It has been more than two years since the U.K.’s Financial Conduct Authority announced that after the end of 2021, it will not compel any banks to provide quotations upon which LIBOR is based. This announcement gave the markets notice that by that date, all financial products linked to LIBOR—a reported $350 trillion worth—should be migrated to alternative reference rates. This is a mammoth transition project for the financial markets, and some progress has been made—a likely LIBOR successor for U.S. dollars has been identified, and U.S. banks have begun assessing their LIBOR exposures—but an enormous amount of work remains to be done. The transition has many moving parts, each of them presenting potential legal risk.
So Far: The Last Two Years
Identifying a successor to LIBOR. LIBOR is, of course, the reference rate for trillions of dollars of derivatives, syndicated loans, floating-rate notes, bilateral business loans, securitizations, residential mortgages, student loans, and other financial instruments. But over the years, the market on which LIBOR is based—the London interbank market—has lost much of its trading volume, and as a result, LIBOR has lost much of its reliability as a market-based reference rate.
This development, together with allegations of LIBOR manipulation, led to calls for more reliable reference rates, and in 2014 the Federal Reserve Board and the New York Fed convened the Alternative Reference Rates Committee (the ARRC), which includes a diverse set of banks and other private sector entities, to work on a successor reference rate for USD LIBOR. In 2017, the ARRC recommended the Secured Overnight Financing Rate (SOFR) as a successor to USD LIBOR. SOFR reflects the cost of overnight borrowing using Treasury securities as collateral—the rate in the overnight repo market. This market better reflects banks’ actual cost of funding, and the market’s high volume of transactions makes this rate more reliable than LIBOR.
While these differences with LIBOR make SOFR a more suitable reference rate, they also complicate the transition. SOFR is a risk-free rate, so it needs the addition of a credit spread before it is comparable to LIBOR. And SOFR is an overnight rate, so SOFR cannot conveniently fill LIBOR’s use for settlement in different tenors, at least until a forward-looking term SOFR is developed. Many observers doubt that there will be a forward-looking term SOFR by the end of 2021.
Establishing the successor rate in the market. The New York Fed began publishing daily SOFR in May 2018. Since then, the volume of SOFR-linked instruments has been growing, though not as rapidly as some observers had hoped. Industry experts still cannot say when SOFR will build the market volume it needs to gain acceptance as LIBOR’s successor (and some observers are skeptical it ever will). This uncertainty about when (and even whether) SOFR will develop sufficient market volume presents obvious problems for financial institutions that are trying to plan their transition from LIBOR. Additional alternative reference rates have been proposed, such as AMERIBOR, the American Interbank Offered Rate, which is based on unsecured overnight rates for lending taking place across the American Financial Exchange, further complicating matters.
Developing contract language for the transition. Despite the lack of certainty at this time about the successor rate, banks and other market participants needed to move forward with the complex task of developing post-LIBOR language for their various financial contracts. The ARRC has recommended fallback language, in the event that LIBOR is no longer available (and in certain other specified circumstances) for several categories of cash products, and the International Swaps and Derivatives Association, Inc. (ISDA) is developing industry protocols amending, on a multilateral basis, derivatives contracts in similar circumstances.
The recommended language for cash products typically provides that when LIBOR is no longer available, it will be replaced with a specified reference rate such as SOFR, and if that rate is not yet available, for a waterfall of fallback options. This is the “hardwired” approach. For bilateral and syndicated loans, the ARRC recommendations include an alternative approach, the “amendment” approach. This provides that when LIBOR is no longer available, the parties will amend the agreement to adopt a rate to be identified at the time of the amendment. This approach includes a streamlined amendment mechanism, for example, authorizing one party to choose the successor rate and providing other parties a right of negative consent. It may well be that the amendment approach will be the more common approach until a specific successor rate is established in the market.
