Retirement of LIBOR - Contractual consequences

• The FCA has announced its intention to withdraw the LIBOR benchmark setting scheme by 2021.
• It is not clear whether transitional arrangements will be put in place to cover current financing transactions at the date of LIBOR retirement.
• Neither is it clear what replacement benchmarks will be used for different currencies and tenors.
• Parties need to consider what the consequences of LIBOR Retirement will be for their existing contracts.

Introduction

The Financial Conduct Authority (FCA) of the United Kingdom has announced its intention to retire the LIBOR benchmark interest rate setting scheme (LIBOR Retirement) by 2021. It is not clear what will replace it. According to the FCA, consensus has been reached among derivative market participants on the preferred alternative reference rates. In April 2017, the Risk Free Rate Working Group in the UK selected the Sterling Over Night Index Average (SONIA) as its proposed alternative benchmark, while in June 2017 the Alternative Reference Rates Committee in the US announced its choice of a broad Treasuries repo rate. Other alternative benchmarks include the Euro Over Night Index Average (EONIA), Swiss Average Rate Overnight (SARON) and Tokyo Overnight Averaged Rate (TONAR). However, the adoption of these alternatives is not certain. The Loan Market Association (LMA) has indicated that although it is in discussions with the relevant trade associations such as LSTA, APLMA, JSLA, ACT, ISDA, ICMA, AFME and others on a co-ordinated approach, ultimately a transition to a new rate needs to be a market led solution.

As their name indicates, many of these alternatives are currency and tenor-specific. For example, SONIA relates exclusively to Sterling and it is not immediately obvious how an overnight rate can be used to replace a three-month LIBOR rate. The underlying economic assumptions are different. In addition, the risk free overnight rates are based on historical data so rates would not be available until the end of a given interest period.

The FCA has suggested that there may be a transitional period following LIBOR Retirement during which LIBOR will be maintained as a shadow benchmark rate for use in transactions which are still current. This will require panel banks to continue submitting quotes after 2021 and the administrator to agree to continue performing its role in a rapidly diminishing market. Part of the reason for LIBOR Retirement is the lack of hard data to justify the LIBOR rates published. Following LIBOR Retirement, it seems inevitable that fewer banks will provide quotes: consequently, the amount of such available data will inevitably diminish and LIBOR quotes will be even less reliable.

Parties need to consider the consequences of the LIBOR Retirement on contracts reliant on LIBOR if:

1. No transitional arrangements are put into place maintaining LIBOR which are effective in the context of that particular contract
2. There is no new law relating to the interpretation of LIBOR following its Retirement
3. There is no agreement between the parties as to how the particular contract should be amended

Although legislative change (in which a law would state that the term “LIBOR”, when used in a contract, would henceforth be interpreted as being a reference to a new benchmark rate) would be superficially the most attractive solution, it would in fact be problematical in that:

1. Its “one size fits all” approach may produce unsatisfactory consequences in some contracts
2. That change would need to be implemented, preferably consistently, in every country whose laws are used to govern contracts based on LIBOR

The effect of LIBOR Retirement on a particular contract needs to be analysed in the context of the terms of that contract. This briefing considers its effect on a loan agreement following the LMA single currency term facility agreement (the LMA Facility) which uses LIBOR as a benchmark rate.

Screen Rate

The LMA Facility provides for the benchmark to be LIBOR as determined in accordance with the “Screen Rate”. The Screen Rate is defined by reference to the relevant Thomson Reuters page but the definition continues to say that “If such page or service ceases to be available, the Agent may specify another page or service displaying the relevant rate after consultation with the Company”.

The “relevant rate” refers back to the London interbank offered rate and so this proviso does not assist where LIBOR is replaced by a conceptually different benchmark.

The LMA Facility provides for an option allowing the amendment of the definition of the Screen Rate with the agreement of the obligors and the “Majority Lenders”. If that option is not taken up, unanimous lender consent for a replacement benchmark will be required.

If no agreement is reached on how the definition of Screen Rate should be amended and no transitional arrangements are put into place, there will be no Screen Rate available following LIBOR Retirement. In those circumstances it is necessary to consider the market disruption clause set out in the relevant facility. It is important to note that market disruption clauses are often heavily negotiated and vary significantly from transaction to transaction. In this briefing, we are confining ourselves to a consideration of the LMA Facility.

Market Disruption Clauses

The LMA Facility offers two options for dealing with the situation where the Screen Rate is not available. The first option suggests an initial fall back to historic Screen Rates which is inappropriate as its effect would be to freeze the benchmark at rate at the date of LIBOR Retirement.

The second option falls back to a Reference Bank rate or, if not available, the lenders’ cost of funds (either on a weighted basis or on a lender by lender basis) until such time as a substitute basis is agreed. It is reasonable to assume that a Reference Bank rate will be difficult or impossible to obtain – many banks are currently refusing to participate in this system.

Parties should be aware therefore that, absent any other agreement or legislative change, the effect of LIBOR Retirement will almost inevitably be a fall back to some form of cost of funds calculation. Borrowers will lose the protection given to them by having an objective benchmark which insulates them from the consequences of an increase in a lender’s cost of funds caused by the deterioration of its credit.

Lenders should also be aware that the market disruption clause is quite difficult to operate when it falls back onto cost of funds. There were many disputes relating to this clause at the time of the global financial crisis in 2008 and it is in this context that the precise wording of the clause becomes key.

Options for New Facilities

The consequences of LIBOR Retirement with no effective transitional period need to be considered. It may be that some parties will be willing to take the risk that this situation will not arise or assume that, if it does, they will be able to reach some agreement as to an appropriate replacement with their counterparties.

To facilitate any agreement on a replacement rate, parties may seek to ensure that new facilities allow the definition of Screen Rate to be amended with Majority Lender consent.

Alternatively, the parties could try to pre-agree a new fallback benchmark rate to be used following LIBOR Retirement – but it is not immediately obvious what that rate should be.

When a new benchmark rate is agreed, it is highly unlikely that it will be appropriate to amend documents simply by replacing references to LIBOR with ones to the new rate. The mechanics involved in calculating the base interest rate will need adjustment. If the possibility of a new benchmark rate being used at some point in the future is agreed, it will be necessary to include a further assurance clause under which the parties agree to make such amendments to the contract as are necessary or desirable to ensure the proper implementation of that new benchmark.

The assumptions made when pricing the facility may become obsolete. In most cases, a change in the benchmark rate should not affect the margin agreed between borrower and lenders. However, it may be that the economics of the facility are not based on the lenders being exclusively compensated for their cost of funds by the payment of LIBOR. For example, some margins include a “liquidity premium” the purpose of which is to compensate the lenders for LIBOR being too low and which may no longer be appropriate if a new, more accurate benchmark rate is agreed. Certain banks are able to fund loans at rates below LIBOR and so gain an additional return by using LIBOR as a benchmark rate and will not want to lose that benefit if LIBOR is substituted. There may be financial repercussions to the replacement of LIBOR which need to be considered. 

It is difficult to foresee the full implications of LIBOR Retirement – but there will be implications, both mechanical and financial. Imaginative thinking will be required over the next four years to ensure that the $350 trillion worth of LIBOR-based contracts are smoothly transitioned to a new basis. It will not be easy.