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There is a move to transaction-based benchmarks for calculating LIBOR rates. Saaman Pourghadiri, barrister at Outer Temple Chambers, questions whether this change in methodology is likely to lead to frustration in current contracts.
What are the current plans to overhaul LIBOR or create alternative reference rates?
Following the regulatory findings made in relation to the manipulation of LIBOR in June 2012 and thereafter, a series of reviews into benchmarks were instigated by global bodies such as the International Organization of Securities Commissions (IOSCO) and the Financial Stability Board (FSB). In July 2014 the FSB published recommendations for the reform of interbank unsecured lending markets (IBORs), including LIBOR, and the development of new ‘nearly risk free’ benchmark rates (RFRs).
Currently LIBOR is compiled from data gathered by submitting banks who are asked ‘At what rate could you borrow funds, were you to do so, by asking for and then accepting inter-bank offers in a reasonable market size just prior to 11am?’ That is to say LIBOR is based on estimates provided by banks as to what rate they could hypothetically borrow at.
The FSB recommended changing the approach to calculating LIBOR (and other IBORs) from a submissions-based approach to one based on actual market transactions. ICE, LIBOR’s administrator, has issued consultation papers considering the mechanics of moving to such a system. It is hoped that such a change will strengthen the integrity of the benchmark making it harder to manipulate, ensure that the benchmark is grounded in actual borrowing and is more transparent.
LIBOR is published every day for a variety of currencies and a variety of tenors, for some of those currencies and tenors there will be days with insufficient market liquidity for a benchmark to be published purely by reference to real transactions. ICE’s proposals to deal with the problem of insufficient liquidity ultimately fall back on individual judgment to ensure that the various benchmarks are populated. ICE will publish a roadmap for the evolution of LIBOR to a transaction-based benchmark early this year.
Consultation on the introduction of RFRs in financial centres across the globe is ongoing. Again the FSB has recommended that such benchmarks be grounded in real transactions so much of the work is concerned with identifying appropriate transactions for the new benchmarks to be based on.
What advantages would this have for the market and market-participants generally?
A major advantage of the changes for submitting banks is that a transaction-based benchmark is less susceptible to manipulation and so the banks themselves bear less regulatory risk, though of course transaction-based benchmarks are not immune to manipulation, one need only look to the regulatory investigations and findings concerning the FOREX fix.
The FSB identified a growing appetite for a benchmark which does not include a premium reflecting banks’ credit risk perhaps arising from the increased use of collateral and the obligation to clear many derivatives through central counterparties (CCPs). It is thought that the publication of RFRs will enable market participants to obtain financial products which better reflect the risk they carry.
What effect would this have on existing contracts referencing LIBOR? Would parties be able to argue that a contract could be terminated based on contractual frustration?
Financial transactions with a notional value of some $230trn reference LIBOR (in varying currencies and maturities), with another $190trn referencing other IBORs. Plainly it is of critical importance that any changes to the method by which LIBOR is calculated do not disturb those transactions.
The first stage in the legal analysis is to construe the contract in question to understand what the contract means when it is describing the reference rate as LIBOR. Often contracts will refer to LIBOR as published on a particular screen. Where LIBOR is still published then the contractual term is satisfied. Furthermore standard terms, such as those published by the International Swaps and Derivatives Association (ISDA), contain fall back provisions determining how a reference rate will be calculated in the event of a benchmark no longer being published. Again the parties will look first to these fall back provisions.
The second stage in the analysis is whether a party might argue that while LIBOR is still published, the change in methodology is such that the contract is frustrated and they are discharged from further performance. Lord Simon summarised the test for frustration in National Carriers Ltd v Panalpina (Northern) Ltd  AC 675 at p 700:
‘Frustration of a contract takes place when there supervenes an event (without default of either party and for which the contract makes no sufficient provision) which so significantly changes the nature (not merely the expense or onerousness) of the outstanding contractual rights and/or obligations from what the parties could reasonably have contemplated at the time of its execution that it would be unjust to hold them to the literal sense of its stipulations in the new circumstances; in such case the law declares both parties to be discharged from further performance.’
The ICE proposals do change the inherent nature of LIBOR from a polled benchmark to a transaction based benchmark. This change is significant, but the legal analysis concentrates on the impact of such a change in methodology. Assuming that the change in methodology does not systematically increase or decrease LIBOR then it is difficult to see how a change in methodology could be said to frustrate a contract.
This conclusion can be fortified by reference to the commercial purpose of a given contract. For example, it might be argued that loans which reference LIBOR reflect a margin for the lending party over and above their own cost of borrowing. LIBOR currently is, and following reform will be, an estimation of the cost of funds to a bank. Derivatives designed to hedge risk will use (or should use) the same reference rate as the underlying risk. Again, the commercial purpose of the contract is to hedge risks associated with movements to the underlying rate. This commercial purpose is preserved whatever methodology is used to calculate the reference rate.
One of ICE’s proposals is to broaden the pool of submitting banks. Smaller banks may well carry higher credit risk and so such a change might systematically increase LIBOR. It will be a question of fact whether such a systematic increase is so severe as to lead to frustration.
The market concern around frustration is perhaps more understandable where the underlying benchmark no longer exists. Where this is the case and the contractual fall back arrangements do not for whatever reason offer a workable alternative there is a more plausible argument that a contract has been frustrated.
Should banking lawyers be looking to add additional language into their contracts now to avoid future problems?
While the current proposals will leave LIBOR intact, the number of currencies and tenors for which LIBOR is published have been reduced and may well reduce further. This is particularly so because there still has not been a return to the levels of interbank lending seen prior to the 2007–2009 financial crisis. This is a function of a variety of factors including increases to banks’ capital requirements, changes to capital ratios encouraging funding with longer maturity and increased liquidity from central bank measures such as quantitative easing.
Those drafting contracts ought to consider the robustness of the fall back provisions in the event that a reference rate ceases to be published. For example parties might assent to ISDA’s 2013 Discontinued Maturities Protocol which sets out how the reference rate is to be calculated where a particular tenor of LIBOR is no longer published. However, this protocol does not assist in circumstances where rates for an entire currency are withdrawn. Here, parties may wish to consider bespoke fall back arrangements.
Out of an abundance of caution, it might also be thought sensible for draftsmen to consider express language to the effect that changes in the methodology by which a reference rate is calculated will not of themselves be grounds for terminating a contract, perhaps with caveats for changes which have a substantive impact on the LIBOR rate in a particular direction.
Saaman Pourghadiri is a barrister at Outer Temple Chambers who specialises in commercial litigation and financial services. His current or recent financial services work includes acting for a number of individuals in relation to the global investigations into the FOREX market, claims arising out of the mis-selling of interest rate hedging products and assisting the Bank of England in developing and implementing its approach to regulating CCPs.
Interviewed by Barbara Bergin.
The views expressed by our Legal Analysis interviewees are not necessarily those of the proprietor.
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