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.
There are several issues that remain open regarding the discontinuation of LIBOR (the London Interbank Offered Rate) and the orderly transition to another reference rate heading into 2020. From the moment the Financial Conduct Authority of the UK (FCA) clarified it would no longer compel banks to submit rates to calculate LIBOR beyond the end of 2021, market participants have been actively trying to figure out what to do in a “Life after LIBOR” environment, notwithstanding that the publication of LIBOR may not necessarily end after 2021.
There is consensus that any iteration of LIBOR past 2021 (for example, a LIBOR rate elaborated and published by a private industry group following substantially similar market conventions to this date) may not reflect the economic equivalence of how we understand LIBOR as it is today.
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.
In the U.S., the Federal Reserve Board and the New York Fed convened the Alternative Reference Rates Committee (ARRC), which has been entrusted with ensuring a successful transition away from LIBOR. In this context, the ARRC has selected SOFR (the Secured Overnight Financing Rate) as the preferred alternative to USD LIBOR and has formulated template language dealing with the permanent discontinuation of LIBOR with respect to the following products: adjustable rate mortgages, bilateral business loans, floating rate notes, securitizations and syndicated loans.
So, as we enter 2020, where do we stand? Here are three things that you may need to know:
Existing LIBOR fallback language in contracts may not work if it does not account for a permanent discontinuation of LIBOR.
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.
In other cases, the agreement may already provide for an alternative fallback rate (for example, PRIME) without an adjustment to the applicable margin, considerably increasing financing costs to the borrower. These and other situations may result in disputes among the parties, especially if one of the parties can exert benefit from the current language, or the termination of the agreement under a theory of contract frustration or impossibility to perform. It is likely that a lender has a template contract it uses in multiple transactions or that a borrower with sufficient leverage may have negotiated borrower-friendly provisions. However, the devil is always in the details, and to determine any undesired consequences, time and effort may need to be spent in assessing any risks and potential exposure.
The ARRC fallback template language is becoming market standard. Still, it presents additional issues.
The ARRC in 2019 gave clear guidelines and templates that parties may include in their contracts during this transition period. Until a SOFR market develops and matures, expect banks and other private lenders to continue using LIBOR, at least during 2020. While these templates are considered by many as “neutral” or “middle of the road,” in 2020 lenders may be pushing for more lender-friendly provisions such as a higher LIBOR floors, additional lender discretion or eliminating certain consent rights in the borrower’s benefit currently in the suggested templates. However, a major open point remains: the ARRC continues to work on a methodology to calculate the margin adjustment once a new reference rate replaces LIBOR. But there are no guarantees that market participants will accept such recommendation or methodology at face value or whether there will be significant pushback by parties that may be negatively affected by an increase in cost or a loss resulting from any such calculation.
Use of SOFR is getting traction; however, a SOFR forward-looking term rate is still in the works.
In the U.S., SOFR is already being used by market participants for securitizations, floating rate notes and loans, although people would agree that an established market does not exist. Multiple factors have contributed to a slow adoption of SOFR as the preferred or main alternative reference rate, such as a still young — although quickly developing — SOFR derivatives market, recent volatility in SOFR rates and the preference for other rates in certain industries such as PRIME, Ameribor or the U.S. Dollar ICE Bank Yield Index. The biggest hurdle for a complete conversion to SOFR seems to be the establishment of SOFR forward-looking term rates similar to the way LIBOR currently works and is determined (i.e., at the beginning of the interest period). The ARRC has said a forward-looking SOFR rate will be available by the end of 2021.
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.
So, what happens in 2020?
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.
For many institutions and organizations, both public and private, 2020 will be the year of reckoning as they face the reality that change is inevitable and the effects of a disorderly transition may be catastrophic. Considering that many consumer products, such as student loans or commercial real estate loans, would be impossible to amend given the large number of counterparties or are currently the subject of securitization transactions, there could be a significant push by industry leaders to enact legislation to correct any defects in existing contracts and instruments referencing LIBOR.
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.
Some hope that the FCA will revert from its original position and allow LIBOR to be quoted and published past the end of 2021, even if such LIBOR rate may not be representative if not enough panel banks submit daily rates. Because the continuation or sufficiency of LIBOR cannot be taken for granted, to ensure a successful transition in 2021, market participants are encouraged to:
• 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.
• Assess inventory and determine exposure: This is not just a legal due diligence analysis, but also an economic, accounting and tax exercise, including of the general infrastructure and systems.
• 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.
• Develop a response program: Certain regulators at the state and federal level may require a response plan. For example, the U.S. Securities and Exchange Commission has suggested issuers to disclose risks related to the transition of LIBOR. Also, when engaging clients who may not be sophisticated, a step-by-step guide may help with any questions they may have.
• Educate your team and stay current with developments: The ARRC website is a great source for news and updates.
• Adopt a new reference rate: For new financings, when possible, adopt a new reference rate like SOFR or PRIME. •