The End of LIBOR
Antonoplos Discusses the End of the London Inter-Bank Offered Rate
Peter D. Antonoplos
Washington D.C., July 24, 2019 – The London interbank offered rate (LIBOR), the “world’s most important number,” is being phased out by 2021. The popular index was created almost 50 years ago on August 15, 1969, and began as a floating, market-determined interest rate for syndicated loans. However, with the increase in financial technology that has connected economies around the world, the index has blossomed into an interest rate for an estimated $350 trillion in outstanding financial arrangements around the world. LIBOR encompasses most financial contracts such as public and private loans and bonds; consumer financial products such as credit cards, mortgages and student loans, and some $200 trillion in interest rate derivatives.
With fewer interbank transactions being reported to the LIBOR commission, the index is becoming an unreliable benchmark for global financial markets and regulators are now scrambling to find a new yet trusted interest rate index. As LIBOR will be extinct by 2021, the US Federal Reserve, the UK’s Financial Conduct Authority (FCA) and other regulators have led working groups to develop risk-free rates (RFRs) as an alternative to LIBOR.
The Alternative Reference Rates Committee (ARRC)—a U.S. private industry group convened by the Federal Reserve Board and the New York Federal Reserve Bank to plan the market’s transition away from US dollar LIBOR—has selected the Secured Overnight Financing Rate (SOFR) as the intended replacement interest rate benchmark for US dollar-denominated transactions. The UK has chosen the Sterling Overnight Index Average (SONIA) as the new interest rate benchmark for pound sterling transactions. The U.S. and the UK are not the only countries preparing for the collapse of LIBOR as countries whose transactions include the euro, Swiss franc, and Japanese yen, have developed their own risk-free rates (EONIA, SARON and TONAR, respectively).
Differences between LIBOR and SOFR
With LIBOR being phased out by 2021, the financial markets face a series of significant challenges. While SOFR may be a comparable and stable index, basic differences between LIBOR and this new benchmark will cause issues during the initial switch.
First, LIBOR is an inter-bank, unsecured lending rate, whereas SOFR is based on overnight transactions secured by US Treasury securities, a rate considered “risk-free.” Thus, LIBOR is generally higher than SOFR, by as much as 20 basis points or more depending on the stress present in the credit markets. Moving from LIBOR to SOFR would mean a lower interest rate, however, in existing contracts, a transition from LIBOR to SOFR would require an upward adjustment or “replacement benchmark spread” to help ensure that the interest rate levels on existing loans remain compatible. With SOFR propped against the volatile securities repurchase markets, creating a replacement benchmark spread will present a challenge for current loans occurring between creditors and borrowers. With a long-term focus yet short-term issues, the ARRC is expected to recommend a specific methodology for determining the replacement benchmark spread, however, existing contracts between creditors and borrowers will not be required to adopt the offered measures.
A second issue that needs to be addressed before the transition is that while LIBOR is available for various tenors (e.g, one-month, three-month, six-month, etc.), SOFR is currently only available as an overnight rate on the website of the SOFR benchmark administrator (the Federal Reserve Bank of New York). Corporate treasurers are currently reluctant to use SOFR due to the lack of forward-looking predictions concerning how the new benchmark will perform long-term. Though private entities are developing their own forward-focused SOFR curves for different periods (the CME Group, for example, currently publishes one-month and three-month SOFR futures), in order for the index to gain widespread market adoption, the predictions will need to be expanded and become even more forward-focused.
Finally, in order to combat the issues created by the lack of published forward-looking term SOFR charts, other methods of calculating SOFR are under consideration. One option would be to focus SOFR from the beginning of an interest period on a daily (overnight) basis, with the final interest rate for the period being determined at the end of each interest period. While this option would better reflect market interest rates during the interest period, neither the creditor nor the borrower would have the predictability that LIBOR offered in terms of future interest income or expense. This plan would also require corporate treasurers to be informed immediately preceding the payment date how much interest would need to be paid, thus, raising operational issues for both creditors and borrowers. The issue would be problematic for U.S. borrowers, however, crippling for those non-US borrowers who are required to close a foreign exchange transaction in advance to effect US dollar payments.
Amending Existing Contracts
The greatest challenge that will be experienced when transitioning from LIBOR to SOFR lies in amending the contractual terms of existing financings that are due to mature after 2021. An estimated $35 trillion of currently outstanding LIBOR-linked financial transactions are set to need a new index after 2021 (the United States GDP is currently $19.4 trillion). Concerns have been raised about so-called “Phantom LIBOR,” where LIBOR remains in legacy contracts after the point when the benchmark is no longer supported or reported.
