LIBOR Transition: The Road So Far and Frequently Asked Questions

The disruption caused by COVID-19 (and the clamour of Brexit), the UK authorities have repeatedly emphasised that no one should assume that LIBOR will continue to exist after 2021. Notably, as regards sterling LIBOR, the top-level priorities of the Working Group on Sterling Risk-Free Reference Rates (the “SRFR Working Group”) include that markets and their users are fully prepared for the end of sterling LIBOR by the end of 2021. In particular the SRFR Working Group has recommended that, from the end of March 2021, sterling LIBOR is no longer used in any new lending or other cash products that mature after the end of 2021. Throughout the remainder of the year, existing contracts linked to sterling LIBOR should be actively transitioned where possible.[1]

The authorities have acknowledged that certain “tough legacy” contracts—existing LIBOR-linked contracts that have no or inadequate fallbacks and no realistic ability to be amended prior to LIBOR’s cessation—required additional measures to facilitate their transition to a non-LIBOR rate. Accordingly, the UK government proposed amendments to the UK BMR, via the FS Bill, to grant the FCA additional powers to manage an orderly wind-down of a “critical benchmark,” such as LIBOR. The new powers will extend the circumstances under which the FCA may require an administrator to change the methodology used to calculate such a benchmark if doing so will protect consumers or ensure market integrity. These powers will be available in the event that the FCA makes an announcement that the relevant benchmark is no longer representative and will not be restored to representativeness. In such circumstances, use of that benchmark must cease. However, the FCA will have the power to permit continued use, including in legacy contracts, where it considers this to be appropriate. The UK government’s proposals are based on a solution proposed by the SRFR Working Group for LIBOR to be stabilised via a “synthetic methodology” as a means of managing the wind-down of LIBOR. The replacement methodology has not yet been determined and the FCA has recently consulted on possible methodology changes.[2] The FCA indicated that it does not envisage compelling continuation on a synthetic basis for euro or Swiss franc LIBOR. Conversely, the FCA stated that this course of action appeared appropriate for the more commonly used sterling settings, and that it would continue to assess whether this might also be the case for more commonly used yen and US dollar settings.

In July 2020, the European Commission published a proposal for a regulation amending the EU Benchmarks Regulation regarding the designation of replacement benchmarks for certain benchmarks in cessation, including LIBOR. Under the proposal, a statutory replacement rate designated by the Commission would take the place of LIBOR in financial instruments, financial contracts and measurements of the performance of an investment fund which involve an EU ‘supervised entity,’ and which do not include a suitable fallback mechanism. The Commission intended to adopt a recommendation encouraging EU member states to select the replacement rate chosen for EU-supervised entities as the statutory replacement rate in their national statutes. The Commission’s proposal has been further developed in the legislative process, with political agreement being reached in December 2020. A consolidated version of the text agreed between the Council of the European Union and the European Parliament, dated December 8, 2020, extends the scope of the proposal to any “contract” or MiFID financial instrument that is governed by the law of a member state and references the relevant benchmark and any contract that is subject to the law of a third country but the parties to which are all established in the EU and where the law of that third country does not provide for an orderly wind-down of a benchmark.[3] In addition, a framework for the replacement of a benchmark by national legislation in certain circumstances is provided for.[4]

In turn, industry bodies published a number of guidance notes and model documents to help companies manage the transition from LIBOR. The LMA published further model documentation relating to LIBOR transition in syndicated loan documentation including: (i) Risk-Free Reference Rate terms and a model replacement of screen rate clause; (ii) a term sheet for multicurrency term and revolving facilities agreements incorporating rate switch provisions; (iii) an exposure draft multicurrency term and revolving facilities agreement incorporating rate switch provisions and (iv) a model rate switch agreement.

In October 2020, the International Swaps and Derivatives Association published the ‘IBOR Fallbacks Supplement’ and ‘IBOR Fallbacks Protocol,’ providing guidance on incorporating robust fallbacks for derivatives linked to certain interbank offered rates (“IBORs”), with the changes having come into effect on January 25, 2021. Such fallback mechanisms in the relevant currency would apply following a permanent cessation of the IBOR in that currency. For derivatives referencing LIBOR, these would also apply following a determination by the FCA that LIBOR in that currency is no longer representative. In each case, the fallbacks will be adjusted versions of the risk-free rates identified in each currency. As set out in its consultation, the synthetic methodology tabled by the FCA is also based on the risk-free rates, combined with a fixed spread that is identical to the spread in the ISDA protocol fallbacks.

