1 Why is market disruption such a hot topic?
Seismic events continue to affect the financial services industry. In 2007, one clear early sign of the liquidity “credit crunch” was an increase in the rates at which banks lent to each other on the London interbank market. This trend has continued and is reflected in high LIBOR rates, as quoted by the British Bankers’ Association. However, more and more banks have found that these quoted LIBOR rates, although high, are still significantly lower than their own cost of borrowing in the London interbank market. In these circumstances banks are looking again at facility agreements in which the interest payable to them is calculated on the assumption that LIBOR is an accurate reflection of their cost of funds.
If in fact a lender cannot access funds at LIBOR, it may ultimately have no choice but to pass on its additional cost of funds to its borrower. As such it is likely that the syndicated loan market will see increasing attempts to invoke market disruption clauses in existing transactions. Market participants will also need to think about how to structure interest calculations to address this issue before entering into new loan arrangements.
2 What does the Loan Market Association (LMA) market disruption clause say?
Most syndicated facility agreements assume that LIBOR is either the BBA’s LIBOR rate published on the Reuters screen (the Screen Rate) or (if the Screen Rate is not available) the average rates supplied to the agent by relevant reference banks.
A typical market disruption clause sets out how interest is calculated if a market disruption event occurs. A market disruption event will have happened if:
(a) the Screen Rate is not available and none or only one reference bank provides a LIBOR quotation; or
(b) enough lenders in a syndicate (typically between 30 and 50 per cent) notify the agent that their cost of funds exceeds LIBOR.
This paper considers the scenario in (b).
3 What happens when the market disruption clause is invoked?
If a lender wishes to invoke the market disruption clause it must notify the agent in writing that its cost of funds exceeds LIBOR before interest is due to be paid in respect of an interest period. The agent will need actively to monitor receipt of such notices so that it knows when enough notices have been reached to trigger the threshold for the market disruption provisions to be effective.
If the threshold is reached before close of business on the quotation day for the relevant interest period, the interest rate specified in the facility agreement is substituted with a rate which is the sum of (a) each lender’s cost of funds from whatever source it reasonably selects (i.e. LIBOR ceases to form part of the calculation), (b) the margin and (c) any mandatory costs.
Once the market disruption has been invoked each lender must notify the agent of its cost of funding, not just those lenders which have invoked the market disruption clause.
Under the LMA provisions, if a market disruption event occurs and either the agent or the borrower so requires, they have to enter into negotiations (for a period of not more than 30 days) to try and agree a substitute basis for determining the rate of interest. However, any substitute rate of interest will only be adopted if all parties agree.
4 Substitute bases for calculating interest Possible substitute bases include:
- Reference banks
The floating rate element of the interest is calculated by using quotations supplied to the agent by reference banks drawn from the syndicate. LMA agreements already contain this method of calculation but only provide for it to be used if no Screen Rate is available.
From a lender’s point of view, any reference bank solution is likely to result in some lenders still having a higher cost of funds because of the different borrowing powers of syndicate members. From the borrower’s perspective (and depending on how the calculation is made) this may result in a lower overall rate than that which it would bear if it was paying each lender’s cost of funds.
The reference bank method may however be a better default position for lenders than the Screen Rate for two reasons:
(a) rates quoted to the BBA by its reference banks are published whereas rates quoted to an agent by lenders in a particular syndicate are private. In practice this means lenders may be more willing to admit to a higher cost of funds, which is closer to their actual cost of funding; and
(b) BBA reference banks are generally larger banks which are likely to have lower costs of funds than other institutions. Lenders within a particular syndicate may (but not necessarily will) have costs of funds which are closer to those of other lenders in that syndicate.
- All lender costs of funds
Interest is calculated as the sum of (a) the margin, (b) the cost of funds of each lender from whatever source it may reasonably select and (c) any mandatory costs.
This method of calculating interest is effectively the one used in the market disruption clause, so is unlikely to be used as a substitute after the market disruption clause has been triggered. However, it could be used as the basis for calculating interest in new deals where LIBOR is not seen to be an appropriate base of funding.
However, some issues to be aware of are:
- The agent will have a significantly greater administrative burden. The agent will need to be comfortable that the method of calculating interest is not too complicated to work in practice.
- The agent will want to ensure the facility agreement allows it to charge an increased fee and/or for any additional management time involved.
- The facility agreement will need to set out clearly all information flows between borrower and lenders so that the agent can manage the extra information it is receiving without breaching confidentiality requirements.
- Each lender’s funding rate is market sensitive confidential information and exchanging this with competitor lenders could lead to breaches of competition law. An agent may be fined for its part in a cartel even though it is not a competitor or even a participant in the same market; fines for breaches of competition law can be substantial. The agent will want to deal separately with each lender (and even ring fence the information from other divisions of its own bank). A borrower too might conceivably become a conduit for the exchange of market sensitive information, so should not disseminate any price-sensitive information it receives. The agent should also probably consider strengthening agent protection provisions, such as the ability for the agent not to take action which it reasonably considers might constitute a breach of any duty of confidentiality, law or regulation.
- Careful thought needs to be given as to how to calculate the floating rate which represents the lenders’ costs of funds. For instance:
- If the rate is a “blended” rate how will the facility agreement set this out?
- Rather than being blended, should calculation of interest due on each lender’s participation use that lender’s own cost of funds (as it would when the market disruption clause is invoked)?
- To what extent should the Borrower know (or be able to challenge) the basis on which an individual lender has calculated its cost of funds?
5 Just when you thought it was safe
Also bear in mind:
- Interest rate swaps are usually linked to a benchmark floating rate (e.g. BBA LIBOR) so could an alternative method of calculating interest be used where the facilities are hedged? Would a hedging counterparty ever price its hedging against a syndicate’s cost of funds or a rate derived from reference banks within a syndicate (particularly as lenders in any syndicate can change over time)?
- Should borrowers be able to stop transfers to lenders which have higher costs of funds?
- Could alternative methods of calculation influence the secondary market? If a lender has transferred all or part of its economic interest in a loan by way of a sub-participation, the sub-participant’s cost of funds will not be relevant in determining the interest rate payable by the borrower, because the original lender remains lender of record. Therefore a sub-participant may receive less than it would have done if it were lender of record.