unusual market behaviour. For example, the issuance of dollar-collateralised loan obligations (CLOs) recently soared to a new record. Total issuance in 2021 reached $140bn in October, while August and September marked the busiest issuance months ever recorded. This frenetic activity has been linked to the transition from Libor, as investors and managers squeeze what they can from the US regime as dollar CLOs will continue to be pegged to dollar Libor until December 2023.
For UK parties, concerns have been raised about the lack of an express protection from claims under the UK’s transition regime. While early consultations considered such a move, simple contractual continuity provisions have prevailed. It means that in the UK, as soon as the relevant trigger is activated, synthetic Libor will apply automatically. Where parties are left at a disadvantage as a result of this switch, there will be an economic incentive to bring a claim. Depending on the underlying facts, allegations of mis-selling may resurface.
The UK position contrasts with New York, which prevents claims for those contracts that are switched to the recommended benchmark replacement. Arguably, this should reduce the risk of speculative litigation flowing from the move away from Libor.
This divergence and potential for regulatory overlap may result in forum shopping: parties bringing claims in a jurisdiction with more advantageous replacement rates, or where litigation safe harbour parameters are different.
For those organisations that have not already engaged with Libor cessation, a comprehensive impact assessment should be undertaken to determine the use of Libor in their business and to evaluate any potential financial exposure. If parties do not approach issues arising from Libor cessation head-on and constructively, it is likely that there will be fertile ground for litigation.
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28 November 2023
28 November 2023