Legal implications of the replacement of IBORs
The replacement of the IBORs has multiple regulatory and civil law impacts for credit institutions. The alternative reference interest rates, which have not been sufficiently tested yet, entail risks. In addition, contracts for relevant products have to be modified. In the context of risk management, the drying-up of individual derivatives markets must already be taken into consideration.
Long version of the article „Ablösung des Libor ist Chefsache“ („Libor’s Replacement is a Management Issue“), published in „Börsen-Zeitung“ no. 197 on 13 October 2018 | by Moritz Maier, Osman Sacarcelik and Dennis Schetschok
Reference interest rates are intended to provide the financial and capital markets with neutral and objective benchmarks for comparison. They are used to set the price of loan interest and act as important guide value for many financial products. Interbank Offered Rates (IBORs) are the most important type of such benchmarks. They indicate the interest rates at which institutions in the interbank market will grant unsecured loans. IBORs differ primarily in the reference currency but also in the term of the underlying interbank loans. Various interest rates relating to specific maturities are published accordingly under the generic term of an individual IBOR, such as the London Interbank Offered Rate (LIBOR) or the Euro Interbank Offered Rate (EURIBOR). The Euro Overnight Index Average (EONIA), by contrast, indicates the interest conditions of an overnight loan granted between institutions in Euro as an individual value.
Problems arise when markets no longer put trust in reference interest rates. In 2012, it became apparent that the LIBOR had been manipulated for years by employees of the panel banks who provide the data for its calculation. One consequence of these occurrences was substantial fines. The LIBOR is also coming under pressure as a result of Brexit, as European companies might – at least in the case of a “hard” Brexit – be in a position where they can no longer trust the LIBOR as a reliable source of reference. The Chief Executive Officer of the British Financial Conduct Authority (FCA), Andrew Bailey, announced on 27 July 2017 that the LIBOR panel banks would no longer be required by regulatory law to participate in the LIBOR calculation as of 1 January 2022. As things stand at present, the panel banks will therefore dispense with any further data transfers, especially on account of the liability risk associated with participating in the LIBOR calculation. The LIBOR is therefore highly likely to have been phased out by 31 December 2021.
EU Benchmarks Regulation causes regulatory pressure
Regulatory pressure has also been brought to bear on all the IBORs under the EU Benchmarks Regulation (Regulation (EU) 2016/1011; BMR). This Regulation, which has been directly enforceable since 1 January 2018, takes particular account of the principles established by the International Organization of Securities Commissions (IOSCO) which serve as a global standard for the regulation of benchmarks. The BMR provides the administrators of reference interest rates with detailed requirements in respect of the input data and methodology used for the calculation and in respect of transparency. If the IBORs depart from these requirements, administrators will only have until the end of 2019 at the latest to make adjustments. In this background context, the IBA (Intercontinental Exchange Benchmark Administration), administrator of the LIBOR, and the EMMI (European Money Markets Institute), administrator of the EURIBOR, announced their intention to reform their reference interest rates and, as far as possible, to calculate them on the basis of real transactions. The EONIA will be discontinued at the end of 2019, however, as the EMMI is not planning any reforms which would entail carrying out the calculation in accordance with BMR requirements in the future. Consequently, no provision is made for its use beyond the year 2019 under Article 51 (4) clause 2 BMR. Another debatable point is whether the reform efforts for the LIBOR and EURIBOR are regarded as BMR-compliant.
Faith in alternatives to IBORs is not sufficient
The risk management process in institutions requires that the consequences of the discontinuation of reference interest rates be taken into account in strategy and risk planning. Faith cannot be placed in any assumption that the expiring IBORs can be directly replaced by alternative benchmarks. In any event, no viable alternatives to the IBORs have emerged as yet. The efforts of the Financial Stability Board (FSB) to this end and its currency working groups are still at square one. The first publication of the ESTER (Euro Short-Term Rate), the new reference interest rate currently preferred for the Eurozone, is not expected before the fourth quarter of 2019. It will not be clear whether the ESTER or other so-called Risk-Free Rates (RFRs), such as the US Secured Overnight Financing Rate (SOFR) or the British Sterling Overnight Index Average (SONIA), will actually replace the IBORs until such time as the market refers its financial products in sufficient number and volume to these – new – reference interest rates. This is not a foregone conclusion. This view is taken as a result of the many differences between the current IBORs and RFRs. One notable problem is that the relatively short reference period of only one night for RFRs does not adequately reflect the market situation for medium-term and long-term loans and financial products. A complete replacement of the IBORs will only be possible if alternative reference interest rates for the different maturities are also formed for the different currency zones (term structures).
The fact that the phase-out of the IBOR will bring not only economic but also an entire row of legal consequences should have registered with institutions and insurance companies when the circular from the British regulatory body, the FCA, dated 19 September 2018 did the rounds, if it hadn’t already. In the letter, the FCA asked companies under its supervisory authority to submit a plan approved by their respective management boards by 14 December 2018, setting out the risks identified in connection with the end of the LIBOR and corresponding preparations and countermeasures. Institutions are also required to appoint a LIBOR officer at management level to monitor the situation and to see to it that the preparatory measures and countermeasures are put in place. It is likely that the national and international authorities will follow the example of the FCA, including with regard to other IBORs.
