Application of synthetic US Dollar Libor under English and US legislation

On 23 November 2022, the FCA launched a consultation on the wind-down of US dollar LIBOR, proposing to compel the publication of one-month, three-month and six-month US dollar LIBOR on a synthetic basis until the end of September 2024. The consultation proposes that synthetic US dollar LIBOR be calculated as CME Term SOFR for the relevant tenor plus the applicable ISDA spread. Any such synthetic rate would not be representative of its underlying market and would therefore not be available for use in new instruments - only in certain legacy instruments.

In this briefing we consider how synthetic US dollar LIBOR would interact with related US and English legislation and discuss the likelihood of jurisdictional divergences.

US Act

The FCA consultation follows the entry into force in March 2022 of the US Adjustable Interest Rate (LIBOR) Act (US Act), which provides for the statutory replacement of US dollar LIBOR under US law-governed contracts¹, instruments, agreements, obligations and assets that either (i) contain no fallback provisions or (ii) fall back to a rate that is determined by dealer poll or is based on US dollar LIBOR (such as the last published rate). The statutory replacement rate will be based on the Secured Overnight Financing Rate (SOFR) and will include any applicable ISDA spread. It is scheduled to be implemented on the first London banking day after 30 June 2023.²

The actual replacement rate has yet to be announced, but in July 2022 the Federal Reserve proposed:

• ISDA's Fallback Rate (SOFR) as the replacement rate for derivatives; and
• CME Term SOFR plus the applicable ISDA spread as the replacement rate for non-derivative transactions referencing one-month, three-month, six-month or twelve-month USD LIBOR.

The proposed replacement rate for non-derivative transactions is the same as that proposed by the UK's FCA for synthetic US dollar LIBOR. Accordingly, assuming that the FCA and the Federal Reserve implement their replacement rates as currently proposed, the FCA's methodology for calculating synthetic US dollar LIBOR and the methodology for calculating the US statutory replacement rate will be the same.

No pre-cessation trigger - US Act treatment

Contracts and instruments that have viable cessation fallbacks but do not have a pre-cessation trigger would not be in scope of the US Act, as they would not be considered to have "no fallback provisions". Absent official guidance to the contrary (and subject to the discussion below) these contracts and instruments would continue to reference US dollar LIBOR in its synthetic form, as the cessation fallbacks would not have been triggered. However, as the calculation methodology for synthetic US dollar LIBOR is expected to be the same as that for the statutory replacement rate, such contracts and instruments would effectively fall back to the same rate as those falling back under the US Act, avoiding market bifurcation.

As discussed above, synthetic US dollar LIBOR will not be considered to be representative of its underlying market. In light of this, the Federal Reserve has canvassed market opinion as to whether official guidance should be issued to the effect that contracts and instruments with viable cessation fallbacks but without a pre-cessation trigger should fall back to the contractually agreed rate, despite the lack of an applicable trigger. This would avoid the potentially undesirable outcome of a contract falling back to a non-representative rate despite more appropriate fallbacks having been agreed by the parties. Any such guidance would move a large proportion of pre-2020 floating rate notes and structured products away from synthetic US dollar LIBOR and onto contractually agreed fallback rates.

Additionally, market participants are concerned that uncertainty around the application of synthetic US dollar LIBOR in contracts and instruments with workable fallbacks but no pre-cessation trigger could lead to disputes. The use of synthetic LIBOR in these types of contract will depend on the relevant LIBOR definition, as some agreements contain definitions that would not extend to synthetic LIBOR. For example, some agreements refer to a single published LIBOR rate (such as a Reuters page); this type of LIBOR definition would likely cover synthetic LIBOR, but other contracts define LIBOR using its broad methodology. In these contracts, it is unclear whether synthetic LIBOR would fit within the existing definition. This grey area is significant enough for the Federal Reserve to acknowledge that synthetic US dollar LIBOR could create ambiguity in non-covered contracts. Currently, final rulemaking for federal legislation has yet to emerge.

UK BMR

On the other side of the Atlantic, the UK Benchmarks Regulation (UK BMR), as amended by the Critical Benchmarks (Reference and Administrators' Liability) Act 2021, provides that, once US dollar LIBOR has been officially designated an "Article 23A benchmark" thereunder (meaning that it is no longer representative or is at risk of becoming so), all non-transitioned English law US dollar LIBOR contracts and instruments will automatically switch to synthetic US dollar LIBOR, where it is available.

No pre-cessation trigger – UK BMR treatment

The UK BMR specifically provides that contracts that contain fallback provisions but do not have a pre-cessation trigger would not fall back to the contractually agreed rate if synthetic US dollar LIBOR were available, and would instead automatically switch to the appropriate synthetic rate.

Safe Harbours

One area that may be of concern to market participants is the respective protections afforded by the safe harbour regimes under the UK BMR and the US Act.

Under the UK BMR, contracting parties cannot argue that use of a synthetic rate constitutes breach, material change, or frustration of the contract. In contrast, the US Act provides safe harbours for use of the statutory replacement rate but does not provide equivalent protection for use of a "non-representative rate". Although the calculation methods for the synthetic rate and the statutory rate are currently set to be the same, this omission could feasibly give rise to potential claims under US-law governed contracts and instruments that ultimately reference synthetic US dollar LIBOR because they do not have a pre-cessation trigger.

Jurisdictional divergence?

The table below sets out the replacement rates that will apply in respect of contracts and instruments governed by English and US law, assuming that the proposals discussed above are adopted.

Assuming that the FCA and Federal Reserve proposals discussed above are adopted, there will be little divergence in practice. In most cases, the fallback will result in the same outcome – contractual fallbacks or CME Term SOFR plus the applicable ISDA spread - albeit via different legal mechanisms and under different names.

If, however, the Federal Reserve issues guidance that contracts and instruments with viable fallbacks but no pre-cessation trigger should fall back to the contractually agreed rate, there may be circumstances where the outcome of the fallback mechanics differs under English law and US law where it would otherwise have been aligned.

Authors: Sarah Gant, Lloyd Harmetz, Mike Logie and Kirsty McAllister-Jones

Footnotes

_{1. The US Act itself does not limit its application to US law contracts. However, the Federal Reserve has proposed rules to clarify that the US Act only applies to contracts and instruments governed by US federal or state law.}

_{2.  The date on which the extant US dollar LIBOR tenors will either be discontinued or will cease to be representative of their underlying rate.}