Libor transition – tough legacy contracts
“Tough legacy” in the context of transition away from LIBOR refers to existing LIBOR referencing contracts that are unable, before the end of 2021, to either convert to a non-LIBOR rate or be amended to add fallbacks. While significant progress has been made in relation to new contracts either referencing a Risk-Free Rate (RFR) or incorporating fallbacks, market participants and industry bodies have flagged to regulators that there will be a number of legacy LIBOR referencing contracts without appropriate fallbacks that will continue post 2021. In the UK, the Working Group on Sterling Risk-Free Reference Rates established a Tough Legacy Taskforce (Taskforce) to provide market input to help identify issues around “tough legacy” contracts in the context of the transition away from LIBOR. The Taskforce published its paper (Taskforce Paper) at the end of May and this note highlights the key aspects arising from the Taskforce Paper.
- While the overarching message is that firms should proactively continue to transition contracts away from LIBOR before the end of 2021, the Taskforce proposes that the UK Government considers legislation to address tough legacy exposures in English law governed contracts. An approach similar to the ARRC proposal for legislative relief under New York law (ARRC Proposal) would also help bring about international consistency. However local differences across products could apply - for instance, LIBOR loans under English law typically fall back to cost of funds whereas LIBOR loans in the US typically fall back to the prime rate. The ARRC Proposal excludes business loans which fall back to the prime rate.
- There is no guarantee that a legislative solution will materialise or that it would cater to all products and circumstances. Therefore, other solutions such as LIBOR being published for a period pursuant to a synthetic methodology following panel bank departure should also be considered.
- The Taskforce considers that there is a case for action for each of derivatives, bonds, loans and mortgages (details below). It also refers to other commercial contracts that contain LIBOR references and that it would be helpful for these to be considered as well.
- The legislative proposal should consider not just contracts referencing sterling LIBOR but English law contracts referencing the five different currency LIBORs.
- A one size fits all solution may be difficult particularly as the derivative markets are moving to backward looking, compounded rates whereas certain cash market participants may prefer solutions where the rate continues to be set in advance.
On a scale of difficulty, derivatives have been considered as easier to transition than bonds and loans. This is primarily because of ISDA’s forthcoming IBOR Fallbacks Protocol which will facilitate large scale amendments of legacy contracts by adhering parties. In addition, parties will also be able to use methods such as portfolio compression to reduce the number of LIBOR referencing derivatives contracts between them. However, the Taskforce recognises that there will still be a number of derivatives that are part of the “tough legacy”. These include:
- Situations where a derivative is used to hedge a “tough legacy” exposure or it forms part of a more complex structure;
- Non-linear derivatives where the effect of adopting the ISDA fallbacks may change the economic substance of the transaction; and
- Where one or more parties to an uncleared derivative does not adhere to the ISDA protocol.
Fallback provisions in legacy bonds have typically not contemplated the permanent discontinuation of LIBOR and usually rely on the application of the last available LIBOR fix for the remaining life of the bond. This effectively turns floating rate instruments into fixed rate instruments. Some other legacy bonds involve the exercise of discretion which may not be straightforward or do not contain any fallback provisions at all. While consent solicitations have been used in a small number of cases to transition legacy English law governed bonds to alternative rates, the Taskforce recognises that it is unlikely to be feasible to transition the whole of the legacy LIBOR bond market for the following reasons:
- It may not be possible to obtain the necessary consent from bondholders;
- Consent solicitations can be a long and expensive process;
- There is insufficient time available to transition the number of outstanding LIBOR bonds; and
- Within more complex arrangements (securitisations and repackagings), where the originator or sponsor no longer exists or is insolvent or where the economic interest in the transaction has been sold to a third party, there may no longer be a decision maker nor a party willing to assume the costs of amendment.
The Taskforce also recognises that even where negative consent mechanics are provided for (such as many of the more recent securitisation transactions), these may be ineffective in streamlining a transition for instance, where enough investors object to the changes proposed by the issuer, meaning a full vote is required.
