LIBOR’s Days Are Numbered – What Should a Commercial Borrower Do?

LIBOR, a key interest-rate benchmark for commercial loans, is published daily by the UK’s Financial Conduct Authority (FCA).  After December 31, 2021, the FCA will no longer require banks to submit their daily rates, which FCA uses to calculate LIBOR.  Once that happens, it is unlikely LIBOR will continue to be published by FCA or others.

What is LIBOR?
LIBOR, the London Interbank Offer Rate, is the composite interest rate that banks report they would have to pay to borrow, on an unsecured basis, from each other. It has become an important reference rate or benchmark for many other interest rates, including for many variable-rate commercial loans in the United States. LIBOR, the “world’s most important number,” influences the rates of an estimated $260- $350 trillion in active loans and derivatives.

Why is LIBOR going away?
LIBOR is based on what banks report they think they would pay to borrow, not what they did pay to borrow. The speculative nature of LIBOR led to some prominent traders colluding with banks to manipulate LIBOR, and therefore derivative markets, for financial gain. Many of these schemes were prosecuted following the 2008 financial crisis.

In addition, regulatory reform has led to fewer interbank loans and reduced demand for bank debt.  Fewer loans, a shaky reputation, and no more rate-reporting make LIBOR a lame duck.

What will replace LIBOR?
The Fed has identified the Secured Overnight Financing Rate (SOFR) as the most likely substitute rate. SOFR is based on the overnight cost of secured borrowing, with the collateral being Treasury securities. The Fed thinks that SOFR is less likely to be manipulated than LIBOR, since SOFR is based on a wider range of actual, secured transactions. SOFR reporting began in April 2018.

What can commercial borrowers do now to prepare?
For loans tied to LIBOR, most commercial loan documents already allow the lender to select an alternative or substitute rate if LIBOR becomes unavailable or unreliable. A borrower can be proactive by reviewing all existing loan agreements with terms that extend into 2021 and beyond, and if they use a LIBOR benchmark, contacting the lender to discuss the transition away from LIBOR.  In that conversation, it’s important for the borrower to understand not only the difference between LIBOR and the lender’s new benchmark rate, but also the spread. For instance, a typical variable rate commercial loan might set the interest rate at LIBOR plus a spread of 200 basis points or more. The spread for a different interest rate benchmark, however, will likely need to be different than the LIBOR spread to be fair to both parties.

What about new loans?
For new loans, particularly short term loans, some commercial borrowers are choosing to avoid the uncertainty of variable rate loans altogether by opting for fixed-rate financing. For new variable rate loans, some lenders and borrowers are choosing other rates from the start, such as a bank’s prime rate. SOFR appears to be too new to have gained much market traction, at least for commercial real estate loans of the kind we typically see. 

Rather than specifying a new benchmark that may not gain market acceptance over time, it’s probably a better idea to retain flexibility by using language that requires the lender to exercise good faith in choosing a LIBOR replacement rate and spread that are approximately equal to the LIBOR rate and spread specified in the loan agreement. In a perfect world, the choice of replacement rate and spread would be subject to the borrower’s reasonable approval, but typical pro-lender commercial loan documents don’t inhabit a perfect world.