What is LIBOR and why does its phase-out matter?

By Rebecca F. Clarkson, special to Business in Savannah

LIBOR, the London Interbank Offered Rate, sometimes referred to as the Eurodollar rate in loan documents, is calculated and published on a daily basis by averaging the price at which each of eighteen banks believes it can purchase unsecured funds on that date. In the United States, LIBOR is the most used reference rate in commercial loan transactions with a floating interest rate. To calculate the floating interest rate, a reference rate is used to determine the applicable interest rate at designated times. A floating interest rate may reset on the first day of each quarter at LIBOR plus one percent. Any change in LIBOR has a direct impact on a borrower of a floating rate loan.

Due to misreporting by some of the banks participating in the calculation of LIBOR, LIBOR is being phased out and will not be available after December 31, 2021. Most commercial loans have a term of between three and five years. A loan with a maturity of three and a half years or more will exist after the LIBOR phase-out, and a loan with a maturity date on or before December 31, 2021 may be extended and remain outstanding after the LIBOR phase-out. A borrower executing loan documents (whether for a new loan or an amendment to an existing loan) should ensure that it is comfortable with how the phase-out of LIBOR is addressed in the loan documents.

LIBOR is popular with lenders because, theoretically, it best reflects the actual cost to the lender of making the loan to the borrower. LIBOR is appealing to borrowers because it is an independently calculated rate that is not tied to an individual lender’s financial health. LIBOR phase-out has been resisted because the other rates do not as closely reflect the actual cost to the lender, requiring the lender to build in other mechanisms for managing its risk, which may make a loan more expensive for the borrower. There is no clear successor rate to LIBOR.

The Federal Reserve Bank of New York has proposed the Secured Overnight Financing Rate (SOFR), which has been published on a daily basis since April 3, 2018, as the replacement for LIBOR. Lenders have shown reluctance to adopt SOFR, instead including provisions providing a mechanism for selecting a successor rate once LIBOR is no longer available. Because almost all loan documents being prepared at this time include provisions to address how the interest rate will be calculated when LIBOR is no longer available, borrowers of floating rate loans need to negotiate now to best protect their interests.

The most popular change has been a revision of the market disruption provision to add language providing for a successor interest rate. Some documents include a stand-alone provision providing how the successor interest rate will be determined. Still others have revised the LIBOR definition to include a method for determining a successor interest rate. More important than where the language appears is what the language says. The new provisions have varied from the administrative agent, representative of the lenders, independently selecting the new interest rate to the administrative agent, lender(s), and borrower working together to select the successor interest rate. The market is yet to see a deal that permits the borrower to select the successor interest rate. It is important that the borrower be entitled to at least consent to the new interest rate. Otherwise, the borrower could be stuck with a loan at a significantly higher interest rate than that calculated using LIBOR.