The Benchmark Regulation ("BMR") came into force in 2016 and applies since 1 January 2018. It aims to regulate benchmarks, including interest rate benchmarks such as London Interbank Offered Rate ("LIBOR"), used in the EU in order to make such benchmarks more reliable. For this purpose, the Benchmark Regulation introduced licensing and registration requirements but also obligations for users of benchmarks to deal with, and provide for plans in case of, interruptions or cessations of benchmarks. The BMR, however, does not give supervising authorities the right to directly amend financial instruments or contracts if the parties to it are unable to replace a benchmark for whatever reason. So any of these plans are subject to civil law requirements and restrictions applicable to a financial instrument or contract under its governing law.
In 2017 the UK Financial Conduct Authority ("FCA") as the competent authority for the supervision of LIBOR announced that it no longer would compel panel banks to quote LIBOR after 2021. This announcement set in motion a global effort to find robust, transparent rates to replace LIBOR and other IBORs by inter alia so called risk free rates , including suitable fallbacks taking into account the global economic effects of such a transition. There are, however, a number of contracts that (i) mature after the potential cessation date of the affected benchmarks they reference, (ii) do not include any or at least suitable fallback provisions and (iii) cannot be renegotiated in time to migrate to a replacement rate or to include fallback provisions (e.g. Bonds requiring the consent of all bondholders). These cases are also referred to as "Tough Legacy".
As a result, the European Commission ("EC") has proposed an amendment to the BMR to enable amendments of certain financial instruments or contracts by way of a directly applicable regulation. This kind of an civil law overriding governmental act is not new in connection with benchmarks. For example in Germany, the transition from FIBOR to EURIBOR occurred by way of law. However, given the global nature of the current IBOR transitions, governmental contract amendment solutions need to be aligned to global market developments in order to achieve what needs to be achieved: a transition without (i) substantial market deterioration and (ii) litigation risks.
The EC Proposal addresses Tough Legacy on a directly applicable European level. It aims to avoid a significant disruption in the functioning of the financial markets in the EU by, in particular, adding a new Article 23 (a) to the Benchmark Regulation. This new article provides for a new power of the European Commission to designate a mandatory replacement benchmark and, by operation of law, replace all references to the benchmark that has ceased to be published in financial instruments, financial contracts and measurements of the performance of an investment fund within the scope of the Benchmark Regulation ("BMR Covered Contracts"). In scope of the Benchmark Regulation are those contracts that make use of a benchmark1. The EC Proposal concerns the use of a benchmark within the EU in BMR Covered Contracts and, therefore, only applies to EU Supervised Entities2, irrespective of the governing law of the contract. Furthermore, the EC designation power is limited to situations where the cessation of the publication of the respective benchmark may result in significant disruption in the functioning of financial markets in the EU.
As set out above, contracts and financial instruments that do not involve a EU Supervised Entity are not in scope of the EC Proposal. This means that any other contract that contains a reference to a benchmark that will be discontinued is not covered by the EC Proposal. The EC, however, urged national legislators to come up with similar national legislation, which would cover benchmarks referenced in contracts and financial instruments involving non-supervised entities. We are, at this point, not aware that any such legislation has been proposed.
In the meantime, the German Presidency of the Council of the European Union made further Proposals to the EC text. The most material change is the change of the scope of the contracts covered by the new Article 23(a), which also shall be moved in a separate Chapter 4a of the BMR (Replacement of Benchmark by Legislation). The Presidency Proposal refers generally to "contracts that reference that benchmark". The Presidency Proposal also no longer restricts the scope to EU Supervised Entities. This means that loans and bonds of corporates that use an affected benchmark also are in scope of the EC power. Moreover, the Presidency Proposal text clarifies the meaning of a "suitable" fallback, highlighting in the reasoning the ability to respond to international market developments, and changing the justification of the contract intervention act by the EC from the avoidance of a "significant disruption in the functioning of financial markets in the EU" to "significant and adverse impact on the market integrity or financial stability in the Union or one of its member states".
