Undeterred by the COVID-19 pandemic, the transition away from the London Interbank Offered Rate, commonly known as LIBOR, remains to occur at the end of 2021. Although the effort began in 2014, federal and state regulators, financial institutions, and other interested stakeholders continue to grapple with handling this change best and mitigating the risks involved. Recent estimates suggest that there are about $1.8 trillion of business loans with floating rates based on LIBOR and $1.2 trillion in consumer adjustable-rate mortgages based on, or otherwise tied to, LIBOR. Securitizations and the derivatives market add another $192 trillion of financial products based on LIBOR.
Around the world, the impacts of, and potential solutions to, LIBOR’s discontinuance are being evaluated. In the United States, the Alternative Reference Rates Committee (ARRC), empaneled by the Federal Reserve Board and Federal Reserve Bank of New York, is spearheading these efforts. The ARRC has spent countless months determining an appropriate alternative to LIBOR — ultimately recommending the Secured Overnight Financing Rate (SOFR) — and has spent just as many months exploring appropriate fallback language for institutions to use in their contracts.
Contracts Without Fallback Language
The LIBOR change has vast implications for the financial industry and to borrowers. One particular area of concern is LIBOR-based loans that either has no fallback language or fallback language that is inadequate and inconsistent with current circumstances or regulators’ recommendations. For these loans, the question becomes: Can, and more importantly, how, will these contracts be enforced?
In a perfect world, one would hope that the respective parties to the loan documents could simply agree that an alternate rate is needed and devise an appropriate substitute. Unfortunately, the world is not perfect.
Without an agreement between the parties or specific and articulate language in the underlying loan documents that dictate a clear and unambiguous alternate rate, the LIBOR index’s discontinuance will lead to some borrowers arguing either that no interest rate may be assessed or that the bank-suggested alternative is unacceptable. Lenders will likely find themselves defending against claims such as unfair or deceptive trade practices, breach of contract, and breach of the covenant of good faith and fair dealing. In the absence of safe harbor legislation, they will have no resort but to turn to the courts for relief.
One likely avenue lenders may pursue is to seek reformation of the agreement. Contract reformation is an equitable principle of law that permits a court to amend an instrument when it does not reflect the actual agreement reached between the parties on account of mutual mistake.
In the LIBOR context, the mutual mistake is the erroneous belief that LIBOR would remain the available index to calculate the interest rate for the entire term. The lender will argue that the court may address that mistake by substituting a different index.
While there is some authority to support that proposition, there is perhaps more that holds to the contrary. If that is the outcome, the lender may instead find itself pursuing an unjust enrichment claim, a principle of law that exists in the absence of an enforceable contract. The argument would go that it would be unjust for the borrower to be enriched by the borrowed funds without repaying the requisite interest. In an unjust enrichment scenario, the parties would be able to argue the appropriate interest rate, including referencing index rates like SOFR.
Given the likely landscape, litigation will take, financial institutions would be well advised to consider the following steps to mitigate risk.
- Examine all outstanding LIBOR-based loans and identify which have inadequate or insufficient language concerning when an alternate rate must be implemented and how the parties will determine the said rate. Those loans that do not adequately address the same need to be revised by agreement of the parties, and that process must start now.
- For those identified loans, begin an open and honest conversation with the other parties to the loan transaction about when the rate will be substituted and what the substitute will be. Transparency will be critical in assessing the bona fides of the lender’s recommended timing and selection of any alternative rate. Lenders should be prepared to demonstrate how the proposed alternate rate compares to LIBOR and its anticipated effects on the borrower’s payment obligations. Once the parties are fully informed and agree to the alternate rate and timing thereof, an amendment to the loan documents should be prepared and signed by all parties setting forth the new understanding and agreement.
- If the parties cannot reach an agreement as outlined above, the lender should document all the efforts it made to reach an agreement with the borrower party or parties in preparation for an ultimate challenge to the validity or enforceability of the underlying loan documents. Such will evidence good faith and fair dealing on behalf of the lender and may mitigate its risk of liability or an adverse judgment by the court. The sooner the lender can evidence its attempts to communicate with the borrower, the better.
While much about LIBOR’s discontinuance remains uncertain, the reality is that financial institutions should act now. Those that do will be better prepared to meet the legal and business challenges that may arise in the future.
James T. Shearin, Brion J. Kirsch, and Amanda G. Gurren are attorneys at the law firm Pullman & Comley with offices in Connecticut, Massachusetts, and New York.