Transitioning ‘tough legacy’ LIBOR contracts – different strokes for different folks?

October 2020 | EXPERT BRIEFING | BANKING & FINANCE

financierworldwide.com

In 2017, the UK’s Financial Conduct Authority (FCA) announced that after 2021 it would no longer compel panel banks to submit the rates required to calculate the London Interbank Offered Rate (LIBOR). As a result, market participants need to transition their financial contracts to alternative rates by the end of 2021. Panel banks’ contributions to LIBOR are intended to reflect the interest rate at which banks could borrow money on unsecured terms in wholesale markets.

LIBOR was therefore meant to serve as a proxy for a risk free or near risk free interest rate. It is used globally in a range of contracts, including mortgages, securities and business loans, as well as non-financial contracts. With LIBOR underpinning approximately $300 trillion worth of contracts, few expected a transition to be easy.

At the start of 2020, firms were warned that it was to be a critical year for the transition. The fact that LIBOR rates – and hence costs for borrowers – rose as central bank interest rates were lowered in response to COVID-19, and underlying market activity was low, only strengthened the resolve of the authorities to see the industry accelerate transition efforts. While the disruption caused by the pandemic has caused some interim LIBOR transition milestones to slip, the authorities have remained adamant that the ‘central assumption’ still stands: LIBOR is less and less a representative benchmark and is increasingly fragile and more susceptible to liquidity and amplification effects in financial markets. LIBOR will therefore cease to be published after the end of 2021 as scheduled.

Nonetheless, the regulators have acknowledged that some existing LIBOR-linked contracts have no or inadequate fallbacks and no realistic ability to be amended prior to LIBOR’s cessation. For example, for certain legacy bonds, the necessary bondholder consent to amend may not be forthcoming, or in large syndicated loan deals involving a large number of lenders, it may not be possible to garner the necessary consent levels, especially in older contracts where unanimous lender consent may be required. This is to say nothing of complicated securitisation structures where economic interests may have already been sold on, making it difficult to identify decision makers willing to invest the time or costs of amendment, or contracts that may already be subject to a dispute between parties. For these ‘tough legacy’ contracts, many have called for a legislative fix, following the precedent of legislation enacted in 1998 to cater for the discontinuance of sovereign currencies being replaced by the euro. Proposals for such legislation have already been put forward with respect to New York state law and European Union (EU) law. However, the UK government proposes a fundamentally different solution.

New York proposal – a US dollar LIBOR only affair

The New York state legislative proposal was published on 6 March 2020 by the US Alternative Reference Rates Committee (ARRC). ARRC is a group of private market participants convened by the Federal Reserve Board (FRB) and the Federal Reserve Bank of New York (FRBNY) to help ensure a successful transition from US dollar LIBOR to its recommended alternative, the Secured Overnight Financing Rate (SOFR).

The key elements of the ARRC’s proposals are listed below.

Scope. The proposed legislation would apply to US dollar LIBOR contracts governed by New York law.

Trigger Events. The proposed legislation would apply in the event of statutory trigger events, such as, either a permanent cessation of LIBOR, or the occurrence of a pre-cessation trigger event related to LIBOR. A permanent cessation would require a public statement by or on behalf of the administrator of LIBOR (or by the administrator’s regulatory supervisor, or certain other prescribed persons or entities) announcing that LIBOR has ceased or will cease to be published. A pre-cessation trigger would occur if a public statement is issued by the regulator of the administrator announcing that LIBOR is no longer representative.

Mandatory application of the statutory benchmark replacement rate. Contracts that are silent or without adequate fallback language to address the cessation of LIBOR will automatically transition to the ‘Recommended Benchmark Replacement’ (RBR) under the proposed legislation — likely SOFR, as published by the FRBNY, plus a spread adjustment selected by the FRB, the FRBNY or ARRC. The proposed legislation would also override fallback language that references a LIBOR-based rate, such as last quoted LIBOR, in favour of the RBR. Similarly, fallback language that requires polling for LIBOR or other interbank funding rate would be nullified. The statute would not override legacy language that falls back to an express non-LIBOR based rate, such as Prime.

