LIBOR transition is one of the most significant challenges facing financial institutions today, but it is not just a regulatory issue. Here are some practical tips to help you mitigate thLIBOR transition is one of the most significant challenges facing financial institutions today, but it is not just a regulatory issue. Here are some practical tips to help you mitigate the litigation and regulatory risks.e litigation and regulatory risks.
LIBOR transition presents a number of serious challenges to regulated firms. One of the most significant is how a firm remediates its legacy book of deals to transition those deals to the new risk free rates.
Our article ‘Time for a Change’ outlines a solution-focused approach to the legal and commercial complexities associated with the remediation process which we hope will be a helpful starting point. There are a number of litigation and regulatory risks that firms should be aware of when undertaking this remediation exercise to ensure they design an appropriate negotiation strategy with their counterparties. The litigation risk arises from this basic problem: panel banks have agreed with the FCA to continue to make LIBOR submissions until the end of 2021, but the benchmark is unlikely to persist in its current form much beyond that deadline. So what happens to the trillions of dollars of LIBOR referenced contracts that expire after 2021? What if you cannot agree a replacement benchmark with your counterparties? We discussed these knotty issues and the wider topic of LIBOR transition during our Emerging Themes webinar on 21 January 2021.
The starting point in any contractual analysis is the contract itself. Firms will need to consider what fallback language (if any) is in their LIBOR referenced contracts. This will vary for different product types. Historically, there are three main types of fallback provisions:
- Reference bank quotations – ISDA derivative contracts typically incorporate a fallback within the definition of LIBOR that is based on an average of quotations provided by reference banks. But few banks are likely to want to assume the risk of continuing to quote after 2021.
- Previous LIBOR screen rates – in many bond transactions, the documentation refers to the most recently available screen rate if LIBOR is not available on a particular day. If LIBOR disappears and the parties rely upon this fallback, it will have the unintended consequence of converting a floating rate to a fixed rate.
- Lender’s cost of funds – many loans based upon LMA documentation will reference the lender’s cost of funds as the ultimate fallback if LIBOR is not available. Whilst banks do calculate their cost of funds, that is typically on a portfolio basis. Apportioning those costs to individual contracts would be subjective and potentially contentious.
None of these fallbacks are really fit for purpose if LIBOR ceases to exist. They were aimed at temporary unavailability, for example computer glitches or market disruption events.
"If there are no workable provisions in the contract to deal with the disappearance of LIBOR, parties might argue for implied terms."
There may be other potentially relevant provisions in your contracts, for example a force majeure provision (see, for example, section 5(d) of the 2002 ISDA Master Agreement) or a Material Adverse Change clause. The burden will be on the party seeking to invoke that type of clause, and case law demonstrates that the threshold is high. The FCA and PRA are also unlikely to look kindly on firms invoking clauses which penalise the customer, for example by giving rise to an event of default. If there are no workable provisions in the contract to deal with the disappearance of LIBOR, parties might argue for implied terms. It will depend upon the interpretation of the relevant contract, but under English law it is difficult to imply an essential term like the price of the contract. Without agreement or legislative intervention, there is a real risk that some contracts will be frustrated. Frustration is a longstanding common law concept which discharges a contract with immediate effect if there has been such a significant change that it would be unjust or impossible to insist on ongoing performance. There are not many cases where it is successfully invoked because courts are reluctant to rip up contracts in that way. It nevertheless must be a risk where the rate of interest cannot be calculated under the contract or the stipulated rate is unlawful to use under the tough legacy regime (referred to below). If the contract is frustrated, all unperformed and future obligations are immediately discharged but the parties can recover monies paid before the discharge under s.1(2) of the Law Reform (Frustrated Contracts) Act 1943. That might be not be a desirable outcome for either the borrower or lender to a loan contract. There is a new Financial Services Bill currently before Parliament which seeks to address some of this uncertainty. The Bill allows the FCA to prohibit use of LIBOR but designate specific categories of contracts – so-called ‘tough legacy contracts’ – as exempt from this prohibition. The FCA will also be given powers to direct changes in how LIBOR is calculated in order to allow those exempt contracts to continue to use after reference banks cease to submit i.e. creating a ‘synthetic’ LIBOR. The details of this tough legacy regime are still very much up in the air. We do not know which contracts will qualify as tough legacy contracts, and the FCA has been at pains to stress it will be a restricted category – perhaps to avoid giving firms false comfort that they do not to reach a consensus with their counterparties. We also do not know what a synthetic LIBOR would look like, and whether that would even meet the contractual definition of LIBOR under each contract. Whether or not the tough legacy regime applies, there is clearly a risk that a counterparty would view itself as being in a worse position than before the LIBOR cessation and seek redress in the Courts. It could formulate its claims in a number of different ways, for example a breach of express/implied terms, frustration of the contract, misrepresentation by the bank, unjust enrichment etc. The litigation would be played out in front of a watching regulator which has stressed the need to pay due regard to the interests of customers and treat them fairly.
