References to LIBOR in late payment clauses: mind the gap

The London Inter-Bank Offered Rate (LIBOR) was a reference rate of interest used historically in a vast number of financial contracts including cash products (such as loans, bonds and other debt securities) and derivatives transactions.

It was an interbank interest rate calculated using data from a number of panel banks active in the London financial markets, representing a rate at which (theoretically at least) those banks were prepared to lend to one another.

Parties to commercial contracts used "LIBOR" as a proxy for the cost of tying up money over time. To refer simply to "LIBOR" without further precision was very ambiguous. In fact LIBOR (further explained here) was, until recently, quoted as an annualised interest rate for five currencies (USD, GBP, EUR, CHF, JPY) and also for a range of (forward looking) tenors. So for instance the sterling LIBOR rate for three months would have been different to a dollar LIBOR overnight rate.

LIBOR came under increased public scrutiny after the LIBOR scandals of 2007-12, which centred upon the alleged manipulation of the rate by panel banks for their own ends.

After a comprehensive review of LIBOR, and whether it remains fit for purpose, the Financial Conduct Authority (FCA) announced in 2017 that market participants should not rely on LIBOR being available after 31 December 2021. The Bank of England (BoE) and the FCA remained committed to this deadline despite COVID-19 and since the beginning of 2022, sterling LIBOR has only been quoted for a limited number of settings, for the most part on a synthetic basis (no longer relying on submissions from panel banks). "Synthetic LIBOR" for sterling will now only be available for a limited period.

• The 1- and 6-month synthetic sterling LIBOR settings will cease at end-March 2023.
• The 3-month synthetic sterling LIBOR setting will cease at end-March 2024.

Late payment clauses will typically impose an agreed interest rate on the late payer in order to compensate the creditor, who may have to fund its own related expenses. There is also a deterrent element here; the prospect of a late payment fee is a 'stick' to deter late payment, although care should be taken not to set the rate so high that it could be regarded as a penalty – see section 5 (Drafting pitfalls).

The statutory interest rate

It's important, however, to remember the default position for creditors in commercial contracts if the documentation is silent on consequences of late payment. Under the Late Payment of Commercial Debts (Interest) Act 1998 (the "Late Payment Act"), a term will be implied into contracts for the supply of goods or services enabling interest to be claimed on late payments at a statutory rate, currently consisting of the Bank of England base rate plus 8 per cent.  This rate has not been changed since 2002 and may appear generous given current low rates of commercial interest.  The implied term can, however, be displaced if the contract provides for "some other substantial contractual remedy" for late payment.

Other developments

The UK Government had hoped that the Late Payment Act would help to promote a culture of prompt payment but in practice, problems with late payment persist. In particular, suppliers are often understandably reluctant to claim late payment interest from their customers (even where they would be legally well within their rights to do so). More recently, the Government has taken a number of other steps intended to discourage late payment including:

• measures requiring all large UK companies and LLPs to publish information on their payment practices and performance twice a year (see our related briefing here); and
• consulting on strengthening the powers of the Small Business Commissioner to enable them to impose fines on businesses which fail to pay smaller businesses on time (see our briefing here).

In December 2022, the Government announced a Payment and Cashflow Review which will look again at the existing measures, alongside other ways in which business (particularly SMEs) could be supported in managing cashflow such as use of technology, finance and improving awareness. For more detail, see our briefing "Late payment clauses: time for a review?" 

In view of the LIBOR wind-down, parties will need to settle on a substitute rate. SONIA is likely to be a component of the replacement rate for LIBOR in sterling loan markets, particularly for loans with sufficient scale. However, there are issues which in our view make SONIA somewhat problematic as a candidate to replace LIBOR in late payment clauses.  For example, when using SONIA to calculate interest over a longer period there are several options.

• The daily overnight rate could be "compounded", which gives rise to complex calculations (a necessary feature in large scale commercial lending, but unattractive for late payment clauses).
  
  
• Parties might use the rate quoted on a given reference day, e.g. the first day of the 'late' period or on the first day of a calendar month, which could lead to unpredictable results when there are spikes in the daily overnight rate.
  
