LIBOR . . . Coming to an End?

LIBOR is the reference rate for hundreds of trillions of dollars in financial contracts, ranging from syndicated loans, floating rate bonds and notes, to individual home mortgages, consumer and student loans, and other simple and complex debt financings (including securitizations) and derivatives. Many, although not all, lenders and borrowers that are party to the vast array of financial instruments that carry interest rates based on LIBOR are busy preparing for the post-LIBOR era – which is widely expected to arrive on January 1, 2022, when LIBOR as we know it may cease to be published.

Many of the articles written to date, like the ARRC and SFIG releases referred to below, address issues relevant to new LIBOR-based contracts, including how and whether the SOFR (Secured Overnight Funding Rate) should replace LIBOR, the terms of the trigger provisions to effect a fallback to an alternative rate and related matters. Most of the discussion below will focus on legacy contracts.

Nik Mathews and Jonas Robinson of Orrick have previously commented extensively on the challenges for derivatives transactions in light of the prospective LIBOR transition. See Orrick Derivatives in Review.

What’s in My LIBOR-based Financial Instruments?

“People might have bonds that have been in existence a decade, or a corporate treasury might put money into a benchmark-linked deposit that is referenced to Libor. People need to quickly work out what they have exposed"

There has been talk of an alarming lack of preparedness for the possible end to LIBOR.

In addition to considering the issues discussed below, the best way to prepare is by knowing the scope of your own exposure with regard to contracts and assets with maturities beyond 2021.

Lenders and borrowers who have entered into large numbers of LIBOR-based financial contracts, including derivatives, or who own large volumes of individual home mortgages, consumer loans, student loans or other LIBOR-based assets would be well advised to systematically catalogue the relevant LIBOR provisions in these instruments.

These instruments may include uniform “trigger” provisions intended to identify a test for when LIBOR no longer governs the contract, and uniform “fallback” provisions intended to identify an alternative reference rate, or there may be vast, or slight, differences in those provisions. Being able to identify and evaluate with precision the relevant provisions in existing contracts and assets that reference LIBOR is critically important to confronting challenges relating to the potential end of LIBOR publication.

A review of at least the following should be considered.

• Fallback Provisions. What, if anything, do the instruments say about the use of alternative benchmarks if LIBOR becomes unavailable?
• Alternative Benchmarks. What are the alternatives provided?
• Choice of the Alternative. Who chooses the alternative benchmark to be used if there is more than one to choose from?
• Margin. Is an adjustment to the spread to LIBOR provided for?
• Has the Fallback Provision Been Triggered? Who determines when and whether the alternative benchmark should be used, and on what basis?
• Amendment/ Consent Provisions. What are the amendment and related consent provisions in the event a change is desired?

The first step in preparing for potential LIBOR cessation is to ensure that contracts have robust LIBOR fallback language. In other words, if LIBOR were to cease tomorrow, to what interest rate would your loan or CLO “fall back”?  Many syndicated loans would fall back to Prime. Inasmuch as Prime is 5% - well above LIBOR – this could create a financial hardship for borrowers (which also is bad for the lenders that lend to them). Meanwhile, a number of securities fall back to the last reported LIBOR (which is not good for investors that thought they were invested in floating rate products). And some products are simply silent (which may be good for litigators, but probably not so good for the counterparties). LIBOR Fallback (Consultations) Are Here! (Excerpt from LSTA website, September 25, 2018)

New LIBOR-based Contracts

Parties structuring and negotiating LIBOR-based contracts now are working to manage the prospective transition by including trigger and fallback provisions that are tailored to account for the expectation that LIBOR will no longer be available after 2021. As discussed below, there are many considerations to take into account and it may not be possible to eliminate all commercial and legal risk to borrowers and issuers.

The ARRC has released LIBOR fallback consultations for syndicated business loans, for Floating Rate Notes (FRNs), for Bilateral business loans and for securitizations. These consultations outline draft language for new LIBOR-based contracts. The ARRC intends to publish additional consultations and final recommendations in the near future.

SFIG also recently released its LIBOR Task Force Green Paper, which contains a set of recommended practices for the LIBOR benchmark transition. The Green Paper, like the ARRC releases to date, addresses issues related only to new transactions.

Legacy LIBOR-based Contracts

The transition is a knottier challenge for “legacy” contracts – existing contracts that reference LIBOR and that will remain in effect beyond 2021. Large numbers of legacy contracts provide for alternatives to LIBOR, but they were drafted in anticipation of the possibility of only a temporary, short-term interruption in LIBOR’s availability. Even those provisions do not fully and precisely address the issues that could be contentious.

Some legacy contracts do not even address the possibility that LIBOR would no longer be available during the life of the contract.

Amendments to Legacy Contracts?

Many if not all of the issues referred to below could, conceptually, be addressed by amendments to these legacy contracts. Amendments to bi-lateral contracts will, of course, be a function of the relative leverage of each of the parties, and contracts that require consent of large numbers of investors may not be possible.

