The End of LIBOR: Keeping Your Best Interest in Mind
The London Interbank Offered Rate (LIBOR), which is the basis for the interest rates for millions of commercial real estate loans, is scheduled to be phased out by the end of 2021 according to the United Kingdom’s Financial Conduct Authority (FCA). The Secured Overnight Financing Rate (SOFR), which represents the cost of borrowing cash overnight collateralized by Treasury securities, is the likely successor to LIBOR in the U.S., but it is not yet a mandatory replacement.
While many loan documents address the possibility of LIBOR’s unavailability, most loan documents fall into three categories. First, there may be language that converts the LIBOR component to the last LIBOR rate quoted, which would essentially convert a variable payment into a fixed payment. Second, some loan documents contemplate a more specific alternative (e.g., prime rate, SOFR, etc.) that could be a higher or more volatile rate than LIBOR, resulting in a potentially unplanned increase in borrowing costs. Finally, some contracts do not contain any alternative to LIBOR, which could lead to potential conflict, and even litigation, if the borrower and its lender fail to agree on an alternative rate prior to LIBOR’s unavailability.
Borrowers and their counsel should review their existing loan documents that mature after 2021 to understand and plan for how their loan payments will be affected by the existing LIBOR replacement language, and if such language does not exist, they may want to approach their lenders to negotiate a mutually acceptable alternative to avoid future litigation.
Going forward, borrowers should proactively address interest rate components and their alternatives at the term sheet stage of their negotiations with future lenders. Stronger borrowers may be able to negotiate that replacement rates will be subject to their consent or, at the very least, that they will be consulted in establishing such replacement rate. Another approach is for the interest rate to revert back to a base rate of interest when LIBOR is no longer ascertainable, which would effectively convert the loan to a fixed rate loan.
Although SOFR is currently the leading replacement for LIBOR, the market has been slow to adopt it. Some lenders include language in their loan documents that permit them to opt-in to a replacement for LIBOR early (i.e., before LIBOR is phased out). To avoid becoming subject to a replacement index that increases the borrower’s interest rate or its volatility in a way that is inconsistent with the market, borrowers should consider requesting the right to consent to lender’s right to an early opt-in to a replacement index for LIBOR, and detailed language requiring any replacement of LIBOR to be commonly accepted throughout the market, including by leading institutional commercial real estate lenders.
Regardless of the approach taken, ensuring that alternative interest rate language exists in both current and future loan documents will help borrowers avoid litigation and plan for the financial impact of LIBOR’s phase out.