This analysis summarises the current work being carried out by a variety of bodies related to the possible replacement of London Interbank Offered Rate (LIBOR) as a benchmark rate in finance documents across a range of markets and outlines some implications for loan agreements.
What is LIBOR?
ICE LIBOR (formerly known as BBA LIBOR) is a benchmark rate produced for CHF (Swiss Franc) EUR (Euro) GBP (Pound Sterling) JPY (Japanese Yen) USD (US Dollar) with seven maturities quoted for each—ranging from overnight to 12 months, producing 35 rates each business day. For more on LIBOR, its calculation and the institutions involved in submitting data to allow it to be calculated see the ICE LIBOR webpage.
What is happening to LIBOR?
The speech made by Andrew Bailey of the Financial Conduct Authority (FCA) in July 2017 focused finance market participants attention on the issues that will arise in documenting finance transactions if LIBOR is no longer published. The thrust of the speech made by Mr Bailey was that there should be a move to transition away from LIBOR towards alternative reference rates by 2021.
LIBOR (and other Interbank Offered Rates or IBORs) has become unsustainable despite recent efforts to reform the methodology of calculation and additional regulation.
There are two main reasons why many people consider that LIBOR has become unsustainable:
- The Wheatley reforms required those submitting data to allow LIBOR to be calculated to make ‘clear and explicit use of transaction data to corroborate their submissions’. This placed a greater emphasis on their own transactions over observations of third party transactions or the use of quotes in the relevant markets. A drop off in activity in the inter bank markets since the financial crisis—particularly acute in some currencies and for some maturities—meant there was a real dearth of data from actual transactions to use in making submissions;
- Before Wheatley such a lack of data from actual transactions would not have mattered. Submissions would be made but based not upon actual transactions of the submitting bank but observations of third party transactions in the same markets or quotes by third parties offered to submitting banks. Wheatley put a stop to this fallback and required submitting banks to use their own ‘expert judgment’ to determine a submission in the absence of real data. Many submitting banks were reluctant to use their expert judgment against this background and were uncomfortable about the potential reputational risks faced by them if this continued indefinitely.
As Mr Bailey put it in the speech:
‘The absence of active underlying markets raises a serious question about the sustainability of the LIBOR benchmarks that are based upon these markets. If an active market does not exist, how can even the best run benchmark measure it? Moreover, panel banks feel understandable discomfort about providing submissions based on judgements with so little actual borrowing activity against which to validate those judgements.’
The FCA has persuaded submitting banks to continue to make submissions using their expert judgment when there is no real world data through to 2021 to allow LIBOR to continue to be published.
The ‘Regulation on indices used as benchmarks in financial instruments and financial contracts or to measure the performance of investment funds’ (EU Benchmarks Regulation) entered into force on 30 June 2016 and most of the provisions apply from 1 January 2018. It gives the FCA power to compel banks to make submissions in order to allow LIBOR and other rates to be calculated and published. However, Mr Bailey stated in his speech:
‘we do not think it right to ask, or to require, that panel banks continue to submit expert judgements indefinitely. Indeed, the powers available to us under EU Benchmark Regulation, do not allow us to compel indefinitely.’
The speech prompted an acceleration of the work already underway to understand what would need to be done to mitigate any potential disruption to the markets given the ubiquitous presence of LIBOR (and other IBORs) in finance documents across the world. If LIBOR and other IBOR rates suddenly ceased to be available there would be severe dislocation in the market. Existing deals might not contain fall back provisions allowing appropriate or commercial rates of interest to be charged and for new deals an appropriate new benchmark rate would need to be specified and the mechanics for its use inserted into the documentation. As we describe below this is not a simple matter of substituting a new named rate for LIBOR.
EU Benchmark Regulation—lenders must consider changes to documents
Article 28(2) of the EU Benchmark Regulation states:
‘supervised entities other than an administrator as referred to in paragraph 1 that use a benchmark shall produce and maintain robust written plans setting out the actions that they would take in the event that a benchmark materially changes or ceases to be provided. Where feasible and appropriate, such plans shall nominate one or several alternative benchmarks that could be referenced to substitute the benchmarks no longer provided, indicating why such benchmarks would be suitable alternatives. The supervised entities shall, upon request, provide the relevant competent authority with those plans and any updates and shall reflect them in the contractual relationship with clients.’
This means lenders have to ensure that they have made arrangements to cope with the termination of LIBOR and other benchmark rates. This includes an obligation to ensure that their transactions are able to withstand LIBOR ceasing to be published.
