From 31 December 2021, the Euro, Swiss Franc, Japanese Yen and Sterling LIBOR will no longer be published. To avoid a cliff edge (and resulting market chaos) on that date, the FCA has confirmed that certain LIBOR settings will continue to be published1 for the duration of 2022 under a "synthetic" methodology, based on term risk-free rates. This is addressed in the Critical Benchmarks (References and Administrators' Liability) Bill2
Broadly, this proposed legislation aims to ensure that references to Sterling LIBOR in existing contracts will be interpreted as references to a synthetic LIBOR rate where a transition to an alternative rate has not been made in time. The Bill also provides that contracting parties cannot argue that use of synthetic LIBOR constitutes breach of contract, material change or frustration. It also gives the administrator of the benchmark a degree of immunity. While the Bill offers some comfort to the markets, there remain significant risks for lenders in the transition process, which we consider in this article.
Key differences between LIBOR and SONIA
In the UK, the Bank of England and the FCA have identified the Sterling Overnight Index Average (SONIA) as the preferred alternative rate. In contrast to LIBOR (which is a forward-looking term rate with a built-in credit and liquidity premium which is heavily reliant on expert judgement submissions) SONIA is a nearly "risk free" rate. It is a backwards-looking overnight rate anchored in real transaction data. The profoundly different way in which LIBOR and SONIA work means that it is impossible to effect a straightforward exchange of one rate for the other. A loan linked to SONIA will be an entirely different product to a loan linked to LIBOR, requiring support from completely different IT systems and different contractual provisions to address its calculation, as well as a fundamental rethink of secondary pricing related issues such as break costs and fallback rates based on cost-of-funds.
Whilst efforts have been made to adapt SONIA to make it fit the particular needs of the syndicated loan market the fact remains that, unlike loans linked to forward-looking LIBOR, the interest payable on a loan linked to SONIA will only be known at the end of the interest period.
Over the past couple of years the consistent message delivered by regulators has been that lenders and borrowers should seek to actively transition away from LIBOR to new alternative rates such as SONIA. The Financial Conduct Authority has kept the pressure up on supervised entities by making it clear that failure to engage with the transition process will be a conduct issue.
However, the fact remains that only a matter of days now remain until 31 December and many lenders, despite their best efforts, still have quite a lot to do in order to secure transition of their loan books.
For this reason, moves are now underway to put in place contingency plans when the key Sterling LIBOR tenors cease to be published on 31 December.
Why is LIBOR being phased out?
In short, LIBOR is being phased out as a loan benchmark because of its vulnerability to manipulation, evidenced by the scandals which came to light in 2012 involving LIBOR manipulation by the rate-setting banks. LIBOR manipulation by these banks led to fines totalling billions of pounds, with several senior bankers losing their jobs as a result of the manipulation, and a number facing criminal charges. The scandal sowed widespread distrust in the financial industry and led to a wave of fines, lawsuits, and regulatory actions in the UK and US. Further, following the 2008 financial crisis, the volume of underlying transactions also dropped so significantly that, taken as a whole, LIBOR became unsustainable.
What litigation risks might there be in the transition away from LIBOR?
Given the problems associated with the potential LIBOR replacements, the requirement for banks to advise on replacement rates which meet their customers’ needs represents a significant challenge. In addition to the regulatory risks, there are clear litigation risks. A failure to disclose the fact of or risks associated with new or existing LIBOR-linked contracts may lead to mis-selling claims, particularly if the bank becomes the resulting beneficiary. On the other hand, banks will be wary of opening themselves up to the risk of negligence claims (or at the very least negative client outcomes) if they steer clients towards alternatives which ultimately have an adverse financial outcome.
Lenders need to identify, insofar as possible, the way in which alternative rates will work. While this is challenging, particularly in the current market environment, it is crucial. In the event of future litigation, evidence of thoughtful analysis having been undertaken is likely to minimise the risk of a finding that regulatory, contractual or tortious obligations have been breached.
It will also be important to clearly delineate the role being undertaken. Financial institutions may want to avoid providing advice (for example, leading a specific client through its decision-making process), in which case it will be important to show that only information about the choices available is being provided, with the ultimate decision being taken by the borrower and other relevant parties. Non-reliance clauses will be particularly important in these scenarios.
