During the unprecedented events of 2020, some may have forgotten about the upcoming phaseout of LIBOR at the end of 2021 – but now is a good time for borrowers to refamiliarize themselves with the potential ramifications of the change.
Do you remember those halcyon days of yore, such as in 2017 when the Financial Conduct Authority (FCA) of the United Kingdom announced that it would no longer support London Interbank Offer Rate (LIBOR) quotes and that LIBOR would phase out at the end of 2021?
It was a disruption in the financial marketplace, and financial institutions were left to determine what alternative reference rates would replace LIBOR. Fast forward to 2020, with the new disruptive force of COVID-19 dominating the headlines and affecting businesses, many borrowers may have forgotten about the phaseout of LIBOR, and to some extent, they may have hoped that it would be delayed until the effects of the pandemic lessened. This hope was only increased by the fact that several financial institutions have continued to underwrite loans with maturity dates after 2021 using LIBOR as the applicable interest rate.
However, in March of 2020, the FCA issued a statement that LIBOR’s termination after 2021 is still planned. In addition, the Alternative Reference Rates Committee (ARRC), which was established by the Board of Governors of the Federal Reserve System and the Federal Reserve Bank of New York to identify alternative reference rates to replace LIBOR, published on its website that it will continue on the path of eliminating LIBOR at the end of 2021. Following these announcements, financial institutions need to continue to review their loan portfolios to assess the impact that the phaseout of LIBOR will have on the portfolios, and just as important, borrowers must focus their attention on what happens when LIBOR ceases to exist and what the impact will be on any borrower’s outstanding indebtedness.
The first step for a borrower to undertake is simple. If you did not start reviewing your outstanding loan documents in 2017, start reviewing them now. Determine whether your outstanding financing is using LIBOR as the interest rate. If not, breathe a sigh of relief and go back to worrying about the effects of COVID-19. However, if LIBOR is the interest rate for the loan, carefully review the documents to determine whether they address what happens if LIBOR ceases to exist. It could be the documents do address this issue, but it is then important to review what the consequences are. Some financial institutions used standard language that if LIBOR was unavailable, loans would convert to the prime rate as quoted by the Wall Street Journal. As of the week of September 14, 2020, the prime rate was 3.25 percent (for the same week in 2019, it was 5.25 percent). As shown on the ICE Benchmark Administration website, the 30-day LIBOR rate for September 11, 2020, was 1.52 percent. This is a great difference in interest rates, and a change from LIBOR to a prime rate could seriously impact a company’s cash flow, particularly if numerous loans are structured in this manner.
Some lenders did think about what would happen if LIBOR ceased to exist, and language could be in loan documents that states that if LIBOR ceases to exist, then a replacement index will be used. Depending on how the language is drafted, a lender may have a great deal of leeway to determine
the replacement index. For example, if the replacement rate language provides that the lender will use a commercially reasonable index that it is also using for similarly situated borrowers, there is some comfort in knowing that the lender will be treating your loans the same as others. However, without naming the specific replacement index, some borrowers will be concerned as to what the financial institution intends to do.
ARRC has so far stated that it is supporting using the Secured Overnight Financing Rate (SOFR) as a replacement index for LIBOR. Unlike LIBOR, which is an average of what financial institutions say they would have to pay to borrow from another financial institution and which borrowings are unsecured, SOFR is based on the cost of overnight cash borrowings secured by U.S. Treasury securities. One of the prime advantages of SOFR, as opposed to LIBOR, according to ARRC, is that the SOFR rates are based on actual transactions, and SOFR is produced in a more direct and transparent manner, whereas LIBOR was based on estimates of rates for future transactions. This distinction should alleviate concerns that SOFR will be subject to the same fraud and manipulation that previously occurred in determining LIBOR.
Carefully review your loan documents to determine whether they address what happens if LIBOR ceases to exist.
If your loan documents do not identify a replacement index (or provide parameters for determining the replacement index), it might be up to the borrower and financial institution to mutually agree to a replacement rate. This could very well lead to neither party agreeing to a replacement interest rate, which could lead to a default of the loan when it is time to reset the interest rate, or at the very least, force the borrower to search for replacement financing. This is a position that some borrowers may not want to face right now. With the economic impacts of COVID-19 affecting businesses and causing financial institutions to tighten their underwriting conditions, especially in industries hardest hit by the pandemic, seeking replacement financing may not in the best interest of a borrower.
So, if you are unsure what replacement index will be used after reviewing your loan documents, or if you are concerned that you might need to seek replacement financing, the next critical step is to contact the financial institution. Reach out to the lender and start the conversation as to what the loan will look like after 2021. Although many lenders have been focused on the new lending programs that have come into the market because of the pandemic, it is not too early to have the lender shift his or her focus on what is going to occur next year. While major financial institutions have been following ARRC’s proposed timeline to terminate LIBOR, the pandemic has shifted the world’s collective focus and caused many institutions to deal with new problems that are occurring in realtime, as opposed to those that are going to occur in the future.
However, it is up to you as the borrower or borrower’s counsel to help shift the focus back onto your financial transactions. Starting the review of your loan documents now will help you better understand to what extent the replacement of LIBOR will impact your outstanding indebtedness, which will impact the cash flow of your business. Also, if the loan documents do not specifically state what happens when LIBOR ceases to exist, or if you are in a situation where it appears the replacement index may not be SOFR and you think it may be in your company’s best interest to discuss alternative replacement indexes, it is best to start the conversation with your lender now. If you would need to enter amendments to the loan documents, it is better to start those negotiations now than at the end of 2021.
Although there may potentially be some delay to the complete phaseout of LIBOR, due in part to the pandemic’s unpredictable nature, the FCA and the ARRC are committed to the expiration of LIBOR; it will happen sooner rather than later. Therefore, take the time now to start planning for the new financial world order.
Published December 1, 2020.