The London Interbank Offered Rate (LIBOR) is scheduled to be phased out by the end of 2021, and there is uncertainty about what impact this will have on LIBOR-referenced contracts that extend beyond this date. In this article, Elaina Bales examines the litigation risks that will arise due to the LIBOR changes and what steps business should take now to minimise these risks.
What’s happening to LIBOR?
LIBOR is the benchmark interest rate at which major global banks lend to one another in the interbank market. It is widely used as a reference rate for the pricing of financial contracts that are collectively worth trillions. It is used not only in complex financial products such as floating rate notes, derivatives and syndicated loans but on residential mortgages for banks’ retail customers. It has not been without its controversies, having been at the centre of one of the great scandals of the 2008 financial crisis, when it was revealed that rate-setters at major banks had been fixing their submissions.
Since 2008, market practice has changed, and banks no longer rely on unsecured interbank borrowing for funding. This means there are far fewer transactions on which banks can base their LIBOR submissions. In July 2017, LIBOR’s regulator, the Financial Conduct Authority (the FCA), announced that as the rate was no longer sufficiently active to be genuinely representative of market conditions, the FCA would no longer compel panel banks to provide quotes for LIBOR after the end of 2021. It is expected that when panel banks cease to submit quotes, LIBOR will no longer be published or will effectively become redundant.
LIBOR currencies will be replaced with Risk-Free Rates (RFRs). In the case of sterling, the Sterling Overnight Index Average (SONIA) has been identified as the preferred RFR. There are some key differences between RFRs and LIBOR; RFRs are backwards-looking, ie are published the following day and are reset daily, whereas LIBOR is forward-looking and available in longer periods. LIBOR is numerically larger than SONIA. Parties contracting from now onwards can consider whether it is appropriate to benchmark their agreements to SONIA, or whether to use a different benchmark.
What next for existing LIBOR-referenced contracts?
For existing LIBOR-referenced contracts that continue beyond the end of 2021, it will not always be a straightforward case of replacing references in an agreement to LIBOR with an RFR or another benchmark. Legislators, regulatory and industry bodies in the main LIBOR jurisdictions have been grappling since 2017 with how to mitigate the problem of these so-called ‘tough legacy’ contracts.
In the UK, in October 2020, the government put draft legislation to parliament as part of the Financial Services Bill that aims to provide a ‘legislative fix’ for this problem. The draft bill provides the FCA with enhanced powers to designate a change to the methodology by which LIBOR is set. The practical effect of this is that where a tough legacy contract references LIBOR, it will be treated as a reference to the new methodology, ie a synthetic LIBOR rate. So far, only high-level guidance has been given by the FCA on how this synthetic LIBOR rate may be calculated. It may be a forward-looking term rate based on RFRs plus a spread adjustment. Further, it is not yet clear exactly which legacy contracts will be subject to the legislative fix, as ‘tough legacy’ contracts have not yet been defined. On 18 November 2020, the FCA announced a consultation on its use of the powers under the bill, seeking market participants’ views on the exercise of the proposed powers.
There remains great uncertainty as to the fate of legacy contracts, therefore, and the readiness for transition is not consistent across the market. The derivatives market has led the way, and in July 2020 the International Swaps and Derivatives Association (ISDA) published its 2020 IBOR Fallbacks Protocol and a supplement to the 2006 ISDA Definitions. Where parties adopt the protocol, their ISDA contracts with parties who also adopt the protocol will automatically be treated as having adopted the alternative benchmarks specified. However, no such similar mechanism exists for other types of LIBOR referenced contracts.
Where will the main risks of litigation arise?
Despite policy-makers’ attempts to reduce the situations where disputes may arise, there will inevitably be situations where parties will not be able to agree a solution. Though the legal principles surrounding interpreting contracts where circumstances change dramatically are well established, these have not yet been applied to the LIBOR situation. Given that many LIBOR contracts are standardised, we may see regulators or industry bodies seeking guidance from the courts as to how to interpret certain standard wording. Given the value of the LIBOR market, it is also likely private parties will litigate claims given how much is at stake.
Parties are likely to encounter the below scenarios that could give rise to the following types of claims:
Contractual interpretation disputes
- Renegotiating legacy contracts is unlikely to be straightforward. As none of the alternative benchmarks work in exactly the same way as LIBOR, for each party there will be a financial benefit to arguing a certain methodology applies. Who is correct will depend on how the contract is properly interpreted. The starting point of English law on contractual interpretation is to identify the intention of the contracting parties, looking at the language of the contract and the commercial context. Identifying what the parties intended if the interest rate they expressly chose ceased to be published may not be straightforward where no clue is given in the contract itself.
