While there are many challenges associated with the prospective LIBOR transition at the end of 2021, one of the most daunting challenges has to be the impact of the prospective transition on outstanding financings and other contracts (legacy instruments). We discuss below some of the issues that may arise for legacy instruments once LIBOR is no longer available. Some of these issues are intractable, many may be insolvable. Some, although not all, may be addressed by prospective legislation that has been the subject of discussion within the Alternative Reference Rates Committee (the “ARRC”) and elsewhere.
Looking at the Plumbing/ Contract Inventory. To begin with, while almost all institutions know the capital markets characteristics of their LIBOR based assets and liabilities, many who have large portfolios of assets or large numbers of liabilities do not know the details of the plumbing – the often disparate fallback and trigger provisions in instruments created over time and with varying counterparties. The fallback provisions describe the reference rate that will be used if LIBOR is not available. The trigger provisions describe when the alternative reference rate will become the actual reference rate for an instrument; it describes what it means for LIBOR to no longer be available.
If they have not already done so, both large and small institutions are taking inventory of their LIBOR based instruments in order to unearth the plumbing, to be able to evaluate their risks. Many larger institutions will use AI/ machine learning tools to extract the relevant LIBOR related provisions as well as relevant amendment provisions in the instruments reviewed.
Fallback Provisions and their Perils. There are a number of alternative fallback provisions that will be uncovered by the inventory exercise. None of them appear to be wholly satisfactory and some may just not be palatable to one counterparty or another. First, an institution may find instruments for which there are no fallback provisions. When the number of counterparties is limited and known to each other, there is at least the possibility of negotiation to reestablish an interest rate, although there is no guarantee that there will be a meeting of the minds. There is not an apparent similar negotiation opportunity for more widely distributed financings, leaving the possibility that a material term of the financing agreement will be missing.
Alternatively, legacy instruments may provide that if LIBOR is not available, a poll be conducted of designated banks to establish the fallback rate. Some institutions will have hundreds or thousands of instruments that will require a new rate. As a practical matter, it is not likely that banks will want to be in the business of constantly providing quotes, to say nothing of potential concerns - so long as memories remain fresh of the recent LIBOR manipulation scandal - regarding liability for providing quotes that determine financing rates. Some instruments also provide for a fallback to the last available LIBOR rate, effectively converting a floater into a fixed rate instrument, and thereby causing distress for the borrower or the lender, depending on the path of rates in the future. And then some others (including the majority of syndicated loans) provide for a fallback to the prime rate, currently 4.75%. Current LIBOR rates range from 1.7% to 1.95% for 1 month and 1 year LIBOR. Borrowers are not likely to be pleased when facing such a material hike in borrowing costs.
Some legacy instruments, most notably certain consumer loans, permit the lender or the servicer for the lender to select the fallback rate. It should be expected that lenders and servicers will be sensitive to the frequently heard guidance that value transfer be avoided.
Trigger Provisions/ “Zombie LIBOR”/ etc. In addition to the fallback provision issues, there may also be issues related to when the fallback rates become effective for specific financings. Particularly troublesome will be trigger provisions that simply recite that a specified fallback rate will apply in the event that LIBOR is “not available”. Although the Financial Conduct Authority (FCA) has said that it will no longer require panel banks to provide LIBOR quotes after the end of 2021, the banks will not be prohibited from providing quotes and may continue to do so at the urging of the ICE Benchmark Administration (IBA). The IBA has said that it “will work with globally active banks to seek their support to continue to publish certain widely-used LIBOR settings after year-end 2021”. The Future of LIBOR
How should borrowers and lenders position themselves for the possibility that LIBOR continues to be published by the IBA after the end of 2021? Will the Wall Street Journal, Reuters and Bloomberg continue to publish LIBOR? How should borrowers and lenders position themselves for the possibility that any published LIBOR quotes will be based on input from a very few banks? What if, as has been suggested a number of times, the FCA declares LIBOR to be no longer representative of an underlying market or economic reality? LIBOR: preparing for the end (Andrew Bailey, FCA). The contract inventory referred to above will unearth the extent to which these issues will be problematic with regard to particular instruments.
Risk Assessment. Those institutions who already know the infrastructure of their LIBOR based instruments, and those that complete a contract inventory, then face the prospect of risk assessment, and remediation if possible.
Risk assessment will be a function of whether there are indeed fallback provisions in the instruments, whether any fallback provisions are commercially acceptable and whether they will have practical application, and whether amendments to the instrument are desirable and would be feasible, based on the number of counterparties and their relationships, and the commercial terms to be negotiated. Risk assessment will also require a valuation analysis, including an evaluation of the cost of application of the specified fallback provision as well as of any basis risk (between related assets, liabilities and any derivatives also based on LIBOR and with their own disparate fallback and trigger provisions) that results from such implementation.
Remediation. Short of an effective legislative fix for legacy instruments, remediation of one kind or another will be required in many cases, although may be problematic depending on the circumstances. The possibility of remediation and the options, when required, will be dependent on, among other things, the structure of a financing (bi-lateral loan or high yield bond or securitization widely distributed to investors holding through DTC), the relationship, if any, between the counterparties (on going, long term relationships or anonymous capital markets financings), the value transfer implied by the fallback provision (e.g. a 4.75%. prime rate replacing a 1.8% LIBOR rate, or a 1.8% LIBOR rate becoming the fixed rate but only for the remaining term of a short term financing), and the precision of existing provisions (is there anything left unsaid; how much is left to subjective determination). The need for future remediation may even continue to grow as market participants put off acceptance of SOFR or another alternative reference rate, and put off adoption of the ARRC recommendations, or similar provisions, that seek to clarify both trigger provisions and fallback rates and related adjustments.
Remediation when required may include negotiations whenever possible, and amendments whenever possible. Remediation will be less likely (“impossible”?) for widely distributed financings for which 100% consent is required for an amendment. Perhaps as a last resort, parties may agree to the designation of neutral third parties to select an economically neutral (no value transfer) solution. Arbitrators or mediators, or as a last resort, the courts may fill this role. Other “solutions” (including refinancings, where possible and all in economically advantageous) should be considered as well.
We expect the picture to become clearer as the clock ticks (716 days to go as of January 16, 2020), but the clock will inexorably continue to tick whether or not progress is made on the issues mentioned above.