LIBOR's Long Good-Bye
Ready or not, borrowers are involuntarily seeing changes in the interest rates they are being charged. Why, you ask? Because there are serious, systemic risks associated with the most widely used interest rate basis in the world – the London Interbank Offered Rate (or LIBOR), including the LIBOR Rate for U.S. Dollar denominated loans and other financial products (USD LIBOR). The situation is so serious that regulatory authorities have said that “given consumer protection, litigation, and reputation risks, [they] believe entering into new contracts that use USD LIBOR as a reference rate after December 31, 2021, would create safety and soundness risks . . .”. In our view, all of this means that borrowers should prepare themselves to deal with forthcoming interest rate changes in as effective a manner as possible (and not wait until the inevitable occurs later this year).
THE BACK STORY.
Historically, LIBOR has been an interest rate quoted for borrowing and derivative transactions in U.S. Dollar and other major currencies (UK Pound Sterling, Swiss Franc, Euro, and Japanese Yen) based on rates reported by banks for interbank lending in the London market. Beginning as far back as 2005, there have been lengthy analyses of problems associated with LIBOR and, finally, on September 28, 2012, the United Kingdom’s Financial Conduct Authority (FCA) published its “Wheatley Review” concluding that market participants should reconsider their use of LIBOR. Thereafter, LIBOR was quickly unmasked as subject to manipulation and self-dealing as described in a series of high-profile criminal cases against large financial institutions (such as Deutsche Bank and UBS) and articles (such as “The Unraveling of Tom Hayes: Rain Man in Trouble” by David Enrich, Wall Street Journal 2015). And the underlying issues continue to be litigated to this day. See , In re ICE Libor Antitrust Litigation, case number 20-1492 before the U.S. Court of Appeals for the Second Circuit.
In response to these scandals, in 2014, the Board of Governors of the Federal Reserve System and the New York Federal Reserve Bank, in cooperation with the U.S. Department of Treasury, the U.S. Commodity Futures Trading Commission, and the U.S. Office of Financial Research, convened the Alternative Reference Rate Committee (the “ARRC”). Comprised of major market participants , the ARRC was charged with identifying an alternative to LIBOR for U.S. Dollar denominated transactions, preparing a plan of action to facilitate the use of the alternative reference rate and suggesting best practices for avoiding another meltdown in the future.
DEALING WITH THE PROBLEM.
The ARRC estimated that the total exposure to USD LIBOR in 2016 to be close to $200 trillion (10 times the U.S. Gross Domestic Product). In fact, according to the ARRC:
“Due to the broad use of USD LIBOR as a reference rate, all financial market participants, including retail customers, corporations, issuers, investors, asset managers, service providers of financial products and large financial institutions are impacted by the risks associated with USD LIBOR….In addition, LIBOR is extensively used across a range of business processes (for example, accounting, valuation , and financial modeling) across many industries….[B]eyond financial products and legal contracts, businesses that have exposure to USD LIBOR embedded in their business processes are also likely to be impacted.” Alternative Reference Rates Committee, Frequently Asked Questions Version: December 18, 2020, Section 9.”
By 2017, the ARRC identified the Secured Overnight Financing Rate (SOFR) as its recommended alternative to USD LIBOR. As a rate calculated based on the cost of overnight borrowing secured by U.S. Treasury securities, SOFR is a virtually risk-free rate (unlike LIBOR which depends on submissions by lenders as to their costs of interbank borrowing), but (i) with an underlying transaction value (averaging daily between $700 billion and $1 trillion) larger than other U.S. money markets, (ii) with a widely diverse range of direct and indirect market participants, (iii) being administered by the New York Federal Reserve Bank, and (iv) being subject to review by the New York Fed Oversight Committee, SOFR has impressive credibility – just what is wanted in the replacement for USD LIBOR.
To complete its proposal for the use of SOFR as a reference rate when USD LIBOR ceases to be available, the ARRC proposed “fallback language” for various types of transactions, including bilateral and syndicated loans, to insure smooth transition of rates when appropriate and to avoid undue market disruption and impairment of normal functioning of markets including business and consumer lending. (Many, if not most, existing USD-LIBOR based loans currently have “fallback” provisions providing that, if USD-LIBOR is not available, a “prime rate” will apply (and, to borrowers, that “fallback” rate is almost always an unwanted rate that is higher than USD-LIBOR has been)).
THE PLOT THICKENS.
