LIBOR Fallbacks In Focus: A Lesson In Unintended Consequences

Market participants are undertaking significant work to prepare for a transition away from LIBOR. The recent launch and reform of preferred alternative reference rates to USD LIBOR and GBP LIBOR, respectively, are important steps in this transition journey. However, LIBOR-based products are still being created, sold and entered into on a daily basis. A large book of financial instruments is likely to endure past 2021, when the Financial Conduct Authority (the “FCA”) intends no longer to persuade or compel banks to submit to LIBOR.

The question then is what happens to these LIBOR-based products when LIBOR is no longer available? As Andrew Bailey, the Chief Executive of the FCA, has noted, this depends on “the preparations that users of LIBOR make in either switching contracts from the current basis for LIBOR or in ensuring that their contracts have robust fallbacks in place that allow for a smooth transition if current LIBOR did cease publication.”

So, what contractual fallbacks are in place today and what would happen if publication of current LIBOR were to cease, triggering those fallbacks?

The answer is complex. Outside the derivatives world, fallback language is frequently inconsistent, particularly across products and institutions. The definition of LIBOR, the trigger for the fallbacks, and the fallbacks themselves vary significantly, even within the same product sets. Additionally, existing contractual fallback language was typically originally intended to address a temporary unavailability of LIBOR, not its permanent discontinuation.

This means that, in many cases, existing fallback language will produce unintended results that can dramatically affect the very structure and economics of the product. In some cases, floating rate products will become fixed, while in other cases, interest rates for the borrower may increase substantially.

Given the potential consequences of some existing fallback language, continuing to enter into contracts using such language carries real economic and potentially other risks. Market participants should move to using fallback language that is written with the permanent discontinuation of LIBOR in mind to minimize these risks.

This publication focuses on the legal framework and other issues related to fallback language. To give a more tangible sense of what may be at stake and the efforts required to transition, we provide in-depth analyses in three important product areas: derivatives, credit facility transactions, and unsecured securities issued in the capital markets.