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Syndicated Lending Update: Eurodollar Market Disruption Clause
October 14, 2008
LIBOR (London Inter-Bank Offer Rate) pricing in most syndicated credit agreements is based on the lender obtaining a eurodollar deposit on the LIBOR market and then lending those funds to the borrower at LIBOR for the applicable interest period plus a margin. Credit agreements with a LIBOR pricing option generally include a fairly standard set of protections aimed at preventing the lenders from taking a loss as a result of the borrower selecting LIBOR pricing. As the poor conditions in the credit markets have intensified in recent weeks, financial institutions have reported widespread concern that the LIBOR pricing option no longer adequately reflects their cost of obtaining funds. As a result of this concern, increased attention is being paid to the "Eurodollar Market Disruption Clause" (also called the "Eurodollar Disaster Provision") contained in most credit agreements. The mechanics of a typical Eurodollar Market Disruption Clause and issues related to invocation of the clause are important to understand.
1. Mechanics of the Eurodollar Market Disruption Clause
(a) Typical Clause. The Eurodollar Market Disruption Clause typically requires the determination of the Required Lenders (the same voting percentage that would apply to most amendments) that LIBOR does not adequately and fairly reflect the cost to the lenders of funding LIBOR loans. Once Required Lenders make that determination, the obligation of all of the lenders to make new LIBOR loans or to rollover existing LIBOR loans will be suspended until the administrative agent (usually at the instruction of the Required Lenders) provides notice to the borrower and the lenders that the circumstances causing the suspension no longer exist. Any borrowings or rollovers requested during the suspension would be then made as base rate loans instead of LIBOR loans. The clause would not typically require outstanding LIBOR loans to be immediately converted to base rate loans; instead, outstanding LIBOR loans would need to be repaid or converted to base rate loans as the interest periods for outstanding LIBOR loans expire.
(b) Variations. Although some form of the Eurodollar Market Disruption Clause is contained in most domestic syndicated credit agreements with a LIBOR pricing option, the exact terms vary between documents. A common variation is a lower percentage of lenders required to suspend the LIBOR pricing option. The Required Lender threshold is used so that LIBOR will be unavailable only when lenders have widespread sentiment that the price quotes from LIBOR pricing services do not adequately reflect the cost of obtaining funds. In recognition that such pricing issues will sometimes be country specific or regional in scope, some credit agreements allow a small group of lenders or even a single lender to invoke the clause. Credit agreements that have a low threshold sometimes provide for the affected lenders to receive compensation for their increased cost of funds from the borrower in lieu of suspending the LIBOR pricing option for all lenders.
2. Application of the Eurodollar Market Disruption Clause
Although lenders have rarely used the Eurodollar Market Disruption Clause because of the Required Lender threshold, the severity and global scope of the problems in today's credit markets may make the possibility of a successful use of the clause more likely. Some considerations regarding the application of the clause are discussed below:
(a) Cost of Funds at Issue. The clause often refers to a situation where LIBOR does not "adequately and fairly" reflect the cost to the lenders of funding LIBOR loans. This puts the lenders' cost of funds at issue. If the lenders attempt to invoke the clause, borrowers may demand to see evidence of the lenders' cost of funds. A dispute may subsequently arise as to the method of the lenders' calculation of their cost of funds and whether LIBOR "adequately and fairly" reflects their cost of funds.
(b) Role of the Administrative Agent. The administrative agent is not usually required to coordinate the Required Lenders' use of the clause. The administrative agent may choose to poll the lenders on this issue on its own initiative or at a lender's request. However, credit agreements do not usually contain an affirmative obligation of the administrative agent to poll the lenders, even if requested to do so by a member of the bank group. This can lead to practical problems in determining whether enough lenders constituting Required Lenders are in favor of using the Eurodollar Market Disruption Clause.
(c) Alternatives. If it appears likely that the Required Lenders support using the Eurodollar Market Disruption Clause, the administrative agent and the borrower may want to negotiate an alternative solution that would mitigate the need for invocation of the clause. Some potential alternatives include (i) negotiating a floor on LIBOR pricing in the credit agreement, (ii) increasing the LIBOR margin during the period of market disruption, (iii) limiting available interest period options under the credit agreement to those that are more available in the marketplace, or (iv) using an alternative costs of funds.
(d) No Analogous Provision for Base Rate Pricing. Note that the Eurodollar Market Disruption Clause remedy is suspending the LIBOR pricing option only. Borrowers would typically still be able to borrow new loans priced according to the base rate. If LIBOR plus the applicable margin exceeds the base rate plus the applicable margin (which has recently been reported by some financial institutions) or the lender's cost funds exceeded the base rate, the base rate pricing remedy would be inadequate. Because the base rate is usually the higher of the administrative agent's announced prime rate and the federal funds rate plus a margin, domestic syndicated credit agreements do not normally provide for a remedy if the lenders' cost of funds exceeds base rate pricing.