Back to the Future: Traditional Common Law Solutions to Impending LIBOR Problems

Isaac Hudis

The London interbank offered rate (“LIBOR”), a measure of short-term interest rates and a key benchmark for trillions of dollars’ worth of contracts, is dying.[1] Market participants and financial regulators have searched for a replacement since 2012, when several banks admitted to manipulating LIBOR for profit.[2]  In response, the U.K.’s Financial Conduct Authority (“F.C.A.”) issued a warning that companies should not rely on LIBOR’s continued existence after the end of 2021.[3] As the deadline looms, U.S. regulators,[4] market participants,[5] and even law firms[6] continue to bang the warning drum: parties must voluntarily renegotiate their contracts, or else. According to a recent survey, fewer than half of companies reported feeling confident that they will be ready when LIBOR disappears.[7] This widespread unpreparedness makes it seem increasingly likely that companies, and eventually courts, will have to deal with the “else.” The looming question, then, is not just how judges might resolve contract disputes arising out of the end of LIBOR, but how judges should resolve them.

It is relatively easy to frame the problem in terms familiar to most judges. If parties form a contract based on X, but X changes in a material, unexpected way, what becomes of the parties’ obligations going forward? Can one party void the contract? If one party suffers because of the change, can courts provide an equitable remedy? Common law offers various legal frameworks for analyzing these problems, including mutual mistake and impracticability. Presumably, a judge could simply plug in “LIBOR” for X, and solve. However, the limitations inherent in these common law doctrines may render them unwieldy tools for judges to apply to LIBOR cases.

Mutual Mistake

Under the doctrine of mutual mistake, a “mistake of both parties at the time the contract was made as to a basic assumption on which the contract was made [that] has a material effect on the agreed exchange of performances” renders the contract voidable by the adversely affected party “unless he bears the risk of the mistake.”[8] A judge could reasonably provide a remedy for LIBOR disputes under a theory that both parties misunderstood the risk that LIBOR may cease to exist, that such a mistake served as a basic assumption on which the contract was formed, and that, under the contract, neither party bore the risk of LIBOR’s disappearance.

One potential hiccup for courts, however, would be deciding whether the end of continued updating of LIBOR fits within the doctrinal definition of “mistake.” Under § 151 of the Restatement, a mistake means “a belief that is not in accord with the facts.” The comments to this section clarify that “[a] party's prediction or judgment as to events to occur in the future, even if erroneous, is not a ‘mistake’ as that word is defined here.”[9] Courts could conclude that the presumed future existence of LIBOR constituted an erroneous prediction of future events, not a “belief that is not in accord with the facts,” and, therefore, refuse to find a LIBOR-referencing contract voidable under the doctrine of mutual mistake. For example, if, after 2021, some rate reflecting the final calculation of LIBOR remains publicly available and accessible, albeit in a static, non-updated form, a judge may find that parties were not actually mistaken as to LIBOR’s continued existence.[10] Rather than a mistake, this argument goes, the parties in fact made an erroneous prediction regarding how LIBOR would (or would not) fluctuate relative to other measures of short-term interest rates. Having found that the parties to the contract simply made a bad bet, a judge would likely find the doctrine of mutual mistake inapplicable to their LIBOR dispute. 

Impracticability

Impracticability provides an alternate basis for relief under common law. Restatement (Second) of Contracts § 261 discharges a party’s duty to perform if “performance is made impracticable without his fault by the occurrence of an event the non-occurrence of which was a basic assumption on which the contract was made.” Arguably, the discontinuation of LIBOR renders a party’s contractual duty to pay LIBOR plus X basis points impracticable, and thus courts should offer a remedy.

Unfortunately, the doctrine of impracticability may not prove as useful as it might appear from the text of the Restatement. The Restatement’s use of the word “impracticability” rather than, say, “impossibility” reflects an attempt to ease the burden parties must show before courts will excuse their obligations.[11] However, some jurisdictions, including New York, require the “supervening event” be unforeseeable at the time the parties formed the contract.[12] Although the Delaware Supreme Court has not ruled on whether impracticability requires unforeseeability, lower courts have refused to excuse a party’s performance when that party could have foreseen the supervening event at the time it entered the contract.[13] Thus, at least in New York and perhaps in Delaware too, impracticability would not excuse performance for a contract formed after the F.C.A announced that LIBOR would be phased out, and judges may even refuse to apply it to contracts formed before the announcement if courts concluded that parties could have foreseen the demise of LIBOR and the eventual need to find a new benchmark rate.

What’s a Court to Do?

