The end of LIBOR – a risk free change?
As many now know, the London Interbank Offer Rate (LIBOR) is to be phased out by the end of 2021 and will cease to be published. But what does this mean for the financial market, particularly in more heavily affected sectors?
What is LIBOR?
LIBOR is a benchmark reference interest rate at which major global banks lend to one another. It is calculated on each business day in a number of different currencies and is assessed for different periods of the year – for example, overnight, one week and one to twelve months. The rate is calculated and published each day by the Intercontinental Exchange. Not only does LIBOR help businesses decide the price of transactions (by indicating borrowing costs between banks), but it serves as a measure of trust in the financial system as it reflects the confidence banks have in each other’s financial health.
Why is LIBOR being phased out?
The change comes as a result of the Financial Conduct Authority’s (FCA) desire to use risk free rates (“RFR”), which are overnight rates and so less susceptible to manipulation. This was no doubt in response to the LIBOR fixing scandal revealed in 2011, as well as the rigging inquiry by the Serious Fraud Office (closed in October 2019).
What do the changes mean?
Institutions that have previously operated using LIBOR will need think ahead to ensure that firstly, LIBOR based products are no longer used. This ideally should be happening from now. Secondly, any agreements which are still subject to LIBOR, but which still have effect beyond 2021, should be assessed and a framework put in place to manage the transition to an alternative RFRs. The most likely outcome is a shift to risk free rate SONIA in the UK (with other RFRs being applied to different jurisdictions). Unlike LIBOR, SONIA is an overnight rate, measured on each day over the interest period to produce a final interest rate at the end.
What risks do the changes pose for the market?
A swap to a RFR will not be without its challenges. Examples of sectors which will be affected are the Healthcare (including GPs), Real Estate, Property Development and social housing sectors. Not only will LIBOR exposures be built into, for example, mortgages, loans, deposit facilities, derivatives and floating rate notes, but also into commercial leases and service contracts. Therefore, no sector is likely to be free from risk.
Most contracts at the time of creation may not have contemplated that LIBOR would permanently cease, so may not have adequate provisions in place dealing with such a change. For contracts that do, these may include “fall back” provisions setting out what will happen if LIBOR is unavailable, but even then most will not contemplate a permanent cessation and so relying on these clauses will not be without its own problems.
RFRs are numerically lower than LIBOR, so the value of these products will inevitably change and there will be exposures to interest rate risk, impacting on mutual liabilities and creating a gain for one party, but a loss for another. This could lead to a dispute in circumstances where an equivalent SONIA value or compensation cannot be agreed to address the balance that is required. Parties will therefore be faced with risk management, legal and accounting issues where disparities arise between LIBOR and its replacement.
What can parties be doing to mitigate the risks that they face?
Navigating the changes commercially and practically will be key. Companies should not only speak to their bank, but also seek financial and/or legal advice at an early stage in order to adequately prepare for the transition.
Those affected can consider taking the following steps:
- Check contract terms. As mentioned above, contracts may contain “fall back” term setting out what will happen if LIBOR is not available (but may not envisage that LIBOR ceases altogether). Check whether these terms need to be amended, as it may serve to save a contract from being frustrated.
- Agree a variation. Agree that LIBOR is replaced with the RFR, for example, SONIA, with the addition of an Extra Spread, to be negotiated and irrespective of contractual terms already in place. Most contracts will include a term enabling variation upon the written agreement of the parties. This should be done well ahead of the transition at the end of 2021 to avoid businesses being left with a ‘Hobson’s choice’ deal when there is little time to negotiate (and which would also heighten the risk of mis-selling if an alternative product is put forward which is not appropriate).
- Consider the alternatives.
- If the contract cannot survive with the cessation of LIBOR, it may be ‘frustrated’. Frustration occurs when something occurs without fault of the parties to render the contract physically or commercially impossible to fulfil. It must be impossible and not merely inconvenient. If Frustration occurs, the parties are immediately discharged from all further performance of and further liability under the contract. However, this is rarely straightforward and is fact-sensitive, so legal advice must be taken and the consequences carefully analysed.
- Is there a Force Majeure clause? The relevant contract may contain a Force Majeure clause. This deals with the triggering of an event that brings the clause into operation and defines the consequences of such an event. Force Majeure clauses have been brought to the forefront recently with respect to COVID-19, but legal advice should be taken before seeking to rely on such a clause as they are typically narrowly drafted.
- Familiarise yourself with SONIA and what this means for your business. It is not a like-for-like replacement so it is important not to assume it will serve you in the same way. Changes within the business may need to be made and contracts may need to be renegotiated (and well in advance of 2021).
The team here at Charles Russell Speechlys are well placed to carry out the necessarily legal analysis of your contracts and advise you on your options. We can also recommend financial experts who can work with us to quantify the economic consequences and or assist with negotiations. Please do not hesitate to contact Stephen Burns and Katie Bewick if you require assistance who would be happy to discuss your options with you.