LIBOR - A legislative solution?
As the end of 2021 deadline for the cessation of LIBOR approaches, supervising bodies on both sides of the Atlantic are working on legislative changes to aid the transition to risk free rates.
In March 2020, the Alternative Reference Rates Committee – the ARRC, a committee convened by the Federal Bank of New York to oversee the transition from USD LIBOR to SOFR – proposed new legislation to help unpick the legal uncertainty with the transition from LIBOR for USD contracts.
In June 2020, the UK followed suit with the announcement that the UK government intends to pass legislation to amend the Benchmarks Regulation to give the FCA enhanced powers to ensure an orderly transition away from LIBOR. This was largely in response to a call to action by the UK's working group (the RFRWG) following their review of the "tough legacy" issues in a LIBOR transition
Although both are considering a legislative solution, the UK and US are proposing vastly different approaches to the LIBOR transition problems. Here, we explore the different approaches being proposed in the UK and US, and the likely impact of such changes in the UK market.
US legislative solution
In March 2020, the ARRC released its Proposed Legislative Solution to Minimize Legal Uncertainty and Adverse Economic Impact Associated with LIBOR Transition. This is a proposal for a new law designed to cover all USD LIBOR contracts that are governed by New York state law.
The legislation proposed by the ARRC would:
- prohibit a party from refusing its contractual obligations as a result of LIBOR being discontinued
- establish that the ARRC-recommended benchmark replacement would be a "commercially reasonably substitute for and commercially substantial equivalent to" LIBOR, and
- provide a safe harbour from litigation for those who chose to adopt the ARRC-recommended replacement benchmark.
The practical effect of this would be that:
- where an existing LIBOR-based contract provides for no fallback to LIBOR cessation, or a fallback to a historic or interpolated screen rate or polling of 'reference banks' the legislation would automatically (and mandatorily) fill the gap with an ARRC-recommended SOFR rate and spread adjustment
- where contracts provide a level of agent or lender discretion to choose the replacement rate the legislation would apply on a "permissive basis" ie the agent or lender could adopt the ARRC's recommended replacement benchmark and benefit from safe harbour from litigation, and
- contracts with a fallback to a rate other than LIBOR (eg the overnight 'prime rate' commonly used in the USD market) will not be affected by the legislation.
Although parties will be able to elect to opt-out of these provisions, absent such an express "opt out" the legislation will address USD LIBOR issues in contracts which are governed by New York law. The legislation won't however address USD LIBOR exposures which are subject to any other governing law, nor does it address New York law contracts referencing any LIBOR rate other than USD.
UK legislative solution – identifying the "tough legacy" deals
The first step towards a legislative solution in the UK was the UK working group's review of the nature and scope of the issues involved in transitioning aware from LIBOR.
The RFRWG's Tough Legacy Taskforce was established to identify those areas of the market where a consensual transition to a new risk-free reference rate would be particularly difficult – the so-called "tough legacy" deals.
The taskforce considered various segments of the market, as well as current contractual fallbacks, the practicability of amending those contracts, and the linkages with other legacy contracts in order to assess the case for legislative change.
The RFRWG reached the following conclusions:
- Derivatives – the solution offered by the new ISDA IBOR Fallback Protocol is optional and there are likely to be number of uncleared derivatives maturing beyond the end of 2021 that may require a legislative solution.
- Floating rate notes – obtaining noteholder consent to facilitate the amendments and the level of discretion afforded the trustee or agent who may have to choose the replacement benchmark under the documentation will pose challenges in some cases and therefore may require a legislative solution.
- Bilateral and syndicated loans – borrowers in bilateral loans markets are generally less sophisticated and therefore less likely to be amenable to actively transitioning to SONIA. Amendments to syndicated loans may require all lender consent which may be challenging in practice and often revert to an individual lender's cost of funds which is problematic for both borrowers and lenders. There is a volume issue for this segment of the market; for the clearing banks in particular, the sheer number of SME and small corporate loans will mean that actively transitioning their entire book from LIBOR will be a huge administrative undertaking. Therefore, the loan market may require a legislative solution.
