Cy-près solutions: navigating contractual continuity in a post-LIBOR world

Introduction

In Standard Chartered PLC v Guaranty Nominees Ltd & Ors [2024] EWHC 2605 (Comm), the English Commercial Court provided a solution to the impact of the cessation of the London Interbank Offered Rate (“LIBOR”) on perpetual preference shares which provide for the payment of dividends determined by reference to that rate. The decision will be of relevance to a large number of existing contracts, which often reference LIBOR in respect of calculating interest.

Facts

Standard Chartered PLC (“SC”) issued USD 750m in preference shares in 2006 to raise Tier 1 capital. Guaranty Nominees Ltd (“GNL”) held these shares as a nominee for a Depository, which issued American Depository Shares (“ADSs”). The ADS holders, referred to as the “Funds” by the Court, held the economic interest in the Preference Shares.

The Preference Shares were perpetual, meaning that they had no maturity date. Dividends were originally paid at a fixed rate of 6.409% p.a., but after 30 January 2017 the dividend was calculated at a floating rate of “1.51% plus Three Month LIBOR”.

Dividends on the Preference Shares were payable at the discretion of SC’s board and were non-cumulative.

The Preference Shares were governed by the laws of England and Wales, while the ADSs were governed by New York law. It was common ground that the Court would reference only English law in making a determination.

The definition of “Three Month LIBOR”

The definition of “Three Month LIBOR” relating to the ADSs (being the rate offered for a 3-month period on USD deposits as published on a specified Telerate screen page) contained a primary means of ascertaining LIBOR, with three alternatives: the First Fallback, the Second Fallback and the Third Fallback. The following is a summary of these fallback positions:

1. If the three-month LIBOR rate did not appear on the specified Moneyline Telerate page, the rate would be calculated as the arithmetic mean of at least two offered quotations from four major reference banks in London.
2. If fewer than two quotations were provided, the rate would be calculated as the arithmetic mean of the rates quoted by three major banks in New York for loans to leading European banks.
3. If the selected banks were not quoting, the fallback rate would be the three-month US dollar LIBOR in effect on the second business day in London prior to the relevant dividend period.

Cessation of LIBOR

LIBOR was a cornerstone of the financial markets for decades; however, the financial crisis which began in around April 2007 revealed a number of fundamental flaws in the LIBOR determination methodology. Allegations were made of collusion between panel banks. Regulators including the US Department of Justice carried out investigations into the manipulation of LIBOR, which culminated in a series of LIBOR panel banks being fined for inappropriate conduct in relation to their LIBOR returns. Concerns in relation to the LIBOR rate led to regulatory and industry initiatives with a view to identifying floating rates which could be used as alternatives to LIBOR. Those efforts were extensive and produced a large amount of material, some of which was placed before the Court and relied upon by both SC and the Funds. The Court set out in great detail a summary of those relevant events in the judgment (and in an Appendix to the judgment – a summary of which is included at the bottom of this Law-Now).

As part of regulatory and market moves away from reliance on LIBOR and towards adoption of the alternative rates, it was agreed that “synthetic” LIBOR rates would be published for a limited period. In that regard, it was agreed that the synthetic USD LIBOR rates should be based on the “CME Term SOFR” plus the “ISDA Spread Adjustment”.

At the end of September 2024, in the course of hearing the case, synthetic USD LIBOR ceased to be published, concluding a significant chapter in the history of financial markets.

SC’s case

With the cessation of USD LIBOR at the end of September 2024, there was no challenge that the First and Second Fallbacks were inoperable because, simply, banks could not and would not provide the rates.

SC’s primary argument centred on the Third Fallback which stated that “…if the banks selected by the Company, are not quoting as mentioned above, it shall mean three month US dollar LIBOR in effect on the second business day in London prior to the first day of the relevant Dividend Period”. SC’s primary case was that the phrase “three month US dollar LIBOR in effect” in the Third Fallback should be construed as “a rate that effectively replicates or replaces three month USD LIBOR”. Specifically, SC’s argument focused on the interpretation of the phrase “three month US dollar LIBOR in effect”. SC contended that this phrase should be construed to mean “a rate that effectively replicates or replaces three month USD LIBOR” (“SC’s Interpretation Claim”).

Alternatively, SC proposed the implication of a term, allowing SC to use a reasonable alternative rate. The specific implied term suggested by SC was “…where the express definition fails, SC should use a reasonable alternative rate to three month USD LIBOR” (“SC’s Implied Term”). SC argued that combining the CME Term SOFR plus the ISDA Spread Adjustment (the “Proposed Rate”) met the requirements of such a ‘reasonable alternative rate’.

The Funds’ case

The Funds initially sought a declaration that a term should be implied into the terms of the Preference Shares requiring SC to redeem the Preference Shares. The Funds’ position evolved into a more complex two-stage approach.

Stage One Implied Term

The Funds proposed that where USD LIBOR ceased to be available, SC should redeem the Preference Shares, subject to the Companies Act, other applicable laws and regulations, the Articles of Association, and the prior consent of the FCA (the “Funds’ First Stage Implied Term”).