All market participants have an incentive to ensure that viable alternative benchmark rates are made available in the run up to 2021 in case LIBOR and other IBOR rates no longer are made available by IBA.
What will replace LIBOR?
Its is possible that ICE Benchmark Administration (IBA) will continue to publish LIBOR albeit based upon some different calculation methodology linked to transactions from a larger set of submitting institutions. How it will gather market data on which to base any new LIBOR is not yet clear. IBA has publicly statedthat it is working on the basis that although LIBOR will have to evolve it is by no means certain it will cease to exist. IBA pointed out that corporates like that LIBOR has a ‘typical good bank spread’ as well as maturity and liquidity elements difficult to replicate. It also alluded to the fact that there is room for more than one rate in the marketplace as this would provide an element of healthy competition and flexibility.
It is obvious that if LIBOR can continue to be published and is calculated on a meaningful basis that a lot of time and effort that would otherwise be spent dealing with issues for new and existing loan agreements that mature after 2021 would be saved.
Risk free rates (RFRs)
Most of the work to find new rates to use as benchmarks has focused on strengthening existing IBOR methodology and identifying so called risk free rates as alternatives to IBORs. The work has been carried out under the auspices of the Financial Stability Board (FSB) with significant input by the Board of the International Organisation of Securities Commission and ISDA. An overview of the work they are undertaking can be found on their webpage Reforming Financial Benchmarks and they publish regular updates on how the work is progressing here.
The main focus of the work given the possibility that LIBOR will become unsustainable in the future through lack of data has consequently been on finding RFRs that can be used and identifying what changes would need to be made to market practice and documentation to accommodate the transition from LIBOR to these RFRs.
The various working groups set up by the FSB have identified candidate preferred RFRs for four of the five currencies for which LIBOR has been published. These are:
- For GBP Sterling Overnight Index Average (SONIA) a rate for unsecured overnight transactions.
- For USD Secured Overnight Financing Rate (SOFR) a rate for secured overnight transactions.
- For CHF Swiss Average Rate Overnight (SARON) an average of rates used in the Swiss Franc interbank repo market.
- For JPY Tokyo Overnight Average Rate (TONA) a rate for unsecured overnight transactions, and
- For EUR the decision on a preferred RFR has yet to be made.
Much further work is needed before detailed plans to adopt these RFRs as new benchmarks can be made. In due course steps will likely be taken by market participants to use these RFRs as fallback or new benchmark rates in order to comply with the obligations imposed by Article 28(2) of the EU Benchmark Regulation including making appropriate provisions in existing and new finance documentation to use these new rates to calculate interest.
How do RFRs differ from LIBOR?
- LIBOR is a rate used for unsecured transactions some RFRs relate to secured transactions.
- LIBOR is set taking into account the credit risk of the borrowing institution ie it is not risk free. RFRs do not take into account credit risk.
- LIBOR is set for various maturities not just overnight and for the longer terms includes an additional credit risk element not included in overnight RFRs.
- RFRs do not use one uniform method for their calculation—the way SONIA is calculated differs from the way SARON is calculated—this is not such an acute issue with different LIBOR rates, and
- LIBOR is a forward looking rate that can be set at the beginning of an interest period and allows a borrower to calculate its interest bill in advance. This facilitates cash flow budgeting. RFRs in their current form have no term element and so would need to be modified for use in term loans possibly by compounding overnight rates for the relevant period in arrears. This would mean RFRs would be backwards looking. Borrowers might find this problematic at least initially.
Another major issue with RFRs is that work is needed to assess how each different RFRs should be modified for use as rates in finance transactions extending over longer terms than overnight. Additionally, an new element taking into account credit risk would need to be added to the base RFR to produce something more analogous to LIBOR as a reference rate. How this additional modifier is calculated and whether it would need to be different for each of the candidate RFRs is currently under discussion.
How all of these elements—such as new modifiers for risk and term loans and any other changes to the base RFR (eg where there are differences in the method of calculation of each RFR and there is to be a multicurrency loan)—are to be documented to make a usable interest provision in a loan agreement have yet to be settled.
When will the new benchmark rates be available?
Currently, there is no fixed date for a transition from LIBOR to RFRs as work is continuing on the issues discussed above. The best that can be said is that 2021 appears to be the target year for the transition to be effected. The FSB and ISDA (membership required) have published some details about the proposed timeline for the transition with a new report due from ISDA in the first half of 2018.
IBA believes the transition away from LIBOR would take more than 4 or 5 years to effect if dislocation in the market is to be avoided simply because there are so many existing finance documents out there which will still be live after 2021.
