Replacement of LIBOR: Is Litigation Inevitable in the Derivatives Market?

March 9, 2020

With the announcement by the Financial Conduct Authority that the London Interbank Offered Rate (LIBOR) may cease to exist, the financial markets are facing a major upheaval in this respect. Market participants, financial institutions and lawyers alike are working around the clock to ensure the transition from LIBOR to risk-free rates (RFRs) is as seamless as possible.

While it remains essential for market participants to engage with their counterparties, it is also prudent to be aware of the litigation risks associated with the transition. It is not as simple as changing from LIBOR to the RFRs. Rather, the transition involves a major review of all relevant contractual provisions in the International Swaps and Derivatives Association (ISDA) documentation and consideration of appropriate provisions to address the LIBOR component in transition. To the extent the parties have not already done so, they should begin this process now to avoid what the general counsel of the Federal Reserve Bank of New York coined “a DEFCON 1 litigation event.”

This wide-scale review and resulting negotiation between contractual parties and potential loss of value by one party to the contract may give rise to disputes leading to potential winners and losers in the process. This briefing highlights (i) the current fallback position in derivatives markets and (ii) potential areas for disputes and legal arguments in respect of such disputes.

ISDA Position and Fallbacks

The derivatives market operates by way of the ISDA Master Agreement (whether the 1992 or 2002 form) and by the usage of industrywide mechanics for adoption of amendments. With respect to LIBOR transition, ISDA addresses or is seeking to address the issues in the following ways:

  1. Proposed Changes to the 2006 ISDA Definitions. ISDA is proposing to include new fallbacks from LIBOR to the RFRs and adjustments required as a result of the differences between LIBOR and RFRs. The 2006 ISDA Definitions will be the mechanism by which these fallbacks and adjustment provisions will be included in new derivatives transactions.

  2. ISDA Protocol. ISDA will publish a protocol to allow participants to include the fallbacks and adjustments mentioned above in legacy derivatives (entered into prior to publication of the amended 2006 ISDA Definitions).

  3. Existing ISDA Position. The existing fallback in the ISDA documentation provides that, if LIBOR is not available, the Calculation Agent must calculate a replacement rate by using an arithmetic mean of quotations (the deed poll method). This requires the Calculation Agent to obtain at least two quotations from specific reference banks or “major banks in London.” This fallback option is limited in that such reference banks may not be prepared to provide these quotations. It is arguable, given the volume of legacy trades on the books of banks and financial institutions, that there could be a considerable amount of legacy trades that are not amended because parties have not adhered to the relevant ISDA protocol or agreed to the RFR by way of a bilateral agreement. In such circumstances, parties will need to rely on the deed poll method, which is silent on what happens if the required quotations cannot be obtained or provided by the reference banks or major banks (as applicable). In that scenario, it may be left to the courts to determine the solution, and in this respect, below are potential legal arguments parties may make regarding such disputes.

Possible Disputes and Legal Arguments

  1. Contractual Interpretation/Implied Terms. If the deed poll method or any of the other contractual provisions relevant to LIBOR cessation give rise to a dispute, a party may argue that a reference to LIBOR should be read as a reference to the relevant RFR, or that a term should be implied to that effect. There will be arguments about whether this is possible, given the significant differences between LIBOR and RFRs.

  2. Contractual Machinery. A party might argue that the cessation of LIBOR means that the machinery which is meant to be used to calculate relevant amounts under the derivatives contract has broken down; that that machinery, on the true construction of the contract, was a “subsidiary and non-essential” part of the contract; and that the court should, as a result, substitute that broken machinery (i.e., a calculation by reference to LIBOR) for some other machinery (for example, a calculation by reference to RFRs) based on Sudbrook Trading Estate Ltd v Eggleton and others [1983] 1 AC 444. However, it may not be realistic for a sophisticated party to try to establish that the LIBOR “machinery” was a “subsidiary and non-essential” part of the derivatives contract, as the use of RFRs as an alternative “machinery” may result in a significantly different outcome for the parties.

  3. Force Majeure. A force majeure clause may excuse parties from performance of a contract following the occurrence of a certain event that prevents a party from performing the contract and that is outside its control. This will be relevant only to the 2002 ISDA (as the 1992 ISDA does not contain a force majeure clause). Under the 2002 ISDA, a force majeure event will trigger an early termination of outstanding trades. While discontinuation of LIBOR may not be a conventional example of a force majeure event, parties may be motivated to make such arguments because the force majeure provisions in the 2002 ISDA provide for a systematic set of consequences. Whether the cessation of LIBOR will trigger the force majeure clause in the 2002 ISDA will be open to interpretation.

  4. Frustration. A contract may be “frustrated” where something unexpected occurs after its formation that renders it impossible to perform, or transforms the performance obligations into something radically different to what was contemplated when the contract was entered into. If no quotations are obtained through the deed poll method, a party might argue that the contract has been frustrated because it has become impossible to perform or carry out the transactions under the ISDA Master Agreement. In the absence of a force majeure clause in the 1992 ISDA, the case for frustration would be more attractive.

  5. Good Faith. If a derivatives contract expressly provides a financial institution with a contractual discretion in connection with replacing LIBOR and such financial institution seeks to exercise that discretion by replacing LIBOR with something particularly advantageous to it (such as an increase in value), the counterparty may argue that this would be in breach of an obligation to act in good faith.

Generally, however, English courts avoid implying a general duty of good faith in commercial agreements. If parties wish to impose a duty of good faith, that must be done expressly, with sufficiently clear and certain wording. Nonetheless, English court decisions over the last few years do make this less clear where the court might look to imply a duty of good faith in certain types of commercial relationships considered to be “relational contracts.”

In any event, most ISDA documentation includes a requirement in respect of value calculations for the parties to act in a commercially reasonable manner and any duty to act in good faith would be qualified as a result.

As in any dispute or litigation matter, the potential claim will turn on the facts and relevant contractual terms. To the extent that claims are brought, financial institutions will be keen to manage them effectively and are likely to wish to avoid the public glare as much as possible, both to minimise any reputational issues and to limit any floodgates effect. Therefore, if any particular financial institution has not yet engaged in a wholesale review of its legacy derivative positions in order to gauge any potential dispute or litigation risks, it should be making a concerted effort to identify those contracts which are most at risk of challenge on or before the 2021 cutoff date. Please contact any of the authors of this briefing or your regular McGuireWoods contact if you have questions about, or would like assistance with, such a review.

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