Draft legislation has been introduced to deal with the smooth transition of legacy contracts to synthetic LIBOR after the end of 2021 when LIBOR as we currently know it ceases. The Critical Benchmarks (References and Administrators’ Liability) Bill, if passed, is intended to ensure that the use of synthetic LIBOR (where contracts have not been actively transitioned away from LIBOR and where use is permitted) will not give rise to claims of breach of contract, material change of contract or of contract frustration.
In this note we look at some key questions around synthetic LIBOR, the terms of the Bill and what it means for contracts which have not transitioned away from LIBOR by 31 December 2021 when LIBOR ceases.
What is synthetic LIBOR?
As we explained here, synthetic LIBOR is the LIBOR benchmark calculated using a revised methodology specified by the FCA which will be published for use only by certain legacy contracts which have not actively transitioned away from LIBOR by 31 December 2021.
The legal framework for synthetic LIBOR lies in the Benchmarks Regulation (BMR) as amended by the Financial Services Act 2021 (FS Act 2021). The combined effect of new powers conferred on the FCA by the FS Act 2021 is to allow the regulator to provide for the continued publication of LIBOR for use in permitted contracts for a limited period of time after 31 December 2021. The FCA can compel the continued publication of LIBOR using a revised methodology, known as “synthetic LIBOR”, and permit certain legacy contracts to continue to use the synthetic form of the benchmark.
What is the revised methodology for synthetic LIBOR?
We discussed the FCA's consultation on its proposals in relation to the methodology for synthetic LIBOR here. A policy statement is expected from the FCA shortly.
When can synthetic LIBOR be used?
Synthetic LIBOR will be available for use in certain contracts which have not transitioned away from LIBOR by the time LIBOR ceases. These contracts have become known as 'tough legacy contracts'. We explain what tough legacy contracts are here. The Bill, however, allows use of synthetic LIBOR in a wide category of contracts or other arrangements. Where contracts fall within the scope of the BMR we don't know yet which of those will be permitted by the FCA to use synthetic LIBOR, but we are expecting the FCA imminently to start its consultation on which of those legacy contracts should be exempted from the prohibition on the use of LIBOR after it ceases.
What is the purpose of the Bill?
The Bill seeks to ensure that the powers conferred on the FCA in the FS Act 2021 can be used effectively, and in particular, where the FCA exercises those powers to provide for the continuity of certain LIBOR settings, that parties to tough legacy contracts can use synthetic LIBOR with confidence.
When the FS Act 2021 was published feedback indicated that legal certainty was required for parties that will rely on synthetic LIBOR. There were concerns that parties to contracts which relied on synthetic LIBOR might stop performing their contractual obligations, or legally challenge the enforceability of the contract or bring claims against counterparties applying synthetic LIBOR. The Bill seeks to mitigate the risk that these types of dispute might reduce market confidence in the use of synthetic LIBOR in tough legacy contracts, and of any resulting disruption to the integrity of the UK financial markets.
The Bill applies to contracts or arrangements made under the laws of England, Wales, Scotland or Northern Ireland.
What does the Bill do?
The Bill creates legal certainty that references to LIBOR in a contract will be treated and interpreted as references to synthetic LIBOR where that rate is available. Parties are treated as having always agreed that the contract should reference synthetic LIBOR. This establishes in law that the designation of LIBOR, and any changes to the LIBOR calculation methodology required by the FCA, do not in themselves provide grounds for contracting parties to argue that use of the synthetic benchmark amounts to a breach of contract, or to a material change to the contract, or to frustration of the contract.
Does the Bill contain any safe harbour provisions?
No. The Bill does not protect parties from the risk of litigation where they use synthetic LIBOR, but it does provide protections for the benchmark administrator when it follows FCA directions to calculate LIBOR using a revised methodology.
What does the Bill mean for contracts that don't transition away from LIBOR?
The Bill is widely drafted to cover references to LIBOR in 'contracts or other arrangements', which is considerably wider than the definitions of financial contracts and financial instruments in the BMR. This means that commercial loans (bilateral and syndicated) and other commercial contracts which fall outwith the scope of the BMR and which reference LIBOR will, where they do not have robust contractual fallbacks, reference synthetic LIBOR if they have not transitioned by 31 December 2021.
For financial contracts and financial instruments covered by the BMR we are, as mentioned above, awaiting confirmation from the FCA of those contracts which will be excluded from the prohibition on the use of synthetic LIBOR.
If our contracts can use synthetic LIBOR do they still need to be transitioned away from LIBOR?
Yes. Synthetic LIBOR, where it is available, is only intended to be a temporary solution. We don't know how long synthetic LIBOR will be published for, so contracts running beyond that timeframe will still require active conversion to alternative rates, or otherwise to adopt robust contractual fallbacks.
While synthetic LIBOR provides a short term solution to contracts which have not been converted or amended before 31 December 2021, adopting SONIA compounded in arrears - which is expected to be the new centre of gravity in sterling markets - gives market participants the benefit of having all products on the same rates, and of higher liquidity and lower hedging costs. Furthermore, synthetic LIBOR may not be the preferred economic solution for LIBOR users. Active conversion gives market participants control of their contracts and remains the FCA recommendation notwithstanding the introduction of the Bill.
Final thoughts
The Bill (if enacted - and time is pressing for this) undoubtedly provides a welcome degree of legal certainty to parties to those contracts which can and do reference synthetic LIBOR after LIBOR ceases, but it does not seek to protect parties against all risks of litigation arising from the use of synthetic LIBOR in those contracts. Disruption of contracts and markets will likely be avoided in the short term but disputes and claims not addressed in the Bill are to be expected once the impact of referencing synthetic LIBOR on payments and on contract management begins to emerge.
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