How would unavailability of LIBOR affect loan agreements?
Different considerations apply depending on whether you are looking at:
- an existing loan agreement where the loan falls due for repayment after 2021 when LIBOR may no longer be published with fallback provisions;
- a new loan agreement for a loan maturing after 2021 where there is an opportunity to draft provisions to deal with any cessation of LIBOR
- an existing loan agreement which contains no fallback options to replace LIBOR.
Legacy agreements—existing fallback provisions
Most well drawn loan agreements, notably the recommended forms of facility agreement available to members of the Loan Market Association (LMA) will contain a series of fallback options if the relevant Screen Rate for LIBOR is not available.
To summarise the existing suite of fallback options comprise one or more of the following to be used if the Screen Rate for that loan is unavailable:
- use of an interpolated Screen Rate
- use of a Screen Rate which is available for a shortened Interest Period (with additional options to interpolate or use historic rates)
- use a Reference Bank Rate
- use a Cost of Funds basis coupled with an obligation to try to agree with obligors a new rate
- use of the last interest rate determination for all future periods
None of these options is really designed to deal with the situation where LIBOR ceases to be available for an indefinite period of time.
The first point to check is what existing fallback options are contained in the relevant documents. These content of these fallback provisions have changed considerably over time.
The current version of the LMA facility agreements also allows the parties to choose to include an optional clause dealing with the replacement of the Screen Rate which determines LIBOR for the purposes of the loan. It provides for any amendments relating to a replacement benchmark rate to be approved by a majority of lenders (and what constitutes a majority will be defined in the loan agreement) and the obligors. This provides a mechanism to effect appropriate changes to the documentation if LIBOR ceases to be available for good. Once the work on RFRs has been completed and if LIBOR is then no longer available it could be used to effect the necessary changes if the threshold agreement level is met. It avoids the need to get the consent of all parties to effect the amendment and so provides an additional level of comfort that no disruption will take place.
New loan agreements—extending fallback provisions
The work on new benchmark rates is far from complete so most new loan agreement will continue to refer to LIBOR for the foreseeable future. Until the characteristics of the new benchmark rates are known and the practical implications of their method of calculation understood better it is not possible to draft provisions to accommodate the transition with any certainty. The best that can be achieved at the current state of knowledge it to ensure that the majority lender/obligor consent provision is included. It might be desirable to provide that these consents should also allow the facility agent to make associated amendments to reflect the manner in which any new benchmark rate based upon RFRs may have to be calculated (to add elements for credit risk and to compound for the relevant term) which is likely to take time to work out in practice. It might also be prudent to widen the scope of the trigger for the provision so that it can be used if, for example, the agent/other party is of the reasonable opinion LIBOR is no longer an appropriate rate to use because its method of calculation is changed by IBA in some material way that disadvantages one or other party.
What if my loan agreement contains no fallback options?
The position is much more complicated if a loan agreement contains no fallback options allowing a new rate to be set.
There is always the option that the lender(s) and the borrower can agree a new rate and amend the documentation as needed.
If the parties cannot agree on a new mechanism for calculating interest would the loan agreement be frustrated in its entirety or remain valid but with no obligation on the part of the borrower to pay interest because the mechanism for calculating the rate no longer worked?
If such a case came before an English court there is no doubt that the court would be keen to arrive at a solution to the problem that would minimise disruption in the finance markets. However, it is not easy to see how the principles of contract law that would be applicable would allow a court to arrive at a decision which achieved that objective for the following reasons:
- Convincing a court to imply a term into a loan agreement to replace any LIBOR based mechanism for calculating interest is not an easy task. The threshold for implication of a term is high and not the least of any claimants problem would be identifying with the requisite degree of certainty what term the parties would have chosen to use had they in fact thought about the matter.
- Can it really be said that the LIBOR based interest provision is simply a mechanism chosen by the parties to arrive at a figure enabling the court to substitute some other machinery. While this might be possible in some contracts which reference LIBOR peripherally it is doubtful that in a loan agreement where interest is a core obligation that a court would be willing to rewrite the price paid for the use of the money by the borrower.
- Any argument before a court that a LIBOR based interest clause should be construed in a manner which allow it to be read as referring to some other benchmark rate which might be calculated on a wholly different basis is likely to be rejected unless there is something in the terms of the loan agreement that clearly points to such a conclusion.
These difficulties suggest it is imperative for parties to loan agreement which contain no fallback mechanisms to start the process of changing the loan agreement in good time for 2021.