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21 Apr 2020
BY Deborah Carmichael

The phasing-out of LIBOR: a helpful guide to the “must-have” features of contractual fall-back language

Market participants are undertaking significant work to prepare for a transition away from the London Interbank Offered Rate (“LIBOR”). The Financial Conduct Authority (“FCA”) in the UK has made it clear that the publication and dissemination of LIBOR cannot be guaranteed after 2021. The launch and reform of preferred alternative reference rates to USD LIBOR and GBP LIBOR are important steps in this transition journey.

However, LIBOR‑based products are still being created, sold and entered into on a daily basis. The question then is what happens to these LIBOR-based products when LIBOR is no longer available. As Andrew Bailey, the chief executive of the FCA, has noted, the answer to this question depends on the preparations that users of LIBOR make in either:

  1. switching contracts from the current basis for LIBOR (ie, developing a LIBOR transition plan); or
  2. in ensuring that their contracts have robust “fall-back language” in place that allows for a smooth transition if (or rather when) current LIBOR ceases publication.

“Fall-back language” refers to the contractual provisions which specify, among other things:

  1. the trigger events for a transition from LIBOR to a replacement rate,
  2. how an appropriate replacement rate should be determined and
  3. the spread adjustment (and other revisions) required to align the replacement rate with the benchmark being replaced (with the primary objective being ensuring that parties are in substantively the same commercial position in a pre- and post-LIBOR environment).

So, what contractual fall-backs are in place today and what would happen if publication of current LIBOR were to cease, triggering those fall-backs? The answer to these questions is complicated.

Outside of the derivatives world and even where parties use LMA-style documents, fall-back language is frequently inconsistent across asset classes and institutions. The definition of LIBOR, the trigger for the fall-backs and the fall-backs themselves vary significantly, even within the same asset class. Even where there is a degree of alignment/uniformity, existing contractual fall-back language was typically originally intended to address a temporary unavailability of LIBOR, not its permanent discontinuation. It is widely acknowledged that if LIBOR becomes unusable, much of the existing fall-back language could lead to significant changes to contract economics or uncertain outcomes. In our last article, we recommended the use of robust fall-back language in new contracts referencing LIBOR to help facilitate a smooth transition to the currency alternative rate.

In the South African market, clients have asked whether using the cost of funds and market disruption technology baked into the existing LMA-type documents is appropriate to determine a fall-back rate when LIBOR is permanently discontinued. The answer, for a number of reasons, is that it is probably safer not to do so.

As mentioned, legacy fall-back language, such as cost of funds and market disruption clauses, were not designed as a permanent fix to interest rate disruption. We say this because:

  • the triggers for the application of these fall-backs do not speak specifically to the phasing-out of the benchmark rate (instead, the cost of funds clause (outside of a market disruption) is a clause of last resort usually available where the other fall-backs (such as an interpolated screen rate or reference bank rate) are no longer available for an interest period; alternatively, it applies where the lender determines that the cost to it of funding the relevant loan exceeds the benchmark rate for the relevant interest period (ie, during a market disruption)); and
  • if the fall-back to the lender’s cost of funds is permanent, a (potentially material) change to the cost of utilising the relevant facility will be made without borrower buy in. Although cost of funds clauses (if they follow the LMA-style formulation) generally permit the borrower to request that the parties enter into negotiations for a fixed period with a view to agreeing a substitute basis for determining the rate of interest, where the parties do not request engagement or cannot agree, it is ultimately for the lender to determine a rate that expresses the cost to it of funding the relevant loan from whatever source it may reasonably elect. If parties intend using the legacy cost of funds fall-back wording as their long-term fix to the discontinuation of LIBOR, it may be particularly difficult for borrowers to determine the impact of the transition away from LIBOR on their funding costs.

All this means that, absent clearly-defined parameters, legacy fall-back language is likely to generate winners and losers. Litigation regarding the interpretation and enforceability of legacy fall-back cannot be ruled out. Bank counterparties will no doubt try to argue that the language was drafted to address the temporary unavailability of LIBOR, not its permanent unavailability, and that some other approach to calculating the interest rate should be adopted outside what is provided for in the contract.

In order to avoid the potential economic impact and litigation risk related to legacy fall-back language, some market participants have considered amending existing contracts to include more flexible (and appropriate) fall-back language, including wording that explicitly contemplates the discontinuance of LIBOR and the use of an alternative reference rate to LIBOR. The process for amending existing contracts and the likely degree of difficulty required for any such amendment are, of course, dependent on the relevant contract’s particular amendment provisions and other factors such as the size of syndicates. Despite this, adopting new fall-back language in legacy loans (particularly for longer-term loans) remains the recommended approach.

In the credit space, the LMA’s recommended screen rate replacement provisions have been available for some time, but these have recently been worked into the template loan documents published by the LMA, which indicates a level of industry-acceptance (at least for English law governed documents). These provisions are a great starting point for new loans. Market participants should however bear in mind that different asset classes will require different treatment.

ISDA on the other hand has finalised a fall-back protocol and counterparties to derivatives are likely to find it significantly easier to amend their contracts through adherence to the protocol rather than trying to engage in negotiations with all of their counterparties. However the protocol mechanism requires that both counterparties agree to adhere to it to amend their contracts. If adherence is not widespread, it is more likely that market participants will need to expend more effort examining their existing contracts and trying to negotiate amendments on a counterparty-by-counterparty basis, which is likely to be administratively difficult, if not impossible, to effect on a wide scale.

Below is a summary of what are, in our view, essential features of fall-back language:

  • The provisions should clearly define the benchmark trigger event: the trigger must define the circumstances under which the references to the benchmark rate in the contract will be replaced.
  • The provisions should clearly define the benchmark replacement: the benchmark replacement definition must identify the rate, or waterfall of rates, that will replace the current benchmark rate following the trigger event.
  • The provisions should clearly define the benchmark replacement adjustment and the levels of consent required to effect knock-on amendments to the contract: the language should clearly spell out how the spread adjustment (which may be positive, negative or zero, added to the replacement rate to account for differences with the current benchmark rate) and other knock-on amendments required to achieve a substantially similar commercial position pre- and post-benchmark rate replacement, will be agreed.

The transition from LIBOR to alternative reference rates presents numerous challenges for both existing and new products. Although uncertainty remains and industry direction continues to evolve, we believe that adopting a “wait-and-see” attitude is unwise. Financial institutions and other market participants should act now to develop and use contract language appropriate for a permanent discontinuance of LIBOR, both for new contracts and for any existing contracts that are amended before 2021.

For further information or assistance with your (L)IBOR transition plan contact:

Deborah Carmichael
Executive | Banking and Finance
dcarmichael@ENSafrica.com
+27 82 787 9495