Stephenson Harwood partner Lisa Marks, trainee solicitor Harry Wilson and rail paralegal Jacques Domican-Bird explain the changes to Libor, and their effects on lenders
The Libor global benchmark interest rate is currently used for financial transactions estimated to be worth $350trn. Libor is published for five currencies and seven different maturities, the most common of which is the three-month dollar Libor.
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In 2012, it was reported that several banks had been manipulating Libor by reporting inaccurate borrowing costs for a number of years, and five traders were subsequently imprisoned in 2015 and 2016. This has contributed to the call for the adoption of alternative benchmarks.
Another major factor is that Libor is based on increasingly fewer actual transactions, requiring some rates to be estimated by the Libor contributors. Also, Libor includes banks’ own credit risk – something which banks are understandably reluctant to disclose. As a result, there is a push for a risk-free rate, which will be harder to manipulate.
In June 2017, the Working Group on Sterling Risk-Free Reference Rates (the Working Group) produced a white paper highlighting Sonia as the preferred near risk-free rate (the RFR White Paper).
Following a speech in July by Andrew Bailey, head of the Financial Conduct Authority, the financial services sector has been urged to consider Sonia and other alternative rates to Libor. In this speech, Bailey indicated that Libor would be phased out by 2021.
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By GlobalDataHowever, Sonia is not a natural successor to Libor for all financial products. The Loan Market Association (LMA) has already written to the Bank of England (BoE) highlighting the complications that would arise in the syndicated loan market from phasing out Libor in favour of Sonia.
One important issue identified by the LMA is that Libor is a forward-looking rate, while Sonia is a backward-looking rate based on historic data.
Libor’s demise would also have an effect on other documentation in the financial services sector – for example derivative contracts, bonds and leases.
Derivative contracts
As noted above, the RFR White Paper identified Sonia as its preferred risk-free rate. This is particularly relevant for derivative contracts, as a key objective of the Working Group had been to identify a preferred risk-free rate for sterling markets, and promote its use as a robust alternative to Libor, “particularly in sterling interest rate derivatives”.
Most derivative contracts are concluded on standard documentation produced by the International Swaps and Derivatives Association (ISDA). ISDA’s usual route to effect amendments to its existing contracts is via a protocol. However, adoption of a protocol is voluntary and ISDA has already made it clear that for the widespread adoption of a rate such as Sonia to work effectively, any such rate should apply across the board – and to both new and legacy trades.
Bonds are debt securities issued to multiple beneficiaries, who often hold their interests at the end of chains of intermediaries. Issuers who issue bonds or notes which reference Libor and which have a maturity date extending beyond 2021 will need to turn their minds to how best to make their documentation future-proof.
Amending bond documentation can be notoriously difficult, protracted and costly, as fundamental changes require bondholder consent – usually via a bondholder meeting. Perhaps we will see lower quorum thresholds at bondholder meetings becoming more standard to cater for this type of amendment. In any event, the uncertainty adds an extra risk factor which will need to be disclosed in the offering circular.
Even where the principal payment obligation is not expressly based on a floating rate, such as rents in leases, documentation can have other types of floating rate incorporating Libor, for example default interest rates. A possible alternative to Libor in this context may be to use base rates, in particular the BoE base rate, as a benchmark.
It is clear that there is no natural successor to Libor. The truth is, if there had been an obvious replacement, it probably would have been identified well before now. Different areas and products in the financial services industry use Libor in different ways and for different purposes, and it is essential to take this into account when assessing how best to deal with its phasing out.
Consequently, at this point in time, when there is no certainty as to Libor’s replacement, most sectors are concentrating on shoring up the provisions in documents which enable the parties to agree a successor benchmark rate.
For example, the current fall-back drafting seen in LMA forms of syndicated facility agreements addresses the position where there is no screen rate available, and is widely accepted to cater only for the short-term unavailability of Libor. However, the Replacement of Screen Rate provision in the amendments and waivers clause of LMA facility agreements does provide a mechanism for the parties to agree on a replacement benchmark rate. Therefore, most lenders are opting to take their chances with this provision, rather than trying to second guess what might happen in the future.
It is though worth bearing in mind that current LMA drafting sets this as a majority lender decision and certain lenders may require such a fundamental change to be a unanimous decision.
Also, the LMA’s Replacement of Screen Rate clause provides a mechanism by which the parties can agree a replacement rate. It does not seek to set any hard and fast rules around what the parties can and should agree in the event of Libor’s discontinuation.
Indeed, it is important to bear in mind that clauses that seek to set out a more comprehensive “agreement to agree” framework will need to be drafted carefully to avoid problems of unenforceability.
