Libera nos a LIBOR

In a decision with general importance to financial markets, Standard Chartered Plc v Guaranty Nominees Limited and others [2024] EWHC 2605 represents the first time that the English court has ruled on the issue of which interest rate to apply to a security in the absence of contractual agreement or workable fallback since LIBOR was phased out. 

The court’s judgment provides a useful restatement of its approach to interpreting contractual terms in general and contains guidance on how to interpret similar clauses after LIBOR’s cessation.

In reaching its decision, the court affirmed its willingness to be flexible in interpreting a long-term contract where there was a common intention for the contract to survive and found that, in this case, a variant of the Secured Overnight Funds Rate (SOFR) (discussed further below) was a reasonable alternative to three-month USD  LIBOR, reference to which will be found in many commercial agreements.

Unusually, the case was placed in the Financial Markets Test Case scheme, to be heard by a two-judge panel of Sir Julian Flaux, The Chancellor of the High Court, and Mr Justice Foxton sitting as, in effect, a Divisional Court – highlighting the issue’s importance to the wider market.

LIBOR, SOFR and the preference shares

In December 2006, Standard Chartered Plc (SC) issued certain preference shares (Preference Shares) for the purpose of raising Tier 1 Capital. The Preference Shares were first issued to Guaranty Nominees Limited (GNL) as nominee for JP Morgan Chase, which in turn issued American Depository Shares (ADS) in respect of those Preference Shares to various investors.

The Offering Circular in respect of the ADS identified that SC, but not the ADS holders, had the option to redeem at intervals of 10 years, subject to SC’s articles and applicable law. The Preference Shares were otherwise perpetual.

The Offering Circular also provided for the payment of a semi-annual dividend at a fixed rate and, after 10 years (i.e., after January 2017), at a floating rate of ‘1.51% plus Three Month LIBOR’.

The defined term ‘Three Month LIBOR’ provided for three ‘Fallback’  mechanisms for determining the applicable LIBOR rate if the usual means to do so were frustrated.

As readers will no doubt be aware, the years following the financial crisis revealed issues with LIBOR, owing to the evolution of the interbank market itself and controversy around how the rate was historically determined. A process began to phase out LIBOR and encourage counterparties to agree on a replacement. Variations on SOFR (being the daily rate for overnight lending secured by US Treasuries) were considered by many to be the most appropriate for transactions, loans or securities denominated in US dollars.

In the United Kingdom, the ICE Benchmarking Association – the successor publisher to the British Bankers’ Association – published synthetic LIBOR rates for the final time on 30 September 2024, on the second of the three days on which the court heard this case.

Background to the dispute

Anticipating LIBOR’s phaseout, in November 2022, SC sought a special resolution to replace three-month USD LIBOR, which would soon not be available, with a particular variant of SOFR. However, the proposed amendment failed because the requisite 75% majority was not secured.

On 12 April 2024, SC issued a claim seeking declarations concerning the rate by reference to which the dividends payable on the Preference Shares should be calculated for the dividend periods commencing on or after 30 October 2024. SC’s application was supported by expert evidence that expressed the view that a slightly different SOFR variant – a forward term SOFR published by the CME with the addition of a spread adjustment (the ’Proposed Rate‘) – was the appropriate rate to apply.

Given the cessation of LIBOR, it was common ground that neither the express definition nor the first two out of three ‘Fallbacks’ could be used to calculate the applicable dividend rate, and so the resulting dispute centred around the appropriate construction of the Third Fallback and whether a term should be implied.

SC argued that the phrase ‘three month US dollar LIBOR in effect’ (our emphasis), as referenced in the third Fallback, should be interpreted to mean ‘a rate that effectively replicates or replaces three month USD LIBOR’. In the alternative, SC argued that a term should be implied into the terms governing the Preference Shares that would allow SC to use a ‘reasonable alternative rate’ to the LIBOR rate (i.e., the Proposed Rate). Further, SC proposed that a similar term be implied into the definition of Three Month LIBOR in the Offering Circular.

Whilst GNL took no active part in the proceedings, certain of the ADS holders (the ‘Funds’) intervened, opposing SC’s claim and seeking the implication of terms that would have the effect of (i) the forcing the redemption of the Preference Shares or (ii) until such redemption became possible, applying some mechanisms for calculating the Preference Shares’ dividend payments.

The court’s decision

The court found that a term should be implied with the effect that where three-month USD LIBOR ceases to be capable of operation, a ‘reasonable alternative rate’ to that rate should be adopted at the date the dividend falls to be calculated. The court also found that the reasonable alternative rate in this instance was the Proposed Rate.

Contractual interpretation
After examining the ‘usual suspects’ of principles of interpretation summarised most recently in Sara & Hossein Asset Holdings Ltd v Blacks Outdoor Retail Ltd¹ and the test for the implication of terms set out in Marks & Spencer Plc v BNP,² the court considered how long-term contracts may attract different considerations to short-term ones, something it termed a ‘second order’ principle.