Product contracts are subject to urgent need for adaption
Another follow-on effect from the replacement of the IBORs will be the need to adapt the contracts for relevant products. This amendment requirement already gives rise to legal risks. The amendments themselves also build a case for legal risks. There is consensus here that the arrangements currently contained in loan agreements and financial product contracts, which provide for an alternative benchmark valuation in the event of a short-term default of the IBORs (so-called fallback clauses), do not take into account the permanent default of these reference interest rates. Historical inclusions of such fallback clauses become inapplicable if the reference points of the last publications of the IBOR to which reference is made recede further and further into the past, pushing the reference point of the valuation of the reference interest rate further and further away from the current market situation. Renegotiation clauses offer too little legal security for the contracting parties, however, while the complete absence of a fallback clause can even lead to the premature wind-up of contracts.
Various design forms conceivable
The restructuring or adaptation of the product contracts already required today in this background context is pitted against the challenge that reliable alternatives which could directly supersede the existing IBORs have not yet emerged on the financial markets. The model amendment clause published by the Loan Market Association (LMA) on 25 May 2018 can be seen as one approach to finding a solution, whereby the fallback clause already contained in the standard LMA contract templates for loans and financial products can be adapted with the discontinuation of the LIBOR in mind. The aim of the LMA is to further increase the degree of flexibility already present in the current optional standard fallback clause. The current standard fallback clause stipulates that, in the event of the default of the reference interest rate, the parties to the contract are to agree by mutual consent such amendment as is necessary to validate an alternative reference interest rate recognised for the underlying currency. The adjustment recommended by the LMA extends the scope of this amendment option to include further events prior to the actual default and to include further alternatives with regard to the benchmarks validated for consultation. At the same time, the LMA lowers the threshold of mutual consent for syndicated loans in its recommendation by leaving it to the contracting parties to decide for themselves which majorities are necessary on the part of the syndicated lenders for the introduction of an alternative reference interest rate.
As an alternative to a higher level of flexibility, however, the parties to a financial product contract could also seek to reduce discretionary decisions as far as possible in spite of the uncertainties outlined above and act now to put the tightest possible arrangements in place for the discontinuation of the reference IBOR. The advantage of this approach, which is also advocated by such bodies as the Alternative Reference Rates Committee (ARRC) which is affiliated to the US Federal Reserve, would be the early introduction of clear criteria in order to plan ahead.
Another point to bear in mind is that contract revisions and amendments must be measured against the requirements in respect of control of general terms and conditions. The relationship of equivalence and the interests of the contracting parties must be taken into account with reference not only to private clients, but also to corporate clients (cf. German law in section 310 (1) in conjunction with section 307 of the German Civil Code (Bürgerliches Gesetzbuch - BGB)). Financial disadvantages for the client due to the mere discontinuation of the reference interest rate would therefore be difficult to justify without the approval of the client.
Re-papering and individual solutions for practical implementation
In the meantime, proven automated processes can be used for the practical implementation, especially for the analysis of the status quo and for the execution of so-called re-papering projects. The automation will facilitate the necessary adjustments. In cases involving a large number of different product contracts, however, there will also be a need for case-by-case reviews and individual solutions which take account of the specific contract structure and the interests in each situation.
Provisioning requirements and drying-up of individual derivatives markets
From a regulatory perspective, the need to adjust contracts will lead to market price risks and operational risks because unclear contractual relationships can result in loss of revenue and legal risks which establish the need to set aside reserves. Section 25a (1) of the German Banking Act (Kreditwesengesetz - KWG) and BTO 1.3 MaRisk require institutions to identify such risks at the earliest possible stage and to initiate countermeasures. Users of benchmarks like the LIBOR have also been obliged since the beginning of this year, under Article 28 (2) BMR, to produce “robust written plans” to provide for the event of a short-term or permanent default of the reference benchmarks in order to comply with regulatory law.
Another regulatory aspect of the IBOR conversions which has hitherto been disregarded is the impact on the risk management of the institutions. Institutions manage their interest rate risk and liquidity risk by hedging interest rates on the capital market. To this end, they enter into interest rate swaps on a substantial scale with other professional contracting parties. The replacement and conversion of the IBORs are generating various uncertainties in this respect because transactions bearing reference to “old” and “new” interest rates are expected to run in parallel during the transition period. On the one hand, the resulting differences in the yield curves and interest rate developments must be taken into account in the risk strategy. On the other hand, however, the timing and reaction speed of the institutions also play a decisive role because the fewer products there are which are based on “old” reference interest rates, the greater the extent to which liquidity will dry up in the corresponding derivatives market. Hedging on the basis of the expiring IBORs will then be difficult at best but considerably more expensive at the very least. Without hedging transactions, interest rate risks and liquidity risks would have to be fully integrated into the risk planning process which would, in turn, lead to an increase in the provision of equity and an adjustment of risk strategies.
The institutions should therefore formulate a changeover strategy for the replacement of the IBORs which takes due account of the requirements of all the relevant business divisions. The necessary reforms can only be carried through successfully if all the relevant parties pull in the same direction and act in concert to put a comprehensive overall strategy in place, from the departments responsible for markets and clients and the divisions overseeing the assets and liabilities of the institution right through to the accounting and IT units.
Managing directors are responsible for necessary actions
The need for action outlined above is not only an abstract requirement within the sphere of responsibility of the institutions but it is also a concrete requirement within the sphere of responsibility of the management. Section 25c KWG, especially paragraph 3 subsection 2, emphasises that senior managers are responsible for the due and proper organisation and the further development of their institutions. They will only be fulfilling this supervisory responsibility if they are able to assess the risks and take the necessary countermeasures. Failure to comply with the requirements in this regard will place them in jeopardy with regard to civil liability – irrespective of how one may view symbolic penal legislation – and also at risk of such criminal sanctions as might arise pursuant to section 54a (1) in conjunction with the aforementioned section 25c KWG, for example. Replacement of the IBORs therefore clearly falls within the responsibility of the management.