This article has been written by Vaibhav Jain.
It has been published by Rachit Garg.
Table of Contents
Introduction: tough legacy contracts
Tough legacy contracts are those contracts which do not contain any fallback provisions for the transition away from Libor nor can they can be converted or amended to include such provisions. Moreover, all the tough legacy contracts have the same denominator despite coming in many forms. Some of the examples of the tough legacy contract are:
- Bonds: Since transition away from legacy LIBOR bonds is expensive, time-consuming and may even require the consent of all of the bondholders).
- Bilateral and Syndicated Loans: Because of the diverse nature of borrowers, expensiveness and resource availability and other challenges).
- Derivatives: Generally, whenever they are availed in a contract, then the contract is itself considered ‘Tough Legacy’ or they form part of a more complex structure).
In May 2020, the Tough Legacy Taskforce established by ‘Working Group on Sterling Risk-Free Reference Rates’ published a paper entitled “Statement on the identification of ‘tough legacy’ contract across assets classes”. Therein, the Taskforce identified common characteristics of tough legacy contracts:-
- LIBOR references in complex or structured transactions or arrangements in which one or all of the constituent elements (for example, underlying financial contracts or collateral, derivatives and/or the main financing itself), where reliance on fallback provisions in individual constituent elements would potentially introduce instability into the structure;
- a broad distribution of the debt instrument/contract leading to challenges with obtaining consent;
- An enormous amount of outstanding contracts (even if no other tough legacy features exist);
- Nature of customers (such as retail holders of mortgages or bonds).
Libor and tough legacy contracts
LIBOR is the acronym for London Interbank Offer Rate, regulated by the Intercontinental Exchange or ICE. The primary concern of LIBOR is to provide a global reference rate in the interbank market for any unsecured short-term borrowing. It is computed for five different currencies, producing 35 different rates on every business day. The currencies which LIBOR include are the Swiss franc, Euro, Pound Sterling, Japanese Yen and US Dollar. It has seven different maturities ranging from overnight to 12 months. However, LIBOR played a pivotal role in worsening the 2008 financial crisis, moreover, there are numerous scandals involving LIBOR manipulation among the rate-setting banks.
As a result, Financial Conduct Authority(FCA) used its dominance sanctioned by Article 21(A) of BMR and made its long-awaited announcement on MARCH 5, 2021 that all LIBOR settings will either cease to be provided by any administrator or will no longer be representative:
- After 31 December 2021, for all sterling, Swiss Franc, Euro and Japanese yen settings, and the 1-week and 2-month US dollar settings; and
- After 30 June 2023, for the remaining US dollar settings.
Impact of cessation of libor on tough legacy contracts
Over the past few years, market participants have been trying to amend their existing LIBOR contracts or ‘Tough Legacy’ contracts to append fallback provisions to contemplate the cessation of LIBOR.
Cessation of LIBOR has presented a potentially critical problem due to which an estimated $16 trillion worth of “tough legacy” contracts have been left without clear and uniform guidance. Therefore, without any federal action, borrowers and lenders would face uncertainty and potentially expensive litigation. Fed Vice Chair Randal Quarles also called for legislation to help safeguard financial market stability, testifying before the House Financial Services Committee that there was “really no way to address” the legacy contracts other than legislation
According to several Financial and Juris experts, the “tough legacy” or “broken” contracts don’t have a specified replacement rate for borrowers and lenders to use instead of LIBOR, which is set to be discontinued in June of 2023. Therefore, without any uniform law, many parties may end up having to turn to litigation to settle the rate decisions.
Synthetic libor and tough legacy contracts
Article 23A of ‘BMR’ or ‘Benchmark Regulation’ enables the authority to designate a critical benchmark, that has or is on a verge of becoming unrepresentative, as an “Article 23A” Benchmark. This designation prohibits the supervised entities from using such benchmark, under Article 23B, except when the Legacy use has been permitted under Article23C by the authority.
On 29 September 2021, the FCA officially announced, that from 1 January 2022 one-month, three-month, and six-month Sterling and Yen will be designated as “Article 23A” Benchmarks. This means the supervised entities will be prohibited from using these 6 LIBOR benchmarks from 1 January 2022, by virtue of Article 23B.
However, the FCA has made an exception under Article 23C, permitting these supervised entities to use benchmark under a changed methodology, called “Synthetic LIBOR”, in accordance with Article 23D. But the supervised entities will not be permitted to use “ Synthetic LIBOR” for cleared derivatives.
Despite that, FCA has made it clear that the parties should not be anticipated to use “Synthetic LIBOR” for the long term, as “Synthetic LIBOR” is just a bridging solution for those ‘Tough Legacy’ contracts which can’t be converted.
Scope of Synthetic LIBOR in US Legislation
FCA expects that the implementation of “Synthetic LIBOR” should flow through to global users of such existing LIBOR contracts, that cannot be amended. However, the firms outside the UK’s statutory framework will need to take legal advice on how “Synthetic LIBOR” will attract in their contract provisions.
The FCA further stated that the flowing throw of “Synthetic LIBOR” to a global user of existing LIBOR contracts depends on how LIBOR is described within their contract and the other countries’ Legislative framework.
Validity of tough legacy contracts in us legislations
Cessation of LIBOR has left, numerous existing LIBOR contracts without any appropriate fallback provisions permitting them to either convert to a non-LIBOR contract or to be easily amended to provide fallback provisions. These contracts are known as “tough legacy” LIBOR contracts. Contracts concerning LIBOR in bond transactions, where amendments require approval from a majority of bondholders present a specific example of a “tough legacy” LIBOR contract, as they are difficult to amend.
