Earlier this year, the Financial Conduct Authority signalled that, by 2021, a reliable alternative to LIBOR will replace the infamous benchmark rate.
This proposal has come following the LIBOR manipulation scandal and after criticism that LIBOR can no longer fulfil its objective of accurately representing the market for unsecured wholesale term lending to banks. This is, in part, because the underlying market that LIBOR seeks to measure is no longer sufficiently active to provide representative rates.
No clear alternative to LIBOR has emerged at this stage. A working group, set up by the Bank of England, has been formed to examine alternatives to LIBOR. One possible alternative is a reformed version of the Sterling Overnight Index Average, or “SONIA”. SONIA is based on actual trades in the more active UK overnight unsecured lending and borrowing market. Similar methods are used in Europe and Japan to calculate benchmarks and, as they do not require any ‘expert judgment’, the risk of manipulation is significantly reduced.
However, SONIA on its own cannot be a direct replacement for LIBOR as it is a benchmark for overnight interest rates only and has no forward looking element. Andrew Bailey, Chief Executive of the FCA, suggested that a new rate could be introduced combining the dynamic measure of a reformed SONIA with the calculation of a one-off set of term credit spreads.
Only one thing at this stage is clear: in an already uncertain market, this will only add an additional layer of uncertainty. Therefore market practitioners will need to find practical and commercial solutions to mitigate as much of this risk as possible and ensure they have robust documentation in place.
Ultimately, for legacy documentation with maturity dates extending beyond the end of 2021, the existing drafting will determine how parties allow for any discontinuance of LIBOR. If there is no express right to amend documents following its discontinuance, Lenders will need to assess the impact this will have and discuss appropriate ways forward with the borrower. Where there is a right to amend documentation, it will be common for all parties to need to agree to such amendments and allow for any transition period.
Given it is unclear, at this stage, what any replacement to LIBOR will look like, new documentation cannot set out a clear succession path. Therefore, the best parties can do is agree practical consent thresholds to allow for relevant amendments to their documents when the time comes. Lenders will want to hard-wire in the ability to amend the documents as it sees fit whereas borrowers will want to limit the ability for lenders to change these terms unilaterally to their detriment.
The precedent forms of banking documentation produced by the Loan Market Association (the “LMA”) are a good starting point. They have long contained fall back interest rate benchmark mechanisms for when LIBOR rates are not available. However this drafting does not provide a suitable or practical long term solution.
There is an option in the LMA documents for the screen rate to be replaced with the consent of the parent and the ‘majority lenders’ which will no doubt be utilised and negotiated more often and allows for a reduced consent threshold.
Outside of larger syndicated loans, Lenders will typically have a stronger negotiating position and will almost certainly insist on a unilateral right to amend their documents in such a scenario. Borrowers should take note of this and consider this as a risk factor when assessing the tenor of their term loan borrowings.