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References to LIBOR in late payment clauses: mind the gap

References to LIBOR in late payment clauses: mind the gap

Overview

Late payment clauses in commercial contracts commonly refer to LIBOR as a proxy for the cost of money over time and a hedge against inflation. But do you understand what is meant by "LIBOR"? Did you know that the rate will soon be discontinued? How will this impact on the drafting of new late payment clauses (or construing clauses in existing contracts which include a reference to this rate)?

What is LIBOR?

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

It is an interbank interest rate which is calculated using data from a number of banks which are active in the London financial markets and represents a rate at which (theoretically at least) those banks are prepared to lend to one another.

Parties to commercial contracts commonly use "LIBOR" as a proxy for the cost of tying up money over time. To refer to "LIBOR" without further precision is very ambiguous. In fact LIBOR (further explained here) is 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 will be different to a dollar LIBOR overnight rate.

Cessation of LIBOR - what next?

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 remain committed to this deadline and have confirmed that there is no intention to extend it as a result of COVID-19. The next milestone in the transition away from LIBOR will be formal announcements from the FCA and ICE Benchmark Administration (the administrator of LIBOR) as to the timing of discontinuance.

SONIA: not an exact replacement of LIBOR

It is important to understand that, in the UK at least, there is no automatically applicable replacement rate for LIBOR and no legislative solution proposed. Hence disputes could arise where a contract referring to LIBOR remains in force after the rate is discontinued. Central bank working groups have been set up to facilitate transition for different currencies. For sterling lending, the Bank of England Working Group's proposed successor rate is SONIA (the Sterling Overnight Index Average). There are crucial differences between the two rates:

  • LIBOR is a forward looking term rate, reflecting the price at which banks are prepared to lend to each other for a given period (3 months is the most widely used interest period). It therefore features a bank credit risk component, which caused LIBOR rates to spike during the 2008 financial crisis.
  • SONIA is a backwards looking overnight rate; a measure of the rate at which interest is paid on sterling short-term wholesale funds in circumstances where credit, liquidity and other risks are minimal. Consequently SONIA is usually a lower rate than LIBOR.

Accordingly, during the course of today, it's possible to find out what the LIBOR number will be for the next three months. The same cannot be said for SONIA, which is a different number every business day.

Late payment clauses - a reminder

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).

Floating and fixed rate elements

Late payment clauses frequently comprise a floating rate element which serves as a "base" (e.g. a commercial or central bank base rate or a specified LIBOR rate), plus a fixed rate "uplift" (X per cent. per annum). The floating rate (e.g. three month sterling LIBOR) is designed to hedge against inflation. A decade ago, LIBOR exceeded 5 per cent. and so it served as a substantial tool to help creditors cover their cost of funds. However, in the current low interest environment, the "stick" to deter late payment is really that X per cent. uplift. As at March 2021, both the SONIA and the LIBOR overnight rate are currently hovering around 0.05 per cent. - with the effect that the floating rate element of the equation would currently make little difference to the overall late payment amount.


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.

What is a substantial remedy?

There is limited caselaw on what constitutes a "substantial remedy" but rates which are materially lower than the statutory rate provided for by the Late Payment Act have been held to meet this test, e.g. clauses providing for late payment interest in the range of 3-5 per cent. above the base rate of a commercial bank. For customers, therefore, it is obviously desirable to replace the implied statutory rate with a less generous, express remedy. Although it is arguably to the benefit of suppliers for their contracts to remain silent on late payment (so that the statutory rate will apply), in practice it is also fairly common for suppliers' standard terms to provide for an express remedy at a lower rate (perhaps reflecting a concern that some customers may view the statutory rate as excessive).


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
  • 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).

What rate could be used to replace LIBOR in late payment clauses?

In view of impending LIBOR discontinuation, 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).

Central bank rates

Parties to a contract may find it easier to substitute a central bank rate into the late payment equation and the result would be substantially the same, with the creditor retaining some hedge against inflation and/or cost of funds. Another factor to consider is that central bank rates tend to remain the same for months at a time and are usually quoted as a round number. Indeed, SONIA typically tracks the Bank of England Bank Rate very closely and is likely to result in a similar outcome (although SONIA tends to be fractionally lower).

In view of these factors, parties may conclude that it is preferable to replace LIBOR with a central bank rate. The choice may depend on where the parties are located or the currency used in the contract.

Drafting pitfalls

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. 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.

Negative interest rates

In the case of reference to central bank rates, a complicating factor is the spectre of negative interest rates, already a reality in some jurisdictions.  If the late payment rate factors in a large enough level of uplift (based on a fixed rate), then a negative central bank rate of -0.10% might make little commercial difference to the outcome. Nevertheless, it will help to clarify whether, in calculating the rate, negative rates should be ignored (i.e. if negative, the base rate should simply be regarded as zero and the late payment interest will consist solely of the fixed rate "uplift").


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.

What is a penal rate of interest?

In Jeancharm v Barnet (2003), late payment interest of 5 per cent per week (rather than per annum) was found to be penal.  Although the test for penalty clauses has since been modified by the Supreme Court, our view is that a rate equating to over 200 per cent. per annum remains likely to be regarded as penal, even under the revised test.  This case also highlights the importance of ensuring that it is clear how late payment interest is to be calculated.  On the face of it, 5 per cent. sounds reasonable - but when applied on a weekly basis, it involves substantially higher sums than most late payment rates, including the statutory rate (which are calculated on a yearly basis).

What if a late payment clause using LIBOR has not been amended?

As explained above, LIBOR is not expected to be available beyond the end of 2021.  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).

How Travers Smith can help you

Given the impending discontinuation of LIBOR, our recommendation is to amend any late payment clauses using LIBOR ahead of 31 December 2021, 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.

LIBOR - our wider experience

As regards LIBOR cessation more generally, we have extensive experience in advising clients on LIBOR impact assessment and transition plans.  Our close relationships with industry bodies such as ISDA, ICMA, the LMA, AIMA and BVCA mean that we are well placed to advise you on what needs to be done to amend contracts to incorporate LIBOR fallback mechanics.

Further reading

A number of organisations have published guides for companies.

  • In September 2020, UK Finance published a helpful guide on LIBOR transition priorities for business customers (available here).
  • In March 2021, UK Finance published a short guide on LIBOR rate change for SMEs (available here).

Read our other LIBOR briefings:

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