Steiner-Goldstein
Steiner-Goldstein ()

In light of the fact that many real estate lenders rely upon the London Interbank Offered Rate (LIBOR) as a principal index rate, there has been a great deal of concern throughout the industry about the anticipated phase-out of the much-used index, currently anticipated to occur at the end of 2021. As real estate financiers debate whether they may benefit from LIBOR’s replacement in the long-term and what existing or newly-minted index rate may ultimately replace LIBOR, lawyers working in the field should concentrate on ensuring that loan documents are drafted to preserve the benefit of lenders’ bargains even in the absence of the key index rate used to determine the loan’s all-in interest rate.

Contemplating a Substitution

Interest rates for floating rate loans based on the LIBOR index are typically priced on the basis of a 30-day LIBOR contract plus some negotiated “spread” over such index rate; the sum represents the loan’s “all-in” rate. In light of past events whereby specifically identified index rates unexpectedly became obsolete, many drafters of real estate finance documents regularly contemplate a substitution of the LIBOR index with an alternative “base rate” or “prime rate” should LIBOR cease to be a viable means for determining a loan’s interest rate. For instance, in the following loan document provision, a LIBOR loan is allowed to convert to an alternative “base rate” when LIBOR can no longer be ascertained:

In the event that lender shall have determined that by reason of circumstances affecting the interbank Eurodollar market, adequate and reasonable means do not exist for ascertaining LIBOR, then lender shall forthwith give notice of such determination to borrower. If such notice is given, the related outstanding LIBOR-based loan shall be converted, on the [effective date identified in such notice], to a Base Rate-based loan.

The related loan documents would provide that the “base rate” may be a “prime rate” published in a leading financial periodical (for example, the Wall Street Journal) or some other index that the lender determines would be a reasonable substitute for LIBOR. Provisions for an alternative index to calculate interest are essential at all times but especially in light of the current expectations concerning the availability of LIBOR.

Courts Weigh In on Rates

If the index used to calculate interest for a particular loan should no longer exist, and the applicable loan documents do not provide for lender’s selection of an alternative index, a borrower may object to the replacement index proposed by the lender or even argue that the interest rate be limited to the applicable interest rate spread due under the loan. In these cases, the parties may need to resolve their disputes in court.

Courts in several jurisdictions have addressed the specific issue where the index rate identified in particular loan documents has become impossible to determine. For example, in F.D.I.C. v. 272 Post Rd. Associates, No. 5:91:CV:433 (TFGD), U.S. Dist. 1994 WL 902825 (D. Conn. April 14, 1994), the Federal Deposit Insurance Corporation (FDIC) became the owner and holder of a note on a commercial construction loan after the original lender, a bank, failed. FDIC moved for summary judgment of strict foreclosure against the borrower after borrower’s default. The promissory note provided for a floating interest rate of one percent above the “prime rate” as announced by the lender/bank publicly from time to time. Since the lender stopped publishing its prime rate when it failed, the defendants argued that (i) the note was unenforceable because the parties never agreed to a material term (i.e., the proper method for determining the interest rate in the event that the specified index ceased to exist) and (ii) if the note was enforceable, defendants were only obligated to pay interest after the lender failed at a rate of one percent based on an implied prime rate of zero. The court rejected these arguments, however, and found that “FDIC may substitute an appropriate interest rate index to apply to a loan that is based upon the prime rate of a failed bank.”

Similarly, in Ginsberg 1985 Real Estate Partnership v. Cadle Co., 39 F.3d 528 (5th Cir. Nov. 23, 1994), appellant debtors challenged the district court’s grant of summary judgment for Cadle Co., as successor lender on a promissory note dispute stemming from Cadle’s calculation of interest based on a substitute rate after the original lender failed and no longer published the prime rate referred to in the note’s interest rate definition. Appellant debtors contended that upon its failure, the original lender’s prime rate ceased to exist, and as a result, since that time, the note had failed to specify an interest rate that was agreed upon by the parties. They argued that the Texas Legislature’s six percent interest rate, which is imposed in the absence of a specified rate, should apply. The court rejected this argument, however, and held that the Cadle’s “‘substitution’ approach, or its application of a ‘continuing’ interest rate, is supported by Texas law and precedents in this circuit.” The failure of the original lender was an unforeseeable event, and Texas law favors continuity in the rate of interest. The court found an implicit agreement to use an analogous prime rate in the event of an unforeseeable benchmark bank failure.

Regardless of the results of the foregoing cases, lenders may not always be able to rely on every court to imply a reasonable index rate when the contract fails to anticipate the unavailability of a referenced index. For example, in New Whitehall Apartments v. S.A.V. Associates, No. 570644/16, N.Y.S.3d, 2017 WL 2854667 (N.Y. App. Term July 3, 2017), the First Department Appellate Term of the New York Supreme Court found that only in limited instances could a court prevent the failure of a contract containing ambiguous or omitted essential terms by transposing, rejecting or supplying words to clarify the meaning of the contract. This approach is strictly construed, however, and only applies where some absurdity has been identified or the contract would otherwise be unenforceable either in whole or in part. We note the absence of an alternative index rate does not in and of itself render a loan agreement unenforceable and a court may not apply an alternative index based on this rationale.

Conclusion

Since it is clearly better to draft LIBOR-alternative language into loan documents rather than relying on equitable relief from a court, careful lawyers should continue to supplement their loan documents with provisions such as the one identified in this article. In light of the extensive warning provided to the industry of this upcoming change, there should be ample opportunity to draft or re-draft loan documents in order to maintain a lender’s anticipated bargain in the absence of LIBOR.

