Since its creation by the British Bankers Association in the 1980s, the London Interbank Offering Rate (“LIBOR”) has been used as a reference rate for borrowing costs between banks. The LIBOR calculation today is coordinated by the International Continental Exchange Benchmark Administration, which receives information on a daily basis from a group of global money market banks on what they would charge each other for interbank loans.
However, over the years, LIBOR has become the standard reference rate for many financial instruments such as swaps and derivatives, commercial loans, securitized notes, and even consumer home mortgages. LIBOR is one example of an interbank offering rate (”IBOR”). There also are IBORs denominated in different currencies, including Euros and Japanese Yen, but LIBOR is seen as the predominate IBOR in the market.
In 2008, news broke that some of the LIBOR panel banks had been collaborating to “fix” the rate with submission of artificially low numbers, allegedly to assist their traders in profiting from positions they might hold in LIBOR-based financial products. Investigations were initiated by regulators in the United States, United Kingdom and Europe. Many banks paid large fines and individual bankers also were subject to fines and other penalties.
With the LIBOR reputation seemingly permanently tarnished, in 2017, the UK Financial Conduct Authority (FCA), the regulator that oversees the setting of LIBOR, announced that LIBOR and the other IBORs may be phased out after 2021.
However, in addition to formulating a new standard reference rate going forward, a major question is what happens to all the current financial transactions tied to LIBOR and the other IBORs?
In addition to adopting a new reference rate, contracts in transactions referencing LIBOR are now more and more including “fallback language” to address what happens if LIBOR does indeed disappear. The adoption of standardized fallback language is increasingly important. Although some groups, such as the Loan Syndications and Trading Association, have developed contract language to aid in future credit agreements, the adoption of standardized contract language does not solve all legacy contract problems. For example, within the securitizations sector, in most cases in the United States, you must have 100% noteholder consent required to make a change in the benchmark reference rate, a difficult, if not impossible, task.
The Financial Stability Board, a group of international central bankers that promotes international financial stability, and the Financial Stability Oversight Council, the US regulator that oversees systemic risk to the US financial system, and many others, have raised concerns that elimination of LIBOR could pose a systemic risk to the international financial system as well as risks for the financial institutions involved in these transactions.
At this point, there are at least three possible approaches to the LIBOR transition:
- The first approach is an extension of LIBOR beyond 2021 for legacy instruments. This arguably has the least risk for contractual disruption, and therefore, litigation. However the FCA has made it clear that publication of LIBOR is not guaranteed beyond 2021.
- The second approach is to use a replacement risk-free rate, with various ideas being floated in the market. The alternative rate in the United States that has been chosen in the majority of circumstances is SOFR, the Secured Overnight Financing Rate that has been proposed by the New York Federal Reserve Bank. SOFR is comprised of three overnight U.S. Treasury repurchase rates, and there are variants of SOFR for use in different situations. In May 2018, the International Swaps and Derivatives Association included a definition of SOFR for use in contracts governed by ISDA Master Agreements.
- The third approach would be legislative relief. This could lessen the risks of litigation, but there are also litigation risks associated with a legislative mandate for contractual fallback language, including impracticability, force majeure, mutual mistake, breach of covenants of fair dealing, or liability or damages under the US securities laws.
“The LIBOR Transition” is a periodic series of updates discussing reference interbank offering rates, such as LIBOR, and the challenges involved in navigating a successful transition from their use as reference rates of choice in the market. Norton Rose Fulbright has assembled a group of its lawyers from around the globe to stay on top of these issues and assist clients in the transition to new reference rates. More information can be found on our Norton Rose Fulbright web site.