"Start your LIBOR transition project now if you haven’t already done so."
So how should a firm go about seeking an agreement with its legacy counterparties and mitigating the litigation and regulatory risk? Here are some practical tips:
1. Start your LIBOR transition project now if you haven’t already done so.
You will need to undertake a number of steps internally before you are even in a position to start discussions with counterparties – identifying the universe of legacy contracts, considering fallback provisions, deciding the most appropriate replacement benchmark, drafting amendments, determining a communications strategy etc. You do not want to leave those negotiations so late that you are seen as imposing solutions on your counterparties at the last minute. The FCA and PRA are also likely to be interested in the progress of your transition project. One of the difficulties in this context, however, is that many counterparties and financial institutions themselves are reluctant to commence negotiations for remediation of legacy deals in earnest while the market does not yet appear to have reached consensus on key matters relating to the transition to risk free rates. This issue is further compounded by the fact that regulators, in particular the FCA, have laid out timelines for when they expect regulated firms to begin remediating legacy deals. In light of this tension between regulatory expectations and market realities, firms should ensure that they are well placed to commence remediation negotiations at short notice, even if they do not formally pull the trigger for several months as market consensus evolves.
"Align your approach with market standards as much as possible. We recognise that there is no current market consensus, but we are slowly moving there."
2. Do not use the negotiations as an opportunity to secure a better commercial deal.
One of your objectives in determining the most appropriate replacement benchmark should be to minimise economic value shift. You should record how you think your approach meets that objective. For example, a potentially contentious issue will be the amount of any credit spread adjustment (“CSA”). This is intended to compensate a lender for the fact that a backward looking Risk Free Rate (for example, SONIA which is based on overnight transactions) will typically be lower than the forward looking LIBOR which incorporates counterparty and liquidity risk. The rationale for the chosen methodology for calculating the CSA should be recorded.
3. Align your approach with market standards as much as possible.
We recognise that there is no current market consensus, but we are slowly moving there. Industry standards are most advanced in the derivatives space, led by ISDA’s work (see, for example, the ISDA IBOR Fallbacks Supplement and IBOR Fallbacks Protocol). The LMA has also published a number of updated templates in the leveraged finance sector. The FCA has already made it clear that firms will demonstrate fairness to their clients more easily if they have adopted market standards.
4. Try to adopt a consistent approach to the key issues for each product type across different counterparties and locations (for example, fallback rates, compounding methodologies, credit spread adjustments, break costs etc). That may not always be possible given, for example, the differing approaches of counterparties, the different tough legacy regimes in different jurisdictions etc. But be ready and able to justify differences in approach for different counterparties. You need an answer as to why you were willing to offer particular terms to one customer but not to the other.
5. Adopt a clear and transparent communications strategy.
Involve your client relationship managers who may need to explain concepts to clients that are not straightforward (e.g. compounding with or without an observation shift, using a cumulative or non-cumulative formula etc). It may help to prepare visual materials such as flow diagrams. Make sure you highlight to clients all the key areas of the contract that are being amended. This is not necessarily just the interest rate provision. For example, a move to a new benchmark may have a consequential impact on other key provisions such as financial covenants, prepayments and break costs.
6. Do not assume advisory duties.
If your clients need legal or financial advice on their options they should seek that independently. Include a robust ‘basis of dealing’ clause so that it is clear you are not purporting to advise.
7. Do not make statements or projections that could turn out to be wrong or misleading.
Whilst your objective may be to put the client in the same position in which it would have been had LIBOR continued, you cannot be sure that the amendments will have that effect. Statements like ‘you won’t be any worse off’ are a hostage to fortune!
"Retain a comprehensive audit trail of all negotiations so that you can subsequently show a regulator and/or a court that you acted reasonably."
8. Develop a strategy for when counterparties refuse to agree.
Will you seek to rely on a synthetic LIBOR under the tough legacy regime? Will you offer other terms in an effort to reach a compromise e.g a restructured contract with a different repayment profile, a termination or unwind on mutually agreed terms etc. Retain a comprehensive audit trail of all negotiations so that you can subsequently show a regulator and/or a court that you acted reasonably.
The most widely used interest rate benchmark in the world is coming to the end of its life. But vast numbers of financial contracts still reference it and are not fit for purpose in the post-LIBOR world. Firms need to negotiate amendments to those contracts this year. They should approach those negotiations carefully in order to mitigate their litigation and regulatory risk.