The Alternative Reference Rates Committee (“ARRC”) published the New York state legislative proposal in March 2020 to facilitate transition from US dollar LIBOR (“USD LIBOR”) to its recommended alternative, the Secured Overnight Financing Rate (“SOFR”). The proposed legislation would apply only to USD LIBOR contracts governed by New York law, in the event of statutory trigger events, including a permanent cessation of LIBOR, or the occurrence of a pre-cessation trigger event related to LIBOR. Contracts that are silent or without adequate fallback language to address the cessation of LIBOR will automatically transition to the recommended benchmark replacement (“RBR”) under the proposed legislation—likely SOFR, as published by the Federal Reserve Bank of New York, plus a spread adjustment selected by the relevant authority. The proposed legislation would also override fallback language that references a LIBOR-based rate, such as last quoted LIBOR, in favour of the RBR. The planned adoption of this proposal in 2020 was delayed due to COVID-19 but adoption is expected in 2021. In November, the ICE Benchmark Administration (“IBA”), as administrator of LIBOR, proposed to stagger cessation of USD LIBOR tenors beyond 2021. While subject to consultation which closed on January 25, 2021, the IBA proposed to cease publication of the lesser utilised one-week and two-month USD LIBOR settings immediately after publication on December 31, 2021, and the remaining (more widely utilised) USD LIBOR settings immediately after publication on June 30, 2023—thereby allowing many legacy contracts to mature before USD LIBOR ceases altogether. The timeline for sterling, euro, Swiss franc and yen LIBOR remains unchanged as the IBA’s consultation proposed ceasing publication of all LIBOR settings in these currencies at the end of 2021.

FCA Director of Markets and Wholesale Policy, Edwin Schooling Latter, stated, in a speech on January 26, 2021, that the FCA sees “no case for delaying decisions or announcements beyond the time necessary properly to assess the consultation responses that have now been received”.[5] In particular, if IBA confirms that following its consultation it intends to cease LIBOR settings, and if the FCA is satisfied that cessation can occur in an orderly fashion and decides not to compel continued production on a synthetic basis of a relevant setting, then the FCA could announce that the settings will cease. It is also possible that the FCA makes a “pre-cessation announcement” (in terms of ISDA documentation) in respect of one or more settings. This would be where it is clear that the relevant panel will end, but the FCA envisages consulting on requiring continued publication on a synthetic basis (or is still assessing whether to do so). Whether a relevant setting is subject to a cessation announcement, a pre-cessation announcement, or both, announcements covering all settings could be made on the same day. As pointed out by Mr Schooling Latter, spread calculations would as a result be fixed on the same day (but not actually applied until after the last date of proposed panel bank publication).

Mr Schooling Latter also signalled certain other important policy developments that are likely in the coming months. Notably, the FCA expects to issue consultation proposals in the spring 2021 on a framework for using powers under the FS Bill to restrict new use of a LIBOR setting where IBA will cease publication and to define which legacy contracts will be allowed to use synthetic LIBOR. The first power is relevant to US dollar LIBOR under IBA’s proposals. Even where a US dollar LIBOR setting continues to be published on a representative basis until end-June 2023, there will be restrictions on new use after end-2021.

The FCA’s proposals may allow new use only in defined categories of risk-management transactions used to manage legacy exposure (following the approach of US regulators). As regards “tough legacy” contracts, Mr Schooling Latter described the following cases as falling “unambiguously into the ‘tough legacy’ bucket”: (i) a retail mortgage where the lender must have borrower consent to change, but cannot get the borrower to respond to change proposals; and (ii) a bond where the issuer offers conversion to compounded SONIA plus a credit adjustment spread calculated on the same basis as in ISDA documentation, in line with market consensus on a fair fallback, and the bondholders do not reply or withhold their consent in an effort to push for terms that are out of line with these market standards.

Concerns remain as to whether the different proposals for LIBOR transition outlined by the UK, US and EU regulators will, in practice, work across all relevant jurisdictions, or if the lack of a harmonised solution will result in a conflict of laws (although the amendments made by the EU co-legislators to the EU’s draft law may practically reduce the scope for conflict).[6] For example, it is uncertain whether English courts will be obliged to recognise the Commission’s statutory replacement rate in English-law governed contracts, and, in respect of New York law governed contracts featuring USD LIBOR, the RBR may apply as a matter of New York law, despite the fact that LIBOR could continue to exist if the FCA has used its powers to direct a change of methodology (that is different to its current plans).

