1. What’s the Issue?
In light of the various price-fixing scandals surrounding the London Interbank Offered Rate (“LIBOR”) and the limited activity in the London interbank market, the U.K. Financial Conduct Authority (“FCA”) announced in 2017 that it will no longer sustain the publication of LIBOR as a reference rate by the end of 2021. The Federal Reserve Bank of New York has warned that “[e]veryone in the financial services industry needs to be aware that the date when the existence of LIBOR can no longer be guaranteed is fast approaching.” While there is has been speculation that the COVID-19 pandemic will alter the transition, UK regulators have reaffirmed that while the crisis could “affect some of the interim transition milestones,” nonetheless “[t]he central assumption that firms cannot rely on LIBOR being published after the end of 2021 has not changed and should remain the target date for all firms to meet.” Put simply, LIBOR will soon be discontinued.
LIBOR is the most widely used interest rate benchmark in the world, referenced in some $373 trillion notional value of financial transactions. LIBOR’s discontinuation poses risks to parties to all financial instruments—derivatives, bonds, loans, mortgage-backed securities, collateralized loan obligations, and more—that are linked to LIBOR or similar regional benchmark rates. Many LIBOR-linked transactions are expected to be outstanding after 2021 (often referred to as “legacy contracts”). As the FCA has noted, “it would be extremely difficult to amend contractual terms across all legacy contract holders,” raising the question, “what happens to legacy contracts that still reference LIBOR at that point?” The COVID-19 pandemic could complicate the issue, as many borrowers and lenders put preparations for the LIBOR transition on the back burner as they focus on more pressing business challenges—and as credit-market ructions unsettle previously held assumptions about the behavior of alternative reference rates.
Most market participants did not anticipate that LIBOR would be discontinued. Accordingly, many financial transactions provide no contractual fallbacks—or the fallback provisions in place (such as the 2006 ISDA Definitions) may not effectively cover LIBOR’s discontinuation. Michael Held, General Counsel at the Federal Reserve Bank of New York, summarized: “You can imagine the litigation risk when the reference rate for a 20-year contract disappears and there’s no clear path to replace it. Now imagine 190 trillion dollars’ worth of those contracts. This is a DEFCON 1 litigation event if I’ve ever seen one.”
Market participants should treat the end of LIBOR as a fact that could have a serious impact on their business. Preparations for LIBOR’s cessation are needed, urgently—not just from a tax, accounting, and disclosure perspective, but from a litigation and disputes-resolution perspective, as well.
2. Surely Central Banks and Regulators Have This Under Control?
Central banks and regulators have tried to inject some urgency into transition planning, but the industry response has been mixed. Alternative reference rates such as the Secured Overnight Financing Rate (“SOFR”) in the United States and the Sterling Overnight Index Average (“SONIA”) in the United Kingdom are now available. These alternative benchmarks (sometimes called “Alternative Rates”) are measured differently, and thus behave differently, from LIBOR. SOFR, for example, is based on actual prices for collateralized funding through the U.S. repo market, rather than borrowing rates (often estimates) in the London interbank market. As a result, SOFR is generally lower than LIBOR, and more volatile (during the COVID-19 pandemic SOFR has fallen to 0.01%). But contracting parties can assess those risks and negotiate accordingly in connection with new contracts and new trading strategies.
The issue of legacy contracts is trickier. That market participants may adopt SOFR as a benchmark for contracts negotiated today does not mean SOFR will, can, or should be grafted into legacy contracts negotiated years ago with LIBOR in mind. In the United States, the Securities and Exchange Commission, the Office of the Comptroller of the Currency, the New York Department of Financial Services, and other regulators have stepped up oversight of regulated institutions’ exposure to LIBOR cessation and transition risk and their plans to address it. In the United Kingdom, the FCA has issued guidance to regulated firms on the planned transition from LIBOR to SONIA, while the Bank of England has published considerations regarding “the conduct of consent solicitations to transition English law legacy bond contracts from LIBOR to SONIA.” In Switzerland, the Financial Markets Authority has been urging market participants to address the risks arising from the discontinuation of LIBOR and warned banks about litigation risks arising from legacy contracts.
