The Federal Reserve Board ("FRB") began publishing the Secured Overnight Financing Rate ("SOFR") in April. This rate was developed to be a more reliable benchmark than LIBOR, which lost credibility a few years ago when it was disclosed some bank traders were manipulating the rate. The FRB bases SOFR on transactions in the Treasury repurchase market, where banks and investors borrow or loan Treasuries overnight. Large banks and groups are already adopting SOFR as an alternative to LIBOR. Most commentators believe this will be the new standard, at least in the United States. Some other countries are developing their own standard base rates. LIBOR may be going away by 2021, when the British regulator plans to cease supporting it. Lenders should revise their lending agreements soon, before LIBOR disappears or loses support.
LIBOR, or the London Interbank Offered Rate, became the standard for most financial lending or rate-setting transactions in the late 1980s. Before that, a host of other "standards" were referenced in lending documents, and lenders often negotiated that extensively. LIBOR was created in response to the complicated financial environment of the 1980s, when rate swaps, other complicated financial transactions, and foreign currency exchange became common. This necessitated quick action and an international standard for interest rates in large financial transactions. LIBOR was/is set on a daily basis, using a formula to compare what international London banks self-report that they charge other banks to borrow money. LIBOR was particularly useful, because it quoted rates for five currencies and seven time periods. It quickly became the standard worldwide.
In 2012, a former trader at Barclays Bank in London admitted traders at London banks had been manipulating LIBOR since about 1991. This was confirmed quickly, and the Financial Conduct Authority ("FCA" - British bank regulator) took over LIBOR reporting. Confidence in the accuracy of LIBOR declined after the manipulation was uncovered. The FCA announced it would cease to support LIBOR after 2021. That led the FRB to develop and announce its own standard daily rate, SOFR.
LIBOR's pervasiveness creates a large concern. Most loan and swap documents still refer to LIBOR, although that will change. At least $350 trillion in financial instruments are tied to LIBOR. Compare this to a U.S. GDP of about $20 trillion. Most of financial paper still uses what soon may be a defunct rate.
We recommend the following:
- Stop using LIBOR as soon as possible, particularly on loans maturing on or after 2021. Instead, use SOFR, which can be found here.
- Amend old loan forms to substitute SOFR for LIBOR where it makes sense. For example, it may not make sense for a loan maturing in 2019, but it might for a loan renewable through 2023.
- SOFR is published as a single number, rather than different numbers for different credit periods, so one may have to adjust the loan language and the premium to accommodate SOFR.
- Stay alert in case another, universally accepted substitute arises.
- Add a market disruption clause to new loan documents. This will provide a mechanism to replace a chosen base rate whenever the loan administration agent reasonably determines the chosen base rate is unreliable or unsuitable. The specific language of the market disruption clause will vary depending on lender choices and existing language in the loan documents.
If you have other questions or need help revising your agreements, please contact Spilman's Banking & Finance team