The London Interbank Offered Rate or “LIBOR” originated in the 1970’s, around the time sovereign debt and cross-border M&A financing were exploding. It represents the average of the interest rates offered by depository banks in the London market for deposits of different tenures, ranging from overnight to 30-day interest periods up to 360 days. It does not represent actual interest rates, but offered rates, for unsecured loans. Until 2014, LIBOR determination and publishing was administered by the British Bankers Association. Since then, LIBOR has been administered by the Intercontinental Exchange Benchmark Association which has decided that it will no longer be a quoted reference rate after 2021.
LIBOR is arguably the most commonly used interest reference rate in the world. It is applied in transactions ranging from home mortgages to long-term corporate debt instruments. In 2018, it was estimated there was over $300 trillion in indebtedness worldwide (including swaps, derivatives, and other obligations) that accrues interest pegged at one or more rates based on LIBOR. LIBOR’s rise and rapid acceptance was the result of several factors including: it is not just a U.S.-based rate like the Prime Rate; it is generally lower than the Prime Rate on any given day; it applies to different currencies; it is possible to have LIBOR either float daily or “lock” or “fix” the rate for 30-day periods up to 360 days; and it is reported on Reuters screens daily, making it easily accessible and verifiable.
During the 2008 Financial Crisis, the market uncertainty caused a number of banks to be unwilling to submit offered rates for protracted periods of time. This made LIBOR simply unavailable. A few years later, in 2012, a number of banks including Barclays, UBS, and Deutsche Bank, were found to have criminally conspired to fix LIBOR rates for the advantage of their own trading desks.
The rate-fixing developments of 2012 led the U.S. Board of Governors of the Federal Reserve System to push to replace LIBOR with another rate that was more market-based and harder to “fix”. The Alternate Reference Rate Committee (a representative group of American money center and regional banks, the “ARRC”) was established by the Federal Reserve Bank of New York in 2017 and tasked with finding an alternate reference interest rate for U.S. banks.
SOFR Emergence in the U.S.
The Secured Overnight Financing Rate or “SOFR” is an average of rates that institutions actually set for overnight loans that are secured by U.S. Treasuries. The ARRC has identified SOFR as a possible successor to LIBOR for credit transactions in the U.S. for several reasons. First, the rate is publicly available. Second, it involves actual transactions, not potential ones. Third, the market is fairly deep and broad, as it has been increasingly used since 2017. Despite these positive characteristics, however, SOFR does not fill completely the void that the abandonment of LIBOR will create.
There are a number of important differences between SOFR and LIBOR. They include the following:
- SOFR applies only to U.S.-based credit transactions denominated in Dollars.
- It is only overnight. To establish the rate for longer periods, an average of the overnight rates for the period in question must be calculated.*
- It is retrospective, not prospective. Therefore, a borrower will not know in advance what the interest rate for its indebtedness will be overnight or over a longer borrowing period.
- It represents an average rate set for secured transactions, not unsecured deposits, resulting in lower overall quotes.
Other Proposed Alternative Rates
As mentioned above, SOFR applies only to U.S. Dollar transactions. To address the upcoming loss of LIBOR, other countries have also begun to establish their own reference rates to replace LIBOR with mixed success. Furthest along is the U.K. with the Sterling Overnight Index Average “SONIA”. Japanese credit transaction participants have begun to embrace the Tokyo Overnight Average Rate “TONAR”, and countries in the Euro Zone have started referring to the Euro Standard Average Rate “ESTAR” in the Euro Zone. Finally, Swiss Franc transactions are beginning to reflect the Swiss Average Rate Over Night “SARON”. All of the above alternative reference rates, unfortunately, share many of the same flaws as SOFR, the most important of which is their retrospective, not prospective, nature.
Best Practices for Lenders and Borrowers
In light of the termination of LIBOR at the end of 2021 and the lack of a clear successor rate structure, both lenders and borrowers who are parties to existing credit documentation which includes interest pegged to LIBOR would be well served by initiating discussions promptly to renegotiate the affected documentation and identify alternative interest rates. Most provisions in credit documents that include LIBOR options already have provisions that contemplate the temporary unavailability of a LIBOR quote for one or more interest periods. Such provisions, however, do not contemplate the permanent unavailability of LIBOR as will be the case after next year. To assist market participants in this process, the ARRC has developed so-called “Fallback Language” to be incorporated in new or existing credit documentation.**
Therefore, at a minimum, if only a LIBOR option appears in existing documentation (or documentation to become effective this year), the parties should modify such documents during calendar year 2020 to include one or more of the following elements: (a) the Fallback Language recommended by the ARRC; (b) a substitution of LIBOR with a “Prime Rate” or “Base Rate;” (c) a mechanism to allow the lender and borrower to set their own short, medium, and longer-term fixed rate options on a case-by-case basis that refer to Treasury Bills, Treasury Notes, or other government-issued obligations; and (d) in cases where other currencies or cross-border funding is involved, reference to SONIA, TONAR, ESTAR, SARON or other similar reference rate, as appropriate.
Debt markets worldwide face a serious deadline at the close of 2021 when LIBOR will no longer be administered by the Intercontinental Exchange Benchmark Association and cease to be available as a reference rate. SOFR and the other alternative rates proposed thus far in other countries share several important flaws that greatly reduce the likelihood that those rates will offer creditors and borrowers an effective alternative to LIBOR. In short, “Life after LIBOR” is far from certain for many participants in a wide range of debt financing transactions in the U.S. and abroad. To address this uncertainty, lenders and borrowers are strongly advised to review existing documentation, include Fallback Language in such documents, negotiate mutually-acceptable options, and make the needed amendments as soon as possible this year.
*Starting in 2020, the New York Federal Reserve Bank will begin publishing average SOFR rates for varying interest periods. These rates are expected to follow the 1, 30, 60, etc., day interest periods of LIBOR. Again, these rates will differ from LIBOR in that they are averages of past rates, not offered rates for future deposits, as is the case with LIBOR quotes.
**ARRC has developed a series of different “Fallback Language” provisions for Floating Rate Notes, Syndicated Business Loans, Bilateral Loans, and Securitizations. Please refer to Summary of ARRC’s LIBOR Fallback Language (November 2019) published by the New York Federal Reserve Bank.
If you would like additional information, please contact FisherBroyles partner:
Stephen J. Di Cioccio
Partner/Chair, Banking & Financial Services Practice Group
New York, NY
Direct: (917) 696-7752