A Transition Away From LIBOR – What It Means For ECB Lending In India.

LIBOR may be the most popular acronym in the international financial markets, and rightfully so. It has for decades been the benchmark rate adopted worldwide for financial transactions ranging from loans, bonds and derivatives. Often touted as the ‘world’s most important number[1], it first made its appearance in 1969 and has since then established itself as the go to reference rate for all things money.
 

London Interbank Offered Rate (LIBOR), as the name suggests, is a benchmark interest rate based on which banks are willing to lend money to one another on an unsecured basis. Currently, calculated for five currencies (USD, GBP, EUR, CHF and JPY) and for seven tenors (Overnight/Spot Next, One Week, One Month, Two Months, Three Months, Six Months and 12 Months)[2], each LIBOR rate is published by the ICE Benchmark Administration (IBA) (the administrator for LIBOR) on every applicable London business day.
 

While the LIBOR may have had a rich past, its present appears uninviting and future bleak. The 2008 financial crisis marked a paradigm shift in the manner and extent to which banks did business with one another. As banks were mandated to follow stricter capital adequacy norms, the number of interbank unsecured lending transactions greatly reduced. This caused the size of the market feeding the LIBOR computations to decline, and as a result, banks instead of suggesting rates based on actual data were speculatively basing them on their perception of what the rate should be – which was serving neither the interest of the borrower nor the lender utilizing the rate. The year 2012 was also controversial for LIBOR as allegations of manipulations were made, with a major bank agreeing to pay fines of $450 million to UK and US regulators[3] and various other banks being investigated. Hence, it did not come as a big surprise when, in 2018, the Financial Conduct Authority (FCA) of the United Kingdom declared that it will no longer compel panel banks to submit lending rates to support the LIBOR after the end of 2021, signaling the inevitable fate of the world’s most important number.
 

The transition away from LIBOR can be widely regarded as one of the biggest challenges faced in the financial industry. And while each jurisdiction is moving at its own pace, the recent announcement by IBA reiterating its intention to retire certain LIBOR rates by the end of 2021 has accelerated industry efforts to implement the transition without major setbacks. While this announcement may have us jolted, it’s not panic station yet as the FCA recently has announced that the IBA will continue to publish the USD Overnight, One Month, Three Month and Six-Month rate until June 30, 2023. This from an Indian industry standpoint is somewhat a sigh of relief as majority of the ECB lending, foreign currency lending and bond documents in India are pegged to either the Three Month or Six-Month LIBOR rate. However, while this does provide some additional time for borrowers and lenders to act, it’s in everyone’s best interest to understand what the transition may entail, from amendments to existing documents to templatising contractual provisions for new agreements, both predicated on a successful market wide search for a viable alternate rate.
 

Legal Impact
 

From a documentation perspective, the impact would be felt on existing as well as new facility agreements, in both cases where the facility continues beyond June 30, 2023. In terms of the former, the focus would be on what the current agreements state and what options are available to the parties while for the latter, the emphasis would be to decide whether to adopt an alternate reference rate from the outset or put in place a contractual mechanism to facilitate the transition from LIBOR to the alternate reference rate.
 

• Existing facility agreements: The majority of external commercial borrowing facility agreements are based upon LMA (Loan Markets Association) / APLMA (Asia – Pacific Loan Markets Association) formats. Typically, in such formats, the ‘backup language’ i.e. the contractual provisions which provide for a replacement rate in case the agreed benchmark rate is not available, are not robust enough to deal with a permanent change in the benchmark rate. The definition of ‘Screen Rate,’ for example, which we find in these agreements will usually make a reference to LIBOR as displayed by a particular information service provider like Thompson Reuters on a particular address page, and will only contemplate a scenario where such page or service provider is no longer available, and the facility agent / lender may then specify another page or service provider where such LIBOR rate is displayed after consultation with the borrower. This would only help if the rate is temporarily unavailable at a given address, rather than it being permanently unavailable. The other fallback is on the market disruption clause which usually identifies the non-availability of the screen rate or a situation where not more than one reference bank has supplied a rate as a market disruption event. Upon such an event occurring, parties can enter into negotiations for a given period to agree on any substitute reference rate to replace LIBOR, failing which, the rate of interest of each participating lender will be linked to its respective cost of funds. The outcome, potentially resulting in undesired economic consequences and scope for legal interpretations and challenges by the aggrieved party. For example, a borrower would lose the safeguard given to it by having an objective reference rate which isolates it from an increase in lenders cost of funds due to any credit downswing of the lender. Accordingly, parties may be faced with no choice but to reopen executed agreements and agree on a transition mechanism from LIBOR to a new benchmark rate when the former is retired. While the borrower would typically have to consent to such amendment, for lenders, voting thresholds under agreements would have to be considered.
   

