From LIBOR Cessation to “synthetic” LIBOR

The transition from the London Interbank Offered Rate (LIBOR) to Alternative Risk-Free Rates (RFR) is a global event with large impact and major challenges for those involved in the financial markets operating with floating reference rates. From 1 January 2022, publication of most LIBOR settings ended. The financial industry has mobilised all its forces ahead of the upcoming deadline to bring the transition to a “safe haven”. However, not all financial instruments and financial contracts referring to LIBOR settings could be remediated in time prior to the end of 2021. Therefore, there could be a risk of contractual disruption, if interest payments in LIBOR related financial instruments or financial contracts (e.g. loans, bonds, mortgages or derivatives) cannot be calculated. For UK law governed contracts, the UK Financial Conduct Authority (FCA) has taken remedial action and exercised its powers under the UK Benchmark Regulation to compel the ICE Benchmark Administration (IBA) to publish 1, 3 and 6 month GBP and JPY LIBOR rates on a “synthetic” basis for a limited period of time to allow the affected counterparties more time for transition. At EU level, however, there is a lack of a corresponding "transitional solution", thus the question arises as to how to deal with contracts governed by the law of an EU member state referring to 1, 3 or 6 month GBP or JPY LIBOR which could not be switched to new risk-free overnight interest rate benchmarks in time before LIBOR has been phased out.

The “synthetic” LIBOR

All references in UK law governed contracts to 1, 3 and 6 month GBP or JPY LIBOR are, after 31 December 2021, deemed to refer to the “synthetic” version of the relevant rate. The FCA has exercised its powers under Article 23D of the UK Benchmark Regulation (as introduced by the Financial Services Act 2021) to compel the IBA to calculate 1, 3 and 6 month GBP and JPY LIBOR using a changed “synthetic” methodology with effect from 1 January 2022 to reduce disruption, support parties to legacy contracts and ensuring an orderly wind down of LIBOR. Such rates determined under the new methodology are referred to as “synthetic” LIBOR. The new “synthetic” rates are published on the same page as the 1, 3 and 6 month GBP or JPY LIBOR and at or about the same time as the terminated “panel bank” LIBOR rates.

Under the Critical Benchmarks (References and Administrators' Liability) Act 2021, all references in UK law governed contracts to 1, 3 and 6 month GBP or JPY LIBOR are, on and after 1 January 2022, deemed to refer to the “synthetic” version of the relevant rate. The Critical Benchmarks (References and Administrators' Liability) Act 2021 is specified to apply solely to contracts governed by the laws of England and Wales, Scotland or Northern Ireland. Other terminated rates, in particular EUR or CHF LIBOR, are not covered by the Critical Benchmarks (References and Administrators' Liability) Act 2021.

However, it is worth mentioning that the “synthetic” LIBOR is considered to be non-representative. Therefore, any pre-cessation/non-representativeness fallbacks contained in UK law governed contracts are triggered notwithstanding the Critical Benchmarks (References and Administrators' Liability) Act 2021.

Challenges in relation to the “synthetic” LIBOR from a German law perspective

As there is currently no solution comparable to the aforementioned approach in the UK at EU level that addresses the termination of GBP and JPY LIBOR in their representative form, the legal analysis of EU law governed contracts referencing GBP and JPY LIBOR will depend on the relevant local law and practices in the respective EU member state. In Germany there is currently no solution how to deal with “synthetic” LIBOR in respect of German law governed contracts referencing GBP and/or JPY LIBOR. Therefore, for German law governed contracts, in particular, the following questions may arise with respect to the cessation of GBP and JPY LIBOR rates.

First, could a German law governed financial instrument or financial contract referencing 1, 3 or 6 month GBP or JPY LIBOR be deemed to refer to the “synthetic” LIBOR version of the ceased rate after 1 January 2022?

Second, what could be the likely effect of the cessation of GBP or JPY LIBOR rates in their representative form as a matter of German law? For example, is the contract likely to be frustrated, or could a court substitute an alternative rate?

Treatment of the “synthetic” LIBOR from a German law perspective

At this stage, the European Commission has not yet designate any statutory replacement rates under the EU Benchmark Regulation for EUR, GBP and JPY LIBOR.

Therefore, the effect of the cessation of the LIBOR rates generally depends on the relevant provisions and the exact wording of the relevant contracts.

