The Financial Conduct Authority (FCA) has made clear that after 2021 it will no longer compel banks to submit LIBOR quotations or sustain the LIBOR benchmark, and that regulated parties proposing LIBOR for contracts beyond 2021 must explain the risks involved.
A key question is how existing contracts which reference LIBOR and extend beyond December 2021 (so called “legacy contracts”) will operate. Participants may agree (or have the right to impose) terms to amend their contracts to deal with the cessation of LIBOR (either a new rate or a new fall-back provision). However, if the parties are unable to amend their legacy contracts, they will need to rely on existing language.
This article examines the litigation risks associated with legacy contracts. The analysis in any particular case turns upon the language of the contract and the facts of the transaction but some general themes can be identified.
Legacy contract terms
Most legacy contracts provide alternative methods of calculating the interest rate (so-called “fall-back” provisions). Fall-back provisions apply where the relevant LIBOR screen rate is unavailable.
It is possible that voluntary LIBOR submissions will continue beyond December 2021. In that case, the published LIBOR rate is unlikely to reflect market pricing (so-called “zombie LIBOR”). This may raise other potential disputes, but arguably the fall-back provisions would not be triggered.
In general, there are three relevant types of fall-back provisions. All three types are designed for temporary interruptions to LIBOR. They do not contemplate LIBOR being permanently unavailable and it seems likely each could give rise to litigation in a post-LIBOR world:
- Reference Bank Rate: An arithmetic mean of quotations typically provided by four reference banks. However, if LIBOR is withdrawn, banks might not be willing to undertake the liability risks of making submissions voluntarily to other market participants. This might mean that no quotations are available.
- Historic Screen Rate: Applies the most recently available screen rate. This will convert the contract from a floating rate to a fixed rate agreement, fundamentally altering the economics of the contract. This is plainly undesirable in circumstances where the parties cannot predict in advance who would benefit from such an outcome.
- Cost of Funds calculation: Requires the lender to determine its reasonable costs of funding the particular transaction. Banks do calculate their cost of funding, but on a portfolio basis. Deriving the cost of the particular transaction from the portfolio as a whole is necessarily imprecise and subjective, and could be open to challenge.
It is therefore uncertain to what extent these fall-back provisions will be effective following the retirement of LIBOR. This is likely to lead to disputes between parties as to what interest rate should be paid. There are three tools the Court is likely to apply to resolve such disputes:
Parties may argue that the Court should interpret the relevant fall-back provision in a way which obviates these problems.
This outcome is unlikely given that commercial common sense and the surrounding circumstances of the transaction cannot be used to undermine the actual language used in the relevant contractual provision. If the language of the fall-back provision is clear, the Court will not go beyond that to identify potential practical or commercial problems in applying it. The Court will not interpret the problems away unless there is some ambiguity in the clause itself. If the parties have clearly thought about what to do when a LIBOR screen rate is not available and made unambiguous provision for that eventuality, then the wording of the contract will be applied.
(i) Substitution of a new fall-back provision
The Court has the power to substitute contractual machinery which has broken down, so long as the machinery is not an essential term of the contract. The question is whether the fall-back provisions are essential, or are simply machinery to give effect to some other essential term.
It seems highly unlikely the reasoning would apply here. The parties have chosen a specific interest rate which is calculated in a particular way. In a loan agreement or interest rate swap, how interest is to be calculated is a core, fundamental term. The parties will argue that it is essential. The fall-back provisions are not just different methods of achieving the same goal, they actually produce different rates.
In reality, it will likely be possible to apply the machinery. However, the results will be unusual and will benefit one party or the other. Disputes are therefore likely to arise.
(ii) A freestanding implied term
The Court might imply a new term to remedy defects in the fall-back provisions. For example the Court might be asked to imply a term that if the fall-back provision becomes commercially unworkable, a reasonable alternative interest rate will be implied (for example, SONIA).
However, whether a term should be implied is assessed from the time of entry into the contract, not with the benefit of hindsight. Because the parties chose to include these fall-back provisions in the contract, it will be argued the parties envisaged (and provided for) LIBOR becoming unavailable.
Moreover, calculation of interest is an essential term. It will be argued that implying a “reasonable rate” in place of a fall-back provision would rewrite the entire bargain.
A contract will be frustrated if the very nature of the rights and obligations change in a way which was not anticipated by the parties. It is not enough that the contract becomes more expensive or onerous.
It may be argued that a Historical Screen Rate fall-back provision fundamentally changes the parties’ rights and obligations by switching a floating-rate instrument to a fixed rate. However, the difficulty is that the parties themselves agreed this is what would happen if LIBOR was unavailable.
In the case of a Bank’s Cost of Funds calculation, it seems highly unlikely a frustration argument could succeed. It is not enough that the contract becomes more onerous for one party. There must be some fundamental change to the rights and obligations of the parties. Again, the parties themselves have agreed that this is what would happen.
Arguably, the contract might be frustrated in the case of a Reference Bank Rate. In that case, the contract may break down entirely because no reference banks are willing to submit quotations. In those circumstances, the contract would simply cease to function because it will be impossible to calculate an interest rate using the clause as written. This might be a risk in the ISDA context where the fall-back is a Reference Bank Rate (although the 2002 ISDA Master Agreement incorporates a force majeure clause, which might also arguably be engaged and lead to a close-out netting calculation).
It is important that parties to legacy contracts immediately start reviewing their transaction documents to assess their exposure to litigation risks arising from legacy contracts.
This article was originally published by Thomson Reuters Regulatory Intelligence.