Last updated: January 25, 2018
On July 27, 2017, the U.K.’s Financial Conduct Authority (FCA) announced that banks would no longer be compelled by the FCA to support LIBOR past the end of 2021. The administrator for the LIBOR Benchmark, ICE Benchmarks Administration (ICE), has said they will continue to publish LIBOR after 2021. However, regulators have signaled that continued reliance on LIBOR could present a systemic risk. According to the regulators, this systemic risk exists because LIBOR continues to suffer from a lack of real transactions underpinning it and, beginning in 2022, many banks may drop out of the LIBOR submission pool, further undermining LIBOR as a benchmark.
The threat of banks exiting after December 31, 2021 means that regulators will likely continue to push market participants, particularly large banks, to transition away from LIBOR. The December 31, 2021 date provides a relatively short timeframe for transitioning to LIBOR alternatives. The massive amount of economic activity tied to LIBOR creates the potential for significant value transfers between buy-side and sell-side participants if not handled correctly.
Since 2014, regulators have been working with industry stakeholders to develop a uniform approach to the phase-out of LIBOR. Given the complexities, regulators and industry have not yet identified a consensus approach. Chatham has been participating in these efforts by engaging with regulators and participating in International Swaps and Derivatives Association (ISDA) working groups.
The amount of economic activity tied to LIBOR and the complexity of transitioning away from it means that the transition to alternative rates needs to begin well before December 31, 2021. Loan and derivative documentation are a critical part of any transition. To prepare for the likely transition, Chatham has outlined important factors to consider in loan documentation when grappling with the future unavailability of LIBOR.
Review of LIBOR-related terms
In commercial loan documentation, LIBOR is typically defined by reference to a specific Fixings Screen at a certain time (e.g., Bloomberg Office ICE LIBOR Fixings Screen LIBOR01 Page at 11:00 a.m., London time). If the Fixings Screen is not available, most standard LIBOR definitions will include a polling fallback. Typically, the polling fallback will require the lender to contact a set number of London reference banks, request a quote for the lending rate the bank offers to other prime banks in the London interbank market and take the arithmetic mean of such quotations. If the lender obtains fewer than two quotations, the lender generally will request quotes from major banks in New York City. This general polling fallback approach is consistent with the standard fallback language found in the ISDA Master Agreement.
- Polling language should be considered: To the extent that polling language is not incorporated into the LIBOR definition of the loan agreement, a polling fallback should be included.
Once the LIBOR definition has been reviewed, the next step is to determine whether the loan agreement addresses the potential unavailability of LIBOR. If LIBOR is unavailable, standard loan agreements generally will include a waterfall where LIBOR first will fall back to a substitute rate such as Prime or Fed Funds and, if that is not available, to a second substitute rate. To the extent that they are included in a loan agreement, these unavailability provisions usually will be found as subsections within the Interest Rate section of a loan agreement.
- LIBOR unavailability should be addressed: If the phase-out or unavailability of LIBOR is not specifically addressed in a loan agreement, it is advisable to incorporate language addressing the phase-out or unavailability of LIBOR in the loan agreement.
- Prime may not be the best fallback: Though Prime is often used as a LIBOR fallback, Chatham generally advises avoiding Prime because it has the potential to increase costs. Prime-based derivatives typically are not very liquid. Therefore, transaction costs for Prime-based derivatives are likely to be higher. Fed Funds rates or quotes generally have better liquidity and, therefore, lower transaction costs.
In most fallback provisions, there will be a loan spread. In cases where there is a 0% floor on the loan spread, conversion to Prime will often be more punitive for the borrower than conversion to Fed Funds. If Prime is used in the LIBOR unavailability waterfall, the liquidity of the selected Prime index and the potential for higher transaction costs in Prime derivatives should be considered in negotiating a fair adjustment to the loan spread.
- LIBOR unavailability should be triggered by objective, verifiable criteria: Common LIBOR unavailability triggers include: 1) LIBOR is unavailable (e.g., banks are not providing LIBOR quotes); 2) LIBOR no longer reflects the lender’s cost of funding; or 3) LIBOR is illegal. Unavailability provisions should be triggered by objective criteria. Triggers based on subjective criteria (e.g., “lender in its sole and absolute discretion shall have determined that LIBOR is no longer available”) should be avoided.
The substitute rate selected in the event of LIBOR’s unavailability is critical. To date, there is no market consensus regarding standard substitutes. Different substitute rate definitions are possible, and regulatory and industry efforts to define standard substitutes are ongoing. Consequently, market participants should consider keeping substitute rate definitions as broad as possible, providing flexibility in loan agreements to allow whatever fallback rates are ultimately adopted by the marketplace to be effectively incorporated into the loan agreement. For that reason, substitute rate definitions that cite a specific rate, index, committee or organization should be avoided since a different substitute rate than the one identified may ultimately be adopted by the market. Substitute rates may be defined in loan agreements under a number of different names, including Alternate Index and Alternative Index.
Loan Spread Adjustment
Market participants should review any loan spread adjustment contained within a loan agreement. One party should not gain at the other’s expense simply because the loan agreement requires the substitute rate to be adjusted by specific loan spread adjustment to determine the interest rate for the loan. Typically, loan spread adjustments are a one-time adjustment to the spread when the substitute rate is triggered. For example, if the substitute rate is triggered and, at that time, LIBOR is 1.25% and the Secured Overnight Funding Rate (SOFR) is 1.00%, then the borrower spread would increase by 25 basis points. Even where the substitute rate results in a reduced basis between LIBOR and the substitute rate over the remaining term of the loan, there could still be an increased borrowing cost once the cost of the loan spread adjustment is added into the equation. To avoid or at least minimize value transfer, a loan agreement’s spread adjustment needs to be reviewed to see how it would change the economics of a transaction in the event of LIBOR unavailability.
Lender Required Hedging Provisions
Consideration should be given to how provisions requiring hedging are drafted in a loan agreement. In particular, the potential for a mismatch between the rate or index used in the loan agreement versus that used in the hedge in the event of LIBOR unavailability must be considered. As an example, for interest rate caps, provisions that define items like a required strike price/rate as a fixed number based on a LIBOR index should be reviewed. To avoid a potential mismatch, the cap’s strike price should be relative to the index used to calculate interest in the loan. For example, hedging requirements could be tied to the level of debt service coverage required in the loan agreement rather than a specific number. Other terms that may be desirable are those that allow for an existing hedge to be amended to reflect the substitute rate, rather than the hedging agreement being required to be completely replaced.
These are some of the issues that should be considered as market participants prepare for the unavailability of LIBOR and the resulting impact on loans and derivatives. It is not meant to be an exhaustive list, but rather to provide a sense of the complexities in loan documentation related to the unavailability of LIBOR. If you have questions or would like additional information, please contact:
Corporate Sector: Rich Weins, firstname.lastname@example.org, 1.484.731.0224
Real Estate: Rob Mangrelli, email@example.com, 1.484.731.0419
Financial Institutions: Todd Cuppia, firstname.lastname@example.org, 1.484.731.2761
Regulatory Policy: Eric Juzenas, email@example.com, 1.484.731.0061