How do you navigate the upcoming changes to LIBOR?
What is Libor?
LIBOR is an interest rate benchmark which is often used to calculate the 'floating' element of an interest rate. LIBOR is the most common interest rate benchmark in the UK and is based on banks' submissions of their interbank borrowing rates i.e. the rate that the bank itself could borrow the cash in the interbank market. Those rates are averaged out and an official LIBOR rate is published each day. It is this official rate that most lenders use.
What has happened?
Since the financial crisis, the banks no longer fund themselves in the same way and so LIBOR is being sustained by the use of 'expert judgement'. This is open to manipulation as occurred in the mid-2000s during the rate fixing scandal and consequently the FCA and Bank of England confirmed plans to phase out LIBOR by the end of 2021.
What is happening?
LIBOR is available in 5 currencies and so each relevant jurisdiction has established an alternative to LIBOR.
For Sterling, this replacement is the Sterling Overnight Index Average ("SONIA"). This is based on actual transactions in the underlying markets and so less likely to be manipulated. LIBOR can be fixed in advance for a set period whereas SONIA is an overnight rate, measured on each day over the relevant period to produce a final interest rate at the end.
RFRs and LIBOR are calculated on a different basis and so the transition won't be as simple as swapping one rate in and one rate out. For example, LIBOR was forward looking for various periods of time whereas SONIA is backward looking and provides overnight rates. To take a practical example, if a borrower decided to draw a loan from a floating rate facility agreement, it could chose, say, a 3 month interest period and LIBOR could be set at that level at the start of the interest period. This would give certainty to the borrower of the floating rate that it must pay. SONIA, on the other hand, is backward looking and so can't be calculated until the end of the period.
Some existing contracts will not have considered that LIBOR will be discontinued and consequently lack contractual provisions to determine the alternative rate. Alternatively, some will include language in case of an issue with LIBOR ("Fallback Language") which may have been included for a temporary event and won't be appropriate for the contract in the long term. In order for the contracts to continue, these documents will need to be reviewed and amended ahead of the discontinuation of LIBOR.
Where is LIBOR used and what should I do?
Bank facilities – the primary place for LIBOR to be used. The good news is that the FCA has set out its expectations of regulated financial services firms in relation to the fair treatment of its customers, and therefore any amendments to contracts should be proactively led by the financial institution. In fact, the Working Group on Sterling Risk-Free Reference Rates has recommended that:
- By the end of Q3 2020 lenders should be in a position to offer non-LIBOR linked products to their customers;
- After the end of Q3 2020 lenders, working with their borrowers, should include clear contractual arrangements in all new and re-financed LIBOR-referencing loan products to facilitate conversion to SONIA or other alternatives; and
- All new issuance of sterling LIBOR-referencing loan products that expire after the end of 2021 should cease by the end of Q1 2021.
Corporates will need to consider what the practical implications of changing the rate will be and ask their relationship banks to walk them through the calculation process.
Intra-group loans. LIBOR is often referenced in the pricing of intra-group loans. These will need to be amended and a new reference rate included. The intra-group loans may have been put in place as back to back arrangements with external financing, and so will need to mirror any amendments to those contracts.
Derivatives. LIBOR is often seen in many interest rate and currency swaps, for example, hedging future movements in LIBOR rates to hedge expected LIBOR-based debt, both for those swapping from floating to fixed and fixed to floating. Some of these may be able to be fixed by an industry led solution, such as an ISDA protocol, but each swap will need to be considered.
Lending to third parties. for example, in any invoice discounting or financing of franchisees.
Commercial contracts and finance leases:
LIBOR has historically been used as a reference rate in commercial contracts. We see LIBOR in, for example, late payment clauses, price escalation clauses in long-term supply or purchase contracts, break clauses, gross up provisions or price adjustment mechanisms in share or business purchase agreements. Each of these will need proactive engagement in how the contract will work post LIBOR – will a corporate's standards need to be amended? What is an appropriate replacement? How will this be communicated to the counterparties?
LIBOR can be used for accounting and reporting disclosures in financial statements or as a benchmark for internal reporting or analysis. Accounting advice is a must in this regard.
What do I need to do?
1) Ensure that no new contracts reference LIBOR unless they include adequate fall-back language (unless the contract is expected to mature prior to the end of 2021)
2) Identify which of your contracts that will mature after the end of 2021 reference LIBOR:
- Do the LIBOR contracts include Fallback Language?
- Is the Fallback Language appropriate or was it put in place to deal with, for example, a market disruption rather than a permanent change? If it isn't satisfactory, engage with counterparties to consider amending the contract.
- If there is no Fallback Language, does the contract need to be amended? What will be the alternative reference rate?
- Liaise with your finance provider / counterparty and discuss what steps need to be taken.
3) Consider whether any internal systems need to be reviewed – for example, do any standard documents need to be amended? Do any processes need to be reviewed e.g. is overdue interest linked to LIBOR?
How can we help?
We can review your existing contracts as a first step, identifying issues and making an inventory of LIBOR exposures. We can assess whether the issue falls away because of the timing, whether the contract has been 'future proofed' with appropriate Fallback Language, or whether the contract needs amending. We can then help with rectification and correspondence with counterparties if required. We can support you with this for a fixed fee - please get in touch if you would like to discuss these options.