Across Oman and the Middle East, USD LIBOR has been used as a benchmark for the calculation of interest in US Dollar denominated loans and other financial transactions. In particular, it has been used in the oil and gas sector where such loans are usually denominated in US Dollars to reflect the fact that oil and gas is priced in US Dollars.
In addition, we have seen USD LIBOR used as a benchmark in US Dollar denominated commercial contracts and agreements in relation to the calculation of default interest. There are many such contracts in the oil and gas sector, including exploration and production sharing agreements and drilling contracts. It has also been widely used in the Middle East in other sectors including the infrastructure and projects sector, particularly as many of the currencies in the Middle East have a fixed rate of exchange against the US Dollar.
In this article, we consider why LIBOR is being phased out, the new benchmark, why it is not just a replacement benchmark, the transition of existing documentation, credit adjustment and finally the way forward.
Why is LIBOR being phased out?
Following the financial crisis in 2008, interbank lending and borrowing began to decrease as lenders looked for other means to obtain finance. In addition, due to the incorrect reporting of interest rates by certain lenders to the LIBOR benchmark administrator, LIBOR became vulnerable to rate manipulation and its credibility eroded. Therefore, the Financial Conduct Authority of the UK (FCA), which regulates LIBOR, has decided to phase out one-week and two-month USD LIBOR rates by 31 December 2021, and the remaining USD LIBOR rates by 30 June 2023.
The new benchmark
SOFR is the Secured Overnight Financing Rate being recommended by the Federal Reserve Bank of the US to replace USD LIBOR in US Dollar denominated loans. It is a risk-free overnight rate which means it has no credit element built in to take account of the credit worthiness of each party. It is calculated looking backward to the prior day’s deals, and so is calculated anew on a daily basis. It is a secured rate as it is underpinned by repurchase agreements (repos) which are a form of short-term borrowing for dealers in US government securities.
An alternative to SOFR is “Ameribor” which continues to gain traction, particularly in some sectors in the US. Ameribor includes a credit element and is therefore more representative of lenders’ cost of funds. It is aimed at the needs of small, medium and regional banks across the US that do not borrow at either LIBOR or SOFR to fund their balance sheets.
The banking regulators in the US have been careful to say that SOFR is not the only choice available to the market to replace LIBOR. In this article, we have assumed that SOFR will be the alternative benchmark used by the majority of non-US market participants.
Why is it not just a replacement benchmark?
SOFR is very different from LIBOR. LIBOR (London InterBank Offered Rate) is available in different tenors (overnight/spot, one-week, one-month, two-month, three-month, six-month and twelve-month) and is a forward-looking rate, with the interest rate being agreed at the beginning of each interest period that lasts for a precise length of time. Therefore, LIBOR may offer greater certainty, as the interest rate is pre-set for a particular tenor. SOFR is generally less predictive, as daily overnight rates are determined by looking back at the previous day. LIBOR also contains credit and liquidity premiums charged to reflect the credit status of the bank and tenor risk, which are not present in risk-free rates like SOFR.
While SOFR is fundamentally different from LIBOR, the market has been keen to ensure that the economics of the risk-free rates are as close as possible to those of LIBOR. Market participants do not want one party to the financing to benefit from the transition from one benchmark rate to another benchmark rate, it should be neutral between the parties. Loans based on SOFR risk-free rates cost less because they do not include the credit and liquidity premiums included within LIBOR, so lenders are expected to increase the margin or add a credit adjustment spread to balance the change in the benchmark.
Transactions based on LIBOR also contain provisions to cover breakage costs incurred by a lender if the borrower repays a loan early. That is inapplicable when using a daily rate like SOFR, so lenders may institute other provisions to compensate their costs for early repayment by borrowers. Lenders may also seek to adapt SOFR in a way that the amount to be paid at the end of an interest period (such as 3-month period) can be determined at an earlier date and paid on the last day of the interest period as is the case with LIBOR currently.
Transition of existing documentation
Most existing loan documentation have a number of alternative options if the relevant LIBOR rate is unavailable for any reason. These are usually set out in order in the documentation so that the parties work through each fall back option, starting with the first fall back option, until they find an option which works (replacement rate waterfall). The Loan Market Association loan agreements have historically included a number of fall back options including the actual cost of funds of the lender.
As per the recommendations of the Alternative Reference Rates Committee in the US (ARRC), many parties have accepted term SOFR as the initial fallback to the relevant USD LIBOR rate. A forward looking term SOFR may be constructed based on the SOFR derivatives markets once those markets have developed enough liquidity. But from the ARRC’s announcement on 20 April 2021 which sets forth various key principles for a forward-looking SOFR term rate, it is still undetermined whether a term SOFR will ever be available.
Daily simple SOFR is the next alternative often used in the replacement rate waterfall. As interest accrues over the interest period, parties using (i) daily simple SOFR in arrears or (ii) SOFR compounded in arrears, will not know the final interest amount due until the end of the interest period. In order to provide the borrower with sufficient time to pay interest at the end of the interest period, several potential conventions are being considered :
Payment delay – The averaged SOFR for the period is paid [X] days after the end of the interest period. For example, as the total interest due is not known on the last day of the interest period, interest is paid 5 days after the end of the relevant interest period.
Lookback – For each day of the interest period, the SOFR from [X] days earlier is used. For example, the interest rate for the first day of the current interest period will be the rate from the date falling 5 days early. Therefore the total interest can be calculated 5 days before the end of the interest period and so the interest payment can be made on the last day of the interest period.
Lockout – The averaged SOFR over the interest period (excluding the last X days) “locks” the last X-days’ rates. For example, the average SOFR of the interest period (excluding the last 5 days) is used to calculate the interest for the last 5 days, allowing the total interest to be calculated in advance and the interest payment made on the last day of the interest period.
The market convention for credit adjustment in the UK is to use a credit adjustment spread based on the difference between LIBOR and the new benchmark rate. This credit adjustment spread will then be added to the benchmark rate and margin to calculate the total interest payable by the borrower.
However, in the US, it is anticipated that most parties will devise a revised margin to make SOFR more economically similar to LIBOR.
The way forward
ARRC is pushing all financial markets to move to SOFR by 1 January 2022 for all new transactions. While the plan is for certain tenors of USD LIBOR to continue to be published until June 2023, it is unclear if such rates will remain representative as the number of transactions using USD LIBOR decreases. If the rates are considered to be unrepresentative, there is the possibility the rates will stop being published earlier.
It may feel that there is no need to commence this process now as there is still plenty of time, but we strongly recommend that a due diligence exercise is started to identify any current documents which reference LIBOR, both financing agreements and commercial contracts and agreements.
Then the parties need to engage with their counterparties to work out the best option for the replacement of LIBOR in that document. It may take time to work out the best alternative and document it. It is possible to include a number of fall back options as it is unclear at this moment if there will be a SOFR term rate, for example. Some parties may wish to include a caveat that such option is consistent with market conventions, in the event the options change over the next year.
Finally, it needs to be clear at what point the new bench rate will apply. Will it be from the date of the document, the date that the relevant tenor of LIBOR is discontinued or some other point in between?
In addition, any standard form documents need to be reviewed and any references to LIBOR updated.
If you have any questions on the transition from LIBOR, please contact us. For more information on the regulators’ announcements in March 2021, see our LawNow of 5 March 2021.