Written By: Kathleen C. McConnell, Esq.
LIBOR (the London Interbank Offered Rate) is anticipated to be phased out and unavailable after December 31, 2021[i]. So, what happens to borrowers who are tied into a LIBOR rate loan that extends beyond December 31, 2021? Below are some general frequently asked questions and answers.
DO I HAVE A LIBOR RATE LOAN?
If you borrowed a loan with a variable, floating or adjustable interest rate based on a LIBOR benchmark or index, this should be clearly set out in your promissory note and/or loan agreement. If you entered into a swap agreement based on a LIBOR benchmark or index, this should be set out in your swap agreement terms. If the LIBOR loan terms extend beyond December 31, 2021, then it is expected that your loan interest rate will be transitioned to a replacement rate index when LIBOR is discontinued.
WHAT IS SOFR?
SOFR (the Secured Overnight Financing Rate) is the proposed replacement for LIBOR in the United States[ii]. SOFR “is a broad measure of the cost of borrowing cash overnight collateralized by Treasury securities”.[iii] SOFR has been recommended by the Alternative Reference Rates Committee (ARRC) as the replacement for LIBOR in the Unites States.[iv] Historical performance of the SOFR has been published for the period commencing August of 2014 by the Federal Reserve Bank of New York.
WHAT WILL MY REPLACEMENT INTEREST RATE BE WHEN LIBOR IS DISCONTINUED?
What do the loan documents say? Generally, a LIBOR-based loan document package will include some form of replacement rate language in the event LIBOR becomes unavailable. For loans prior to 2016, sample clauses are:
- “If…means do not exist for ascertaining the LIBOR Rate…then…the LIBOR rate shall automatically convert to a Prime Rate…”; or
- “Borrower’s right to utilize LIBOR Rate pricing as set forth in this Note shall be terminated automatically if Lender, by telephonic notice, shall notify Borrower that one month LIBOR deposits are not readily available in the London Inter-Bank Offered Rate Market, or that, by reason of circumstances affecting such Market, adequate and reasonable methods do not exist for ascertaining the rate of interest applicable to such deposits. In such event, amounts outstanding hereunder shall bear interest at a rate equal to Lender’s Prime Rate or such other rate of interest as may be agreed to between Lender and Borrower…”
Under these sample clauses, your replacement rate index is likely to be the lender’s then-current prime rate, or a mutually agreed rate possibly based on SOFR. In many cases, the existing fallback language in LIBOR loan documents were drafted with only a temporary unavailability of LIBOR in mind and may have unintended consequences whereby variable rates become fixed, or the borrower’s interest rate increases substantially. Lenders may be at risk for litigation disputes regarding a change in the interest rate benchmark that is unfair to the borrower and that was not adequately addressed or anticipated in the underlying loan documents.
More recent loan documents may include the fallback language recommended by the ARRC between July 2018 and November of 2019.[v] This fallback language may expressly refer to an index recommended by the Federal Reserve System. A sample clause is:
- “…If a Replacement Event occurs, the Note Holder will select a new index (the “Replacement Index”) and may also select a new margin (the “Replacement Margin”), as follows: (1) If a replacement index has been selected or recommended for use in consumer products, including residential adjustable-rate mortgages, by the Board of Governors of the Federal Reserve System, the Federal Reserve Bank of New York, or a committee endorsed or convened by the Board of Governors of the Federal Reserve System or the Federal Reserve Bank of New York at the time of a Replacement Event, the Note Holder will select that index as the Replacement Index. (2) If a replacement index has not been selected or recommended for use in consumer products under Section (G)(1) at the time of a Replacement Event, the Note Holder will make a reasonable, good faith effort to select a Replacement Index and a Replacement Margin that, when added together, the Note Holder reasonably expects will minimize any change in the cost of the loan, taking into account the historical performance of the Index and the Replacement Index…”[vi]
Review your loan documents however, as these sample clauses may not apply to your particular transaction.
With respect to swap agreements, the 2006 ISDA forms definition required the ‘calculation agent’ to obtain quotes from major dealers in the relevant interdealer market if LIBOR became unavailable, however, the ISDA on July 12, 2018 published notice regarding consultations about benchmark fallbacks stating that because, among other things, dealers may be unwilling and/or unable to give such quotes, the ISDA replacement rates for LIBOR will be the RFRs (risk-free rates) identified by the private/public sector worldwide working groups that are establishing alternative benchmarks to LIBOR.[vii] In the United States this proposed benchmark index is SOFR. Legacy swap agreements containing the 2006 form fallback language would need to be amended to update the fallback rate benchmark and trigger provisions. The methodology for amendment to these legacy ISDA agreements remains unclear.
