Trillions of dollars’ worth of financial documents use the London Interbank Offered Rate, or LIBOR, to set the interest rate of a transaction. The ICE Benchmark Administration currently maintains a reference for LIBOR by averaging banks’ estimates of how much it costs to borrow from another bank for term periods of one day up to a few months. But the rate that has served as a global benchmark for nearly half a century is now on its way out.
At the end of 2021, the U.K. Financial Conduct Authority (FCA) will no longer require banks to submit their quotes for LIBOR rates. The question – “What will replace LIBOR?” – allows for much speculation at this point, though work has been done to pick a replacement. In the United States, the Alternative Reference Rates Committee (ARRC) has chosen a broad Treasuries repo financing rate as its preferred LIBOR alternative, which is tied to the cost of overnight borrowing collateralized by U.S. Treasury securities. In the U.K., the Risk-Free Rate Working Group (RFRWG) has chosen the Sterling Overnight Index Average (SONIA) as its preferred alternative to LIBOR, which is based on actual transactions in the U.K. overnight unsecured lending and borrowing market.
As a result, interest rates using LIBOR as an index will likely become deficient after 2021. Understanding the practical reality of a transition away from LIBOR involves reviewing every contract that uses LIBOR as an index to determine the potential impact. New contracts – or renewals, forbearance agreements, or extensions traditionally using LIBOR – will need to consider alternative indexes and the addition of protective fallback provisions.
No Alternative or Fallback Provisions
Where a contract contains no alternative provision to LIBOR, parties should renegotiate the interest rate provision or risk the contract having a missing term.
Generally, it appears likely that courts will be willing to substitute a rate of interest where the interest rate is essential to the determination of rights and duties and LIBOR is no longer available. The court may also supply the interest rate from its own understanding of the intentions of the parties.
In FDIC. v. Cage, a receiver of a failed bank sued borrowers to recover on a promissory note. The note relied on the “rate which shall be One and One Half percent above the prevailing commercial prime rate of AmBank.” AmBank (American Bank) failed, however, and there was no governing body to set the prime rate of AmBank. The court held it had inadequate information upon which to determine the appropriate interest rate based on the terms of the contract and the termination of AmBank’s prime rate. The parties were given the opportunity to agree to an appropriate interest rate, or the court would compute an amount of interest due. As the parties could not agree, the court found it was able to substitute the New York prime rate for the AmBank interest rate based on affidavits from an FDIC liquidation assistant:
“The question presented to this Court is whether the defunct status of AmBank precludes calculation of an appropriate rate of contractual interest on the Defendants’ promissory note and thereby destroys the negotiability of the note. Defendants base their claim that interest on the note is uncollectible on the fact that the note specifically states that interest will be calculated according to the prime rate of AmBank. Defendants argue that there is no legal authority supporting substitution of the New York prime rate for the prime rate of AmBank, but Defendants cite no authority establishing that the use of the New York prime rate would be unreasonable in this case.”
The court relied on the opinion of two other district court decisions (FDIC v. Condo Group Apartments and FDIC v. Rogers Park I) finding that where the interest rate on a note is determined by reference to the prime rate of a failed institution, it is reasonable to compute the interest rate based on an alternative prime rate selected by FDIC.
In Murr v. Midland Nat. Life Ins. Co., an annuity contract had an initial interest rate of 3.4 percent and a guaranteed minimum interest whose adjustment formula was dependent on the interest rate of newly offered annuities. The missing variable resulted from Midland’s discontinuation of certain types of annuities such that there was no new interest rate to substitute into the formula. The court found that it was bound to enforce terms as written and that it could not substitute a different meaning than the one for which the parties intended and embodied in unambiguous terms. However, because the missing term created ambiguity and there was nothing in the contract to provide for the replacement of the term, the court was able to use extrinsic evidence to supply a term.
For contracts or financial documents governed by the Uniform Commercial Code, the UCC provides a fallback provision for determining interest rates where the instrument provides for one “but the amount of interest payable cannot be ascertained.” In such a situation, the interest rate is the judgment rate in effect at the place of payment of the interest, at the time interest first accrues.
It is possible that LIBOR will continue to be published in some form. Given that LIBOR covers many types of currencies and suggested alternatives have been identified by particular regulatory bodies within each country, there may be a rationale to continue publishing LIBOR past 2021, but it is likely that many fewer banks would submit their individual LIBOR estimates and the rate would be significantly less reliable. If LIBOR continues to be published, it is likely loan documents referencing LIBOR would still be valid. Again that largely depends on the language of each document.
Alternative or Fallback Provisions
Most LIBOR fallback provisions in current contracts were written as a result of issues from 2007 to 2012. As a result, the provisions contemplate temporary disruptions of LIBOR instead of its end. One example is where the methodology of LIBOR changes or becomes unreliable but the index is still being published. Another example is a provision that allows a bank to temporarily determine another rate where the governing body changes interpretation or administration of an interest rate, or the legality of the rate is called into question, but not necessarily the publishing of such a rate. Litigation could arise in such a case as to whether the bank had the ability per the contract language to substitute a completely new interest rate or index indefinitely, or whether the bank was only authorized by the terms of the contract to find a suitable temporary alternative until another rate could be negotiated or established.
Another concern is whether the alternative rate provided in the contract can also withstand confusion and potential litigation. The International Swaps and Derivatives Association (ISDA) is working on creating fallback rates to use if LIBOR is permanently discontinued, but that will likely only be useful to over-the-counter derivatives market participants. However, many commercial loan documents that rely on LIBOR are used in conjunction with over-the-counter derivatives market documents, and changes in one market will need to consider all the documentation supporting a transaction.
Issues in the chosen alternative will likely also pose problems. While the ARRC is currently working on implementation of its preferred alternative rate to replace LIBOR, problems stemming from the methodology and practical use of those rates in conjunction with rates chosen by other advisory boards should be anticipated through language in loan documents.
Although disputes and possibly litigation may arise as to when an alternative rate may be used and the actual effect of the alternative provisions, any dispute will likely not affect their legal validity or enforceability, based on past LIBOR reform litigation.
Additional Provisions to Consider
Although fallback provisions are already contained in many LIBOR-dependent documents, additional provisions should be considered that avoid foreseeable issues with future indexes or the triggering event of fallback provisions. For example, express language could provide that changes in the methodology by which a reference rate is calculated will not be grounds for terminating a contract. Another provision, based upon the inherent reliability of any chosen index, could provide that parties agree to negotiate in good faith should a reference rate be eliminated completely.
The best course of action in preparing for the LIBOR phase out is to review any financial documents that mature after 2021 and assess which rely on the LIBOR interest rate. An attorney can assess the viability of fallback provisions, if any, and update the documents to include new fallback provisions relevant to potential problems associated with the phase out of LIBOR and new indexes referenced in the future. Based on the specific provisions of each contract, an attorney can formulate methods of renegotiating loan documents that will require updated provisions. Now is the time to consider the impact.