Preparing for LIBOR ending - actions for corporate borrowers
LIBOR will soon be no more and those with legacy contracts are being urged to act now before its cessation on 31 December 2021.
- From 31 December 2021, LIBOR, the globally used benchmark interest rate, will no longer be published for most settings;
- The Bank of England's working group has recommended the Sterling Overnight Index Average rate (SONIA) as the preferred reference rate to replace LIBOR;
- It is estimated that contracts with a total value in excess of $350 trillion will need to be converted from LIBOR to SONIA or another replacement rate;
- The fallback position in contracts which do not already anticipate a move away from LIBOR is typically a "cost of funds" calculation which is invariably more expensive for borrowers than using a LIBOR + margin basis for calculating interest rates;
- Those subject to facility agreements or other finance agreements which reference LIBOR should be taking preparatory steps now, including: undertaking a review to assess where and how LIBOR features in the company's contracts, reviewing those contracts with a particular focus on any fallback provisions and discussing with their lenders how the cessation of LIBOR can be managed.
What is LIBOR?
The London Interbank Offered Rate (LIBOR) is a benchmark interest rate at which major global banks lend to one another in the interbank market for short-term loans. A panel of banks are asked to submit the rate of interest which they would charge. Those figures are averaged to calculate LIBOR. LIBOR is then used as a reference rate to calculate the interest payable in respect of a wide range of financial transactions.
The intention was that LIBOR would reflect actual transactions in the interbank lending market, so that it would be a more accurate and up to date reflection of economic and market conditions than the Bank of England base rate. However, in 2012 it emerged that those responsible for reporting their own banks' rates for the purposes of calculating LIBOR had colluded with each other to manipulate the reported rates. In the wake of the scandal it became clear that LIBOR, amongst other interbank offer rates, was neither an accurate nor reliable benchmark and susceptible to manipulation. Despite attempts at reform, the credibility of LIBOR very much remains in question. For this reason and a significant reduction in the number of unsecured interbank transactions on which LIBOR is based, LIBOR will shortly be phased out. An alternative benchmark rate was sought and it was proposed that this should be a rate which is not susceptible to manipulation by false reporting, also known as a risk-free rate (RFR).
What is changing?
From 31 December 2021 all LIBOR rates will either cease to be published or will no longer be representative for sterling, euro, Swiss franc and Japanese yen LIBOR settings, as well as the 1-week and 2-month US dollar LIBOR settings.
From 30 June 2023, the remaining US dollar LIBOR settings will also cease.
Whilst various risk-free rates have been identified as replacements for LIBOR, the working group convened by the Bank of England recommended the Sterling Overnight Index Average (SONIA) benchmark as its preferred RFR.
The majority of the sterling loan market is expected to transition to SONIA, compounded in arrears. However, for certain transactions it may be more appropriate to use a fixed rate of interest, a central bank rate (e.g. the Bank of England's Bank Rate), a forwarding looking term rate based on SONIA or a different alternative rate altogether.
Whereas LIBOR is quoted for multiple currencies, RFRs are currency-specific. For example, the proposed RFR to replace US dollar LIBOR is the Secured Overnight Financing Rate (SOFR). This, paired with the varying publishing times owing to different time zones, will need to be accommodated for in any affected contracts.
The transition from LIBOR is one of the most complex challenges for financial institutions in recent years. LIBOR exists in five currencies and seven borrowing periods, and is used in calculating floating or adjustable interest rated for numerous financial products. The transition is not simply about new transactions but converting outstanding LIBOR contracts – which are widely estimated to be worth in excess of $350 trillion in value.
Contracts which refer to LIBOR and will remain live after December 2021 but which do not contain a mechanism to deal with the discontinuation of LIBOR at the time of drafting (Legacy Contracts) will need to be amended to convert to a replacement rate. For the most part, Legacy Contracts will be those entered into prior to 2017, however careful review of all contracts will be required (more below).
These Legacy Contracts may not perform as expected before LIBOR ends. Liquidity in the unsecured market is expected to decline and as a consequence there may not be sufficient transaction-based submissions in the future for the rate to remain representative. If there is no provision in a Legacy Contract for an alternative means of calculating the applicable interest rate, the fallback position is typically a "cost of funds" approach which requires the lender to make a manual calculation of the cost of providing the lending. This is not only time consuming but costly and such costs will inevitably be passed on to borrowers. Therefore, the time to act is now.
What can borrowers do now to prepare?
Carry out a comprehensive review
- In the first instance, businesses should initially carry out a review to assess where and how LIBOR is used in the business and its contracts. The scope of the review will largely depend on the nature of business and the financial transactions which the business has entered into. Dependant on the size of the business and the extent to which it relies on LIBOR, electronic discovery software and artificial intelligence can be utilised to assist with this review;
- The review of contracts which use LIBOR should consider:
- parties to the contracts;
- expiry date of the contract;
- whether the contract includes effective fallback provisions – rates to be used in the absence of LIBOR, with a "cost of funds" approach to be avoided where possible;
- economic and litigation risks of the existing fallback provisions, for example as a result of increased interest costs or the risk of disagreement about the applicable rate;
- impact on accounting and tax aspects; and
- Many companies will have entered into interest rate hedging (or swap) arrangements with lenders in order to obtain a degree of certainty of costs and managing its cash flow. Care will need to be taken to ensure that the same benchmark is used for both the loan and the swap and that it is not necessary to exit these arrangements (with the accompanying risk of extremely high early termination costs).
- Do the fallback provisions in a contract accommodate a permanent cessation of LIBOR or were they simply inserted to deal with a temporary technical issue affecting the calculation of LIBOR? Relying on fallback provisions which were not drafted with the permanent cessation of LIBOR in mind may have unintended consequences. The interest rate may default to a historic screen rate - effectively turning a variable rate of interest to a fixed rate of interest. This may be particularly undesirable for one party;
- To be effective, fallback provisions need to specify:
- The trigger event to prompt transition from LIBOR to a replacement rate;
- The replacement rate;
- The spread adjustment to align the replacement rate with the LIBOR benchmark;
- Where the contractual fallback provisions leave the position either unclear, open to interpretation or unintentionally more advantageous to one party, there is a real risk of a dispute arising. Parties should take steps to address these uncertainties;
- If the Legacy Contract doesn’t include any effective fallback provisions these will need to be introduced by an amendment of the Legacy Contract following renegotiation between the parties. Whilst also this affords the ability to carry out a general administrative "tidying up exercise", care should be taken that banks are not seeking to use this an opportunity to re-open negotiations of commercial terms;
- Banks and other financial institutions are required by the FCA to communicate with their customers in good time in order to allow time to consider all of the options available and respond in advance of the December 2021 deadline.
Michelmores' Banking and Finance team have already advised a number of borrowers in relation to the transition away from LIBOR. We can assist businesses with reviewing contractual provisions, advising on exposure and negotiating amendments if required. If you would like to discuss the impact of these changes on your business please contact Anna Thompson.
Anna Thompson is a Senior Associate in Michelmores' Banking and Finance team. She has extensive experience advising a wide range of borrowers on finance transactions. Her clients include corporate borrowers, banks, alternative funders and development finance institutions.