While LIBOR-based loans generally provide a definition of LIBOR and certain “fallbacks” in case LIBOR is no longer determinable based on the method provided in the document. The issue with these “fallbacks” is that they are designed to be used only when LIBOR is unavailable (LIBOR not being displayed on the designated rate screen on the interest rate determination date), not when LIBOR no longer exists. Three provisions that deal with the chance that LIBOR may not be available during a certain day are as follows, (a) LIBOR cannot be determined, (b) dollar deposits are not being offered in the London interbank market or (c) LIBOR no longer reflects the lender’s cost of funding a loan. If any three of these scenarios were to occur, the alternate base rates would often hinge on the Prime Rate, the Fed Funds rate (plus a margin) or some other agreed-upon rate. However, these alternate rates were only meant to be initiated for a short period of time and not as a permanent replacement for LIBOR based rates.
Newer contracts that use the LIBOR definition of rates will usually provide a fallback that is broader and able to adapt quickly if LIBOR rates were to no longer exist, however, financial groups have been struggling to develop a consistent approach. In 2018, the ARRC released a series of market consultations that dealt with potential fallback language for syndicated loans, floating-rate notes, bilateral loans, and securitizations. The ARRC published further documents in 2019 that concerned fallback language for syndicated loans and floating-rate notes, based on recommendations from market participants. While at least one major bank has adopted the ARRC recommendations in whole, fallback language is still in the early stages of its development and it will be difficult for lenders to develop adequate language until the uncertainties surrounding SOFR are resolved.
Though accepted fallback language has become more developed as loan modification negotiations for bilateral loans between lenders and borrowers are relatively straightforward, any discussion of a benchmark spread adjustment may be a challenge. In a time of market stress, when LIBOR and SOFR diverge more significantly, these discussions become even more difficult. The coordination between financial institutions and administrative agents will be critical to normalize the amendments necessary to deal with issues regarding break-funding, make-whole and increased costs, among other clauses.
Floating rate notes (FRNs) that have been widely distributed and generally require the approval of noteholders holding 100% of the outstanding notes to amend existing terms and conditions affecting interest rates will be the greatest challenge to phasing out LIBOR. To the extent a LIBOR-based FRN is held by a significant number of retail investors, and the terms of the FRN require 100% approval for amendments and have an old-style LIBOR definition, then liability management exercises (such as debt-for-debt exchange offers) should be considered to help mitigate the risk.
New Loan Agreements, Prior to LIBOR Cessation
The ARRC is focusing on amendments for LIBOR contracts and has proposed two different approaches for current agreements that are still using the LIBOR index: the “amendment” approach and the “hardwired” approach. Each approach has slight differences and benefits when applied to syndicated loans or bilateral loans. The “amendment” approach would kick in when a defined LIBOR replacement trigger occurred. For example, the lender (in the case of a bilateral loan) or the borrower and the administrative agent (in the case of a syndicated loan) will have agreed to amend the contract to replace LIBOR with an alternate benchmark rate such as SOFR unless the other party or parties to the loan agreement object in writing within a certain timeframe. The “hardwired” approach would also be given a defined LIBOR replacement trigger yet LIBOR would automatically be replaced with SOFR, compounded SOFR or another alternate benchmark rate determined in loan agreement using a predetermined “waterfall.”
A benefit associated with the “amendment” approach is that this agreement provides each party within an agreement greater flexibility to establish a rate to replace LIBOR upon the occurrence of a LIBOR replacement trigger. However, with this flexibility, parties who opt for the “amendment” approach may not be able to agree on a replacement rate when LIBOR replacement is triggered. This would lead the inadequate fallbacks that are currently placed within LIBOR based loans to remain in the loan agreement. In cases where neither party would be able to agree on a new interest rate, litigation would be likely as depending on the specific wording of these fallbacks and the then-current market, the result will either be inadequate, unduly expensive or unworkable especially for loans that have longer tenors.
While the “hardwired” approach has the advantage of not depending upon the parties reaching an agreement to a replacement rate at the time a LIBOR replacement trigger occurs, the parties risk agreeing in advance to a replacement rate that does not currently exist. The “hardwired” approach includes a required benchmark spread adjustment based on spread adjustments which are published by relevant governmental bodies or the International Swaps and Derivatives Association (ISDA). Without such provisions, borrowers and lenders alike will have different incentives in determining when and at what time a LIBOR replacement trigger actually occurred. For example, borrowers would prefer an early switch to SOFR and lenders would choose a later switch. Foreseeing this issue, the ARRC has dedicated considerable time in developing objective and knowable triggers.
With the market data currently available, parties are seemingly more comfortable with the amendment approach than with the hardwired approach. This occurrence stems from the current lacking information regarding replacement rates.
Hedging. The ISDA undertook their own separate consultations for the derivatives markets in July 2018 and announced their final recommendations at the end of the year. There is concern that the ISDA fallbacks and ARRC fallbacks may not align as the ISDA research occurred before the ARRC. The potential issue is that each agency may prescribe different measures to treat the misalignment between loans / notes and their respective interest rate hedges and when this occurs, confusion about what direction to go after LIBOR will ensue. For example, if a contract were to use the ARRC’s pre-cessation trigger, it would prescribe a remedy before LIBOR before it has ceased to be published, while any associated hedges using ISDA’s fallback language would continue to be based on LIBOR until it is officially discontinued. The loan and derivatives markets are another area likely to experience issues relating to the method of determining replacement benchmarks. The ISDA announced that they will opt to employ a compounded replacement rate which shall be calculated in arrears as its fallback for derivatives. Unless the loan market adopts a compounded SOFR in arrears, there will be a mismatch between loans and their associated hedges.
