Advising on alternatives to LIBOR: the risks in going risk-free
LIBOR will cease to be published (or at least LIBOR panel banks will no longer be compelled to submit quotes) in December 2021.
LIBOR will cease to be published (or at least LIBOR panel banks will no longer be compelled to submit quotes) in December 2021. Given that LIBOR underpins circa $300 trillion in financial contracts globally1, the scale of the task involved in moving away from LIBOR cannot be underestimated.
The general counsel of the Federal Reserve Bank of New York described this imminent juncture as “a DEFCON 1 litigation event”. That was before COVID-19. The turmoil of the last month for the financial and capital markets has potentially relegated LIBOR transition from DEFCON 1 status. However, notwithstanding COVID-19, LIBOR transition still currently looms large2.
The Herculean task of LIBOR transition presents a number of significant challenges for lenders. In this article, we focus on the risks attaching to the difficult questions of when and how lenders should advise their borrower clients on appropriate alternatives.
LIBOR transition timeline
The COVID-19 pandemic has definitely not helped lenders to address these questions. Prior to the outbreak, two key dates had been announced by the Financial Conduct Authority (FCA) in connection with LIBOR transition: 30 September 2020 as the last date upon which new cash products linked to sterling LIBOR should be issued; and 31 December 2021 as the last date upon which any existing products should reference sterling LIBOR.
On 29 April 2020, however, the FCA, the Bank of England and members of the Working Group on Sterling Risk-Free Reference Rates issued a joint statement on the impact of COVID-19 on LIBOR transition. The statement acknowledged that it would no longer be feasible to complete the transition away from LIBOR for new cash products by the original target date of 30 September 2020 and that financial institutions should now aim instead simply to be in a position to offer non-LIBOR linked products by that date. Further, it recommended that the issuance of new LIBOR-linked loan products expiring after the end of 2021 should cease by 31 March 2021.
This extension of the deadline will be a welcome relief for most financial institutions. Even before COVID-19, the syndicated loans market was far from “ready” with a post-LIBOR solution for new loan agreements. In the midst of the pandemic, lenders are now grappling with the implementation of government-backed lending schemes, alongside dealing with the inevitable wave of borrower requests for loan covenant relaxations and default waivers – all while their staff are still adapting to remote working practices.
In the short term, at least, focus is likely to have shifted away from LIBOR transition.
Agreeing and implementing an alternative rate for a new contract is far from straightforward. However, the task of amending existing contracts to reflect the phasing out of the interest rate upon which they were based presents even greater challenges for lenders as every affected loan agreement requires amendment individually. Further, failure to amend LIBOR-linked contracts that will remain in existence after the discontinuation of LIBOR (so called “legacy contracts”) introduces other potential contractual considerations which have been the subject of much commentary, such as force majeure, frustration and others.
One of the key issues relating to the amendment of existing contracts is the treatment of existing “fallback provisions”. These are clauses designed to address the unavailability of LIBOR (usually on a temporary basis). Many fallback provisions did not envisage the permanent discontinuation of LIBOR and the FCA has recommended contracts that reference LIBOR are replaced or amended before fallback provisions are triggered as they are unlikely to result in a suitable permanent replacement rate.
Alternatives to LIBOR
SONIA (the Sterling Overnight Index Average), administered by the Bank of England, has now been identified by the Bank of England and the FCA as the preferred rate to replace LIBOR in the UK.
In contrast to LIBOR (a forward-looking term rate with a built-in credit and liquidity premium which is heavily reliant on expert judgement submissions) SONIA is a nearly “risk free” rate. It is a backwards-looking overnight rate anchored in real transaction data. The profoundly different way in which LIBOR and SONIA work means that it is impossible to effect a straightforward exchange of one rate for the other. A loan linked to SONIA will be an entirely different product to a loan linked to LIBOR, requiring support from completely different IT systems and different contractual provisions to address its calculation, as well as a fundamental rethink of secondary pricing related issues such as break costs and fallback rates based on cost-of-funds.
Work is underway to create a forward-looking term rate linked to SONIA, but the regulators have made it clear that lenders should not and must not delay transition in the expectation of a SONIA-based term rate solution. Also, if and when a term rate is available, such a rate should only be a solution for use in certain limited situations.
