Johnny Shearman, Head of Knowledge and Legal Services, discusses the difficulties and risks that the transition away from LIBOR will create, in Compliance Monitor.
Johnny’s article was published in Compliance Monitor, 12 July 2021, and can be found here.
The transition away from the London Interbank Offered Rate (LIBOR) continues and, whilst progress has been made, parties still face significant risks when dealing with legacy contracts and from the emergence of diverging approaches to the transition across key jurisdictions. A failure to navigate these risks now may give rise to fresh legal claims in the near future.
In July 2017, the Financial Conduct Authority (FCA) announced 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. Arguably, the shift away from LIBOR represents one of the biggest challenges for financial institutions in recent times. However, despite the sheer scale of the task, over the past four years, some significant strides have been made.
Contracts linked to the UK’s preferred alternative benchmark, the Sterling Overnight Index Average (SONIA), are now commonplace and have become the default in certain markets such as UK corporate debt. For some financial 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.
However, this relates to new business and LIBOR transition is also about converting undischarged, or legacy, LIBOR contracts. Legacy contracts are those that reference LIBOR but are due to expire after the 2021 cessation date.
Andrew Bailey, then Chief Executive of the FCA, raised the issue of dealing with legacy contracts during a speech delivered in New York in 2019. The message was critical then and it remains so now, as contracts relying on LIBOR may not perform as expected when LIBOR ceases.
In broad terms, most legacy contracts were entered into at a time when parties did not foresee a permanent discontinuation of LIBOR and the drafting of these contracts reflects this. This has made converting legacy contracts difficult and, while conversion may be possible in certain circumstances, it is likely to give rise to a number of legal and financial implications.
Some legacy contracts contain fallback provisions that provide for circumstances where LIBOR goes unreported. However, to ensure a smooth transition, the language used in the contract must be unambiguous and provide a clear way to transition from LIBOR to an alternative rate. Typically though such fallback provisions were not drafted to accommodate a permanent cessation of LIBOR but rather an interim solution. For example, a rate may default to a historic screen rate, effectively turning a variable rate to a fixed one. Therefore, relying on these provisions to navigate permanent LIBOR cessation may well have unintended consequences.
Matters are complicated further where financial structures involve multiple contracts across different parties. For example, a floating rate mortgage may have a specific mechanism to replace LIBOR. Often these mortgages generate loan repayments which fund payments to bond holders. However, those bonds may include a different mechanism to replace LIBOR. The result of these differing conversions may be particularly economically undesirable for one party when applied in the long term.
Should parties fail to pre-emptively address these uncertainties in a constructive manner, the risk of a dispute arising is a real. This is especially the case where the contractual fallback provisions leave the position more advantageous to one party in circumstances where this had not been the intention of the parties or even an accepted risk at the time the contract was drafted.
Tough legacy issues
In addition to legacy contracts, there is a pool of contracts referred to as tough legacy contracts. These are contracts that lack robust fallback provisions and cannot be converted to an alternative rate ahead of the cessation of LIBOR.
The question of how to handle tough legacy contracts has proved to be a challenge. However, in June 2020, the UK announced its solution. The FCA will be given powers 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.
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. Even now, the FCA is continuing to consult the market in respect of its enhanced powers, and it seems likely that clarity as to which contracts will be caught by the UK’s proposed fix will not be forthcoming until the autumn. The last-minute nature of the FCA’s strategy is questionable but it is likely to be tactical to keep the market to stick to the current proactive transition efforts.
No global fix
Given that the FCA and the UK’s other regulatory bodies are largely focused on the transition of products away from sterling-linked LIBOR, it is easy to overlook the global challenge LIBOR transition presents. Overseas jurisdictions are also having to tackle the transition away from LIBOR products linked to other currencies and operating under different governing laws. The result is that the LIBOR transition is being handled differently around the world.
In contrast to the FCA being given powers to allow a synthetic LIBOR-based methodology to be deployed for tough legacy contract, in New York, the Alternative Reference Rates Committee (ARRC), is bringing about a legislative proposal to address legacy contracts that are linked to US dollar LIBOR and governed by New York law.
The ARRC’s legislative fix will mean that any contracts that do not contain an appropriate fallback provision will automatically transition from LIBOR to the Secured Overnight Financing Rate (SOFR), the proposed US dollar-linked alternative rate. However, SOFR is facing criticism as it has been deemed by many market participants as inadequate in light of sudden fluctuations that have been observed. Therefore, New York’s proposal may be more of a hurdle than a gateway if the dissent continues, resulting in other LIBOR alternatives, such as the American Interbank Offering Rate, being used.
In Europe, the European Commission intends to amend existing EU regulation to accommodate the cessation of LIBOR. It will mean that the European Commission will be able 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. However, this statutory replacement rate will only be available for contracts that reference LIBOR at the time it ceases to be published. As the statutory replacement will be a matter of law the EU hopes it will reduce the scope for contractual disputes.
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. The protocol and supplement to ISDA’s 2006 definitions will facilitate large-scale amendments of legacy contracts by adhering parties. However, contracting parties should give careful consideration to whether the protocol is appropriate, given that it is optional and may not provide an effective fallback in all instances.
The risk that arises with these varied approaches to legacy issues is that inconsistencies will lead to uncertainty for market participants. For example, it is just 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. This level of regulatory arbitrage means a greater risk of litigation where parties are not aligned on the way forward.
Another area of significant divergence stems from the Intercontinental Exchange’s Benchmark Administration’s (IBA) decision to delay, until June 2023, ceasing to publish the most widely used tenors of US dollar LIBOR. This means that a significant number of financial products linked to US dollar LIBOR will be sustained beyond the end of this year creating a two-tier transition. A key reason for the delay has been mounting criticism of SOFR. It was felt that further time is needed to enable business to transition away from US dollar-linked LIBOR products. The IBA’s approach has largely been welcomed but it does add a further layer of complexity for those companies that have products linked to both US dollar and sterling LIBOR.
Time to act
Many organisations have already commenced their LIBOR transition programmes but have found it to be a long and arduous process. Therefore, for those companies that are yet to engage with the transition, the time to act is now.
As a first step, companies should run a comprehensive impact assessment to consider how and where LIBOR is used in the business. This will be highly business-specific and depend on the financial products in use. Where it is found that contracts do need to shift away from LIBOR it will be important to record any negotiations and amendments. This exercise will need to be undertaken in line with the variation provisions in the contract, including any notice requirements, and with the appropriate authorisations. Where these steps are not followed, questions as to the validity of the variation may arise. If parties are not careful there is a risk of a dispute arising over the smallest of mistakes.
Such a review can readily be achieved for a small number of contracts but, for multiple products across different businesses, and potentially different jurisdictions the challenge is compounded. Using again the mortgage payments and bonds structure as an example, what may be commercially acceptable to one party, or one transaction, may not be for others.
Failure to agree a way forward now may result in parties considering a range of legal arguments to allege that LIBOR’s cessation means that they are discharged from future responsibilities under an unfavourable contract. For example, by reason of frustration or because LIBOR cessation constitutes a force majeure event.
Where one party is left at a disadvantage, even following a consensual restructuring, one can expect to see fresh claims going through the courts. It is therefore important that parties face head-on the issues arising from the LIBOR transition.
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