The end of LIBOR: Commercial contract risks

16th December 2019

Many businesses will have loan agreements and other commercial contracts that include provisions tied to the LIBOR interest rate.  LIBOR will be phased out by the end of 2021.  Walker Morris’ Commercial Dispute Resolution specialists Gwendoline Davies and Louise Norbury-Robinson offer proactive, practical advice on the contractual risks associated with the loss of LIBOR.

Loss of LIBOR: What do businesses need to know?

Following on from the rate-fixing scandal of the mid-2000s, the Financial Conduct Authority (FCA) and the Bank of England have confirmed plans to phase out the London Interbank Offered Rate (LIBOR) by the end of 2021.  LIBOR is the benchmark used by many financial institutions to set interest rates.

LIBOR is to be replaced, for GB Sterling, with an updated version of the Sterling Overnight Index Average (SONIA).  SONIA, which is based on actual transactions (as opposed to the estimates on which LIBOR is based), is less likely to be open to manipulation.

However, worldwide, $ trillions in loans, including UK mortgages, credit card debt, business loans, investments and many other types of commercial contracts, are tied to LIBOR.  So, on a practical level, what will the phase-out mean for businesses?

What are the practical implications?

The key issue is how existing contracts which refer to LIBOR and which are due to continue beyond the end of 2021 (known as legacy contracts) will work.

In some cases parties will simply agree to amend their legacy contracts to refer to SONIA or some other appropriate rate or calculation; and in some cases contracts will allow a party to impose terms or a substitute rate to address the issue.  However, many loan agreements and commercial contracts will not have envisaged, and will not cater for, the cessation of LIBOR.  Many other loans and contracts will include provisions which were intended, at the time the contract was made, to deal with temporary interruptions to LIBOR and there is a significant risk that such clauses (known as fall-back provisions) might not work or suit the parties when LIBOR is permanently unavailable.

For example, reference bank rate fall-back provisions (which rely on a number of reference banks providing quotations which enable a rate to be calculated) will not work if banks are unwilling to take on the liability of providing quotations to be applied in contracts on a permanent basis.  Other provisions, known as historic screen rate fall-back provisions, substitute a fixed contractual interest rate for what was the LIBOR floating interest rate.  It is easy to see that, in some cases, that could entirely alter the economics of a contract – potentially to the significant detriment of a party.  Finally, cost of funds fall-back provisions allow for calculation of an interest rate by reference to the costs of funding incurred by lenders.  Such provisions can be unsatisfactory and imprecise because lenders’ costs of funding are generally calculated on a portfolio, rather than an individual contract, basis.

Nevertheless, where any loan agreement or commercial contract contains fall-back provisions which are unambiguous on their face, fundamental principles of contract law [1] mean that it would be unlikely that a court would interpret or imply terms so as to re-write how the contract should operate in the absence of LIBOR.

It seems inevitable, therefore, that disputes will arise over the coming months and years in relation to some legacy contracts.  As this situation is largely unprecedented; and because, as the law stands, the courts are unable to undermine clear contractual wording based merely on commercial common sense and contemporary factual circumstances, it will be difficult to assess the merits and likely outcome of such disputes/litigation.

What steps can businesses take?

It is therefore essential that businesses understand and, where appropriate, devise strategies to deal with, the impact on their loan/contractual arrangements of the loss of LIBOR.  There are some practical steps that businesses can, and should, take without delay:

• Businesses will first need to be able to identify and locate every contractual provision that is LIBOR-linked. For large businesses – particularly those operating across different offices, divisions, systems and/or on a multi-national level – that could seem like a daunting challenge.  However, there are workable solutions.  For example, by using the same technology and approach that litigators adopt during the disclosure/e-disclosure exercise in complex data- and document-heavy cases or regulatory investigations, comprehensive and effective contract reviews can be taken across all of a business’ records and operating systems.  This way businesses can discover and document – and even categorise and organise – every LIBOR-linked item.
• The next step will be for LIBOR-linked items to be reviewed to determine whether and how they can withstand the loss of LIBOR. For example, do contract terms allow sufficient flexibility for a suitable replacement rate or mechanism to be agreed or imposed?  Do any fall-back provisions work in their current form?  Are amendments required; and, if so, does the contract allow for variation, and on what terms?
• If there is a risk that existing arrangements will not be able to withstand the loss of LIBOR, what are the options for the parties in terms of terminating the contract? Is there an early termination (or ‘break’) clause?  Is there any scope for arguing that the contract has been frustrated [2]?
• Buy-side firms (such as private equity funds, mutual funds, life insurance companies, unit trusts, hedge funds, and pension funds) and financial advisers and intermediaries should ensure that they understand their customers’ exposure to LIBOR. They should devise investment strategies that take into account the costs to, and practical implications for, their customers, including offering alternative products where possible.
• Alongside the decision to withdraw LIBOR, the FCA has set out its core expectations of regulated financial services firms in relation to the fair treatment of customers. Those expectations cover firms’ governance and accountability; their communications with customers; the offering of new products with risk-free rates or alternative rates; and acting in customers’ best interests.  Where businesses are concerned about loans and investments, they should assess whether their lenders or other financial services firms have acted in accordance with the FCA’s expectations.
• As well as considering individual contractual arrangements, businesses should assess whether the loss of LIBOR affects internal and structural matters. For example, a change in the benchmark rate could affect the value of all borrowings across the business and of any portfolio investments.  It could, therefore, result in the need for new standard/precedent documents; new processes; new risk management systems; new reporting; and new training requirements for employees.
• It is clear that any business potentially affected by the loss of LIBOR in 2021 should take urgent specialist financial and legal advice. Expert assistance with the planning and taking of practical steps to understand and proactively deal with the issues will help to make the transition from LIBOR as painless as possible.

For further advice and assistance in relation to the loss of LIBOR and the potential impact on your commercial contracts, please do not hesitate to contact Gwendoline, Louise or any member of Walker Morris’ Commercial Dispute Resolution team.

[1] See our recent briefings on contract interpretation and implying terms for more information and advice.

[2] See our previous briefing on frustration.