LIBOR Discontinuation post 31st December, 2021 – Impact on External Commercial Borrowing Agreements

London Interbank Offered Rate (LIBOR), initiated in 1969 and officially announced by British Bankers Association (BBA) in 1986, is the world’s most widely used benchmark interest rate for financial and non-financial contracts.  LIBOR is an average interest rate at which panelled banks lend to each other in the international interbank market for a short-term loan.

LIBOR is a benchmark for short term rates of interest ranging from overnight to periods such as one month, three months, six months or twelve months and currencies like Dollar, Pound Sterling, Euro, Japanese Yen, and Swiss Franc.

LIBOR plays a critical role in the global financial market and currently a benchmark for over US$400 trillion financial contracts worldwide. The variation in LIBOR also one of the key indicators for investment managers in the capital market.

The year 2008 crises and further 2014 changed the financial benchmarks which are regularly followed over three decades. The regulator and banks raise the issues on LIBOR post-failure of Lehman Brothers.  Financial Conduct Authority (FCA) along with other regulators in July 2017 has raised their concerns on the sustainability of the LIBOR benchmark which makes LIBOR to be discontinued after December 2021.

Many countries have started evaluating alternative benchmarks such as Sterling Overnight Index Average (SONIA) by the United Kingdom, Secured Overnight Financing Rate (SOFR) by the United States and Japan’s Tokyo overnight average rate (TONAR) by Japan.

The discontinuation of LIBOR having a fundamental impact on financial institutions and borrowers globally as well as in India. The essay focuses on the transition of existing foreign loan agreements (also known as External Commercial Borrowing agreements) having the validity until December 2021 and a new foreign loan agreement yet to be executed by Indian companies.

ECBs are commercial loans raised by eligible Indian entities from recognized foreign entities with conditions such as minimum maturity, permitted end-uses, maximum all-in-cost ceiling, etc. The Reserve Bank of India (“RBI”) governed the ECBs policy and has revised the extant framework for ECBs through circular dated January 16, 2019.

The RBI restricts the borrowing cost to the Benchmark rate plus 450 bps spread. LIBOR is a benchmark rate that is normally used in the ECBs agreements by foreign institutions. It is important to evaluate the impact of discontinuation of LIBOR by the foreign institution as well as the borrower on the following:

• Agreements that are executed with LIBOR as the benchmark and having the maturity post-December 2021.
• Alternative benchmark to be used on the agreements which are yet to be executed.

The discontinuation of LIBOR will have an impact on companies that have borrowed the funds from an international market with LIBOR as the benchmark rate. The company require to consider the following steps:

1. The existing loan agreement required to be reviewed in the context of LIBOR. It is important to understand whether the existing agreement has a ‘Fallback language’ clause. Fallback language refers to the clause that defines the process through which the replacement rate can be identified if a benchmark is not available or exist. Fallback language comprises three key components: trigger event, benchmark replacement, and benchmark replacement adjustment.
2. The absence of Fallback language clause in the existing loan agreement is required to do the following steps:

• Identification of new benchmark rate
• Identification of financial risk post-adoption of the new benchmark rate
• Identification of legal risk post-adoption of the new benchmark rate
• Identification of compliances to be done post-adoption of the new benchmark rate

3. Identify the new benchmark rate such as Sterling Overnight Index Average (SONIA) by the United Kingdom, Secured Overnight Financing Rate (SOFR) by the United States and Japan’s Tokyo overnight average rate (TONAR) by Japan. Normally all financial institutions have already selected the new benchmark rate.
4. Negotiate the new benchmark rate with the existing lender to an extent that existing borrowing cost (under the existing loan agreement) does not increase post-adoption of the new benchmark rate.
5. The company requires to do all the steps which are necessary to amend the benchmark rate in the loan agreement such as board meeting, notices, consent from institution namely. The new loan agreement should have a fallback language clause which can mitigate future risk.
6. The company requires to apply for a modification of External Commercial Borrowing to Reserve Bank of India. The companies normally receive the approval within 15 days post submission of required documents.

The companies which are planning to raise funds from an International market before December 2021 with LIBOR as the benchmark rate. The company requires to consider the following steps:

1. The loan agreement required to incorporate the ‘Fallback language’ clause. The Fallback language clause acts as a guide for identifying the new benchmark rate in case the existing benchmark be unavailable.
2. The Fallback clause normally has the following components:

• Event on which fallback language will be applicable – it will be applicable in case of termination of the existing benchmark rate.
• New benchmark rate –Evaluate the other benchmark rates and incorporate the said new benchmark rate in the agreement on the event of discontinuation of the existing benchmark rate.
• Adjustment of the new benchmark rate – The new benchmark rate varies with the existing benchmark rate. Both parties require to evaluate the commercial risk and obligation of each party post-adoption of the new benchmark rate.

3. The companies through alternative benchmark rate and robust fallback language in loan agreement provides for a smooth transition in the event of a benchmark cessation and mitigate the future commercial and legal risk.
4. The company requires to execute the loan agreement with the financial institution and apply for the Loan Registration Number to Reserve Bank of India. On the receipt of Loan Registration Number, the financial institute can provide a loan to the company.

The transition of the new benchmark rate is expected to be one of the most significant changes in the global financial market. The foreign institutions and companies require to adopt the proper strategy to transit the LIBOR to the new benchmark rate.

The companies should evaluate alternative benchmark rates and amend their loan agreements with a ‘Fallback language’ clause. The agreement should define a clear transition strategy and roadmap like the obligation of each party, the method to adopt a benchmark replacement rate, adjustment of the benchmark replacement rate to avoid future disputes.