We have today issued a client advisory on the final report proposing reform to the LIBOR quotation process (see “LIBOR Reforms -- The Wheatley Report”)That advisory summarizes the recommendations of the Wheatley Report and examines their implications for market participants.
The present advisory focuses on more immediate, practical consequences for existing contracts that reference LIBOR as a benchmark. It has been estimated that there are some US$300 trillion of outstanding swap contracts that use LIBOR as a means of calculating the floating rate obligation, and the same will be true of many loan and other financial agreements. Many of these contracts may have a number of years to run until final maturity. The impact of the LIBOR reforms on transitional agreements may therefore be assumed to be significant.
The Key Issues
Could the floating rate payer under to a swap avoid or reduce his payment obligations on the basis that the LIBOR reforms have resulted in a higher rate? Or could the fixed rate payer mount the reverse argument, on the basis that he has been prejudiced by a lower LIBOR rate applied to the obligations of its counterparty?
Equally, the borrower of a LIBOR-linked floating rate loan may feel that its interest costs have increased as a result of the changes to the approach to the calculation of LIBOR.
The same issue may also arise in other contexts. But in each context, the principle will be essentially the same – namely, do the LIBOR reforms create a right to terminate a contract, or to require a variation of its terms?
It should be emphasized that this advisory is limited to the litigation risk flowing solely from the benchmark reforms. Where a party to a swap is itself a LIBOR panel bank that is shown to have been involved in manipulation of the benchmark, then fact-specific and legal issues of an entirely different order may arise. Proceedings of that kind are already underway both in the United Kingdom and in the United States.
Substantive Impacts of LIBOR Reforms
As noted in our “Reform” advisory, the question posed of LIBOR panel banks will –at least for the present time-- remain the same, namely:
“At what rate could you borrow funds, were you to do so, by asking for and then accepting inter-bank offers in a reasonable market size just prior to 11 am?”
But, as noted in that advisory, the response to the question is likely to differ because of the prescription of closer guidelines for the formulation of submissions. In addition, the ultimate rate is also likely to be affected by the use of a wider range of panel banks.
It is therefore relatively easy to state that the reforms are likely to have an impact on levels of LIBOR. But as a practical matter, it is likely to be very difficult to establish whether and when LIBOR is higher or lower than would otherwise have been the case. Quotations under the “old” LIBOR system will naturally cease to be available and – at least in terms of a forensic legal inquiry— any attempt to draw comparisons between the levels “old” and “new” LIBOR is likely to be a matter of speculation.
Any party seeking to build a case on the basis that he has been disadvantaged by the LIBOR reforms will therefore face very significant evidential challenges. This factor may, of itself, be a significant deterrent to the uncertainties and expense of litigation. But – even assuming that disadvantage or prejudice can be proved—would this have any implications for the validity of a contract or the effectiveness of its LIBOR-related provisions?
Contractual Terms and LIBOR
As a general rule, contracts remain effective and enforceable in accordance with their stated terms. A court has no power to re-write or to revise a contract merely because the background factual matrix has changed since the contract was originally made.
In this context, it must be borne in mind that many contracts will simply refer to a LIBOR rate as specified by a particular price source. For example:
- swap contracts based on ISDA standard terms will generally refer to “USD-LIBOR-BBA” as “…the rate for deposits in US Dollars which appears on the Telerate Page 3750… If such rate does not appear on the Telerate Page 3750, the rate…will be determined as if the parties had specified “USD-LIBOR-Reference Banks” as the applicable Floating Rate Option…”; and
- syndicated facility documentation based on the Loan Market Association standard forms will refer to a “Screen Rate” which “…means… in relation to LIBOR, the British Bankers Association Interest Settlement Rate… displayed on the appropriate page of the Reuters Screen. If the agreed page is replaced or service ceases to be available, the Agent may specify another page or service displaying the appropriate rate…”
It should be said that neither of these clauses refers to the mode of calculation of the rate that appears on the relevant screen page; they merely refer to the finished product. Consequently, if a rate appears on the page concerned, then that rate should apply for the purposes of the agreement. No further inquiry or argument is permissible. It follows that a change in the underlying bases on which the necessary market data is collated and calculated would not affect the validity or enforceability of the contractual provisions just described.
