In February 2021, the EU Benchmarks Regulation – which regulates indices used to price financial instruments and contracts or to measure the performance of an investment fund – has been amended to ensure that a statutory replacement benchmark can be put in place by the time a systemically important benchmark is no longer in use. The new provisions involve some considerations regarding fallback clauses and actions to be carried out by market participants and, in particular, by issuers.
Regulation (EU) 2021/168 (the Amending Regulation) introduced significant amendments to Regulation (EU) 2016/1011 of the European Parliament and of the Council of 8 June 2016 on indices used as benchmarks in financial instruments and financial contracts or to measure the performance of investment funds (the EU Benchmarks Regulation) as regards, inter alia, the designation of replacements for certain benchmarks.
The Amending Regulation, which is applicable as of 13 February 2021, has mainly been introduced to ensure that when a widely used benchmark is phased out, it does not harm financial stability in the EU and result in disruptions to the relevant economy.
The announcement of the Financial Conduct Authority regarding the cessation of the London Interbank Offered Rate (LIBOR) after the end of 2021 has been a kind of wake-up call for Europe. There are many contracts and/or financial instruments documenting debt, loans and/or derivatives that still reference LIBOR with a maturity date beyond 31 December 2021 and do not envisage contractual fall-back provisions that could regulate the cessation of LIBOR. In other terms, LIBOR is widely used in outstanding contracts and/or financial instruments that cannot not be practicably transitioned away from such benchmark by actions or agreements by or between contract counterparties themselves.
Thus, the EU established a mechanism for transitioning affected contracts and/or financial instruments to suitable replacement benchmarks.
How does it work?
The statutory replacement of a benchmark applies to:
- any contract or financial instrument as defined in Directive 2014/65/EU (MiFID II) that references a benchmark, and is subject to the law of an EU member state; or
- a contract that references a benchmark and is subject to the law of a third country, where the law does not provide for the orderly wind-down of a benchmark (provided that all parties to such contract are established in the EU).
The designation of a statutory replacement benchmark is an additional tool that applies if, inter alia, the above contracts or financial instruments do not contain fallback provisions or do not contain “suitable” fallback provisions pursuant to the Amending Regulation. In such cases, the designated benchmark shall replace all references to the benchmark to be replaced in such contracts and financial instruments.
The authority to designate one or more statutory replacements for a benchmark shall be vested in:
- the European Commission – with respect to (i) benchmarks that have been designated as critical under the EU Benchmarks Regulation (such as EURIBOR) and (ii) third-country benchmarks, the cessation of which would significantly disrupt the functioning of financial markets in the EU or pose a systemic risk to the financial system in the EU (such as LIBOR) – through the adoption of implementing acts which shall, inter alia, follow a public consultation and include the date from which the replacement or replacements for a benchmark applies; or
- the national competent authority of a an EU member state where the majority of contributors is located, with respect to the “critical” benchmark set out in Article 20, paragraph 1, lett. b) of the EU Benchmarks Regulation.
In any case, the parties to a contract may agree to apply a different replacement for a benchmark to the one designated by the European Commission or the national competent authority.
In addition, the Amending Regulation provides for (i) specific trigger events that must occur for the purposes of the designation of one or more replacements for a benchmark by the European Commission/national competent authority, and (ii) the conditions under which the fallback provisions shall be deemed unsuitable for the purposes of the statutory replacement of a benchmark.
In particular, a fallback provision shall be deemed unsuitable for the purposes of the statutory replacement of a benchmark designated by the European Commission if:
- it does not provide for a permanent replacement benchmark; or
- its application requires consent from third parties that has been denied; or
- the replacement benchmark according to such fallback no longer reflects or significantly diverges from the underlying market or the economic reality that the benchmark in cessation is intended to measure, and its application could have an adverse impact on financial stability.1
In addition, the “unsuitability” of a fallback provision is limited to the cases where it does not provide for a permanent replacement benchmark with respect to the replacement of a benchmark by national law.
First of all, it is recommended for market participants and, in particular, European issuers not to sit back and rely on this statutory replacement mechanism, but to focus on their fallback clauses.
They should (i) identify all of their contracts or financial instruments that reference certain benchmarks (such as LIBOR) and verify if they include fallback provisions; and, if this is the case, (ii) review all of their fallback clauses to assess their “suitability” for the purposes of the EU Benchmarks Regulation, as amended by the Amending Regulation.
Where appropriate, issuers should consider amending contracts and financial instruments in advance before the relevant benchmarks cease to apply.
In addition, issuers should draft fallback clauses in “new” contracts and financial instruments in the light of such new provisions and, where appropriate, the new ISDA IBOR Fallback Protocol, which is effective as of January 2021 and which includes new fallback provisions connected with key interbank offered rates (so-called IBORs) in the event, inter alia, an IBOR becomes permanently unavailable while firms continue to have exposure to that rate.
European issuers should also review their “contingency plans” required by Article 28, paragraph 2 of the EU Benchmarks Regulation, where such plans designate one or several alternative benchmarks that could be referenced to substitute the benchmarks that would no longer be provided. Such review seems necessary, even if, as anticipated above, the designation of a statutory replacement benchmark is an additional tool that does not apply when the parties to a contract agree to apply a different replacement benchmark.
Finally, it is recommended for European issuers to implement a strategy for communicating to end-clients/users their plan to move to “alternative benchmarks” and the transitions and steps to be taken to support such a move.