In our view, the planned BMR amendment is drafted in order to provide the EC with a "tool" to reduce legal uncertainty and risks to financial stability in the EU resulting from IBOR cessations. The proposed legislation is intended as a "last resort" and is drafted to be subsidiary to any (suitable) contractual arrangement between parties. Accordingly, the BMR amendment should, in our view, not be regarded as the ideal solution to the challenges relating to the cessation of LIBOR. While the BMR amendment provides an additional tool to deal with certain affected contracts, for the time being legal certainty should primarily be achieved by market participants proactively amending all affected financial instruments and contracts (for example by way of the upcoming ISDA protocol for OTC derivatives). This also appears to be the main message and intention of the EU legislator.
There are, however, still many details that are unclear to the market and that need to be addressed in the regulation or by way of guidance. For example:
- The term contract as used in the Presidency Proposal text is not further defined. We would anticipate that, based on the initial EC proposal, bonds – which are in certain jurisdictions not contracts but single sided securitized debt claims – as well as all other BMR Covered Contracts also should be targeted by the BMR amendment. The reasoning of the Presidency Proposal points in that direction but a further clarification should be made in line with the terms used in the BMR.
- The scope of the Presidency Proposal is unclear as to whether all contracts of EU Supervised Entities and other non-supervised entities independent of their governing law are covered. The text of the proposal does not expressly limit the scope of the EC powers to contracts governed by a law in the EU (keeping in mind the fact that the BMR does have a certain extraterritorial effect). It could therefore also apply to New York law governed bonds or contracts issued or entered into by an EU Supervised Entity. The only restriction is that there must be a significant and adverse impact on the market integrity or financial stability in the Union or one of its member states to justify the exercise the administrative contract amendment powers. This means that NY law governed contracts with non EU entities should remain outside the powers of the EC. However, if a single EU entity is part of the contract, it could be covered but the justification test is not easy to satisfy and disputes are therefore to be expected.
This uncertainty with respect to the extraterritorial effect of the BMR amendment needs to be clarified. In any event, it is doubtful that a court in the United States would enforce the imposition by the EC of a replacement benchmark in an agreement governed by the law of a U.S. jurisdiction, particularly in a situation in which an EU Supervised Entity entered into a transaction with an U.S. entity and the U.S. entity objected to the replacement benchmark mandated by EC.
- The analogous New York State legislation that has been discussed would not impose a replacement benchmark if the contract already had a non-LIBOR fallback rate (such as the U.S. prime rate (or "base rate" or "adjusted base rate"), which is the customary fallback in a New York law-governed credit agreement). The BMR amendment would impose a benchmark if the existing fallback was not "suitable" (See Section (2)(b) of the proposed Article 23(a)). The original Explanatory Memorandum for the proposal says that a fallback is not suitable if it accommodates only "... a temporary suspension of [LIBOR] ..." (at § 5.2.1.). A U.S. prime rate fallback probably would constitute a fallback only for a temporary suspension of LIBOR. However, the Presidency Proposal revisions provide a definition of "suitable" that may well result in a fallback to the U.S. prime rate (or the "base rate" or "adjusted base rate") being suitable for purposes of the regulation. If that's not the result, then almost every credit agreement governed by New York law that is covered by the BMR amendment would be deemed to have an inadequate fallback and subject to the possible imposition by the EC of a mandatory replacement benchmark.
- Many syndicated credit facilities have both European and non-European lenders. It would be unwieldy, and likely be objected to by the administrative agent of a credit facility, if the effect of the Presidency Proposal were to impose two different benchmarks – the EC replacement for the European banks and the contractual fallback for the non-European banks – in a single credit facility.
- The market also is speculating whether and how the EC will finally make use of its power, apply adjustment spreads and respond to different market approaches or different product specific fallbacks.
The proposal of the German Presidency shows that the EU is keen to ensure that – given Brexit by the end of the year – IBOR transition risks can finally be avoided by way of administrative actions. However, the EU also states that it is of utmost importance to have a common international practice and that the EU should have the possibility and, accordingly, flexibility, to align replacements as much as possible with other jurisdictions. This seems to mean that the EU offers to the market a stand-by administrative tool helping to implement transition solutions established by working groups or associations in contracts in certain jurisdictions or markets if market participants make no use of the solutions offered (like adhering to amendment protocols or similar instruments).
1 For the definition of "use of a benchmark" see Art. 3 para. 1 no. 7 of the Benchmark Regulation.
2 Art. 3 para. 1 no. 17 of the Benchmark Regulation.
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