Background
Last summer, the United Kingdom’s Financial Conduct Authority announced it would no longer require LIBOR panel banks to report interbank transactions after 2021, thus ending the interest rate index upon which an estimated $350 trillion of loans are based. The decision to end LIBOR is based in large part on the fact that there are no longer enough transactions in the underlying London interbank market to generate an accurate LIBOR rate. The result of the decrease in interbank lending has required the panel banks to submit rate predictions based upon expert opinion rather than objective data. In addition, LIBOR has been susceptible to manipulation in the past, including the well-publicized scandal reported in 2008 which resulted in $9 billion in fines and multiple convictions.
Alternatives to LIBOR
Since the announcement that LIBOR will be phased out, lending institutions and the Federal Reserve have considered alternatives to LIBOR that are more reflective of borrowing costs, but as of yet there is no consensus on a replacement rate.
The United States government created the Alternative Reference Rates Committee which has proposed the Broad Treasury Financing Rate (BTFR) which represents the rate at which banks will make overnight loans collateralized by U.S. treasuries. The BTFR should be published by the Federal Reserve in 2018, however, there remains uncertainty in the industry as to whether BTFR will be generally accepted as the LIBOR replacement.
Impact on Loan Documents
Lenders will need to undertake a thorough review of their loan documentation to determine whether a procedure is established for replacement of LIBOR. Many loan documents generated over the last several years have begun to include at least a rudimentary provision for replacing LIBOR if it becomes temporarily unavailable, often defaulting to the lender’s prime rate, however, many older loan documents which remain in effect do not define a LIBOR replacement.
Many LIBOR replacement provisions in loan documents were not intended to be permanent, but rather, were designed to become effective in the event of the temporary unavailability of LIBOR. In cases where the loan document will remain effective beyond 2021 and there is either no replacement rate or the replacement rate is not designed to be a permanent replacement rate, an amendment will ultimately be needed to define the applicable replacement index (and margin) to avoid confusion once LIBOR is no longer available.
Until a market consensus on a replacement rate has formed, we are encouraging our lending clients not to negotiate the LIBOR provisions in amendments or new loan documents. A lender agreeing to interest rate provisions involving LIBOR over the next couple of years will undoubtedly result in a variety of nonstandard interest rate terms for its borrowers which will necessitate the lender having to track these changes and calculate interest rates on a case-by-case basis. A consistent approach to dealing with a replacement rate is of paramount importance so that a lender is not tasked with having to internally track multiple rates or indices.
To the extent a lender determines that changes to interest rate provisions are advisable, the lender should retain the right to select the replacement index in its sole and absolute discretion, and in no instance should borrower consent or approval be required. Provisions allowing a lender to select a comparable replacement index and margin upon LIBOR ceasing to be reported, which result in a rate equivalent to that in effect immediately prior to LIBOR ceasing to be reported, are starting to be requested by many borrowers, and seem to be generally acceptable to lenders in those instances in which the LIBOR rate alternatives need to be addressed.