Commercially reasonable equivalent. The proposed legislation would provide expressly that the RBR will constitute a commercially reasonable equivalent to LIBOR.

Contractual continuity. Neither the discontinuance of LIBOR nor the use of the RBR to replace LIBOR will constitute a breach, avoidance or nullification of a contract, security or instrument. Accordingly, the discontinuation of LIBOR or use of the RBR will not discharge or excuse performance under any LIBOR-linked contract or give any party grounds to unilaterally terminate or suspend performance under any contract, security or instrument.

No amendment, modification or impairment of rights. Use of the RBR (or the implementation or performance of any ‘Benchmark Replacement Conforming Changes’ required to implement the RBR) will not amount to an amendment or modification of a contract or be deemed to have a material or adverse effect on any person’s rights or obligations under or in respect of the contract.

Litigation safe-harbour. A person will not incur any liability for damages or be subject to any claim, cause of action or request for equitable relief arising out of, or related to the use of the RBR. Where a contract gives a party the right to exercise contractual discretion or judgment regarding the fallback, that party will have the option to transition from LIBOR to the RBR and to benefit from the litigation safe harbour.

Mutual opt-out. Parties can agree (in writing) to opt out of the application of the legislation, at any time before or after the occurrence of a statutory trigger event.

UK proposal – a different approach

In a written statement on 23 June 2020 made by the chancellor of the exchequer, the UK government announced its intention to give enhanced powers to the FCA under the Benchmarks Regulation, as ‘on-shored’ into UK law at the end of the Brexit transition period on 31 December 2020 (UK BMR), as outlined below.

Scope and trigger events. The new powers will extend the circumstances under UK BMR in which the FCA may require an administrator to change the methodology used to calculate a ‘critical benchmark’, including LIBOR, if doing so will protect consumers or ensure market integrity. These powers will be available in the event that the FCA makes an announcement that the relevant benchmark (such as LIBOR) is no longer representative and will not be restored to representativeness.

Statutory replacement rate. The proposed legislation will make clear that, in principle, where a benchmark loses representativeness, use of that benchmark must cease. However, the FCA will have the power to permit continued use, including in legacy contracts, where it considers this to be appropriate.

Synthetic LIBOR and methodology changes. The replacement methodology has not yet been determined and it will be left to the FCA to do so. The FCA intends to seek stakeholder views on possible methodology changes in subsequent consultations. The FCA’s aim would be to achieve feasible and robust methodology changes that would, if the new powers are used, reduce the risk of published LIBOR values diverging from the value of fallbacks that come into effect in line with market consensus on how to calculate fair fallback values for LIBOR during a pre-cessation period.

The UK government’s proposals are based on a solution mooted by the Working Group on Sterling Risk-Free Reference Rates (the UK equivalent of ARRC), for LIBOR to be stabilised via a ‘synthetic methodology’ as a means of managing the wind-down of LIBOR during a pre-cessation period where the benchmark no longer meets the regulatory standard of being representative of the underlying market it seeks to measure.

EU proposal – following ARRC’s example

On 24 July 2020 the European Commission published a proposal for a regulation amending the EU Benchmarks Regulation (EU BMR) as regards the designation of replacement benchmarks for certain benchmarks in cessation, including LIBOR. Its main points are outlined below.

Scope. A statutory replacement rate designated by the Commission would take the place of LIBOR in financial instruments, financial contracts and measurements of the performance of an investment fund which involve an EU ‘supervised entity’ – certain types of regulated entities such as a bank, investment firm or insurer – and which do not include a suitable fallback mechanism.

Trigger events. Like the ARRC legislative proposal, the statutory replacement rate would become applicable or available upon the cessation or pre-cessation of LIBOR (with similar definitions as under the ARRC legislative proposal).

