The 2012 LIBOR scandal, in which a group of bankers manipulated the global interbank rate, rocked the financial world. LIBOR, long used to establish interest rates on commercial and consumer loans, is scheduled to sunset in 2021. The question “what will replace LIBOR?” has persisted. Oscar Stephens provides an overview of the current situation and offers a preview of SOFR, the top contender for LIBOR’s replacement.
To avoid any risks associated with a LIBOR rate that may no longer exist or reflect the economic equivalence of financing costs at the time the parties entered into a transaction, market participants in the U.S., the UK, the European Union, Switzerland and Japan, among other relevant markets, have been working in parallel to determine replacement or alternative reference rates and what language can be incorporated to contracts and financial instruments still using LIBOR during this transition period.
So, as we enter 2020, where do we stand? Here are three things that you may need to know:
Normally, agreements will provide for situations where LIBOR is not published or cannot be determined. In certain cases, especially in agreements dated in 2017 or earlier, LIBOR fallback provisions would offer temporary solutions (for example, revert to the last published LIBOR rate, hence converting the financing from floating to fixed), but those agreements tend to be silent in instances when LIBOR has been permanently discontinued.
The ARRC fallback template language is becoming market standard. Still, it presents additional issues.
Market participants continue to adjust. Recently, the Loan Syndications and Trading Association (LSTA) published a concept credit agreement that implements a SOFR-based benchmark rate. In the derivatives market, Central Counterparty (CCP, a derivates clearinghouse) reported swaps linked to SOFR have expanded since the July 2018 launch, with more than $1 trillion cleared at the CCP in 2019. In other positive news, the U.S. Treasury Department and the U.S. Internal Revenue Service issued guidance in 2019 assuring taxpayers that switching to existing financial instruments from LIBOR to another rate are not taxable transactions.
ARRC and the International Swaps and Derivatives Association (ISDA) will continue to work in coordination to ensure that both the cash and derivatives markets are synchronized. Actions will include the consistent use of “in arrears” SOFR, establishing of clear mechanics to calculate any spread adjustments from LIBOR to an alternative reference rate, and providing consistent fallback language to use during the transition period. These points will be key to finally and formally continue with an orderly transition to SOFR-based products while a derivates market for SOFR continues to develop.
In its November 2019 meeting, the ARRC proposed legislation that would “reduce the adverse economic outcomes of legacy LIBOR fallbacks” in contracts governed under New York law for all asset classes. The proposed legislation would apply on a mandatory basis to contracts considered “silent” and to other contracts with LIBOR-based fallbacks, and, on a permissive basis, to contracts where the determination of an alternative rate falls upon a party exercising discretion, such as a calculation agent or administrative agent. At the federal level, Treasury Secretary Steven Mnuchin testified before the House Financial Services Committee in December 2019 and suggested that the Department of Treasury “may come back to Congress” to pass legislation dealing with LIBOR transition issues. With 2020 being an election year, it is difficult to predict whether something will be enacted this year.
• Build a team: Appoint a LIBOR “czar” in charge of transition issues and coordinating any actions among the legal and commercial teams. Set aside a budget, create a timetable and appoint responsible parties are some of the suggested steps.
• When needed, develop a contract amendment or renegotiation strategy: Even if the existing terms under the contract may work in your benefit, there may be reputational, financial or legal considerations that may need to be addressed.
