Seward & Kissel LLP — Front Page Focus: Life After LIBOR

March 10, 2020


LIBOR is a global interest rate benchmark used as a price reference for financial contracts, including derivative, bond and loan documents. After regulators discovered that it had been manipulated, it was discredited, leading to the announcement by the UK’s Financial Conduct Authority in 2017 that the publication of LIBOR will be phased out in 2021. Various jurisdictions are developing their own benchmarks. Not handling the transition properly could create exposure in the form of economic, operational, and legal risk. The following sets forth a summary of various areas that may be impacted by this change:

  • Corporate Finance, Lending and Securitization:

    • Loan Facilities and Certain Other Corporate Finance Transactions.
      • Participants in loan facilities and certain other financing transactions that reference LIBOR should evaluate the best approach to address the LIBOR phase-out. There are various options, including the Alternative Reference Rates Committee (“ARRC”) “Amendment Approach” and the ARRC “Hardwired Approach.”
      • As many parties have been opting for a wait-and-see approach until the market’s position on the adoption of the Secured Overnight Financing Rate (“SOFR”) as a LIBOR successor becomes more settled, the consensus position has been to incorporate the ARRC “Amendment Approach” recommended language with few if any material changes, though some lenders and borrowers have successfully negotiated small deviations from the form language and we are starting to see some new facilities include the “Hardwired Approach.” Legal counsels need to take care when inserting the ARRC form language in their agreements. A number of minor revisions are typically required to conform the form language to the terms and definitions of the applicable agreements.
      • Parties should review existing agreements to determine whether LIBOR fallback provisions already exist, as well as the amendment provisions and consent requirements to implement such LIBOR fallback provisions.
    • Securitization.
      • Depending on the asset class and market, many new securitizations (including CLOs) have been including LIBOR succession language. For example, a significant portion of new CLOs include the ARRC “Hardwired Approach” fallback language. Some recent facilities have also included language that conditions the move to such replacement to either the majority of recent new issue CLOs utilizing such rate or the majority of the underlying floating rate assets utilizing such rate. Securitization market participants are still discussing alternative approaches and solutions relating to legacy transactions.
      • As set forth above, parties should review existing agreements to determine whether LIBOR fallback provisions already exist, as well as the amendment provisions and consent requirements to implement such LIBOR fallback provisions.
    • Trustees and Agents.
      • Third-party trustees and agents should review LIBOR fallback provisions to ensure they have no obligation to (i) determine when a trigger or benchmark replacement event has occurred, (ii) determine what replacement benchmark should be selected, (iii) determine what amendments are necessary to implement a benchmark replacement or fallback, or (iv) exercise any discretion or subjective decision-making in relation to the foregoing. To the extent that subjective decision-making is required, trustees or agents will want to confirm internally that such provisions are acceptable and, if not, attempt to amend those provisions now to remove or limit such discretion.
      • Third-party trustees and agents should review agreements carefully to ensure that they have no liability in connection with the failure or delay of any responsible party to implement a fallback or replacement benchmark, including any inability of a third-party trustee or agent to perform its duties as a result of such failure or delay.
    • Operational Concerns. Given the significant differences between LIBOR and SOFR, market participants should consider what operational challenges they may face in implementing a SOFR-based replacement benchmark, including the impact on payment schedules, notices, reporting and other administrative matters, as well as the adjustments, if any, that they will make to SOFR when setting the benchmark for their agreements. Steps should be taken now to prepare to update and adopt the necessary back office systems and operations to successfully and seamlessly implement a new SOFR-based benchmark rate.
  • Derivatives:

    • ISDA Protocol and Fallback Provisions. The International Swaps and Derivatives Association (“ISDA”) intends to publish a benchmark fallback protocol in the first half of 2020 that will amend the 2006 ISDA Definitions to include appropriate fallback language. The amendments will include both “permanent cessation” and “pre-cessation” fallbacks for each of the relevant IBOR benchmarks. It is expected that market adherence to this protocol will exceed 90%. With respect to cleared swaps, CME and LCH are expected to adopt the ISDA fallback provisions by rule, effective for all cleared swaps.
    • Regulatory Guidance. The Financial Conduct Authority in the United Kingdom has stated that after the third quarter of 2020 regulated swap dealers should not enter into swaps referencing LIBOR in the financing leg. It is expected that the Federal Reserve will follow with similar guidance.
    • Swap Documentation. In preparing for LIBOR transition, parties to swaps should diligence their outstanding swap documentation to determine what financing terms apply.
      • Swaps with LIBOR-linked financing legs that extend into the fourth quarter of 2021 or beyond should be amended so that LIBOR is replaced by the appropriate risk-free rate (e.g., SOFR replaces USD-LIBOR).
      • Adherence to, or incorporation of, the ISDA benchmark fallback protocol terms will provide appropriate fallback language in the event the parties are unable to amend transactions prior to the cessation or non-viability of the relevant IBOR benchmark.
    • Transition Risk. Swap market participants should also begin to model transition risk and explore the use of hedge instruments, if applicable.
  • Real Estate:

