LIBOR transition: government proposes legislation to deal with 'tough legacy' contracts

The government said that the changes would allow the FCA to manage an orderly transition from London Interbank Offered Rate (LIBOR), which is expected to cease to be available in its current form at the end of 2021.

LIBOR is a measure of the average rate at which banks are willing to borrow certain funds and is used as a pricing mechanism for financial products. But following scandals about its manipulation regulators and banks have agreed to stop supporting the rate at the end of 2021. Firms are expected to adopt alternatives by then.

The FCA will be able to change the calculation methodology for LIBOR so that, for example, it is no longer based on panel bank submissions, but instead could be calculated by reference to a risk free rate with an appropriate adjustment.  These powers would be exercisable where the regulator has found that the benchmark’s representativeness will not be restored and where action is necessary to protect consumers or to ensure market integrity.

While giving the regulator the ability to specify limited continued use of LIBOR in legacy contracts, the government has made clear that the amendments would strengthen existing law to prohibit use of LIBOR in new business once the rate is declared to be unrepresentative. This is in addition to the regulator's expectation that firms cease issuing LIBOR products by the end of March 2021.

The FCA has warned that the exercise of these powers might not be applied in all circumstances or for all LIBOR currencies and tenors, for example where the inputs necessary for an alternative methodology are not available in the relevant currency.

Accordingly, both the government and the FCA have reiterated that market participants should continue to take active measures to shrink the pool of contracts referencing LIBOR as far as possible, leaving behind only those contracts that genuinely have no or inappropriate alternatives to using the rate and where there is no realistic ability that these contracts can be renegotiated or amended – so called "tough legacy" contracts.

Full details of the proposals will follow FCA consultation and FCA statements of policy and so it remains to be seen whether and how the FCA will exclude arrangements which in their view do not constitute 'tough' legacy contracts. What is clear is that the government and the FCA do not see this mechanic as an alternative to LIBOR transition where a contract can feasibly be amended. It seems likely that workable fallbacks, however commercially undesirable, would also put an arrangement outside the scope of the proposals.

Whilst the UK proposals may be helpful in relation to arrangements which refer to the calculation of LIBOR by reference to the 'screen rate' provided by the LIBOR administrator, ICE Benchmark Administration, they may not assist with contractual interest calculation mechanics which refer more broadly to the rates at which banks lend to or from each other in the relevant interbank market.

The FCA will also be aware that the way in which these powers are exercised should not interfere with the way functional fallbacks work in existing contracts. It would be contrary to expressed FCA and UK government policy for the continued publication of LIBOR under a different methodology to mean that contractual fallbacks applicable on the cessation of LIBOR would not be triggered.

Comparatively, the FCA has taken a different approach to that proposed by the Alternative Reference Rates Committee (ARRC) in the US. Instead of changing the way LIBOR is calculated, the proposed ARRC New York legislation would override existing fallback language that references a LIBOR-based rate and instead require the use of the legislation’s recommended benchmark replacement.