August 20, 2019
WE DO KNOW LIBOR IS GOING AWAY-BUT HERE’S WHAT WE DON’T KNOW YET
LIBOR (or the London Inter-bank Offered Rate), the most widely utilized reference rate for financial transactions in the world, will cease to be quoted at the end of 2021. A mind-boggling $200 trillion in LIBOR-based financing contracts were outstanding in 2018. Although the impending demise of LIBOR has been predicted for many years following the well-documented LIBOR price-fixing scandal that shook the banking industry, the reality of LIBOR’s demise has gone from a distant theoretical concept to a present and pressing issue for those in all areas of the finance industry.
The focus on the end of LIBOR has shifted beyond trading desks and bank underwriting departments to middle market and even smaller borrowers. Borrowers who likely never read, and counsel who frequently did not focus on, the seemingly abstract and often impenetrable language relating to LIBOR alternatives have now begun asking specific questions about how, when, and what alternative rate will be imposed. Lenders and lessors alike need to be prepared to answer specific questions about these alternatives and also have to be aware of some of the more complicated issues tied to LIBOR’s end. While borrowers may be directly focused on interest rates, many lessees cannot always directly see that the interest factors that underlie their transactions are directly impacted by the LIBOR market. Although an equipment lease or financing transaction may be stated on fixed terms and rates that make no reference to LIBOR on their face, it is likely that the rate the leasing or financing company is paying to its source of capital is expressly tied to LIBOR.
The impact and the issues raised by the impending end of LIBOR are multifaceted. First and foremost, the industry is faced with selecting and setting a new rate model. Although there are several choices available depending on the type of transaction, none are perfect analogues for the market LIBOR was supposed to reflect. LIBOR was supposed to approximate the rate at which certain banks could borrow funds from each other, were they to do so by asking for and then accepting inter-bank offers in a reasonable market size. Essentially, this represents a low but not risk-free rate from which financial institutions can set comparable rates. In anticipation of the loss of LIBOR as a benchmark rate, the U.S. Alternative Reference Rates Committee (ARCC) was established by the Federal Reserve Board and New York Federal Reserve Bank. ARCC has selected SOFR (the Secured Overnight Financing Rate) as its recommended reference rate for dollar-based lending transactions. Unlike LIBOR, SOFR is a risk-free rate because it is based exclusively on the rate at which a financial institution can borrow funds in a transaction fully secured by United States Treasury securities. SOFR is also subject to greater volatility and has historically been prone to spikes at the end of each fiscal quarter and year, when institutional borrowing tends to increase. Most importantly, SOFR changes daily and is not published for tenors greater than one day (unlike LIBOR, which is commonly quoted for seven different borrowing periods ranging from overnight to a full year, with banks commonly using 30-, 60-, and 90-day periods). These differences pose a series of challenges, including the following:
- Should the margin over the rate be adjusted to reflect the difference in the risk the rate reflects?
- Is the borrower’s rate set on the first day of the month and held for a month, or does it change on a daily basis?
- If SOFR is used as a reference to establish a rate, is it appropriate to use a single day as a basis or a trailing average to adjust for volatility in the absence of forward-looking rates for varying terms? Alternatively, the loan could accrue at the rate in place at the beginning of the month and be trued up to the actual daily interest over the course of the month, which would likely be a nightmare for borrowers estimating their month-end interest obligations.
Obviously, SOFR is not the only rate available to lenders; others such as the Prime Rate, the Federal Funds Rate, and the yield on comparable-term United States Treasury instruments stand as some of the alternatives. However, given its designation by ARRC as the recommended replacement for LIBOR, SOFR is expected to become the dominant rate in the next few years.
While the resolution for pricing new financial instruments is almost certain to settle primarily around SOFR, the more delicate issue is how to address existing financing transactions that extend beyond 2021 (including long-term, variable-rate LIBOR-based transactions, derivative contracts, and long-term debt instruments). Parties to such transaction are faced with the dilemma of how to reprice such transactions when LIBOR ceases to be available (or even earlier as it becomes less reliable). Although most variable rate credit facilities have alternative rate concepts built in for a suspension of LIBOR availability, most such provisions contemplate temporary disruptions and not permanent cessation. As such, the relevant language was not the focus of negotiations that perhaps it should have been.
Frequently, existing LIBOR-priced loans provide for a fallback rate in the absence of a readily available LIBOR quote. Rarely, if ever, are such fallback rates equivalent or close analogues to LIBOR. Frequently, the fallback rate falls back on a base rate in the loan instrument (often the Prime Rate). In some cases (especially those transactions that did not contemplate a base rate option), the fallback rate is as ambiguous as a “comparable rate of interest selected by the Lender in its discretion.” Since the fallback rate is almost always higher than the applicable LIBOR rate and margin, many savvy borrowers at least negotiated for a penalty-free prepayment right on imposition of the new rate. In any event, the alternate rate imposition is likely to force the borrower and lender back to the negotiating table to agree on a new rate.
The imposition of the new rate on existing facilities has raised other likely unanticipated consequences that regulators are beginning to focus on. Recently, the Financial Accounting Standards Board (FASB) issued tentative guidance regarding the accounting treatment of an “end of LIBOR” rate change. Under current rules, companies must assess whether a change in the interest rate underlying a contract will alter the future cash flows from such contract and in certain circumstances recast the agreement as a new contract for accounting purposes. The FASB has initially indicated that a LIBOR-related rate change could be treated as a continuation of an existing contract (provided certain conditions are met). In addition to accounting concerns, a rate change can implicate a change in treatment for tax purposes that must also be addressed. Tax-exempt transactions are especially sensitive to changes and can result in a reissuance for tax purposes or worse, taxability.
The end of LIBOR will have a broad impact throughout the finance industry. Borrowers and lenders alike must be especially mindful of the tax and accounting effects of rate changes not specifically contemplated by the underlying instrument. They would do well to seek the advice of counsel prior to unilaterally imposing or otherwise agreeing to such changes because the effects may not be remediable. While much uncertainty surrounds how the transition from LIBOR will develop over the next two years and beyond, prudent financial professionals will want to stay closely involved with this evolution and be prepared to meet the challenges and answer the questions that will emerge.