The Good, The Bad, And The Dead: The Legacy, Scandal, And Discontinuance Of Libor
Lenders have long relied on the London Interbank Offered Rate, or, “LIBOR”, as a benchmark interest rate for variable rate financial products. In late July of 2017, the United Kingdom’s Financial Conduct Authority announced that LIBOR would be phased out by the year 2021. With an estimated US$350 trillion in outstanding financial products, including loans, that are underpinned by LIBOR, this is an extremely urgent matter for lenders. Not only is the matter urgent, but also involves a cumbersome process of taking inventory of current loans on the books that are based on LIBOR, reviewing the loan documents, and, if necessary, amending the loan documentation.
The purpose of this Client Alert is twofold, to provide some background on the discontinuance of LIBOR; and to provide an outline of how to handle amendments to current loan documentation and loan documentation going forward.
I. What is LIBOR? Why is It a Good Benchmark Rate?
For nearly four decades the London Interbank Offered Rate (“LIBOR”) has served as the reference rate at which banks borrow funds from other banks. LIBOR, which measures the cost of unsecured borrowing between banks across five currencies (the US Dollar, the Euro, the British Pound, the Swiss Franc and the Japanese Yen) and seven tenors (Overnight, 1 Week, 1 Month, 2 Months, 3 Months, 6 Months and 12 Months), is a barometer for the global economy and is widely used by financial institutions which operate internationally. It is an interest rate average calculated by submissions from a panel of contributor banks in London.
LIBOR is an effective benchmark rate, as it is forward-looking, and is designed to predict a bank’s actual cost of funds over a given time period in the future corresponding to the relevant tenor. If LIBOR is accurate, then a bank can reasonably price loans on a forward basis by simply adding a margin reflecting the bank’s cost of operations and profit margin. LIBOR as an index also gives the borrower certainty of payment. For example, in a loan with twelve-month LIBOR as an index, the rate will reset every 12 months, and the borrower will know its exact cost for the upcoming period.
II. The LIBOR Scandal and the Discontinuance of LIBOR.
In April of 2008, amid the financial crisis, The Wall Street Journal published an article suggesting that some of the panel banks may have understated borrowing costs in their submissions for LIBOR determination in order to mislead others about the financial positions of these banks. By July 4, 2012, the breadth of the scandal was evident, and two days later the United Kingdom’s Serious Fraud Office opened a criminal investigation into manipulation of interest rates. While financial crimes occur frequently, the breadth and sheer monetary value of the financial products impacted by this scandal makes it extremely far reaching and dangerous.
This scandal triggered concerns about the reliability and sustainability of certain IBORs in the unsecured interbank funding market. Panel banks have had an understandable reluctance to contribute rates to support LIBOR, given the risk of future liability based on claims of manipulation. As a result, current submissions by panel banks are to a great extent based on “expert judgment” or estimates of the rates the submitting banks would be charged, rather than actual or comparable transactions. LIBOR, therefore, suffers both from reputational concerns, and from an absence of healthy underlying market data, and is disfavored by policy makers.
As a result of the scandal and subsequent reliability concerns, the United Kingdom’s Financial Conduct Authority announced that LIBOR would be phased out by the year 2021. The Secured Overnight Financing Rate (“SOFR”) was chosen as the replacement to LIBOR. In addition to hopefully being a more reliable benchmark, SOFR differs from LIBOR in many ways. SOFR is an overnight, secured, nearly risk-free rate, whereas LIBOR is an unsecured inter-bank lending rate published for different tenors. SOFR is a broad measure of the cost of borrowing cash overnight collateralized by United States Treasury securities involving a wider array of market participants. LIBOR is designed to reflect lending to prime banks and contemplates some credit risk. Thus, in transitioning index rates from LIBOR, interest rate mechanics and margins will likely need to be adjusted. Although some market participants have begun using SOFR as an alternative to LIBOR, the market is still working through the methodology of using SOFR.
