An extract from The Lending and Secured Finance Review, 7th Edition
Overviewi Market conditions
Corporate lending activity in the first half of 2020 was dominated by the covid-19 pandemic, with amendments and waivers, extension requests and short-term liquidity facilities being sought by many borrowers to deal with the immediate effects of the global lockdowns. The UK government put in place support initiatives, including the Coronavirus Corporate Financing Facility (CCFF) and the Coronavirus Large Business Interruption Loan Scheme (CLBILS). The government also made temporary and permanent changes to the UK insolvency regime in response to the pandemic in the form of the Corporate Insolvency and Governance Act 2020 (discussed below in Section II.iii). Further lockdowns towards the end of 2020 and beginning of 2021 prompted predictions of a further wave of covenant breaches and amendment transactions. Levels of activity turned out to be generally more muted than expected. Corporate lending volumes increased in the second half of the year, and have continued to rise in 2021 so far. Many borrowers are still favouring amend and extend transactions over full refinancings, with tenors of three to five years typically on offer, depending on the sector and credit strength of the borrower.
Event-driven financings resumed in the second half of 2020 for both investment-grade and leveraged borrowers, across all sectors and deal sizes. Purchasers either restarted transactions that had paused as a result of the pandemic, or took advantage of the opportunities for merger and consolidation that emerged as a result. These conditions are expected to continue during the remainder of 2021, as covid-19 restrictions are gradually eased and global economies look to recovery.
Key themes during 2020, which are expected to remain dominant during 2021, were the transition from LIBOR to risk-free rates and the increasing prominence of sustainability-linked finance. There has been a sharp rise in both risk-free rate (RFR) linked lending and LIBOR transition transactions since the beginning of the year, which is set to continue as the deadlines from which LIBOR will cease to be available become imminent (see further Section II.iii). Environmental, social and governance (ESG) features proliferated in working capital facilities during 2020. More recently, ESG features have started to emerge in event-driven financings (including leveraged loans). The growth of the ESG market has been supported by increasing focus from regulators, trade associations and market participants (see further Section II.iii).ii Market participants and documentary developments
A mixture of participants remain active in the English-law loan market. Traditional banks continue to play an important and active role in the loan market, and remain dominant in investment-grade lending. In other sectors, particularly in the leveraged, real estate and infrastructure finance markets, alternative credit providers such as direct lending funds and institutional investors (collateralised loan obligations (CLOs), finance and insurance companies, hedge, high-yield and distressed funds, and loan mutual funds) are more prominent.
Most English-law syndicated loan transactions use the Loan Market Association (LMA) recommended forms as a starting point for negotiations. In addition to various types of facility agreements and ancillary documentation for the investment-grade market (the Investment Grade Agreements) and leveraged lending (the Leveraged Finance Documentation), the LMA collection comprises multiple templates for more specialist products, including real estate finance, developing markets lending and pre-export finance. The LMA's documentation library is currently in the process of being updated to reflect the transition of the syndicated loan market from LIBOR to RFRs.
The LMA has not yet produced template terms for green or environmental, social and governance (ESG)-linked loans, but has been instrumental in the production of principles for both green and social loans and for the ESG loan market as well as a variety of guidance material. ESG-linked lending is anticipated to remain an important area of focus over the coming year.
These topics and related documentation are discussed in Section II.
Legal and regulatory developments
Managing the steady flow of legal and regulatory changes remains an ongoing challenge for loan market participants. Some of the topics outlined below have been a feature of loan documentation discussions for some time. In some cases, sufficient consensus has emerged to enable them to be addressed in the LMA templates, leaving only points of detail to be negotiated. Where there remain diverging views, the contractual treatment must be agreed on a transaction-by-transaction basis.i Transition from LIBOR
The Financial Conduct Authority (FCA) confirmed on 5 March 2021 that most LIBOR rates will cease publication in their current form on 31 December 2021. Certain US dollar LIBOR tenors will continue to be published until the end of June 2023 for the purpose of supporting the run-off of legacy transactions. The FCA's announcement, combined with targets set by working groups and regulators for the cessation of new LIBOR business, means that the bulk of new lending transactions must now reference RFRs rather than LIBOR, or at least contain provisions that facilitate the transition to RFRs at an appropriate future date. Work is also underway to amend the body of existing loans referencing LIBOR that extend beyond the cessation deadlines to accommodate RFRs.
