One of the most important processes in financial markets in recent years has been the transition from using interbank offered rates (“IBORs”) and in particular the London interbank offered rate (“LIBOR”) as the interest rate benchmark, to using “risk free” rates (“RFRs”). This culminated in the cessation of thirty-five different LIBOR rates on 31 December 2021. Publication of the 1, 3, 6 and 12-month US dollar LIBOR settings will cease immediately after 30 June 2023.
We consider below some of the practical implications of the cessation of LIBOR and some of the consequent issues for loan documentation.
Sterling Working Group Recommendations
The UK Financial Conduct Authority’s (“FCA’s”) Sterling Working Group on UK Risk Free Rates (the “Working Group”) previously recommended conventions for referencing Sterling Overnight Interbank Average Rate (“SONIA”) in loans, and SONIA remains the Working Group’s recommended alternative to Sterling LIBOR. These recommendations are not binding and recognise that an alternative methodology or rate may be more appropriate or convenient in a specific situation, and that market conventions may continue to evolve over time.
The key features of SONIA as generally implemented in accordance with the Working Group recommendations are:
- Compounding in arrear, non-cumulative approach;
- Lookback without observation shift, although lookback with observation shift is seen as a robust and viable alternative; and
- Credit adjustment spread (“CAS”).
Approach Taken by Banks and Borrowers to These Recommendations
During 2021, we have seen documentation for a series of existing financing transactions being amended to incorporate rate switch mechanisms, whilst new financings are incorporating RFRs from the outset. This activity accelerated significantly in the last quarter of 2021 with the approaching deadline for LIBOR cessation. Frameworks are now largely in place globally, although some bank, agent and borrower systems are still being updated, for example to cater for term RFRs. Borrower engagement with the process and understanding of the issues involved has been good overall.
The market is in general following the Working Group recommendations in one form or another. While we have seen the majority of banks in the Irish market adopt the compounding in arrear, non-cumulative approach along with the lookback without observation shift, we have seen some adopt the cumulative approach (which we understand is driven by a systems requirement).
Following the transition to RFRs, the market is now entering a more practical phase of establishing new market practices and corresponding frameworks, conventions and choices. Below we look at some of the issues arising in practice.
We have seen two approaches in the market: one where the CAS is expressed separately (so RFR + CAS + Margin) and the other where the margin is amended to include the CAS (so, RFR + Margin (which includes CAS)). The former approach appears to be the market preference at the moment. One factor driving this is that a CAS is generally required to be expressed as a standalone pricing element where a loan has historically been priced on a LIBOR basis. This is because a RFR will typically be lower than LIBOR and the cessation of LIBOR is not intended to erode the economic allocations of existing loans. Given that much of the market movement regarding RFR has been to document switches from LIBOR to RFR midway through a loan’s term, to factor CAS into margin may be viewed by borrowers as increasing lenders’ profit margin midway through the term of a loan. A follow-on trend in this market context is that new loans will include CAS as a standalone pricing element so that, for transparency purposes, margins don’t appear to be increasing the profits of lenders across the market. As the market settles during the course of 2022, it is our view that the latter approach (ie, margin being amended to included CAS (if applicable)) might become more prevalent.
Other issues in relation to CAS are also still being settled, including the difference between historic and forward spreads, which is leading to discussions between the financing parties.
Consistency With Hedging Arrangements
The IBOR Fallbacks Supplement and Protocol published by the International Swaps and Derivatives Association (ISDA) provide solutions to the problem of contractual continuity, but they might not be appropriate if the relevant loan is not transitioning in the same way. For example, the respective floating rates might have different methodologies as to observation shift, lookback or calculation of the CAS.
This mismatch could lead to a borrower not receiving enough under the hedge to cover its liabilities on the loan and there might be adverse tax consequences. Borrowers must also be confident of being able to meet their hedging covenants under the loan documentation.
Parties might be comfortable with the level of risk, so that exact matching of loan and hedge may not be necessary. On the other hand, a bespoke arrangement might be required, although this is a lengthy process. The best solution depends on the precise deal in question, the resources of the parties and their assessment of the risks. We are seeing a variety of approaches, and the market has not yet developed a standard practice in this regard.
The concept of break costs was originally based on the assumption that lenders will have funded a loan by "match-funding" arrangements (that is, borrowing an amount equal to the amount of the loan for a period equal to the interest period). It may therefore be argued that the use of a RFR suggests that lenders are likely to be obtaining funding on a rolling overnight basis, which undermines the commercial rationale for the break costs concept.
With the introduction of RFRs, it might be possible for lenders to incur and to quantify break costs in an alternative manner, for example by reference to breakage costs that would arise on an appropriate fixed/floating interest rate swap broken at the date of repayment/prepayment. This would require the development of a recognised and established methodology, as well as a sufficiently liquid market in the relevant swap contracts; time will tell whether a generally accepted market practice will arise in this respect.
