No more LIBOR? – impact on finance agreements
A recent speech given by the CEO of the UK Financial Conduct Authority (FCA) has been widely reported as signalling the end of LIBOR. This is an overstatement. However, we can no longer assume that LIBOR will continue to exist or be referenced in finance documents beyond 2021. This development raises the obvious question as to whether we need to change finance documents to reflect the possibility that LIBOR may cease to exist.
At this stage, it is difficult to make meaningful changes to finance documents as there is too much uncertainty. In a number of markets, commercial discussions regarding a replacement rate are at an early stage. A number of working groups have been established to consider potential near risk free rate alternatives to LIBOR in different currencies. The Bank of England recently published a white paper proposing SONIA as its favoured option.
Market participants face a number of challenges in identifying a workable option. The main focus of current legal discussions is whether greater flexibility can be built into documents to allow parties to agree a replacement rate with a minimal consent process. Key decisions here are what an acceptable consent level might be, what the appropriate trigger should be and how that might be best expressed.
Where is LIBOR post regulatory reform?
LIBOR has undergone a period of change in response to regulatory recommendations since the manipulation scandals. One of the changes was the introduction of a new transaction-based calculation methodology with more transparent and objective submission criteria for panel banks.
The new calculation methodology includes a waterfall methodology to ensure that a rate can be published in all market circumstances. When there is insufficient market activity, panel banks must supplement transaction data with expert judgement.
What did the CEO of the FCA actually say?
The key points made in the speech were the following:
- Despite recent reforms, the unsecured wholesale term lending market for banks is not active enough to support a transaction-based LIBOR
This means that panel bank submissions are too reliant on expert judgement. Panel banks are increasingly uncomfortable about using expert judgement when there are few underlying transactions.
- The FCA has to encourage panel banks to continue to submit rates
This is unsustainable in the long term. The FCA has asked panel banks to voluntarily agree to continue to sustain LIBOR until 2021, which they have agreed to do.
- Markets cannot rely on LIBOR continuing to be available indefinitely and should begin to plan a transition to an alternative reference rate
The end of 2021 is not a drop dead date for LIBOR. However, after 2021 it will no longer be supported by the FCA encouraging or obliging panel banks to contribute. Note that LIBOR could continue to be published after the end of 2021 since the administrator of LIBOR has not stated that it will discontinue publication. By highlighting the lack of data available to sustain a transaction based LIBOR and the consequent pressures on panel bank submissions, the FCA is signposting the flaws in the continued reliance on LIBOR. The aim appears to be to focus market participants on the need to identify and transition to a replacement rate as a priority.
- A planned and orderly transition from LIBOR is necessary to avoid market disruption
The speech contains a number of clear messages in favour of sustaining the current situation, to the extent possible, until suitable transition arrangements are in place.
What changes should be made to finance documents?
LIBOR is used as a benchmark rate across a diverse range of financing transactions (eg loans, bonds, derivatives, structured products). Market participants will need to consider whether potential alternative rates are suitable for transactions in their market. There may not be a "one size fits all" replacement across the spectrum. Finance documents in different markets contain different fall backs, consent and amendment provisions and administrative parties. These factors mean that there are different considerations in terms of documentary changes for each market. There are however some common themes in initial thinking:
(a) Existing fall-backs
What would happen to legacy deals if LIBOR ceases to exist and no changes have been made to existing documents? Most finance documents provide fall-backs for the absence of LIBOR. These provisions generally anticipate a temporary state, meaning the fall-back is often not a sustainable or attractive long term prospect. There is therefore a general desire to make changes to finance documents rather than rely on the existing fall-backs.
In the derivatives market, ISDA has working groups seeking to identify ways to make the contractual fall backs more robust if a key -IBOR were to be permanently discontinued. Once in agreed form, they are expected to publish a market consultation on the proposed fall-backs and any related amendments to the ISDA 2006 Definitions. We are not aware of similar developments in other markets at this stage. The impact of the EU Benchmark Regulation from 1 January 2018 will mean that LIBOR fall-backs may come under greater scrutiny.
(b) Automatic switch to a replacement rate
There have been discussions in a number of areas about whether it is possible or advisable to include an automatic switch to a replacement rate on the discontinuation of LIBOR.
There are a number of reasons why it is not advisable to include this sort of automatic substitution. First, without knowing what that replacement rate will be, parties do not know how it will affect the agreed commercial deal. It is possible that the adoption of a new rate will require adjustments to pricing to achieve a comparable rate of return. It is also likely that any new rate will require administrative changes which will call for more complex drafting amendments than can be factored in at this early stage. In many cases, changes to the interest rate mechanics in finance documents will need to take into account connected transactions as there is a danger of creating mismatches.
(c) Replacement rate amendment provision
An alternative to having an automatic switch is to include a provision that allows greater flexibility for parties to agree on a replacement rate without entering into a full consent process.
By way of example, since November 2014, all Loan Market Association (LMA) loan agreements have included an optional provision that allows the majority lenders and the obligors to agree a replacement if a "Screen Rate" ceases to be available. We understand that trade associations in other markets are considering whether an adapted form of this provision should be added to their standard documents.
The drafting of these provisions will require agreement on what level of consent would be acceptable in the relevant market for LIBOR to be replaced and the appropriate trigger for the provision. The current LMA provision is triggered upon the cessation of LIBOR. A broader approach would be for it to cater for a range of possible scenarios, for example, the market switching to an alternative rate while LIBOR continues to exist.
As with the automatic switch over to a replacement rate, there are likely to be substantial mechanical and pricing related changes required if an amendment is agreed. This may include the addition of an adjustment mechanism to protect the commercial deal.
These provisions are likely to provoke some debate. Some view the applicable benchmark as fundamental to the economics of the deal, making it inappropriate to be amended by anything other than an all-party consent.
In both the securitisation and the U.S. leverage loans market there has been discussion about amendment consent being sought by negative consent methods. This would allow a replacement rate to be proposed by the issuer/borrower upon the occurrence of certain trigger events, with the lenders/certain investors then having a window within which to effectively reject the change.
(d) Agent/trustee discretion
There has also been discussion in the U.S. leverage loans market and the securitisation market about giving the agent/trustee the discretion to elect a replacement rate in the scenario that there is a market-wide switch to one rate. There are a number of challenges with this proposal. The first is being able to describe the parameters of the modification in a manner acceptable to all parties, given the current uncertainty, although this may become clearer over time. A second is the likelihood of an agent or trustee being comfortable with discretion of that order.
This case summary is part of the Allen & Overy Legal & Regulatory Risk Note, a quarterly publication. For more information please contact Karen Birch – firstname.lastname@example.org, or tel +44 20 3088 3710.