Episode #5: The Transition from LIBOR (Melissa Jones-Prus, Chris Knight and Victoria Judd)

Victoria Judd: Thanks, Chris. LIBOR is the London Interbank Offered Rate. It measures the average rate at which banks are willing to borrow funds in the London interbank market. It is calculated based on submissions from a group of panel banks. Each panel bank uses data and their expert judgment for the purpose of their submissions. It’s fair to say that LIBOR is possibly the most important global benchmark for calculating interest, underpinning about US$370 trillion of financial contracts, including loans, debt securities, derivatives and mortgages. It has 35 settings, with five currencies (including U.S. dollars, sterling and euros) across seven time periods—from overnight to 12 months.

Melissa Jones-Prus: To your second question Chris: following the 2007/2008 global financial crisis, a light was shone on widespread allegations of LIBOR manipulation by a number of financial institutions dating back to the early 2000s. As a result, in recent years, fewer banks have been reporting their LIBOR rates. Among those that continue to report LIBOR, their reporting has been based on fewer transactions as more stringent bank capital requirements have resulted in significantly reduced transaction volumes in the unsecured inter-bank lending market. Consequently, LIBOR has become less representative of the underlying market and more reliant on expert judgment. These factors, taken together, called into question the long-term sustainability of LIBOR as a reliable interest rate benchmark.

Knight: The result, as we know, was that, from as early as 2014, a number of jurisdictions set up working groups to explore possible alternative risk-free rates to LIBOR. This includes the Alternative Reference Rate Committee (or ARRC for short) in the U.S., and the Loan Market Association (or LMA for short) in the UK.

Judd: Right, and then, in 2017, the UK’s Financial Conduct Authority announced that market participants should not rely on LIBOR being available after 2021.

Knight: And, of course, this all matters to the aviation industry because the overwhelming majority of aircraft loans and leases are U.S. dollar denominated and use U.S. dollar LIBOR as their benchmark rate. Now, Victoria, what is the latest information on the timing for LIBOR cessation?

Judd: Well Chris, in March this year, the entity responsible for publishing LIBOR rates, the ICE Benchmark Administration, announced that almost all LIBOR settings would cease to be published after December 31, 2021. This includes all sterling, euro, Japanese yen and Swiss franc LIBOR settings, as well as the one-week and two-month U.S. dollar LIBOR settings. The exception is for certain USD LIBOR settings, namely overnight and one-, three-, six- and 12-month U.S. dollar LIBOR. These will cease to be published after June 30, 2023, although the publication of a synthetic form of one-, three- and six-month USD LIBOR is a possibility to assist with what are known as “tough legacy contracts.” These are contracts that will not realistically be able to be renegotiated or amended to transition to an alternative benchmark before LIBOR stops being published.

Knight: Okay, and so, as aircraft financing arrangements generally use one-month or three-month U.S. dollar LIBOR, the June 2023 LIBOR discontinuation date applies to most, if not all, relevant aviation transactions. With this date getting closer, regulators are strongly encouraging the movement away from LIBOR as soon as possible in existing transactions. What about new transactions? Melissa, should parties be avoiding using LIBOR here?

Jones-Prus: That’s what regulators are recommending, Chris. The ARRC in the U.S. for example has repeatedly emphasized that no new LIBOR-based loans should be entered into after December 31 of this year, warning that the failure to follow this advice would create, quote, “safety and soundness risks” for the financial system.

Knight: So, with LIBOR due to fall away, it raises the question, what replacement benchmark should be used? The first point to note here is that, given country-specific independent working groups are dealing with LIBOR replacement separately, there will no longer be a uniform benchmark rate for the various LIBOR currencies. For example, the LMA, in the UK, has recommended the Reformed Sterling Overnight Index Average—otherwise known as SONIA—for sterling LIBOR, whereas in Europe, the Working Group on Euro Risk-Free Rates has recommended the Euro Short-Term Rate for Euro LIBOR. Melissa, what’s the position in the U.S.?

Jones-Prus: The ARRC has long recommended SOFR (which stands for the Secured Overnight Financing Rate) as the preferred replacement for USD LIBOR. But SOFR is, by its nature, a measure of the cost of borrowing cash overnight (so it is not forward-looking). SOFR has accordingly not historically been a term-based rate. However, in connection with LIBOR transition, the ARRC recommended the development and use of a term SOFR rate as the preferred option among various LIBOR alternatives. The derivatives marketplace CME Group responded to the call and this past July announced that it had developed a Term SOFR reference rate to be administered by the Federal Reserve Bank of New York. The CME Group’s Term SOFR rate has been formally endorsed by the ARRC, which was a critical milestone for LIBOR replacement. Although Term SOFR had been the preferred fallback to USD LIBOR for some time, until this past summer, it was a theoretical concept and not a real benchmark.

