Legal implications of LIBOR transition in Banking Industry

Starting from its inception in the 1970s in the international interbank market for short-term loans, the London interbank rate (“LIBOR) published by the Financial Conduct Authority (FCA) of UK, is a world standard, which reflects the rate for transactions and pricing models with which the banks lend to each other and is currently worth more than $ 350 trillion. LIBOR will cease to publish after 2021 and will be replaced by a ‘risk-free’ alternative. As a result, there is a requirement of new mechanism which can fulfil the global demand and while doing this there are various legal issues that need to adhere to compulsorily like the companies in various loan documents would need to ensure that new terminology and alternative rates and the modification or transition of the benchmark rates for existing transactions will pose some problems and concerns.

LIBOR and its role in financial crisis of 2008

Abusive use of credit default swaps (CDS)

The abusive use of credit default swaps (CDS) played a major role in driving the financial crisis of 2008. American International Group (AIG) was among the player who was actively involved as they issued the abrupt amount of credit default swaps on subprime mortgages and various other finance-related products. AIG went into bankruptcy because of the crisis and this created the fear that the securities are not properly insured and LIBOR took this to another level making loans more expensive as a result the cash flow in the market was not enough hence the crisis.

Manipulation of LIBOR rates

In 2012, investigations were made in regard to this and it was found out that multiple banks like Barclays, Rabo Bank, Deutsche Bank, Royal Bank of Scotland, and the UBS bank manipulated the LIBOR rates for making out the profit. The Barclays story: By telling LIBOR calculators that they should lease money at reasonably inexpensive rates to reduce the risk of the bank and isolate itself, Barclays manipulated LIBOR. Barclays accepted “misconduct” in price-fixing, as part of a deal with the US and UK authorities in 2012.

Replacement of LIBOR

Financial institutions should move away from LIBOR entirely to so-called “risk-free rates” (“RFR”), which are indexes usually focused on overnight deposit rates and are deemed to be more resilient, according to the Financial Stability Board, which is made up of regulators from G20 countries, in its report “Reforming Major Interest Rate Benchmarks.

Legal Issues

The move from Libor would only be essentially administrative if the new reference rates were to vary from the way they are measured and not in the resulting standard. The new rates, however, are likely to vary significantly from LIBOR, often drastically particularly during times of financial stress. Overnight rates are the numerous alternate reference rates offered by various countries. LIBOR rates are written for a variety of terms, the most general of which are one, three, six, and twelve months. Furthermore, two of the alternative rates are covered, removing the credit spread associated with bank loan risk that is usually used in LIBOR. Furthermore, since the unsecured alternative rates are instantaneous, they have a very little credit gap compared to the LIBOR term rates. Contracts based on the recent overnight reference rates will have to pay differently than contracts based on longer-term LIBOR rates.

Contractual Interpretation and negotiations

Most LIBOR contracts will indeed be renegotiated regardless of the transfer date, and neutrally amending contractual deals will be very complicated, if not impossible. Based on the reference rate they want to substitute LIBOR; parties may be in a better or worse situation with a revised deal. Parties can seek to compensate for this by providing a reward to the worse-off group in the form of a spread modification, a financial contribution, or other means. These discussions, however, do not take place under the same backdrop as the LIBOR contract’s initial negotiations. Borrowers may find themselves in a weakened bargaining position if at some point in time, business conditions are worse than they were before the contract was signed, or if the borrower is approaching the covenant limits. This may mean that lenders use their stronger negotiating power to place new covenants on borrowers, charge them additional fees, or even raise the interest rate they would pay.

Force Majeure

Many contracts include force majeure provisions that exclude individuals from binding commitments in the case of unforeseen circumstances. If the parties are unable to agree on a new benchmark that accurately represents the contract’s original economic impact, a party seeking to terminate the arrangement can claim force majeure.

Frustration

A contract may be “frustrated” if something unforeseen happens after it is established that makes it difficult to fulfil or turns the performance expectations into something completely different from what was intended when the contract was signed. If no prices are submitted/obtained using the dealer poll form, it may be claimed that the arrangement has been frustrated, and the parties have been released from potential commitments (without the need for closing out the settlement, as in the case of ‘Force Majeure). 8 This is of utmost relevance to the derivatives market than the loan market.

Suggestion

Few steps must be taken to avoid various Legal and contractual issues:

1) Reviewing all the contracts and separating them based on whether they have the required fallback provisions or not.

2) Identifying the alternative RFR based on the contracts of different category.

3) Identifying the ways of calculating the alternative RFR and the ways to calculate the economic difference between LIBOR and the selected RFR

Conclusion

These discussions, however, would not have occurred against the same backdrop as the first talks for the LIBOR contract’s initial negotiations. Borrowers may find themselves in a weakened negotiation position if business conditions deteriorate after the contract is signed, or if the borrower approaches the covenant restrictions. That may imply that lenders can use their leverage to impose new restrictions on borrowers, charge them additional fees, or even hike the interest rate they must pay. It’s unclear how common these claims would be, but considering the widespread use of LIBOR as a reference rate in a broader variety of financial markets and goods, the chances are very high.

Author:  Vikrant – a law student of Kirit P. Mehta School of Law, NMIMS, Mumbai,  in case of any queries please write back us via email at support@ipandlegalfilings.com or at IP And Legal Filings.