19 August 2020
What is LIBOR?
LIBOR is the acronym for the London Interbank Offered Rate. LIBOR is essentially the cost of borrowing between banks.The rate of interest rate for many loans is calculated as LIBOR plus a margin. At present, certain calculation banks (such as the Bank of England) are required to submit their estimated rate of LIBOR to the Intercontinental Exchange (ICE).The ICE use these submitted rates to calculate a trimmed average which in turn determines LIBOR for the wider market. LIBOR is available for five different currencies: pounds sterling, U.S. dollars, euro, Japanese Yen and Swiss Francs.
After the LIBOR fixing scandal, which came to light in 2012, certain changes were put in place in relation to LIBOR. For example, ICE took control of the calculation of LIBOR and the legislature introduced new legislation, by way of the Financial Services Act 2012. This placed LIBOR under UK regulatory oversight and enacted criminal sanctions for LIBOR fraud. The risk of litigation, reputational damage and the compliance issues raised, led to some banks becoming reluctant to submit LIBOR estimates to ICE. At present, some banks remain obligated to submit rates so that there is a sufficient number of rates submitted to enable the ICE to calculate a trimmed average.
On 27 July 2017, Andrew Bailey, Chief Executive of the Financial Conduct Authority (FCA) gave a speech about the future of LIBOR. Mr Bailey stated that "we do not think markets can rely on LIBOR continuing to be available indefinitely. Work must therefore begin in earnest on planning transition to alternative reference rates that are based firmly on transactions. Panel bank support for current LIBOR until end-2021 will enable a transition that can be planned and can be executed smoothly. The planning and the transition must now begin." Furthermore Mr Bailey highlighted that, "The transition away from LIBOR will take time, but will be less risky and less expensive if it is planned and orderly rather than unexpected and rushed."
Scale of amendments
The scale of the amendments required is vast. Researchers at the Bank of International Settlements (BIS) estimated that, as of mid-2018, there were about $400 trillion worth of financial contracts that referred to LIBOR.
The Bank of England and the FCA have recently endorsed a target of Q1 2021 for lenders to "significantly reduce the stock of LIBOR referencing contracts." As we are now in the middle of Q3 2020, the 2021 deadline announced by the FCA no longer seems as far away as it did back in 2017. Despite the ticking clock, loan agreements and other contracts are still being drafted with LIBOR as the specified benchmark, in large part owing to the fact some lending institutions are still deciding which replacement rate they will transition to.
On first impressions you may be thinking that LIBOR transition will only affect the banking legal sector, but the impact of LIBOR abolition is far reaching. Loan agreements are obviously the most affected contracts, however, in addition, bonds, notes, derivatives, M&A transactions which have complicated locked box account arrangements, and other commercial contracts where default damages or default interest rates are calculated by reference to LIBOR, or where LIBOR is used as a discount rate to calculate present value, all fall within the basket for amendment if they terminate after 2021.
Contractual parties will need to amend contracts terminating after 2021 to incorporate fallback provisions to deal with the scenario of LIBOR becoming unavailable, or to fully transition to alternative reference rates such as SONIA (Sterling Overnight Index Average) for sterling, SOFR (Secured Overnight Financing Rate) for US dollars and €STR (Euro Short-Term Rate) for euro. Whilst fallback provisions may already exist in some contracts, in most cases they were designed to address the temporary period of unavailability of LIBOR, such as a temporary market disruption of IT system malfunction, rather than the permanent discontinuation of LIBOR. Accordingly, existing fallback provisions are usually insufficient to deal with the LIBOR replacement scenario facing the market in 2022 and beyond and therefore will need amendment.
The International Swaps and Derivatives Association, Inc. (ISDA) stated it "plans to amend certain ‘floating rate options’ in the 2006 ISDA Definitions to include fallbacks that would apply upon the permanent discontinuation of certain key IBORs and upon a ‘non-representative’ determination for LIBOR". ISDA plan to do this by way of a Supplement to the 2006 Definitions. ISDA are also expected to issue a protocol to deal with amendments to legacy derivative contracts which do not use the 2006 Definitions.
Thankfully most security documents will not have LIBOR provisions present, but security documents may be affected by an amendment to the underlying loan agreement. In some cases, an amendment to the underlying loan agreement will mean that the continuing security granted by the related security documents needs to be confirmed by way of a deed of confirmation.
Rishi Sunak, the current UK Chancellor of the Exchequer, announced on 23 June 2020, that the UK Government will introduce amendments to the EU Benchmarks Regulation 2016/1011 as amended by the Benchmarks (Amendment and Transitional Provision) (EU Exit) Regulations 2019 (the “UK BMR”). This is to ensure that the FCA powers are sufficient to manage an orderly transition from LIBOR. Mr Sunak stated: "It is in the interests of financial markets and their customers that the pool of contracts referencing LIBOR is shrunk to an irreducible core ahead of LIBOR’s expected cessation, leaving behind only those contracts that genuinely have no or inappropriate alternatives and no realistic ability to be renegotiated or amended. The Government recognises, however, that legislative steps could help deal with this narrow pool of ‘tough legacy’ contracts that cannot transition from LIBOR."
The Government plans to implement these legislative steps by way of the upcoming Financial Services Bill (the “Bill”). This Bill strengthens the existing laws by, amongst other things, amending the UK BMR to ensure the FCA have sufficient powers to manage and direct any wind-down period prior to the cessation of LIBOR so as to protect consumers and / or ensure market integrity. The Bill would allow the FCA to direct a methodology and require an administrator to change a critical benchmark, in circumstances where the regulator has found that the benchmark is no longer representative and where action is necessary to protect consumers and / or to ensure market integrity.
However, parties should be wary about relying on legislation to transition. The FCA message is very clear that you should amend your LIBOR legacy transactions where you can, and that this remains the best route for contracting parties. If parties choose to rely on the aforementioned legislative fallback, then they will not have control over the economic terms of that action. Nevertheless, the UK BMR will serve to protect parties who cannot amend their contracts, the so-called "Tough Legacy" contracts.
On 25 March 2020, the FCA, the Bank of England and the Sterling Working Group issued a statement on the impact of COVID-19 on LIBOR transition planning: "[the] central assumption that firms cannot rely on LIBOR being published after the end of 2021 has not changed and should remain the target date for all firms to meet." However, they did concede that there has been an impact on timing and some interim transition milestones may be necessary. Given that many institutions are still deciding on which replacement rate to transition to, and combining that with Brexit impacts and COVID-19 disruptions, it seems likely that some slippage in the December 2021 deadline may occur but nothing is certain at present. What is certain is that LIBOR is not here to stay and transition must occur to a replacement rate.
If you have any queries the Banking team at Carson McDowell would be happy to help.
*This information is for guidance purposes only and does not constitute, nor should be regarded, as a substitute for taking legal advice that is tailored to your circumstances.