The UK's LIBOR safe harbour legislation: a missed opportunity?

The Critical Benchmarks (References and Administrators' Liability) Bill (Bill) was today introduced to the UK Parliament and the first reading took place.

The Bill introduces a legal "safe harbour" within the primary legislative framework for the UK's LIBOR legislative solution, the Financial Services Act 2021 (FSA 2021). It follows a consultation paper published by HMT earlier this year: Supporting the wind-down of critical benchmarks (see our blog post: LIBOR transition: What is a “safe harbour” and why does the UK’s legislative toolkit need one?).

In this blog post, we set out our initial thoughts on the impact of the new Bill on LIBOR transition, in particular: (i) the broad parameters of the contractual continuity provision; (ii) the notable absence of protection from claims; (iii) its application to non-financial contracts; (iv) its interaction with contractual fall-backs; and (v) the likely impact on the litigation risks of LIBOR transition.

Background

The FSA 2021 provides an overarching legal framework giving the FCA new and enhanced powers to manage the wind-down of a critical benchmark (i.e. LIBOR), as discussed in our blog post: LIBOR transition measures in the new Financial Services Bill: the legal framework, market impact and risks. While the legislation is drafted in general terms as to the wind-down of a critical benchmark, this blog post will focus on its impact on LIBOR transition.

The FSA 2021 makes amendments to the UK Benchmarks Regulation (UK BMR), which forms part of retained EU law: The Benchmarks (Amendment and Transitional Provision) (EU Exit) Regulations 2019. References to Articles in the FSA 2021, are to Articles of the UK BMR.

In a nutshell, the FCA has the power to designate LIBOR as an "Article 23A" benchmark, resulting in a general prohibition on the use of LIBOR by supervised entities. The FCA will be able to invoke its Article 23A power immediately after 31 December 2021, following its announcement earlier this year that LIBOR (save for certain USD tenors) will either cease to be provided by any administrator or will no longer be representative after this date (see our blog post: LIBOR Discontinuation: FCA non-representativeness announcement).

Although the use of LIBOR by supervised entities will be prohibited after 31 December 2021, the FCA has the power to exempt certain contracts from the general prohibition (Article 23C) and to change the methodology by which LIBOR is set in those contracts (Article 23D). Not all LIBOR currency tenor pairs will be converted to a new methodology and in its proposed decision released in June 2021 (CP21/19), the FCA confirmed its intention to restrict the use of its Article 23D powers to change the methodology for 1-month, 3-month and 6-month sterling and Japanese yen LIBOR settings only. Accordingly, publication of other LIBOR settings will cease permanently at the end of 2021 (save for the USD tenors continuing to end-June 2023).

These powers will have the effect of switching automatically the reference rate in "tough legacy” contracts from the relevant LIBOR setting to so-called "synthetic LIBOR". The breadth of the "tough legacy" definition is, therefore, critical to understanding which legacy LIBOR contracts will be converted to synthetic LIBOR. The market is awaiting clarity on this question following the FCA's consultation on its Article 23C powers (see our blog post: LIBOR transition: critical FCA consultation on “tough legacy” definition).

HMT consultation and outcome

While the LIBOR legislative fix has been broadly welcomed by the market, there are concerns that the mechanism adopted in the FSA 2021, namely the conversion of LIBOR contracts to synthetic LIBOR contracts, could give rise to contractual uncertainty and disputes.

In response to approaches made to HMT by a number of stakeholders, articulating the need for a legal safe harbour in the legislation to reduce these risks, HMT published a consultation paper in February 2021: Supporting the wind-down of critical benchmarks (see our blog post: LIBOR transition: What is a “safe harbour” and why does the UK’s legislative toolkit need one?).

In its consultation paper, HMT set out two features proposed by stakeholders for inclusion in the safe harbour, to reduce such risks:

(1) Contractual continuity

Express legal certainty as to the continuity of legacy LIBOR contracts that are automatically transitioned to synthetic LIBOR by the FSA 2021, to prevent parties from refusing to perform contractual obligations, frustrating the contract or triggering a force majeure clause on the basis that LIBOR no longer exists once it has been converted to the synthetic LIBOR rate.

(2) Protection from claims

Protection from claims based on either: (a) the designation of LIBOR as an Article 23A benchmark; or (b) the change its methodology under Article 23D (i.e. claims based on the change in interest rate payable under the contract when legacy LIBOR contracts are converted automatically to the synthetic LIBOR rate).

HMT published a very brief summary of the outcome of the consultation, confirming that it intended to bring forward further legislation.

Critical Benchmarks (References and Administrators' Liability) Bill

Following on from the consultation, the Critical Benchmarks (References and Administrators' Liability) Bill has been introduced. The key features of the Bill that are likely to be of most interest to financial institutions are considered in further detail below (the provisions dealing with the liability of benchmark administrators are not covered in this blog post).

