Janine Alexander and Audrey Favreau discuss Libor transition and loans, and set out what borrowers in the real estate finance market need to know
The London interbank offer rate (Libor) is the benchmark reference rate commonly used in commercial loans to calculate interest payments in variable (floating) rate loans.
Following the large-scale Libor fixing scandal exposed in 2011, and a general decline in the importance of interbank lending within the financial markets, the Financial Conduct Authority (FCA) has indicated that it wants to move the financial markets away from using Libor as a benchmark in favour of instead using risk-free rates (RFRs), which are based on actual transaction data and so less susceptible to manipulation, by the end of 2021.
The FCA announced in July 2017 that it will no longer compel or encourage banks to provide quotations for Libor after the end of 2021 and told market participants that they should therefore plan a transition to an alternative rate based firmly on actual transactions data before then.
Each currency of Libor has its own existing alternative RFR identified by the relevant working groups (see box).
However, for the loan market these rates cause some operational and commercial difficulties, with the working groups now discussing how to develop risk-free rates better suited to purpose. Considerable uncertainty therefore remains, even now with the 2021 deadline looming, as to exactly what alternatives will be available.
What does this mean for borrowers with new loans?
There are differences between RFR and Libor, which are significant for the loan market. The fundamental difference is that existing RFRs are based on historical transaction data and so (unlike Libor) there is no element of “forward looking” to the expected movements in the interest rate market over the interest period built into the rate.
The practical and commercial effect of this is that where interest rate payments are referenced to RFRs, such as the Sterling overnight index average (Sonia), borrowers can expect loans to be offered on terms where the borrower has less notice as to the interest payments they will make as they are likely to be calculated at or shortly before the date when payment is due, rather than at the beginning of the interest period as is usual for Libor loans. Therefore, it will no longer be clear well in advance what will be payable.
Industry working groups are continuing work to try to develop “forward looking” rates based on RFRs. For Sonia it is hoped this will be available in 2020, but it requires development of a market for overnight index swaps or a futures market referencing RFRs.
In the meantime, “averaging” or “compounding” mechanisms are being developed into contracts using the daily RFR rates published over the interest period (or a period starting and ending a few days before the interest period to allow at least some notice of the payment required).
Borrowers in the real estate market should make sure they understand the financial and practical implications of the interest payment mechanisms and benchmarks proposed, in particular:
- Which benchmark rate is proposed, and how and when will the payment be calculated?
- Is there a mechanism to change to a preferred alternative rate if one is developed?
- Is any short-term interest rate hedging required to ensure sufficient cash will be available if payment is required on short notice in a volatile interest rate environment?
- How will any repayment or prepayment fee be calculated if the loan is repaid/prepaid before the interest due for the period has been established?
- If there is interest rate hedging associated with the loan, is it documented “back to back” or is there any remaining exposure? For example, if an “averaging” mechanism is used based on Sonia over three months for the loan interest payments, then a straightforward Sonia swap based on Sonia published for a particular day will leave potentially significant exposure if the rate becomes volatile.
- If there is a mechanism to alter the rate if a new benchmark rate preferable to the parties emerges in future, is there also provision to alter any interest rate hedging so that it remains “back to back”?
What does this mean for borrowers with existing loans?
Real estate borrowers with existing loans referencing Libor should consider the following:
- What will be the contractual position after 2021 based on your loan agreement(s) as drafted?
- Is there a fallback provision specifying an alternative benchmark/mechanism to Libor? Does the fallback provision apply in this situation?
- Is the fallback/alternative commercially acceptable as a permanent basis for the loan going forward? Such provisions include a variety of mechanisms, including using the lender’s own cost of funds as the benchmark, allowing the lender to specify an alternative rate or even using the last Libor “screen rate” available (which in this situation converts a floating rate loan to a fixed rate loan).
- What happens if Libor continues to be published but because of the transition and discontinuance of most banks’ submissions it does not reflect market pricing (so-called “zombie Libor”)?
- Would your fallback provision be triggered if “zombie Libor” continues to be published because some banks continue to make submissions? Is there a mechanism for the borrower to change to another rate?
- Can the lender amend the benchmark rate without borrower consent? If not, the lender is likely to seek to amend that position in advance of 2021. Borrowers should therefore carefully review any proposed amendments to their loan agreements which give the lender the right to change the rate without borrower consent (or otherwise change the position that agreement is required). Such amendments may be proposed as part of any wider, unrelated amendments or restructurings.
- If there is interest rate hedging associated with the loan, do the fallback mechanisms match? Mismatches in the benchmark used after 2021 between an interest rate swap and the underlying loan creates exposure to the difference between the rates and may lead to additional cost and/or exposure (or the need for additional hedging to cover the risk that the rates will move in different directions).
What borrowers should do now
Borrowers in the real estate market need to understand and plan for the impact on their business. Despite the current lack of a new reference rate, there are steps you can be taking now to prepare:
- Identify loan agreements based on Libor which are due to mature after 2021 and any associated interest rate hedging.
- Understand what fallback mechanisms are contained in these agreements, and which parties must consent to replace Libor with an alternative rate.
- Consider whether the position under your current loan documentation will be commercially acceptable to you when Libor is discontinued (or becomes a rate which does not reflect the market rate for lenders’ cost of funds, ie “zombie Libor”).
If you judge the position to be commercially acceptable, consider waiting for the lender to approach you with any proposals and assess carefully with legal and specialist financial advisers the economic effect of those proposals. Review carefully any proposed amendments allowing the lender to change the rate without consent in advance of proposals as to a new reference rate.
If the contractual position as drafted is not commercially acceptable, seek to negotiate an amendment with the lender to specify a rate acceptable to both parties, with pricing adjusted as necessary on a negotiated basis to avoid “value transfer”. Alternatively, agree a mechanism to deal fairly with selecting a new rate when the position is clearer overall in 2021.
The strength of the borrower’s negotiating position will depend on the individual circumstances, and it may be that engagement as to the new reference rate is not possible until close to the discontinuation.
However, waiting for the lender to raise this issue without assessing the available options and their commercial effect risks being underprepared for negotiations with the lender. It may mean there is insufficient time to investigate refinance options before Libor is discontinued in the event that a commercially acceptable solution cannot be agreed.
Janine Alexander is a partner and Audrey Favreau is an associate in the banking and financial disputes team at Collyer Bristow
