IBOR Transition

Overview

On June 23, 2020 the UK Government announced that it intended to pass legislation to give the Financial Conduct Authority (FCA) the power to direct and permit the use of a stabilised LIBOR in so called “tough legacy” contracts¹ for a wind-down period after LIBOR has been found by the FCA to be “unrepresentative” for the purposes of the EU Benchmark Regulation.

The significance of the announcement is that it confirms the possibility that a stabilised LIBOR based on a revised methodology may be used in legacy contracts following the cessation of LIBOR in its current form (which is expected to occur sometime after the end of 2021).

Background

In its announcement the Government specifically acknowledges the Tough Legacy Taskforce Report published by the Risk Free Rate Working Group (RFRWG) which observed that “legislative steps could help deal with this narrow pool of ‘tough legacy’ contracts that cannot transition from LIBOR”. In the report the Taskforce specifically commented that:

“... Other solutions to the tough legacy problem should be pursued in parallel. For example, the Taskforce has considered the scenario of LIBOR being stabilised via a so called ‘synthetic methodology’ for a wind down period following panel bank departure (which is expected to happen at some point after the end of 2021) especially if those departures put LIBOR at risk of being unrepresentative under the EU Benchmark Regulation (EU BMR). The Taskforce noted that this scenario would require either an administrator willing to modify the methodology for LIBOR and/or potentially official sector intervention to modify it; and it would be important that the rate could be used in existing contracts without those contracts needing to be changed.”

Scope of proposed legislation and powers

The proposed legislation will:

• Amend the Benchmark Regulation to give the FCA enhanced powers to manage an orderly wind-down of critical benchmarks such as LIBOR.
• Provide the FCA with new regulatory powers that would enable it to direct a methodology change for a critical benchmark, in circumstances where the regulator has found that the benchmark’s representativeness will not be restored and where action is necessary to protect consumers and/or to ensure market integrity.
• Amend existing law to prohibit use of an individual critical benchmark where its representativeness will not be restored, whilst giving the regulator the ability to specify limited continued use in legacy contracts.
• Refine ancillary areas of the UK’s regulatory framework for benchmarks to ensure its effectiveness in managing the orderly wind down of a critical benchmark, including that administrators have adequate plans in place for such situations.

The FCA issued a corresponding press release in which, among other things, it explained:

“The legislation would empower the FCA to protect those who cannot amend their contracts [to move away from LIBOR before the FCA has found that LIBOR is not representative of the market it seeks to measure and representativeness will not be restored] by directing the administrator of LIBOR to change the methodology used to compile the benchmark if doing so would protect consumers and market integrity. This is consistent with the recommendations put forward by the Sterling Risk Free Rate Working Group (RFRWG) in its Tough Legacy report in May. Although this would not make the benchmark representative again, it would allow the FCA to stabilise certain LIBOR rates during a wind-down period so that limited use in legacy contracts could continue, if suitable robust inputs to support such a methodology change are available.”

How will LIBOR be “stabilised” for legacy contracts?

The FCA has advised that it will publish further statements of policy and seek stakeholder views on possible methodology changes, but the indications are that it is likely that the methodology will be based on use of a risk free rate for the applicable currency with additional fixed credit spread. The FCA will also seek views on the consensus already established in international and UK markets in relation to the additional fixed credit spread.

What does this mean for the transition of contracts generally?

The proposed legislation will give the FCA greater control over the cessation of LIBOR and its impact on legacy contracts. While detailed legislative proposals are not yet available, what is clear is that the proposed legislation will not result in the amendment of LIBOR for all English law contracts. As currently proposed, the FCA’s new powers would only be available after the FCA had found that LIBOR is “no longer representative” for the purposes of the EU Benchmark Regulation. This is typically the fallback trigger to use an alternative rate to LIBOR in many commercial contracts including, in particular, ISDA contracts and more recent LMA based loan documents. Therefore, the proposed legislation will only assist those, typically older, legacy contracts that do not contain the “no longer representative” fallback trigger.

It is also expected that the FCA will limit the use of stabilised LIBOR to specific products and circumstances. However, it is likely that any changes to LIBOR methodology made by the FCA will still be relevant for legacy contracts that are not subject to English law and for parties that are not regulated by the FCA. The extent to which such contracts and parties are impacted by any change to LIBOR methodology made by the FCA will depend upon the terms of the specific contract, how the definition of? LIBOR is amended and the possible implementation of other LIBOR cessation related legislation in other jurisdictions, for example the ARRC’s proposed “legislative fix” that would be implemented by New York State and apply to legacy contracts governed by New York law.

Within this context, it is noteworthy that Edwin Schooling Latter has in recent public statements advised that it is possible that the FCA could announce as early as November or December this year that LIBOR will be discontinued at the end of 2021; it was observed that an announcement made at the end of this year would give market participants a whole year to prepare for the discontinuation of LIBOR.

Both the Government’s and the FCA’s statements are at pains to note that a methodology change to LIBOR may not be feasible or a complete solution for all legacy contracts and an active transition of such contracts away from LIBOR remains the only route that will provide contractual certainty and control of economic outcomes. Therefore, parties should where possible seek to amend legacy contracts to include “hardwired” fallbacks or agree to amend to reference an alternative rate prior to the end of 2021.

Finally, the proposed legislation will not affect the position for new contracts which should already, and in any event no later than the end of September 2020, either reference risk free rates or where they do reference LIBOR include hardwired fallbacks.

Conclusions

The Government’s announcement will be welcomed by market participants as providing some much needed assistance and direction in relation to the terms on which so called tough legacy contracts may continue to operate following the cessation of LIBOR in its current form.