This article, appearing in the April 18, 2019 Business Law Blog of the State Bar of Wisconsin, is brought to you through the consent of the following authors, together with the permission of the Business Law Blog of the State Bar of Wisconsin. We are pleased to bring this article of international importance to you from such experts. We hope you enjoy this!
Patricia J. Lane, Chicago 1986, is a partner with Foley & Lardner LLP, Milwaukee, where she specializes in the finance practice area.
Louis E. Wahl IV, Minnesota 2012, is an associate with Foley & Lardner LLP, Milwaukee, where he specializes in the finance practice area.
In 2021, the London Interbank Offered Rate – the benchmark reference rate that underpinned hundreds of trillions of dollars of finance contracts for three decades – will no longer be used. Patricia Lane and Louis Wahl IV discuss the cessation of what has been called “the world’s most important number,” and offer recommendations for addressing its cessation in credit agreements, securities, and other finance contracts.
In July 2017, the United Kingdom’s Financial Conduct Authority (FCA) announced that it and the panel banks whose submissions are used to determine the London Interbank Offered Rate (LIBOR) will only sustain LIBOR until the end of 2021.
The FCA declined to provide a successor reference rate for LIBOR, leaving it to the international finance community to select a successor to what has been called “the world’s most important number.”
The magnitude of the situation cannot be overstated – it is estimated that LIBOR cessation has the potential to disrupt $200 trillion of U.S. dollar LIBOR contracts, ranging from consumer auto loans to derivatives, including $4 trillion of syndicated loans and $500 billion of collateralized loan obligations.
Suffice it to say, a transition from LIBOR presents the finance industry with a monumental, arguably unprecedented challenge.
LIBOR and SOFR
In the United States, a new reference rate has emerged as the preferred successor to LIBOR, the Secured Overnight Financing Rate (SOFR).
SOFR is an overnight, secured reference rate administered by the Federal Reserve Bank of New York. It broadly measures the cost of borrowing cash overnight with U.S. Treasuries as collateral, and therefore reflects fewer risks than unsecured rates. On the other hand, LIBOR is an unsecured reference rate and tends to be higher than secured rates to reflect counterparty risk.
SOFR is based entirely on transactions in the U.S. Treasury repurchase market, and encompasses a robust underlying market (about $750 billion per day). In contrast, LIBOR is only partially based on actual transactions and encompasses a much smaller market (for example, the average daily trading volume for three-month LIBOR is less than $1 billion per day).
Moreover, the process for determining SOFR is relatively more transparent compared with LIBOR’s. One notable drawback of SOFR is that it tends to be more volatile than LIBOR, especially at month and quarter-end dates, by virtue of it being tied to U.S. Treasury bill issuances.
Suggestion: Use Fallback Language
While there is increasing momentum for SOFR to replace LIBOR and notable SOFR-based debt issuances closed in Q4 2018 and early Q1 2019, the market has not yet widely adopted SOFR (or a variation thereof) as LIBOR’s successor. Until that time, affected parties need to implement interim plans immediately.
For credit agreements, securities, and other finance contracts using LIBOR as a reference rate and with obligations maturing beyond 2021, we recommend that LIBOR fallback language be incorporated therein to address LIBOR cessation.
If a finance contract already includes fallback language, check to see whether the existing language merely addresses the temporary unavailability of LIBOR (for example, if the relevant LIBOR screen rate is unavailable) as compared to the permanent unavailability of LIBOR. Until recently, fallback language addressed only the former. Such legacy language is inadequate to provide a workable solution when LIBOR becomes permanently unavailable.
Fallback Language: What’s Necessary
To address LIBOR cessation, fallback language should at a minimum provide that, in the event LIBOR becomes permanently unavailable or is no longer a widely-accepted benchmark for new indebtedness or obligations, the contracting parties will endeavor to establish an alternate rate of interest to LIBOR that gives consideration to the then-prevailing market convention for determining a rate of interest for transactions of that type, and that the parties will enter into an amendment to the subject agreement to appropriately incorporate such alternate rate of interest.
Such fallback language should permit other adjustments to the terms of the finance contract that might be required to ensure that the parties are in the same economic position once the fallback language is triggered, including appropriate adjustments to the spread.
In addition, fallback language may need to address the mechanics and approval thresholds to amend the subject finance contract to give effect to the alternate rate of interest and other related terms.
This last point becomes particularly relevant in the context of finance contracts that require the consent of multiple parties (such as syndicated credit agreements and indentures), so a streamlined amendment process should be included with respect to the replacement of LIBOR.
Conclusion: Update Your Contracts and Monitor Market Developments
Given the size and scope of LIBOR usage as a reference rate throughout the finance industry, it is essential that affected parties update their credit agreements, securities, and other finance contracts with appropriate fallback language, and actively monitor market developments regarding SOFR and its possible replacement of LIBOR as the preferred reference rate for finance transactions.