In this context, and by way of comparison, it may be noted that the composition of LIBOR panels for various currencies has changed over the years and this may have had an impact on LIBOR levels from time to time. Yet it does not appear to have been argued that this affected either the validity of the rates themselves or the enforceability of contracts that referred to them.
A possible difficulty is posed by the fact that both definitions in the sense that they both contemplate that the BBA will be responsible for the publication of the LIBOR rate. But, as noted in our “Reform” advisory, the BBA will cease to have any role in the formulation of LIBOR. The Loan Market Association wording effectively avoids this problem by allowing the facility agent to designate a replacement price source in this type of situation. It could thus designate the “new” LIBOR formulation for the purposes of the agreement. The quoted ISDA wording should also remain effective, in the sense that reference to the BBA forms a part of the definition but the quoted rate would appear to govern so long as it appears on the stated Telerate page. These clauses should therefore continue to operate even though a new LIBOR administrator is appointed.
In other contracts that refer to LIBOR, it will be an implied term of the contract that, in the event of a disappearance of that benchmark, the parties would refer to the nearest equivalent or replacement benchmark. It is clear that the “new” LIBOR arrangements are intended to substitute the “old” LIBOR structure, with the result that the agreement would continue to function in the same way.
Consequently, and subject to a few reservations noted at a later stage, it will generally be the case that current contracts that reference LIBOR will continue to be valid and effective notwithstanding the transition to the new LIBOR arrangements. It should not be necessary to renegotiate existing agreements, although no doubt this will occur in some cases out of an abundance of caution.
The Doctrine of Frustration
Under English law, a contract may be terminated by the doctrine of frustration.
In essence, the doctrine may come into operation if (i) there has been a change of circumstances since the date of the contract, (ii) that change was not foreseen by the parties, (iii) the new situation is not covered by the terms of the contract and (iv) as a result of the changed circumstances, performance of the contract would be radically different from that originally contemplated by the parties.
It is suggested that there is no scope for the operation of this doctrine in relation to subsisting, LIBOR-linked contracts. The obligations of the borrower or counterparty will continue to be calculated by reference to an independently ascertained floating rate index that is reflective of interbank offered rates in the London market. There is thus no radical change in that party’s obligations. Even if it can be shown that the relevant obligations would have been a few basis points lower under the “old” LIBOR system, this would not result in the frustration of the agreement. Case law establishes that the doctrine does not apply merely because the cost of performance is increased for one of the contracting parties.
In addition, many contracts specifically make provision for the ascertainment of a rate in the event that a given price source ceases to be available. As noted above, the existence of contractual provisions addressing the situation will preclude the operation of the doctrine of frustration.
It follows that the LIBOR reforms will not adversely affect the continuing validity of contracts that make reference to that benchmark.
In the light of the analysis set out above, it appears that LIBOR-linked agreements will remain valid and effective notwithstanding the LIBOR reforms. Such agreements will also continue to operate by reference to the contractually specified price sources.
Yet there will remain difficulties in specific contexts. As noted in our “Reform” advisory, LIBOR quotations will in due course cease to be available for the Australian, New Zealand, Canadian, Swedish and Danish currencies, and less frequently used maturity periods for the major currencies will also be dropped from the process. In the absence of a replacement index or price source for those currencies/maturities, it will be necessary to have recourse to “fallback” clauses that generally provide for price information to be collected from specified reference banks. Whilst this will involve a greater degree of administrative work, such contracts will continue to operate in accordance with their terms and there will be no scope for the operation of the doctrine of frustration.
The impending LIBOR reforms may have an impact on contracts referencing that benchmark for marginal currencies or rarely used maturities. In most cases, however, such contracts will continue to operate by reference to “fallback” interest rate calculation provisions. This may cause some inconvenience to in terms of the administration of such contracts but will not affect their legal validity or enforceability.
For the most part, however, the vast majority of contracts expressed in the mainstream currencies will remain effective by reference to LIBOR as calculated and published in accordance with the reforms. It will not be necessary to have recourse to “fallback” provisions, nor can it realistically be asserted that the reforms will lead to the frustration or termination of LIBOR-linked contracts.
In practice, it will also be very difficult for a LIBOR payer to demonstrate to a court that he has been financially disadvantaged by the calculation of LIBOR under the new regime.
For these reasons, and in the absence of any unusual factors, it is our view that any contractual litigation that seeks to challenge the calculation of LIBOR under transitional contracts is unlikely to be successful.