HERBERT SMITH FREEHILLS HEAD OF BANKING LITIGATION RESPONDS TO NEWS THAT THE FCA WILL GET ENHANCED REGULATORY POWER TO PHASE OUT LIBOR

Responding to the news that the forthcoming Financial Services Bill will give the FCA enhanced regulatory powers to manage and direct any wind-down period prior to LIBOR cessation, Rupert Lewis, head of the banking litigation team at Herbert Smith Freehills LLP has commented as follows.

“We do not yet have full details of what the legislation will look like, but the following at least is clear.  First, the proposed primary legislation will not directly impose legal changes on LIBOR-referencing contracts governed by UK law, but will rather grant the FCA certain "appropriate" regulatory powers. Second, this means that the UK is taking a significantly different approach to the US (where draft legislation proposes direct changes to contracts governed by US law). Third, the proposed new powers given to the FCA will enable the regulator to change the methodology of how LIBOR is calculated, following an announcement that LIBOR is no longer representative (which is likely to happen shortly after the end of 2021, when LIBOR panel banks are no longer compelled and so cease to submit rates). Fourth, while the FCA has not confirmed what the change in methodology will be, all indications are that "legislative LIBOR" will be calculated using the relevant risk-free rate (SONIA in the UK), adjusted for the relevant term of the contract and with a fixed credit spread adjustment.

“The most obvious difficulty with the proposed legislative solution is that it will automatically change the interest rate payable under the contract when the methodology for calculation of LIBOR changes. It is a blunt tool and – even with a spread adjustment to account for the difference between LIBOR and the relevant risk-free rate (SONIA in the UK) – the rate payable under the contract will change overnight, with the inevitable possibility of "winners" and "losers". This will provide fertile ground for disputes, with the particular risk of creating mismatches between different parts of a portfolio, where some products move to legislative LIBOR, but others are amended via bilateral agreement or (for example, in the case of hedging products) an ISDA protocol.

The Government intends to take these measures forward in the forthcoming Financial Services Bill, but the more important developments and detail are likely to be communicated through a series of statements of policy by the FCA, in which it will confirm its approach to the new powers provided by the legislation. Accordingly, while the market has been offered some comfort that a cliff-edge scenario will be avoided, there is still enough uncertainty to make sure that most market participants do not take their foot of the pedal of LIBOR transition – which is presumably the delicate balance that the Government and regulators intended to strike.”