Applying existing common law doctrines like mutual mistake or impracticability to LIBOR cases will prove daunting. Given the volume of contracts that will still reference LIBOR after 2021 and the potential economic value of those agreements, judges must approach the doctrinal issues that arise in LIBOR disputes with a firm grasp on the policies of contract law and the practical effects of different courses of action. In resolving the complicated questions that will emerge if and when parties that fail to renegotiate their contracts reach the courthouse steps, judges should consider two fundamental policies of contract law.

First, courts should focus on honoring the intent of the parties at the time the contract was formed. Where sophisticated parties agreed to use LIBOR simply as an approximation of general short-term interest rates, courts may consider reforming the agreement to link the payments to a suitable replacement rate, such as the New York Fed’s Secured Overnight Funding Rate (“SOFR”). However, given recent volatility in SOFR relative to LIBOR, courts ought to pay particular attention to how well a particular replacement rate really would give the parties what they hoped to achieve from LIBOR.[14] In contrast, if it appears that the parties sought exposure to LIBOR specifically as opposed to other benchmarks, courts may wish to hold back in providing a remedy at all.

Second, courts should minimize incentives for parties to engage in strategic behavior. Specifically, courts should not countenance a more sophisticated party using the end of LIBOR as an opportunity to pull one over on a less sophisticated counterparty. In that case, courts may wish to consider restitution to the adversely affected party in addition to or instead of reformation of the agreement.

             Of course, the facts of the case will probably drive the result more than ex-ante appeals to contract law policy. After all, “[a]ll happy [contractual arrangements] are alike; each unhappy [contractual arrangement] is unhappy in its own way.”[15] Still, by analyzing the disputes that arise out of the death of LIBOR within the context of common-law solutions and contract-law policy, courts can hopefully promote a smooth, efficient, and fair transition toward a post-LIBOR world.

 

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[1] Max Colchester, Scandal-Hit Libor to Be Phased Out, Wall St. J. (July 27, 2017), https://www.wsj.com/articles/u-k-calls-time-on-scandal-hit-libor-1501148216?mod=article_inline.

[2]Tracking the Libor Scandal, Dealbook, N.Y. Times (March 23, 2016), https://www.nytimes.com/interactive/2015/04/23/business/dealbook/db-libor-timeline.html?module=inline#/#time370_10900.

[3] Andrew Bailey, Chief Exec. of the Fin. Conduct Auth., Speech at the Securities Industry and Financial Markets Association’s LIBOR Transition Briefing in New York, NY (July 15, 2019), https://www.fca.org.uk/news/speeches/libor-preparing-end.

[4] Public Statement, Sec. and Exch. Comm’n, Staff Statement on LIBOR Transition, (July 19, 2019), https://www.sec.gov/news/public-statement/libor-transition.

[5] Fallback Contract Language, Alternate Reference Rates Committee, https://www.newyorkfed.org/arrc/fallbacks-contract-language [https://perma.cc/HW83-P88W].

[6] Vicki E. Marmorstein et al., Latham & Watkins, LIBOR Discontinuation and Transition – What Investment Managers Should Know (Aug. 20, 2019), https://www.lw.com/thoughtLeadership/libor-discontinuation-and-transition-what-investment-managers-should-know.

[7] Samantha Regan et. al., 2019 LIBOR Survey: Are You Ready to Transition?, Accenture (Sept. 16, 2019), https://www.accenture.com/us-en/insights/financial-services/libor-transition-survey [https://perma.cc/6XEX-DLVY].

[8] Restatement (Second) of Contracts § 152 (Am. Law Inst. 1981).

[9] Id. § 151 cmt. a.

[10] See Marc Gottridge, Where the Post-Libor Litigation Tsunami Will Hit, Law360, (May 13, 2019, 4:53PM EDT) https://www.law360.com/articles/1158341/where-the-post-libor-litigation-tsunami-will-hit (Discussing the possibility that LIBOR’s administrator could continue publishing some form of LIBOR even after 2021 and that existing LIBOR-referencing contracts may revert to a fixed rate representing the “last available Libor rate”).

[11] Id. § 261 cmt. d.

[12] See, e.g., Kel Kim Corp. v. Cent. Mkts., Inc., 519 N.E.2d 295, 296 (N.Y. 1987).

[13] See, e.g., CRS Proppants LLC v. Preferred Resin Holding Co., LLC, 2016 WL 6094167, 9 (Del. Super. Ct., 2016).

[14] Daniel Kruger & Vipal Monga, Repo-Market Tumult Raises Concerns About New Benchmark Rate, Wall St. J. (Sept. 23, 2019), https://www.wsj.com/articles/repo-market-tumult-raises-concerns-about-new-benchmark-rate-11569247352.

[15] Leo Tolstoy, Anna Karenina 1 (Richard Pevear & Larissa Volokhonsky trans., Penguin Classics 2004) (1878).