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This analysis summarises the current work being carried out by a variety of bodies related to the possible replacement of London Interbank Offered Rate (LIBOR) as a benchmark rate in finance documents across a range of markets and outlines some implications for loan agreements.
ICE LIBOR (formerly known as BBA LIBOR) is a benchmark rate produced for CHF (Swiss Franc) EUR (Euro) GBP (Pound Sterling) JPY (Japanese Yen) USD (US Dollar) with seven maturities quoted for each—ranging from overnight to 12 months, producing 35 rates each business day. For more on LIBOR, its calculation and the institutions involved in submitting data to allow it to be calculated see the ICE LIBOR webpage.
The speech made by Andrew Bailey of the Financial Conduct Authority (FCA) in July 2017 focused finance market participants attention on the issues that will arise in documenting finance transactions if LIBOR is no longer published. The thrust of the speech made by Mr Bailey was that there should be a move to transition away from LIBOR towards alternative reference rates by 2021.
LIBOR (and other Interbank Offered Rates or IBORs) has become unsustainable despite recent efforts to reform the methodology of calculation and additional regulation.
There are two main reasons why many people consider that LIBOR has become unsustainable:
As Mr Bailey put it in the speech:
‘The absence of active underlying markets raises a serious question about the sustainability of the LIBOR benchmarks that are based upon these markets. If an active market does not exist, how can even the best run benchmark measure it? Moreover, panel banks feel understandable discomfort about providing submissions based on judgements with so little actual borrowing activity against which to validate those judgements.’
The FCA has persuaded submitting banks to continue to make submissions using their expert judgment when there is no real world data through to 2021 to allow LIBOR to continue to be published.
The ‘Regulation on indices used as benchmarks in financial instruments and financial contracts or to measure the performance of investment funds’ (EU Benchmarks Regulation) entered into force on 30 June 2016 and most of the provisions apply from 1 January 2018. It gives the FCA power to compel banks to make submissions in order to allow LIBOR and other rates to be calculated and published. However, Mr Bailey stated in his speech:
‘we do not think it right to ask, or to require, that panel banks continue to submit expert judgements indefinitely. Indeed, the powers available to us under EU Benchmark Regulation, do not allow us to compel indefinitely.’
The speech prompted an acceleration of the work already underway to understand what would need to be done to mitigate any potential disruption to the markets given the ubiquitous presence of LIBOR (and other IBORs) in finance documents across the world. If LIBOR and other IBOR rates suddenly ceased to be available there would be severe dislocation in the market. Existing deals might not contain fall back provisions allowing appropriate or commercial rates of interest to be charged and for new deals an appropriate new benchmark rate would need to be specified and the mechanics for its use inserted into the documentation. As we describe below this is not a simple matter of substituting a new named rate for LIBOR.
Article 28(2) of the EU Benchmark Regulation states:
‘supervised entities other than an administrator as referred to in paragraph 1 that use a benchmark shall produce and maintain robust written plans setting out the actions that they would take in the event that a benchmark materially changes or ceases to be provided. Where feasible and appropriate, such plans shall nominate one or several alternative benchmarks that could be referenced to substitute the benchmarks no longer provided, indicating why such benchmarks would be suitable alternatives. The supervised entities shall, upon request, provide the relevant competent authority with those plans and any updates and shall reflect them in the contractual relationship with clients.’
This means lenders have to ensure that they have made arrangements to cope with the termination of LIBOR and other benchmark rates. This includes an obligation to ensure that their transactions are able to withstand LIBOR ceasing to be published.
All market participants have an incentive to ensure that viable alternative benchmark rates are made available in the run up to 2021 in case LIBOR and other IBOR rates no longer are made available by IBA.
Its is possible that ICE Benchmark Administration (IBA) will continue to publish LIBOR albeit based upon some different calculation methodology linked to transactions from a larger set of submitting institutions. How it will gather market data on which to base any new LIBOR is not yet clear. IBA has publicly statedthat it is working on the basis that although LIBOR will have to evolve it is by no means certain it will cease to exist. IBA pointed out that corporates like that LIBOR has a ‘typical good bank spread’ as well as maturity and liquidity elements difficult to replicate. It also alluded to the fact that there is room for more than one rate in the marketplace as this would provide an element of healthy competition and flexibility.
It is obvious that if LIBOR can continue to be published and is calculated on a meaningful basis that a lot of time and effort that would otherwise be spent dealing with issues for new and existing loan agreements that mature after 2021 would be saved.
Most of the work to find new rates to use as benchmarks has focused on strengthening existing IBOR methodology and identifying so called risk free rates as alternatives to IBORs. The work has been carried out under the auspices of the Financial Stability Board (FSB) with significant input by the Board of the International Organisation of Securities Commission and ISDA. An overview of the work they are undertaking can be found on their webpage and they publish regular updates on how the work is progressing here.
