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.
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.
Existing LIBOR fallback language in contracts may not work if it does not account for a permanent discontinuation of LIBOR.
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 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.
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.
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.
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:
• 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.
• Adopt a new reference rate: For new financings, when possible, adopt a new reference rate like SOFR or PRIME. •
