If you have worked on an international construction contract, the chances are high that you’ve encountered LIBOR. If you are currently working with a contract referencing LIBOR, you should start planning for life without it; LIBOR as we know it will cease no later than 31 December 2021.[1]

The effect of the LIBOR transition on financial markets has been widely analysed, but consideration of the impact on construction contracts is muted. This article outlines some key legal and commercial considerations arising from the phase-out of LIBOR that are relevant to the construction industry.

What is LIBOR?

The London Interbank Offered Rate (LIBOR) is, broadly, the average interest rate at which banks are willing to lend to other banks.

Since 2013, LIBOR covers five currencies[2] and seven maturities[3], which produces 35 different rates of interest. The Intercontinental Exchange Benchmark Administration (IBA) designates a panel of banks for each currency, and the panel banks submit their subjective view of what they would have to pay, if they were to go to the market that morning for an unsecured loan. The IBA then uses these responses to determine the daily LIBOR benchmarks[4]. The twenty LIBOR banks have agreed to continue providing their rates until the phase-out is completed[5].

What does LIBOR indicate?

LIBOR is intended to indicate what it would cost one premier financial institution to obtain money from another, over a specified period, with no security for the loan. This gives an indication of the cost of unsecured borrowing at the lowest possible risk[6] in that currency and maturity pairing, against which other lenders benchmark their risk by comparison.

However, the UK Financial Conduct Authority (FCA) believes that the number of transactions in the 35 pairings is already insufficient (and has been for some time) to inform a truly reliable benchmark[7].

What does this mean for construction contracts?

In domestic construction contracts in a local currency, an adjusted central bank interest rate is typically the sole interest rate[8]. In international contracts with multiple currencies, or where the domestic currency is not the contract currency, a LIBOR+ rate is often defined as the relevant rate of interest. The cessation of LIBOR rates in 2021 will create a gap in those contracts.

Filling the gap

In contracts where LIBOR rates cannot be renegotiated, referred to as ‘tough legacy’ contracts, the UK government is introducing laws to allow the FCA to create a ‘synthetic LIBOR’ rate that will continue to be published after 31 December 2021.

Synthetic LIBOR, as proposed, would be calculated by a methodology set by the FCA. These rates will then legally satisfy the definition of LIBOR under a contract referencing that rate, at least within FCA’s regulatory environment, i.e. the UK.

The FCA has announced its intention to move forward with synthetic rates for certain Sterling terms, and is keeping its options open with regard to certain US Dollar and Japanese Yen maturities also[9]. However, in relation to all other rates, the FCA is clear that it does not envisage introducing synthetics, which creates an obvious problem in relation to construction contracts using those rates[10].

For the synthetic currencies, it is unclear how, if at all, the regulations would apply to construction contracts within the UK, and any UK legislation will have no direct impact on contracts not subject to UK law. This leads to uncertainty whether a relevant authority or tribunal outside of the UK would be compelled or persuaded that a synthetic LIBOR rate can satisfy existing LIBOR provisions in a contract that is not subject to UK law.

In any event, it is clear that the FCA wants everyone to cease using LIBOR as soon as possible or, at least, introduce fallback provisions for the period after 31 December 2021. In this respect, synthetic LIBOR should be seen as a last resort; it should not be relied on where possible.

Therefore, in order to avoid contractual uncertainty for those rates being retired, and potential issues around the application of synthetic rates where relevant, all parties to a contract with a LIBOR rate should be advised to consider alternatives.

Agreeing a new rate

Parties may simply agree another benchmark to replace LIBOR in their contract. Yet even this solution, though legally simple, may not be commercially easy. There will be a degree of negotiation in agreeing a new rate, as it gives each party an opportunity to adjust their exposure.

A detailed discussion of benchmarks is beyond the scope of this article, but there are fundamental issues of comparability with LIBOR:

1. Newer benchmarks indicate the cost of secured borrowing, which reflects significantly lower risk than LIBOR, which is unsecured.
2. Most available benchmarks are only overnight (one day), meaning rates for other maturities are not available.
3. Even TIBOR and EURIBOR[11], which are similar in methodology to LIBOR and reflect unsecured lending, do not necessarily track LIBOR’s movements, due to the different market dynamics in Tokyo or Europe versus London.