- Retail mortgages – retail mortgage markets borrowers will be less sophisticated and therefore active transition will be more difficult for lenders, although, unlike in the US, the UK has a limited number of LIBOR-linked mortgages. Despite the relatively small number of these, LIBOR linked retail may require a legislative solution.
Critically, and somewhat surprisingly, the paper concluded that there was a case for action in every asset class it considered.
The taskforce specifically noted the challenges of a "one size fits all" approach and reinforced the benefits of any active transition away from LIBOR wherever possible. It also raised a flag regarding the challenges of jurisdictional cooperation given the extensive number of contracts which deal in a currency which is not the domestic currency of the jurisdiction of the governing law of that contract.
A solution proposed by the taskforce, which has been picked up in the proposed legislative changes, is the introduction of a "synthetic methodology" for calculating LIBOR for a wind down period after the end of 2021. This should allow these tough legacy contracts to continue to reference LIBOR until their scheduled maturity.
UK legislative solution – changes to the BMR
In response to the findings of the taskforce, the UK government's proposed legislation would – rather than follow the US approach of amending the underlying LIBOR-referencing contracts – amend the Benchmarks Regulation 2016/1011 (as amended by the Benchmarks (Amendment) (EU Exit) Regulations 2018) (the BMR). The rationale behind this is to give the FCA greater powers to require the administrator of LIBOR to change to methodology for calculating the benchmark if it deems it necessary in order to protect consumers or the integrity of the market.
This would enable the continued publication of LIBOR using a different and more robust methodology and inputs to create additional options for managing the wind-down of LIBOR prior to its ultimate cessation.
Since the FCA announced that it would not continue to compel panel banks to make LIBOR submissions beyond the end of 2021, a key market concern has been that when the panel banks submissions cease, the FCA will be forced (under the BMR) to declare that LIBOR was no longer representative of the underlying market.
This would result in a 'zombie LIBOR' as the benchmark may continue to be published for a short time after the declaration of non-representativeness. In effect, what the FCA proposes is a 'synthetic LIBOR' to avoid the widespread market disruption that would result from a sudden permanent cessation. This contrasts with the approach being adopted in the US, where the proposed legislation would effectively amend NY law contracts to replace LIBOR with a completely new rate, compound SOFR.
The FCA intends to seek the views of market stakeholders on the possible changes to the methodology. There is no definitive suggestion as to what the changes to LIBOR might look like yet.
The difference of approach between the US and UK to the LIBOR transition challenges is stark, and partly a response to the significantly greater consumer exposure to LIBOR in the US than the UK.
The proposed UK legislation will be a welcome development for many market participants especially those with books of loans to less sophisticated borrowers and LIBOR-linked retail products where active transition to SONIA or an alternative risk-free rate would be very difficult.
However, the FCA's continued assertion that the focus of market participants should be on consensually transitioning away from LIBOR, and the emphatic statement that "where it is feasible for parties to contracts to transition away from LIBOR by mutual agreement, they should do so and should not look to these legislative changes to provide them with an alternative to transition" leads us to suspect that the legislative changes will not be the panacea the market is hoping for.
Whether by limiting the use of a synthetic LIBOR rate to certain specified types of transactions or incentivising change through other means, it appears that the FCA will continue to drive for a consensual transition away from LIBOR by the end of 202. Until there is more clarity on the nature of any relevant legislation, market participants would be wise to press ahead with that process.
Interestingly, the EU Commission's proposed amendments to the Benchmark Regulation (EU) 2016/1011 in July would give the Commission the power to "designate a statutory successor for a benchmark whose cessation would result in significant disruption in the functioning of financial markets in the Union". In short, the proposals would mean existing contracts would automatically transition to an EU Commission-approved rate and are therefore more akin to the US legislative fix than the solution posited by the FCA.
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