In the first months of 2021, the impending cessation of LIBOR was addressed mostly by the incorporation of 'rate switch' provisions into facility documentation. A rate switch loan references LIBOR initially, but provides for an automatic switch to the appropriate RFR at the earlier of an agreed date, or the date upon which the LIBOR becomes unavailable for use. As the deadline for the cessation of new sterling LIBOR business has passed, the rate switch structure is no longer available for sterling loans, which must instead reference SONIA from the outset.
In September 2020, the Sterling Working Group on UK Risk Free Rates recommended conventions for referencing SONIA in loans including the use of SONIA compounded in arrears, with a five banking day lookback period (the Sterling Loan Conventions). The five banking day lookback involves compounding the RFR over an observation period, which is equivalent in length, but starts and ends five banking days before the relevant interest period. This convention enables interest to be determined in advance of the end of the interest period, to facilitate the timely mobilisation of payments. The Sterling Loan Conventions suggest that the compounding methodology is adopted without the observation shift convention, although recognise that the use of an observation shift may be a robust option. The observation shift denotes the approach to weighting the RFR for days on which it is not published (i.e., weekends and bank holidays). If the observation shift method of calculation is adopted, the RFRs published during the period are weighted according to the number of calendar days in the observation period. If there is no observation shift, the RFRs published during the period are weighted according to the number of calendar days in the interest period.
The LMA's new recommended forms of facility agreement referencing RFRs reflect the Sterling Loan Conventions (and for simplicity, apply them to all RFR currencies). The interest and related provisions in the LMA's RFR facilities are being widely adopted, in most cases with minimal adjustment, and, mostly, compounded RFRs are being calculated without observation shift. The key discussion points in current transactions include the structure; whether the loans should (or must) reference RFRs from the outset; and whether to adopt a rate switch mechanism, or even, in some cases, an agreement to renegotiate the benchmark provisions at a later date. Much depends on the currencies required. Other discussion points include pricing and related issues, in particular how to calculate the spread between LIBOR and the compounded in arrears RFR and whether that should form a separate component of the pricing, as well as the operation of zero floor provisions and market disruption provisions in the context of RFRs.ii Sustainable finance
Throughout 2020, sustainable impact investing became an important driver for many financial institutions, fuelling an increase in ESG-linked lending. Sustainable or ESG loans look to align terms to the borrower's performance against an agreed set of ESG-related performance targets. For example, the margin on an ESG facility may adjust depending on whether those targets are met (upwards or downwards). An independent opinion provider is typically engaged by the borrower to verify whether those targets have been satisfied.
This is to be contrasted with 'green' or 'social' lending, which focuses on the use of proceeds, with a requirement that they are used to invest in green or social projects within pre-agreed parameters. Verification is also required for green and social loans, to assess the merits of the particular project for which the funding is intended.
To assist the development and standardisation of the sustainable lending market, the LMA (in conjunction with the Asia Pacific Loan Market Association (APLMA) and the Loans Settlement and Trading Association (LSTA)) has produced the following documents:
- the Green Loan Principles (GLP), published in 2018, comprising voluntary recommended guidelines that seek to promote consistency and integrity in the development of the green loan market by clarifying the criteria for which a loan may be categorised as 'green'. To aid consistency with the green bond market, the GLP build on and refer to the Green Bond Principles published by the International Capital Markets Association (ICMA);
- the Sustainability Linked Loan Principles (SLLP), published in 2019, which provide a framework for lending to incentivise the borrower's achievement of predetermined sustainability performance targets (SPTs). Similarly to the GLPs, the SLLPs are intended to promote consistency within the sustainability-linked market, covering topics such as setting the SPTs as well as reporting and review of the borrower's performance against those SPTs; and
- most recently, in 2021, the Social Loan Principles (the SLP) were published, which provide a framework for market standards and guidance for social loans, where the proceeds of the loan are used for predetermined social projects, building on the Social Bond Principles published by the ICMA. The SLPs cover topics such as the use of proceeds and process of evaluation and selection of social projects, together with guidance on the monitoring and reporting on the project and proceeds of the loan.
