09.18.2019 Goodbye LIBOR - Hello Operational Headache!
A sea of change is on the horizon for benchmark interest rates as financial regulators respond to the need to replace the London Interbank Offered Rate (“LIBOR”). LIBOR has lost the favor and, in some respects, the trust of banks, investors and regulators in light of scandals precipitated by “LIBOR-fixing” (fraudulent manipulations by traders) at several banks. Even though the UK’s Financial Conduct Authority (the “FCA”) reinforced governance around setting the rate, regulators have pressed banks to remove references to LIBOR from their new contracts and have planned to abolish the rate by 2021.
With a rate as pervasive as LIBOR, the transition will burden market participants both in terms of their day-to-day operations and from a regulatory and reporting compliance standpoint. A new rate must be chosen for future documents. Regulators and participants alike have pointed to the Secured Overnight Funding Rate (“SOFR”) as a likely replacement, but this is a solution to just half the problem, and is an imperfect one at that. Because SOFR is a secured overnight rate and LIBOR is an unsecured term-based rate, there will be issues with conforming SOFR-based floating rates to the rate structures of existing documents.
Effecting a transition from LIBOR to a replacement rate will require banks to handle those instruments already in effect that have floating rates based on LIBOR. Some issues that may affect parties to these loans include:
- First, many documents use the Prime rate as a back-up; this could present a problem given that the Prime rate has often been, and may in the future be, higher than LIBOR by a couple of basis points or more.
- Second, some banks may have reserved the right to select a replacement rate of their own choosing, without any notice to, or consent from, the borrower. This poses an inherent risk of perceived unfairness to borrowers. In other case, banks may have reserved the right to select a replacement rate, which is subject to the borrower’s approval. This, of course, puts the borrower in the driver’s seat in some respects, which could cause significant operational concerns.
- Third, in the context of swaps, current ISDA documentation does not provide for a fallback rate if LIBOR is phased out. ISDA is, however, working on amendments to the 2006 ISDA definitions in light of the impending abolition of LIBOR, and on the development of new ISDA protocols to amend legacy swap transactions that reference LIBOR.
- Finally, the end of LIBOR can present issues for municipal finance transactions where the replacement and resetting of rates might constitute reissuance of tax exempt debt, resulting in tax consequences. The IRS and the Treasury Department may issue guidance regarding the LIBOR phaseout and its impact on taxes, but no timeline has been set for when such guidance may become available.
This is an evolving issue, and, as regulators plan and implement the replacement strategy, banks must also stay informed and in front of this major transition. While the solution remains in flux, this is something that all banks that offer LIBOR-based financing should be focused on to ensure a smooth transition.