In a decision that will give significant practical assistance to the financial sector, the High Court has held that the Secured Overnight Funds Rate (SOFR) is an appropriate replacement rate for LIBOR.
The cessation of the publication of LIBOR has left a hole in financial contracts of all kinds. The High Court's decision in Standard Chartered PLC v Guaranty Nominees Ltd & Ors [2024] EWHC 2605 (Comm), however, gives clear guidance on how these clauses should be construed in LIBOR's absence, and the rate that should be used in its place.
What is LIBOR?
LIBOR, or the London Inter-Bank Offered Rate, was a benchmark interest rate. From 1969, a range of LIBOR in respect of different currencies and lending periods were published on a daily basis. These rates were then used as a base for setting interest rates on various debt instruments, including mortgages, loans and bonds, as well as in a wide range of derivative transactions.
The collapse of LIBOR
In 2012, it was revealed that some of the financial institutions involved in setting the LIBOR were manipulating the rates for their own gain. The result was investigations, fines, jail terms and reputational damage to the financial sector.
William Dudley, President and CEO of the Federal Reserve Bank of New York, said that “The global financial crisis exposed excessive risk-taking and a long series of lapses in judgment, and the LIBOR scandal further undermined trust in the ethical standards of the banking industry,” and called for “aggressive action” to move to a more resilient benchmark.
Ultimately the markets settled on SOFR as a new benchmark rate. LIBOR, once referenced in an estimated $400 trillion of financial contracts, was no longer produced, and ceased to be used in contracts. Finance parties have largely agreed to migrate their agreements away from any reference to LIBOR, however, it remained a necessary component of a huge number of ongoing pre-existing contracts. As a result, for some years "synthetic" LIBOR were produced to allow these provisions to function. However, as of September 2024, the publication of LIBOR has now ceased entirely.
The rise of SOFR
The Secured Overnight Financing Rate (SOFR) is a benchmark interest rate that measures the cost of borrowing cash overnight collateralised by Treasury securities. It was introduced by the Federal Reserve Bank of New York in April 2018.
The SOFR is based on transactions in the Treasury repurchase market, where investors offer banks overnight loans backed by their Treasury securities. The rate is considered a broad measure of the cost of borrowing cash overnight collateralised by Treasury securities in the repurchase agreement (repo) market. It is widely considered to be one of, if not the most, appropriate replacement rate for LIBOR.
Background to the case
This case concerned the appropriate way to deal with contracts which still rely on LIBOR for key mechanisms now that no form of LIBOR is published.
In this case, the claimant had issued preference shares in 2006 to raise capital (the Shares). Under the terms of the shares (the Terms), dividends were initially to be paid at a fixed rate, then at a floating rate tied to the Three Month US Dollar LIBOR.
As LIBOR was phased out and replaced by alternative reference rates, the claimant sought to establish through the courts how the Shares' dividends should be calculated in the absence of LIBOR. The Terms made no express provision for what should be done in the absence of LIBOR. The claimant argued that in these circumstances, either:
- on their true construction the Terms should be construed as requiring the claimant to use "a rate that effectively replicates or replaces" LIBOR; or
- a term should be implied that in the absence of the relevant LIBOR, the claimant should use "a reasonable alternative rate".
The claimant argued that, in either case, a rate based on the SOFR was the appropriate for LIBOR (the Replacement Rate).
The defendant holders of the Shares, however, disagreed. They argued that a term should be implied into the Terms that, in the absence of LIBOR, the Claimant would be required to redeem (or buy back) the Shares.
The Court's decision
The court rejected the claimant's argument that the term "three-month US dollar LIBOR in effect" could be construed to include a rate that "effectively replicates or replaces LIBOR".
However, the court accepted the claimant's argument that it was necessary to imply a term that dividends should be calculated using a "reasonable alternative rate" to Three Month LIBOR when the express definition ceases to be capable of operation. Further, the court concluded that the Replacement Rate was such a "reasonable alternative rate" and could be used by the Claimant for that purpose.
The Court noted that there could be economic conditions in which the Replacement Rate would be materially different to what the 3-month USD LIBOR would have been. However, the ultimate net effect of using the Replacement Rate over the life of the Shares could only be a matter of speculation. More importantly, any potential differences in outcome between LIBOR and the Replacement Rate "do not come close to placing the Proposed Rate outside the scope of the implied term with all of the adverse and commercially unattractive consequences that would entail."
Application to the wider market
This decision of course turned on the particular facts of the case. However, the Court spelt out in terms its wider implications for the financial markets:
"In our view, the arguments which have led us to find the implied term at [66] above, and to reject the Funds' implied term, are likely to be similarly persuasive when considering the effect of the cessation of LIBOR on debt instruments which use LIBOR as a reference rate but do not expressly provide for what is to happen if publication of LIBOR ceases. Once again, the use of a floating LIBOR rate as a reference rate in instruments of that kind is essentially a measure of the wholesale cost of borrowing over time. The specific reference to LIBOR is likely, therefore, to be a non-essential term, and the inoperability of the mechanism should not defeat the continuation of the contract.
Further, any implied term by which the cessation of LIBOR would give rise to an automatic redemption would be at least as, if not more, unworkable in debt instruments, where it would trigger immediate payment of the full amount of the outstanding principal sum without the statutory limitations controlling the redemption of share capital. An implied obligation to redeem the loan on the cessation of LIBOR would have the same accelerating effect as a stipulated event of default in a loan instrument even though:
- the accelerating event would be entirely outside the control of either party;
- events of default in loan contracts are generally carefully defined and clearly set out because of the dramatic consequences they have; and
- none of the protective provisions which usually accompany event of default provisions – notice provisions and cure opportunities – would be present."
Whilst not binding, this commentary is likely to give significant guidance to parties to financial arrangements which depend on LIBOR for key contractual mechanisms. It should be noted, however, that this decision does not mean that the SOFR will always be the (or be the only) "reasonable alternative rate". In some cases, it may be possible to argue that an alternative rate will be more appropriate.