Alongside each set of principles, the LMA has also published guidance notes to aid interpretation of the principles in the market.
Sustainability-linked financing in particular saw a significant increase in lending in the UK throughout 2020, both in the context of investment-grade corporate working capital facilities and, increasingly, in the leveraged loan market (including some event-driven financings). As mentioned above, sustainability-linked loans contain ESG-related SPTs, typically referred to as key performance indicators (KPIs), selected by the borrower. Depending on whether or not the KPI targets are achieved by the borrower, the margin will adjust upwards or downwards. In addition, the lenders will usually expect ongoing information on the borrower's performance in relation to the KPIs during the life of the loan. This reporting can be provided either by the borrower or by an external opinion provider appointed by the borrower. To smooth the process, one or more of the lenders may act as a sustainability coordinator to assist with negotiating the KPIs and liaising with the borrower on behalf of the lenders on ESG-related matters. The sustainability coordinator will not, however, assume any fiduciary duties to the rest of the syndicate. Negotiations generally focus on the setting of the KPIs, together with the nature and extent of the reporting and auditing of the borrower's performance.iii The Corporate Insolvency and Governance Act 2020
In June 2020, the Corporate Insolvency and Governance Act 2020 (CIGA) was enacted. The CIGA introduced (among other things) permanent reforms to the insolvency and restructuring regime, including: (1) a new moratorium procedure; (2) the introduction of a new restructuring plan; and (3) a ban on the operation of 'ipso facto' clauses.New restructuring plan
The restructuring plan introduced by the CIGA is similar in some respects to the existing English law scheme of arrangement: creditors and members are divided into different court-sanctioned classes and required to vote on a restructuring plan proposal, which then itself requires court sanction. However, a key feature of the new plan is that it will be possible for the court to exercise its discretion to sanction a plan even if one or more classes of creditors votes against this – thus enabling cross-class cramdown (or potentially cram up) of creditors.New moratorium procedure
The CIGA's moratorium procedure is designed to give a company breathing space to present a rescue plan. Once a company has entered into the new moratorium, a monitor (who must be an insolvency practitioner) is appointed to oversee the moratorium. The directors remain in control of day-to-day operations, but their powers are constrained in some respects and various actions require the consent of the monitor.
The moratorium protects companies against winding-up petitions and most types of legal proceedings, provides a payment holiday in respect of certain liabilities incurred before it came into force, and limits creditors' ability to take enforcement action (including in relation to the enforcement of security). However, there are limitations on the moratorium's scope: (1) certain debts are excluded from the payment holiday and must continue to be paid (including amounts due under financial services contracts, which is defined to cover loans, derivatives, securitisations and most debt capital markets transactions); and (2) not all companies are eligible for the moratorium (for example, banks are excluded).Restrictions on the operation of 'ipso facto' clauses
The CIGA also introduced restrictions on the operation of certain clauses triggered by a party's entry into insolvency proceedings (the 'ipso facto' clauses). The CIGA renders of no effect any provision that has the effect of terminating or allowing the supplier to terminate or do any other thing in relation to any contract for the supply of goods or services upon the entry into of certain insolvency procedures by the recipient or purchaser. The supplier is required to continue to make supplies during the relevant insolvency procedure and cannot make payment of outstanding debts a condition of continued supply. Suppliers are also prohibited from terminating contracts where the right arose before the company entered into the insolvency procedure, but was not exercised. There are broad exclusions to this restriction, most notably for a wide range of financial contracts that include lending, derivative, securitisation and most DCM arrangements (but not, significantly, unsecured or unguaranteed bonds) and for arrangements where either the supplier or the company is a 'person involved in financial services' (which is a broad exemption covering, among other things, insurers, banks, investment banks and investment firms, securitisation companies, payment institutions and recognised investment exchanges).Temporary measures
The CIGA also introduced temporary measures (which have most recently been extended until 30 June 2021), designed to mitigate the short term impact of the covid-19 pandemic, including:
- restrictions on the presentation of winding-up petitions; and
- amendments to the wrongful trading provisions for certain companies, providing that, while the courts can still find a director liable for wrongful trading, the court must assume when assessing any financial penalty that the director is not responsible for any worsening of the company's or its creditors' financial position that occurs in the period from 1 March 2020 to 30 September 2020, or from 26 November 2020 to 30 June 2021.
