|August 14, 2014|
Previously published on July 30, 2014
The Wheatley Report on LIBOR, published nearly two years ago, noted the potential problems of relying on reference bank rates as a fall-back cost of funds benchmark "in the event of longer-term disruption to the publication of LIBOR". It recommended that industry bodies and market participants find alternative contingency benchmarks. While no alternatives have yet become widespread in the syndicated loan market, including the usual reference bank mechanics in loan agreements is becoming increasingly problematic, as fewer banks are willing to perform the reference bank role. Catherine Astruc explains why, and suggests some ways of addressing these difficulties.
Why are some banks refusing to be reference banks?
Since July 2013, LIBOR contributing banks have been subject to a code of conduct. Some contributing banks have expressed concern that by providing quotes as a reference bank they could breach their obligation in that code of conduct to keep rate information confidential.
Under the LIBOR Code of Conduct, contributing banks must not:
"disclose rates which will be submitted in the future or have been submitted to the LIBOR Administrator but not yet published to any external individual or internal individual".
However, there is an exception which allows contributing banks to disclose to those who:
"have a commercially reasonable business need to know, or ... are a customer of the contributing bank entering into a transaction with it priced by reference to the submitted rate, appropriate arrangements for preserving confidentiality being in place".
Under most syndicated facility agreements, reference banks only need to provide rates when there is no "Screen Rate". However, it is still possible that a reference bank could be asked to provide a rate to an agent that it has previously submitted in its role as LIBOR contributing bank. To address this, it is becoming more common for facility agreements to include "Confidential Rate Information" clauses under which all parties agree to keep confidential any cost of funds rates that reference banks provide. (This confidentiality would also usually apply to rates individual lenders provide on a market disruption event.) This should address the concern that a bank may breach the LIBOR code of conduct by performing the role of reference bank.
Even with the protection of these clauses, some banks are still uncomfortable taking on the reference bank role. Increasingly, banks are taking the view that, by providing a rate, they could be exposing themselves to a risk that someone will challenge the accuracy of that rate in the future, and draw the bank into potentially damaging litigation.
What are the options if the syndicate members will not be reference banks?
Choose banks that are not part of the syndicate
The LMA's facility agreements assume the reference banks will come from the syndicate. There are good reasons for this. It has always been less likely that a bank will provide rates on request for a transaction it has no involvement in. This is even more the case in the current market mood. Even before the reference bank role became less popular, non-transaction parties were sometimes chosen as reference banks. For example, this happens in debt capital market transactions, loan agreements where syndication is to happen after signing, and even on some bilateral loans. However, in practice, reference banks have rarely been called on to provide quotes in these circumstances, and so there is limited evidence that this works.
Remove the reference bank rate mechanism entirely
Without a reference bank rate back-up, if it is not possible to use the published LIBOR rates for an interest calculation, there will be a market disruption event. Each lender will get its own cost of funds. This is less attractive for borrowers and agents. However, with screen rate interpolation mechanisms now standard, the absence of a reference bank rate is only likely to make a difference on a complete breakdown in the public quotation of LIBOR. Parties can further reduce this risk by agreeing other ways in which publicly quoted LIBOR can be used as a basis for setting the interest rate; for example using the most recently available rate if there is a short-term discontinuation of LIBOR.
Defer choosing the reference banks until they are needed
The agreement could define the reference banks as "those banks designated as Reference Banks by the Agent from time to time, in consultation with the Borrower". This is arguably less logical than removing the reference bank rate. If a lender does not want to be a reference bank on the date of the agreement, why would it want to be one later? However, borrowers may find this approach more palatable. The borrower might prefer to have a veto on the choice of reference banks (rather than a consultation right). However, if agreement cannot be reached on the identification of the reference banks, there is more likely to be a market disruption event, which a borrower will usually want to avoid. Agents will want to ensure they have no liability for choosing, or failing to choose, a reference bank.