By Peter Carney, partner at UK law firm TLT
Over the last two years, UK regulators have been steadily increasing the volume and urgency with firms on the need to get prepared for the end of LIBOR, which will cease to be published on 31 December 2021. With parallels to Brexit, it is virtually impossible to be in the financial services industry in the UK and ignore the regular updates and messaging coming from the Prudential Regulation Authority (PRA), Financial Conduct Authority (FCA), the Bank of England, the working group on risk free rates and the ever gathering snowball of articles and materials from the professionals in the market.
Ignorance is bliss?
Most if not all firms either headquartered or operating in the UK have an awareness of the implications of LIBOR's imminent demise, ranging from reasonably aware and taking some initial steps to in-depth knowledge and well advanced in transition planning. However, there are many international banks (some of which will have branch offices in the UK) who have not yet appreciated the challenges which the end of LIBOR poses, or started thinking about the steps required in advance of 31 December 2021. In some cases, the branch offices in the UK and elsewhere can see the risks ahead but head office may not have given it the attention it deserves.
For any banks adopting this kind of "head in the sand" approach, the message has to be: get up to speed quickly and understand how the end of LIBOR will impact on the business as a whole.
Is a wait and see approach defensible?
Perhaps the lack of engagement in some quarters is not attributable to a lack of awareness, but instead to an expectation that the market, regulators, government or a combination of all of these will step in and produce a workaround, which will avoid the need to tackle the issue when there are no doubt more pressing matters higher up the agenda. Of course, the UK regulators have been at pains to warn all firms that LIBOR will cease and that gambling on external forces solving the problem is not the right move.
Despite this and with the end of LIBOR still 2 years away, depending on the scale of the organisation, a "wait and see" strategy appears an understandable one to adopt; but it is not without risk.
The fact is that international banks have commonly used English law documents including LIBOR provisions (usually based on LMA or APLMA standards) for loans all over the world, even where there is no substantive connection with the UK. The effect of the end of LIBOR on those documents will be a matter of English law and it is vital that international banks understand the implications so that they can at the very least understand the risks associated with a "wait and see" policy. Head offices of international banks may not face the direct level of scrutiny of the UK/EU or US regulators that their branch offices face, but they cannot escape the need to understand and engage with the underlying challenges.
What are the challenges?
The implications of the end of a rate which underpins so many loans, as well as other financial products and contracts, is multi–faceted and listing them all would be a major undertaking. In terms of loans though, it is worth highlighting a select few:
- Any LMA based loans maturing after 31 December 2021 will need to be amended to transition to the appropriate chosen alternative rate (whether a risk free rate (RFR), fixed rate or base rate). Whether these legacy loans adopt the latest LMA wording or not, this will usually require the agreement of the borrower (and potentially other lenders and counterparties depending on the structure of the loan). The re-papering exercise in itself could amount to a significant project, particularly when the amendments required switch from a forward looking rate to a backwards one are not insignificant: this is not a case of swapping a LIBOR definition for a SOFR one.
- The scale of the challenge will depend on the size of the legacy loan book and the likelihood of borrowers cooperating. There are reasons why they might not – particularly if they see that the margin is increased to take account of any price adjustment between LIBOR and RFRs/base rates. In terms of cost, lenders should not assume that the costs of amendment can be passed on to the borrower – this may well not be covered under the indemnities in the loan agreement.
- The risks of a do-nothing approach are potentially high – existing fall-back language in the LMA documents is intended for a short term outage of the LIBOR screen rate – it is not appropriate for permanent discontinuance. Lenders who do nothing may be subject to claims from borrowers that, for instance, the end of LIBOR amounts to a frustration of the loan contract bringing it to an end, or litigation over the calculation of interest based on the lender's calculation of cost of funds.
- Switching from a forward-looking rate to base rate or to an RFR will entail significant adjustment in terms of the back office functions and processes required. This could take time and require training and testing in advance.
- Any hedging will need to be taken into account in switching to an RFR or base rate.
There are many more challenges ahead. The dire warnings from regulators and commentators alike are undoubtedly well founded. The end of LIBOR presents a massive challenge to lenders and the market as a whole.
What should banks be doing?
The message from the UK regulator couldn't be clearer: lenders should be taking steps now. In this context, most firms in the UK have been asked to produce details of their respective LIBOR exposure by 31 December 2019. A clear marker has also been put down that new LIBOR issuances should not be made after Q3 2020. Most LIBOR related articles culminate with the now-familiar warnings if immediate steps are not taken.
But how should international banks approach this? There is always the risk that a huge amount of time and costs is expended at a time when so much is unknown.
Lenders do appear to be in a difficult position. On the one hand they are being told that they should not anticipate that LIBOR will continue and that they should take immediate action to transition, but there is currently no "oven ready" infrastructure for RFRs to switch to. Term RFRs do still remain a possibility, but the leaders in the loan markets are a long way off blazing a trail to show how it should be done.
Faced with this, international banks, often with more modest resources, are quite understandably being cautious about expending time and effort now. The dire warnings do not necessarily apply to all lenders in the same way – how a firm reacts will depend on its size, location, the nature of the loans etc. Perhaps it is time therefore to differentiate between firms and how they should respond.
Taking steps does not necessarily mean launching into a massive re-papering exercise straight away. There are steps that can and should be taken sooner rather than later which do not necessarily involve incurring significant costs. Although the approach of each lender will be different, these should include the following:
- Identify the extent of LIBOR exposure – obviously this will cover LIBOR loans but should extend to other contracts and products which are LIBOR based.
- Document extraction – one common issue faced is finding the documents which reference LIBOR to establish what the terms are. While most will have been written on standard templates, there will be variances. Before any analysis can be undertaken, lenders need to identify and get hold of the relevant documents but that document extraction is likely to be challenging and time consuming.
- Project Team – establish a project team including the appropriate parts of the business and with senior leadership to ensure that it is sufficiently empowered to take the steps required.
- Transition Plan – draw up project plans for transition covering all the business areas effected, responsibilities, timings/milestones and steps required.
- Communicate – if there is a lower level of understanding of the implications of LIBOR's demise in some quarters in the international bank community that is likely to be the case amongst borrowers as well. Lenders should therefore be considering alerting borrowers to the issue now so that, when more proactive steps are required, it should at least be a simpler conversation to have. This will apply to existing borrowers with LIBOR loans but also new borrowers.
- New terms – with new/refinancing borrowers, if new loans are on LIBOR, consider the terms with the borrower's lawyers: hardwiring fall-backs, including indemnities etc.
- Understand the implications – probably most importantly for the international banks who may be waiting for a cue from the bigger market players, understand their own challenges associated with LIBOR and keep a very close eye on developments.
There are many questions that currently remain unanswered. The FCA will likely continue its engagement with firms as the end of LIBOR draws closer, but it remains unclear to what extent they will provide additional guidance and support. What is clear, is that the FCA expect firms to start making decisions and implementing their LIBOR transition strategies now, in readiness for the significant impact this change is likely to have on the industry.
So far, the financial services industry has been holding its breath waiting for the outcome of Brexit negotiations, regulatory changes and the recent general election in the UK. However, it's now essential for banks to take proactive steps to ready themselves, identify their LIBOR exposure, and implement smart solutions to minimise business disruption during the impending transition.