The London Interbank Offered Rate (LIBOR) and other interbank offered rates, used as reference rates in variable-rate loans, derivatives and other financial instruments, are expected to be discontinued at the end of 2021. In the United States, despite lingering uncertainty, LIBOR likely is going to be replaced by the Secured Overnight Financing Rate (SOFR). U.S. Dollar (USD) LIBOR is commonly used in floating-rate commercial real estate loan agreements as a benchmark index, putatively reflecting the lender’s cost of funds, with the borrower paying interest at a rate calculated as USD LIBOR plus a margin or “spread” reflecting market conditions and the price of the borrower’s credit risk to the lender. Whereas LIBOR reflects the current market for unsecured wholesale term lending to banks in a specific currency and for various terms in the London interbank market,[1] SOFR reflects the retrospective, actual cost of borrowing cash overnight by means of repurchase (“repo”) agreements[2] secured by U.S. Treasury securities.[3]

Since SOFR is measured by reference to transactions secured by Treasury securities, which have a negligible risk of default, and is therefore “designed to exclude counterparty credit risk and account solely for economic factors,” SOFR is a so-called “risk-free rate.”[4] Given the secured nature of the underlying financing (i.e., repo agreements secured by Treasury securities), SOFR is expected to be lower than LIBOR.[5] Any transition from LIBOR to SOFR therefore would require an adjustment to the spread charged to borrowers in order to maintain comparable overall rates and avoid unintended value transfers between lenders and borrowers. The discontinuance of LIBOR will affect outstanding loans and derivatives contracts, either triggering interest rate fallback provisions or, in their absence or in the event such provisions fail to adequately account for LIBOR’s permanent replacement, requiring amendments to existing contracts. LIBOR’s discontinuance will also require attorneys currently negotiating new loans or existing loan amendments to account for the differences between LIBOR and SOFR in a climate of uncertainty as a consensus on implementing SOFR (or another LIBOR alternative) gradually crystallizes.