In the case that the relevant contract only includes references to LIBOR without any suitable fallback provisions or provisions regarding the cessation of reference rates, the contract would need to be interpreted in accordance with section 157 German Civil Code (Bürgerliches Gesetzbuch - BGB). Section 157 BGB states that contracts are to be interpreted as required by good faith (Treu und Glauben), taking customary practice into consideration. An interpretation that “synthetic” LIBOR shall be applicable would only be possible, if the “synthetic” LIBOR can be considered as a commercial equivalent to LIBOR, ie if no party suffers a disadvantage from applying “synthetic” LIBOR. As there is no customary practice yet in relation to LIBOR and “synthetic” LIBOR such practices cannot be taken into account. Further, the concept of supplementary interpretation also allows to fill gaps in contracts where the parties have inadvertently omitted to cover an essential point in their contracts. However, since a supplementary interpretation of the contract is supposed to close an initial loophole retroactively the question of whether, at the time of contracting, the parties would have conceived of LIBOR ceasing to exist, and if so, what they would have envisaged happening in consequence, will therefore be a key consideration. In this case courts would assess whether the parties could have envisaged LIBOR ceasing to exist and what the parties would have agreed, had they been aware of the gap. It is questionable, if it could be argued that “synthetic” LIBOR would have been agreed between the parties, in particular, if the commercial result is different. Looking at the current market there are other options used such as compounded reference rates which might be considered as alternatives by a court. As a result, it is hard to say at this point in time, how a court would interpret the contract and which alternative it would use to fill the gap in the contract, if at all.

In the case that the relevant contract includes suitable fallback provisions it will be even more difficult to argue that there is a gap in the contract which needs to be filled. In this case it is more likely that the courts would apply the relevant fallback or cessation provisions of the contract to determine an alternative reference rate.

Notwithstanding the above, any pre-cessation/non-representativeness fallbacks are triggered in any event since the “synthetic” LIBOR is considered to be non-representative.

Further, it can be discussed, if section 313 BGB might apply. According to section 313 BGB an amendment of the contract can be demanded, if circumstances which became the basis of a contract have significantly changed since the contract was entered into and if the parties would not have entered into the contract or would have entered into it with different contents, if they had foreseen this change, taking into account of all the circumstances of the specific case, in particular the contractual or statutory distribution of risk and if one of the parties cannot reasonably be expected to uphold the contract without alteration. If an amendment of the contract is not possible or one party cannot reasonably be expected to accept it, the disadvantaged party may even be able to terminate the contract pursuant to section 313 (3) BGB. However, section 313 BGB is only used by courts in very limited cases and primarily the concepts of interpretation of contracts as set out above shall be used. Considering that FCA first announced the future cessation of LIBOR in July 2017, the parties could have envisaged LIBOR ceasing to exist or the position under the contract if it did and discuss relevant amendments at an earlier stage.

Outlook

Currently, there are no standardised approaches yet in the German market in respect to the issues outlined above. At this stage, there are no established views on the extent to which “synthetic” LIBOR can be readily applied to German law governed contracts with LIBOR exposure. Whilst some representatives in the market are of the opinion that “synthetic” LIBOR may be considered as an alternative basis, if nothing else has been agreed between the counterparties, recourse to the “synthetic” LIBOR might only be feasible, if neither party has any disadvantages by using this “synthetic” rates and both parties agree to the usage of “synthetic” LIBOR.

From a German law perspective, the result of an interpretation of the relevant financial instrument or financial contract in accordance with section 157 BGB is likely to be the primary consideration, if nothing else has been agreed between the counterparties. The assumption of an interference with the basis of the transaction is quite likely ruled out due to its subsidiarity. In any case, it is obvious that an one-size-fits-all approach is neither available nor effective or appropriate. Affected and non-transitioned financial instruments or financial contracts with LIBOR exposure must be examined on a case-by-case basis to determine if they could be deemed to refer to the “synthetic” version of the relevant rate or another equivalent. Only by examining each individual financial instrument or financial contract, legal certainty can be achieved for contracts which have not yet been remediated. Therefore, affected market participants should seek further legal advice with regard to the review and interpretation of the contracts, in particular in order to assess the relevant circumstances of each individual case, and concluding potential supplemental agreements.

On November 2021, the Chairman of the Euro Risk-Free Rates Working Group (EUR RFR WG) wrote in a letter to a representative of the Securities Markets department at the European Commission, in order to suggest the alignment for tough legacy contracts under EU law with the approach taken by the UK under English law as described above, i.e. the use of “synthetic” LIBOR. In order to achieve this, the adoption of specific legislation by way of designation of a statutory replacement rate under the EU Benchmarks Regulation based on the “synthetic” LIBOR is demanded. This designation should provide legal certainty for effected contracts as well as a consistent approach for all tough legacy contracts. Nevertheless, the EUR RFR WG is also aware of certain challenges and operational aspects which require further discussion on the path to a full alignment with the UK approach. Meanwhile, the European Commission has announced that the adoption of implementing regulations to designate statutory replacement rates is planned for the first quarter of 2022. The statutory replacement rates will replace contractual references to certain GBP and JPY LIBOR rates in the EU by operation of law from the date on which the implementing act applies.

However, it remains to be seen when the European Commission will finally designate a replacement rate for GBP or JPY LIBOR, as well as the EUR LIBOR, how contractual continuity will be ensured and its impact on German law governed contracts.