Consequently, efforts have been made to adapt SONIA to make it fit the particular needs of the syndicated loan market. Prior to COVID-19, the solution had been moving towards compounded SONIA in arrears with a lag (to try and give the parties to a loan agreement reasonable notice of the interest payable). However, the fact remains that, unlike loans linked to forward-looking LIBOR, the interest payable on a loan linked to SONIA will only be known at the end of the interest period.
The fundamental differences between LIBOR and risk-free alternatives have been thrown into sharp relief during the extreme financial stress currently being experienced by the markets. In the US, the preferred alternative rate, SOFR, has moved in the opposite direction to LIBOR. SOFR’s recent drop potentially reflects the intervention of the U.S. Federal Reserve, whereas LIBOR’s upwards climb is generally accepted as a perception of elevated risk in the banking sector to come. The dramatic differences in the way in which the rates respond to the current crisis highlights the potentially huge consequences of transition at the current time.
If the syndicated loans market doesn’t move to SONIA, what are the other options?
While banks will no longer be compelled to submit quotes for LIBOR, there is currently no legislation which will prevent banks from continuing to submit data and for that to be published, either by the current LIBOR publisher (ICE Benchmark Administration) or another.
However, in July 2019, Andrew Bailey of the FCA cautioned “Even if LIBOR does continue for a further period after end-2021, it would have changed. There is a high probability it will no longer pass regulatory tests of representativeness.”
As recently as February 20203, in an effort to discourage the continued use of LIBOR, the Bank of England confirmed that from October 2020 it will start increasing “haircuts” on collateral linked to LIBOR which it lends against. The Bank of England lends to firms against a wide set of eligible collateral. However, to protect public funds, it applies a risk-averse “haircut” to that collateral to protect against possible falls in its value in the period between a counterparty default and collateral sale, including in times of potentially severe stress. Haircuts reflect different risk characteristics. The current average “haircut” is approximately 25% and for LIBOR-linked collateral, the Bank of England will gradually increase this to 100% by the end of 2021. LIBOR-linked collateral issued after October 2020 will also be ineligible for use at the Bank of England.
There are of course potential alternative benchmark rates available, other than SONIA. For example, the Bank of England base rate, or a “fixed” rate. However, these solutions have not been routinely used in the syndicated loans market to date and indications are that lenders are not now flocking to use them in preference to a SONIA-linked solution. It is of course important to remember that LIBOR was originally a rate devised by and for the syndicated loans market (and was later adopted more widely for other financial markets and products). It is difficult (both practically and conceptually) to rip up the existing rule book.
When to make the change?
In the US, a proposal for legislation mandating use of a recommended benchmark replacement and prohibiting parties from claiming breach of contract following LIBOR discontinuance (or use of the recommended benchmark replacement) has been issued4. Whether or not such legislation is enacted in the US remains to be seen. Certainly in the UK, prior to the COVID-19 outbreak, the prospects of a legislative solution to help address LIBOR transition issues seemed low.
Absent any legislation mandating the transition from LIBOR to SONIA, there remains a question mark over whether, when and how banks should advise clients to implement that change.
Part of the problem (in addition to COVID-19) is that the syndicated loans market needs to move together. While a lender may feel comfortable devising its own LIBOR replacement solution for bilateral lending (and certain lenders have issued new bilateral loans linked to SONIA in the market) the syndicated loans market only works smoothly when all participants are in step. This requires market consensus on how the SONIA-based solution will operate, followed by a considerable amount of work within banks to adapt loan systems to cope with the fundamental change. Another issue is that LIBOR and SONIA (in arrears and any term form) are different (SONIA is typically lower than LIBOR, amongst other things), although this could be addressed via credit adjustment spread mechanisms.
Further, some contracts (such as swap agreements) will have to be unwound before the rates can be replaced. Deferring the move to a new benchmark therefore delays the transaction costs of setting up a new swap, at a time when minimising costs could be paramount. As an added challenge, while the stated aim is for financial markets and products to transition in a co-ordinated way, there is no guarantee that the swaps market will move to exactly the same replacement solution.
However, banks cannot adopt a wait-and-see approach.. The regulators have made clear that this is not an option for lenders. Furthermore, due to the current transition timeline, the sheer volume of products and processes which will need to be changed means that banks need to start engaging with clients now to hold discussions about alternative rates at a time when the rates themselves are untried, untested and – in many cases – simply unavailable.