  
• A middle ground might be to use a simple average of SONIA for the period during which amounts are outstanding. This would avoid the potential volatility of using a single reference date. However the rate would only be able to be calculated at the end of the period.

A complicating factor is that the daily SONIA rate is quoted to four decimal places (see the Bank of England statistics at the bottom of the page here). One alternative would be to use "Term SONIA" instead of sterling LIBOR. This rate has the advantage of being known at the beginning of the relevant period (like LIBOR). Indeed, Term SONIA is a key ingredient of the so called "synthetic LIBOR" rate which the FCA has required to be published for a limited period (see section 2). The £RFR Working Group has published a summary of the key attributes of the various competing Term SONIA Reference Rates here.

As noted in the discussion of SONIA above, ease of calculation is an important factor when drafting a late payment clause. Think of the person running the calculations! A well drafted clause only requires the creditor to locate the reference rate once (or infrequently). For instance, a clause might refer to the rate quoted on the first day of the 'late' period or on the first day of a particular calendar month. A pitfall to avoid would be to refer to a rate which changes daily (e.g. simple SONIA) and to require the rate to be calculated daily.

Another consideration is the ease with which the rate can be found. A rate which is readily verifiable will help to avoid disputes.

Penalty clauses

Finally, it is important to ensure that the late payment interest rate is not set at a level which could be regarded as penal (and therefore unenforceable).  It is highly unlikely that a rate set at or below the statutory rate of Bank of England base rate plus 8 per cent would be regarded as penal, even though this may appear generous by comparison with current commercial lending rates.  In addition, recent caselaw on penalty clauses suggests that it is permissible to have regard to the need for a deterrent effect, not just the need to compensate the innocent party for its potential loss – see our related briefing here. That said, the clause must not be "exorbitant or unconscionable" – see textbox below for an example.

As explained in section 2 above, since the beginning of 2022 the 3, 6, and 12 month LIBOR tenors have been published on a synthetic basis. For contracts entered into prior to 1 January 2022, the Critical Benchmarks (References and Administrators' Liability) Act 2021 provides that a reference in "a contract or other arrangement" to LIBOR will be construed as a reference to synthetic LIBOR. In most cases this will override any express contractual fallbacks that would otherwise have operated on cessation of LIBOR. Essentially, the contract will be treated as if it had always provided for the reference to include the synthetic benchmark.

The FCA has announced that it will not require publication of synthetic LIBOR for the 6 and 12 month settings after 31 March 2023, and for the 3-month setting after 31 March 2024. For contracts made on or after 1 January 2022 or for any contract still in force after the relevant synthetic sterling LIBOR setting ceases to be published, the situation will be more complex. Thereafter, if a clause has not been amended so as to substitute an alternative rate, the courts will need to reach a view on what the parties would have intended to happen in this situation. Their starting position may well be that the parties must have intended a late payment remedy to apply and therefore the key question is whether it is possible to infer what should replace LIBOR. However, as noted above, this is not a straightforward question to resolve.  For example, SONIA is not an exact replacement for LIBOR and its use as a substitute may simply give rise to further disputes over how the interest should be calculated.

In view of these complexities, there is a risk that in some cases, a court could conclude that it is unclear what the parties intended – and that either the statutory rate should apply (which effectively favours the supplier) or there should be no remedy at all (on the basis that, as the clause was primarily intended to protect the supplier, the onus was on the latter to ensure that it was updated to deal with the consequences of LIBOR cessation).

Given that LIBOR will soon be unavailable (even on a synthetic basis), our recommendation is to amend any late payment clauses using LIBOR, both in existing contracts and in any standard "boilerplate" that will be used for future contracts. This should avoid uncertainty and unnecessary disputes over what the parties intended. Solutions may vary depending on factors such as the currency used in the contract and the location of the parties.

We have advised a number of clients on this issue and can help you work out the best options for your business going forward.  If you are reviewing boilerplate/standard terms, there may also be other changes that you will wish to consider alongside LIBOR cessation, such as:

• the impact of Brexit on jurisdiction clauses and a range of other contractual issues – see our related resources here; and 
• whether the period that you allow for payments might benefit from review in the light of the developments discussed in our briefing "Late payment clauses: time for a review?", which is part of our series on pricing and payment issues in commercial contracts.