In light of the fact that many real estate lenders rely upon the London Interbank Offered Rate (LIBOR) as a principal index rate, there has been a great deal of concern throughout the industry about the anticipated phase-out of the much-used index, currently anticipated to occur at the end of 2021. As real estate financiers debate whether they may benefit from LIBOR’s replacement in the long-term and what existing or newly-minted index rate may ultimately replace LIBOR, lawyers working in the field should concentrate on ensuring that loan documents are drafted to preserve the benefit of lenders’ bargains even in the absence of the key index rate used to determine the loan’s all-in interest rate.

Contemplating a Substitution

Interest rates for floating rate loans based on the LIBOR index are typically priced on the basis of a 30-day LIBOR contract plus some negotiated “spread” over such index rate; the sum represents the loan’s “all-in” rate. In light of past events whereby specifically identified index rates unexpectedly became obsolete, many drafters of real estate finance documents regularly contemplate a substitution of the LIBOR index with an alternative “base rate” or “prime rate” should LIBOR cease to be a viable means for determining a loan’s interest rate. For instance, in the following loan document provision, a LIBOR loan is allowed to convert to an alternative “base rate” when LIBOR can no longer be ascertained:

In the event that lender shall have determined that by reason of circumstances affecting the interbank Eurodollar market, adequate and reasonable means do not exist for ascertaining LIBOR, then lender shall forthwith give notice of such determination to borrower. If such notice is given, the related outstanding LIBOR-based loan shall be converted, on the [effective date identified in such notice], to a Base Rate-based loan.

The related loan documents would provide that the “base rate” may be a “prime rate” published in a leading financial periodical (for example, the Wall Street Journal) or some other index that the lender determines would be a reasonable substitute for LIBOR. Provisions for an alternative index to calculate interest are essential at all times but especially in light of the current expectations concerning the availability of LIBOR.

Courts Weigh In on Rates

If the index used to calculate interest for a particular loan should no longer exist, and the applicable loan documents do not provide for lender’s selection of an alternative index, a borrower may object to the replacement index proposed by the lender or even argue that the interest rate be limited to the applicable interest rate spread due under the loan. In these cases, the parties may need to resolve their disputes in court.

Courts in several jurisdictions have addressed the specific issue where the index rate identified in particular loan documents has become impossible to determine. For example, in F.D.I.C. v. 272 Post Rd. Associates, No. 5:91:CV:433 (TFGD), U.S. Dist. 1994 WL 902825 (D. Conn. April 14, 1994), the Federal Deposit Insurance Corporation (FDIC) became the owner and holder of a note on a commercial construction loan after the original lender, a bank, failed. FDIC moved for summary judgment of strict foreclosure against the borrower after borrower’s default. The promissory note provided for a floating interest rate of one percent above the “prime rate” as announced by the lender/bank publicly from time to time. Since the lender stopped publishing its prime rate when it failed, the defendants argued that (i) the note was unenforceable because the parties never agreed to a material term (i.e., the proper method for determining the interest rate in the event that the specified index ceased to exist) and (ii) if the note was enforceable, defendants were only obligated to pay interest after the lender failed at a rate of one percent based on an implied prime rate of zero. The court rejected these arguments, however, and found that “FDIC may substitute an appropriate interest rate index to apply to a loan that is based upon the prime rate of a failed bank.”

Similarly, in Ginsberg 1985 Real Estate Partnership v. Cadle Co . , 39 F.3d 528 ( 5th Cir. Nov. 23, 1994 ) , appellant debtors challenged the district court’s grant of summary judgment for Cadle Co., as successor lender on a promissory note dispute stemming from Cadle’s calculation of interest based on a substitute rate after the original lender failed and no longer published the prime rate referred to in the note’s interest rate definition. Appellant debtors contended that upon its failure, the original lender’s prime rate ceased to exist, and as a result, since that time, the note had failed to specify an interest rate that was agreed upon by the parties. They argued that the Texas Legislature’s six percent interest rate, which is imposed in the absence of a specified rate, should apply. The court rejected this argument, however, and held that the Cadle’s “‘substitution’ approach, or its application of a ‘continuing’ interest rate, is supported by Texas law and precedents in this circuit.” The failure of the original lender was an unforeseeable event, and Texas law favors continuity in the rate of interest. The court found an implicit agreement to use an analogous prime rate in the event of an unforeseeable benchmark bank failure.

Regardless of the results of the foregoing cases, lenders may not always be able to rely on every court to imply a reasonable index rate when the contract fails to anticipate the unavailability of a referenced index. For example, in New Whitehall Apartments v. S.A.V. Associates, No. 570644/16, N.Y.S.3d, 2017 WL 2854667 (N.Y. App. Term July 3, 2017), the First Department Appellate Term of the New York Supreme Court found that only in limited instances could a court prevent the failure of a contract containing ambiguous or omitted essential terms by transposing, rejecting or supplying words to clarify the meaning of the contract. This approach is strictly construed, however, and only applies where some absurdity has been identified or the contract would otherwise be unenforceable either in whole or in part. We note the absence of an alternative index rate does not in and of itself render a loan agreement unenforceable and a court may not apply an alternative index based on this rationale.

Conclusion

Since it is clearly better to draft LIBOR-alternative language into loan documents rather than relying on equitable relief from a court, careful lawyers should continue to supplement their loan documents with provisions such as the one identified in this article. In light of the extensive warning provided to the industry of this upcoming change, there should be ample opportunity to draft or re-draft loan documents in order to maintain a lender’s anticipated bargain in the absence of LIBOR.