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Sector Insights

Impact of announced changes to LIBOR on loan documentation

15.11.2017 Maritime

Beatrice Russ

Beatrice Russ Partner

At the end of July, the Financial Conduct Authority (“FCA”) announced that it will be supporting a transition from LIBOR to other benchmark rates by the end of 2021. Following the LIBOR scandal, the FCA has been trying to anchor LIBOR submissions and rates, as far as possible, to actual transactions, to ensure the rate is genuinely representative of market conditions. However, market activity has been insufficient to sustain this and LIBOR is instead being arrived at by the use of “expert judgment” of panel banks. This position is generally regarded as unsatisfactory.

So far, there has been no clear indication from any of the market’s participants as to the reference rate that will replace LIBOR in transactions in the loan market, leading to uncertainty as to how to deal with LIBOR currently and in the future amongst lenders and borrowers alike.

How will this impact individual loan transactions?

Until the anticipated transition takes place, panel banks have been asked to continue to submit rates to allow for a planned and smooth transition. However, loans being documented now or in recent years are likely to have a maturity extending beyond 2021 and, in the absence of an appropriate alternative rate, it is likely that such deals will be based on LIBOR.

In the absence of any clear guidance as to the future of LIBOR, loan parties will need to fall back on current documentation. Most loan documentation bases its provisions regarding unavailability of LIBOR on the Loan Market Association (“LMA”) standard documentation, which provides a waterfall of fallbacks in the event that the Screen Rate is unavailable:

1.  Interpolated Screen Rate: If the Screen Rate for LIBOR is unavailable, the Interpolated Screen Rate for the interest period of the loan is to be used (with such rate being calculated with reference to previously available Screen Rates for LIBOR). This is the short term solution.

2.  Reference Bank Rate: Where there has been a complete discontinuation of LIBOR, the benchmark defaults to a “Reference Bank Rate”, which is an arithmetic mean of quotations provided by typically four reference banks (but it can, of course, be fewer). Please note though that a “Reference Bank Rate” may not be available.

3.  Cost of Funds: Where no “Reference Bank Rate” is available, the LMA Facility provides that the “Cost of Funds” shall apply, with each lender to notify the agent of its own costs of funds (i.e. the cost to that lender of funding its participation from whatever source it may reasonably select). The notified rates may then be passed on to the borrower directly, or the documentation may provide for a weighted average rate to form the new benchmark. This solution is not popular with borrowers as it is impossible to price in advance.

4.  Amendment of Benchmark with Consent of Majority Lenders and the Obligors: There is an optional provision, introduced into the LMA documents in 2014, which provides that where the Screen Rate is unavailable, the Finance Documents can be amended to provide for another benchmark rate with the consent of the Majority Lenders and the Obligors. This is potentially controversial, as interest is typically seen as a fundamental term of the contract and, therefore, a matter for all lender consent.  

Although the LMA Facility provides for a method of calculating the benchmark in the event that LIBOR is discontinued, these fallbacks are not entirely satisfactory, and (other than in respect of clause 34.4(a) (Replacement of Screen Rate)), were largely designed to cater for the temporary unavailability of LIBOR rather than its permanent discontinuance.  Lenders are traditionally highly sensitive over the cost of funds, and such a method will naturally lead to an increased amount of work for agents, which they are unlikely to be willing to accept as standard. There is also concern in the loan market that the widespread use of the Cost of Funds as a solution will inevitably create a downward pressure on pricing.

Although the current provisions are likely to provide some assistance in the short term, there is still the need for a comprehensive or permanent solution. In the absence of certainty, there is no point in inserting provisions into loan documentation now which, at best, would amount to an unenforceable agreement to agree.

To date, there has been no clear alternative to LIBOR put forward by the market. We will keep this situation under review.

Article authors:

Beatrice Russ