The retirement of LIBOR and your loan documentation
As most readers will be aware, the Financial Conduct Authority (“FCA”) announced at the end of July that it will be supporting a transition from LIBOR to other benchmark rates by the end of 2021. Panel banks have been asked to continue to submit rates until this date so that the transition can be planned and executed smoothly. Although UK and EU legislation gives the FCA the power to compel banks to make submissions, where necessary, the FCA has made clear it would prefer not to use these powers, but will if it has to.
The FCA has rooted its decision in its conclusion that there is not enough meaningful transaction-based data to continue to sustain LIBOR. Since taking on the role of regulating LIBOR in April 2013, the FCA has been keen to try to anchor LIBOR submissions and rates, as far as possible, to actual transactions, to ensure the rate is genuinely representative of market conditions. However, the FCA has now concluded that as the underlying market that LIBOR seeks to measure (the market for unsecured wholesale term lending to banks) is no longer sufficiently active, LIBOR is instead being sustained by the use of “expert judgment” by panel banks to form many of their submissions. As such, it is believed that LIBOR no longer reflects actual practices and transactions, which naturally makes it vulnerable to manipulation. Furthermore, the FCA has referenced in its reasoning a concern that the understandable reluctance of panel banks to make submissions (which are effectively based on their opinions rather than data, as there is so little underlying borrowing activity against which to validate their judgments) could ultimately lead to the departure of panel banks, which in a worst case scenario would make the production of LIBOR in the current manner impossible.
Since the FCA’s announcement, there has been no clear indication from any of the market’s participants as to the reference rate which will replace LIBOR in transactions in the loan market. It is estimated that syndicated loan issuance based on GBP LIBOR or US LIBOR in 2017 (to the end of September) was approximately $2.23 trillion (over 68% of total syndicated loan volumes and that does not even take into account other LIBOR currencies or bilaterals). Maturities for loans vary depending on the relevant sector of the market, and it is common to see loans with a maturity of five years or more. As such, it is anticipated that a large number of legacy deals will be impacted by any discontinuation of LIBOR post-2021. In addition, loans that are being documented now are likely to have a maturity that extends 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 what the future holds, this article seeks to briefly outline how the unavailability of LIBOR is currently dealt with under the Loan Market Association (“LMA”) standard documentation, and the potential alternative rates that have so far been mooted as a replacement.
Current LMA Standard Documentation
The below review is based on the provisions found in the standard LMA single currency term facility agreement (the “LMA Facility”) which uses LIBOR as a benchmark rate.
The LMA Facility provides for the benchmark rate to be LIBOR as determined in accordance with the “Screen Rate”. The LMA Facility provides for a waterfall of fallbacks in the event that the Screen Rate is unavailable:
- 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). However, this provision is in effect only of use where there is no rate available for a given period, as opposed to the discontinuance of LIBOR all together.
- 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). However, this method is not without issue. Namely, similarly to the FCA’s concerns over panel banks’ willingness to make LIBOR submissions, not many banks traditionally want to be a reference bank and reference banks in any event cannot be compelled to provide a quotation. As such, a “Reference Bank Rate” may not be available.
- 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.
- Amendment of Benchmark with Consent of Majority Lenders and the Obligors: Another option available is under clause 34.4(a) (Replacement of Screen Rate) (which 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. As mentioned above, most banks are unwilling to be reference banks, leading to the likely unavailability of a Reference Bank Rate, and the Cost of Funds method is also problematic and undesirable. Firstly, it is clear that the Cost of Funds method was only intended to act as a final backstop in circumstances of market disruption where there is no LIBOR Screen Rate available, and not as a long-term solution to the discontinuance of LIBOR. Secondly, the LMA Facility foresees that borrowers may require the right to revoke a utilisation request where it emerges that pricing will be on a Cost of Funds basis. The Cost of Funds calculation also raises issues for lenders and agents. 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, which is unwelcomed by the market given margins are already at a historic low relative to probable risk.
It is clear from the above that although current LMA documentation offers some solace in the event that LIBOR is discontinued, it most definitely does not provide a comprehensive or permanent solution. Consequently it is essential that a universally accepted alternative rate is adopted. To date, there has been no clear alternative to LIBOR put forward by the market. In contrast, in the derivatives market, the following have been identified as alternative risk-free rates:
- The Sterling Overnight Index Average (SONIA) – this has been proposed by the swaps-industry working group as a replacement for LIBOR, as a near risk-free alternative derivatives rate that reflects bank and building societies’ overnight funding rates in the sterling unsecured market, administered by the Bank of England.
However, such a rate is unlikely to be workable for the loan market, mainly as it introduces a disconnect between the tenor of the benchmark and that of the funding provided. For example, it is not clear how an overnight rate can be adequately used to replace a three-month LIBOR rate, a sentiment that has been echoed by Jeffrey Sprecher, chairman and chief executive of ICE Benchmark Administration (IBA) (the current administrator for LIBOR). Furthermore, the LMA has commented, in its response to the Bank of England White Paper on SONIA, that the use of a compounded overnight rate for longer periods creates uncertainty in the cash markets as it would mean that the borrower and lender would not know the rate until the end of the interest period. A move to an overnight rate also poses operational issues, as loan systems are not currently set up to assess and calculate interest based on overnight rates. Consequently, the LMA advocates that any replacement rate for LIBOR should be a forward-looking term rate, rather than a backward-looking rate like SONIA.
- Treasuries repo rate – this is a rate linked to the cost of overnight borrowing cash secured against US government debt, and has been recommended by the Alternative Reference Rates Committee (a US government body). Similarly to SONIA this rate is unlikely to be workable for the loan market.
As mentioned above, many existing deals and new loans currently in documentation will be affected by the discontinuance of LIBOR post-2021. The LMA has stated that, until an alternative benchmark is roundly adopted by the loan market, it will not be making any changes to its template documentation to cater for the issue. It is not as simple as inserting a provision requiring parties to switch to an, as yet unknown, alternative benchmark at some, as yet unknown, future time, for numerous reasons, not least the unintended consequences this could have for the underlying economics and commercial bargain of the deal.
Accordingly, and while this is an uncertain and somewhat unsatisfactory situation which one can only hope will be clarified in the very near future, all that can be recommended at this stage is, as regards new deals, to ensure that the appropriate LMA-type fallbacks for absence of Screen Rate are incorporated, with particular consideration being given to including the 2014 optional clause; and as regards existing deals which reference LIBOR, to review their terms to identify what fallbacks (if any) are provided for, whether they are sufficient, and whether any amendments to documentation (to bring them in line with the LMA fallbacks, for example) are desirable. We will keep this situation under close review.