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Q & A: Will the death of LIBOR be the birth of a new wave of litigation?

  • United Kingdom
  • Financial services and markets regulation - Briefings and articles

18-07-2019

What is LIBOR?

LIBOR is the unsecured rate at which wholesale banks lend to each other. It is calculated using an average of the rates submitted by 20 panel banks in the UK. LIBOR is widely used as the reference for setting the rate of interest in many other types of lending.

When is it going?

In 2017, the FCA[1] announced that it expected LIBOR to cease publication by the end of 2021.

Why is it going?

As wholesale banks have largely stopped lending to each other on an unsecured basis, the panel banks have had to rely on their judgment of what they think that rate would be. This makes LIBOR vulnerable to manipulation (as the LIBOR scandals of the past decade show). This presents risks for the panel banks and the FCA.

Where is LIBOR used?

LIBOR is widely used as the reference rate in financial products. These include derivatives, bonds, loans to corporates and some mortgages. It is often used as a back to back rate to hedge risks in associated financial contracts. It can be deeply embedded in a wide range of applications and infrastructure used by financial firms, for example in valuation, pricing, performance and risk management[2].  

What will take LIBOR’s place?

In the UK, the Working Group on Sterling Risk Free Reference Rates has selected a reformed SONIA, Sterling Overnight Index Average.

When will LIBOR switch to SONIA?

It won’t. It is a different reference rate. Unless the government introduces legislation which changes existing contractual references to LIBOR to SONIA (which is highly unlikely), then existing contractual references to LIBOR will remain unless parties agree to switch to a new rate.

What does this mean for legacy contracts referencing LIBOR post 2021?

It depends what the contract says.

Contracts will usually contain fallback provisions but these generally assume that LIBOR is not available for a day or so. If the fallback provides for the last published LIBOR rate to be used then floating rates will suddenly become fixed if LIBOR is no longer published.

If the fallback provides for the polling of “reference banks” to calculate a rate in the absence of LIBOR, it is questionable whether those banks will be prepared to continue to give a rate meaning that the fallback will be unworkable.

Where a trustee has the power under the documentation to select an alternative rate (as may be the case in a securitisation), then the trustee will need to follow the provisions of the contractual documentation and comply with its fiduciary duties in setting a new reference rate.  

A move away from LIBOR will result in winners and losers. Where the sums at stake are significant, and the mechanism to follow uncertain, the likelihood of litigation increases. We may also see parties who have made a bad bargain in a contract, seek to use the end of LIBOR as an excuse to exit their agreement.

What about new contracts referencing LIBOR?

In June 2019,[3] the Bank of England called “last orders” on new contracts referencing LIBOR.

Post-July 2017 products that rely on LIBOR post 2021, may present mis-selling risks for firms. Possible claims could arise under s.90 and s.90A of the Financial Services and Markets Act 2000 or the common law of misrepresentation. Claims are more likely if it has not been made clear to investors that LIBOR will be discontinued at the end of 2021 and a new rate (or a robust fallback provision) identified for that eventuality.  

What about regulatory risks?

In September 2018, the FCA and PRA issued a “Dear CEO” letter to major banks and insurers seeking an update on the steps they were taking to transition away from LIBOR and confirmation of the Senior Manager(s) responsible for that transition.

The thematic findings[4] on the responses to that letter show that whilst some are making good progress in identifying and managing their governance, prudential and conduct risks, others are not doing as well. As 2021 grows closer, the FCA and PRA are likely to increase their supervisory engagement. For those firms who fail to prepare as expected, the threat of enforcement action is a possibility.  

What next?

The end of 2021 is less than 30 months away. The sooner the potential risks are identified and considered the easier the task will be. Eversheds Sutherland have a range of tools which can help identify and manage these risks and would welcome the opportunity to discuss the challenges that transition away from LIBOR presents to your business with you.



[1]  Speech by Andrew Bailey, Chief Executive of the FCA on the Future of Libor, 27 July 2017

[2]  Bank of England Prudential Regulation Authority and FCA: Firms’ preparations for transition from London InterBank Offered Rate (LIBOR) to risk-free rates (RFRs): Key themes, good practice, and next steps. June 2019.

[3]  Speech by Dave Ramsden, Deputy Governor for Markets & Banking on Last Order:Calling Time on LIBOR

[4]  Bank of England PRA and FCA: Firms’ preparations for transition from London InterBank Offered Rate (LIBOR) to risk-free rates (RFRs): Key themes, good practice, and next steps. June 2019.

 

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