There are also significant challenges and litigation risks associated with switching products related to loans, such as hedging instruments, to risk free rates. Switching hedged loans to risk free rates is a particularly tricky area due to the challenges associated with aligning the transition of the two products – both in terms of timing and the new reference rate. A mismatch will result in basis risk, which may or may not be an issue for a particular loan or transaction.
The Critical Benchmarks Bill and the key proposals
The theory behind the publication of synthetic LIBOR rates is that continued use of synthetic LIBOR will allow some contracts to reach their natural maturity and roll-off. However, the FCA has been very clear that in most cases, it should be viewed as providing a further period to complete transition of legacy contracts, rather than an alternative. Synthetic LIBOR is not to be viewed by parties as being a permanent solution. Furthermore, the availability of synthetic LIBOR rates will be subject to annual review and therefore the ongoing availability of synthetic LIBOR beyond 2022 cannot be assured.
The scope of the proposed legislation is deliberately broad. It is intended to apply to all contracts and arrangements governed by the laws of the UK. It is also intended to be capable of applying to contracts that describe LIBOR (even if the words "LIBOR" are not actually used).
The Bill also aims to cater for the situation in which a contract provides for a contractual fallback in the event that LIBOR ceases to be available (either temporarily or permanently). In broad terms, if a contract contains provisions that will move the contract away from LIBOR as a result of unrepresentativeness or permanent unrepresentativeness of LIBOR (a so-called “pre-cessation” trigger), this should usually mean that the contract moves away from the relevant sterling or Japanese yen LIBOR setting to the relevant benchmark set out in the fallback provisions at the time, or just before, it becomes unrepresentative.
However, in relation to those contracts referencing 1, 3 or 6m sterling or yen LIBOR that only include fallbacks which operate when a benchmark ceases permanently, these fallbacks are not likely to be triggered while these LIBOR settings continue to be published using a synthetic methodology for a wind-down period (although this will obviously depend on the wording of individual contracts). Rather, these fallbacks are likely to operate only when the relevant LIBOR settings cease to be published in any form.
Only syndicated sterling loans drafted relatively recently are likely to include contractual fallback mechanisms or "rate switches" which kick in upon the occurrence of "pre-cessation" trigger events. Most syndicated loans will instead include contractual provisions providing contractual fallbacks which apply in the event of the temporary unavailability of the LIBOR Screen Rate (with the fallbacks commonly being to Lenders' cost of funds).
Consequently, it appears that many sterling and yen syndicated loans which have not actively transitioned to a new rate will, after 31 December 2021, automatically move to reference synthetic LIBOR.
There are some issues which parties will need to grapple with if this happens. For example, one issue is that synthetic LIBOR is not going to be published for Sterling for any period less than a month. However, on syndicated loans it is often necessary to calculate interest for "stub periods" of less than a month and the documents will contain no workable methodology to deal with this.
It also seems inevitable that the automatic "switch" to synthetic LIBOR could result in financial consequences for some parties. Lenders will probably be most vulnerable to regulatory censure and potential litigation where they have failed to engage fully and proactively with the transition process. The FCA has certainly delivered a consistent message that supervised firms need to engage actively with the transition process and that failure to do so will be a conduct issue.
Notably, the Bill does not include any "safe harbour" to protect parties using synthetic LIBOR from the risk of litigation. Instead, it confirms that the deeming provision neither creates any new liabilities nor extinguishes any existing causes of action. This approach of course consistent with the reluctance of English law to interfere in the freedom of contract. However, it is a different approach to the approach being taken in the US: the US tough legacy legislation has a broad "safe harbour" from claims.
Another issue which is important (and extremely complicated) is the interaction between the various "tough legacy" legislation which is being enacted (or to be enacted) in different jurisdictions. The interplay between the various pieces of tough legacy legislation is far from clear and could potentially give rise to complex conflict of laws issues.
It is clear that a lot of hard work has been going on by regulators and legislators to try and minimise the scope for chaos when the plugs are pulled on a number of key LIBOR screen rates on 31 December.
It will, however, remain to be seen exactly what impact the discontinuation of LIBOR and the imposition of a synthetic rate on certain contracts and parties will have on the market and what litigation risks this will cause.