1-month and 3-month USD-LIBOR Publication Extended to June 2023
As 2020 comes to a close, and the clock ticks down to the end of LIBOR, the administrator of LIBOR (the ICE Benchmark Administration Limited, or IBA) announced that it will consult on discontinuing publication of some of the most popular tenors of USD-LIBOR (overnight, 1-month, 3-month, 6-month and 12-month USD-LIBOR) after June 30, 2023, a full 18 months later than originally scheduled. The IBA will also consult on the discontinuation of 1-week and 2-month USD-LIBOR, along with most other denominations of IBORs, after December 31, 2021.
This extension of certain tenors of USD-LIBOR to mid-2023 is intended to allow for the majority of legacy USD-LIBOR contracts to mature or terminate prior to LIBOR’s demise, thereby ensuring a much smoother transition away from LIBOR. That said, the publication of these tenors of USD-LIBOR is still subject to compliance with applicable regulations by the UK Financial Conduct Authority and others, including those related to LIBOR being “non-representative” (meaning a determination that the rate no longer reflects the underlying market or economic reality that it is intended to measure). This means that even if the IBA continues publishing certain tenors of USD-LIBOR through mid-2023, market participants will still need to ensure that they are prepared for the rate to phase out sooner.
While this announcement does create some breathing room for market participants, most of our recommended action items for bank clients have not changed. Banks still need to take stock of their LIBOR-based contracts, determine which of these do not already include the appropriate fallback terms, educate customers on the transition away from LIBOR, and work with these customers to execute amendments as needed, so that when LIBOR goes away (whether in 2023 or sooner), there is an unambiguous replacement rate and effective date for replacing LIBOR. And, as discussed below, this announcement does not sanction the execution of any new USD-LIBOR based contracts past 2021.
Banking Regulators Issue Guidance re: LIBOR Fallback Terms
In response to the IBA’s announcement regarding the discontinuation of various tenors of USD-LIBOR, the Board of Governors of the Federal Reserve System, the Office of the Comptroller of the Currency, and the Federal Deposit Insurance (the Banking Regulators) published a statement on November 30, 2020 that included a warning for banks: entering into new USD-LIBOR contracts after December 31, 2021 will create safety and soundness risks, and the Banking Regulators will “examine bank practices accordingly.” The Banking Regulators also listed certain extremely limited scenarios in which it would be acceptable to execute new LIBOR-based contracts past that date.
Further, the Banking Regulators stated that new contracts executed prior to December 31, 2021 should either (i) reference a non-LIBOR rate, or (ii) include robust fallback language with a “clearly defined alternative reference rate” (emphasis added). While this statement does not create an explicit regulatory requirement for banks, the Banking Regulators are unambiguously stating that, going forward, they will consider banks’ reliance on LIBOR and the substance of their contractual LIBOR fallback terms in their safety and soundness examinations. More specifically, banks that continue to rely on fallback terms in new LIBOR-based contracts that only set forth parameters for choosing a replacement rate (rather than specifying a precise replacement rate), and that create too much discretion for one party in choosing such a rate, may be negatively impacted in their upcoming supervisory examinations.
Shifting Towards Certainty and a “Hardwired” Approach to LIBOR Fallback Terms
The Banking Regulators’ statement comports with the updated recommendations from the ARRC with respect to LIBOR fallback terms for bilateral business loans. There, the ARRC discussed the prevalence of its “amendment” approach (in which a LIBOR-based contract is amended and replaced with a to-be-named rate at a later date), and the impracticalities of amending thousands of contracts in a short period of time after LIBOR goes away, as well as the impact of creating “winners” and “losers” based on the open-ended nature of these fallback terms. Because of these concerns, and because of the benefits associated with delineating a specific replacement rate, the ARRC only included its “hardwired” and “hedged loan” approaches in its most recently updated recommendations. The former approach specifies the LIBOR replacement (term SOFR when available or simple SOFR plus an adjustment), and the latter approach applies the replacement rate and adjustment set forth in the Supplement to the 2006 ISDA Definitions (discussed below) to the relevant LIBOR-based loan contract. Specifically, the ARRC stated that “cash markets will benefit by adopting a more consistent, transparent and resilient approach to contractual fallback arrangements for new LIBOR Products.”
Likewise, in derivatives markets, the ISDA IBOR Fallbacks Protocol and Supplement to the 2006 ISDA Definitions (discussed in this client alert), both include fallback terms that would replace USD-LIBOR with compounded SOFR plus a static spread adjustment. Adherence to the ISDA IBOR Fallbacks Protocol, while not required, is expected to be widespread, meaning that the vast majority of derivatives market participants are committing to a specified fallback rate (compounded SOFR) in the coming weeks.
Between this mass adoption of SOFR as a replacement rate in derivatives markets, revised recommendations from the ARRC to discontinue reliance on the “amendment approach,” and regulatory pressure (if not overt regulatory requirements) from the Banking Regulators for banks to shift towards fallback terms with a specified replacement rate, it appears that the winds are shifting toward a “hardwired” approach, in which there is a known replacement for USD-LIBOR at the time of execution of a new contract. While some market participants, including many of our community and regional bank clients, may not be ready to commit to a specific LIBOR replacement (whether SOFR or otherwise), now is the time to consider replacement rate options and updating LIBOR fallback terms in new contracts accordingly.
LIBOR Fallback Terms in Loan Documentation: Key Takeaways
What we want our clients to take away from this update on the LIBOR transition:
- After December 31, 2021, market participants should not execute any new contracts that reference USD-LIBOR.
- Starting as soon as practicable, LIBOR fallback terms in new loan documentation should designate a specific replacement rate (along the lines of the ARRC’s hardwired or hedged loan approaches).
- Already-executed loans that include comprehensive LIBOR fallback terms that only set forth parameters for choosing a replacement rate (including our firm’s most recent recommended fallback terms and the ARRC’s amendment approach) do not need to be amended at this time.
- The ISDA IBOR Fallback Protocol continues to be a suitable means of amending legacy derivatives contracts to incorporate the appropriate LIBOR fallback terms.
- Because of the prevalence of the ISDA Protocol and the ARRC’s recommended fallback terms, SOFR is expected to be the USD-LIBOR replacement in the vast majority of transactions, but it does not mean that there is any obligation to adopt it as a replacement for USD-LIBOR (and in fact, some community and regional banks are considering other alternatives, including Ameribor and Prime).
Our firm has updated our customized recommended LIBOR fallback terms to comport with the Banking Regulators most recent guidance, and we will be circulating this directly to clients.
Questions? Please reach out to Alec Fraser or Cheryl Isaac.