HOW DO I FIND OUT ABOUT MY LIBOR RATE CHANGE?
Contact your lender and ask, if your lender has not already contacted you. It is possible that your lender has not yet finalized its LIBOR transition plans and replacement rate terms.
WHICH IS BETTER, LIBOR OR SOFR?
We cannot determine or predict the performance of SOFR against LIBOR or its impact on borrowers. Below are some of the published pros and cons:
- The LIBOR price-fixing scandal that commenced in 2008 undermined the credibility of LIBOR worldwide, and the UK Financial Conduct Authority does not guaranty the publication of LIBOR beyond December 31, 2021. LIBOR is likely to become unavailable as a benchmark.
- SOFR is “a broad measure of the cost of borrowing cash overnight collateralized by U.S. Treasury securities in the repurchase agreement (repo) market” produced by the New York Federal Reserve Board in cooperation with the US Office of Financial Research.[viii] It is based on historical data measured from actual transactions of record (which regularly exceed $800 billion in daily volumes). LIBOR was determined using survey data self-reported by private-sector banks to indicate the average interest rate at which major global banks could borrower from one another and proved to be subject to manipulation.
- LIBOR provides forward-looking term rates tied to seven different term maturities (overnight, one week, and one, two, three, six and 12-month terms) and is calculated in five currencies (US dollar, euro, British pound, Japanese yen and Swiss franc). SOFR currently is a backward-looking rate, issued daily (without reference to a maturity term) using historical transaction information in US dollars only based on the US market. The ARRC (Alternative Reference Rates Committee established by the NY Federal Reserve) has set a goal of seeing forward-looking term rates once SOFR derivative markets develop sufficient depth, by the end of 2021.[ix] The ARRC in November of 2019 published LIBOR fall back language using SOFR + a spread adjustment as the replacement rate in the event LIBOR were to become unavailable before anticipated, which is designed to adjust for the applicable LIBOR term maturities products.[x]
- Some analysts believe that SOFR may be a more volatile rate than LIBOR or the EFFR (the Effective Federal Funds Rate).
WHY IS EVERYONE STILL USING LANGUAGE LIKE “EXPECTED”, “PROPOSED” AND “ANTICIPATED” FOR THE REPLACEMENT RATES, AND FOR THE DECEMBER 31, 2021 DISCONTINUANCE DATE FOR LIBOR?
LIBOR is “a benchmark imbedded in as much as $340 trillion worth of financial contracts worldwide.” [xi] The transitioning of existing LIBOR loans and markets to a replacement index is a costly and complicated ongoing worldwide project with great risk of litigation and market confusion. It appears there is a level of uncertainty and caution with respect to finalizing the LIBOR discontinuance date with absolute certainty at this point in time.
[ii] “Get Ready for SOFR: A Primer”, Wells Fargo Securities Economics Group, Special Commentary, January 31, 2020, citing as sources Bloomberg LP, Federal Reserve Board and Wells Fargo Securities. https://www08.wellsfargomedia.com/assets/pdf/commercial/insights/economics/special-reports/sofr-20200131.pdf
[iv] The Alternative Reference Rates Committee (ARRC) is a group of private-market participants convened by the Federal Reserve Board and the New York Fed to help ensure a successful transition from U.S. dollar (USD) LIBOR to a more robust reference rate, its recommended alternative, the Secured Overnight Financing Rate (SOFR). https://www.newyorkfed.org/arrc
[v] ARRC Fallback Contract Language, https://www.newyorkfed.org/arrc/fallbacks-contract-languagehttps://www.isda.org/a/SZYEE/ISDA-Publishes-Consultation-on-Benchmark-Fallbacks.pdf
[x] Summary of ARRC’s LIBOR Fallback Language, Alternative Reference Rates Committee, November 2019 https://www.newyorkfed.org/medialibrary/Microsites/arrc/files/2019/LIBOR_Fallback_Language_Summary.pdf[xi] “The End of Libor: The Biggest Banking Challenge You’ve Never Heard Of,” Sinead Cruise and Lawrence White, Reuters, October 8, 2019 https://www.reuters.com/article/us-britain-libor-transition-analysis/the-end-of-libor-the-biggest-banking-challenge-youve-never-heard-of-idUSKBN1WN0H4