The legal authorities and several industry groups are taking proactive steps to amend the provisions of LIBOR contracts in order to provide a fallback mechanism, allowing the contracts to replace LIBOR rates with RFRs (Risk-Free Rates), protecting and securing the financial interests of customers while maintaining the integrity of the United States’ financial system. However, such proactive steps of industry groups and Legal authorities have found difficulty in doing so as there are numerous fundamental differences between RFRs and LIBORs, as RFRs are only overnight night rates but LIBOR is available in multiple tenures, moreover, LIBOR incorporates bank credit risk premium, whereas RFRs don’t.
As a result, for contractual continuity of the ‘Tough Legacy’ contracts, President Biden signed On March 15, 2022 legislation known as the “Adjustable Interest Rate (LIBOR) Act,2021”. The act under Section2(b) seeks to provide clearly defined or practicable replacement benchmark rates when LIBOR is discontinued and to preclude litigation for such ‘Tough Legacy’ contracts by constructing a uniform process on a nationwide basis. The Adjustable Interest Rate (Libor) Act, 2021, was approved by the House Financial Services Committee on July 29, 2021. The act was accepted by the market at the large, as it battled with the impact of the cessation of LIBOR. There are several states, such as New York, that have passed or are considering passing a similar law, however, Section 6(a) of the Adjustable Interest Rate (LIBOR) Act,2021 expressly provides “any provision, law, statute, rule, regulation of any State, which institutes a uniform process, on a nationwide basis, for replacing LIBOR in tough legacy contract, is superseded by this legislation.
Section 4(a) of the Adjustable Interest Rate (LIBOR) Act,2021, provides for existing ‘Tough Legacy’ contracts. These are those contracts, that, either contain no fallback provisions, or, contain fallback provisions but, neither provide a specific benchmark replacement nor identify an authorised person who has the authority or responsibility to determine a replacement (known as “Determining Person”) will automatically be changed to “Board-Selected Benchmark Replacement” on the first London banking date after June 30, 2023.
The operative text of the act provides, that the act manages to provide a considerable amount of flexibility to ensure all parties impacted due ‘Tough Legacy’ contract can smoothly transition from LIBOR, while Section 4(g) of the act also ensures that the act is tailored narrowly enough to avoid unduly burdening such LIBOR contracts that either specifies provisions of this act shall not apply to them or already contain effective fallback provisions for determining a benchmark replacement.
The New York (NY) State Legislature has also passed a statutory solution to tackle “Tough Legacy” LIBOR contracts, which aims to minimize the expensive litigation relating to the transition away from USD LIBOR: ‘Senate Bill 297B/Assembly Bill 164B’. Section 18-401(1) of the Bill provides, any contracts caught within its ambit will be transitioned automatically (“by operation of law”) from the relevant USD LIBOR rate to the “recommended benchmark replacement” rate. The bill further states, that SOFR[SECURITY OVERNIGHT FINACIAL RATE] provided by the Federal Reserve Bank of New York, defined under Section 18-400(12), shall be selected by the US regulators as the benchmark.
Conclusion
To conclude we can say that, all those contracts which do not contain fallback provisions to convert to a non-LIBOR contract or are difficult to amend to provide such fallback provisions are known as the ‘Tough Legacy’ contracts. These ‘Tough Legacy’ contracts include various bonds, loans, derivatives and mortgages.
As Section 2(a)(2) of the Adjustable Interest Rate (LIBOR) Act, 2021 states, LIBOR is used as a benchmark rate in more than $200 trillion of contracts worldwide, which is why LIBOR, is set to be discontinued in June 2023, has created a situation of turmoil in the market. The FCA also acknowledges cessation of LIBOR can render financial contracts, impact financial stability and cause causes losses to customers. All the Tough legacy contract holders to contemplate the cessation of LIBOR, have been trying to amend their existing LIBOR contracts to non-LIBOR contracts. Moreover, there is a prominent demand from the public for the Legislature to intervene and provide a specific replacement rate for the existing LIBOR contracts to safeguard their financial interest and stability. Yet, many experts are of the view that such contract holders would have to turn to expensive litigation to settle their rate decisions.
Thus, for upholding the contractual validity of the existing LIBOR contract, US President Joe Biden on March 1, 2022, provided a bridging solution and signed an act known as “Adjustable Interest Rate(LIBOR) ACT,2021 which provides practicable replacement benchmark rates after the cessation of LIBOR. The act under Section 4(a) provides for the existing ‘Tough Legacy’ that contains no fallback provisions or if they contain fallback provisions but don’t provide a specific benchmark replacement rate, they will automatically after June 30, 2023, be changed to “Board-Selected Benchmark Replacement”. On top of that, the act has been tailored down under Section4(g) to avoid burdening such LIBOR contracts, which already contain fallback provisions for determining replacement rates. The New York (NY) State Legislature has also passed a statutory resolution, i.e., ‘Senate Bill 297B/Assembly Bill 164B’ to tackle such “Tough Legacy” LIBOR contracts. Section 18-401(1) of the bill states that any contracts within its scope will be transitioned automatically from the relevant USD LIBOR rate to the “recommended benchmark replacement” rate.
Reference
1. Article 21A, 23A, 23B, 23C, 23D OF BMR.
2. Section of 2(a)(2), 2(b), 4(a), 4(g), 6(a) of The Adjustable Interest Rate (Libor) Act, 2021.
3. Section 18-401(1) and 18-400(12) of Senate Bill 297B/Assembly Bill 164B.
4. https://www.bakermckenzie.com/- /media/files/insight/publications/2020/06/londms12014417v1finalversion11981284v19liborclientalerttoughlegacy.pdf
5. https://www.fca.org.uk/publication/consultation/cp21-29.pdf
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