The new European reference rate €STR (Euro Short-Term Rate) was published for the first time on 2 October 2019. This marked the beginning of the end for the former reference rates EURIBOR and EONIA. We take a closer look on the impact that the transition away from the IBOR rates will have on Lenders, Borrowers and Investment Funds.

EURIBOR and EONIA are not the only traditional reference rates that are being replaced by new reference rates. The trend is seen throughout the world, e.g. with LIBOR (GBP) being replaced by SONIA and LIBOR (USD) being replaced by SOFR.

The transition to the new reference rates is due to the recommendations by the Financial Stability Board in 2014, which were made because of the LIBOR scandal revealed in 2012. It has not yet been decided which reference rate will replace the Danish CIBOR and CITA; however, Finans Danmark has suggested a reference rate backed by the O/N deposits in the Banks.

Loan documentation and LIBOR

Most loan documents, e.g. credit facilities, use the LIBOR rate as a basis for the interest on the facility, being that the borrower must pay a given percentage over the LIBOR as interest on the facility. Often, the loan documents, based on the LMA or ISDA standards, will contain a "Fallback" provision, which applies once the agreed reference rate is no longer available. The provision entails that the interest is decided on the historic date of the agreed reference rate, which, for facilities that extend beyond the planned end date of LIBOR (GBP) (2021), may entail that the interest no longer reflects the actual macroeconomic situation at the given time.

Investor documents and LIBOR

Certain investment funds are required to prepare a prospectus and/or a Key Investor Information Document ("KIID") for potential investors. Such documents will often include the historic and expected performance of the fund, which the fund has had or expects to have (e.g. the different result scenarios in a KIID), respectively. These financial performance indicators will often be calculated with the use of a reference rate.

The investment funds may also have other documents, which are based on an IBOR rate, e.g. the fund may use the IBOR as a benchmark to measure how well the fund performs in the market. A change in reference rate, which could entail a reference rate above or below the previously used reference rate, may therefore result in the fund's historic and future performance no longer being compared to each other and showing different results. At least if not correlating for the difference between the two rates.

The Benchmark Regulation

If they do not amend their loan and other financial documents which are based on the IBOR rates, both lenders and borrowers will experience that it will no longer be possible for the relevant authority controlling the relevant IBOR to continue publishing the rate, due to the provisions in the Benchmark Regulation. This is because the Regulation requires that critical benchmarks (per 29/11-2019: EURIBOR, EONIA, LIBOR, STIBOR and WIBOR) must be representative. When many the panel banks of the IBOR's withdraw, this will reduce the accuracy of the benchmark, and thus the relevant IBOR rate will no longer be representative.

Supervised entities under the Benchmark Regulation (e.g. credit institutions, investment firms in accordance with MiFID, insurance undertakings and AIFM) are required to have written plans on which actions they will take in case of cessation of a benchmark, including which reference rate would substitute the previous reference rate. Such entities should therefore, if such action has not previously been undertaken, consider which reference rate to reference once the IBOR rates are no longer available.

Implications for businesses

The implications will vary for each company, depending on the activities carried out by the company. However, all companies will in some way be affected by the change in reference rates, constituting a possible risk for the business model. The most obvious being the spread between the previous and new reference rate, which could potentially entail significant differences between financial contracts subject to the IBOR rate and the contracts subject to the new reference rate (which is partially mitigated in case of ENOIA, where it has been redefined to be €STR + a fixed spread). Moreover, the valuation of financial assets possessed by a company may be affected due to the spread between the rates, thereby causing a (technical) loss of capital (i.e. the assets of the firm stay the same, but are worth less) when the switch between the two rates is made.

For investment funds benchmarked to an IBOR rate, such change in asset value could impact both the fund itself and the investors because the basis of calculation is changed, entailing better or worse performance depending on the spread then previously calculated and estimated.

Moreover, all funds and other entities which have published a prospectus, KIID or any other document which may contain a reference to an IBOR rate should be attentive to the fact, if the financial indicators provided are based on the previous reference rate as a change in reference rate may entail, that these documents will also have to be amended since they will no longer be adequate.

Which actions can my company take?

In any case companies will have to review existing documents and amend any documents, which are based on an IBOR rate, to be based on one of the new reference rates in order to avoid complications once the transition to the new reference rates takes place. Additionally, the company should make sure that any contracts or documents entered into over the next years that are based on an IBOR rate contain adequate provisions for the transition to the new reference rate in cases where the IBOR rate is no longer available or representative.

Further information

contacts

Claus Bennetsen

Partner

Lars Lüneborg

Partner