Synthetic LIBOR and tough legacy contracts - FCA's enhanced powers

Last June the UK Government announced that it would take legislative steps to assist with a narrow pool of “tough legacy” contracts that cannot transition from LIBOR by the current deadline of end-2021. The purpose of this Law-Now is to discuss these proposed steps and the recent public consultations.

On 21 October 2020 the UK Government introduced the Financial Services Bill to Parliament. This Bill includes amendments to the Benchmarks Regulation as it now forms part of UK domestic law (“UK BMR”), which provide the Financial Conduct Authority (“FCA”) with new and enhanced powers to oversee the orderly wind-down of benchmarks such as LIBOR. Under the proposed new Articles 23A and 23D, the FCA will be able to designate a benchmark as “critical”, direct a change in its methodology and extend its publication for a limited time period for the benefit of “tough legacy” contracts only. UK supervised entities will be prohibited from using the critical benchmark other than for the orderly wind-down of the specifically determined “tough legacy” contracts.

Alongside the Financial Services Bill, the Government published its Policy Statement on Amendments to the BMR to support LIBOR transition (“Policy Statement”). In the Policy Statement the Government still emphasises the need for transition from LIBOR to continue and for reduction of the pool of LIBOR-linked contracts. To date there has been no formal definition of “tough legacy” contracts. In the Policy Statement these are described as “contracts that genuinely have no realistic ability to be renegotiated or amended to transition to an alternative benchmark”.

Although the introduction of the Financial Services Bill to Parliament is progress on the LIBOR transition journey, in our previous article here, we explored the issues relating to identification of “tough legacy” contracts and “Synthetic LIBOR”. These issues continue to be in play and there will unlikely be complete clarity on these until the FCA sets out how it will exercise its proposed powers. In that respect, the Policy Statement clarifies that “[b]efore exercising certain new powers, the FCA will be required to issue statements of policy to inform the market about how it intends [to] operationalise the legal framework set out under the BMR. The FCA will be able to engage with industry stakeholders and international counterparts as appropriate through this process”.

In November 2020, the FCA published two consultations on its proposed policies with respect to: (a) the designation of benchmarks under new Article 23A; and (b) the exercise of the FCA’s powers under new Article 23D. In these consultations the FCA invited views on issues including:

• The factors the FCA plans to consider when determining to designate a benchmark as an Article 23A “critical” benchmark;
• How the FCA should evaluate the practicality of transition and the scale of the “tough legacy” contracts;
• The scale of “tough legacy” contracts which is required to justify intervention; and
• How orderly transition could be achieved without the FCA exercising the proposed Article 23D powers.

The consultations closed on 18 January 2021. The Financial Markets Law Committee (FMLC), whose role is to identify issues of legal uncertainty or misunderstanding in the wholesale financial markets, and the Loan Market Association (“LMA”) have both published their responses.

In its response, the FMLC highlighted the following areas for consideration by the FCA when determining whether and when the FCA might exercise its new proposed powers under Articles 23A and 23D:

1. Allowing the publication of a “Transition LIBOR” for “tough legacy” contracts may give rise to mixed messages regarding successor rates, setting the Transition LIBOR up against the other successor rates being used in the market. As a result, reliance on the Transition LIBOR should be discouraged and the definition of “tough legacy” contracts should be circumscribed tightly.
2. Given the EU and US legislative proposals for dealing with successor rates there is potential for conflict and overlap between the approach of each of the UK, the US and the EU in relation to resolving legacy contracts. There appears to be a divergence in approach and careful international co-operation is required.

In its responses, the LMA raised the following additional points:

1. The need to balance the benefit of these proposed measures for those legacy contracts without fallback mechanisms, and to consider the position of the legacy contracts which documented fallback mechanisms triggered upon material change to a benchmark’s methodology. Counterparties to legacy contracts with agreed fallback mechanisms may lose their ability to move to a more favourable alternative rate or they may be left unable to exercise the contractual mechanisms to adopt a fallback alternative rate.
2. The potential for mismatch between loans and their respective hedging arrangements if consideration is not given to the impact of the FCA’s measures on related contracts.
3. Once a benchmark is designated under Article 23A, the automatic consequence seems to be that a UK supervised entity would be prohibited from using it, but careful consideration needs to be given to syndicated facilities with UK supervised entities which are participating with finance parties from other jurisdictions.

As we discussed in our previous article on this topic, the key issues are the determination of the “tough legacy” contracts which will be subject to the proposed legislative fix and the methodology which will be used for calculating the “Synthetic LIBOR” or “Transition LIBOR”.

There is a risk that parties halt or slow their transition proposals, pending further legislative progress, as they may be hopeful of an easier solution than transition to an RFR. However, until there is more certainty as to which contracts will be within the scope of the FCA’s proposals and around cross-border risk if international regulators take a different approach from the FCA, these issues may be better addressed now.

In the derivatives market, the ISDA 2020 IBOR Fallbacks Protocol and IBOR Fallbacks Supplement to the 2006 ISDA Definition (launched on 23 October 2020) came into force on 25 January 2021. Please click here for our analysis on the impact and issues arising from the ISDA 2020 IBOR Fallbacks Protocol and the IBOR Fallbacks Supplement, and for our LIBOR Transition Insight, please see click here.