Knight: And what is the benefit of a term-based rate versus traditional SOFR?

Jones-Prus: Term SOFR, like LIBOR, is forward-looking, which allows for a more seamless transition for LIBOR-based contracts. It also creates greater certainty than simple SOFR—because transaction parties will know, in advance, the benchmark interest rate applicable for each interest period. In many ways, Term SOFR affords the best of both worlds—on the one hand, it is a “risk free” rate because it is based on actual, cleared transactions in the marketplace, and is therefore less susceptible to manipulation than LIBOR. On the other hand, term SOFR, because it is a term rate, will be a close stand-in for LIBOR, from both from a documentary and operational perspective.

Knight: We should also note that SOFR, unlike LIBOR, is a secured rate. It is therefore generally a lower rate than LIBOR, which includes a credit risk premium. How will this be addressed in loan documentation, Melissa?

Jones-Prus: Well, SOFR-based loan agreements will need to incorporate a spread adjustment to address the difference between the unsecured (and generally higher) LIBOR rate and the secured (and generally lower) SOFR rate. The AARC has recommended a static spread adjustment—which was obtained by calculating the five-year historical median difference between LIBOR and SOFR, as set on March 5, 2021. While this makes a lot of sense, there are some issues associated with ARRC’s proposed spread adjustment. One concern is that the spread between LIBOR and SOFR is currently much less than the ARRC’s recommended spread adjustment because interest rates are currently so close to zero. This means that a loan priced at SOFR plus the ARRC spread adjustment will today have a higher “all in” cost than a similar LIBOR-based loan.

Judd: So, Melissa, it seems that the ARRC’s approach, while well-founded, is not economically neutral in the current interest rate climate, and will tend to benefit lenders over borrowers?

Jones-Prus: That’s right, Victoria. The LSTA and others have accordingly discussed possible alternatives to the ARRC spread adjustment to account for this imbalance, including (i) a spot spread adjustment, (ii) a spot spread adjustment with graduated increases or a flip to the ARRC spread adjustment at LIBOR cessation, (iii) a negotiated spread adjustment and (iv) no spread adjustment coupled with a margin adjustment. Each approach has its own strengths and weaknesses, which we don’t have time to get into today. But I did want to highlight for our listeners that market practice has not quite converged around the ARRC-recommended spread adjustment and that they may be seeing and asked to consider some of these alternative approaches in the coming months.

Knight: Turning then to documentation, how should parties be dealing with LIBOR transition?

Jones-Prus: Unless the parties decide to enter into SOFR-based loans from the get-go, which is not something we’re currently seeing in the aviation finance space, “hardwired” fallback language should be included in both new deals and legacy US$ LIBOR deals so that upon the occurrence of a rate switch trigger event, the benchmark rate will automatically convert to a new rate. Although uptake of the hardwired approach was initially quite slow in our space, in the last six months or so it has become market standard.

Knight: And what does the typical “hardwired language” look like, Melissa?

Jones-Prus: Lenders and borrowers in the U.S. are generally aligned with the use of the ARRC’s recommended hardwired language, although there is sometimes some negotiation around trigger events and borrower consent rights. As I’ve mentioned, the recommended language sets out a hierarchy of fallback rates—first, term SOFR, and second, a compounded daily SOFR rate, in each case plus a spread adjustment.

Knight: How is the Loan Market Association in the UK dealing with this, Victoria?

Judd: As with the LSTA, the LMA proposed a deferred agreement-to-agree approach, triggered by the occurrence of a replacement screen rate event. The LMA has been encouraging parties to agree terms for conversion of the benchmark rate in advance via its own hardwired fallback provisions contained in its recommended form of multicurrency rate switch agreement, and we are seeing some new deals include this language. These provisions enable the switch from LIBOR to SOFR or SONIA, among others.

Knight: Okay, and are there any differences in approach to the hardwired language between the LMA and the ARRC?

Judd: Yes, let’s look at a few of the differences.

First, the reference rate trigger. Both the LMA and the ARRC language contain a number of possible LIBOR permanent cessation triggers, but the LMA (unlike the ARRC) includes the possibility for a “Backstop Rate Switch Date.” If agreed by the parties, LIBOR transition mechanics would kick in at this date, even failing the occurrence of any Rate Swich Trigger Event Date.

The second difference—and the main difference to the U.S. approach—is the constitution of LIBOR replacement. The LMA wording refers to a backward-looking rate calculated in arrears. In contrast, and as Melissa has already noted, the ARRC “hardwired language” provides for a waterfall, starting with the forward-looking term SOFR. Though a term SONIA rate is available in the UK, from the LMA’s perspective use of term risk-free-rates is discouraged as risk-free rates compounded in arrears are considered more robust and reliable.

