On 23 June 2020, Rishi Sunak, Chancellor of the Exchequer, set out the UK Government's intention to introduce legislation to provide a solution for 'tough legacy contracts' that 'genuinely have no or inappropriate alternatives' to LIBOR and no realistic ability to be renegotiated or amended'1. The statement, a summary of which can be found here, shows the Government recognises that the LIBOR transition timetable has been slowed by the Covid-19 pandemic and that legislative assistance to mitigate the unintended and potentially damaging results of LIBOR transition for counterparties of "tough legacy" contracts is required. However, Andrew Bailey (Bank of England Governor) noted yesterday that, whilst the UK Government's desire to expand the powers of the FCA in this respect is a welcome and necessary part of the endgame of LIBOR transition, any such 'solution' will likely result in a "one size fits all" approach that should only be used in the minority of transactions where amending a contract that references LIBOR is not possible. Institutions should not rely on the FCA's powers to solve the issue of LIBOR transition where they can agree replacement reference rates that are commercially acceptable in particular transactions.
Where can I find the legislative solution?
The legislative solution will be set out in a forthcoming Financial Services Bill which will ensure that the FCA has the powers required to manage an orderly transition from LIBOR. The solution will include amendments to the Benchmarks Regulation 2016/1011 (the "EU BMR"), as transposed into English law as a result of Brexit by the European Union (Withdrawal Agreement) Act 20202 (the "Retained EU BMR") and as amended by the Benchmarks (Amendment and Transitional Provision) (EU Exit) Regulations 2019 3 (the "UK BMR").
Why the UK BMR?
The EU BMR was originally introduced to provide a framework to protect against the manipulation of financial benchmarks and to ensure their reliability.
The UK BMR is a statutory instrument which amends the Retained EU BMR to ensure that the regime for benchmarks continues to operate effectively in the UK now that the UK has left the European Union (with necessary changes to reflect the UK's exit from the European Union, for example, to transfer powers from the European Securities and Markets Authority to the FCA).
The proposed amendment of the UK BMR will enhance the powers of the FCA to act in the event that a benchmark rate like LIBOR becomes unrepresentative of underlying markets.
What FCA powers are envisaged?
The legislative solution is intended to add to the FCA's powers to enable it to direct a methodology change for a critical benchmark (like LIBOR) in circumstances where the benchmark is no longer representative, the benchmark's representativeness will not be restored and where action is necessary to protect consumers and/or to ensure market integrity.
The effect of the above powers would be to enable the FCA to direct the implementation of a new, but temporary, LIBOR rate based on a new methodology (a "Transition LIBOR") in order to sustain the publication of the rate in a robust manner. The Transition LIBOR rate would not be based on the existing methodology of calculating LIBOR through obtaining interbank rates from a panel of banks. Instead, the Transition LIBOR rate would be based on a methodology chosen by the FCA, with no requirement for the rate to necessarily be representative of the market.
The FCA, in a supporting statement released on 23 June 20204, noted that it would seek market input on the methodology changes that would, if the powers were used, reduce the risk of the Transition LIBOR value diverging from the value of fallbacks that come into effect in line with market consensus. The FCA plans to publish a policy on how it could exercise its change in methodology power in due course. We would note that market participants have, of course, been discussing the creation of a "synthetic" LIBOR rate for many years that would, in effect, amount to a SONIA rate plus spread and it is welcome that the UK government has now indicated its full support for some form of Transition LIBOR.
Proposed UK approach v US approach
The proposed legislative approach in the UK is distinct from the approach proposed by the New York Fed's Alternative Reference Rates Committee ("ARRC") in the US.
The ARRC approach, a summary and analysis of which can be found here, mandatorily overrides fallback language in New York law governed agreements that reference a LIBOR based rate, nullifies fallback language that requires polling for LIBOR or other interbank funding rates, and inserts the ARRC recommended benchmark replacement as a LIBOR fallback in contracts that do not have fallback language. The approach is therefore to mandatorily, and automatically, impose changes on LIBOR-referencing contracts that do not have a suitable fallback.