Conduct risks in advising on transition to alternative rates
In early 2020, the working group on LIBOR transition5 published a suite of documents highlighting conduct risks. Specifically, banks have been told they should engage proactively with their clients. Precisely what proactive engagement means is unclear but it seems reasonable to assume that banks need to make clients aware of the risks attaching to new and existing LIBOR-linked contracts.
Additionally, the guidance suggests that banks are required to find a LIBOR replacement which meets “the customer’s needs”6 and which is “fair”. In particular, the FCA has indicated it will pay close attention to any contracts which are transitioned to a higher replacement rate or which otherwise introduce inferior terms.
Where fallback provisions are inserted in contracts, banks have been told they need to “communicate effectively” how these fallback provisions are expected to operate.
In short, the regulators' guidance is that banks need to get involved in discussions with customers about the best replacement rate for their contract.
Scope of duty in advising on transition
Given the problems associated with the potential LIBOR replacements, the requirement for banks to advise on replacement rates which meet their customers’ needs represents a significant challenge.
In addition to the regulatory risks, there are clear litigation risks. A failure to disclose the fact of and/or risks associated with new and existing LIBOR-linked contracts may lead to mis-selling claims, particularly if the bank becomes the beneficiary.
On the other hand, banks will be wary of opening themselves up to the risk of negligence claims (or at the very least negative client outcomes) if they steer clients towards alternatives which ultimately have an adverse financial outcome.
A key statement of law on the scope of the duty of care in professional services is contained in Manchester Building Society v Grant Thornton UK LLP  EWCA Civ 40. In this case, the court confirmed that the first port of call in determining the scope of duty is to decide whether the professional is providing “information” or “advice”. A professional will be providing advice where they are “responsible for guiding the decision-making process”, as opposed to simply providing the information to allow the client to make the decision. In the context of a bank, there is a further clarification: a bank which sells a product to its customer on an execution-only basis is not under a tortious duty to advise on the risks inherent in that transaction. For such a duty to exist, clear evidence would be required of a bank assuming responsibility and reliance on that assumption by the client.
The difficulty for banks in the context of LIBOR transition is that finding a replacement rate for a client which meets that client’s needs introduces a degree of communication on the risks inherent in the transaction – as well as the rate transition itself. Walking the line between adverse regulatory consequences on the one hand and liability for potentially far greater damages claims on the other then becomes much more difficult.
Risks in managing LIBOR transition cannot be avoided but they can be minimised. The starting point is clearly for banks and other lenders to inform borrowers of the need for change and to ensure they are made aware of the impact of that change and the attendant costs in good time.
Lenders also need to identify, insofar as possible, the way in which alternative rates will work. While this is challenging, particularly in the current market environment, it is crucial. In the event of future litigation, evidence of thoughtful analysis having been undertaken is likely to minimise the risk of a finding that regulatory, contractual or tortious obligations have been breached.
Finally, it will be important to clearly delineate the role being undertaken. Financial institutions may want to avoid providing advice (for example, leading a specific client through its decision-making process), in which case it will be important to show that only information about the choices available is being provided, with the ultimate decision being taken by the borrower and other relevant parties. It would also be prudent at the very least for banks to include disclaimers of liability (including non-reliance representations by clients) in relevant communications and documents.
Financial markets across the globe are in turmoil. In addition, banks in the UK have the added complications of Brexit to deal with. Whether or not LIBOR transition remains on its current trajectory is hard to tell. It will certainly present significant challenges for the syndicated loans market. 2 March 2020 was the deadline for interest rate swaps based on LIBOR to be transitioned to SONIA. The derivatives market is ahead of the syndicated loans market in its transition journey, but market evidence suggests that LIBOR swaps still continue to be traded.
Whatever decision banks take on the method of engagement with their borrower clients, it is clear that with such a substantial change comes significant litigation risk.
2 In a statement on 25 March 2020, the Financial Conduct Authority, the Bank of England and the Working Group on Risk Free Reference Rates confirmed that December 2021 remains the target date but noted there may be future changes to interim transition milestones.
3 Turbo-charging sterling LIBOR transition: why 2020 is the year for action – and what the Bank of England is doing to help. Speech by Andrew Hauser of the Bank of England (26 February 2020).
5 UK Working Group on Sterling Risk Free Reference Rates
6 This excludes transactions over £25 million, for which SONIA compounded in arrears is deemed appropriate.