After nearly two (2) years in the making, the International Swaps and Derivatives Association, Inc. (ISDA)[1] released its ISDA 2020 IBOR Fallbacks Protocol (the Transition Protocol) on October 9th. Release was delayed since ISDA, as a consortium of banks subject to claims of collusive behavior under antitrust laws, wanted confirmation from the Antitrust Division of the US Department of Justice that implementation of the Transition Protocol was unlikely to harm competition. This confirmation was obtained on October 1st.

The Transition Protocol relates to both legacy derivatives and new derivatives to deal with the anticipated termination of the calculation of US Dollar LIBOR as well as numerous other currency Interbank Offered Rates (IBORs) throughout the world.

Enumerated below is a summary of the concerns raised by a review of the Transition Protocol:

Relevant Dates

Publication Confusion

Though released on October 9th, the Transition Protocol states that it is published and finalized on October 23rd. It later states that it is to be published by ISDA, and effective, on January 25, 2021. 

Cut-Off Date

At some point, ISDA has the right, in its sole and absolute discretion, to designate a closing date of the Transition Protocol and not accept any further IBOR transitions under this protocol.

Effective Date

Amendments contemplated by the Transition Protocol are to be effective on the later of (i) the execution of a letter agreeing to the Transition Protocol (the Adherence Letter) by the bank counterparty, and the borrower counterparty or its agent[2] (collectively, the Adhering Parties), and (ii) January 25, 2021.

Non-Negotiability

As with all ISDA documents, the Transition Protocol ‘is intended for use without negotiation.’ Given the concerns outlined in this Client Alert, no borrower should execute an Adherence Letter without substantial modifications and clarifications.

Irrevocability

Although the Transition Protocol permits a borrower counterparty to revoke its adherence to the Transition Protocol, the contemplated amendments are effective notwithstanding the occurrence, or deemed occurrence, of a revocation. Consequently, it is not clear of the effectiveness of a revocation, absent Court challenge, unless it occurs on or before January 25, 2021.

General Enforceability Issues

There are numerous legal concerns whether implementation of the Transition Protocol, through the execution of the Adherence Letter and the related Amendments, would be enforceable. These concerns include, but are not limited to: 

• as mentioned above, the seemingly ineffectiveness of a revocation
• the binding nature on third-party credit support providers who have not executed the Adherence Letter[3]
• the choice of the laws of England and Wales[4] despite the fact, at least with respect to US Dollar LIBOR, that:
  • most underlying existing swap documents are governed by New York law so it is unclear of the interplay between the underlying swap document New York law provisions and the amendments to such documents being controlled by the laws of England and Wales[5]
  • most borrower counterparties have no legal nexus to this jurisdiction, though it is likely that some, but not all, bank counterparties have such legal nexus
• an agent’s authority to legally bind a borrower counterparty absent explicit authority to enter into the Transition Protocol

Authority Issues

Borrower

When swaps were first utilized in the United States, most bank counterparties insisted that there be a specific authorizing resolution, at least for municipal issuers and conduit borrowers, to permit them to enter into a swap.[6] Now, per the Transition Protocol, the Adherence Letter and the related amendments are permitted to be entered into, whether or not a borrower counterparty has any authority expressly referencing the Transition Protocol, the Adherence Letter and the related amendments. Based upon the substantial financial and legal ramifications of the Transition Protocol, prior authority to enter a swap with significant changes may not legally suffice.

Agent[7]

Like authority for a borrower counterparty, (i) no express authority to enter into the Adherence Letter on behalf of a borrower counterparty is required for an agent unless specifically requested by a bank counterparty and (ii) a lack of express agent authority may be legally deficient. Due to the apparent rush to implement the Transition Protocol, bank counterparties will likely not request such express agent authority. This is especially probable since an agent’s execution is deemed binding on the borrower counterparty under the Transition Protocol, whether or not there is express authority by the agent. This also may be difficult to justify as enforceable in any court.

By way of example, the Transition Protocol states that authority of agents under investment management agreements may provide sufficient authority to agents. However, these agreements tend to have general authority language which may not be sufficient. In addition, agents may be held responsible under such agreements to borrower counterparties for, among other things, breach of its fiduciary duty to serve in the best interests of the borrower counterparty and/or for negligence or gross negligence.

Effectiveness of an agent’s authority to bind a borrower counterparty becomes effective after fifteen (15) calendar days even if the borrower counterparty is not aware of the actions of the agent. It is difficult to understand how a borrower counterparty can enter into an Adherence Letter and the related amendments, or permit its agent to so on its behalf, without adequately addressing all of the foregoing concerns.

Other Serious Negative Consequences

Structural Changes

Critical components for a borrower in any financing agreement are:

• amount
• term
• rate (or spread)

With respect to US Dollar LIBOR, the Transition Protocol amendments state that the Calculation Agent (typically the bank counterparty) is to apply the most recently published spread on the Secured Overnight Financing Rate (SOFR). However, the published spread does not currently exist – the Alternative Reference Rate Committee (ARRC)[8] recently published a request for proposals to identify an administrator or administrators who will be responsible for the calculation and publication of the SOFR spreads. It is the goal that such administrators be identified and pre-adjusted spreads published by March 2021 – a date months after Adherence Letters and the related amendments are first contemplated to be executed.

This published spread can be adjusted by the bank counterparties to account for any differences in term structure or tenor of SOFR, likely at the sole and absolute discretion of the bank counterparty, making the spread – a critical component of any financing – unknowable to a borrower counterparty. My experience is that it is not prudent for any borrower counterparty to bind itself to an unknowable interest rate.

