At the end of last year, the Loan Market Association (LMA) updated its facility agreements, including changes to the interest rate definitions and mechanics. Many Islamic finance transactions use a conventional interest rate benchmark, such as LIBOR, to calculate the profit or variable rental. Richard de Belder and Adam Pierce explain how one of the recent LMA changes may affect those transactions.
LMA Screen Rate definition and ICE LIBOR Error Policy
One recent development that the LMA's amendments reflect is the LIBOR administrator's publication of a new "ICE LIBOR Error Policy" in November 2014. This provides that, although LIBOR will continue to be published at around 11.45am each business day, a LIBOR contributor bank (i.e. one of the banks that provide the rates on which LIBOR is calculated) can now report any error in the rate(s) it has submitted to the LIBOR administrator up to 3pm on that day. If that error impacts on what the quoted rate should have been, the LIBOR administrator will republish the rate at some point between 3pm and 4pm.
Under the ICE LIBOR Error Policy, any recalculated rate will from that point on be treated for all purposes as if it were the rate originally published. So under existing standard documentation, if LIBOR is corrected, the rate used to calculate the interest under the loan will be the corrected rate. However, the LMA has pointed out various potential problems with this approach. For example:
- Agents will need to monitor any republishing of the rate, so that they can comply with their obligation to notify the other parties promptly of the interest rate that will apply to the loan.
- If lenders are unable to obtain funding at the republished rate, they will have less time to notify the agent that that is the case with a view to invoking the market disruption provisions. On current drafting, they have only until close of business on the day the interest rate is fixed to do so.
As a result, in the "Screen Rate" definition in the LMA documents, there is now an option to exclude the effect of any "correction, recalculation or republication" of LIBOR by the LIBOR administrator, for the purposes of determining the rate used to price the loan.
This may also be relevant for other publicly quoted interest rate benchmarks. For example, the EURIBOR Code of Conduct also requires an error policy to be put in place by its Calculation Agent.
Significance in Islamic finance transactions
As in a conventional loan, the investment agent in an Islamic finance transaction may conclude that, once it has obtained the relevant LIBOR (or equivalent benchmark) figure at around 11.45am on a "Quotation Day", it does not want to have to check for corrections to that figure until the cut-off time for corrections has passed (4pm in the case of LIBOR). But are there any additional, Islamic finance specific, issues?
As a start, in many Islamic finance transactions, the Shari'ah scholars will not permit market disruption provisions of the type found in conventional loans. Where that is the case, the potential timing issue for calling a market disruption event after a LIBOR recalculation (referred to above) will not apply. However, sometimes market disruption provisions are included, but adapted to obtain clearance from the Shari'ah scholars. Where that is the case, the timings should be reviewed against the LIBOR recalculation terms.
More significantly, for a transaction to be Shari'ah compliant, there must be an absence of gharar (or uncertainty) in the transaction terms. So, if it is not possible to fix and ascertain the price at the point of sale, this can be a significant problem.
Take, for example, an ijara transaction where the variable rental is notified to the lessee based on LIBOR as published at around 11.45am. Depending on how the notice is framed and the response required by the lessee, it may be difficult or impossible to reissue the notice amending the variable rent if there is a subsequent change in LIBOR. It would be advisable to get the views of the Shari'ah advisers as to whether an amending notice can be issued. If there is any doubt then the safest solution may be to delay issuing the notice until after 4pm.
In the context of a revolving commodity murabaha facility, it will be important to see what the documentation says about how and when the profit rate is notified (based on LIBOR). Where an offer is issued based on LIBOR as published at around 11.45am, can it be accepted before 4pm thereby creating a binding sale contract? It may be advisable to structure the offer and acceptance process so that it occurs after 4pm.
However, these potential issues are only likely to arise if the rate is fixed and notified on the date of the contract itself. If, instead, that happens (for example) two business days earlier, then the effect of any corrections is likely to be known before the contract is concluded.
This is based on an article that originally appeared in Islamic Finance News.