• New facility agreements: At the outset, parties can opt for an alternate reference rate albeit with some underlying risk that market convention may favour another reference rate in the coming years. Alternatively, and with arguably lesser risk, they can agree to a transition mechanism to enable movement from LIBOR to the alternate reference rate sometime through the life of the facility. The mechanism could consist of a trigger date – which would be a date no later than June 23, 2022, a pre-decided reference rate replacement, and a reference rate replacement adjustment. The adjustment would be used to re-determine the applicable spread since spreads between term LIBOR and term alternative reference rate could differ for several reasons[4]. A conceptually similar rate switch mechanism was published by the LMA in a draft multi-currency term and revolving facilities agreement[5], which allowed parties to utilise LIBOR until its retired, whilst also having a mechanism to switch to the new rate thereafter. The parties would necessarily have to construct the commercial terms concerning the new rate upfront[6]. To bring in flexibility for any unforeseen eventualities, parties can also agree to a further assurance clause specific to the interest rate mechanism, pursuant to which they will have to work towards making necessary amendment to effectively implement the new reference rate.
   

While there is no doubt that the transition away from LIBOR will require industry participants to band together and dedicate time and effort to redress any fallout from the change, undertaking timely actions as outlined above could be a step in the right direction. However, with that noted, at the heart of any transition strategy is the search for a viable reference rate to serve as an alternate to LIBOR.
 

Viable Alternatives
 

What will replace the LIBOR is a question which has sent regulators, banks and financial institutions into overdrive with establishing networks of working groups, committees and task forces to investigate and recommend alternative rates. In India, the process has been largely driven by the Reserve Bank of India which has tasked the Indian Banks’ Association to work on LIBOR transition arrangements including alternate rates and methodologies[7].
 

While several alternate reference rates are being considered such as the Sterling Over  Night Index Average (SONIA), Swiss Average Rate Overnight (SARON) and Tokyo Overnight Averaged Rate (TONAR) for the various financial markets, the rate being touted as one of the favourites is the Secured Overnight Financing Rate (SOFR) in matters of USD lending transaction. The Alternative Reference Rates Committee set up by the US Federal Reserve has endorsed SOFR as its recommended alternative to USD LIBOR[8]. It represents the cost of borrowing cash overnight collateralised by US treasury securities – also known as the repurchase market. As per estimates, over USD 750 billion worth of daily transactions are executed in the US Treasury overnight repurchase market. Therefore, in contrast to LIBOR, it is premised on actual market activity, rather than a once-in-vogue estimated borrowing rate. Even with the support of the US Federal Reserve, the SOFR market is still nascent and will require active backing by industry participants to cement its place as the successor to USD LIBOR. The APLMA in November 2020 published two draft facility agreements for US dollar syndicated loan transactions for discussions in the Asia Pacific region with each agreement adopting a different methodology for calculating SOFR[9].
 

The notion that SOFR is likely to be the viable alternate to LIBOR for USD lending transactions is also picking up traction in India. State Bank of India and Indian Oil Corporation have in March this year executed the first external commercial borrowing deal using the SOFR[10]. The deal may very well mark the first step in ending the search for a viable replacement to USD LIBOR in lending transactions.
 

Conclusion
 

In spite of the upheaval that the discontinuation of LIBOR has caused, there is no denying that there is a fundamental deficiency in the LIBOR process, which has justified the FCAs decision to pull the plug on the world’s most important number. The transition from LIBOR will no doubt be filled with challenges, requiring every stakeholder in the financial, regulatory and legal space to participate with an aim to make the transition process seamless and with minimum undesired results.
 

 

For further information, please contact:

 

Ruchira Shroff, Partner, Cyril Amarchand Mangaldas

ruchira.shroff@cyrilshroff.com
 

[1]‘LIBOR Primer: Setting the Stage for SOFR’, available at https://www.jpmorgan.com/solutions/cib/markets/libor-sofr

[2] Available at https://www.theice.com/iba/libor

[3] Back to Basics: What is LIBOR, available at https://www.imf.org/external/pubs/ft/fandd/2012/12/basics.htm 

[4] ‘Libor: The rise and fall’,  available at https://www.rbi.org.in/Scripts/BS_ViewBulletin.aspx?Id=19898RBI

[5] ‘The end is nigh – FCA announces end dates for LIBOR – the impact on existing contracts’, available at https://www.lexology.com/library/detail.aspx?g=6c51e0ba-d9f4-4624-9339-f29064563ead.

[6] See supra note 1.

[7] See supra note 7.

[8] ‘The ARRC Selects a Broad Repo Rate as its Preferred Alternative Reference Rate’, available at https://www.newyorkfed.org/medialibrary/microsites/arrc/files/2017/ARRC-press-release-Jun-22-2017.pdf

[9] ‘APLMA launches the first SOFR-based facility agreements for syndicated loans in Asia Pacific’, available at https://www.mayerbrown.com/en/perspectives-events/blogs/2020/11/aplma-launches-the-first-sofrbased-facility-agreements-for-syndicated-loans-in-asia-pacific.

[10] ‘SBI and IOCL ink $100 million first SOFR linked deal in the ECB market’, available at https://www.moneycontrol.com/news/business/sbi-awarded-mandate-for-first-sofr-linked-ecb-deal-by-indian-oil-6654131.html