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The Output: Bringing it all together
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Global | Publication | October 2019
On July 27, 2017, Andrew Bailey, the Chief Executive of the UK Financial Conduct Authority (the FCA) announced that the FCA would no longer compel or persuade banks to make submissions to LIBOR as from the end of 2021. This announcement came as a result of longstanding concerns regarding the robustness of LIBOR as a benchmark.
LIBOR was originally a survey-based benchmark, compiled by panels of banks answering the question “at what rate could you borrow funds were you to do so by asking for and then accepting interbank offers in a reasonable market size just prior to 11 am?” In the wake of the LIBOR manipulation scandal, regulators found that there were very few transactions taking place to support some of the currencies and tenors for which LIBOR was published. As such, LIBOR submissions were largely based upon expert judgement rather than transaction data. This led to concerns that LIBOR was unrepresentative and vulnerable to manipulation.
Given the lack of underlying transactions supporting LIBOR, banks have become increasingly reluctant to make submissions to the benchmark, prompting regulators to take steps to persuade panel banks to contribute in order to support its continued publication. However the situation is increasingly unsustainable. There is a real risk that when banks cease to be compelled by the FCA to submit to LIBOR, the benchmark will become more volatile and may no longer pass regulatory tests of representativeness. As such, the announcement by the FCA represents an attempt by the regulator to conduct an orderly transition away from LIBOR to more robust benchmarks and prevent market disruption.
So called “risk-free rates” have been designated for each currency for which LIBOR is currently published. Risk-free rates are benchmarks generally based on overnight deposit rates. They are considered to be more robust as they are based upon a larger volume of observable transactions.
However risk-free rates differ from LIBOR in several important ways:
The risk-free rate for US dollars is SOFR (Secured Overnight Financing Rate). It is a broad measure of the cost of borrowing cash overnight collateralized with US Treasury securities and is compiled using data from numerous sources including (i) tri-party repo transactions, (ii) General Collateral Finance repo transactions and (iii) bilateral Treasury repo transactions cleared through Fixed Income Clearing Corporation. It is published at 8 am Eastern Time with respect to transactions occurring on the previous day. SOFR is a relatively new risk-free rate and was published for the first time in April 2018. It is administered by the Federal Reserve Bank of New York.
It is prudent for market participants to transition away from LIBOR to risk-free rates prior to the end of 2021. However from a documentary perspective, this is not a simple matter of amending references to LIBOR to SOFR or another suitable risk-free rate. Due to the inherent differences between LIBOR and risk-free rates, this change will also impact the mechanics of the loan agreement or financing document. The following points will need to be considered:
Most finance documentation will contain a mechanism for determining the rate of interest if LIBOR ceases to be published. For example in the vast majority of Loan Market Association-based documentation, if LIBOR ceases to be published, then ultimately financiers would be able to charge interest based upon their cost of funds from whatever sources they may reasonably select. Such provisions were only intended to address short term interruptions to the publication of LIBOR rather than a complete cessation. They are unlikely to lead to a desirable future basis for the continuation of the transaction.
However some aviation finance documentation referencing LIBOR may not contemplate LIBOR cessation at all. This is most likely to be the case in operating leases which reference LIBOR either as a means of calculating floating rate lease rentals or as a means of calculating a default rate. As such, any change to an alternative benchmark would require the parties to agree to amend the relevant document and a failure to do so would lead to uncertainty and, in some transactions, possible disputes.
At the time of writing, LIBOR is still commonly referenced as a benchmark in aircraft finance documentation. At present, the majority of lenders and financiers are not in a position where they are able to offer financing using a risk-free rate as systems are not yet in place to do so. It is likely that this position will start to change, most likely for bilateral transactions at first, as the market moves towards a consensus for the method of calculating interest referencing a risk-free rate.
Recently the Loan Market Association published a form of compounded SOFR referencing loan agreement as an exposure draft for discussion purposes. This is a helpful development, however it is by no means a final form of precedent and will require careful review by industry participants.
As such, in new transactions which reference LIBOR it is best to build in a mechanism for agreeing a future change to a risk-free rate. Ideally this would contemplate a change in benchmark prior to the actual cessation of LIBOR given that LIBOR may become more volatile and unrepresentative before publication of the rate ceases. Parties may also want to discuss who should bear the cost of required changes to documentation and borrowers and lessees may want to consider what should happen if they disagree with a proposed change in benchmark and whether they would want to have the right to terminate or prepay in such circumstances.
Parties should also bear in mind whether some references to LIBOR in aviation finance documentation are needed at all. An example of this is the use of LIBOR in an operating lease default rate where LIBOR is being used as a benchmark without any relationship to underlying financing arrangements. In such circumstances it may be easier to use another benchmark, such as a risk-free rate or a central bank base rate, instead of LIBOR to avoid future amendments being required.
Although the use of risk-free rates is not yet common in aviation finance transactions, market participants should prepare themselves for a transition away from LIBOR. We would recommend the following steps are taken:
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We started by discussing what it means to be a Strategic Business Partner, and, after working through the rest of the pyramid, here we are.
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