The introduction of the CIGA led lenders to examine whether the new insolvency processes are within the scope of customary insolvency-focused representations, undertakings and events of default. The measures (both permanent and temporary) introduced by the CIGA have not resulted in any changes to the LMA's recommended forms of facilities agreement. There have been some minor adjustments to security documentation, to take account of the new moratorium procedure, and a review of intercreditor terms (in particular the ability of senior creditors to direct the voting rights of junior creditors), as a result of the new cross-class cramdown mechanism introduced by the new restructuring plan.iv Pension Schemes Act 2021
Defined benefit (DB) pension liabilities are likely to receive renewed focus in corporate and financing transactions when provisions in the newly-passed Pension Schemes Act 2021 (PSA) take effect. The PSA was enacted after a consultation process that started in 2018, and is intended to strengthen the powers of the UK Pensions Regulator to intervene in corporate activities that threaten DB pension scheme benefits and recoveries (the 'moral hazard' regime). The consultation was prompted by recent high profile corporate restructurings and collapses where DB pension schemes were negatively affected, together with criticism of the UK Pensions Regulator: the resulting PSA is intended to boost the UK Pensions Regulator's existing powers while introducing additional criminal and financial penalties to further deter reckless or intentional behaviour that prejudices a DB pension scheme.
The majority of the new powers are likely to come into force in autumn this year.
The 'moral hazard' regime was introduced by the Pensions Act 2004, which granted powers to the Pensions Regulator to protect the position of DB pension schemes by requiring employers to provide additional support to schemes in certain circumstances. These powers allow the Pensions Regulator to issue contribution notices (CNs) and financial support directions (FSDs) to either the scheme employer or a person 'associated or connected'2 with the scheme employer. FSDs are more general in nature and permit the UK Pensions Regulator to require employers to provide additional financial support for the pension scheme's obligations where the Regulator believes it is reasonable to do so. CNs focus on specific actions (or failures to act) that have negatively affected the DB pension scheme.
To issue a CN under the Pensions Act 2004, the Pensions Regulator has to be of the (reasonable) opinion that one of two tests have been met: (1) the target of the CN must have been a party to, or 'knowingly assisted' in, a deliberate act or failure to act, the main purpose of which was to prevent recovery of a DB pension scheme debt; or (2) the target's act or failure to act has 'detrimentally affected in a material way' the likelihood of accrued DB pension scheme benefits being received. Defences are available if (in summary) the target of the CN can show that it considered the DB pension scheme and took reasonable steps to mitigate the effect of the act. A voluntary clearance procedure is also available, whereby the UK Pensions Regulator can confirm that it would not be reasonable to issue a CN or FSD.
In addition, the Pensions Act 2004 introduced a series of 'notifiable events', intended as an early warning system for the Pensions Regulator of the occurrence of events relating to either the DB pension scheme or the scheme employer, which may impact on the DB pension scheme as a creditor. Examples include a breach by the employer of financing covenants and certain changes of control, with non-compliance potentially triggering fines or being considered as a ground for issuance of a CN or both. If an event occurs, it must be notified in writing to the UK Pensions Regulator as soon as reasonably practicable.
