What will the end of LIBOR mean for borrowers and lenders?
Market participants will be aware the UK Financial Conduct Authority (FCA) formally announced in March this year that “all LIBOR settings will either cease to be provided by any administrator or no longer be representative” immediately after 31 December 2021. To help facilitate the transition away from LIBOR, market participants are expected to start using alternative risk-free reference rates (RFRs) from 21 September 2021.
What specific impact the immediate transition will have on LIBOR-referenced contracts where no alternative has been agreed by the contracting parties in the interim remains uncertain and there is therefore significant risk of litigation in this area. Here Alexander Edwards and Hannah Sharp of Rosling King LLP take a closer look at long term implications and risks from the LIBOR transition and what the market will look like post-2021.
The Working Group on Sterling Risk-Free Reference Rates, which comprises a plethora of market participants and trade associations representing different sectors and markets, has identified the Sterling Overnight Index Average (SONIA) as being the most appropriate available benchmark floating reference rate to replace LIBOR in the sterling markets.
SONIA, which has been administered by the Bank of England since April 2016, is based on actual transactions and reflects the average of the interest rates that banks pay to borrow sterling overnight from other financial institutions and other institutional investors. As a backward-looking overnight rate, it is inherently different from LIBOR, which is a forward-looking term rate based on estimates by the banks of the rates at which they could borrow from other banks.
SONIA is therefore viewed as a robust alternative RFR to LIBOR as it is anchored in active, liquid underlying markets. Further advantages of SONIA are:
• It does not include a term bank credit risk component so is a better measure of the general level of interest rates than LIBOR.
• It can be compounded to be used in term contracts. Compounded SONIA also tends to be relatively predictable.
From a borrower’s perspective, one needs to be aware of the several different conventions that exist for calculating SONIA interest payments. This means one needs to take as much care as possible to ensure one’s hedging instruments and loan documentation are as aligned as possible. That said, at the current time, it is not always possible to achieve a perfect alignment between hedge and loan agreement, and not all providers offer the same range of hedging products.
Another practical consideration for borrowers to note when dealing with SONIA lending and hedging products is that they are not going to know the amount of interest due until very close to the payment date. This contrasts with LIBOR where, on the reset date at the beginning of an interest accrual period, the contracting party knows exactly what it is going to have to pay in 3 or 6 months’ time. With SONIA, it will be between 2 – 5 days before the interest is due that the contracting party will know absolutely what the payment is going to be.
Transitioning a Loan from LIBOR to SONIA
There are several approaches that may be taken when transitioning from a LIBOR-linked contract to SONIA-linked contract. The best option will depend on whether the loan is bilateral or syndicated and the security package in question.
Aside from considering the appropriate RFR (most likely SONIA), lenders will also need to consider several other terms in the loan agreements, for example: interest periods; fall-back provisions; application of any break costs; and market disruption provisions.
Lenders are advised to complete an internal audit of the existing loan contracts – this is to establish what loan facilities already include any pre-emptive provisions catering for the transition to SONIA and, if so, whether these are appropriate/practical. Subject to the nature of the contracts, it may be that some of the loan documents need to be amended.
Keeping healthy cash flows is also highly desirable – as one might not know the exact interest cost before one pays the interest, it is necessary to make sure there is enough contingency in one’s cash flow to cover any excess, i.e. if there is volatility in the market. Borrowers should ensure that lenders provide interest notifications as soon as possible.
There is significant litigation risk associated with the transition away from LIBOR to an alternative RFR such as SONIA. Below are some of the key areas of concern:
Huge numbers of so-called “legacy contracts” were entered into during a period when the contracting parties did not envisage that LIBOR would ever be phased out. Such contracts may not contain robust fallback provisions dealing with the unavailability of LIBOR. Where there are fallback provisions, they are often provisions that were intended to cater only for the situation where LIBOR was not published for a short period of time, but did not envisage the permanent abolition of LIBOR. Most such fallbacks provide for the last available rate to be used, essentially converting a floating rate into a fixed rate.
Given that the alternative RFRs will not work in precisely the same way as LIBOR, renegotiating legacy contracts is unlikely to be straightforward. It is probable that disputes will arise during the renegotiation process, and inevitable that there will be winners and losers in each case.
The FCA is particularly concerned about so-called “tough legacy” contracts. This term refers to contracts for which there is genuinely no realistic prospect of renegotiating or amending the contract to reference an alternative benchmark before the discontinuation of LIBOR on 31 December 2021. Examples of what might constitute a “tough legacy” contract include retail mortgage contracts, which cannot be individually renegotiated with customers.
In recognising the need to adequately address any potential issues when dealing with “tough legacy” contracts, the Government has legislated to amend the UK Benchmarks Regulations by way of the Financial Services Act 2021, which received Royal Assent in April. The amendments grant the FCA additional powers to help ensure an orderly wind-down of LIBOR through the creation of an alternative methodology (a “synthetic LIBOR”) to be used in place of LIBOR following the end of the year. The FCA is currently consulting on the exercise of its powers under the Act.
Whatever the precise outcome, any synthetic LIBOR would necessarily produce a different result to LIBOR itself, which means that there will be a winner and a loser under each contract, bringing with it the potential for disputes.
Mis-selling claims might arise if financial institutions, despite knowing about the intended phase-out of LIBOR, fail to include provisions in the contract for LIBOR transition. This is particularly likely in the context of consumer contracts, since it can be assumed that consumers would have no knowledge of the transition away from LIBOR.
The doctrine of frustration comes into play when an existing contract is rendered physically, legally or commercially impossible to fulfil, or where the obligation is transformed into an obligation that is radically different from that undertaken at the moment of entry into the contract.
In the context of LIBOR-linked contracts, frustration may occur where a loan agreement is entirely silent on remediations and fallbacks with the result that there is no means of determining a fundamental term, for example the pricing of the debt. This is likely to occur when dealing with complex, multilateral contracts that will not be able to transition before the cessation of LIBOR on 31 December 2021.
The extent to which the Courts will conclude that a LIBOR-linked contract is frustrated is up for debate. Although each case will be dependent upon the specific wording of the contract, given the significant ramifications such a ruling would have for the financial markets, and the number of contracts that could be affected by such a decision, we would expect the Courts to exercise caution in this context.
It is expected that many LIBOR-linked contracts will include force majeure clauses that bring an end to the performance of obligations where a party is prevented from performing its duties due to events outside of its control. Should parties not be able to agree a new benchmark that closely aligns with the original terms of the contract, a party could seek to rely on the force majeure clause.
Again, the extent to which a party can rely on force majeure will depend upon the exact wording of the clause, and the Courts are likely to be cautious about allowing such claims.
The FCA has published a series of questions and answers for firms relating to conduct risk during the LIBOR transition. When transitioning across to alternative RFRs, it is imperative that firms consider their regulatory obligations alongside conduct and governance risk.
The bottom line is that the FCA expects firms to actively engage with LIBOR transition and work to the LIBOR transition timetable set out by the FCA/Bank of England. The FCA also expects the LIBOR transition to be implemented in such a way that does not prejudice the interests of one’s clients. There may even be a stronger impetus on firms to be fair where clients are consumers or unsophisticated clients.
This article is intended merely to highlight issues and not to be comprehensive, nor to provide legal advice.