LIBOR: Changes to Consider
On 27 July 2017, it was announced that the London Interbank Offered Rate (LIBOR) will be discontinued by the end of 2021. More specifically, the Financial Conduct Authority in the United Kingdom (FCA) will stop requiring banks and financial institutions to contribute rates for calculation of interest.
For approximately 30 years, most finance documents, including loan documents, debt instruments, and certain derivatives, use LIBOR as a benchmark for calculating short-term interest rates in five major currencies. Indeed, LIBOR is sometimes referred to as the “most important number” in the finance industry.
In the midst of financial crisis, however, a number of scandals arose relating to manipulation by banks of LIBOR. That being said, the reason for its demise is not necessarily these scandals, but the lack of activity in the short-term interbank market, which according to the FCA makes it an unreliable and unsustainable benchmark. Still, as recently reported by Financial Times, 2021 may not be the end of LIBOR at least in the US market — as five years is not enough time to replace and find an alternative for US$ 350 trillion outstanding derivatives, loans, and mortgages that are linked to LIBOR.
- According to the Covenant Review, a research firm focused on loan and bond covenants, anticipated changes will be implemented in a systematic manner, as was done in the case of the introduction of a floor for LIBOR rates. In most cases, finance documents (especially capital market and derivative documents) include provisions to deal with the phase-out of LIBOR and include mechanics to calculate interest based on a base rate. Nonetheless, a number of loan documents may not include such alternate methods for calculating interest rates. Therefore, there are things that lenders and financial institutions need to consider in terms of replacing LIBOR in the finance documents, namely:
- For existing and new loans and financial instruments, start evaluating alternative indexes provided by the FCA, including the Sterling Overnight Index Average (SONIA), EURO Overnight Index Average (EONIA), Swiss Average Overnight Rate (SARON) and Tokyo Average Overnight Rate (TONAR). Further, Alternative Reference Rates Committee (ARRC), a dealer-led industry group backed by regulators, announced a US replacement called the Broad Treasury Financing Rate (BTFR), which may become a feasible alternative. In Islamic finance, we may start to see the utilization of Islamic Interbank Benchmark Rate (IIBF), a reference rate that was established in 2011 but has not been used very often, for the purposes of calculating profit and commission amounts.
- Any financial institution entering into new financial transactions that reference LIBOR should include in their finance documentation provisions allowing the lender to substitute an alternative rate if LIBOR is no longer available, or use a different reference rate. There are usually provisions that allow the use of a “base rate” for the purposes of calculation of interest, in case LIBOR is not available or is lower than the floor rate.
- All existing transaction documents should be reviewed to (1) confirm that mechanics are in place for the substitution of a reference rate or use of a base rate in the event LIBOR is no longer available, and (2) evaluate the need for amendment (which amendment may not be necessary for any given financial transaction that matures prior to the end of 2021). Further, for institutions restructuring financial transactions — where the original maturity extends past the 2021 deadline for LIBOR’s discontinuance — then amendments that allow for the substitution of a new reference rate or use of a different reference rate may need to be included in the operative documentation.
- The internal legal counsel and compliance officers in financial institutions should work with outside counsel to monitor and implement guidelines received from regulators and industry focus groups to ensure the smooth transition from LIBOR referenced loans to an alternative index.