Despite significant effort made to amend existing contracts to risk-free rates and/or to incorporate fallback provisions catering for the transition from LIBOR, there remains a pool of "tough legacy contracts" that will continue after the cessation of sterling LIBOR but those contracts may have no, or inadequate, fallback provisions accommodating the transition and, for one reason or another, be unrealistic or difficult to amend.
For that reason, various working groups in the US, the UK and the EU have come to the conclusion that legislative fix is required to address this gap which would otherwise result in such contracts being breached or frustrated post 2021. For the purpose of this article, we will be focusing on the UK's legislative effort in reducing the disruption in these cases which is based on the FCA's consultation paper (CP21/29) and the Critical Benchmarks Bill.
Synthetic LIBOR
The UK Benchmarks Regulation (BMR) was amended earlier this year to empower the Financial Conduct Authority (FCA) to support the orderly wind-down of critical benchmarks. On 29 September 2021, the FCA published a consultation paper on its proposals for use of its new powers under BMR to, among others, require the benchmark administrator to continue the publication of the LIBOR settings for 1, 3, 6 month sterling (GBP) and 1, 3, 6 months Japanese Yen (JYP) (collectively, the Article 23A Settings) on a synthetic basis. The FCA has the power to compel the benchmark administrator to continue with the publication of the synthetic LIBOR rate of up to 10 years however the availability of the synthetic LIBOR rates will be subject to annual review.
The proposed new methodology for calculating synthetic LIBOR rates will include the 2 following components:
- forward-looking term risk-free rate (RFR) of the Article 23A Settings (e.g. the Sterling Overnight Index Average (SONIA) for GBP and the Tokyo Overnight Average Rate (TONA) for JYP), plus
- the ISDA spread adjustment (based on a 5-year historical median spread between LIBOR and the corresponding RFR ‘in-arrears’) that is published for the purposes of the ISDA IBOR Fallbacks for the Article 23A Settings.
In respect of certain LIBOR setting for US dollars (USD), in view that it will remain available until end of June 2023, the FCA has yet to begin the related consultation.
The Critical Benchmarks Bill
On 8 September 2021, the Critical Benchmarks (References and Administrators' Liability Bill (Bill) was introduced to the House of Lords for first reading. The Bill intends to provide legal certainty as to how references to the Article 23A Settings should be interpreted following the publication of the synthetic LIBOR rates and address the liability of the benchmark administrator for the publication of the synthetic LIBOR rates. In summary, the Bill provides that (if passed):
- Contractual continuity: Unless the contract expressly provides otherwise, references in the contract to the Article 23A Settings will be read as references to synthetic LIBOR since the inception of the contract and parties will be taken to have always agreed that this should be the case.
- No creation of new claims: Nothing in the Bill creates any right, obligation or liability in respect of acts or omissions relevant to the formation of the contract which took place prior to the synthetic LIBOR being in effect. This prevents parties from claiming that reliance on synthetic LIBOR is a breach or material change to the contract, or that the contract has been frustrated. Similarly, it does not extinguish or otherwise affect any cause of action which arose before the synthetic LIBOR takes effect, but this may be taken into account when determining any loss or damage. It does not however, include any specific provision protecting parties using synthetic LIBOR from the risk of litigation.
- Impact on non-financial contracts: Non-financial contracts such as commercial contracts and leases that reference LIBOR will be able to treat references to the Article 23A Settings as synthetic LIBOR rates despite not being a regulated or supervised entity under the scope of BMR.
- Interaction with transitioned contract provisions: The Bill will not cut across or interfere with contractual fallback provisions that would allow the contract to transition away from LIBOR to RFR.
- Others: The Bill also provides that HM Treasury can make further regulations as to (i) instances in which the contractual continuity under the Bill does not apply, (ii) specific descriptions that may constitute a fallback and (iii) specifying further cases in which contractual fallback provisions are not triggered.
- Jurisdiction: The Bill will apply to any contract or arrangement governed by the laws of England and Wales, Scotland or Northern Ireland. Given that the US and EU have also legislated separately to resolve the tough legacy problem, there may be some overlap scope between each of these jurisdictions and there may be some theoretical conflict of laws issues. The interaction of the various legislative fixes is yet to be finalised.
Commentary
Contrary to the legislative approach taken in the US, the Bill does not include any specific provision protecting parties using synthetic LIBOR from the risk of litigation.
As the intention is for the synthetic LIBOR rates to be a temporary fix and the ongoing availability of the synthetic LIBOR beyond 2022 cannot be assured, the FCA and the HM Treasury have stressed that the active implementation of the transition from LIBOR remains top priority for parties that have control.
The Bill includes some complicated provisions dealing with the operation of existing contractual fall-backs which parties will need to consider carefully.