Following the discussion and status set out in our September 2020 blog post, Proposal for a Governmental IBOR Transition in the European Union, the proposed amendment to the EU Benchmark Regulation (“BMR”) has been developed further and a consolidated version published reflecting the text agreed by the Council of the European Union and the European Parliament.
As has been contemplated from the first draft, the BMR Amendment addresses European “tough legacy contracts” on a directly applicable level. It aims to avoid a significant disruption in the functioning of the financial markets in the EU by adding a new Article 23 (a) to the BMR. This new article grants new powers of the European Commission (“EC Powers”) to designate a mandatory replacement benchmark and, by operation of law, replace all references to the benchmark that has ceased to be published in specified contracts covered by the regulation (“BMR Covered Contracts”). The European Commission exercises these powers by adopting implementing acts. Equivalent powers are introduced for national legislators in a new Article 23 (b) for member states where a majority of contributors to a relevant benchmark are located.
The scope of BMR Covered Contracts in the current draft of the amendment, however, has been extended since the prior draft beyond financial instruments, financial contracts and funds that are within the scope of the BMR, and clarifications have been added in respect of the governing laws that are within the scope of the EC Powers. The final version now applies to:
“(a) any contract or any financial instrument as defined in Directive 2014/65/EU that is governed by the law of one of the Member States and that references a benchmark; and
(b) any contract that is subject to the law of a third country but the parties to which are all established in the Union and where the law of that third country does not provide for an orderly wind-down of a benchmark.”
Unchanged is the stipulation that the EC Powers relate to BMR Covered Contracts not providing for a suitable fallback. The BMR Amendment explicitly states that a fallback provision shall be deemed unsuitable if : (i) the fallback provision does not cover the permanent cessation of a reference benchmark; or (ii) the application of the fallback provision requires further consent from third parties that has been denied; or (iii) the application of the fallback provision no longer, or only with a significant difference, reflects the underlying market or the economic reality that the ceasing benchmark is intended to measure, and could have an adverse impact on financial stability.
As a result of this suitability condition, for example, a German law LIBOR floating rate note that does not provide for a suitable fallback can be amended by operation of law to a successor rate selected by the European Commission by way of the EC Powers.
Therefore, existing fallback provisions in BMR Covered Contracts will have to be scrutinized as to their suitability and ability to meet the criteria set out above. These criteria also should be taken into account in drafting new fallback provisions.
Even in light of these changes to the BMR Amendment, our initial analysis and conclusion still stand and the BMR Amendment should, in our view, not be regarded as the primary 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. In the case of OTC derivatives, adherence to the ISDA 2020 IBOR Fallbacks Protocol, which will become effective 25 January 2021, is one example of an available amendment option.
One of the issues the we pointed out previously has not been resolved and remains a source of uncertainty that we would like to see addressed: the use in the BMR Amendment of the term “contract”. Unlike the reference to “financial instruments,” the term “contract” is not defined. Fortunately, previous uncertainties arising from the unclear applicability of the BMR Amendment to contracts with only one EU-domiciled party, or to those governed by a third-party country’s law, have been reduced greatly.
For contracts governed by the laws of a third country, the BMR Amendment only applies if (i) all parties are established in the EU and (ii) the relevant third country law does not provide for an orderly wind-down of a benchmark. For example: a NY law governed loan agreement between an Italian borrower and a German lender could be amended pursuant to the BMR Amendment if neither the agreement nor any NY law addresses the permanent cessation of LIBOR. The EC Powers would not extend to a NY law contract of a German borrower with a bank in the United States. While the second prong of this requirement could raise some uncertainties in practice as to what constitutes “provisions for an orderly wind-down of a benchmark,” we view these new restrictions as a vast improvement, as the requirement for all parties to be established in the EU clarifies the scope immensely. We expect opinions to be formed and guidance to be published in the near future on the benchmark wind-down procedure for the most common third-country jurisdictions.
The market is still speculating about the policy that the European Commission will implement to make use of its newly granted EC Powers, apply adjustment spreads and respond to different market approaches or different product-specific fallbacks. The same is true for Member States that now also have the power to designate a replacement benchmark rate, which raises the additional question of potential conflicts between a European approach and a solution on a national basis. During the most recent roundtable discussion hosted by the ECB working group on risk free rates, it was mentioned that the European Commission could apply its EC Powers in several ways taking into account the nature and markets of the relevant contracts (bonds, derivatives, commercial loans, retail loans, etc.) if required to align the respective BMR Covered Contracts with amendments agreed in the respective product area or market.
The BMR Amendment is expected to enter into force without further changes as soon as the procedural requirements allow. The next step, the first reading, is currently scheduled to take place on 18 January 2021.