LIBOR Discontinuance - What You Should Know

LIBOR has long been used as a market index for many financial products including loans.  Recently, LIBOR has been daunted by reputational issues and liquidity stress calling into question its long term viability as a reliable market index.  In late July, the U.K.’s Financial Conduct Authority announced that LIBOR will be phased out by 2021.  With this announcement of the eventual discontinuance of LIBOR, lenders must consider what effect this development will have in the loan market and how it should be addressed in loan documentation.

Most importantly, lenders need not immediately rush to substitute a new, substitute index for LIBOR as it appears there will be an orderly transition period for the market to arrive at a substitute for LIBOR.  The Alternate Reference Rates Committee (“ARCC”) formed by the Federal Reserve has been working on an alternate rate index for more than two years.  The Federal Reserve Bank of New York recently announced that it will begin publishing an alternate index rate in mid-2018, and it is currently taking comment on its proposal for alternate rates.  The ARCC has already identified a broad overnight repo rate secured by U.S. Treasuries, which is called SOFR (Secured Overnight Funding Rate). SOFR is not a direct substitute for LIBOR, however, as SOFR is a secured overnight rate and lower than LIBOR.  The takeaway for lenders is that an alternate index rate is being developed, and the market will likely settle on an acceptable alternative to LIBOR sometime prior to its discontinuance in 2021.

During the transition period, lenders are advised to monitor the Federal Reserve’s announcements on this subject and to keep an eye on the loan market for adoption of a replacement to LIBOR.  This process will take some time, but activity is underway and a solution is not far off.  Lenders are further advised to understand what is happening in regard to LIBOR as customers are sure to have questions about what this means to them, both with respect to existing loans based on LIBOR and in pricing of their loans.

Lenders should consider how discontinuance of LIBOR will impact both existing and new loan documentation.  Most existing loan documents typically contain fallback provisions for determining the applicable interest rate for a loan when LIBOR becomes indeterminable or unavailable.  Typically, such fallback provisions prescribe that such loans become prime rate or base rate loans and/or permit a lender to cease making LIBOR loans.  The most important consideration for lenders is to review their current loan documents to ensure that such fallback provisions exist and to understand them.  If such fallback provisions do not exist in the operative loan documents or are otherwise less than optimal in addressing this eventuality, then lenders should consider what rights and/or opportunities are available to amend the loan documents to address the ultimate discontinuance of LIBOR.

Without knowing the replacement index rate that will emerge in the overall loan market, it is too early to recommend a new index rate.  Lenders may consider, however, the inclusion of a provision in loan documents that allows the lender to amend the loan terms so as to specify a replacement index rate in the event of a discontinuation of LIBOR.

In sum, the transition period away from LIBOR to a new market index is in its early stages.  Lenders should be aware of and understand this issue.  Lenders are encouraged to monitor the relevant developments as a solution emerges.