III. How Can Lenders Adapt Loan Documentation Going Forward?
To date, lenders have taken a variety of approaches in adapting loan documentation, for future loans, to contemplate the discontinuance of LIBOR. Below are three fallback provision approaches that lenders have commonly used in loan documents outlining how a trigger event (i.e. the discontinuance of LIBOR) will be handled:
a. “Hardwired” approach – the parties agree upfront on a “waterfall” of replacement rate and spread adjustment options and include the same in the loan documents.
b. “Amendment” approach – the parties agree that decisions relating to the replacement rate and spread adjustment are to be made in the future, which may or may not require an amendment to the loan documents and the borrower’s consent (depending on whether the parties opt for this requirement).
c. “Hedged loan” approach – the parties agree upfront to refer to whatever is adopted by the International Swaps and Derivatives Association (“ISDA”) for derivatives transactions (more suitable for loan transactions where the parties have also entered into interest rate swaps).
Below is an example of a blended approach, which takes elements from the “hardwired” approach and the “hedged loan” approach to create succinct and clear language, for use in loan documents, on how LIBOR discontinuance will be handled.
(a) Notwithstanding anything to the contrary contained in paragraphs (a)-(b) and (d)-(e) of this Section or in any Related Document, after Lender notifies Borrower of the occurrence of a Benchmark Discontinuance Event (defined below), the Lender may substitute the Applicable LIBOR Rate with an alternate benchmark rate, including any applicable Replacement Benchmark Spread (any such alternate benchmark rate, together with the Replacement Benchmark Spread, a “Replacement Benchmark”). The selection of the Replacement Benchmark will be determined by Lender in its sole discretion, giving due consideration to any evolving or then existing convention for similar U.S. Dollar denominated credit facilities, which may include any selection, endorsement or recommendation by a Relevant Governmental Body. For purposes hereof:
- (i) “Applicable LIBOR Rate” means the LIBOR based rate (as calculated including the rate margin percentage set forth in the applicable LIBOR definition) in effect hereunder at the time of a Benchmark Discontinuance Event.
- (ii) “Benchmark Discontinuance Event” means the occurrence of one or more of the following events with respect to LIBOR:
(A) a public statement or publication by a Relevant Government Body, by the regulatory supervisor or administrator of LIBOR, or by a court, insolvency official or other entity with jurisdiction over the administrator of LIBOR, announcing that the administrator of LIBOR has ceased or will cease to provide LIBOR permanently or indefinitely; or
(B) a public statement or recommendation by a Relevant Government Body that LIBOR is no longer a representative benchmark in the U.S. loan market or that LIBOR should no longer be used; or
(C) Lender determines, giving due consideration to then-current market practices for similar U.S. Dollar denominated credit facilities, that new or amended bilateral loans are incorporating a replacement benchmark rate for LIBOR; or
(D) the date an “index cessation event” (as defined in the ISDA Definitions (as such term is defined below)) has occurred with respect to LIBOR
- (iii) “Relevant Governmental Body” means the government of the United States of America or any court, governmental body or other regulator or agency asserting jurisdiction over Lender, the Federal Reserve Board, the Federal Reserve Bank of New York, or a committee endorsed or convened by any of the foregoing.
- (iv) “Replacement Benchmark Spread” means, with respect to any replacement of LIBOR with an alternate benchmark rate for any applicable interest period, a spread adjustment, or method for calculating or determining such spread adjustment, (which may be a positive or negative value or zero) in each case giving due consideration to the rate margin percentage set forth in the applicable LIBOR definition as well as any evolving or then existing convention for similar U.S. Dollar denominated credit facilities for such adjustments, which may include any selection, endorsement or recommendation by the Relevant Governmental Body with respect to such facilities for the applicable alternate benchmark rate.
(b) At any time after Lender provides notice to Borrower of the occurrence of a Benchmark Discontinuance Event, the following shall replace paragraph (a) of this Section (and the provisions of paragraphs (b) and (d)-(e) of this Section shall be disregarded): (a) Borrower agrees to pay interest on the unpaid principal amount from time to time outstanding hereunder at the rate per year equal to the “Secured Overnight Financing Rate (SOFR)” plus ) __ and __/100 percent (____%)[spread]. For purposes hereof, “Secured Overnight Financing Rate (SOFR)” means the rate announced, on each Business Day, by the Federal Reserve Bank of New York, provided that if such SOFR Rate shall be less than zero, such rate shall be deemed to be zero for the purposes of the Note. Changes in the rate of interest resulting from a change in the SOFR shall take effect on the date set forth in each announcement of a change in the SOFR. Prepayments shall be applied toward principal installments hereunder in the inverse order of maturity and shall not relieve Borrower of its obligation to make remaining payments as scheduled.
