“Borrowers should review their existing contracts to determine whether the stipulated backup rate is appropriate, or if they should take action to achieve more favorable terms.”
The clock is ticking.
Some 18 months ago, the United Kingdom’s Financial Conduct Authority (FCA) announced it was effectively phasing out LIBOR, also known as the London Interbank Offered Rate, by the end of 2021. LIBOR is the average of the estimated rates major London-based banks charge each other, and many consider the subject of LIBOR’s phaseout to be an arcane one — if, that is, they’re aware of it at all.
But for borrowers, the expiration of LIBOR is a major affair: Around the world, some $370 trillion in commercial loans, mortgages, financial derivatives and other contracts have interest rates tied to LIBOR.
“Phasing out LIBOR is hugely complicated and will ripple throughout many different markets, including the syndicated loan market,” said V&E Finance partner David Wicklund. Wicklund, who frequently represents public and private borrowers, said that the expiration of the decades-old benchmark rate means borrowers will see the terms of their contracts change … unless they’re proactive about changing them first.
As borrowers look ahead to 2021, here’s what Wicklund said they should keep in mind.
Current backup rates may disappoint borrowers.
Borrowers’ contracts typically include a backup rate to LIBOR, like the prime rate. But relying on a contract’s existing backup rate after LIBOR’s expiration may not be in a borrower’s best interest, Wicklund explained. “The backup rate often reflects a higher cost of funding than LIBOR, so it’s not a good replacement,” he said. Borrowers, Wicklund said, should review their existing contracts to determine whether the stipulated backup rate is appropriate, or if they should take action to achieve more favorable terms.
The ease of amending credit agreements varies.
One way borrowers can obtain better lending terms is by amending their existing credit agreements. How successful they will be, however, will depend on the rights granted to the parties of the original agreement. In many cases, rate changes and other amendments must be approved by lenders by unanimous or majority votes. Wicklund noted that while lenders “generally like to play nice” with corporate borrowers, they may decide to seek concessions in return for a “yes” vote on a rate change, particularly if the loan is trading for less than par value. For instance, if the original terms called for an interest rate of 1 percent plus LIBOR, lenders may stipulate that the new interest rate is 2 percent plus the replacement rate. “Borrowers have to think about all these things when deciding whether to do an amendment,” he said.
Refinancing may rule the day … with one caveat.
Wicklund predicts that many borrowers will find refinancing their loans to be preferable to efforts to amend existing credit agreements and the concessions that might come with them. “If the lenders could hold you up for a pricing reset, why not just refinance, particularly if the debt is maturing in the near-term?” said Wicklund. But there’s no guarantee that borrowers will be able to secure more favorable terms on their new loans. As with financing in general, how good of a deal they get will depend on market pricing and their own credit quality. If either deteriorated since the original loan was set, a new loan may in fact prove more expensive or may only be available on more onerous terms.
LIBOR has a natural successor …
It doesn’t quite roll off the tongue like LIBOR, but it’s increasingly looking like SOFR, or the Secured Overnight Financing Rate, will ultimately replace LIBOR in most contracts. Major financial organizations like the World Bank and corporate issuers like MetLife recently closed deals with SOFR-based rates, Wicklund noted. “It’s starting to trickle into the market,” Wicklund said. He noted, however, that it will take some time for SOFR to become ubiquitous because it bears some key differences from LIBOR. While LIBOR is priced on one-, two-, three- and six-month intervals, SOFR is an overnight rate. “It’s just a much shorter term rate, at least in its current form,” he said. But in the future, he said, SOFR could develop as a longer-term rate similar to LIBOR.
… but borrowers and lenders are keeping their options open for now.
Because SOFR is still developing and a couple other (however unlikely) successors are also in the running to replace LIBOR, attorneys for borrowers and lenders are including language in new or revised credit agreements to accommodate a new benchmark rate without stipulating what it will actually be. “They’ve basically left the rate open,” Wicklund said. The language varies by contract and ranges from favorable to the borrower to favorable to the lender. On the borrow-friendly end of the spectrum, a borrower and the loan’s administrative agent can, in the future, decide which benchmark rate will be used without lender consent. On the other end of the spectrum, lenders must proactively vote to approve any new benchmark rate. “There’s no clear market standard yet,” Wicklund said. “The language is still evolving.”
As borrowers prepare for a LIBOR-less world, obtaining high-quality legal services is critical to ensuring current and future credit agreements meet their needs. “With the right language in credit agreements, borrowers can maximize their flexibility while minimizing hassles and costs,” Wicklund said. “It’s up to attorneys like us to help educate our clients on the matter and to advocate on their behalf to reach the best possible results.”