Stage Two Implied Term

To the extent that redemption in accordance with the Funds’ First Stage Implied Term was unlawful under the Companies Act, other applicable laws, or if the FCA did not provide its prior consent, the Funds’ proposed alternative options. In summary, those options included:

1. SC paying a sum as if it were a dividend under the terms of the Preference Shares, with the dividend rate being equal to the last published LIBOR rate plus 1.51%.
2. SC paying a sum as if it were a dividend under the terms of the Preference Shares, with the dividend rate being equal to 6.409% (the rate prior to January 2017).
3. Any other term the Court deemed fit.

(Together, the above being the “Funds’ Second Stage Implied Term”.)

Commercial Court Decision

The Court decided that it was “necessary, in order to give business efficacy…to imply a term…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 …”. Of the reasonable alternative rates which the Court considered, it found that the Proposed Rate was the closest.

The Court reiterated the principles of contractual construction and interpretation (including the applicable principles summarised in Sara & Hossein Asset Holdings Ltd v Blacks Outdoor Retail Ltd [2023 UKSC 2 at [29]) and the implication of contractual terms (to which, as expected, there was little dispute between the parties).

In respect of the implication of implied terms, the Court followed Marks & Spencer Plc v BNP Paribas Securities Services Trust Co (Jersey) Ltd [2015] UKSC 72:

1. “An implied term must either be necessary to give business efficacy to the contract, meaning that the contract would lack commercial or practical coherence without the term and /or be so obvious that it goes without saying ([16])”; and
2. “The term to be applied must be capable of clear expression, not contradict any express terms of the contract… and be reasonable and equitable, although a term which meets the previous requirements will almost certainly be reasonable and equitable.”

The Court then supplemented the above “first order” principles with “second order” principles (addressing the first order principles in the particular context). The Court identified three overlapping second order principles:

Long-term contracts

First, the Court recognised that while there are no special rules for interpreting long-term contracts, a flexible approach may be necessary to meet the reasonable expectations of the parties, especially given changing conditions over time. This was supported by references to several cases, including Total Gas Marketing Ltd v Arco British Ltd [1998] 2 Lloyd's Rep 208, 218, Teesside Gas Transportation Limited v CATS North Sea Limited [2019] EWHC 1220 (Comm), and Mamidoil-Jetoil Greek Petroleum Co SA v Okta Crude Oil Refinery AD[2001] EWCA Civ 406. The Court noted that in long-term contracts, the failure to address specific issues may be less significant, and courts are willing to imply terms to preserve the contract’s certainty, especially when one party has already benefited or made investments based on the agreement.

Machinery v. substantial entitlement

Secondly, there was a distinction between provisions of a contract which are intended to define substantive provisions, and provisions which are in the nature of ‘machinery’ intended to qualify the substantive entitlement. This principle was set out in Sudbrook Trading v Eggleton [1983] AC 444 where it was held that where the machinery is a ‘non-essential’ part of the contract, and is incapable of operation, the court can step in to perform the necessary exercise of quantification.

Unforseen events

Lastly, the Court addressed how to handle unforeseen events with contractual implications during the life of a contract.. The Court referred to Debenham Retail Plc v Sun Alliance and London Assurance Co Ltd [2005] EWCA Civ 868. This case dealt with the unforeseen introduction of VAT and it was held that the court must promote the purposes and values expressed or implicit in the contract’s wording to reach an interpretation consistent with those values.

With regard to the “second order” principles, the Court concluded that such principles “seek to ascertain the purpose or structure of the relevant aspects of the parties’ bargain, and to adopt an interpretation which best serves or is most consistent with that purpose in the changed circumstances: in effect, a form of contractual cy-près”.

Further, the Court confirmed that such an approach aligns with the intentions of reasonable parties to long-term contracts and supports important policy of English contract law, which is reluctant to allow the failure of partly executed contracts due to unforeseen circumstances.

SC’s Claims

Against that background, the Court rejected SC’s Interpretation Claim and found that the expression “in effect” in the Third Fallback should be understood in its temporal sense, meaning “in force”, or “in operation” at a specific point in time.

However, the Court accepted SC’s Implied Term Claim but modified the proposed term. The Court emphasised that the identification of the reasonable rate is an objective question, ultimately to be determined by the Court, and allowed for the possibility that the universe of available alternative reference rates might change over the life of the Preference Shares.  

Funds’ Claims

The Court found that the Funds’ proposed implied terms, requiring redemption, did not satisfy each of the criteria for the implication of an implied term i.e., that the proposed term was not necessary to give business efficacy to the (long-term) contract and was not so obvious that it went without saying. The Court noted that the term would bring the provision of capital and the payment of dividends to an end, which was inconsistent with the long-term nature of the contract.

The Court also found that the term was inconsistent with the express terms of the contract and the legal controls on the right of redemption. Additionally, the Court highlighted the lack of clarity in the proposed term, particularly regarding the conditions imposed by the FCA and the steps SC would need to take to redeem the shares with the regulators. On the basis that the Funds’ First Stage Implied Term failed to satisfy the criteria for the implication of an implied term, the Court did not consider it necessary to consider the Funds’ Second Stage Implied Term (since that would only arise if the Funds’ First Stage Implied Term was arguable).