Public vs. Private Settlement

Under underlying existing swap documents, any dispute is to be heard in the relevant court. Generally, for a US Dollar LIBOR-based swap, the relevant jurisdiction forum is the courts of the State of New York or the Southern District of New York.

However, all disputes arising out of, or in connection with, adherence to the Transition Protocol are to be finally settled under the Rules of Arbitration of the International Chamber of Commerce (ICC). Although I have been told by the Firm’s International Arbitration and Dispute Resolution Group that ICC is the ‘gold standard’ for arbitration, particularly in Europe, moving disputes from a public courtroom to a private negotiating room leads to confidential discovery, confidential hearings and confidential settlements. An arbitration also eliminates any adverse publicity for a bank counterparty upon a negative determination.

Importantly, private settlement eliminates the ability of borrower counterparties to even know about the adverse decisions that might be helpful in pursuing their potential claims. Consequently, for bank counterparties, an ICC arbitration forum significantly reduces the number of similar claims and dollar exposure on adverse decisions, and eliminates the ability of class actions where similarly situated borrower counterparties can potentially pool their ideas and financial resources, and streamline proceedings to counter deep-pocketed bank counterparties.[9] This is especially important where damages by any single claimant does not warrant the legal expense and time commitment required to adequately protect its interests.

It is improbable that individuals or companies without any leverage over the larger companies and/or their trade associations have any ability to negotiate the Transition Protocol and the related amendments (see the section entitled ‘Non-Negotiability’ above).[10] Borrowers will undoubtedly be told by the bank counterparties that the Transition Protocol is ‘standard’ ISDA documentation.

Such individuals and companies typically do not read the small print in a form and/or understand the contractual language of the agreement (see all ISDA documentation which is generally impossible for a non-expert or, for that matter, an expert to decipher). This negates the concept of intent and ‘consent’ so heavily relied upon by the Supreme Court in Lamps Plus.

In fact, Justice Ginsburg noted this imbalance of bargaining power by stating in her dissenting opinion to Lamps Plus:

‘I write separately to emphasize once again how treacherously the Court has strayed from the principle that arbitration is a matter of consent, not coercion.’ (internal citations omitted)

A private settlement forum, such as an ICC arbitration, is thus invaluable to any large company with many potential claimants having similar claims, and reduces, if not eliminates, the deterrent impact that an adverse determination has on a company and other companies in its industry undertaking parallel misdeeds.

Though beneficial to certain companies, it is likely that arbitration does not serve the general public’s best interest and, thus, the rationale for the increased frequency by such companies of settlement through mandatory arbitration similar to what is contemplated under the Transition Protocol.

Conclusion

The focus of regulators in the United States and the United Kingdom had been to correctly transition away from LIBOR due to past bank manipulations. However, this should not be done to the detriment of borrowers since this is counter to the very reason for the transition. Although the ‘[Transition] Protocol provides an efficient mechanism to amend a large number of derivatives contracts with many counterparties, and therefore will play an important role in an orderly transition away from LIBOR,’[11] the LIBOR transition should, and can, take place in a fair and reasonable manner to assure the integrity of worldwide financial debt markets.

[1] ISDA is a bank trade association.

[2] The Bank of England (BoE) announced that it has signed up to the Transition Protocol. BoE has accepted the Transition Protocol for both the transactions it undertakes on its own behalf , and those that it enters into as agent for Her Majesty’s Treasury and other entities.

[3] Also see footnote 1 to the Transition Protocol.

[4] Previously, English law was referenced in relevant swap documents. However, in recognition of Brexit and the possible exiting of Scotland and Northern Ireland from the United Kingdom, the governing law of these jurisdictions have been omitted from the Transition Protocol.

[5] See the webinar held by The Knowledge Group, entitled “LIBOR Transition: Demystifying Trends, Developments and Legal Issues” held on September 23rd (the 2nd LIBOR Webinar) where I presented the concerns with Alternative Reference Rate Committee proposed New York legislation to deal with the LIBOR transition. These concerns included (i) safe harbor from litigation if LIBOR is discontinued, (ii) no requirement to use SOFR or the recommended spread, (iii) no liability of bank counterparties for breach of contract for change of material terms of existing contracts and (iv) limitations on borrower counterparty’s ability to void existing contracts. It appears that the Transition Protocol and the related amendments attempt to implement much of the foregoing without the necessity of new New York legislation. See the 2nd LIBOR Webinar beginning at 38:03, with the New York law discussion beginning at 1:07:08.

[6] In 1993, I assisted in the drafting of special Congressional legislation for a Federal entity to, among other things, permit it to enter swaps.

[7] It is important to emphasize that a significant portion of the Transition Protocol deals with an agent’s authority to bind a borrower counterparty. It appears that the Transition Protocol may be trying to bootstrap apparent agent authority to borrower counterparties.

[8] ARRC is generally comprised of bank counterparties and Federal government regulators.

[9] Last year, in Lamps Plus Inc. v. Varela, the Supreme Court ruled that the Federal Arbitration Act does not allow a court to compel class arbitration when the agreement does not explicitly provide for it. Unsurprisingly, ISDA specifically excluded class actions in the arbitration provisions contained in the Transition Protocol and the related amendments. It should be noted that since arbitration clauses are typically part of standard forms drafted by large companies and/or their trade associations, such as ISDA, it is unlikely that any arbitration clauses would provide for class arbitration for the reasons cited above.

[10] Maybe the Adherence Letter should instead be entitled an Adhesion Letter.

[11] See Supervision and Regulation Letter (SR) 20-22, from the Director of the Division of Supervision and Regulation of the Board of Governors of the Federal Reserve System, dated October 9, 2020, to the officer in charge of supervision and appropriate supervisory and examination staff at each Federal Reserve Bank and institutions supervised by the Federal Reserve.