(c) Notwithstanding the foregoing or anything to the contrary herein, if a Swap Agreement with a LIBOR-based rate is in effect between Lender and Borrower in connection with a Loan made pursuant to the Note, then after the occurrence of a Benchmark Discontinuance Event as defined in section 3(a)(ii) above, with respect to such Loan, Lender shall have the right to substitute the Applicable LIBOR Rate with the ISDA Fallback Rate and the applicable ISDA Spread Adjustment. For purposes hereof:
- “ISDA” means the International Swaps and Derivatives Association, Inc. or any successor thereto.
- “ISDA Definitions” means the 2006 ISDA Definitions published by ISDA, as amended or supplemented from time to time, or any successor definitional booklet for interest rate derivatives published by ISDA from time to time.
- “ISDA Fallback Rate” means the rate to be effective upon the occurrence of an “index cessation event” with respect to the Benchmark according to (and as described in) the ISDA Definitions (where such rate may have been adjusted for a tenor equal to the applicable interest period hereunder), but without giving effect to any additional spread adjustment to be applied according to such ISDA Definitions.
- “ISDA Spread Adjustment” means the spread adjustment (which may be a positive or negative value or zero) that shall have been selected by ISDA as the spread adjustment that would apply to the applicable ISDA Fallback Rate.
(d) Any technical or operational changes necessary or desirable in Lender’s sole discretion to reflect the adoption of the Replacement Benchmark and to permit the administration thereof by Lender in a manner substantially consistent with market practice (or, if Lender determines that adoption of any portion of such market practice is not administratively feasible or that no market practice for the administration of the Replacement Benchmark exists, in such other manner as the Lender determines is reasonably necessary to administer the Loan) shall become effective ten (10) business days of written notice of such changes from Lender to Borrower, without any further action or consent of the Borrower.
(e) For the avoidance of doubt, if the Replacement Benchmark as determined under this Section 3 would be less than zero, such replacement benchmark shall be deemed to be zero for the purposes hereof.
IV. How Can Lenders Amend Loan Documentation for Previously Booked Loans?
When it comes to amending the loan documentation for loans that were previously booked and that do not already contemplate a LIBOR discontinuance event and/or replacement rate, the options are much more limited. The “old” fallback language that has been included in loan documents is not sufficient as that language only contemplated a temporary cessation or inability to determine LIBOR, but not a permanent cessation, plus, the usual fallback to the prime rate would likely substantially alter the economics of the loan. That being said, the only real option is to amend the loan documents. Before modifying the loan documents, it is important to review the documents for the location of pertinent terms related to LIBOR. Best practice would be to separately amend each of the note, the mortgage or deed of trust (if there is real estate collateral) and the loan agreement by way of a bilateral modification agreement, for each of the aforementioned documents, by and between the lender and borrower, as these modifications will likely be document specific and lengthy. Then, to further reinforce the modifications to the aforementioned loan documents, and to remove and replace any references to LIBOR in the ancillary loan documents, lender and borrower should execute an Omnibus Modification Agreement, which by its terms removes all references to LIBOR in the loan documents, while simultaneously replacing all references with the replacement index.
When it comes to adapting or amending loan documentation, whether it be for a loan that is already closed or for a future looking loan, best practice would be to create a baseline of clear and succinct language regarding a replacement index and to modify each and every document with any reference to LIBOR, not only the note. This will remove any ambiguity and not leave any room for doubt as to what happens to the interest rate when LIBOR is discontinued.
This alert should not be construed as legal advice or a legal opinion on any specific facts or circumstances. This alert is not intended to create, and receipt of it does not constitute, a lawyer-client relationship. The contents are intended for general informational purposes only, and you are urged to consult your attorney concerning any particular situation and any specific legal question you may have. We are working diligently to remain well informed and up to date on information and advisements as they become available. As such, please reach out to us if you need help addressing any of the issues discussed in this alert, or any other issues or concerns you may have relating to your business. We are ready to help guide you through these challenging times.