On March 5, 2021, the FCA announced that the publication of LIBOR on a representative basis would cease for (i) the one-week and two-month USD LIBOR settings immediately after December 31, 2021, and (ii) the remaining LIBOR settings immediately after June 30, 2023. In other words, it became likely that (i) after December 31, 2021, lenders and borrowers could not rely on US LIBOR as actually reflecting the cost to borrowers of borrowing for one-week and two -month periods and (ii) after June 30, 2023, the lenders and borrowers could not rely on US LIBOR as actually reflecting the cost to borrowers of borrowing for any other period. If LIBOR did not reflect the cost of borrowing to lenders, the lenders could not make loans in the “cost plus” world of commercial loans and, as suggested above, the cost of borrowing would likely increase to a “prime rate” or other rate that is unwanted by borrowers.
Also on March 5, 2021, the ARRC published its opinion that the announcements by FCA (and the ICE Benchmarks Administration which administers LIBOR rates) established a clear end date for USD LIBOR and a path to adoption of alternative interest rates. Therefore, the ARRC stated that:
“Given the supervisory guidance from relevant U.S. authorities regarding no new USD LIBOR exposures post 2021, plus the best practices of the ARRC to achieve this outcome, we expect liquidity to shift away from USD LIBOR in the coming months. It is time for firms of all sizes, intermediaries , and end-users to start executing their plans to transition to SOFR and other robust alternative reference rates.”
In plain English, this means that LIBOR is “going away” at the end of this year (2021) and that lenders and Borrowers need to execute plans for transition to another rate. To be clear about that statement, the ARRC thereafter (on March 25, 2021) published its proposed supplemental fallback language indicating that a Benchmark Transition Event had already occurred and making other conforming changes. See,e.g., ARRC Supplemental Recommendations of Hardwired fallback Language for LIBOR Syndicated and Bilateral Business Loans.
REPLACEMENT OF USD LIBOR BY SOFR.
A. Difference between USD LIBOR and Term SOFR
So what does it mean if financial institutions attempt to transfer their USD LIBOR-based financings into SOFR -based financings as proposed by the ARRC? The ARRC has proposed terminology that readily effects a transition to SOFR, and many loan agreements have already been modified to permit that transition to occur without further amendments. See, e.g. Recommended Fallback Language for Floating Rate Notes and Syndicated Loans and Recommended Fallback Language for Bilateral Business Loans and Securitizations.
However, regardless of whether loan agreements are revised to reflect the ARRC’s recommendations to date, borrowers should seek to understand changes in interest rates, the proposed transition process, and related uncertainties, particularly uncertainties created by the differences between existing and proposed interest rate bases. For example, USD LIBOR has a “forward looking” element built into its application. While SOFR can establish rates based on actual past performance, unlike USD LIBOR it cannot estimate the cost of borrowing for for-established “interest periods” into the future. Similarly, interest rate spreads for SOFR need to be adjusted to reflect the risk-free nature of SOFR (as opposed to LIBOR), and borrowers will need to estimate costs of future borrowing that, in the past, could be fixed for certain LIBOR “interest periods.”
B. Term SOFR
The ARRC (and many other market participants) had expected a forward looking SOFR (Term SOFR) market to develop before transition away from USD LIBOR became necessary, but on March 23, 2021, the ARRC announced that it could not recommend a Term SOFR by mid-2021 and encouraged market participants to continue transitioning away from USD LIBOR based on more reliable reference points, such as SOFR averages and index data. See,.e.g., Market Participants Encouraged to Transition without Reliance on SOFR Term Rate. For example, interest can be calculated in arrears based on daily overnight rights. While such rates cannot be determined upfront as could USD LIBOR Rates, the average of daily overnight rates accurately reflect movements in interest rates over a period of time and can smooth out “idiosyncratic, day-to-day fluctuations in market rates.” See ARRC, A User’s Guide to SOFR: The Alternative Reference Rate Committee (April 2019). However, ever optimistic, the ARRC announced on April 2021, its “Key Principles for a Forward-Looking SOFR Term Rate”, but again, the ARRC encouraged market participants not to wait for a term rate. See,e.g., ARRC Announces Key Principles for a Forward-Looking SOFR Term Rate.
C. Spread Adjustments
Since, as noted above, SOFR is a virtually riskless interest rate (and LIBOR is/was not), to preserve the difference between the cost of a lender’s funding and its lending rate, a spread adjustment needs to be added to the stated interest rate in loan agreements and, in fact, that idea is incorporated into the ARRC’s suggested transition terminology. On March 17, 2021, the ARRC announced that it had selected the London Stock Exchange Group (LSEG) to publish its recommended spread adjustments for use in loans agreements that contain ARRC-recommended fallback provisions, and on April 8, 2020, the ARRC recommended a spread adjustment methodology based on a historical median over a five-year lookback period calculating the difference between USD LIBOR and SOFR. (For consumer products, the ARRC recommended an additional one-year transition period). Real estate borrowers who hedged their interest rate risks with interest rate swaps and similar products should find comfort in the fact that this calculation methodology reflects the same methodology being employed by the International Swaps and Derivatives Association (“ISDA”).
