Does your construction company borrow money to finance its business, whether through a line of credit, term loan or equipment financing? Is your construction company a party to contracts that include a late payment rate or other interest charge? Has your company entered into construction loans for real estate development?

If any of these scenarios apply to your business, and if the interest rate for such financing or contracts is based on LIBOR (the London Interbank Offered Rate), then you should be aware of an upcoming interest rate change, which will affect those agreements.

LIBOR has been used since the 1970s as the prevailing reference rate for calculating interest in commercial and financial transactions. As a result of changes in the financial markets and as a response to the manipulation of LIBOR by several banks almost a decade ago, the United Kingdom’s Financial Conduct Authority (the FCA) announced in 2017 that it did not expect LIBOR to remain as an acceptable benchmark for the setting of interest rates beyond 2021.

What Will Replace LIBOR?

LIBOR is an interest rate average calculated from estimates submitted by a panel of leading banks in London. Each bank submits a notional interest rate to reflect the interest rate that it would be charged to borrow from other banks, and the average is published daily by the Intercontinental Exchange. Each interest rate estimate implicitly reflects the credit risk of each submitting bank. LIBOR was established to set objective, credible interest rates for commercial loans.

Over the course of the intervening decades since its creation, its use has grown so prevalent that financial and commercial contracts totaling nearly $200 trillion include LIBOR as a “base” interest rate.

On March 5, the Intercontinental Exchange and the FCA confirmed that most tenors of U.S. Dollar LIBOR would cease being published on a representative basis on June 30, 2023. One-week and two-month LIBOR will cease being published Dec. 31, 2021.

The Board of Governors of the Federal Reserve System (the Federal Reserve Board), the Office of the Comptroller of the Currency (OCC), and the Federal Deposit Insurance Corporation (FDIC) issued a joint statement on Nov. 30, 2020, encouraging banks to transition away from LIBOR as soon as practicable but, in any event, by the end of 2021.

The agencies believe entering into new contracts that use LIBOR as a reference rate after Dec. 31, 2021 “would create safety and soundness risks and [such agencies] will examine bank practices accordingly.”

This joint statement recommends that new contracts entered into before this date should either utilize a reference rate other than LIBOR or have robust fallback language that includes a clearly defined alternative reference rate after the publication of LIBOR is discontinued.

Many existing loan documents and other contracts include a fallback to the “prime rate” if LIBOR ceases to be available. However, the prime rate is usually higher than LIBOR and is not an ideal long-term reference rate for many market participants. The Alternative Reference Rate Committee (the ARRC), a group of private-market participants convened by the Federal Reserve Board and the Federal Reserve Bank of New York (the NY Fed), has proposed using the Secured Overnight Financing Rate (SOFR) as the replacement for LIBOR.

SOFR represents the interest rate that banks impose on each other in making loans secured by U.S. treasuries. SOFR is a risk-free, daily, overnight rate and is based on actual interbank transactions with daily volumes approaching $1 trillion.

Because LIBOR is a credit sensitive rate and SOFR is a risk-free rate, the financial markets have established spread adjustments that can be added to SOFR in order to more closely align with the former LIBOR rate.

How Will LIBOR Be Replaced?

Three possible contractual approaches can address the phaseout out of LIBOR in loan agreements. First, contracts may specify that the lender or administrative agent selects a replacement rate either at its discretion or with the consent of (or in consultation with) the borrower.

Second, contracts may provide that if a trigger event occurs, the lender (or administrative agent) and the borrower will identify and agree on a replacement rate and enter into an amendment to reflect the new rate.

Third, contracts may already include language that “pre-wires” the selection of a replacement rate based upon certain facts in existence at the time of the occurrence of a trigger event.

For example, on March 9, the ARRC confirmed that Intercontinental Exchanges announcement of a definitive cessation date for LIBOR tenors constituted a “Benchmark Transition Event,” beginning the process of switching from LIBOR.

While a Benchmark Transition Event does not require an immediate transition under the ARRC-recommended fallback language, it does signal that the Benchmark Replacement Date is expected to be on or immediately after the following dates for LIBOR: (i) Dec. 31, 2021 for one-week and two-month LIBOR, and (ii) June 30, 2023 for overnight, one-month, three-month, six-month, and 12-month LIBOR.

Of course, parties to a contract can always agree at any time to amend the contract to reflect a replacement rate regardless of whether an external trigger event has occurred.

How Can Contractors Protect Their Businesses?

First, contractors should determine whether the company is party to any contracts that use LIBOR to calculate interest rates, late payment rates, default rates or any other financial terms.

Second, once executives have identified any such contracts, they should conduct (or hire an adviser such as a lawyer, accountant or financial advisor to conduct) a review of the actual language in each contract to ascertain how each contract will determine a replacement rate when LIBOR ceases to exist. After identifying which replacement rate will be applied (if any), the contractor can assess the financial impact of utilizing that new rate.

Finally, based on the above analysis, construction executives may want to consider approaching lenders and contract counterparties to propose amendments to existing contracts to provide clear and specific language that addresses how to transition to a new reference rate once LIBOR is no longer available or to actually implement a replacement reference rate.

Although the transition away from LIBOR may be disruptive in the short term, moving to SOFR or another similar benchmark reference rate should bring some further stability to the financial markets over the long term.