At present, however, lenders don’t appear to be insisting on break cost clauses and may simply restrict the number of mid-term prepayments to limit any administrative burden.
Length of Voluntary Prepayment Notice Periods
In relation to voluntary prepayments of compounded rate loans, parties need to carefully consider the length of the relevant notice period. This should perhaps be structured to take into account the amount of notice needed by all parties of the amount of accrued interest payable on that prepayment, as well as the processes involved in calculating that amount. To achieve a similar length of notice that the lookback mechanic provides for the amounts of scheduled payments of interest, the notice required for such a voluntary prepayment should be no less than the applicable lookback period.
Also to be considered is the extent to which the consent of the facility agent should be required for a short notice of prepayment of a compounded rate loan, given the facility agent’s role in calculating the amount of accrued interest due.
The issue of fallbacks/replacement of screen rate under IBORs remains (now referred to as “changes to reference rates” in the Loan Market Association (“LMA”) documentation). While the position has largely settled for compounded RFR loans (ie central bank rate and then cost of funds), there is as yet no agreed market consensus on long-term fallbacks for term RFR rates and we will have to wait and see how the market approaches this during 2022. For example, where a loan is term rate-based, it is not yet settled whether the fallback needs to match that term rate.
The suitability or otherwise of the use of a lender's costs of funds as an ultimate fallback has generated much debate and particularly as regards:
- the difficulty that some institutions experience in assessing their "cost of funds" associated with funding their participation in a loan. This can be particularly acute when institutions assess the cost of their funding requirements on an aggregated non-granular basis;
- the administrative burden placed on the facility agent when the interest rate for any particular loan falls to be determined on a cost of funds basis;
- the perception among some borrowers of a lack of transparency.
The use of cost of funds as an ultimate fallback (after central bank rates) has been included in the LMA documentation as an optional fallback for compounded rate loans. Inclusion or otherwise will depend on the structuring of transactions and on commercial agreement. If it is not to apply as a fallback in the event of the unavailability of either a RFR or a central bank rate, parties should consider whether any other fallback could be specified for such a scenario.
Market Disruption Events
Market disruption provisions were traditionally based on the presumption that facilities were priced on the basis of a benchmark intended to approximate (by way of forward-looking quotations) the lenders' likely cost of funds in the secondary market (the “non-margin interest element”), plus a margin.
Parties need to determine whether these underlying funding considerations regarding the non-margin interest element remain relevant to loans which switch to be based on RFRs, and therefore whether the concept of market disruption is appropriate in relation to those loans. In that regard:
- The LMA documents have catered for market disruption for RFR loans. In the LMA documents, the Market Disruption Rate is expressed to be the Cumulative Compounded RFR Rate for the relevant Interest Period plus the relevant CAS. This reflects that market disruption is assessed by reference to the Interest Period as a whole. The Cumulative Compounded RFR Rate for an Interest Period is intended to be economically identical to the combined effect of the application of each individual Daily Non-Cumulative Compounded RFR Rate.
- In practice, however, borrowers may query the need for a market disruption regime in an RFR context and resist its inclusion. Market disruption provisions are historically aimed at protecting lenders’ margins where forward-looking quotations for the non-margin interest element of IBOR loans do not accurately reflect the costs of funding in the market at a given time. Unlike IBORs, RFRs do not rely on forward-looking quotations but rather overnight average rates. As such, the need for market disruption protections to “future-proof” against unforeseen market changes is arguably no longer applicable under RFR regimes, and a borrower may further argue that a lender’s inability to fund at the applicable rate is not indicative of a market-wide disruption.
Tough Legacy Contracts
For some existing financings where the contractual arrangements do not provide adequate fall-back language (“tough legacy contracts”), there is a valid reason why LIBOR-related amendments have been delayed. Tough legacy has become a recognised category of transactions that has been addressed in legislation, for example in the UK to provide for the continuation of synthetic LIBOR.
Regulators continue to stress, though, that tough legacy legislation is not a definitive solution, but only a stop-gap and that active transition to RFRs by amendment should remain the focus. One of the main themes for 2022 is likely to be the need for continued messaging and engagement (especially with borrowers) to encourage segments of the market to catch up.
The FCA will at some stage deliver its decision on the future of synthetic LIBOR for 1, 3 and 6-month Sterling and Yen.
EURIBOR continues for now to be used as an interest rate benchmark for euro loans and currently, there are no plans for its discontinuance. While some of the LMA documentation has options for including reference to EURIBOR at the outset, along with a rate switch mechanism to refer to the Euro Short-Term Rate (€STR), we are not seeing this approach being adopted in the market at the moment. Instead, we continue to see loan documentation include various fallback provisions along the lines of what has been included in documentation for a number of years in light of the market being aware of impending changes to the IBOR regime, under “Change to Reference Rates/Replacement of Screen Rate” language.
It’s an area that we will be keeping a close eye on during the course of 2022.