Legacy loans, both syndicated and bilateral, have been considered amongst the toughest category of contracts to transition away from LIBOR. The Taskforce notes in particular:
- While recent syndicated loans include ‘replacement of screen rate’ wording, which reduces the required lender consent thresholds for amendments to transition to an alternative rate, many legacy loans will require the consent of all lenders;
- Syndicated and bilateral loans may fall back to individual lender cost of funds which is problematic for a variety of reasons, including the difficulty of calculating the relevant cost to the lender of a particular loan;
- Borrowers in the bilateral loan market may be less sophisticated and less attuned to LIBOR transition which may make seeking borrower consent to amendments more challenging; and
- The large volumes of bilateral and syndicated loan contracts, diverse nature of borrowers, cost, resource availability and other challenges makes individual renegotiations of these contracts practically challenging.
While there are only a small number of sterling LIBOR mortgage contracts, the Taskforce recognised that these should be addressed as part of any “tough legacy” legislative solution. Many of these contracts would need customer consent to vary and, in some cases, variation could result in a new mortgage contract which not all providers have the regulatory permissions required to enter into. Further, customers could be harmed if mortgage contracts are not transitioned to an appropriate rate.
- One of the tasks of the Taskforce was to identify the scope of products which might be at risk of forming part of the tough legacy category. This has resulted in a broader identification of tough legacy contracts including taking into account the practicability of amending a contract and linkages with other possible tough legacy contracts. For instance, the Taskforce highlights that there may be LIBOR references in each of the constituent elements in complex or structured transactions or arrangements. Amendments would often be needed to all constituents of the structure to avoid mismatches in cashflow and potential instability of the funding structures.
- Interestingly, the Taskforce also referred to the role of agents and other parties contractually obliged to seek quotations under fallback language and noted it would be helpful for regulatory or legislative assistance to be provided to reduce the burden on these parties.
- Finally, the Taskforce also notes that the nomination of a replacement rate by the regulatory authorities or the relevant national working group would be helpful in the operation of fallbacks which refer to such nomination or rely on the exercise of discretion by one party. This reiterates one of the points made in the letter from the Regulatory Dependencies Taskforce to the FCA.
8. The ARRC Proposal
The ARRC Proposal was released in March 2020 and proposes New York State legislation to address the issue of LIBOR referencing financial contracts not having appropriate fallback language or having language that could alter the contractual economics if LIBOR were discontinued. The ARRC Proposal contemplates a statutorily endorsed benchmark replacement. The proposed legislation would, among other things:
- Prohibit a party from refusing to perform its contractual obligations or declaring a breach of contract as a result of LIBOR discontinuance or the use of the endorsed benchmark replacement;
- Establish that the endorsed benchmark replacement is a commercially reasonable substitute for, and a commercially substantial equivalent to, LIBOR; and
- Provide a safe harbour from litigation when the endorsed benchmark replacement is used.
The proposed legislation would require the use of the endorsed benchmark replacement where a contract lacks a fallback or the fallback provisions prescribe the use of LIBOR. In addition, where a contract provides for a discretionary fallback, the safe harbour is intended to encourage the selection of the recommended benchmark replacement. Finally, the proposed legislation would not impact legacy contracts that fall back to a non-LIBOR replacement rate (see the point on US business loans in the Conclusion below).
The Taskforce recommendations are helpful in highlighting both the challenges and the potential solutions to dealing with “tough legacy” contracts across both multiple currencies and multiple jurisdictions. The recommendations are also consistent with other efforts to ensure that authorities are equipped with the powers to prevent an end of 2021 “cliff-edge” for users of LIBOR. For instance, the European Commission is considering amendments to the EU Benchmarks Regulation to ensure the orderly cessation of a critical benchmark such as LIBOR which includes the power to mandate the continued provision of LIBOR using a different methodology.
However, as the Taskforce has already noted in the context of any legislative solution:
- Time is of the essence and it is important that this be progressed quickly;
- A “one size fits all” solution is unlikely, and it will get more difficult to identify a solution in the context of a structured arrangement involving cash products and derivatives; and
- There is no guarantee that a legislative solution will materialise, that it will materialise across all relevant jurisdictions or that it would be available for all products and circumstances. For instance, the ARRC’s proposal for a legislative solution excludes business loans which fall back to the prime rate on the basis that the prime rate is an alternative base rate which exists and can be used as a fallback.
Market participants should continue their efforts to actively transition away from LIBOR before the end of 2021 noting that there may be legislative solutions which provide relief for some, but not all, legacy products. If you have any questions about this, contact your usual Linklaters contact or any of the contacts listed below.