Frequently asked questions

1. How have parties to new LIBOR loans addressed LIBOR’s discontinuation in their documentation?
   
   The standard interest rate fallback provisions in an LMA form loan agreement default to cost of funds if the screen rate is unavailable. Given that the standard LMA fallback provisions are intended to be a temporary measure and are not meant to be a long- term solution to the discontinuation of LIBOR, parties to new LIBOR loans have adopted (broadly) one of the following three approaches:
   
   

   I. Agreed process for renegotiation: If a trigger event occurs, then the parties will rely on a prescribed amendment process to change the pricing terms of the loan. For example, the LMA’s “Replacement of Screen Rate” clause provides that on a “Screen Rate Replacement Event” amendments to the facility agreement could be made with the consent of Majority Lenders, rather than all lenders. In August 2020, this has been expanded to include an agreed process for renegotiation which imposes an obligation on the parties to renegotiate in good faith the relevant pricing terms if LIBOR continues to be used to calculate the interest rate on the facility agreement at a specified date before the end of 2021.

   II. Pre-agreed conversion terms: Such loans include a hard-wired switch mechanism to flip from LIBOR to an economically-equivalent RFR-based rate at a specified date prior to the end of 2021 or if a specified trigger event occurs. There have been various high-profile deals adopting this mechanism such as the Royal Dutch Shell’s 2019 USD-syndicated revolving credit facility. The LMA rate switch documentation exposure drafts published in November 2020 adopt this methodology. Under the form of the agreement, interest is initially linked to an existing forward- looking term rate (e.g., sterling LIBOR). On a pre-agreed date falling before December 31, 2021, or if a specified trigger event occurs, the interest rate switches to the pre-agreed alternative rate calculated on a compounded basis (e.g., compounded SONIA for sterling).

   III. Pre-agreed fallback terms: This is similar to the hard-wired switch approach, but the trigger is the discontinuation or unavailability of LIBOR instead of an automatic switch on a specified date. This is the approach recommended by ARRC for new US dollar LIBOR transactions. While this has been included in various bond and derivative transactions, there has been limited take-up of ARRC’s recommended language in the European loan markets given the prevalence of LMA-style facility agreements. It is expected that as we progress into 2021, we will see more European loans incorporating the pre-agreed conversion terms in the form of the LMA exposure drafts.

2. If I would like to use a hard-wired approach, how are risk free rates used to calculate interest for loans?
   
   Loan products that have used LIBOR previously are likely to switch to using the applicable risk-free reference rate (e.g., SONIA for Sterling LIBOR and SOFR for USD LIBOR) as compounded in arrears with a look-back period, which is usually set at five business days, plus a credit adjustment spread. Breaking this into its component parts:
   
   

   I. Compounding, in this sense, means the RFR is compounded using the daily published rate; it does not mean “capitalisation” of the interest.

   II. The look-back period is included in order for the parties to determine the RFR over an observation period, which is shifted five business days ahead of the interest period, so that the parties can ascertain what the interest amount is due a few days prior to the actual payment date, which is likely to coincide with the last day of the interest period.

   III. LIBOR is typically higher than the corresponding RFRs since LIBOR, being the wholesale funding rate of the panel banks, has embedded within itself the risk premium to take into account the credit risk of the banks as well as a term premium to take into account liquidity and inflation risks over a longer time horizon. A credit adjustment spread is added to the replacement rate to make it economically equivalent to the IBOR being used and to address the issue of potential transfer of economic value from one party to another as a result of the rate switch.
   
   

The LMA exposure drafts adopt this basic framework, although there are different approaches on the specific details of the methodology. For example, there are two approaches to calculating compounded RFRs, namely with or without “observation shift.” In simple terms, such difference in methodology affects the weighting of daily RFRs over non-business days on which RFRs are not published. While such difference in approach is unlikely to produce significantly different results absent extreme volatility in the RFRs over the calculation period, the difference will nonetheless affect how the amount is calculated. In the earlier RFR-based English law credit agreements, such determination was made “without” the observation shift (also known as the “lag” method) before the “observation shift” method gained more prominence. However, more recently, the “lag” method is making a comeback given that it is perceived by market participants to be more suited to deal with intra-interest period events such as early prepayments or loan trading.    

[1] See: The final countdown: completing sterling LIBOR transition by end-2021.

[2] See: FCA consults on new benchmarks powers.

[3] See: Council of the European Union.

[4] The Council and the Parliament’s text also extends the transition period for the use of third-country benchmarks. EU supervised entities will be able to use such benchmarks until the end of 2023. The Commission may further extend this period until the end of 2025 in a delegated act to be adopted by 15 June 2023, if it provides evidence that this is necessary in a report to be presented by that time.

[5] See: LIBOR – are you ready for life without LIBOR from end-2021? | FCA

[6] See our article published in Financier Worldwide, Transitioning ‘tough legacy’LIBOR contracts – different strokes for different folks?