LIBOR – the end game
From 1 April 2021 new and re-financed loans should no longer reference LIBOR.
That is not an April fools’, but a very real milestone set by the Working Group on Sterling Risk-Free Reference Rates (the Working Group) which wants market participants to cease offering new LIBOR-linked facilities from the end of Q1 2021. This date aligns with the cessation of the publication of LIBOR expected at the end of 2021.
Since the beginning of October 2020 it has been recommended that lenders should be actively offering non-LIBOR linked products to customers and include in any new or re-financed LIBOR-linked lending clear contractual arrangements to facilitate conversion by the end of 2021, either through pre-agreed conversion terms (‘rate switch agreements’) or, preferably, through an agreed process for renegotiation to SONIA or other non-LIBOR alternatives. For further background, see my previous note on the Transition From LIBOR To SONIA.
Does this affect SMEs?
If you are an SME or large corporate which has taken on or is looking to take on institutional debt finance then the short answer is yes this is likely to affect you. Larger loan facilities, especially those based on LMA documentation are likely to feature LIBOR provisions regardless of the loan structure (e.g. bilateral, club or syndicated) or loan products offered (e.g. term lending, revolving credit facilities). The provisions surrounding interest on these loans is and will be changing.
What is changing?
LIBOR has been the UK’s standard benchmark interest rate for corporate lending, leasing and residential loans since the mid-1980s. Regulators have now made it clear that market participants should be moving away from LIBOR with a switch to risk-free reference rates (RFRs) for the calculation for interest. In most cases this will be a backward-looking compounded RFR.
SONIA is an example of an RFR, and the Bank of England and FCA are strongly encouraging its use as the replacement for LIBOR. SONIA is the effective interest rate paid by banks for unsecured transactions taking place “overnight” (in off-market hours) in the British Sterling market. It does not factor in any lender credit risk or rely on submissions from panel banks but is based on a weighted average of actual overnight funding on the wholesale of money markets. Much more in tune with actual market conditions, it is therefore considered risk free (or virtually risk-free). It can also be compounded over a lending period to produce a term interest rate. However, SONIA, and other RFRs, work in a different way to LIBOR (being a backward-looking rate rather than a forward looking projection) and for that reason is not a like-for-like replacement. This means “swapping over” may not be as simple as it sounds and diligence is needed to ensure a contractually clear transition.
So how will it look in practice? In very simplistic terms we can expect the operation of an interest clause to change from “Interest = Margin + LIBOR” to “Interest = Margin + Reference Rate” with the Reference Rate being an RFR.
Those RFR provisions will in turn be made up of a primary rate administered by a pre-agreed institution (e.g. a compounded SONIA rate) and, in the absence of a primary rate, a fall-back rate calculated on clear, pre-agreed formulas scheduled in the loan documentation. The LMA has produced exposure draft wording for calculating the compounded rates in both multicurrency and single currency facility agreements and the Working Group recommends that from 1 April 2021 new and re-financed facilities should be using such interest provisions.
For legacy transactions (i.e. existing facilities referencing LIBOR and expiring after 2021) a waterfall approach for converting from LIBOR to RFRs is set out by the Working Group. The preferred position is for loan parties to agree the administration or fall back calculation for a new RFR now and amend documentation to reflect this. However, operational and commercial issues on both sides may prevent an immediate move to a new RFR, and a transitional period may be required. Here the Rate Switch Method should be followed, allowing a change to a new RFR on either an agreed date or upon the cessation of LIBOR. This gives the parties breathing space to negotiate the finer terms of the RFR switch in the period following completion of a transaction and the imminent cessation of LIBOR.
Least optimal, and only to be used if the options above are not available is a replacement screen rate clause. This states that the parties to a loan will (by a given date or on the occurrence of a specific event) agree a suitable replacement screen rate, but gives little certainty as to what this rate would be. Although the LMA updated its replacement screen rate documentation in February 2020, the Working Group emphasises that such wording does not satisfy the requirement for ‘clear contractual arrangements’. Given that the purpose of the frameworks are to ensure a smooth transition from LIBOR come 31 December 2021, market participants should be using extra efforts to achieve contractual clarity.
Note that the Rate Switch Method and the replacement screen rate clause are intended for legacy contracts. They are not work-arounds for new/re-financed loans which should not include either if concluded after 1 April 2021.
Finally and worth noting is that smaller finance deals which have referenced LIBOR in the past may feel it is now commercially more sensible to shift to a fixed rate of interest. If both parties are happy with the distribution of economic risk on a fixed rate then it may be sensible and we have seen this on smaller transactions.
Lenders should by now be well into reviewing their existing facility documentation and their operational systems to ensure that they are ready for the LIBOR transition, ensuring new precedents have been prepared, a clear message is ready to be communicated to borrowers and all internal parts of the business are aligned to facilitate the transition.
Borrowers can expect their finance documents to change and may want to get on the front foot by speaking with lenders with a view to agreeing new reference rates or a rate switch agreement. If existing facilities are being amended obligors may have to have to re-confirm security obligations or enter into new security documents. Seek legal advice if unsure.
The End Game is coming and the date is 31 December 2021. An immediate deadline is now also in place (1 April 2021). With that said there is a good regulatory framework already established, backed up by draft legal documentation which continues to evolve with growing deal flow. The market also continues to be pro-active in sharing knowledge and finding solutions. The tools are there to ensure a smooth transition from LIBOR but it requires both borrowers and lenders to take action and avoid burying their heads in the sand.
For further information contact Aleks Wulff or Craig Bowers.