LIBOR Phase-Out

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When we last blogged in January about what borrowers can do to prepare for a potential cessation of the London interbank offered rate (“LIBOR”), there was a lot of uncertainty surrounding whether LIBOR would actually be replaced, what that replacement would be, and whether the market would have sufficient time to react.  Due to this uncertainty, we advised taking a “wait-and-see” approach with respect to borrowers reaching out to affirmatively modify their existing loan documents that reference a LIBOR rate to include LIBOR fallback language, except in the cases where borrowers were already in the process of negotiating an amendment for other reasons.  Although there has been some significant movement in both the development of LIBOR fallback language and the determination of the replacement rate since our last blog post, there has not yet been enough movement for us to change our advice at this time.

ARRC FALLBACK LANGUAGE

One major development since our last blog post is the publication by the Alternative Reference Rates Committee (the “ARRC”) of its Consultation Regarding More Robust LIBOR Fallback Contract Language for New Originations of LIBOR Syndicated Business Loans (the “Consultation”) on September 24, 2018.  As noted in our last blog post, the ARRC was established in 2014 by the Board of Governors of the Federal Reserve System and the Federal Reserve Bank of New York for the purpose of recommending a LIBOR alternative, identifying best practices for contract sturdiness in the interest rate market, and creating a plan to implement the new reference rate.  In the Consultation, the ARRC offered two general proposals for sample LIBOR fallback language and asked market participants for their commentary up until November 8, 2018.  The LIBOR fallback language was developed by a working group of the ARRC co-chaired by the Loan Syndications and Trading Association (“LSTA”), a highly influential trade group in the syndicated loan market, which gives it a lot of credibility in the marketplace.

Although the fallback language is not yet finalized, even in its current unfinished state, it provides some valuable guidance for borrowers who are currently involved in negotiations over either a new credit agreement or an amendment to their existing credit agreement.  At a high level, the Consultation takes two basic approaches to LIBOR fallback language, the amendment approach and the hardwired approach, each of which is discussed below.  Please note that the Consultation also discusses the different consent requirements under the amendment approach and hardwired approach, which are not addressed in this article.

THE AMENDMENT APPROACH

The amendment approach provides a streamlined mechanic for negotiating a replacement to LIBOR and a replacement LIBOR spread upon the occurrence of a “trigger event.”  A trigger event is essentially an action that gives rise to the conversion from LIBOR to a new reference rate.  Under the amendment approach, a trigger event is basically either (i) a public statement that LIBOR will fail to be published, or the actual failure of LIBOR to be published (a “Benchmark Discontinuance Event”), or (ii) a determination by the administrative agent or required lenders that new or amended loans are incorporating a new rate to replace LIBOR.  If either of these trigger events occur, the Borrower and the administrative agent may amend the agreement to replace LIBOR with an alternate benchmark rate (including a replacement benchmark spread), in each case giving due consideration to then-existing market convention and endorsements or recommendations by relevant governmental bodies such as the Federal Reserve Board, the Federal Reserve Bank of New York or a committee convened by either or both of them (each a “Relevant Governmental Body”).

As you can see from the above, the amendment approach is flexible in many respects, which is positive in some ways and negative in others.  On the positive side, it allows for LIBOR language to be amended if other lenders are incorporating a rate other than LIBOR, which could be well before the time, if any, that LIBOR becomes unavailable.  This gives borrowers and lenders the flexibility to get well ahead of the LIBOR issue if they desire.  Additionally, the amendment approach does not automatically replace LIBOR with a fixed replacement rate such as the Secured Overnight Financing Rate (“SOFR”), the alternative replacement rate selected by the ARRC.  Instead, it gives borrowers and lenders the ability to choose both the replacement rate and the applicable spread.  On the negative side, the ARRC pointed out in the Consultation that it may not be practicable to use the amendment approach if thousands of loans must be amended simultaneously due to a potential LIBOR cessation.  Moreover, this added flexibility comes at the price of allowing the lender or borrower to “game” an amendment depending on whether the credit market is then lender-friendly or borrower-friendly.  In a lender-friendly market, the lenders could block a proposed rate and force the borrowers into a higher interest rate (such as the alternate base rate).  In a borrower-friendly market, the borrowers could block any proposed spread to the replacement rate.  Although the hardwired approach addresses these concerns, it has its pros and cons as well, which are discussed below.

THE HARDWIRED APPROACH

As suggested by its name, under the hardwired approach the LIBOR replacement language is hardwired into the agreement, which is obviously much less flexible than the amendment approach.  Similar to the amendment approach, the replacement language also becomes effective upon the occurrence of a trigger event, which is either (i) a Benchmark Discontinuance Event, or (ii) an agreed upon number of outstanding publicly filed syndicated loans being priced over term SOFR plus a replacement benchmark spread.  If either of these trigger events occur, LIBOR is automatically replaced in accordance with a waterfall approach where the first available option is chosen from the following: first (1) Term SOFR, or, if not available for the appropriate tenor, interpolated SOFR, then (2) Compounded SOFR, then (3) Overnight SOFR, then (4) a rate chosen giving due consideration to then-existing market convention and endorsements or recommendations by any Relevant Governmental Body.  In addition, the existing LIBOR spread is automatically replaced by a spread adjustment, or method of calculating a spread adjustment, that has been selected, endorsed or recommended by the Relevant Governmental Body or, if not available, the spread adjustment or method of calculating the spread adjustment is selected by the International Swaps and Derivatives Association, Inc.

Like the amendment approach, the hardwired approach has its pros and cons.  On the pro side, it provides borrowers and lenders with the certainty that if and when LIBOR is discontinued, it is highly likely that some version of SOFR will be inserted as a replacement rate with a market replacement spread.  On the con side, as of now SOFR is only being quoted as an overnight rate, so it is currently unclear what the actual replacement to LIBOR (and the replacement spread) will look like if LIBOR is discontinued.  That being said, the ARRC has said that part of its transition plan for implementing SOFR will include the development of multiple forward rates, so it is likely that the waterfall will be fully populated well before LIBOR’s potential cessation.

In summary, although the ARRC has made great strides in drafting LIBOR fallback language, at the current time we do not think it is far enough along to advise borrowers to proactively request amendments to their existing credit agreements with LIBOR-based loans.  However, if a borrower is currently involved in an amendment or a new credit, we still recommend that they consider including either the amendment approach or the hardwired approach in its current form.  Although neither approach is perfect, both are preferable to the option of automatically defaulting to the alternate base rate.   

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.

BACKGROUND

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.