In July 2017, Andrew Bailey, the Chief Executive of the Financial Conduct Authority (the FCA) recommended that LIBOR (the London Interbank Offered Rate) be phased-out by the end of 2021. Market participants should not rely on LIBOR being available after that date, and the FCA is expecting firms to take appropriate steps to ensure they can transition from LIBOR to alternative risk-free reference rates (RFRs) prior to the end of 2021.
In October 2019, the Working Group on Sterling RFRs (the Working Group) wrote to the FCA expressing its concerns about various regulatory barriers firms face in implementing their transition plans and seeking both guidance and an indication of industry best practice from the FCA to support the transition and to ensure that good conduct frameworks are developed. In response, and to help firms best understand the FCA’s requirements, on 19 November 2019 the FCA published a guidance note and a set of Q&As addressing the conduct risk issues which could arise during the transition away from LIBOR. The FCA’s main expectations are: (i) that all firms must have a strategy/plan in place for managing the transition away from LIBOR; and (ii) that all customers are treated fairly. In this article, we will discuss some of the key areas which firms need to consider from a conduct risk perspective.
Governance and accountability
Firms’ Senior Managers and boards must understand the risks associated with the LIBOR transition and take appropriate action to transition to alternative rates before the end of 2021. Firms should identify the Senior Manager responsible for overseeing the LIBOR transition and set those responsibilities out in that Senior Manager’s Statement of Responsibilities.
Alongside having effective processes and controls in place to manage the transition, firms must also consider whether LIBOR-related risks are best dealt with within their existing conduct risk frameworks or whether a separate, dedicated framework is needed. Because LIBOR transition is likely to impact a firm’s overall business strategy and front-office client engagement, it is critical for affected staff to act with due skill, care and diligence and to make and retain adequate records (e.g. keeping appropriate records/minutes of management and committee meetings) to show they have complied with their obligations.
Treating customers fairly when replacing LIBOR with alternative rates in existing contracts/products
Firms must take reasonable steps to treat their customers fairly when replacing LIBOR with alternative rates. According to the FCA, firms are more likely to show that they have complied with their obligations to treat customers fairly where they “adopt a replacement rate that aligns with the established market consensus, reached through appropriate consultation, and is recognised by relevant national working groups as an appropriate solution.” As industry initiatives and market consultations have not yet concluded, the FCA acknowledges that firms will need to exercise their own judgement on how and when to transition from LIBOR exposure in legacy contracts.
Any replacement rate needs to be fair. Firms must not use the discontinuation of LIBOR to move customers with continuing contracts to replacement rates which disadvantage them or otherwise introduce inferior terms. In respect of consumer contracts, firms will also be expected to consider whether any contract term they may rely on to amend a LIBOR-related product or contract (whether it is a unilateral variation term or a term being introduced to address the transition) is fair under the Consumer Rights Act 2015. The FCA is expected to pay close attention to this and any indication of unfair treatment of customers could leave firms having to explain why they have not met their obligations to their customers in this regard. It is therefore extremely important for firms to comply with this requirement.
Transitioning to new products with RFRs or alternative rates
Where a firm is dealing with a client with a legacy contract that extends beyond 2021 which needs to be amended, firms are expected to explain fully to their customers what is happening with LIBOR transition, why it is happening, any fallback provisions in their contracts and how they operate, the risks associated with the transition and how it will affect them. Some customers may not fully understand the risks and implications so a ‘one-size fits all’ approach to customer communications may not be appropriate. Again, firms will need to exercise their own judgment here and consider the knowledge and experience of the particular customer.
The FCA has stated that firms should now be aiming to offer and provide products that reference RFRs or other alternative rates to their customers rather than LIBOR-linked products, and this is clearly the best way to avoid the complications of a customer not understanding how the change will affect them. If, however, firms do continue to offer these products, they need to consider carefully whether these products meet the customers’ needs and can continue to perform as the customer would expect, both before and after the discontinuation of LIBOR. As there is a risk that customers will not fully understand how the discontinuation of LIBOR will affect them, the FCA strongly recommends that firms should consider offering alternative products that do not reference LIBOR.
What’s happening in the UK loan market?
The Working Group is of the view that SONIA (the Sterling Overnight Index Average), compounded in arrears, should be the likely replacement for sterling LIBOR in the loan market. SONIA is an overnight backward-looking rate meaning the amount of interest payable on a loan will not be known until the last day of an interest period. LIBOR, in contrast, is a forward-looking rate meaning the amount of interest payable is known in advance/at the start of the interest period, which helps borrowers with cash flow certainty. Many firms still prefer the production of a forward-looking SONIA rate, but the message from the FCA is clear – the loan market should not delay the transition of new business away from LIBOR until a forward-looking SONIA rate is produced. Other products (e.g. products based on SONIA compounded over an earlier period, fixed rates, Bank Rates or Bank of England Base Rate) may be more appropriate for customers who prefer cash flow certainty.
The Working Group has set a target date of Q3 2020 for firms to stop new lending using LIBOR. The FCA is concerned about the amount of new LIBOR-linked loans which mature post-2021 which are still being entered into, and therefore supports this target date and will be monitoring firms’ progress in this regard during 2020.
Communicating with customers about LIBOR and alternative rates/products
Any information about the risks and impact of LIBOR transition and the move to alternative rates must be communicated to customers in a manner which is clear, fair and not misleading. For example, firms should ensure that customers: (i) have received information about alternatives to legacy products in good time so they can make informed decisions; and (ii) are kept informed about the impact of the discontinuation of LIBOR on existing and new financial products and services. No information about, for example, the benefits, costs and risks of alternative rates/products should be hidden, disguised or reduced. Firms must also consider the knowledge and experience of the particular customer when preparing any communications. Staff training may also be required to ensure they communicate the information to their customers effectively and can answer questions competently. If fallback provisions are to be inserted into contracts to replace LIBOR with a new rate, firms must explain exactly how these fallback provisions are expected to operate. Again, the FCA will be on the lookout here, so clear and effective communication with customers is vital.
Firms that wait too long to communicate with their customers such that the customer is not left with enough time to consider and understand their options and to make informed decisions risk treating their customers unfairly and being challenged about this by the FCA. Additionally, firms should not avoid having discussions with customers for fear of offering a personal recommendation (regulated advice). The FCA has made it clear that it will not accept this as an excuse to avoid communicating with customers. According to the FCA, it is possible to provide an objective overview of the benefits, costs and risks of a range of alternatives to a customer’s existing LIBOR-linked exposure, without straying into regulated advice territory.
What should firms be doing now?
The key message is not to delay speaking to customers about LIBOR transition. Firms should engage with their customers now in order to raise awareness of the issue and to educate them on the implications and risks to them of the transition. This is not however, a one-off obligation. Plans should be put in place to increase engagement and customer-specific conversations as the position on LIBOR transition and replacement rates becomes more certain (in other words, firms should communicate with their customers on a regular basis as the position becomes clearer). The FCA will expect firms to manage the transition process fairly and not in a way which is detrimental to its customers. Communicating key information to customers now should, in our view, help mitigate any challenges around unfairness.
The transition away from LIBOR is a complex challenge for firms. Progress (albeit slow to date in the loan markets) is, however, being made, and firms must now focus on implementing the transition as soon as possible and communicating with their customers in a clear and fair way to mitigate potential conduct risk.
This publication is a general summary of the law. It should not replace legal advice tailored to your specific circumstances.
© Farrer & Co LLP, January 2020