Statutory replacement rate. The Commission would be able to designate a statutory replacement benchmark once it becomes clear that the cessation of LIBOR would result in significant disruption in the functioning of financial markets in the EU. The powers would be triggered as soon as the effective date for the cessation becomes clear. In designating a replacement rate, the Commission will take into account recommendations made by dedicated working groups on replacement rates.

Monitoring of statutory replacement rate. Regulators of supervised entities using the benchmark designated by the Commission will have to monitor whether the replacement mechanism minimises contract frustration, or any other detrimental effects on economic growth and investments in the EU. They will be required to report to the Commission and to ESMA annually.

Contract continuity and litigation safe-harbour. In the accompanying explanatory text, the Commission explains that the proposal is intended to “avoid that a party to a contract involving a supervised entity refuses to perform its contractual obligations or declares a breach of contract” as a result of LIBOR discontinuance and to “provide a safe harbour from litigation for supervised entities that use (reference) the statutory replacement rate”. The proposed amendments to EU BMR may not, by themselves, achieve this.

Mutual opt-out. The Commission intends to adopt a recommendation encouraging EU member states to select the replacement rate chosen for EU supervised entities as the statutory replacement rate in their national statutes. This would also allow an opt-in for contracts that do not involve an EU supervised entity.

The UK chancellor’s statement indicated the government was driven by pragmatism – perhaps it considered that there was not enough time to deliver an internationally coordinated ARRC model solution. The Commission has stated that it was also initially attracted to the UK’s solution, but ‘caveats’ by the FCA warning that market participants could not count on the FCA exercising powers to require a methodology change for one or more LIBOR currencies, caused it to change its mind.

Conclusion – irreconcilable differences or future harmony?

Regardless of the relative merits of the UK solution as compared to the ARRC and EU models, we submit that none of the proposals on their own will provide much of a solution to the tough legacy issue. Imagine the following (plausible) scenario where the FCA declares that LIBOR is no longer representative. Under UK BMR, UK-supervised entities will not be able to use LIBOR unless the FCA uses its powers to permit continued use of the benchmark. The Commission may designate a replacement rate to replace LIBOR once LIBOR ceases, as a matter of EU regulation. Yet it is not clear that English courts will be obliged to recognise the Commission’s statutory replacement rate in English-law governed contracts. For a UK or EU supervised entity’s New York law governed US dollar LIBOR contracts, the RBR would apply as a matter of New York law. However, LIBOR could continue to exist if the FCA has used its powers to direct a change of methodology. Therefore, far from providing certainty and safeguarding financial stability, the proposed solutions could create an irreconcilable conflict of laws.

The UK government has committed to engagement with global counterparts and it is to be hoped that, having put across their opening offers, the US, UK, EU and other regulators will be willing and able to come up with a harmonious solution that will work across all relevant legal jurisdictions. Perhaps the UK could consider moving toward ARRC’s model; the ARRC legislative proposal could be broadened to cover other relevant currencies (or recognise legislation in other jurisdictions in respect of their currencies) and a significant number of jurisdictions could agree on the replacement rates. But this is a tall order and counterparties would do well to ensure that their pools of tough legacy contracts are restricted to an irreducible core.

LIBOR is the world’s most important number. Different strokes for different folks was never going to be workable.

Ferdisha Snagg, Amber Phillips and Jonathan Griggs are associates at Cleary Gottlieb Steen & Hamilton LLP. Ms Snagg can be contacted on +44 (0)20 7614 2251 or by email: fsnagg@cgsh.com. Ms Phillips can be contacted on +44 (0)20 7614 2318 or by email: avphillips@cgsh.com. Mr Griggs can be contacted on +44 (0)20 7614 2312 or by email: jgriggs@cgsh.com.

Ferdisha Snagg, Amber Phillips and Jonathan Griggs

Cleary Gottlieb Steen & Hamilton LLP