As a third difference, as Melissa mentioned, the ARRC has suggested a static fixed spread adjustment (though alternatives are still being discussed). Conversely, under the LMA documentation the spread adjustment is to be determined by the parties on a case-by-case-basis.

Knight: And are there any other observations to make with regard to the LMA rate switch language?

Judd: Yes, the parties are left to determine a number of commercial decisions including, for example, the applicability (or otherwise) of break costs and the market disruption provisions, and the length of the lookback—five days is the convention or starting position but the commercial parties have some flexibility.

Knight: So, in respect of loan, lease or other agreements referencing U.S. dollar LIBOR—should the ARRC or LMA language be used, and does this answer depend on what the governing law is?

Judd: Well Chris, the parties are free to choose—there is no obligation to follow one drafting convention over the other. That said, the New York loan market and the field of aviation finance are closely intertwined, and so it will be interesting to see if this has any bearing on the ARRC rate switch language being more widely adopted than the corresponding LMA language.

Knight: So, Melissa/Victoria, what steps would you recommend lenders and borrowers take now to address legacy transactions?

Jones-Prus: First, financiers, lessors and airlines should review their transactions and identify those that mature after June 2023 and, among those, which are LIBOR-based. Those LIBOR-based contracts extending beyond June 2023 will need to be amended prior to the discontinuation of LIBOR in June 2023.

Where these transactions do not address the discontinuation and replacement of LIBOR, we recommend that parties start the discussion on the path forward now. It would be prudent to enter into an amendment agreeing to hardwired fallback language as soon as possible to avoid having to deal with this at the eleventh hour.

In deals where an “amendment” approach was previously adopted, consider whether the agent can determine the benchmark independently, or if the borrower has consent or negotiation rights. If the borrower does have consent or negotiation rights, we would recommend that parties start the discussion sooner rather than later. On the other hand, if the agent can determine and implement the replacement benchmark independently, there is a bit less of a rush and there will likely be some value in implementing the replacement in conjunction with other similar amendments being undertaken throughout the agent’s loan portfolio.

We would also recommend that parties check whether the IBA announcement as to LIBOR cessation in March would already have constituted a replacement screen rate event under their documents.

Judd: Another thing to look for when reviewing existing contracts is loans or leases which are not floating rate or LIBOR based contracts per se, but which still reference LIBOR in some respect (for example in default rate definitions, make-whole provisions and formulas for calculating notional fixed-rate breakage). These provisions also need to be amended, although full-fledged hardwired fallback language may be overkill if the use of LIBOR in the contract is limited to these sorts of items.

Jones-Prus: I completely agree, Victoria. In these circumstances we are instead seeing use of rates based on the prime rate, the Federal Reserve’s federal funds rate and flat rates. What are you seeing in the UK?

Judd: It tends to the be the Bank of England’s Base Rate in the UK.

Knight: Overall, the message seems to be that all counterparties should engage with one another on this topic now?

Jones-Prus: Absolutely. As we all know, aircraft finance transactions are complex and there are often a large number of players involved. Early engagement and efficient coordination between all interested parties in what could be a lengthy documentation exercise is key. Borrowers, and especially aircraft lessors, who take charge of the process will be better able to align post-LIBOR benchmark replacements across their loans, swaps and operating leases.

Knight: Thanks, Melissa. You just mentioned swaps. Is there a specific concern there?

Jones-Prus: Given that the purpose of hedging is to mitigate a party’s existing or future exposure to the risk of an adverse movement in interest rates, it is critical that there are no mismatches among the loan, lease and swap documents with respect to LIBOR replacement rate definitions, triggers and other related provisions. Otherwise, payment mismatches and associated liabilities may arise.

Knight: Okay, and, Victoria, are there any other relevant considerations?

Judd: Yes. We’ve already mentioned parties needing to think about the application (or otherwise) of break costs and market disruption provisions. Notice periods for prepayments should also be aligned with lookback periods and on a more practical note, internal company operations, in so far as they relate to LIBOR, will need to be reconfigured to accommodate the alternative replacement benchmark.

Knight: So, in summary, the LIBOR cessation deadline is fast approaching. Most aircraft finance transactions will have until June 30, 2023, but this should not diminish the need to engage with the issue on an expedited basis. Parties should audit all deals now, engage with counterparties as soon as possible and either move straight to a risk-free rate—so, term SOFR for U.S. dollar loans—or adopt hardwired fallback language, with the ARRC and the LMA offering helpful drafting guidance here.

Well everybody, that’s all we have time for. We hope that you have enjoyed this podcast and if so please give it a big thumbs up on whatever media platform you have listened to it on!