(i) Express contractual continuity

The Bill aims directly to address any legal uncertainty by clarifying the way in which a reference to LIBOR should be interpreted in a contract or other arrangement after the exercise of the FCA’s powers. The express contractual continuity provision has the following key pillars:

• LIBOR = synthetic LIBOR. Article 23FA paragraph 1 confirms that references to LIBOR should be treated as references to synthetic LIBOR, once it has been designated as an Article 23A benchmark by the FCA and the new synthetic LIBOR methodology has kicked in. This continuity applies however references to LIBOR are expressed, including where LIBOR is described, rather than being named expressly (paragraph 2).
• Synthetic LIBOR deemed from inception. Article 23FA paragraph 5 seeks to prevent parties from arguing that it was not their intention to use synthetic LIBOR in the contract. It does this by stating that once synthetic LIBOR is deemed to be the reference rate, the contract will be treated as if it always referenced synthetic LIBOR.
• Retrospective application. The express contractual continuity provisions apply regardless of when the contract was formed, i.e. the Bill will have retrospective application, and apply to contracts formed before it comes into full force and effect.

(ii) No express protection from claims

Most significantly, while the Bill addresses the question of contractual continuity, it fails to provide express protection from claims.

Although HMT's consultation paper noted the possibility of the safe harbour including only one of the two features suggested (i.e. either contractual continuity or protection from claims), undoubtedly this omission will be met by disappointment and frustration by many market participants, given the broad industry consensus on the need for such protections in the UK's LIBOR legislative solution. This is considered further in the section looking at litigation risk below.

The UK's final form of safe harbour stands in stark contrast to the broad form of safe harbour provided by the New York legislative solution for contracts that are switched to the “recommended benchmark replacement”, which is intended to provide comfort to market participants in adopting that benchmark proactively and reduce the risk of speculative litigation following the transition event (see our blog post: New York legislative solution for LIBOR passed: Impact on transition of legacy LIBOR contracts).

It is important to highlight the inclusion of Article 23FA paragraphs 6 and 7, which seek to preserve the status quo in terms of claims and causes of action that exist prior to the date on which LIBOR is converted to synthetic LIBOR. Unfortunately, it is likely that the real impact and importance of these paragraphs will only be determined in due course by the court, as a matter of statutory interpretation.

(iii) Impact on non-financial contracts

There are a wide variety of non-financial contracts, which reference LIBOR and are unlikely to be amended before the cessation of the benchmark at the end of this year. This section considers the impact of the Bill on such contracts.

The prohibition on continuing to use LIBOR after the end of this year (under Article 23B of the FSA 2021) applies only to financial contracts within the scope of the UK BMR, to which a supervised entity is a party. However, parties to non-financial contracts will be prevented at an operational level from continuing to use the benchmark, given the announcement made by ICE of its intention to cease the publication of LIBOR settings (other than certain USD tenors) at the end of 2021.

The critical question is whether those non-financial contracts can rely upon synthetic LIBOR calculated in accordance with the new methodology under Article 23D, even though they do not fall within the Article 23C exemption (which applies only to "use" of a benchmark within the scope of the UK BMR in financial contracts to which a supervised entity is a party).

This question is answered by Article 23FA, in particular at paragraphs 1, 2 and 9, which confirm that parties will be able to treat references to LIBOR as references to synthetic LIBOR in: (a) any "contract or other arrangement"; and (b) even where LIBOR is not "used" as a benchmark within the scope of the UK BMR. In consequence, parties to non-regulated arrangements should be able to rely upon the contractual continuity provisions in the Bill.

This approach should help to mitigate the risk of creating gaps in coverage between equivalent provisions in the US and EU legislative solutions.

Interestingly, there is no threshold requirement for non-financial contracts to be able to rely upon the contractual continuity provisions and therefore access synthetic LIBOR, i.e. they do not need to satisfy any definition of "tough legacy" as per the requirement for financial contracts seeking to take advantage of the primary legislative mechanism of exemption and change of methodology under the FSA 2021.

(iv) Interaction with transitioned contract provisions

The Bill seeks to avoid inadvertently overriding the fall-backs or replacement rates which have been agreed between contractual counterparties through active transition (Article 23FB paragraphs 2-5). This accords with the regulatory emphasis that firms should continue to prioritise active transition away from LIBOR to alternative benchmarks, and that the legislative fix is not intended to divert attention from active transition efforts. It is also possible for parties to contract out of the safe harbour provisions (Article 23FB paragraph 1).

(v) Effect on the litigation risk

As explained in our previous blog posts on this topic, the UK's legislative solution is a blunt tool, which will change automatically the interest rate payable under the contract when the relevant trigger is activated and LIBOR switches to synthetic LIBOR. For those parties who lose out financially, there will be a real economic incentive to bring claims, and this will provide fertile ground for litigation.

The contractual continuity provisions in the Bill should deter arguments based on refusal to perform contractual obligations, alleged frustration or force majeure. However, there remains the risk of potential litigation and market disruption as a result of speculative mis-selling type claims. The omission from the Bill of protection from claims is, therefore, regrettable, although firms may take some comfort from paragraph 6 of Article 23FA.

In better news, the wide safety net afforded to non-financial contracts, enabling parties to such contracts to rely upon the contractual continuity provisions in the Bill and therefore access synthetic LIBOR, is likely to be welcomed broadly by supervised and unsupervised entities alike.