Today LIBOR is linked to over $250 Trillion (that is with a “T”) in financial instruments and has been used as a reference rate for more than 30 years. However, regulators, for various reasons, are driving a shift to an alternative reference rate. In 2017, ARRC (Alternative Reference Rate Committee) identified the alternative reference rate in the US as SOFR (Secured Overnight Financing Rate). Most community banks use LIBOR sparingly in their loan and deposit contracts. However, if a community bank has even one LIBOR contract, the issue of fallback language becomes essential.
Market participants understand that the transition from LIBOR will be a massive undertaking for the banking industry. Most large and mid-sized banks are now planning their transition strategies. Most community banks have a small number of financial contracts that reference LIBOR. However, for various reasons, community banks may wish to reference LIBOR today in a financial instrument knowing that the reference rate may not exist in the future. Community banks must consider the fallback language to use to transition from LIBOR to SOFR.
One of the issues in transition planning is that despite references to the “end” of LIBOR, the index may continue to exist past 2021. No regulatory body has created a requirement for ICE Benchmark Administration to stop publishing LIBOR. Instead, after 2021, LIBOR panel banks will no longer be compelled to submit pricing data to be published. It is yet to be seen if LIBOR continues to be published and remain a reliable benchmark past 2021.
Regardless of what happens to LIBOR, every community bank that references the index today in a financial instrument must also include fallback language that allows substitution of the reference rate in the future should LIBOR becomes unavailable is unascertainable or unreliable. Any LIBOR fallback language should take into account the following:
- Either select a specific replacement rate or define which parties will choose the replacement rate,
- Set any other parameters for the new rate,
- Account for all scenarios in which LIBOR may not be used (such as become unavailable, no longer be published, become unreliable, etc.),
- Set mechanism to designate a date, or set a date on which the replacement rate will go into effect under the contract,
- Allocate costs/risks associated with the replacement rate in lieu of LIBOR, and
- Account for the corresponding fallback rate that will be used in any related hedging.
In 2019, ARRC published recommended fallback language for floating rate notes and syndicated loans, and for bilateral business loans and securitizations. ARRC also published consultation for recommended fallback language for new closed-end, residential adjustable-rate mortgages for public feedback. ISDA is currently working on fallback language for derivatives and other financial contracts which should be published later this year or early 2020.
Unfortunately, much of the ARRC recommended fallback language is too complicated and wordy for most community banks to include in their commercial contracts. In fact, the ARRC recommended fallback language is longer than the entire promissory note used by most community banks to document a commercial loan.
Mid-Size Bank Coalition of America (MBCA), a business, economic, and financial policy alliance comprised of mid-size banks recently shared LIBOR fallback language from approximately 20 banks. The wordiest fallback language used by an MBCA bank is 1932 words long, and the shortest fallback language is almost 400 words. The average number of words used for fallback language by mid-sized banks is almost 600 words.
However, historically alternative indices/rates were permitted in agreements if LIBOR became “unavailable” and that language is simple and allows the lender discretion of when to substitute a reference rate and what that rate will be. As long as the community bank acts in good faith, and the contract is an agreement is with a commercial entity, community banks should rely on the simplest and most direct fallback language feasible.
For a commercial transaction, documented by agreements where LIBOR is the reference rate, the LIBOR fallback language below has been a standard for banks for many years. The provision is as follows, and the fallback language is underlined:
"VARIABLE INTEREST RATE: The interest rate on this note is subject to change from time to time based on changes in an independent index, which is the per annum rate that major banks charge for deposits in US dollars to other major banks. This interbank market rate will be for a period equal to one(1) month that appears from time to time on the “LIBOR BBA US$ Fixing” screen available electronically from Bloomberg Financial Markets Information Services (the “Index”). The Index is not necessarily the lowest rate charged by Lender on its loans. If the Index becomes unavailable during the term of this loan, the Lender may designate a substitute index after notifying Borrower."
The above language has been used by banks for decades as the fallback language in the event that LIBOR becomes unavailable or is discontinued. It is simple and gives banks the most discretion in replacing LIBOR with SOFR if that becomes a requirement in the future.
While the industry is still uncertain about how LIBOR will transition to SOFR, and most community banks have a limited number of contracts tied to LIBOR, community banks must use fallback language any time LIBOR is referenced in a financial contract.
Submitted by Chris Nichols on October 09, 2019