LIBOR, or the London Interbank Offered Rate, is a benchmark utilized in a variety of financial transactions (including the setting of interest rates in credit agreements). It was intended to be an average of the rates at which banks can obtain unsecured funding in the London interbank market for a specified time period in a specified currency. The rate is based on submissions by banks to the LIBOR administrator (currently ICE Benchmark Administration Limited) of their good faith estimate of borrowing costs and not necessarily actual transactions. Since estimates can at times be imprecise, together with the fact that (particularly after the financial crisis) unsecured credit was not generally available to banks in the London interbank market for periods of time, LIBOR as a benchmark was ripe for reconsideration.
On July 27th, Mr. Andrew Bailey, Chief Executive of the U.K. Financial Conduct Authority (FCA) announced that the FCA will no longer require banks to submit quotes for LIBOR rates in sterling by the end of 2021, indicating that the benchmark that underpins trillions of dollars in financial contracts will be phased out by 2021 and replaced with a benchmark that is more closely tied to interest rates for actual transactions in the lending markets. This announcement has prompted plenty of concerns and more than a few troubling headlines, especially given the extremely common use of LIBOR as an interest rate benchmark in commercial credit agreements, adjustable rate mortgages and other financing arrangements.
Notwithstanding some of the more recent reactions, the financial markets have seemingly taken this development in stride without much turmoil. There are a few reasons for this. First off, there are almost 4 ½ years before this reporting requirement ends, and work has already begun to determine LIBOR’s replacement.1 Second, LIBOR may still be available even if banks are no longer required to report their quotes, although caution has been expressed not to rely on this. Last, in the commercial loan context, customary fallbacks have been built into the “LIBOR” definitions in most well-drafted credit agreements that could provide short term solutions in the event of the unavailability of the LIBOR screen rate.
While the market does seem to be generally in agreement that it is premature to attempt to craft a definitive solution to this issue now, since there is insufficient information as to what will “replace” LIBOR (and how that replacement might affect the all-in rate in any particular credit facility), market participants can take proactive steps now to prepare for the eventual transition away from LIBOR to a new benchmark rate.
First, we would recommend a review of any applicable fallback provisions mentioned above to analyze whether these provisions should be amended now (or in the next couple of years) to attempt to facilitate a smoother transition to an eventual discontinuation of LIBOR (as opposed to temporary unavailability). As highlighted by the August 3rd LSTA article, “LIBOR (Transition) in the Loan Market”, these fallbacks were designed for temporary disruptions rather than a full transition away from the use of LIBOR as a benchmark. Moreover, some fallback language is better than others. For example, some language focuses on the unavailability of the publication of LIBOR, rather than the actual underlying rate itself. If the underlying benchmark rate goes away, as opposed to just the referenced information source, the ability of an agent or designated bank to specify an alternative information source as a screen rate will be of no use. Other fallback language is much more broad, in the sense that it permits a lender or agent to determine LIBOR “in good faith” based on a variety of factors that can include, among others, an offered quotation rate to first class banks for deposits in the London interbank market by the agent or a designated bank as well as a rate determined on the basis of quotes from designated “reference banks”. This creates more flexibility in this context, but it could be argued that it gives the lender or agent too much control in an environment where the traditional LIBOR has simply disappeared.
Second, in addition to fallback options in the actual definition of LIBOR, most credit agreements also contain provisions stating that if LIBOR is no longer ascertainable, or if the making or maintaining of LIBOR loans becomes illegal, then lenders are no longer required to make LIBOR loans and all new loans will be made as (and all outstanding loans will convert to) prime rate or federal funds rate loans. These loans will typically be more expensive than LIBOR loans, however, and thus, as the LSTA also points out, this is not a long term solution either.
Last, for new credit agreements, our recommendation would be that you work with your lawyers and other advisors to draft fallback provisions like those described above that deal with the eventual transition from LIBOR or adoption of a new benchmark in a sufficiently robust way. It would also be advisable to build into your credit agreements a specific ability to amend the agreements in ways that might be necessary in the wake of a LIBOR discontinuation or the adoption of a new benchmark rate. In the syndicated lending context, you may want to consider whether a lower than normal approval threshold for amendments to specify an alternative benchmark is warranted (i.e., majority lender as opposed to unanimous lender approval; agent-only approval in this context would be an even more aggressive approach). Finally, at a minimum, we would also recommend considering the inclusion of a provision in new credit agreements that requires the borrower and the lenders to negotiate in good faith with respect to any transition away from LIBOR or adoption of a new benchmark.
1. For example, in late 2014 the Federal Reserve established an Alternative Reference Rates Committee (ARRC), which recommended on June 22, 2017 that LIBOR be replaced with a broad Treasury backed “financing repo rate” (BTFR) that would be more reliable and data driven than LIBOR, would likely be lower than LIBOR (since it is a secured obligation), and could also evolve with the market. According to the August 17th Loan Syndications and Trading Association (LSTA) article, “LIBOR: Why You Should Care…And Shouldn’t Panic”, the market for trading overnight loans that use U.S. government debt as collateral is liquid and deep, with average daily trading volume of $660 billion, and it will likely remain robust over time; in addition, it was noted that the construction, governance and accountability of the BTFR is consistent with the “Principles for Financial Benchmarks” of the International Organization of Securities Commissions. It was also noted in the August 17th LSTA article that the Federal Reserve Bank of New York will start publishing the BTFR in mid-2018. It has been reported that some banks may start to transition to this standard prior to 2021, but likely not until there is broader buy-in and public comment. Additionally, it is not clear whether this benchmark would be adopted in non-U.S. transactions.