Leaving La Vida LIBOR or SOFR so good? LIBOR will cease in 2021. Are you prepared?
As if the current economic markets were not already volatile and uncertain enough, a new problem is looming on the horizon. The end of 2021 will also mark the end of the London Interbank Offered Rate (“LIBOR”), which is the benchmark not only for banks’ short-term transactions but for banks, corporations, and other entities for determining interest rates in various financial transactions and contracts. LIBOR has been the standard for setting interest rates in commercial contracts for over fifty (50) years when it was used in 1969 by J.P. Morgan in an $80,000,000.00 transaction as the basis for the interest rate. There are varied reasons for LIBOR’s demise, but it largely stems from the 2008 market meltdown when LIBOR’s rates were manipulated.
While banks and financial institutions are not required to use LIBOR, most do because of its history, the manner that it is calculated, and to ensure uniformity not only among an individual bank’s transactions but among all banks. Needless to say, replacing LIBOR will be challenging. The Federal Reserve Board and the Federal Reserve Bank of New York created a committee to find a “suitable replacement” for LIBOR. The committee, the Alternative Reference Rates Committee (“ARRC”) has opted for the Secured Overnight Financing Rate (“SOFR”) as the replacement. The use of SOFR is not required but it is expected to be the new benchmark.
Similar to the Y2K problem in 1999, banks and other financial institutions are now faced with altering and updating their practices to avoid a potentially catastrophic event. Obviously, banks and other lenders cannot simply wave a wand or “plug and play” to fix this problem. The repercussions of LIBOR’s demise will affect not only existing and future contracts but will also affect the balance sheets of scores of financial institutions and corporate entities worldwide. Setting aside the balance sheet issue, lenders should start employing measures now to replace LIBOR in current contracts as well as revising language in new contracts to replace LIBOR as the measuring stick for interest rates.
Here is a checklist for institutions to consider:
- Select a Team to Evaluate the Issue. Lenders should select a team to evaluate the risks and issues associated with LIBOR’s demise and formulate a game plan for its replacement.
- Determine What Rate Vehicle Will Replace LIBOR. While lenders are not required to replace LIBOR with SOFR, lenders must determine what calculus/rate vehicle to employ. Questions naturally arise in determining what to utilize including: (a) if not SOFR, then what will be used; (b) how will the selected rate vehicle be calculated; (c) the availability of the rate vehicle and its adjustment for fluctuations in the market; and (d) the overall acceptance of the rate vehicle. It is crucial that a replacement be selected as early as possible so that the transition will be as smooth as possible.
- Revise and Replace Current Rate Language. Lenders should be working with counsel to revise and replace current interest rate language in their form documents now rather than when LIBOR expires. While the language may be similar to existing LIBOR language, issue will arise as to how the rate will be determined/published, the manner in which the new rate vehicle will adjust, and new “back up” or alternative rate vehicle language if the preferred new rate vehicle also ceases or is replaced. Vetting the new language is crucial and adequate time is needed to test and revise it as well as to replace/insert it into forms or publish as the standard, preferred language. Guidance on these issues can be found at http://nyfed.org/2MGMm3m and at http://isda.org.
- Identify Current Contracts Requiring Renegotiation. As part of steps 1 and 2 above, lenders should also be identifying current contracts that utilize LIBOR and undertake steps to renegotiate these contracts for the new rate vehicle. Identifying and amending/revising current contracts will be a significant undertaking especially in light of the current COVID-19 pandemic and its effects. Lenders should not wait until the 4th Quarter of 2021 to start this process. Identifying those contracts now and commencing an orderly renegotiation for those is crucial to avoiding a logjam later on.
- Be Mindful of Regulations and Requirements. Replacement of LIBOR will also require a close review of other rules and regulations to ensure that the preferred rate vehicle replacement does not violate existing laws. Additionally, lenders should also make sure that the replacement rate vehicle is communicated to shareholders/stakeholders both from a lending perspective and also from a balance sheet/owned assets standpoint. Given the fact that LIBOR impacts earnings, securities laws should also be consulted to make sure that proper disclosures are given as appropriate.
It is crucial to start addressing this problem now especially in light of the current COVID-19 financially impacted world. Given the current state of the world economy and the request of so many borrowers for extensions and concessions, now is the perfect time to start transitioning away from LIBOR. From a distressed loan/workout standpoint, one of the only things worse than a defaulted loan is a defaulted loan with no way to calculate accrued and accruing interest. Banks and lenders would be wise to start addressing this problem now before it is too late.
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