Doomsday for LIBOR
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In July 2017 the CEO of the Financial Conduct Authority (FCA) announced that LIBOR would be phased out by 2021. How will this impact on lending arrangements going forward?
The London Interbank Offered Rate (LIBOR) has been a lynchpin of financial markets internationally since the 1980s. Market participants rely on the publication of the daily LIBOR rate as the basis for numerous financial products, including lending arrangements. On 27 July 2017 the FCA confirmed that from 2021 it will not compel or encourage contributor banks to make LIBOR submissions. While banks can opt to sustain LIBOR if they chose, without the FCA’s backing it is unlikely this practice will continue and markets should prepare for LIBOR to be unavailable from 2022 as a basis for determining interest rates.
The movement away from LIBOR follows years of scandal that have eroded the credibility of the benchmark rate. Focus has now turned to finding an alternative, and while central banks and industry bodies worldwide such as ISDA (the International Swaps and Derivatives Association) are considering replacement rates, no agreement has yet been reached. The prospect of LIBOR’s eradication raises issues for loan arrangements that are already in place, operate by reference to LIBOR or extend beyond 2021. Equally, new standards and provisions will need to be developed for lending arrangements going forward.
LIBOR’s role in lending arrangements
Fundamental to any lending arrangement is the level of interest payable on the loan amount. This is the principal way that financial institutions profit from offering their services. For the past two decades this has principally been determined, particularly in the case of syndicated lending, by reference to LIBOR. This has become a universal and uncontroversial mechanism for calculating the interest payable on loans and it is the mechanism adopted in the Loan Market Authority (LMA) template facility agreement.
A proposed alternative?
In April 2017 the UK’s Risk-Free Rate Working Group selected the Sterling Overnight Index Average (SONIA) as its preferred alternative benchmark rate for the derivative market. No preference has yet been expressed for a suitable alternative in the lending market. One thing that is clear is that it is unlikely that there will be a single internationally and universally accepted benchmark going forwards. This represents a significant departure from the LIBOR years.
On the retirement of LIBOR there will be an issue for lending arrangements already in place that do not contain any fall back provisions and extend beyond 2021. These contracts will still determine interest payable in line with LIBOR, yet there may be no LIBOR rate in existence. How will interest payments be determined under these contracts?
Achieving contractual continuity will be the principal challenge. In an ideal situation the parties would agree on an alternative rate for determining interest. Any alternative is however likely to be more disadvantageous to one party than the other and this may lead to further contractual variations in order to compensate that party.
Achieving consensual agreement is unlikely to be a simple task and may not be possible at all. Post 2021, case law will need to address this issue and the judicial approach is hard to predict. Will rules of interpretation determine that when parties enter into a lending arrangement with reference to LIBOR, those parties intend to be bound by any widely accepted alternative rate in the future (eg, SONIA)? Will courts develop their own alternative valuation mechanisms? Or will these arrangements simply become unworkable?
The effect of LIBOR’s decline needs to be considered carefully in the context of each arrangement that relies on it. There will not be a ‘one size fits all’ solution and financial institutions will need to consider how they deal with this consistently across their lending book.
Going forward, the drafting of facility agreements needs to evolve so that alternative interest rate mechanisms are incorporated at the outset. The difficulty here is how to provide for an alternative when there is currently no consensus on a replacement benchmark rate.
It is common practice for lending agreements to contain market disruption clauses, which arguably already deal with the potential issues raised by LIBOR’s disappearance. Market disruption clauses conventionally provide alternative mechanisms for determining interest rates. This is however often by fall back to either a reference bank rate or a calculation based on the lender’s cost of funds. Neither of these mechanisms provide a long-term solution; while banks are reticent to accept fall back to a reference bank rate, borrowers are left vulnerable by a calculation based on the lender’s costs.
Furthermore if agreement is reached on a new benchmark rate in the future, it will be impossible to simply amend documents by replacing references to LIBOR with references to the new rate, as the mechanics of the entire document will likely need amending. Further assurance clauses will therefore become a necessity, so that parties undertake from the outset to amend their agreement to accommodate the proper implementation of the new benchmark post-2021. Forward thinking drafting will be key.
There is significant uncertainty surrounding the disappearance of LIBOR and the impact this may have on lending arrangements both in the UK and internationally. The drafting of facility agreements must evolve to accommodate alternative interest rate mechanisms and future variations so that a situation in which lending arrangements become unworkable is avoided. Ultimately, a definitive consensus on an alternative rate is needed so that LIBOR-based contracts can transition smoothly onto a new basis; hopefully this will be achieved over the next four years.
Tori Swann is a trainee solicitor in Shoosmiths’ Milton Keynes office, although is currently on secondment.