    • Existing Mortgage Loans. Borrowers and lenders should review the alternative rate language provisions of any existing loans which have a floating rate based on LIBOR. If the existing alternative rate provisions are inadequate or might result in an unfavorable or undeterminable alternative rate, the parties should consider seeking a mutually acceptable amendment to the applicable provisions. Borrowers tend to bear the risk of an unfavorable alternative benchmark being selected. Borrowers with existing LIBOR loans should evaluate whether their existing loans permit refinancing with or without penalty in the event of a rate benchmark change event, and consider refinancing options and timelines to mitigate a potentially unfavorable change in the rate benchmark.
    • Existing Rate Cap and Swap Agreements. Existing Rate Cap or Swap Agreements (entered into in connection with floating rate loans or otherwise) should also be scrutinized for adequacy of alternative to LIBOR provisions. Parties should seek to amend or replace Rate Caps and Swaps with inadequate or unfavorable alternative rate benchmark provisions.
    • New LIBOR Loans. The alternative rate benchmark provisions of any prospective new floating rate loans should be carefully scrutinized to ensure they include adequate provisions for the transition from LIBOR. Borrowers and Lenders should evaluate the outlook for long term adoption of any proposed replacement benchmark. Borrowers should also consider whether competitive alternative financing options which do not reference LIBOR are preferable in the short term while the LIBOR transition remains uncertain.
    • Collateralized Mortgage Backed Securities (CMBS). Lenders making and/or packaging loans for CMBS with a LIBOR component should carefully consider alternative to LIBOR provisions and any necessary disclosures to investors.
  • Shipping:

    • Ship Mortgages. LIBOR’s sunset, and the ensuing transition to an alternate reference rate, will require ship mortgages to be amended, as the change in the interest calculation method is a substantive matter material to the interests of third party creditors.
    • Sale Leaseback Transactions. Many sale-leaseback transactions have a LIBOR component in calculating the charter hire, which will need to be amended.
    • Hedging. Many shipping loans are hedged by an interest rate swap. Any change in the interest rate in the underlying loan will need to be harmonized with a corresponding change in the derivative instrument.
    • Public Company Disclosure. LIBOR’s sunset warrants disclosure in the form of a risk factor, and public shipping companies should consider including such risk factors.
  • Investment Management:

    • Investment Portfolio Exposure. Numerous investment portfolios have LIBOR exposure through various commercial loans, private debt instruments, floating rate notes and securitization products. Many hedges also utilize LIBOR-based derivatives, such as interest rate swaps. Investments that have a LIBOR component will need to be carefully reviewed to determine the best approach.
    • Financial Analytics. LIBOR has often been utilized as an input into various calculations, systems, and models for operations and administration. LIBOR is also used in valuation curves for discounting, asset valuation and stress testing purposes. These analytical tools will need to be updated.
    • Valuation. LIBOR-referencing contracts without fallback language or inadequate fallback language could change in value as the LIBOR end date approaches. Also, to the extent LIBOR is used as an input into a calculation, a pricing or valuation model may need to be updated. Investment managers should consider the impact of these and other factors on valuation procedures.
    • Hedge Funds.
      • Portfolio Performance Benchmarks. LIBOR is often used as a benchmark for investment performance, and it also may be a hurdle when determining a manager’s performance compensation. A new benchmark will need to be substituted and consideration will need to be given about restating prior performance to reflect the new benchmark.
    • Private Equity.
      • Portfolio Company Exposure. Private equity managers should identify portfolio companies that have LIBOR-indexed credit agreements that (i) do not address the phase-out of LIBOR and (ii) require the consent of multiple stakeholders to amend. They should begin sooner rather than later, getting a handle on the scope of arrangements that need to be modified and developing a plan for executing on these changes.
    • Private Credit.
      • Direct Lending. Private credit fund managers that engage in direct lending may need to renegotiate the terms of contracts extending past the LIBOR end date that do not adequately address LIBOR discontinuation.
    • Registered Investment Companies (RICs).
      • Disclosure in Regulatory Documents. RICs should consider whether the potential impacts of LIBOR discontinuation qualify as investment risks requiring disclosure to investors in the prospectus or statement of additional information, in light of the nature and degree of LIBOR-related investments. In addition, RICs should consider potential impacts on disclosures in a fund’s financial statements.
      • Liquidity. LIBOR-referencing contracts without fallback language or inadequate fallback language could become less liquid as the LIBOR end date approaches. RICs and their advisers should consider the impact on the liquidity of these investments, including with respect to the 15% limitation on illiquid investments and liquidity classification (bucketing) requirements under Rule 22e-4 of the Investment Company Act of 1940, as amended (i.e., the liquidity risk management program rule for non-money market funds).
      • Exemptive Orders. RICs should consider evaluating potential implications for the terms and conditions of any exemptive orders that reference LIBOR (such as certain interfund lending orders).
      • Closed-End Funds (CEFs) and Business Development Companies (BDCs). CEFs and BDCs that participate in direct lending may need to renegotiate the terms of contracts extending past the LIBOR end date that do not adequately address LIBOR discontinuation.

Seward & Kissel’s LIBOR Transition Task Force, a team of highly focused and specialized cross-disciplinary lawyers, has developed solutions and protocols to support the Firm’s clients in connection with the adoption and implementation of replacement benchmarks for LIBOR. If you have any questions concerning the foregoing, please contact your primary attorney or a member of the LIBOR Transition Task Force.