Both approaches involve a degree of legal risk. The hardwired approach carries the risk that the designated successor rate will not be fully developed and in place before LIBOR goes away. The amendment approach carries the risk that parties might not agree on an appropriate replacement rate. And as a practical matter, the amendment approach can require large financial institutions to amend a huge number of contracts, all at once, shortly before December 31, 2021—potentially a significant operational challenge. Under either approach, the fallback trigger clause can invite litigation about whether and when LIBOR as we know it is no longer available. The fallback language recommended by the ARRC includes as a trigger a statement by a relevant authority that LIBOR no longer will be published or no longer is representative; that language does not, however, preclude claims prior to the time of any such statement that LIBOR, although it continues to be published based on relatively few panel bank submissions—the “zombie LIBOR” scenario—no longer should apply. And if the successor rate arguably alters a contract’s economics in favor of one party—resulting in a value transfer—the other party may find grounds to challenge it in court.
Looking Ahead: The Next Two Years
LIBOR Transition Plans. Over the last year, most major financial institutions have created transition working groups and developed extensive transition plans.
Reviewing and revising standard transaction documents. Many financial institutions are reviewing their standard documents for future transactions to assess the need for revisions as outlined in the above discussion of fallback provisions or, where deemed appropriate, to make a transition directly to non-LIBOR rates.
Addressing legacy contracts. Many financial institutions have also been working to inventory their existing exposures, which can involve many thousands of contracts. Possibly the biggest challenge many banks face is their huge inventories of legacy contracts: the many LIBOR-based contracts that extend beyond 2021 and, typically, do not properly provide for an alternate rate if LIBOR becomes permanently unavailable. Most of the fallback provisions in these contracts were designed to address only brief interruptions in publishing LIBOR. A common provision, for example, defaults to the last quoted LIBOR when LIBOR is unavailable. If such a provision is applied when LIBOR’s unavailability is permanent, it could lock in the December 31, 2021 LIBOR for years—transforming the basic economics of the contract and all but inviting legal disputes.
Amending these legacy contracts can be difficult or impossible, though the difficulty varies with the type of financial instrument. Some instruments—many bonds, for example—are held by numerous investors, some of whom cannot be identified, but the instruments require unanimous consent for any amendment. Financial institutions are still working out the best solution for their legacy contracts.
Communicating with counterparties. Financial institutions will be contacting counterparties and customers, including consumer customers, to provide information about the transition from LIBOR. Many of these communications will be dictated or governed by regulatory and other compliance requirements—and therefore fraught with potential compliance risk.
Transitioning financial instruments to a specific successor rate. Although the ARRC has spent a considerable amount of time developing fallback language for a wide variety of financial instruments, the ARRC has expressed a strong preference that market participants no longer use LIBOR for new instruments, even with the recommended fallback language, but rather they adopt SOFR at this time. The inclination of financial institutions and other market participants to adopt this approach, however, is limited by the pace of the market’s acceptance of SOFR and the development of an appropriate term SOFR (or adoption by the market of a compounded or average SOFR convention).
Coordinating transition activities across products. Financial institutions frequently fund LIBOR-based assets on balance sheets with LIBOR-based liabilities, and also hedge both assets and liabilities with derivatives. It is not yet clear whether the ARRC recommendations (regarding fallback provisions, trigger events, reference rates, spread adjustments, term adjustments, and the like) for all products, including consumer products, and also the ISDA protocols for derivatives, will be uniform, or uniformly adopted. The choreography of the LIBOR transition for an institution’s liabilities, assets, and hedges is not likely to be precise or contemporaneous.
Meeting operational challenges. The prospective LIBOR transition presents financial institutions with a complicated array of operational and infrastructure challenges. There are too many to list here, but each one poses significant legal exposure if not managed properly. At a major financial institution, revising procedures and updating systems requires significant lead time, providing still more pieces of the transition puzzle that banks must maneuver into place over the next two years.
Complying with regulatory requirements. To conclude with the obvious but important: This wide range of transition activities implicates a very wide range of regulatory requirements, and therefore generates significant compliance and disclosure risks. And financial institution regulators have emphasized that they are focused on the LIBOR transition—for example, stating their expectation that by now, banks should be able to provide their regulators with appropriate assessments of their LIBOR exposure and detailed plans to execute the transition to a successor rate. (Remarks by Randal K. Quarles, Vice Chair for Supervision, Board of Governors of the Federal Reserve System (June 3, 2019).) These regulators’ warnings highlight the risks financial institutions face, with a little more than two years left to carry out their transition plans.