- The situation may be equally difficult, even if the contract does provide for such a scenario. Many LIBOR-referenced contracts already include fall-back provisions, which deal with what happens if LIBOR is not published. But these may not work in practice; many are simply temporary fixes if LIBOR ceases to be published for a short period, and reverting to them could have the effect of economically disadvantaging one party. We are, therefore, likely to see claims arising where parties argue that the fall-back provision cannot be given effect, and so an alternative term should be implied into the contract to give it its true business efficacy.
Conflict of laws
- Many complex multi-party financial instruments reference LIBOR, for example, syndicated lending agreements and bond issues. In those situations, it may not be feasible for all parties to agree amendments. Such arrangements also may involve contracts governed by the law of different jurisdictions, where legislators have taken diverging approaches to replacing the benchmark. For example, the approach being taken in the legislative proposals by the EU and the US is different to the UK’s proposals. The US and the EU have proposed an automatic transition to a replacement benchmark that will apply to all legacy contracts, not just tough legacy contracts. Such differences could have the unintended consequence of related contracts that previously both used LIBOR now being subject to different benchmarks in different jurisdictions, disadvantaging one party. If claims are started in more than one jurisdiction, courts could give inconsistent answers as to which rate applies.
Securities and misselling claims
- In the lead time in between the announcement of the cessation of LIBOR (in 2017) and its implementation in (2021), contracts were still being entered that referenced LIBOR. If no provisions were made in the contract for LIBOR transition, this raises questions as to the parties’ intentions as to what would happen post-2021. Regulated financial institutions were aware of the proposed cessation, and so could face misselling claims from customers alleging they were misled by the representations made to them before entering into the contract. This may be more acute for retail customers who would not necessarily be aware of LIBOR transition. But even in contracts between sophisticated parties with fall-back provisions, there could be scope to argue that one party was misled as to the economic consequences, leaving them worse off.
- Since 2017, issuers of securities referencing LIBOR have included disclosures regarding the discontinuance of LIBOR in prospectuses. The majority of such disclosures will be tightly worded, but there remains the possibility that securities claims by purchasers of LIBOR-referenced securities could be brought if the disclosure was not sufficiently clear to disclose a material fact. Prior to 2017, there were signs that LIBOR was becoming less representative of market lending conditions and that the derivatives market was moving towards using RFRs. Nevertheless, the FCA’s announcement was not anticipated, and so it will be difficult for claimants to argue that they were misled by the omission of such warnings before that announcement.
Impossibility of performance
- Many contracts include force majeure clauses that excuse parties from their contractual obligations on the occurrence of extraordinary events. If parties are unable to agree a new benchmark that reflects the original economic effect of the contract, a party looking to exit the agreement could argue a force majeure has occurred. Whether this is successful will depend on the exact wording of the clause. But given that many LIBOR contracts are industry standard, there could be test cases brought to establish the correct interpretation.
- English law has a doctrine of frustration which allows parties to be excused from future contractual obligations following the occurrence of an event outside the parties’ control. Frustration may apply where the event was not considered by the parties when entering to the contract and if it renders it impossible for the parties to perform the fundamental obligations under the contract. A party may argue their LIBOR-referenced contract is frustrated if no alternative benchmark can replace LIBOR to allow the contract to be performed. However, frustration is narrowly applied by the courts. It is not enough that there are difficulties in performing the contract. It will depend on whether it is impossible to apply a different benchmark based on the specific wording of the contract.
What should businesses be doing now?
To reduce exposure to the litigation risk associated with LIBOR transition, businesses can take the following simple steps now:
- Contractual audit: consider which financial contracts are LIBOR-referenced and run beyond 2021, to identify those that may be problematic. Given the pervasiveness of LIBOR, most businesses will have LIBOR-referenced contracts; even straightforward loan agreements may be LIBOR-referenced.
- Negotiate with counterparties now: be proactive in approaching counterparties to legacy contracts, and attempt agree a solution before LIBOR ceases to be published. As outlined above, these negotiations are unlikely to be straightforward, so parties should seek early legal advice to understand the best outcome for their business.
- Avoid new LIBOR-referenced contracts: be wary of counterparties offering new contracts that reference LIBOR. Financial institutions have duties to provide appropriate products to customers. There may still be situations where LIBOR remains the most appropriate reference rate, but given that transition is fast approaching, this should be questioned before execution.
The cessation of LIBOR is likely to be an administrative headache for businesses that it will be difficult to escape. However, it is worth acting now to reduce the risk of being drawn into disputes that could become protracted and being required to go all the way to court to get a definitive answer.