LIBOR Is Fading Away
For decades, lenders have extended credit facilities, both large and small, using LIBOR-based interest rates and documents relating to these facilities, such as promissory notes as adjustable mortgages, and often contain LIBOR-related provisions.
Background of LIBOR
“LIBOR” ( the London Interbank Offered Rate) is an interest rate average calculated from estimates submitted by the leading banks in London. Organized in 1984 by the British Bankers Association, LIBOR has served as a premier benchmark for short-term (overnight to one year) interest rates around the world, with an estimated three trillion dollars in financing priced using LIBOR.
Since the global financial crisis in 2008, the number of LIBOR-based transactions has been decreasing. Investigations triggered by that crisis led authorities in the United States and the United Kingdom to discover that traders had manipulated LIBOR for bank and personal profit. Major banks were fined billions of dollars, and traders were convicted and sentenced to prison. By the end of the calendar year 2021, LIBOR will no longer be published.
The cessation of the publication of LIBOR has been anticipated for several years, giving rise to the need for “fallbacks,” i.e., replacements for LIBOR. In 2014, the Federal Reserve Board and the Federal Reserve Bank of New York formed the Alternative Reference Rates Committee (ARRC) to lead the transition from USD LIBOR. The ARRC subsequently developed the Secured Overnight Financing Rate (SOFR), which is based on transactions in the United States, as the new benchmark for USD denominated loans and securities. The Federal Reserve began publishing SOFR in 2018.
SOFR and LIBOR have some similarities, but also differ. Both reflect short-term borrowing costs. But, SOFR is based on an average daily volume of actual transactions in the United States totaling more than $1 trillion, while LIBOR is based on volumes of less than 1% of that amount, which is why SOFR is seen as reducing the likelihood of attempted manipulation. Further, SOFR is based entirely on transaction data, while LIBOR is based on transaction data complemented by “expert judgment.” SOFR is “backward looking,” whereas LIBOR is forward-looking, allowing borrowers to know the interest rate for a given interest period at the beginning of the period. Significantly, SOFR is purportedly a “risk-free” rate because it is based on actual transactions in U.S. Treasuries. If for some reason, however, market transactions in Treasuries “freeze up,” as happened in September 2019, the rate setting becomes uncertain. In the event of market disruptions, the level of reserve requirements to meet prudent regulatory standards can be materially different under SOFR than under LIBOR, because of the potential that banks will refuse to lend, so transactions will not occur. Parties involved in financial transactions need to be aware of these differences when they consider replacing LIBOR with SOFR.
The development of SOFR is only one component of a challenging transition away from LIBOR. Another component relates to financial derivatives such as transactions that involve interest-rate swaps, e.g., LIBOR to a fixed interest rate. For a long time, the International Swap Dealers Association (ISDA) has been developing an appropriate fallback, particularly given that the fallbacks in the 2006 ISDA Definitions were not drafted in contemplation of a permanent cessation of LIBOR. On October 23, 2020, the ISDA published its 2020 IBOR Fallbacks Protocol and its ISDA IBOR Fallbacks Supplement, which become effective on January 25, 2021. The Protocol and Supplement will provide parties involved in financial transactions with a means to replace the rate benchmark fallbacks currently incorporated in swap transactions.
Transition and Implementation
With the end of LIBOR only a year away, lenders and borrowers should undertake preparations in earnest. In a joint statement, the Federal Reserve Board, the Federal Deposit Insurance Corporation, and the Office of the Comptroller of Currency have encouraged banks to begin transitioning loans away from LIBOR “without delay” While SOFR and the ISDA Fallbacks Protocol and the ISDA Fallbacks Supplement are significant fallbacks, implementing them presents challenges to lenders and borrowers.
- Existing LIBOR-based loans may or may not contain fallbacks, and even if they do, the fallbacks may be inadequate. For example, a fallback provision in an existing loan may be something as simple as “a comparable replacement rate determined by the Bank”. But a wholesale substitution of SOFR for LIBOR without a careful evaluation of the loan may be risky. As an illustration, legislation that has been introduced in New York would provide a remedy for contracts that lack adequate fallbacks for the discontinuation of LIBOR.
- Even with fallback provisions, documents relating to existing loans may need to be amended. A key consideration for lenders is whether the cost of amending the documents can or should be passed on to borrowers, particularly given that the phase-out of LIBOR was not caused by either party.
- A complicating factor with respect to both existing and new loans is whether a swap is involved. Particular attention will need to be given to the new ISDA Fallbacks.
- With respect to new loans, lenders can use a “hardwire” method whereby fallback provisions included in the loan documents will automatically become effective after LIBOR ceases to be published.
- Alternative reference rates such as AMERIBOR, which is operated by CBOE Global Markets, Inc., on its AFX Platform, may be more appropriate for some lenders, especially smaller institutions. AMERIBOR is a weighted index of overnight unsecured loans and is subject to regulatory supervision by the Committee on Benchmark Oversight. The Federal Reserve Board has expressly recognized that AMERIBOR is an appropriate reference rate for banks.
Conclusion for Lenders
With the cessation of LIBOR, lenders are encouraged to:
- Perform an inventory of their loan portfolios to identify LIBOR-based loans
- Develop a plan to communicate critical information to their borrowers
- Take the steps necessary so that their systems and software can handle the LIBOR transition
- Discuss with legal counsel the actions that need to be taken, including the development of new form documents