With the introduction of the Financial Services Bill (the FS Bill) into Parliament in October last year and regulated firms working hard towards transitioning away from LIBOR by end 2021, this post focuses on the FCA’s proposed new powers to address so-called “tough legacy” contracts.
What are the proposed powers?
The purpose of the FS Bill is to reduce the uncertainty and risk of litigation in respect of tough legacy contracts. Tough legacy contracts are those where there is genuinely no realistic ability to renegotiate or amend the contract to reference an alternative benchmark before the discontinuation of LIBOR at the end of 2021. In summary, the legislation would operate so that:
- the FCA would have powers to designate a critical benchmark that had become unrepresentative, or was at risk of being unrepresentative (in this case, LIBOR) (new Article 21A of the Benchmarks Regulation 2016/1011, as amended by the Benchmarks (Amendment and Transitional Provision) (EU Exit) Regulations 2019);
- that designation would then give rise to a prohibition on the use of that benchmark by UK supervised entities (proposed Article 23B);
- the FCA would have the power to provide an exemption on the use of the designated benchmark, for example, in relation to “tough legacy” contracts (Article 23C); and
- the FCA could then take action to require changes to the benchmark’s methodology for any continued use (Article 23D). This would mean that where a tough legacy contract references LIBOR, it would be treated as a reference to LIBOR, but calculated under a new methodology (known as “synthetic LIBOR”).
On 26 January 2021, Edwin Schooling Latter (Director Markets and Wholesale Policy at the FCA) indicated that we should expect consultation proposals from the FCA in the spring, with a view to making decisions on specific settings in the summer, in order to provide clarity to the markets as early as possible.1
Until then, much uncertainty remains about the scope of the FCA’s proposed powers and how key risks will be mitigated. We consider below some of the possible areas for consultation / further consideration.
What contracts will be defined as “tough legacy”?
The term “tough legacy” refers to existing LIBOR-referencing contracts that parties are unable, before the end of 2021, to convert a non-LIBOR rate or amend to add fallbacks that would operate when LIBOR is discontinued.
The Government has indicated that the scope of the legislative solution will be limited to “only those contracts that genuinely have no or inappropriate alternatives and no realistic ability to be renegotiated or amended.”2 Further, in his speech on 26 January 2021, Mr Schooling Latter warned that when considering the use of synthetic LIBOR in legacy contracts “we will need to strike a careful balance in terms of where this is necessary and desirable”.
While the definition of “tough legacy” will likely be the subject of consultation later this year, some contracts have already been identified as potential candidates by the FCA. In his speech, Mr Schooling Latter gave two examples which he considered “fall unambiguously into the ‘tough legacy’ bucket”: (i) retail mortgage contracts, where consent would be needed to vary, but the lender cannot get the borrower to respond; and (ii) a bond where the issuer offers conversion calculated in line with market consensus on a fair fallback, and the bondholders don’t reply or withhold their consent in an effort to push for terms that are out of line with these market standards.
How would synthetic LIBOR be calculated?
The FCA has given some general guidance on the methodology that may be utilised to calculate synthetic LIBOR and has suggested that a risk free rate based on a forward looking approach made be applied, using the same adjustment spread as ISDA. However, the conversion from LIBOR to a rate calculated on this basis may result in an immediate impact on the amount of interest due under the relevant contract, over which neither party would have control. With this in mind, regardless of the availability of a legislative solution, firms may seek to retain control of their transition processes in any case.
What protection will the legislative solution provide?
The FS Bill is intended to prevent claims relating to tough legacy contracts by substituting a rate into those contracts which satisfies the definition of LIBOR. However, unlike the legislative solution proposed in the US, there is currently no express language within the Bill which sets out the scope of the protection provided to parties by the legislation. Given the scope and breadth of potential claims in the context of the LIBOR transition, this necessarily creates a degree of uncertainty as to what protection will be afforded to parties where the legislative solution applies.
Further consultation is likely to draw out some of the issues highlighted above. However, in the meantime, the message from the FCA is clear: do not wait to see whether the legislative solution will apply: “where parties can practicably agree to convert on the fair terms that have now become standard across derivatives, securities and loan markets, they should do so.”
Find more guidance on managing IBOR transition.