Failure to amend contracts that require an amendment to put in place a LIBOR alternative along with an alternative margin, if appropriate, may well be a source of contention and dispute as we get up to and through the end of 2021. The possibility of dispute will be dependent on whether, among other things, the parties believe that a LIBOR-based rate and the currently specified margin would be higher or lower than the alternative that would be put in place. 

Certain Issues to Be Considered

Issues to be considered with regard to legacy contracts (many applicable to new contracts as well) include those relating to the trigger provisions, the fallback-benchmark rate provisions, and the margin (or spread) provisions. These provisions are particular fodder for litigation when they contain ambiguity or they authorize someone to exercise discretion.

• Trigger provisions

Trigger provisions – the test for when LIBOR no longer governs the contract – often are objective and clear, but sometimes are not. The less clarity and the less objectivity in determining that LIBOR is no longer applicable for determining the interest rate in a contract, the greater the likelihood of a dispute.

• Many trigger provisions are objective and clear – for example, stating that a specified LIBOR rate applies as long as it is published daily by an identified source such as a specific Reuters page or The Wall Street Journal.
• Other trigger provisions contain ambiguity or require the exercise of judgment – for example, stating that a fallback rate can be selected when LIBOR “is no longer a widely recognized benchmark rate”.
• Some legacy contracts have no trigger or similar provision anticipating the end of LIBOR. In those cases, if and when LIBOR ceases to be published, one party may take the position that the contract is missing an essential term and is, therefore, no longer enforceable. A court faced with that case might agree, or might impose the benchmark or rate that it deems to be appropriate.
• Zombie LIBOR/ Reformed LIBOR – In some scenarios, even where a contract contains an objective trigger provision, there is the possibility of a dispute even before LIBOR actually expires.

If the LIBOR referenced in a contract no longer has the meaning the parties anticipated – for example, if it rests on few or no actual transactions, or few LIBOR submissions by banks, the borrower (if Zombie LIBOR is higher than what the borrower perceives to be the market rate) or the lender (if the reverse is the case) might argue that an alternative reference rate should be put in place.

In this regard, the statements by the President of the ICE Benchmark Administration are quite problematic, “A reformed LIBOR could continue to exist alongside these new rates, to serve a different set of customer requirements.” OK for new contracts but problematic for existing agreements: Would LIBOR no longer be available and therefore an alternative benchmark triggered if “a reformed LIBOR” continued to exist?

• Fallback provisions

Even where legacy contracts contain fallback provisions – which are intended to identify an alternate reference rate – the provisions may be ambiguous or may be otherwise vulnerable to challenge on the grounds that the parties anticipated the fallback as a temporary stop gap in case of a temporary interruption in LIBOR and not as an alternative reference rate for the life of the contract. In fact, until new, market-accepted reference rates emerge, it may not be possible to draft language that eliminates ambiguity about possible fallback rates.

• Some fallback provisions refer to rate quotations obtained from a specified number of “reference banks,” but do not provide for the possibility that quotes are no longer provided by the number of banks the parties anticipated when they entered their contract.
• Some fallback provisions refer to “comparable” indexes, a term sufficiently vague to permit disputes over its meaning. This litigation risk might diminish if a market-consensus index emerges for the category of contract at issue.
• In many floating-rate legacy contracts, if LIBOR becomes unavailable, a fallback provision converts the contract to a fixed rate using the last published LIBOR. In those cases, a borrower might argue that this fallback rate was intended only as a temporary stop-gap in case of a temporary interruption in LIBOR, not a permanent rate for the contract’s entire remaining life. The dissatisfied party might contend that the contract is terminated, asserting one of the legal theories described below.

• Spreads over the fallback rate

The market appears to be moving towards the use of a risk-free reference rate as an alternative to LIBOR.^[1] By definition, a risk free rate generally does not change based on developments in the credit markets. Accordingly, the margin (or spread) provided for determining a LIBOR-based interest rate, which is subject to credit risk, is arguably inappropriate for the margin that should be added to a risk free rate.

Most (all?) legacy contracts that provide for a fallback rate do not also provide for a change to the spread provided for to be added to the LIBOR rate. Can any of the parties to the contract require that an alternative spread be applied?

For new contracts, the parties may agree at the outset what a new spread will be if the fallback rate provided for becomes applicable.  In the alternative, the parties may punt at this time and agree to provide for a spread “consistent with accepted market practice”, or to assign to the lender (or an administrative agent) the right to choose the new spread. Some new contracts are being entered into without any reference to a spread adjustment. Each of those alternatives could result in a dispute in the future.^[2]

• Basis risk

There are a number of circumstances in which the end of LIBOR could result in basis risk between assets and liabilities that does not exist today.

For example, while a borrower may be able to determine that a trigger event has occurred on a LIBOR-based liability and may be able to implement a switch to an alternative reference rate, the LIBOR-based assets funded by the liability (whether in a securitization or otherwise) may not contain identical trigger and fallback language and it may be difficult to adjust spreads on the liability and the assets in the same way.