Regulation. Financial institutions are especially likely to be regulated with greater care once the switch from LIBOR to another index occurs. The Financial Stability Board (FSB) and the International Organization of Securities Commissions (IOSCO) have been coordinating international efforts for interest rate benchmark reform. The US’s Federal Deposit Insurance Corporation (FDIC) focused its Winter 2018 issue of Supervisory Insights on the end of LIBOR, while the US Securities and Exchange Commission (SEC) has identified it as a disclosure and operational concern for the financial industry.
Taxation. For American borrowers and lenders, several issues have been raised about the taxation associated with converting existing loans from LIBOR to a replacement rate. The most common question deals with the concern that the conversion from one index to another would result in a determination that there was a material modification of the indebtedness that would lead to a taxable exchange. A similar concern is raised under the Foreign Accounts Tax Compliance Act (FATCA), where a material modification to an existing financial instrument can cause the issue to be deemed a new issuance, thus, jeopardizing the exemption from FATCA withholding for instruments issued before July 1, 2014. The ARRC acknowledged these concerns and sent a letter to the US Treasury and the US Internal Revenue Service requesting formal guidance on these issues and more during 2019.
Potential for Disputes. Based upon the aforementioned concerns regarding the end of LIBOR, there may be instances where it will be a challenge to incorporate the necessary and proper fallback provisions into an existing financial instrument or contract before the end of 2021. As firms analyze their needs and objectives, they should realize that unless there is a statutory fix that would be made applicable throughout most financial market segments, potential disputes and subsequent litigation will likely occur as LIBOR nears its end.
Recommendations and Final Thoughts
With the transition away from LIBOR facing many issues to creditors and borrowers, we recommend the following:
First, parties should review existing loans, notes, and derivatives set to mature after 2021 and understand where they stand as far as exposure to LIBOR. The definition of LIBOR within a contract as well as the provisions for amending the terms and conditions of a the agreement should also be reviewed. Finally, parties should initiate contact with counterparties as soon as possible to smooth the transition from LIBOR to the new index.
Second, parties should understand review standard documents that are present within future transactions, such as under medium term note (MTN), commercial paper (CP) or certificate of deposit (CD) programs, to check whether amendments can or should be made. Potential affirmative action would be to changing existing program documentation to permit less than 100% approval for amending LIBOR-related interest rate provisions, thus, combating the ability of small groups of holdout creditors to block necessary amendments. In addition, companies should begin reviewing credit and hedging documents immediately to avoid costly gaps concerning the fact that SOFR and LIBOR fallbacks may develop in different directions between standard lending/securities documentation and standard ISDA documentation.
Third, parties, particularly lenders and agents, should review their internal systems to understand what adjustments may be required for loan accrual in SOFR. Back- and middle-office systems and procedures, such as client invoicing, will also need to be adapted to fit the new requirements that SOFR or other indexes will require.
Finally, in order to make the transition process away from LIBOR easier, lenders and agents should begin cautioning borrowers and issuers of this fact and preparing them for the changes to come. Smaller institutions may need additional time to educate themselves and take the necessary steps to push forward after the change from LIBOR to another index.
While 2021 may still seem well in the future, the adjustments that market participants from the largest banks to the smallest borrowers will need to make are significant. Thus, in order to prepare for the upcoming replacement rates and fallback provisions, each of these parties must start to become educated on the issue. The time to take stock of your own finances or your company’s exposures must begin now in order to eliminate and mitigate against mistakes from consumers and lenders alike.
The Antonoplos & Associates financial services branch provides our diverse base of banking clients with a comprehensive range of solutions for LIBOR loan related legal issues. Our LIBOR practice provides the banking industry with over twenty years of client focused practice in title litigation, loan modification, title curation and equitable subrogation resolutions in connection with loan portfolios. By striving to holistically understand the issues that our clients face, our financial services attorneys’ are able to provide forward thinking loan documentation and amendments through title curative actions including the correction of legal description errors, resolution by judicial action, equitable subrogation, and securing releases of prior liens, mortgages, and deeds of trust while also prescribing remedies for corrections to promissory notes and deeds of trust.
Antonoplos & Associates financial services lawyers routinely litigate equitable subrogation matters on behalf of nationally and locally chartered banks. Our clients include mortgage lenders, mortgage servicers, banks, banking associations, and other financial institutions including the title insurance industry. Overall, our LIBOR attorneys’ have extensive experience representing loan portfolios and managing mutli-jurisdiction loan modifications and litigation for clients located within the financial services industry.
Peter D. Antonoplos, Esq.Partner
Antonoplos & Associates, Attorneys At Law
1725 Desales Street, N.W.Suite 600,
Washington, D.C. 20036
Email: Peter@ AntonLegal.com