LIBOR, once ubiquitous as the interest rate benchmark in financial transactions around the world, is on its way out. In July 2017, the Financial Conduct Authority (FCA) announced that LIBOR would be phased out by the end of 2021 and, in March 2021, the FCA and the Bank of England jointly announced that as of 31 December 2021, all sterling, euro, Swiss franc, Japanese yen settings and 1-week and 2-month US dollar settings will cease to be published, and the remaining US dollar settings will cease by June 2023.
This blog considers how the phasing out of LIBOR may impact on arbitration; both in terms of disputes that may arise as a result of the switch and in terms of awarding and enforcing awards for interest.
Impact on markets
The main markets impacted by the end of the LIBOR rate will likely be the loan, derivatives, bond and securitisation markets. There has been a significant trend in recent years for the banking institutions involved in these markets to look to arbitration as a means of dispute resolution rather than their traditional reliance on the commercial courts. It is therefore likely that the dispute risks involved with the LIBOR transition will also be seen in arbitration. There are however unique considerations in arbitration relating to the LIBOR phase-out.
Since the announcement that LIBOR would be phased out, banking institutions and other parties have been faced with the need to amend rafts of documents underpinned by the LIBOR rate which will continue in force after the end of 2021. This has mainly been achieved by executing amendments incorporating complex rate switch mechanics.
Issues affecting LIBOR and resulting in its phase-out have also affected other floating interest rate benchmarks (such as EURIBOR and SIBOR) which are based on interbank borrowing markets reliant on an active interbank unsecured term lending market susceptible to manipulation by the panel banks making forward-looking submissions.
The replacement rates of choice have been the Sterling Overnight Interbank Average Rate (SONIA) and the Secured Overnight Financing Rate (SOFR) for GBP and USD LIBOR, although there are other possible replacement rates. These are backward-looking, overnight risk-free rates which are not predicated on the existence of comparable base markets, and are not dependent on submissions by panel banks. However, neither rate works as a straight swap for LIBOR. Because they are (rather than a term rate, like LIBOR), they will therefore inevitably be lower than LIBOR, as they do not include a credit or liquidity risk premium.
Dispute risks
The fact that SONIA and SOFR will be lower than LIBOR will give rise to value transfer issues if the rates are simply exchanged like for like, meaning that rate switch mechanisms are far from simple, and tend to include a “SONIA/SOFR plus” provision. This is fertile ground for disputes once switch mechanisms (or lack thereof) come into play at the beginning of 2022.
Similarly, the lack of certainty generated by use of a retrospective rate (in contrast to knowing with three months’ certainty what the rate would be before any amount was paid using LIBOR) has potential to be problematic. Banks and other market players are using workarounds such as using SONIA/SOFR on a five-day lag, or aggregate SONIA rates on a compounded basis over an interest period to give a “term” rate, but it is easy to see how disputes could arise from this kind of ambiguity.
Other risks involve failure to enter into rate switch agreements by the time the rate has been discontinued, or relying on fall-back provisions in older contracts which provide for alternative benchmarks but were designed for use in the event of a temporary glitch in LIBOR’s availability, rather than its wholesale discontinuance.
Impact on arbitration
The LIBOR phase-out will cross over into arbitration in two main ways. The first is in disputes arising out of potentially contentious issues where the LIBOR switch is the subject matter, such as those described above. These will present the usual concerns associated with high-value, complex financial transactions, in that arbitrators need to be chosen who have appropriate sectoral experience, and this is likely to be an emerging area for expert quantum evidence in coming years.
The second is that LIBOR is often used as the base rate when awarding interest on arbitral awards. If amendments are not made to underlying contracts, there is a risk of arbitrators applying a defunct rate to awards of damages. There are a few scenarios in which this might be an issue:
- The arbitration clause provides for a LIBOR rate. Most arbitration clauses are not sufficiently prescriptive to specify an interest rate benchmark, but this could potentially give rise to issues of enforceability. Is there scope for challenge if the arbitrator goes ahead and applies LIBOR after it is discontinued? Has the arbitrator failed to comply with the parties’ agreement if they do not apply the rate? Has the clause been frustrated and does this affect the arbitration clause’s validity? It seems likely that challenges will be made if arbitrators go either way, largely because of the financial implications of using LIBOR versus a lower overnight risk-free rate on in award. It seems likely too that this will require detailed expert evidence as issues of equivalence will arise.
- Arbitrations on foot at the end of December 2021, where the clause provides for use of LIBOR (or indeed where LIBOR is a factor in other aspects of the dispute). It seems likely that the first port of call would be for the parties to agree an alternative rate, but the same issues as to enforceability or frustration, or both, apply in this scenario. One solution could be to take a rate switch mechanism into the award, but this has the potential to give rise to satellite litigation on the nature of the rate-switch mechanism itself, if designed by the tribunal. Perhaps this is one area where a tribunal-appointed quantum expert might gain some traction.
- Existing awards in which interest is awarded on the basis of LIBOR. There will be a serious question of enforceability if these awards are not fully paid by the time of the phase-out, but parties in this situation have few options. They are unlikely to be able to approach their original tribunal for revision or correction (possibly with the exception of the ICSID rules, which give parties three years to request a revision). This is likely to result in applications to the court, whose approach will become clear, but which may not be very sympathetic given that the phase-out of the LIBOR rules has been known since 2017.
The effect of the LIBOR discontinuance will inevitably result in new disputes given its complexities, and many of these will also arise in arbitration. It remains to be seen what will happen and how equipped the market is to cope when the discontinuance comes into effect on 31 December 2021.
