Rupert Lewis & Ceri Morgan, Herbert Smith Freehills
HSF's Rupert Lewis and Ceri Morgan discuss the legacy of LIBOR contracts for financial markets, as banks prepare to transition away from their use
The UK government’s legislative solution for so-called “tough legacy” LIBOR contracts raises several significant risks and contracting parties would be unwise to take their foot off the pedal of transition efforts.
The well-documented demise of the London Interbank Offered Rate, or LIBOR, will complete an unhappy trilogy of disruptive events for financial markets, hot on the heels of Brexit and the Covid-19 pandemic.
Despite the widespread use of the global benchmark, authorities have mostly viewed the acknowledgement from financial services regulators that discontinuation from LIBOR will be “a DEFCON 1 litigation event”, as being as a market-made problem which requires a market-led solution. They have carefully avoided giving a clear signal that any legislative fix would be forthcoming.
However, in a significant change of tack, the Chancellor of the Exchequer, Rishi Sunak, announced last month that the government would introduce a legislative solution for so-called “tough legacy” LIBOR-linked products. These are contracts which have no appropriate fall-back mechanism and cannot be renegotiated or amended by the end of 2021.
The government intends to use the upcoming Financial Services Bill to grant new regulatory powers to the Financial Conduct Authority (FCA) so that the regulator can change the methodology for calculating LIBOR following a trigger (such as an FCA announcement that LIBOR is no longer representative).
This ‘legislative LIBOR’ will likely use some version of the risk-free rates chosen by each LIBOR currency area—such as the Sterling Overnight Index Average (SONIA), for sterling—plus a fixed spread adjustment.
However, even with a spread adjustment to account for the difference between LIBOR and SONIA, the interest rate payable by parties under LIBOR-linked contracts will change overnight, with the inevitable possibility of winners and losers.
For example, a party paying a LIBOR-linked rate on the trigger date (T) of a statement of non-representativeness will pay a different rate on day T+1 when the rate switches to ‘legislative LIBOR’.
The spread adjustment will not neutralise the rate change on T+1, because it will almost certainly be calculated as the difference between the two rates over a set period (e.g. the past five years). In this sense, it is a blunt tool and unlikely to represent the bargain the parties would have struck.
The change will be immediate and evident on T+1, with parties receiving less or paying more interest under legislative LIBOR than previously. This change will provide fertile ground for disputes.
There will be mis-selling risks. Firstly, there are risks for the original product referencing LIBOR. It is arguable the customer should have been sold a SONIA-linked product, particularly for products post-dating the FCA’s first announcement in July 2017 that LIBOR would cease.
Secondly, there are risks for contracts actively switched from LIBOR (e.g. that the customer would have been better off relying on the legislative solution rather than amending).
There is also the risk of creating mismatches between different parts of a portfolio, where some products move to legislative LIBOR, and others do not, while other products may be amended via bilateral agreement or market protocol. That suggests banks and banking lawyers should remain alert to such potential problems.
Rupert Lewis is a partner and the head of banking litigation and Ceri Morgan is a professional support consultant, both at Herbert Smith Freehills in London.
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