ALTERNATIVES TO SOFR?
SOFR is not necessarily a foregone conclusion as a replacement for USD LIBOR. On November 6, 2020, the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation, and the Office of the Comptroller of the Currency published a Statement on Reference Rates addressing, in part, issues raised by the fact that SOFR is not credit sensitive (being a virtually risk-free rate). As a result, this statement says that banks “should assess the appropriateness of alternative reference rates in light of their funding costs and their customers’ needs” and should include in their agreements “fallback language that provides for the use of a robust fallback rate if the initial reference rate is discontinued.”
Thereafter, on April 8, 2021, the Loan Syndications & Trading Association (LSTA) published its “‘Credit Sensitive Rate Slot-In Rider for Fallback Language” suggesting loan agreement language facilitating the use of term rate alternatives to SOFR. Building on alternative reference rates being developed by Bloomberg, IBA, HIS Markit, and American Financial Exchange, the rider contemplates that, in syndicated credit agreements, alternative benchmark rates would be where (i) the rate is displayed on a screen or other information service selected by the Administrative Agent [or Lender}, (ii) the rate is administratively feasible for the Administrative Agent [or Lender}, (iii) the benchmark administrator publishes the rates in accordance with the International Organization of Securities Commission’s Principles for Financial Benchmarks, (iv) the rate has previously been referenced in a minimum number of other Dollar denominated credit facilities that are identified by the Administrative Agent [or Lender], and (v) the rate is publicly available. Publication of this rider seems to have been prescient, because, on April 14, 2021, ISDA released an estimate that only 4.7% of derivative contracts traded in March 2021 were pegged to SOFR, surely indicating a slow start for the new proposed new benchmark SOFR interest rate.
CONSIDERATIONS FOR BORROWERS
A. What “fallback” is a lender adopting?
While, as indicated above, it is likely that SOFR will play a role in any fallback, a borrower will want to know more about the rate proposed by a lender in order to properly adjust projections and systems reflecting USD LIBOR. Among the questions of importance to a borrower are:
i. what rate would apply if there is no replacement for USD LIBOR agreed upon by the borrower?
ii. if there is a replacement for USD LIBOR, what rate(s) does the lender propose to replace it?
iii. how will the replacement rate be calculated by the lender (term, in-arrears, in-advance)?
iv. can the borrower independently ascertain the replacement rate by reference to an externally available source?
v. what is the anticipated effect of the proposed replacement rate (i.e. historically, how has the rate correlated with other rates such as LIBOR)
vi. when will the replacement will be effective? and
vii. what consent rights does the borrower (or any other party) have with respect to the change in interest rates?
B. How is a lender transitioning away from USD-LIBOR?
The ARRC has proposed three methods for executing the transition away from USD LIBOR – the hardwired approach (in which case terminology spelling out the new alternative rates are spelled out in an agreement prior to transition), the amendment approach (in which a simplified amendment is used to implement changes to effect the transition), and the hedged-loan approach (intended to help align loan agreement changes with related changes under interest rate swap and other ISDA-related products). The recommended language by the ARRC in each for these approaches varies a bit, depending, in part, on whether the underlying loan is a bi-lateral loan or syndicated.
At a minimum, a borrower will want to confirm that its lender’s proposed transition is being made on terms conforming with the ARRC’s and regulators’ recommendations with a view toward maintaining for the borrower (to the extent feasible) its originally-negotiated economics. If a borrower has hedged its loan position, the borrower should consider confirming that the hedged approach is being adopted and will suit its tax, accounting, and other business requirements.
C. System and regulatory limitations
Borrowers have good reason to be proactive in understanding changes being made in their interest rates, but their responses to proposed rates should be made with an understanding of the lenders’ systems and regulatory limitations. Many lenders have invested heavily in adopting systems that will accommodate changes in interest rates and, of course as noted above, have regulatory limitations within which they must operate.
Even though the transition away from USD LIBOR imposes a painful, time-consuming process on virtually everyone, there is no doubt that USD LIBOR is disappearing beginning at the end of 2021, and, in this case, knowledge truly can be power. Understandably, a conversation between borrowers and lenders can raise difficult issues, but borrowers who understand the USD LIBOR issues discussed above can engage with their lenders on an informed basis that benefits all parties. While some lenders may not be prepared for the conversation, others will welcome the opportunity to discuss an issue that has been brewing for a long time.
From a selfish point of view, the sooner that borrowers understand the rate changes coming their way, the sooner that they can formulate their responses and adopt their internal systems accordingly. Few borrowers will want to wait until the end of LIBOR to find out what happens next, particularly if their interest rates automatically convert upward into a Prime Rate!