February 21, 2019 - A recent article suggested that LIBOR might “linger as regulators change tune.” But have the regulators really changed their tune on LIBOR? To determine this, we reviewed the original document (in this case, a speech by the Financial Conduct Authority’s (FCA) Edwin Schooling Latter).
First, Schooling-Latter’s speech did not mince words on the prognosis for LIBOR: though it should continue through 2021, “there is now wide recognition that LIBOR will come to an end.” This upcoming end of LIBOR presents particular challenges for products that rely on LIBOR that may not be able to be fixed before the end of 2021. While this is not a good thing, do not assume there will be a unilateral regulatory fix. Schooling-Latter specifically noted that, “Market participants should not rely on the availability of an option to use LIBOR for legacy contracts.”
We dissected FCA speech generally and applied its conclusions to loans specifically. There are three ways that markets can (and should) address LIBOR cessation. First, include appropriate fallback language in contracts that clearly dictates what happens when LIBOR ceases or is no longer useable. Second, begin writing new contracts on non-LIBOR rates (like SOFR for the US dollar markets). Third, and unfortunately, there may be some contracts – not syndicated loans – where changing contractual references to LIBOR is simply not practicable. In this circumstance, the official sector might need to take additional steps, albeit in a very targeted manner.
So what has the loan market been doing? First, we have been moving forward deliberately on LIBOR fallbacks, which are legal terms that permit contracts to transition from LIBOR to a new reference rate upon a trigger event. The Alternative Reference Rates Committee (ARRC), the US body responsible for transitioning from LIBOR, released a consultation on fallbacks for syndicated loans and bilateral loans in September and December, respectively. The ARRC Business Loans Working Group, co-chaired by the LSTA and ABA, has been working hard to finalize ARRC Recommended Fallback Language, and the ARRC expects to publish loan fallback recommendations in the spring. These loan recommendations are expected to include both an “amendment” approach (which is similar to, but more robust than, fallback language in today’s loan agreements) and a “hardwired” approach (which sets out all the terms of a fallback at inception of a loan, and is aligned with approaches that other cash markets are taking).
While fallbacks are critical, the best way to deal with LIBOR cessation is simply to have moved on to a new rate. In other words, it would be better i) if existing loans could transition away from LIBOR before cessation and ii) if new loans referenced sturdier rates, such as SOFR. In fact, the ARRC Loan Fallback language addresses the first point. It offers a framework for an “opt-in” trigger, which would permit market participants to transition LIBOR-based loans to a replacement rate once it became the market standard. There is no need to wait until LIBOR cessation.
The second way to avoid LIBOR cessation is to write new loans based on SOFR. While this has not yet occurred for loans (at least not to our knowledge), there have been roughly $50 billion of SOFR-based securities issued since last June. These transactions demonstrate that SOFR securities are not a pipe dream and perhaps in 2019 we’ll see the first SOFR loan.
The final problem does not have a neat solution: There are some existing contracts that simply cannot realistically be transitioned from LIBOR. To be clear, we are not talking about easily amendable or prepayable syndicated loans. Instead, some other cash products have long-lived securities that cannot realistically be amended and may simply have no contemplated solution to LIBOR cessation. In this situation, if LIBOR ceases, we could see contract frustration. For this – hopefully rare – situation, the FCA speech suggested that there may be a very targeted response. The European Benchmark Regulation explicitly foresees situations where the cessation of a benchmark would result in a force majeure event and frustration of contracts that reference that benchmark. In this situation, the Benchmark Regulation allows continued publication and use of benchmarks to avoid frustration of existing financial contracts. Such use is restricted to “contracts that already reference the benchmark in certain circumstances”; it does not apply to new contracts.
Reading between the lines, we find three takeaways for loans: First, get your fallbacks in order. Second, when feasible, start issuing new loans on a replacement rate. Third, as loans do have fallback mechanisms already and can be amended, do not rely upon the regulators potentially propping up LIBOR after the end of 2021 for existing loans.
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