How do banks, corporate borrowers, and investors in syndicated loans prepare for a benchmark rate that does not exist?

This conundrum is creating tension between stakeholders in the $900 billion market for below-investment-grade corporate loans as the entire financial system contemplates the possibility that Libor, the longtime benchmark for all manner of instruments, may disappear.

The Loan Syndications and Trading Association has suggested that new loan agreements be crafted to allow any loan to switch to a new benchmark without unanimous consent of the investors in that loan. Covenant Review, a research firm that advises corporate loan investors on their rights, objects, arguing that such a measure would open the door to manipulation by the largest banks — which, remember, is the kind of thing that necessitated rethinking Libor in the first place.

This is something of a gray area for leveraged loans, which are underwritten by banks and broadly syndicated among institutional investors.

The current market standard, according to both the LSTA and Covenant Review, requires consent from each affected lender for any amendments that would reduce the rate of interest on a loan. But it’s not clear that any replacement rate would necessarily be lower than the London Interbank Offered Rate. In fact, if Libor no longer exists, it would not be possible to determine if a new reference rate is lower.

Representatives for both the LSTA and Covenant Review declined to comment for this article.

In the years since the Libor rigging scandal, banks have become reluctant to submit quotes used to calculate the average, and those quotes are hypothetical and rarely reflect actual transactions. In July, the U.K. Financial Conduct Authority said that it would phase out the benchmark by 2021.

Some credit agreements provide for a fallback in case Libor is unavailable, though these were generally designed for temporary disruptions, not a permanent one, the LSTA said in a recent presentation. The agreements may call for an interpolated rate or quotes from designated banks. In the case of certain trigger events, some Libor loans covert to base-rate or prime-rate loans.

U.S. regulators have proposed a new benchmark, to be called the Broad Treasuries Repo Financing Rate, but it does not yet exist. Moreover, it is designed for the swaps market, and may not be well-suited to loans and collateralized loan obligations.

With no clear replacement rate in the offing, new loan documents cannot be drafted to accommodate a new benchmark. So the LSTA says interested parties might consider “hardwiring” credit agreements with the ability to adopt a new benchmark with less than 100% of lenders on board, according to a written summary of the webcast published on the trade group’s website.

That idea does not sit well with Covenant Review.

“We suggest that our subscribers consider resisting any provisions that would permit a replacement rate without majority consent,” the research firm stated in a report published Friday.

It warned that “money center banks have the potential ability to control the selection of replacement reference rate and significantly affect the competitive dynamics of the lending market.”

The report acknowledges that it may not be possible to know whether a new benchmark would result in a lower interest rate. Nevertheless, analysts at the firm argue that “if a replacement reference rate could potentially result in a lower interest rate, then a good argument exists that an amendment to replace Libor with a new reference rate would require unanimous approval.”

Covenant Review also warned its clients that they should not assume that any rate proposed by the Alternative Reference Rates Committee, established by regulators to find a Libor replacement, will be suitable for U.S. loans. It noted that the committee is focused on a rate that is appropriate for over-the-counter swaps, not loans, and that the committee’s members are banks. There are a handful of institutional lenders in an advisory group, but they merely provide feedback.

“We think institutional lenders should get a seat at the main table in any discussion of replacement reference rates,” the report states. “We do not think that the interest of money center banks and institutional investors are aligned on this issue. The control of AARC by money center banks, together with a majority consent provision to select a replacement rate increases the potential for mischief.”

Covenant Review also pointed to a potential “escape clause” for investors, known as the “yank a bank” provision, which permits the borrower to replace any objecting lender in connection with an amendment requiring unanimous or “affected lender” consent. The dissenters would get their principal back, but they’d have to put it to work somewhere else.

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