Contributors
On 27 July 2017, Andrew Bailey, Chief Executive of the FCA, announced in a speech that banks and other market participants need to prepare for LIBOR to be discontinued after 2021. LIBOR has been hit by scandal in recent years and has been the subject of a regulatory investigation. The FCA has found that a significant issue is that LIBOR submissions are based on good faith estimates of borrowing costs and not actual transactions, so in an economic climate where the volume of wholesale bank borrowing is much reduced, it is particularly difficult to submit a daily estimate when there are relatively few actual transactions to support that estimate. In addition, historically there was no clear framework for regulating LIBOR.
The FCA has been supporting LIBOR by persuading banks to provide quotes and says this has been a key factor in ensuring the continued publication of LIBOR. However, the FCA said that after 2021 it will no longer encourage or compel banks to provide LIBOR quotes. ICE, which administers LIBOR, is free to continue to produce LIBOR (and has said it will do so) however the reality is that LIBOR is likely to be phased out following the absence of FCA backing.
In his speech, Andrew Bailey said that it is for market participants to begin planning the transition to an alternative reference rate based on transactions, and ensure that agreements have sufficient fall-backs to allow for a replacement benchmark if LIBOR stops being published. There was initially concern that the announcement of the pending withdrawal of FCA support for LIBOR would lead to banks stopping providing quotes prior to 2021 thereby threatening the controlled transition originally anticipated. This risk receded last month when the FCA announced on 24 November that it has reached agreement with all 20 panel banks that they will remain on the panels they currently submit to until the end of 2021. The FCA statement concludes that as a result of this support it expects the focus to turn to developing alternative rates and working towards a transition that can be executed smoothly.
The Bank of England Working Group on Sterling Risk-Free Rates has recommended that SONIA (the Sterling Overnight Index Average) – a rate based on interest paid on wholesale unsecured overnight loans – should be used as the alternative to LIBOR for sterling loans. On 29 November, the Bank of England announced the next phase of its work with market participants in relation to the transition and handed the Working Group a mandate to catalyse a broad based transition to SONIA over the next four years across sterling bond, loan and derivatives markets. A key priority of this group will be the further development of interest rate derivative products (and maturities) referencing SONIA and supporting the specific sub-group which has been established for the development of SONIA futures. A public consultation in relation to the expansion of SONIA related products is expected in early 2018.
SONIA differs to LIBOR in that it tracks actual transactions rather than being based on submitted rates. A shift from LIBOR to SONIA in the loan market poses a number of practical challenges, not least that SONIA is backward looking and is to be published at 9am for the previous business day, unlike LIBOR which is forward looking and reflects the duration of the relevant interest period. This means that if SONIA was used as a benchmark, borrowers and lenders would not know the interest rate applicable to any given interest period until after the end of that period, and the interest rate would have fluctuated daily through the term. There are therefore calls in the market for the creation of forward looking risk free rates for terms that match typical interest periods under loans (one, three and six months), to provide certainty for borrowers and avoid an administrative burden for lenders having to adjust the rate daily. The FCA has confirmed the development of term SONIA reference rates as a key near-term priority for the Working Group.
Another issue is that LIBOR is published for several different currencies whereas SONIA applies to sterling only, so alternative rates would need to be developed for the other LIBOR currencies. A joined up approach would be needed when developing these rates to avoid varying returns being generated for each currency, resulting in a need for different margins for loans in different currencies under the same facility.
For lenders and their lawyers, these developments raise the question of what effect the discontinuation of LIBOR will have on existing and future loan agreements, which invariably use LIBOR as their benchmark rate. We cannot, at this stage, draft for the use of a future replacement reference rate around which there remains so much uncertainty, so for now transactions will continue to be based on LIBOR but we may need to consider lenders' ability to substitute a replacement reference rate for LIBOR once things become clearer. For syndicated loans, we should consider having a lower lender consent threshold for amendments to the benchmark rate (majority rather than all lender consent). The LMA has an option for amendments to be made to allow for an alternative benchmark where LIBOR is not available with the consent of the Majority Lenders and the Parent.
The LMA precedent documents contain contingencies in the event of LIBOR being discontinued. If no screen rate is available for LIBOR, an interpolated rate of the nearest highest and lowest available screen rates will apply. If no interpolated rate can be calculated there is an option for a shortened interest period and/or a historic screen rate to apply. If that option is not used in the agreement or it is not possible to use a shortened interest period and/or a historic screen rate, LIBOR will be the average rate supplied by certain reference banks at which they could borrow. If no reference bank rate is available then the lender's cost of funds will apply, the parties will enter negotiations for up to 30 days to agree a substitute rate and if they agree a rate it will be binding.
If reviewing a historic deal lenders need to check which (if any) of these fall backs are included, and if working on a new deal they should consider including them. However, lenders may be uncomfortable with the idea of borrowers having visibility on their cost of funds. There could also be a situation where a screen rate for LIBOR was still being published (so the fall back provisions would not be triggered) but the market has moved away from using LIBOR meaning lenders no longer wish to rely on it and thus need to amend their agreements. Even if the fall backs are included in a loan agreement, they were not designed to address the complete disappearance of LIBOR and it is likely that the agreement will still need to be amended to reflect the replacement reference rate.
On a bilateral deal, stating that the benchmark can be amended with the lender and borrower's consent does not add anything substantive as this is the default position, however it does flag to both parties that LIBOR is being phased out and consequently changes may be needed. Stating that the lender can bind the borrower in to a substitute rate is unlikely to be acceptable to a borrower unless market practice evolves such that this becomes an accepted standard position. Borrowers may become less comfortable where the fall backs are included in their document or proposed to be included. Although they are fairly standard they were intended to cater for short term disruption to the market not a long term discontinuance of LIBOR, and when seen in this context their inclusion in a loan agreement may be more of a concern for borrowers.
Whilst the majority of borrowers would be likely to comply with a request from their lender to amend the benchmark rate once an alternative has been accepted by the market, lenders should be aware that they cannot force borrowers to make such amendments to their agreements and in a few cases this could lead to disputes and ultimately litigation, particularly where the underlying relationship between lender and borrower is already fractious. In many cases, loans will be repaid or refinanced before any new benchmark is introduced, which will provide an opportunity to reflect whichever new rate gains consensus in the market.
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