In relation to the above, the PSA introduces the following key changes:
- new grounds for issuing CNS: Two new tests have been introduced to allow the UK Pensions Regulator to issue CNs, the 'employer insolvency' test, and the 'employer resources test'. Both these new tests look to the strength of the DB pension scheme employer (rather than the scheme itself), focusing on the effect the proposed act will have on the employer's resources or on the employer's hypothetical insolvency in the context of the potential recovery by the DB pension scheme as a creditor. These new tests expand the circumstances in which CNs can be issued and are likely to be easier for the UK Pensions Regulator to enforce;
- new criminal and civil offences: One of the more controversial elements of the PSA is the criminal offences it introduces. Two new criminal offences have been enacted to help enforce the moral hazard regime, both of which can apply to any 'person', including individuals (such as directors), regardless of whether that person has any connection to, or association with, the DB pension scheme or its employer: (1) conduct that results in avoidance of employer debt to a DB pension scheme, where the person intended that this is the outcome; and (2) conduct that detrimentally affects in a material way the likelihood of accrued DB pension scheme benefits being received where the person knew or ought to have known that this would be outcome. Defences are available, if the person had a 'reasonable excuse' for their actions: the UK Pensions Regulator is currently consulting on its policy for investigating and prosecuting the new powers, including what will constitute a 'reasonable excuse'. Conviction under these offences can result in up to seven years imprisonment or unlimited fines, or both. It is worth noting that there are no specific exceptions to these offences for lenders or financing transactions where there is a DB pension scheme within the group; and
- new notifiable events: There are expected to be further notifiable events published in secondary legislation later in 2021, requiring notice to be given of: (1) a sale of a material proportion of the assets of a scheme employer with responsibility for at 20 per cent of scheme liabilities; and (2) the granting of security on indebtedness which has priority over the DB pension scheme. New notice requirements are also to be introduced, requiring notice to be given to the UK Pensions Regulator (and pension trustees) as soon as reasonably practicable after the person giving the notice becomes aware of the notifiable event, together with details of any adverse effect on the scheme, any proposed mitigation and what communication there has been with the trustees and scheme members. This is intended to give the UK Pensions Regulator and DB pension scheme trustees greater involvement at an earlier stage. A new financial penalty for breach of these obligations of up £1million is introduced, along with expansion of the existing criminal liabilities.
Since the 2004 Act has been in force, DB scheme issues have routinely formed part of the due diligence and credit risk assessment for financing transactions, together with liaising with the scheme trustees (where appropriate) to determine the extent of any additional support required to mitigate the impact of the transaction on the scheme. While due diligence plays a key role in assessing the existence of any actual or potential DB scheme liabilities, contractual protections, by way of representations or undertakings regarding the existence of and liabilities associated with a DB scheme, together with undertakings relating to compliance with the DB scheme obligations and provision of information to the lenders are also often seen. For some transactions, receipt of a CN or FSD may trigger an event of default, or obtaining clearance from the Pensions Regulator may be a condition precedent.
The changes introduced by the PSA are likely to result in an increased focus on the above provisions and the structuring of financing arrangements. Those involved in restructuring transactions are likely to pay particularly close attention to the PSA's new provisions: early engagement with pension trustees and detailed preparation and professional advice will all be required to minimise the risk of potential liability. Further guidance and regulations are expected to be forthcoming during 2021, which will help interpret the PSA's provisions, so this is an area to watch over the course of the coming year.v National Security and Investment Act 2021
The National Security and Investment Act 2021 (the NSIA) introduces a new regime which seeks to expand and modernise the government's powers to scrutinise and intervene in certain transactions that threaten the UK's national security. In a financing context, it is likely to be relevant where debt is required to back the acquisition of a qualifying entity or asset that falls within the scope of the legislation. This is not limited to foreign investment, entities which have activities in, or supply goods or services to the UK are potentially in-scope.
Transactions which involve an 'acquisition of control' (described further below) within certain specified sectors will require mandatory notification to the Secretary of State. There are currently 17 specified sectors the government has identified, including energy, communications, transport and defence. The Secretary of State for Business, Energy and Industrial Strategy (Secretary of State) also has the power to call in a transaction that does not fall within the mandatory regime, but that it considers poses a risk to national security. This may be exercised for asset acquisitions, which are not subject to mandatory notification, or where a transaction does not fall within the specified sectors but the acquirer or investor raises national security concerns. There is also a voluntary notification regime that would avoid the risk of the transaction being called in at a later date.