The Preference Shares had no maturity date and, subject to SC’s decennial option to redeem, were in effect perpetual. In such cases, and where unforeseen circumstances affect the performance of a contract, the court acknowledged that it may be necessary to adopt an interpretation which ‘best serves or is most consistent with’ the purpose of the parties’ bargain ‘in changed circumstances’.

The court likened this method of interpretation to a form of contractual cy-près’ – the doctrine which enables a court to redirect a charitable trust’s funds to a purpose ‘as near as possible’ to the original purpose that has become impossible to execute.

In particular, the court held here that the presence of ‘Fallback’ provisions indicated a shared understanding on behalf of both parties that issues relating to the publication of LIBOR ‘should not prevent the continued operation of their contractual arrangements’, while the terms of the agreement suggested that LIBOR’s function was only a measure of the cost of unsecured bank borrowing over time – ‘a means to an end, not Holy Writ in itself’ or a ‘value in its own right’.

Accordingly, and acknowledging the long-term nature of the bargain embodied in the Preference Shares, the court implied a term to the effect that if the express definition of Three Month LIBOR ceases to be capable of operation, ‘dividends should be calculated using the reasonable alternative rate to three month USD LIBOR at the date the dividend falls to be calculated’.

By contrast, the Funds’ proposed term, providing for the Preference Shares’ automatic redemption, failed the criteria necessary for an implied term.

Some further points of note may be identified from the judgment. First, this judgment supports the contention that it may be appropriate to imply a term permitting the use of a reasonable alternative rate in cases where the original reference rate ceases to be published and where there are no express provisions dealing with such circumstances. This decision has wider relevance with the judgment specifically noting that:

‘the arguments which have led us to find the implied term […] 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. [T]he use of a floating LIBOR rate as a reference rate […] 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’.

The idea that the cessation of LIBOR should give rise to automatic redemption was declared as being at least, if not more, unworkable in debt instruments, where it would trigger immediate repayment of the full amount of the outstanding principal, without the statutory limitations controlling redemption of share capital that were present in this case. The judgment may consequently make it more difficult for any future party to argue that a contract is frustrated by LIBOR’s (or an equivalent rate’s) abolition.

Second, the court found persuasive expert evidence that the Proposed Rate was a reasonably precise replacement for LIBOR. This may anticipate SOFR’s use in comparable cases.

Third, and notwithstanding the court’s finding that the Proposed Rate was the ‘reasonable alternative rate’, the court made it clear that the identification of the reasonable rate was an ‘objective question, of which the ultimate arbiter is the court, rather than this being an area where SC is permitted to reach its own decision as to an alternative rate which can only be challenged on Braganza grounds’.

Finally, the court’s requirement that the dividend be calculated using the ‘reasonable alternative rate […] at the date the dividend falls to be calculated’ makes clear that the applicable rate may not remain static for the remainder of the Preference Shares’ term.

Comment

In a recent press release on 1 October 2024, marking the final publication of synthetic LIBOR the previous day, Nikhil Mr Rathi, the FCA’s CEO, hailed the LIBOR transition as the ‘epitome of quiet regulatory success, of huge and complex risks unwound diligently over time’.³

Since it became apparent that LIBOR would be replaced, there has been much concern by interested parties, anticipating a wave of LIBOR transition–related disputes. Whilst the present dispute suggests that Mr Rathi may have been overstating matters slightly, he is correct that, assisted by regulators, trade bodies and others, market participants have generally been accommodative to the change, embracing new alternative rates and avoiding disputes.

Returning to this decision however, and to paraphrase Mr Rathi, we might instead characterise the court’s judgment here as the epitome of quiet judicial success in problem-solving.

The identification of a reasonable alternative rate to LIBOR in a SOFR-based rate gives judicial approval to what has already been recognised by expert evidence. The court’s continued willingness to see long-term contracts survive potential frustration is also notable.

However, aspects of this decision remain fact-specific. Where agreements are shorter-term, with no equivalent ‘Fallback’ provisions, the parties’ common intention may conceivably be more difficult to identify, and the court may be less willing to imply terms to ensure that agreement’s survival. Accordingly, whilst the potential Y2K moment of UK LIBOR transition is now largely behind us, market participants will be watching closely for any potential bugs that may still be lurking in the contractual system.

 

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^[1] [2023] UKSC 2, [2023] 1 WLR 575.
^[2] [2015] UKSC 72, [2016] AC 742.
^[3] FCA, ‘The end of LIBOR’, 10 October 2024. 

 

This informational piece, which may be considered advertising under the ethical rules of certain jurisdictions, is provided on the understanding that it does not constitute the rendering of legal advice or other professional advice by Goodwin or its lawyers. Prior results do not guarantee similar outcomes.