Parties will therefore need to consider what their borrowing costs are and which rate can be used to adequately reflect their risk. A simple example would be a contractor borrowing USD on a long-term unsecured basis. The Secured Overnight Financing Rate (SOFR) is unlikely to be representative of this borrower’s risk, even with adjustment. Unfortunately, no simple solution to the issue of adjusting overnight or secured rates is currently available, if it is even possible.

On some contracts, the difference versus LIBOR will be minimal. However, large international projects, which often feature LIBOR rates, are also likely to last longer and involve significant sums in international project finance, which magnifies the impact of such a change. The impact on these projects of a 1% change in contractual interest over several years could be substantial.

It is fair to say that a LIBOR+ rate will often have been included in a contract without detailed financial consideration of whether that specific rate is actually performing its relevant purpose, or whether it will continue to do so in the future. However, although LIBOR+ may have been written into contracts as an industry standard without detailed consideration, the loss of that standard and the lack of direct comparability to another rate should give cause for thought. Removing LIBOR does not create a greater necessity for accuracy than existed previously; the real impact is that the easy option is missing, and parties must now make, and justify, a choice. Even in situations where a new interest rate flows directly from relevant project finance agreements being updated, getting that rate into an existing contract will still remain an issue.

Ripe for disputes

It is clear that specified interest is internationally recognised as an essential contractual element, reflecting the well-known reality of project finance costs. In the event of a dispute over the relevant rate, is this context sufficient for a Court, Tribunal or Panel to replace LIBOR with another benchmark?

If making a claim to an interest entitlement on the basis that the LIBOR provision reflects a real risk to the borrowing party that is passed on under the contract, the absence of LIBOR invites inquiry about the actual cost to the borrower. This becomes relevant either as the quantified risk itself, or because it is informative in deciding an appropriate replacement rate, which may have already been changed in any relevant finance agreement. Quantifying this cost on a large international project could be complex and would certainly be commercially invasive. On the other hand, if the LIBOR rate in a contract is supposed to be a simple shorthand for a complex risk, when that shorthand falls away then it seems arguable that a claiming party should be put to proof.

To argue the other way (i.e. that the LIBOR rate is not supposed to accurately represent the real risk) acknowledges that one party has put a broad and potentially unfair risk onto the other for the sake of contractual convenience. This is especially so in circumstances where interest only flows one way under the contract, which, if obviously disconnected from the real cost of borrowing, begins to resemble a penalty more than a cost.

Of course, this is more-or-less understood in the industry. However, it is not flattering when laid bare, and opens this question: if the interest risk is conceptualised and allocated in this way, then why shouldn’t the party claiming the interest accept the opposite and more limited risk, within the drafting of the contract, that the specified interest clause may become inoperable?

Conclusion

As identified above, there are potential headaches regarding the LIBOR phase-out for project personnel and lawyers to consider. Unsurprisingly, commercial agreement between the parties is likely to be the best route for avoiding any legal complexities. However, this unusual and seismic event in global finance is still ongoing, and further surprises may yet arise for the construction industry as it develops.

References

1. https://www.fca.org.uk/news/press-releases/announcements-end-libor
2. The currencies are: British Pound Sterling (GBP), US Dollar (USD), Euro (EUR), Japanese Yen (JPY) and Swiss Franc (CHF).
3. A maturity is a period of time over which a debt matures, i.e. becomes due to the lender. LIBOR rates are quoted for periods of one day (also called ‘overnight’ or ‘spot’), one week, one month, two months, three months, six months and one year.
4. The precise methodology is explained here: https://www.theice.com/iba/libor
5. https://www.fca.org.uk/news/statements/fca-statement-libor-panels
6. This excludes sovereign, i.e. state or government, borrowers.
7. See footnote 1.
8. For example, Bank of England base rate in England, South African Reserve Bank prime rate in South Africa, etc.
9. One month, three month and six month Sterling LIBIOR will be synthesised. The FCA is still considering synthetics for one month, three month and six month maturities in Yen and Dollar.
10. See footnote 1.
11. Tokyo Interbank Offered Rate and Euro Interbank Offered Rate.