In contrast, the UK approach doesn't seek to directly impose changes to contracts governed by the laws of a country in the UK. Instead, the UK approach seeks to use and expand the existing regulatory powers to empower the FCA to provide a Transition LIBOR rate, using a new methodology, for a limited number of contracts who are unable to transition to an alternative rate.
Is the legislation a formality?
The statement from Rishi Sunak and the FCA supporting statements provide a high-level view of the legislative solution. Further details are expected after the Financial Services Bill is published on the following matters:
- Methodology – there are currently no details on the methodology that will be used to calculate the Transition LIBOR rate, other than that the FCA will seek market input to reduce the risk of Temporary LIBOR diverging too far from fair fallback values for LIBOR during a pre-cessation period. Given some risk free rates have different methods of calculation (for example, forward looking and historic means of calculating the risk free rate) and many risk free rates build in a spread adjustment, it will be interesting to see how the FCA tackles those issues across different finance product offerings. It may be the case that a well-intentioned piece of legislation creates the possibility of challenges to the rate chosen by the FCA.
- Tough Legacy Contracts – there is currently no definition of 'tough legacy contracts' and so there is currently no certainty on the contracts that will be caught by the legislative solution. For example, would the Transition LIBOR be applicable to contracts that have failed to transition solely because a move to a risk free rate would cause a severe administrative burden in the operation of the contract? Would it apply to loan agreements with a large syndicate and where a consensus on LIBOR transition has not been reached due to non-responsive lenders? The scope of the definition will require close inspection to avoid uncertainty and disputes regarding whether a contract is considered a 'tough legacy contract'.
- Undesired Outcomes - if LIBOR continues to be published using the new methodology, fall-back rates in contracts that only apply following LIBOR's unavailability may not be automatically triggered. This may be good news if the fallback option is not suitable for use (for example, because its use was never intended for a permanent cessation of LIBOR), or bad news if the fallback option was mutually agreed by the parties as part of the transition away from LIBOR. The FCA are advising that any agreed fallbacks should ideally come into effect at the point LIBOR becomes non-representative (and enters a pre-cessation period) rather than waiting for its prohibition on use to come into effect. It may be the case that the proposed legislation also pre-empts, and mitigates, the undesired outcome identified above.
- Currencies – the FCA supporting statement provides that the change in methodology may not be appropriate for all LIBOR currencies and tenors. As a result, the FCA may not provide a Transition LIBOR rate for certain currencies and tenor pairs, which may prove challenging for certain 'tough legacy' contracts.
- Benchmark disparity in portfolios – companies very often have a range of financial products in place serving different, but sometimes interconnected, functions. While the different financial markets are looking to align on the transition away from LIBOR as much as possible, in some cases that will likely not be realistic, and 'tough legacy' contracts fall into this category. In a situation where some products shift to a Transition LIBOR rate and others are amended by bilateral agreement, one can foresee the risk of mismatches occurring, even though one of the FCA's stated aims is avoid them.
- Breach of UK BMR – the UK BMR provides that if a benchmark's representativeness cannot or will not be restored, its publication must cease within a reasonable time period.Noting that the FCA has stated that the change in methodology will not necessarily result in the Transition LIBOR rate being representative, it could be argued that the publication of the Transition LIBOR rate would be in breach of the UK BMR. We would expect the proposed amendment to the UK BMR to mitigate such a risk.
Does the legislative solution ease the pressure on LIBOR transition?
There is no certainty that a legislative solution will materialise, either in the UK or in the US. If the necessary legislation and FCA guidance for a legislative solution do materialise before LIBOR ceases to be published, it may be useful in the context of some contracts, which had no realistic possibility of being amended in time. However, the UK Government and the FCA are at pains to stress that parties should continue to mutually agree to transition away from LIBOR where possible. This is particularly because (i) as mentioned above, the use of the FCA powers may not be possible for all LIBOR currencies; (ii) the parties will have no control over the economic effect of the FCA's action such that the Transition LIBOR rate may be completely unsuitable for one or both parties; and (iii) for any new business, an alternative reference rate to LIBOR will be required.
Originally published 16 July, 2020
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