October 1, 2018
In the summer of 2017 Andrew Bailey, CEO of the Financial Conduct Authority (FCA), called for the phasing out of the London Interbank Offer Rate (LIBOR) by the end of 2021. LIBOR is a primary benchmark rate tied to over $350 trillion dollars’ worth of financial products ranging from derivatives, mortgages, and commercial loans. The frailties of LIBOR have been widely demonstrated in the last several years as evidenced by the highly publicized pricing manipulation scandals.
Although there has not been an official decision on its replacement, an international group known as the Alternative Reference Rate Committee (ARRC) with the support of the US Federal Reserve have proceeded to identify appropriate indices. The leading candidate at the present time is something known as SOFRA (Secured Overnight Financing Rate).
The replacement choice is not what puts borrowers at risk. It is the language in their loan documents that needs attention. Most LIBOR-based loan documents give banks wide latitude in naming a replacement should LIBOR be unavailable. And, while it is reasonable to assume that banks will select something that is relatively close to the intended LIBOR + loan spread benchmark, there is no guarantee.
Where things get particularly dicey is with those borrowers that have fixed rates using interest rate swaps. Here’s why.
- With a swap, the borrower ends up signing two sets of documents, loan documents and swap documents.
- Currently, both the loan and the swap rates are based off of LIBOR.
- Currently in a swap, the bank pays the borrower LIBOR and the borrower uses that to pay the LIBOR portion of its loan. It is a wash, leaving the borrower to pay only the fixed, swap rate.
- However, when LIBOR is replaced, the language in each contract may result in disparate new indices. If that occurs, the borrower would be legally responsible for any difference, which could be catastrophic.
Because a LIBOR replacement process and timeframe has not yet been defined, it is unrealistic to expect agreement on a specific replacement within the documents. However, it is reasonable to negotiate language that avoids disparity between the loan and swap replacement. Because the Master ISDA documents are universal, the replacement language within those documents is unlikely to be modified. That means the bank must agree to insert language within the loan documents.