Transactions involving the specified sectors will trigger mandatory notification under the regime if the investor increases its shareholdings or voting rights in an entity over certain thresholds, the opening level being 25 per cent. However, the Secretary of State may call in a transaction where this threshold level is not met, but where the investor acquires a material influence over the company.
Under the regime, the Secretary of State will have the power to call in transactions up to five years after the transaction completes, but only for six months from the time the government becomes aware. Unusually the legislation has retrospective effect and will apply to transactions that complete between 12 November 2020 and the date of commencement of the NSIA (expected to be towards the end of 2021). Under the mandatory regime, transactions become in-scope upon commencement of the Act and can be called in at any time if not notified, the exception being for transactions completed between 12 November 2020 and commencement, where the Secretary of State has a retrospective call in power for up to five years or six months from becoming aware of the transaction.
The timing implications for transactions will need to be considered. The government has 30 working days to assess a transaction; however, this period may be extended so will need to be factored into the transaction timetable. The penalties for completing a transaction without approval include the transaction being declared legally void, up to five years and monetary fines (the higher of 5 per cent of global turnover and £10 million).vi Brexit – documentation issues
The UK formally left the EU on 31 January 2020, and the transition period (during which time the UK was treated as an EU Member State for most purposes) ended on 31 December 2020.
The legal and regulatory changes stemming from the United Kingdom's departure from the European Union (as well as the potential commercial implications of Brexit) have been analysed in some detail. These issues include, for example, the impact of Brexit on dispute resolution options, the use of references to the European Union and to EU legislation in lending documentation and the tax implications of leaving the European Union for payments under loan documentation.
In general, none of the initially identified issues have prompted changes to documentation terms that are being adopted on a market-wide basis, although some minor changes are being made, for example, to references to European Union legislation to reflect its new status under English law.
The LMA has made some minor changes to its template documentation, largely focused on legislative references. These include changes to its form of 'bail-in clause', to reflect that the UK is now a third country for the purposes of the EU Bank Recovery and Resolution Directive, and to include contractual recognition of the write down and conversion powers under the UK's stand-alone bank resolution regime.
Pre-Brexit, English judgments were enforceable in EU Member States pursuant to the EU-law framework on jurisdiction, which was a reciprocal arrangement. However, post-Brexit the EU-law jurisdiction framework no longer applies in the UK (save where proceedings were instigated before the end of the transition period). As regards enforcement of English law judgments in an EU Member State, therefore, unless the jurisdiction clause is within the scope of the 2005 Hague Convention on Choice of Court Agreements, the domestic law of that EU Member State will now apply. In order for a jurisdiction clause to fall within the Hague Convention, it must be a 'two-way' exclusive jurisdiction clause (i.e., limiting both parties to the exclusive jurisdiction of the named jurisdiction).
Historically, the LMA's recommended forms of facilities agreement have included one-sided jurisdiction clauses as standard, whereby the borrower group submits to the exclusive jurisdiction of a specified country, but the lenders retain the flexibility to open proceedings in any relevant jurisdiction; these are being retained post-Brexit, but an optional alternative two-way jurisdiction clause which conforms to the Hague Convention's requirements has been included for use where appropriate.
Outlook and conclusions
2020 was dominated by the covid-19 pandemic, and its ramifications are likely to continue throughout 2021 as borrowers look to refinance facilities put in place to deal with the effects of the pandemic. If the easing of lockdown restrictions continues as planned throughout 2021, the increase in activity seen in the second half of 2020 should continue, including the continuing focus on sustainable lending. Acquisition financing is also anticipated to remain buoyant, as further merger and consolidation opportunities emerge as a result of the pandemic.
In terms of legal and regulatory issues, the transition from LIBOR to risk-free rates will be the main area of focus for most market participants. It involves considerable changes to lending operations, pricing models and documentation and will be a topic to be addressed in almost all loan transactions in 2021.