At this point, however, these are primarily just information-gathering efforts, or are focused on limiting the creation of new LIBOR-referencing contracts by encouraging the adoption of alternative reference rates even before LIBOR technically ceases. In the United States, the Alternative Reference Rates Committee has proposed New York State legislation that would, among other things, require LIBOR-linked instruments to reference SOFR in the absence of a contractual fallback to a non-LIBOR benchmark, and provide a safe harbor from litigation for use of SOFR or another recommended replacement benchmark. But with the New York State Legislature focused on the COVID-19 crisis, the ARRC’s proposal is unlikely to be considered until after the body’s June recess—and, of course, not all LIBOR contracts, relationships, and claims will be governed by New York law. Absent a true legislative solution applicable to each legacy contract, it will be incumbent on those with LIBOR-referencing legacy contracts to determine how their obligations will be calculated after LIBOR ceases to exist. Counterparties will have to try to reach an agreement as to whether to use the contract’s existing “fallback” language (if any), to amend to adopt an industry-standard alternative rate, to amend to adopt something else, or to unwind the relationship entirely. Where the parties do not agree, litigation may ensue.
3. How Might This Affect You?
Some common scenarios involving legacy contracts are set forth below to demonstrate the many legal disputes that are likely to arise from LIBOR’s cessation.
A Single Revolving Credit Facility and Other “Simple” Scenarios: A borrower has a revolving credit facility that references LIBOR plus a spread. Similar to Loan Market Association terms, the facility contains language that, if three-month LIBOR is not published, the rate reverts to “the cost to the relevant Lender of funding its participation in that Loan from whatever source it may reasonably select.”
Initially, there may be a question whether the fallback provision is even capable of practical application on a permanent basis. Even if it is, in certain jurisdictions the parties may ask the more fundamental question of whether the express mechanism was truly intended to govern where LIBOR has permanently ceased, rather than to govern only where LIBOR’s publication is temporarily interrupted. Parties in certain jurisdictions may even argue that LIBOR’s unexpected failure means the parties’ obligations to each other should cease entirely, due to such doctrines as mutual mistake, frustration of purpose, or other legal excuses to performance.
Counterparties will often have opposing financial interests in determining which arguments to advance. If the lender uses customer deposits to fund its lending activities, the “cost of funds” alternative could be consistently below LIBOR. The lender may argue that adopting the fallback mechanism on a permanent basis would thus create an unjustified windfall to the borrower.
The parties’ behavior in negotiating and navigating these issues could also give rise to disputes. For instance, if a group of similarly situated, powerful parties try to coordinate a response or otherwise strongarm clients into their preferred solution, such acts could give rise to antitrust or other concerns. How these issues are resolved (or litigated) will depend on the particular lending market in question. For example, the players and interests involved in the leveraged loan market are markedly different from those at play in the residential mortgage market.
Derivatives, Hedges, and Basis Trades: Assume a plain vanilla 15-year fixed-for-floating interest rate swap referencing LIBOR. The swap is governed by the 2006 ISDA Definitions, which, generally speaking, require the floating rate index to be gleaned from a poll of certain banks in the event LIBOR is not published. The swap is a hedge for interest obligations under a bilateral loan, which also references LIBOR. The loan provides fallback language based on the lender’s “cost of funds” as per the loan agreement example above.
As in the prior example, the parties may disagree as to whether the fallback provisions should govern after LIBOR ceases to be published. As to the swap, it appears ISDA agrees that the existing fallback language falls short: It is preparing a proposed, standardized amendment to use for legacy contracts documented under the ISDA Master Agreement. However, that is a voluntary solution. One party or the other may find it advantageous to refuse to accept the amendment, particularly if the swap is deep out-of-the-money. If refused, the courts will be faced with resolving the relevance of an industry standard created in 2020 for the purpose of interpreting contracts formed years earlier.
This scenario is also complicated by the existence of two related transactions. A divergence between how interest is calculated on an obligation (the loan) versus how interest is calculated on the instrument intended to hedge the obligation (the swap) will impact the effectiveness of the intended hedge. This could not just create unintended economic risk; it could cause larger tax, accounting, and other issues. Coverage ratio issues could arise, and parties may inadvertently be deemed to run afoul of their own investment guidelines if the swap is no longer an effective hedge. A party attempting to remain hedged may want to ensure any amendments to one transaction are mirrored in the other. It may be more likely to succeed, either by negotiation or in litigation, where the related instruments were done as a package with a common counterparty.
Secondary-Market Transactions: A portfolio of 30-year debt instruments is acquired from a financial institution. The debt instruments bear interest rates referencing 12-month LIBOR plus 300 basis points. The purchase agreement contains provisions that the acquirer “has relied solely on information disclosed to it by the Seller in the Data Room [which included all the debt instruments]” and that, “[s]ave for fraud, the Acquirer releases the Seller from any and all liability arising from the Transaction.”
