In the wake of several widely reported LIBOR and other benchmark rate manipulation scandals, reflected in headline-grabbing stories of litigation and official inquiries and investigations, followed in some cases by eye-popping related settlements, policymakers have responded with varied attempts at benchmark rate reforms, which as of early April 2013 remain a work-in-process. Notably, the International Organization of Securities Commissions (IOSCO), which issued a consultative paper in January 2013 that received more than 55 comments, is expected in the near term to announce its global guidelines for benchmarks, including standards for governance, regulatory oversight and dealing with conflicts of interest.
Probably the most important pending benchmark rate reform as a practical matter is the implementation of the Final Report of The Wheatley Review of LIBOR and its 10-point plan for comprehensive reform of LIBOR (Wheatley Plan).
The value of potentially affected transactions (estimated in the Final Report to be in excess of $300 trillion) affirms the importance of appropriate LIBOR reform as well as the need to implement that reform in a way that does not unduly disrupt affected transactions or the related market. Unfortunately, some early practical experience with the implementation of point #6 of the Wheatley Plan—requiring that the British Bankers Association (BBA) cease compiling and publishing LIBOR for those currencies and tenors for which there is insufficient trade data to corroborate submissions—provides evidence that suggests market participants face a real risk of disruption.
Consistent with the Wheatley Plan, secondary legislation came into force in the United Kingdom amending the Regulated Activities Order and making the “administering of, and providing information to, specified benchmarks” a regulated activity under the UK Financial Services and Markets Act 2000. Currently, the only specified benchmark is BBA LIBOR. Although recently reported investigations of possible manipulation of the ISDA swap rate suggest that others soon may be added.
Also, as contemplated by point #6 of the Wheatley Plan, the BBA, after public consultation, announced in late 2012 a timetable for the discontinuance of compilation and publication of LIBOR for certain currencies and maturities (see Annex 1 to the BBA feedback statement), including a complete discontinuance of BBA LIBOR quotations for Australian dollars, Canadian dollars, New Zealand dollars, Danish krone and Swedish krona and the elimination of certain maturities (including two-week and nine-month) for euro, United States dollars, yen, sterling and Swiss francs. Certain of these discontinuances have already occurred, with the remainder scheduled to become effective in May 2013. ISDA has recently published commentary on these discontinuances, which includes a link to a form amendment letter.
Many lenders and borrowers have begun considering how their credit agreements are affected by these discontinuances. At this point, there does not appear to be market consensus about how best to deal with the discontinuance of LIBOR for interest period tenors and currencies. We can, however, suggest several steps that market participants should take.
Examine Existing Credit Facilities. Many credit agreements contain provisions that protect lenders from having to extend LIBOR loans in circumstances where a LIBOR quotation is not available. The following provisions should be reviewed carefully.
- Definition of Interest Period. Many definitions of “Interest Period” in credit agreements provide that interest periods of nine months are available to borrowers, but only if “available to” all relevant lenders. The fact that LIBOR is not being quoted by the BBA does not necessarily mean that it is not available to a lender. Credit agreements that currently provide that a nine-month interest period is available to the borrower if all relevant lenders agree or consent would deal with the issue more clearl
- Definition of LIBOR. Many credit agreements contain several alternatives for calculating LIBOR. The first (and preferred) alternative in most cases is a reference to the BBA rate, often as published on a specified data service. If such rate is not available, many definitions then provide for a variety of fall-back alternatives, including the following : (i) the agent determining a rate based on an average of rates for deposits for such interest period in the relevant currency offered to major banks in the interbank market; (ii) the LIBOR rate being set at the average rate for deposits for such interest period in the relevant currency offered to a set of specified reference banks (most often, several banks that are members of the lending syndicate); and (iii) the LIBOR rate being set at the rate for deposits for such interest period in the relevant currency offered to the agent. LIBOR definitions applicable to non-US dollar currencies may in certain cases refer to alternate, non-BBA benchmark rates. Alternatives other than referring to the BBA rate may be more cumbersome to work with, but they may allow for the possibility of continuing to borrow and fund loans in a currency or tenor for which the BBA has discontinued its rate.
- Market Disruption Provisions. A common provision in many credit agreements is the so-called “market disruption” or “Eurodollar disaster” clause, which generally provides that if the credit agreement agent determines that “adequate and reasonable means” do not exist for ascertaining LIBOR for a requested borrowing for a particular interest period, or if a requisite number of lenders advise the agent that LIBOR for an interest period will not adequately and fairly reflect the cost to such lenders of making or maintaining their loans included in such borrowing for such interest period, the lenders are not obligated to fund such borrowing at LIBOR and (in the case of US dollar denominated borrowings) that such borrowing will instead bear interest at the base rate.
It is possible that the market disruption clause might be invoked by lenders in a situation where, for example, the credit agreement permitted borrowings in a tenor that had been discontinued by the BBA, but where it was possible to determine LIBOR for such tenor under the credit agreement’s LIBOR definition by virtue of an alternative to the BBA quotation set forth in such definition. In a proper case, the lenders might determine that the rate set by the reference banks did not adequately and fairly reflect the cost of lending by such lenders and therefore invoke the market disruption clause. Of course, invoking the market disruption provision may raise reputational and competitive issues for the lender doing so, especially if other lenders are not doing so.
It may be that certain market disruption clauses are too broad because they do not distinguish between the remedies that should be applied in a situation where a particular interest period is unavailable and situations where LIBOR is generally unavailable for all interest periods: for example, certain language may state that if adequate and reasonable means do not exist for ascertaining LIBOR for a requested nine-month interest period, that LIBOR borrowings of all tenors are unavailable. A potential work-around in such situations might be for the borrower to cease requesting borrowings in discontinued tenors, which may technically avoid triggering such a result.
The market disruption clause typically provides that in cases where borrowings in non-US dollar currencies are affected, the interest rate applicable to the borrowing is not the base rate but is instead a cost of funds rate. For example, under the Loan Market Association’s form facility agreement, upon a market disruption event, each lender in a syndicated credit facility is to send to the agent a rate equivalent to the cost to that lender of funding its participation in the borrowing “from whatever source it may reasonably select.” This could obviously lead to a situation where the borrower becomes obligated to pay several different interest rates for the loans comprising a single borrowing, which could be administratively burdensome, among other things. Alternatively, some credit agreements provide for the borrower and the lenders to negotiate a substitute interest rate in the event LIBOR becomes unavailable. The outcome of any such negotiation would of course depend on whether there was an appropriate substitute on which the parties might agree.
- Possible Changes Going Forward. As noted above, we are not aware of a consensus approach dealing with these issues. We expect that credit agreement language on definitions of LIBOR and interest period, and the market disruption clause, may change to eliminate some of the issues set forth above. It is possible that certain of the discontinued tenors may no longer be used, at least as widely as they were before. For the discontinued currencies, other non-BBA benchmark rates will likely be used, such as CDOR for Canadian dollars or BBSW for Australian dollars, and, in fact, the BBA has suggested (but expressly declined to endorse) several possible local alternatives in the BBA feedback statement.
With respect to discontinued tenors, it may be possible to deal with such a situation by interpolating between two tenors that continue to be quoted, as suggested by ISDA for swaps.
With time the market is likely to identify and adopt substitute benchmark rates for those that are discontinued; however, it is unclear how much time this will take and between then and now there will likely be issues of the kind that we describe (and undoubtedly others) that will require the attention of senior managers and counsel.