Comment

The use of LIBOR regularly arises in existing contracts that were drafted prior to the cessation of LIBOR and model/standard form contracts that have not been updated. Following the cessation of LIBOR this is problematic; it results in doubt and uncertainty in what are often important commercial terms of the contract.

This case underscores several critical points:

• First, the starting point to resolving any issue is the express terms of the relevant contract. It may be that the express terms of the agreement provide a mechanism to resolve a problem. In this case, the relevant express terms did not resolve the problem. 
• Second, it was in the context of the express terms not providing an answer that the Court considered whether an implied term should be found to exist and so, the exact nature of that implied term. The test relating to implied terms is well known and clear.
• Third, after deciding that an implied term was required, the Court determined that the most suitable replacement for the three-month USD LIBOR in the contract in question was the CME Term SOFR plus the ISDA Spread Adjustment. This decision was based on extensive regulatory and market consultations and endorsements from major financial regulators in both the US and the UK. This replacement rate is now widely accepted and used across various financial instruments, ensuring a smooth transition from USD LIBOR. Furthermore, Contracts drafted following the cessation of LIBOR now often refer to (for instance) compounded risk-free rates such as SOFR or SONIA calculated at the end of a period (i.e., illustrating a movement from the old constructs of term rates determined at the beginning of the period).
• Fourth, the decision offers valuable confirmation that the well-established criteria for contractual interpretation and the implication of terms are relevant to resolving the issue. The Court emphasised the application of key ‘second order’ principles, which are particularly relevant in long-term contracts. These principles helped in distinguishing between essential terms and non-essential machinery, ensuring that the substantive intent of the parties is preserved.

For the drafters in the industry, the key take-aways are:

• Review model/standard forms carefully to remove and replace references to LIBOR.
• If contracts refer to third party publications, consider including express terms for the fallbacks that should apply should it cease to be published. For example, some long-term gas transport arrangements include provisions to the effect that if any rate or index referred to in the agreement ceases to be published or is materially changed, the parties shall have a period of time to agree an alternative (typically with the requirement that it must maintain the intent and economic effect of the original rate or index). If no agreement is reached by the end of the period, a party can initiate third party dispute resolution processes (e.g. experts, arbitration and/or courts). In the finance space, robust fallback provisions are common and often mandatory. For instance, statutory provisions such as the Benchmarks Regulation require documents to contain fit-for-purpose fallbacks in certain circumstances.
• For existing contracts, in the absence of express terms, the decision of the Court is useful for guidance on what may be the appropriate next steps.

Appendix

Position in the US

The US introduced a replacement rate called the Secured Overnight Funds Rate (being a daily rate for overnight borrowing secured by treasury securities) (“SOFR”). The International Swaps and Derivatives Association (“ISDA”) initiated a market-wide consultation to consider how to address the difference (or “spread”) between SOFR and LIBOR to reflect the fact that LIBOR took into account counterparties’ credit risk whereas the replacement rates are generally “risk-free” rates. The overwhelming majority of respondents expressed the view that a spread adjustment based on a historical median over a five-year lookback period was appropriate. The Alternative Reference Rate Committee (“ARRC”) also endorsed the use of a fixed rather than dynamic spread adjustment and endorsed the spread adjustment proposed by ISDA (“the ISDA Spread Adjustment”). To provide forward term SOFR rates (“Term SOFR”), ARRC recommended use of the Term SOFR rates published by the Chicago Mercantile Exchange (“CME”) Group Benchmark Administration (“CME Term SOFR”). CME Term SOFR is a forward-looking rate calculated on a futures basis by reference to trading in derivatives on the CME and reflects market expectations of SOFR in the future. Subsequently, the Federal Stability Board stipulated a replacement rate for non-derivative and non-consumer transactions on USD three-month LIBOR of three-month CME Term SOFR plus the ISDA Spread Adjustment.

Position in the UK

In the UK, following a series of reforms to the process for producing LIBOR, the administration of LIBOR was handed over from the British Bankers’ Association to ICE Benchmark Administration Limited (“IBA”), who began publishing “ICE LIBOR” in 2014 and who were regulated by the Financial Conduct Authority (“FCA”). Over a period of time, regulators encouraged market participants to transition from LIBOR. In due course, the IBA stopped publishing 24 (non-US) currency and tenor LIBOR settings and continued with synthetic sterling and yen rates for a period (i.e. a rate calculated using market data rather than based on a survey of panel banks).  In June 2021, the Bank of England and the FCA announced their support for the US initiative to move from USD LIBOR to a SOFR rate. The USD LIBOR bank panel ceased to exist on 30 June 2023. The FCA exercised regulatory powers to require the IBA to publish synthetic rates for 1, 3 and 6-month USD LIBOR to support a transition from LIBOR effective from 1 July 2023. The FCA provided that those rates should be “based on the relevant CME Term Reference Rate and the corresponding ISDA spread adjustment”. The FCA stated that it was satisfied that this was a “fair and reasonable approximation of the value panel-bank LIBOR would have had”.

Commercial Court Judges

Sir Julian Flaux C and Foxton J