In addition to the questions discussed above, this scenario adds issues arising from the involvement of another actor—the seller of the loans. The purchase agreement in this scenario is on “seller friendly” terms, but that may not prevent accusations that the seller failed to disclose the risks associated with LIBOR cessation, including what it knew about whether borrowers were expecting their obligations to be governed by some fallback language, by an industry-standard alternative rate, or something else. Similar issues may arise when loan servicing rights change hands, as servicers are responsible for the collection and payment of interest.
Similar disclosure issues may arise in mergers and acquisitions, where the entity being acquired has a significant portfolio of LIBOR-linked instruments. The parties may dispute whether or not standard form warranties and indemnities are sufficient to cover all LIBOR-transition related issues. In an extreme scenario, a party may assert that the LIBOR transition, or a botched attempted transition, could trigger a right to revisit the deal’s terms under a “material adverse change” or similar provision.
Generalizing this point more fully, anybody involved in LIBOR-linked transactions should be assessing whether they have exposure to, or themselves hold claims arising out of, misrepresentation or omission allegations. For example, a publicly traded company that holds a material amount of LIBOR-referencing investments should consider not just the accounting, tax, financial, legal, or other risks of the LIBOR transition, but also whether those risks have all been adequately disclosed.
Bonds, CLOs, RMBS, and Other “Deadlocked” Scenarios Involving Multiple Parties: A company buys a 15-year investment-grade bond from an infrastructure company that refers to 6-month LIBOR. The issuer is seeking to amend the terms of the bond so that it refers to SOFR plus an additional spread. In many situations like this, a change would require the consent of at least a majority of the bondholders. The terms also include a “sweeper” clause which binds the minority of bondholders who do not consent to the change.
Practically speaking, an issuer seeking to amend the terms of its bond indenture will need to offer bondholders terms that are attractive enough to get them to agree to an amendment—presumably, something that is expected to track the investor’s LIBOR-based expectations. But an issuer may find it difficult to reach the required minimum level of support even when offering what it sees as fair terms, particularly in situations where the impacted parties do not share equally in the risks of the amendment.
Even if the issuer is able to reach an agreement with the required number of stakeholders, those who disagree may still consider whether they have a legal right to challenge the amendment, either on substantive grounds (the terms are unreasonably oppressive to a minority) or on procedural grounds (whether sufficient notice given, whether the disclosures adequate, etc.). In an extreme scenario, a party may seek to enjoin the amendment. If no amendment can be worked out voluntarily, debates along the lines discussed above would be carried out, circling around the parties’ reasonable intent. What may be different here is that it may not be that everyone who feels aggrieved will have privity of contract with all of the other relevant actors. Breach of duty claims, fraud/securities fraud claims, and unjust enrichment claims may here be the focus of any disputes that turn into litigation.
A similar deadlocking scenario could arise with respect to Collateralized Loan Obligations (“CLOs”), given the large number of stakeholders in such instruments, and the differential impact an alternative rate might have on different CLO tranches.
Residential Mortgage-Backed Securities (“RMBS”) and Commercial Mortgage-Backed Securities (“CMBS”) are debt instruments under which the noteholder is often entitled to payments linked to LIBOR, backed by a pool of underlying mortgages whose borrowers must make payments linked to LIBOR. Borrowers, master servicers, investors, government-sponsored enterprises, and other parties involved may have diverging interests with respect to what the replacement rate should be used, either at the loan or the note level. As in the examples above, contractual rights here are more likely to mix with tort-like analyses. RMBS may present a particularly messy scenario, given that the security may be backed by loans from many different underlying lenders, making it all the more difficult to get agreement in a cost-effective way. Loan servicers may find themselves caught in the middle, facing restrictions on their ability to modify loans, as well as an ongoing obligation to collect and remit interest payments. These issues could heighten the risk of large middlemen colluding or otherwise strong-arming other actors.
4. What Should You Be Doing, and How Can Quinn Emanuel Assist?
The impact of the LIBOR discontinuation and transition to alternative reference rates can hardly be overstated. In light of the significant potential for economic loss and disputes over the proper interpretation of LIBOR linked contracts, the time to manage your litigation risk in preparation for the post-LIBOR world is now. There are likely to be significant financial rewards for those who act decisively, and potentially grave consequences for those who choose to ignore the impending change.
Quinn Emanuel can assist in (i) identifying any transactions referencing LIBOR, (ii) considering the practical and legal ramifications of the transition for those transactions and advising on the available options, (iii) moving your counterparties to come up with solutions to avert or ameliorate any negative implications, and also (iv) achieving the best solution for you in negotiations with your counterparties and in the courtroom.
With our expertise in the most complex, high-stakes disputes in the banking sector on both sides of the Atlantic and in Asia, we are perfectly placed to assist clients in developing a global strategy to address the upcoming LIBOR discontinuation.
