As a result of the well-publicized scandals involving LIBOR rate manipulation, British regulators announced plans in July 2017 to phase-out LIBOR by 2021 and replace it with a more reliable benchmark. In addition to other markets, the LIBOR phase-out will have a broad impact on the $4 trillion syndicated loan market, including currently existing loan documents that extend past 2021. Specifically, in the case of loan documents that reference a LIBOR rate and automatically fall back to prime or base rate if LIBOR is unavailable, the permanent phase-out of LIBOR will likely lead to the imposition of a higher interest rate if this fallback language is not amended. However, because LIBOR’s replacement has not yet been determined and the phase-out is at least three years away, it is probably premature at this time for borrowers to proactively seek amendments to their credit agreements. That being said, there are a few steps that borrowers can take now to be prepared.
The London Interbank Offered Rate (LIBOR) has been the global borrowing interest rate benchmark for nearly 50 years. Many borrowers pay interest under their credit agreements based upon a LIBOR interest rate, which is typically defined first by reference to the screen rate published by ICE Benchmark Administration Limited (IBA), and then to an alternative reference source if the screen rate is unavailable. Although the LIBOR rate is intended to represent the rate of interest at which major banks in London actually loan funds to each other, the financial crisis liquidity in the LIBOR market has dropped significantly to the point where more than 70% of 3-month LIBOR submissions are based on the judgment of the submitting bank as opposed to actual transactions. Due to this lack of liquidity and the negative publicity surrounding the LIBOR scandal, the United Kingdom Financial Conduct Authority (FCA), which has regulated LIBOR since April 2013, urged the phase-out of LIBOR by the end of 2021 and a transition to an alternative reference rate based on market transactions.
The uncertainty surrounding LIBOR’s fate is twofold. First, although the FCA has encouraged the phase-out of LIBOR, it has stressed that the phase-out is not mandatory and, further, that the IBA may continue to produce LIBOR rates after 2021 if it chooses to do so. Because of this, some commentators believe that LIBOR may continue to be quoted well beyond 2021 side-by-side with LIBOR’s replacement. Second, the FCA has put the burden of finding LIBOR’s replacement primarily on market participants, who have not yet settled on an alternative rate. The front runners at this point appear to be the Broad Treasury Financing Rate (BTFR) in the U.S., and the Sterling Overnight Index Average (SONIA) in the U.K., each of which is being considered as a replacement rate in the derivatives market. However, neither of these rates are ready replacements for LIBOR in the lending market because (i) each is an overnight rate as opposed to LIBOR, which is quoted for seven borrowing periods ranging from overnight to one year, and (ii) each is based on past transactions (i.e., each is “backward looking”) as opposed to LIBOR, which is a stated rate for a forward-looking term.
WHAT BORROWERS CAN DO TO PREPARE
The first thing borrowers can do is review their existing credit agreements to see how the interest rate is determined if LIBOR no longer exists. Although some credit agreements, such as the LSTA and LMA models, contain provisions that fall back to a waterfall of alternative reference rates if LIBOR is unavailable, such as a reference bank rate (i.e., an average of quotes of rates in the wholesale markets), the lenders’ cost of funds, or an alternative rate, many do not contain any fallback other than to simply default to base or prime rate loans. As these rates are historically higher than the LIBOR rate, they can lead to the borrower incurring a significantly higher interest expense than it anticipated at the time the borrower entered into the loan. However, even if a borrower is faced with a potential rate increase, given the uncertainty of both the timing of LIBOR’s phase-out and the replacement for the LIBOR rate, it is probably premature for it to approach its lender seeking an amendment.
If a borrower sees a potential issue with its LIBOR fallback language, it should closely monitor the marketplace to determine when and if it needs to take action. Given the magnitude that LIBOR’s phase-out will have on the loan market, it is highly unlikely that the market will not do all that it can well in advance of the phase-out to effectuate a smooth transition to an alternative standard. In particular, it is likely that LIBOR’s replacement will be determined well in advance of 2021 so borrowers can assess the impact on their credit agreements and be prepared to take appropriate action (e.g., seeking an amendment or prepaying the loan). Further, it is also likely that the FCA will have signaled whether it will continue to quote LIBOR after the phase-out and, if so, for how long. Depending on the length of time FCA continues to do so, borrowers with loans that mature past 2021 may be able to avoid amending their agreements entirely. Finally, by the time the phase-out is implemented, the market will have likely settled on a standard for appropriate LIBOR fallback language, which should then be much easier to incorporate into existing loan documents than starting from scratch. In short, although the temptation as a borrower may be to get ahead of the potential problem by proactively seeking an amendment, the best course of action is to monitor the situation and take a wait-and-see approach. One caveat to this is the situation where a borrower is already in the process of amending its credit agreement for other reasons, in which case it may as well amend the LIBOR fallback provision since the marginal cost of doing so is minimal.