“Legacy Contracts Complicate Libor Transition” – Partner Abdulali Jiwaji and Professional Support Lawyer Johnny Shearman discuss the cessation of Libor by the end of 2021, in Law360.
Abdul and Johnny’s article was published in Law360, 2 March 2020, and can be found here.
The Financial Conduct Authority and the Bank of England have signalled that the next 12 months are critical for Libor transition to ensure that firms are prepared for Libor cessation by the end of 2021. At the beginning of this year, both bodies, in conjunction with the Working Group on Sterling Risk-Free Reference Rates, outlined the priorities and milestones on the transition away from the troubled interest rate benchmark to a new risk free rate (such as the Sterling Overnight Index Average, or Sonia). While the more immediate priority is to cease the issuance of cash products linked to sterling Libor by the end of September 2020, arguably the more difficult task is to deal with legacy contracts, which without intervention could cause significant market disruption.
The Legacy of Libor
Following an international scale investigation, it was found that multiple banks had manipulated Libor for profit during the global collapse of the financial markets in 2008 and, in some instances, before then. In the U.K. alone, nine financial institutions were fined over £757 million by the FCA for Libor-related misconduct. This is in addition to £1.4 billion worth of fines issued by the FCA for foreign exchange market manipulation.
As well as the regulatory investigations, banks in particular have had exposure to related civil claims, based on allegations in relation to 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.
While the courts have (in those cases which have not settled) generally ruled in favour of banks, the courts have clarified that banks may still be liable for statements made when selling financial products. For example, in PAG, the Court of Appeal held that there was an implied representation on behalf of a bank that it was not manipulating Libor at the same time that it was entering into a Libor-related product with a customer. The cases are highly fact-specific.
In any event, despite the scandal, the fines, the civil claims and the fact that the underlying market Libor measures is no longer as liquid as it was previously, Libor remains a major interest rate benchmark, underpinning trillions of dollars of financial contracts including derivatives, bonds and loans.
There are a number of reasons as to why this is the case. Short-term products and those that will expire ahead of 2021 can still feasibly operate and do — although, notably, there has been a steady decline in the number of products referring to Libor since it was announced that the benchmark would no longer be supported beyond 2021. But by far the biggest contributing factor to Libor’s endurance are legacy contracts.
In a speech delivered last year at the Libor transition briefing in New York, Andrew Bailey, chief executive of the FCA, said that Libor transition is not just about new business but about converting outstanding (or legacy) Libor contracts. However, converting legacy contracts is easier said than done as conversion gives rise to a number of legal implications for the contracting parties.
To begin with, the methodologies for calculating Libor and risk-free rates differ. Libor is a forward-looking rate which means the amount of interest payable is known from the start of the interest period. However, SONIA, by comparison, is an overnight backward-looking rate which means the interest payable will not be known until the last day of the interest period. In broad terms, this means that converting a legacy contract may prove to be more financially advantageous for one party depending on which rate is relied upon.
Parties to contracts linked to Libor therefore face unpredictable transfers of value which will likely create winners and losers — with one party gaining more while the other party receives less. One can see scope for aggrieved counterparties to raise disputes based on arguments such as frustration and impossibility, which could lead to disruption on a large scale.
Some legacy contracts may contain fallback provisions which provide for circumstances where Libor is unavailable. However, these provisions are not usually drafted to accommodate a permanent discontinuation of Libor and therefore may have unintended consequences. For example, a floating rate note may fall back to the last Libor fixing and effectively become a fixed rate note in the process. Where the contract provisions leave the position uncertain and open to interpretation, the risk of dispute is high.
It is likely that many contracts will need renegotiating and amending to accommodate a move away from Libor altogether. Any amendments to formal documentation will need to be undertaken in line with whatever variation provisions exist, including any consent and notice requirements and with the appropriate authorisation.
For a single contract, this can readily be achieved, but for multiple products across different businesses, the challenge is compounded exponentially. However, the correct processes must be followed as a failure to do so may lead to a dispute over the validity of amendments and further disruption.
Another risk is that if Libor is replaced with a risk-free rate, parties will need to assess whether this 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 of a new product for tax purposes.
Also, the continuity of hedge relationships will depend on various factors if Libor is replaced with a risk-free rate. To the extent that counterparties are relying on financial institutions for guidance on restructuring and hedging, commercial interests may impact on the impartiality of any advice given.
Lastly, 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 come 2021. For other products, such as forwards and loans, there is, presently, insufficient liquidity across the risk free rates.
There is, therefore, a real risk that there will be many contracts that cannot convert and cannot add fallbacks (these are now being referred to as tough-legacy contracts). In this situation, where the parties disagree on the correct interpretation, decisions will have to be made on the steps to be taken in the knowledge that a legal dispute is likely to develop.
The Time to Act Is Now
The FCA and Bank of England have made it clear that financial institutions cannot delay in taking action to deal with Libor transition. However, while financial institutions will take into account their regulatory obligations, counterparties such as small and medium-sized enterprises should review their position and check fallback provisions as soon as possible.
If 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 next year, to reduce the risk of formal disputes arising.
Where a restructuring leaves one party at a disadvantage, one can expect to see fresh claims going through the courts, again involving allegations of misrepresentation and potentially dishonesty, depending on the underlying facts.