Similarly, the post LIBOR transition of a liability may not be consistent with the post LIBOR transition of a related hedge or other derivative.

• Risk factor disclosure

There has been uncertainty regarding the prospective LIBOR transition for some time now. Have bond issuers (including securitization issuers) properly disclosed the risk of LIBOR not being available, including the basis risk and all other related issues?

Certain Legal Considerations

• Breach of contract. Almost any ambiguity or exercise of discretion can raise a question of contract interpretation and, therefore, support a claim for breach of contract. If a borrower establishes a material breach, the remedy may be rescission.^[3]
• Implied covenant of good faith and fair dealing. This doctrine prevents one party from denying the other the benefit of the contract or from seizing an unanticipated windfall. Courts may use the doctrine to evaluate general fairness in light of changed circumstances.^[4]
• Force majeure. This contract provision permits one party to terminate performance if certain circumstances arise that are beyond the parties’ control and make performance impossible or undesirable.^[5]
• Unexpected-circumstances doctrines. These doctrines are defenses to performance. They can be available even when performance of the obligation at issue is possible but would be very unfavorable for one of the parties. The key factor often is whether the contract arguably allocated the risk of the event at issue – in this context, the risk that LIBOR might cease to exist.
  • Impossibility may apply where performance is impossible because of an event the parties did not anticipate and is beyond their control.^[6]
  • Frustration of purpose may apply where the value of performance to one party has been destroyed.^[7]
  • Mutual mistake of fact may apply where both parties mistakenly believed a fact was or would be true – in this context, that LIBOR would continue to be published.^[8]

Financial institutions may find themselves on both sides of some of these legal issues – as parties to a wide range of financial instruments, and in various settings in roles including lender, borrower, servicer, trustee, and more. Each institution will have to consider the risk that a legal position it takes in one context can be cited against it in another. Thus the complexity of these large institutions multiplies the legal complexity they face as they confront the possible approaching end of LIBOR.

What You Can Do Now

The first thing that can be done now is to take inventory of the LIBOR-based contracts and assets on the balance sheet. What is in these instruments that will matter if and when LIBOR is no longer available? (See discussion above, “What’s in my LIBOR-based instruments?”)

The alternatives to be considered for both new and legacy contracts will be a function of, among other things, the language and context of the specific contract at issue. Lenders and borrowers, as well as other holders of LIBOR-based assets, should scrutinize the relevant contractual language and consider the above possible trouble spots as they consider entering into and/ or amending LIBOR-based contracts.

Extreme care is advised when entering into new LIBOR-based agreements today, ahead of the development of market standards relating to trigger provisions, fallback provisions, spread adjustments and related issues. The ARRC, SFIG and other releases can provide guidance on the development of these market standards.

1. The ARRC has identified the Secured Overnight Financing Rate (SOFR) as the rate that represents best practice for use in certain new U.S. dollar derivatives and other financial contracts.
2. ]Illustrating the uncertainty inherent in identifying appropriate spreads, various groups are working to identify appropriate approaches to spread adjustments for specific categories of financial instruments. For example, for floating rate notes, the Alternative Reference Rates Committee (ARRC) Floating Rate Notes Working Group has drafted a four-part “Waterfall for the spread adjustment.” AARC Floating Rate Notes Working Group (July 2018 Update) at 4. For certain derivatives, the International Swaps and Derivatives Association (ISDA) lists three different possible approaches to spread adjustments: forward approach; historical approach; spot approach. ISDA, Consultation on Certain Aspects of Fallbacks for Derivatives Referencing [certain LIBOR Rates], 11-14 (July 12, 2018).
3. Unger v. Ganci, 136 A.D.3d 1388, 1389 (N.Y. App. Div. 2016) (addressing rescission); 22A Joy Carmichael, et al., NEW YORK JURISPRUDENCE § 501 (2d ed. 2018) (same).
4. Turkat v. Lalezarian Developers, Inc., 52 A.D.3d 595, 596 (N.Y. App. Div. 2008); Restatement (Second) of Contracts § 205 (Am. Law Inst. 1981).
5. Constellation Energy Servs. of N.Y., Inc. v. New Water St. Corp., 146 A.D.3d 557, 558 (N.Y. App. Div. 2017); Restatement (Second) of Contracts §§ 261, 265.
6. Freedman v. Hason, 155 A.D.3d 831, 833 (N.Y. App. Div. 2017); Restatement (Second) of Contracts §§ 261, 263.
7. Jack Kelly Partners LLC v. Zegelstein, 140 A.D.3d 79, 85 (N.Y. App. Div. 2016); Restatement (Second) of Contracts § 265.
8. ATS-1 Corp. v. Rodriguez, 156 A.D.3d 674, 676 (N.Y. App. Div. 2017); Restatement (Second) of Contracts §§151–52, 154–55.