Will publication of synthetic USD LIBOR impact the litigation risks of transition?

Despite numerous warnings from the FCA that “firms shouldn’t be relying on…a "synthetic" US dollar LIBOR as we have given for sterling and yen” (see speech by the FCA's Edwin Schooling Latter on 8 December 2021), last week the regulator confirmed that it would allow market participants to do just that.

In this blog post, we explore how this recent development may impact the litigation risks of LIBOR transition, in particular from a conflicts of laws perspective.

Background

The UK's legislative framework to deal with LIBOR cessation provides the FCA with new regulatory powers to publish so-called "synthetic" LIBOR in currencies and tenors to be determined by the FCA (following consultation with the market). The legislation provides that any references to LIBOR, in a contract or arrangement, should be "deemed" (i.e. read) to be the synthetic form since inception of the contract, regardless of how references to LIBOR are expressed. For a detailed analysis of the UK legislative solution, see our previous blog post: Final part of UK LIBOR legislative solution receives Royal Assent.

To date, the FCA has made three major announcements as to the use of its regulatory powers to require LIBOR’s administrator (Ice Benchmark Administration, IBA) to continue to publish LIBOR in a synthetic form:

1. Sterling/yen LIBOR. On 29 September 2021, the FCA confirmed that it would compel IBA to publish synthetic 1-, 3- and 6-month sterling LIBOR and all yen LIBOR tenors for the duration of 2022 (which would otherwise have ceased on 31 December 2021). See FCA press release.
2. Sterling/yen LIBOR. On 23 November 2022, the FCA confirmed that 3-month synthetic sterling LIBOR will continue until end-March 2024. The three synthetic yen LIBOR settings will cease at end-2022 the 1- and 6-month synthetic sterling LIBOR settings will cease at end-March 2023. See FCA press release.
3. USD LIBOR. On 23 November, the FCA also announced its intention to require publication of the 1-, 3- and 6-month USD LIBOR settings under an unrepresentative synthetic methodology until end-September 2024. See FCA press release.

We examine below the key features of the synthetic USD LIBOR proposal, before considering the potential impact on litigation risks.

Synthetic USD LIBOR proposal

In June 2022, the FCA launched a consultation seeking information on market participants' exposure to USD LIBOR (CP22/11).

There is significant exposure to USD LIBOR outside the US, including in the UK. The ARRC estimated in 2021 that globally, over US$70 trillion of USD LIBOR exposures would remain outstanding beyond the cessation of the USD LIBOR panel at end-June 2023. Having considered responses to the June consultation, the FCA expects that there will be a pool of outstanding legacy contracts governed by UK or other non-US law, that are not covered by the US legislative solution and that have no realistic prospect of being amended to transition away from the 1-, 3-, and 6-month US dollar LIBOR settings by end-June 2023.

Following feedback, the FCA published a further consultation in November 2022 on its proposal to require publication of synthetic USD LIBOR for the 1-, 3-, and 6-month settings (CP22/21). The key elements of this proposal are as follows:

• Temporary. Synthetic USD LIBOR in the settings identified will be available only until end-September 2024. The FCA thinks that a further 15 months (on top of the additional 18 months of panel bank USD LIBOR), should allow the majority of the population of non-US law governed legacy contracts to transition away or reach maturity, and therefore secure an orderly transition.
• Not representative. The FCA has reiterated that, while in its view synthetic LIBOR settings are a fair and reasonable approximation of what LIBOR might have been had it continued to exist, they are not representative of the markets that the original LIBOR settings were intended to measure. As a result, any contracts with non-representativeness fallbacks will be triggered when 1-, 3- and 6-month USD LIBOR panels cease at the end of June 2023, notwithstanding the continued publication of these settings on a synthetic basis (see the FCA's March 2021 statement on the non-representativeness of all LIBOR settings).
• Impact on cessation fallbacks. Some respondents to the November consultation noted the inoperability of cessation fallbacks if LIBOR continues to be published under a synthetic methodology. The FCA remarked that there is a balance to be struck between the impact on: (a) contracts without any fallbacks at all, which are in need of a synthetic USD LIBOR; and (b) contracts which contain cessation fallbacks, whose operation will be delayed by publication of a synthetic USD LIBOR. The extra time provided by synthetic USD LIBOR should allow parties to continue to transition away, and if any contracts containing cessation fallbacks have not been actively transitioned during that extra time, then the cessation fallback will be triggered at end-September 2024.
• Will apply to all contracts except cleared derivatives. The FCA says that it has drawn on experience from the approach taken to sterling and yen LIBOR settings last year, to inform its proposals for USD LIBOR, in particular for the scope of permitted legacy use of synthetic USD LIBOR. In respect of sterling/yen LIBOR, the FCA previously concluded that that there were considerable barriers to transitioning existing contracts away from LIBOR within the timeframe available, and that it was extremely difficult to distinguish with certainty specific classes, categories, types or other subsets of legacy contracts that could be amended within the time available, with the exception of cleared derivatives. These contracts did not need to use synthetic settings because clearing houses could use standardised mechanisms to move them to relevant overnight RFRs. The FCA has concluded that it should follow the same approach for USD LIBOR settings as for sterling and yen LIBOR settings.
• Interaction with the US legislative solution. In the US, federal legislation (the Adjustable Interest Rate (LIBOR) Act (the LIBOR Act - see our previous blog post: US Enacts LIBOR Transition Law) was enacted in March 2022 to establish a process to move contracts governed by US law that contain no, or unworkable, fallbacks, to alternative rates when the USD LIBOR panel ends. For these contracts, references to LIBOR will be replaced, by operation of law, with a SOFR-based benchmark replacement that the Federal Reserve Board (FRB) will identify in regulations. The LIBOR Act also provides a "safe harbour", under which a party who has discretion to select a successor rate may choose the benchmark replacement identified by the FRB with certain protections against liability for doing so. Notwithstanding the broad scope of the LIBOR Act, in the FCA's view, a restriction preventing the use of synthetic USD LIBOR settings in contracts governed by US law would add extra complexity – as well as the risk that some contracts could face legal uncertainty and the potential for litigation. Accordingly, the FCA proposes to make synthetic USD LIBOR settings available for both non-US and US law governed contracts. This is discussed further in the litigation risks section below.
• Methodology for synthetic USD LIBOR. The FCA has confirmed that synthetic USD LIBOR will be calculated on the same basis as the replacement rate under the US LIBOR Act, to avoid bifurcation between legacy USD LIBOR contracts governed under non-US law and US law. The calculation methodology will be the sum of the CME Group Benchmark Administration Limited’s (CME) Term SOFR Reference Rate plus the International Swaps and Derivatives Association (ISDA) fixed spread adjustment for the corresponding LIBOR setting (the ISDA fixed spread adjustments are identical to the spread adjustments specified in the LIBOR Act). There are two term SOFR reference rates available, produced by CME and IBA respectively. It is significant that the FCA intends to incorporate the CME rate in synthetic USD LIBOR, rather than the IBA rate, particularly when the IBA term SONIA rate was selected by the FCA for synthetic sterling LIBOR. However, the FCA has decided to follow the same approach as the US in order to maintain international consistency, to avoid market fragmentation or unwanted basis risk. CME and IBA have both confirmed to the FCA their agreement to produce a synthetic USD LIBOR rate on this basis.

Impact on litigation risks

As the home jurisdiction of LIBOR's administrator, the UK has taken a different approach to its legislative framework in comparison to other key LIBOR jurisdictions (i.e. the US and EU). The FCA expects the publication of synthetic LIBOR to “flow through” to global users of existing LIBOR contracts continuing to reference the rate (subject to other jurisdictions’ legislative frameworks).

The November consultation demonstrates the FCA's intention to offer a bridging solution for users of USD LIBOR, both within and outside the UK.

The impact of synthetic USD LIBOR on non-UK law contracts is likely to be a question of contractual construction according to the governing law of the contract. However, the potential extraterritorial effect may give rise to a risk of conflicts of laws. We suggest how these risks might arise for US law and non-US law contracts below.

US law contracts

The primary risk for US law contracts referencing USD LIBOR, will be for those contracts falling outside of the LIBOR Act (i.e. non-covered contracts).

For any US law contracts covered by the LIBOR Act, the trigger for replacing USD LIBOR with the FRB-selected benchmark replacement is the "LIBOR Replacement Date", which means the date on which the relevant LIBOR setting becomes unrepresentative. Given that synthetic LIBOR settings are permanently unrepresentative, contracts covered by the LIBOR Act should transition to the FRB-selected benchmark and avoid synthetic USD LIBOR.

However, contracts governed by US law that contain workable non-LIBOR fallbacks are generally not affected by the LIBOR Act. If, under the contractual terms, these fallbacks are only triggered by LIBOR’s cessation, then these contracts might use a synthetic USD LIBOR setting for as long as it is published. They would only move to their intended fallback rate under the contract when the synthetic setting ceases. For these non-covered contracts, there is a risk of potential litigation challenging the appropriateness of using a synthetic setting (given the unrepresentative nature of synthetic settings and that contract parties may not have envisaged the existence of such a rate when the contracts were drafted).

Non-US law contracts

As noted above, the rate to be applied to a USD LIBOR-referencing contract which is not governed by UK or US law will depend upon the question of contractual construction according to the governing law of the contract.

In the absence of domestic legislation/regulatory guidance for such contracts, parties may look first to synthetic USD LIBOR, particularly given the FCA's stated intention that synthetic LIBOR should flow through to global users of LIBOR.

However (and while the US LIBOR Act appears on its face to be limited in scope to US law contracts), there may be a risk of parties arguing that the contract is covered by the US LIBOR Act and should not incorporate synthetic USD LIBOR, for example, if the parties or subject matter of the contract have a close connection with the US. This type of risk seems less likely to emerge following the FCA's confirmation that synthetic USD LIBOR will be calculated on the same basis as the replacement rate under the US LIBOR Act. However, there is a divergence in the protections offered by the two jurisdictions, which could provide a commercial advantage to transitioning under one solution or the other, thereby creating uncertainty and risk.

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