The main focus of the work given the possibility that LIBOR will become unsustainable in the future through lack of data has consequently been on finding RFRs that can be used and identifying what changes would need to be made to market practice and documentation to accommodate the transition from LIBOR to these RFRs.
The various working groups set up by the FSB have identified candidate preferred RFRs for four of the five currencies for which LIBOR has been published. These are:
Much further work is needed before detailed plans to adopt these RFRs as new benchmarks can be made. In due course steps will likely be taken by market participants to use these RFRs as fallback or new benchmark rates in order to comply with the obligations imposed by Article 28(2) of the EU Benchmark Regulation including making appropriate provisions in existing and new finance documentation to use these new rates to calculate interest.
Another major issue with RFRs is that work is needed to assess how each different RFRs should be modified for use as rates in finance transactions extending over longer terms than overnight. Additionally, an new element taking into account credit risk would need to be added to the base RFR to produce something more analogous to LIBOR as a reference rate. How this additional modifier is calculated and whether it would need to be different for each of the candidate RFRs is currently under discussion.
How all of these elements—such as new modifiers for risk and term loans and any other changes to the base RFR (eg where there are differences in the method of calculation of each RFR and there is to be a multicurrency loan)—are to be documented to make a usable interest provision in a loan agreement have yet to be settled.
Currently, there is no fixed date for a transition from LIBOR to RFRs as work is continuing on the issues discussed above. The best that can be said is that 2021 appears to be the target year for the transition to be effected. The FSB and ISDA (membership required) have published some details about the proposed timeline for the transition with a new report due from ISDA in the first half of 2018.
IBA believes the transition away from LIBOR would take more than 4 or 5 years to effect if dislocation in the market is to be avoided simply because there are so many existing finance documents out there which will still be live after 2021.
Different considerations apply depending on whether you are looking at:
Most well drawn loan agreements, notably the recommended forms of facility agreement available to members of the Loan Market Association (LMA) will contain a series of fallback options if the relevant Screen Rate for LIBOR is not available.
To summarise the existing suite of fallback options comprise one or more of the following to be used if the Screen Rate for that loan is unavailable:
None of these options is really designed to deal with the situation where LIBOR ceases to be available for an indefinite period of time.
The first point to check is what existing fallback options are contained in the relevant documents. These content of these fallback provisions have changed considerably over time.
The current version of the LMA facility agreements also allows the parties to choose to include an optional clause dealing with the replacement of the Screen Rate which determines LIBOR for the purposes of the loan. It provides for any amendments relating to a replacement benchmark rate to be approved by a majority of lenders (and what constitutes a majority will be defined in the loan agreement) and the obligors. This provides a mechanism to effect appropriate changes to the documentation if LIBOR ceases to be available for good. Once the work on RFRs has been completed and if LIBOR is then no longer available it could be used to effect the necessary changes if the threshold agreement level is met. It avoids the need to get the consent of all parties to effect the amendment and so provides an additional level of comfort that no disruption will take place.
The work on new benchmark rates is far from complete so most new loan agreement will continue to refer to LIBOR for the foreseeable future. Until the characteristics of the new benchmark rates are known and the practical implications of their method of calculation understood better it is not possible to draft provisions to accommodate the transition with any certainty. The best that can be achieved at the current state of knowledge it to ensure that the majority lender/obligor consent provision is included. It might be desirable to provide that these consents should also allow the facility agent to make associated amendments to reflect the manner in which any new benchmark rate based upon RFRs may have to be calculated (to add elements for credit risk and to compound for the relevant term) which is likely to take time to work out in practice. It might also be prudent to widen the scope of the trigger for the provision so that it can be used if, for example, the agent/other party is of the reasonable opinion LIBOR is no longer an appropriate rate to use because its method of calculation is changed by IBA in some material way that disadvantages one or other party.
The position is much more complicated if a loan agreement contains no fallback options allowing a new rate to be set.
There is always the option that the lender(s) and the borrower can agree a new rate and amend the documentation as needed.
If the parties cannot agree on a new mechanism for calculating interest would the loan agreement be frustrated in its entirety or remain valid but with no obligation on the part of the borrower to pay interest because the mechanism for calculating the rate no longer worked?
If such a case came before an English court there is no doubt that the court would be keen to arrive at a solution to the problem that would minimise disruption in the finance markets. However, it is not easy to see how the principles of contract law that would be applicable would allow a court to arrive at a decision which achieved that objective for the following reasons:
These difficulties suggest it is imperative for parties to loan agreement which contain no fallback mechanisms to start the process of changing the loan agreement in good time for 2021.
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Miranda is a solicitor specialising in leveraged and acquisition finance. She trained at Hogan Lovells International LLP and qualified into the international banking and finance team. During her time at Hogan Lovells she worked on a variety of domestic and cross-border transactions, acting for both borrowers and lenders. She also experienced secondments to Barclays Bank PLC and Kaupthing Bank hf.
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