This article seeks to provide a brief summary of recent developments relating to the replacement of LIBOR, with a particular focus on English law term loan documentation, including the drafting produced by the Loan Market Association ("LMA")[1] endorsed by the Working Group on Sterling Risk Free Rates ("RFRWG")[2].
A distinction should be drawn between provisions designed to apply to a fallback scenario (i.e. discontinuance of LIBOR) and provisions designed to apply to a transition scenario (i.e. where a replacement rate becomes available prior to discontinuance of LIBOR), given that regulators such as the UK Prudential Regulation Authority ("PRA") and Financial Conduct Authority ("FCA") have emphasized that they would expect contracts referencing LIBOR to be replaced or amended before LIBOR is discontinued, rather than at the actual point of discontinuance.[3]
The recommended LMA rider[4] is a fallback provision in the sense that it responds to discontinuance of LIBOR. However its only function is to regulate the voting threshold in a syndicated facility for certain matters, namely amendments necessary to give effect to a replacement rate. It does not set out a comprehensive fallback regime (i.e. a set of changes which automatically come into effect when triggered to address discontinuance). Instead it contemplates that facility agreement parties will agree those changes once it is triggered. It has no application to a bilateral facility or where a change in the voting threshold does not have a material impact. It is also drafted on the basis that a replacement rate exists but the parties have not yet transitioned to it when discontinuance occurs.
From our experience, some lenders wish to address the fallback scenario, despite the regulatory guidance which should, if followed, make it unnecessary to do so (because the relevant facility will have been replaced or amended before discontinuance occurs). For such lenders, the starting point is to analyse how the facility agreement as it currently stands would respond to a fallback scenario. The position varies from one facility to another depending on the interest rate fallback options which apply (if any) and the way in which they are drafted. In LMA-based documentation if there is a historic rate fallback that may apply, probably for a finite period. If reference banks are used, their cost of funds may apply. Otherwise the market disruption provisions are likely to apply and substitute the lender’s cost of funds. In some cases there may be no applicable fallback. Based on this analysis a lender might wish to clarify the way in which the relevant facility (existing or to be entered into) responds in a fallback scenario.
Nonetheless, we would expect the main focus of facility agreement parties to be on addressing the transition scenario, given that the development of forward looking term rates based on the risk free rates (RFRs) selected following the Financial Stability Board’s 2014 report[5] is apparently progressing as planned[6], on a timeline which is based on the cessation of LIBOR in December 2021 (in line with announcements made by the FCA)[7]. Therefore a key question for facility agreement parties to consider is whether/when sufficient information is available about the replacement rate to allow a complete set of amendments to facility agreement wording to be produced which will effect a transition.
There appears to be a difference of opinion on this question between the RFRWG (in which the LMA participates) and the Alternative Reference Rates Committee (ARRC) (in which its New York law counterpart, the Loans Syndication Trading Association ("LSTA") participates. The ARRC has produced a draft set of "hardwired" amendments[8] employing a menu of interest rate fallbacks which could be inserted in a facility agreement at this point in time. However the drawback with these provisions is that they rely heavily on the making of determinations and exercise of discretions by the agent, in order to fill in the gaps that naturally arise because of the present lack of information about the SOFR-derived forward-looking term rate. The RFRWG is not supportive of this approach, taking the view that there are too many uncertainties at this stage to be confident that their application will produce the result intended[9]. Further, some administrative parties have indicated that the assumptions the draft provisions make about their capacity and willingness to perform these various functions are potentially problematic.[10]
Assuming a suitable forward looking RFR-derived term rate becomes available, although additional guidance can be expected from the RFR working groups, it is unlikely that facility agreement parties will be able to apply it mechanistically.[11] For example, one issue that facility agreement parties will need to consider is how to address any possible transfer of economic value arising from the transition. A possible solution may be to use a set of "hardwired" provisions which apply a spread adjustment based on an agreed methodology for achieving economic neutrality.
Ultimately the development of forward looking RFR-derived term rates is not absolutely certain; although the USD and Sterling working groups acknowledge that there is substantial demand for them[12], they have also made it clear that it will not be possible for them to be created unless sufficient liquidity develops in other products (particularly swaps and options) referencing the relevant RFR from which a forward looking term rate would be derived.[13] The expected process could also be affected by other factors, including the decentralized allocation of responsibility for the development of RFRs in the respective currencies and potential basis risk in respect of related hedging transactions. Facility agreement parties may therefore decide it is best to try and address both transition and fallback scenarios, but there is a potential dilemma from a timing perspective given that they will want to keep the number of times each facility agreement is amended to a minimum.
EU27 and UK financial institutions are, in general, only permitted to use benchmarks which comply with the Benchmarks Regulation[14] (or UK equivalent,[15] post Brexit) or in respect of which a determination of equivalence has been made or which has been recognised or endorsed under that Regulation. Where the regulatory regime applicable to a lender gives it a greater degree of flexibility, then a wider range of options may be available (e.g. other benchmarks[16]), which may affect the transition strategies available to it and its counterparties.
More generally, materials have been produced by the working groups and trade bodies for market participants to help them manage transition, risk identification, systems and infrastructure issues and other matters[17]. In line with the requirements of the Benchmarks Regulation, the FCA in September 2018 wrote to the CEOs of large banks and insurance companies regulated by it requiring them to produce a summary of their assessment of key risks relating to LIBOR transition and details of the actions they plan to take to mitigate those risks[18]. Surveys conducted by industry bodies vary as to the level of awareness and preparedness among market participants[19]. The LIBOR Trade Association Working Party commented in September 2018 that "there is still a lack of awareness of the issues relating to LIBOR transition, particularly so in developing markets"[20].
Although, as already mentioned, the FCA stated in 2017[21] that it will not require panel banks to continue contributing input data beyond December 2021, it recently also indicated[22] that it considers it has the power under the Benchmarks Regulation to permit or require publication and limited use of LIBOR for a period following general cessation, to the extent necessary to avoid the occurrence of force majeure, frustration or breach of existing financial instruments. Although the possible exercise of such a power would have a significant impact in terms of the analysis set out above, it leaves a number of questions and areas of uncertainty including:
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whether facility agreements which contain LMA market disruption provisions would be considered as affected by force majeure for these purposes[23];
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how the scenario contemplated would be treated in terms of fallback/transition provisions;
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the methodology that would be used to produce LIBOR in these circumstances particularly if a large number of contributors have decided to cease providing data;
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how long the limited extension of LIBOR would be available, bearing in mind that some affected agreements will have a long duration. The relevant Article[24] of the Benchmarks Regulation[25] refers to a "reasonable time period";
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whether there is any cut-off date for the entry of new agreements/instruments which may be permitted to use LIBOR following general cessation.
[1] https://www.bankofengland.co.uk/-/media/boe/files/markets/benchmarks/risk-free-reference-rates-replacement-of-screen-rate-clause.pdf?la=en&hash=69D8106F9D8FC4BE97F67A214B456D4DEC5A893E
[2] It should be noted that, as stated by the RFRWG, "developments in this area are many and frequent, with statements being issued by benchmark administrators, regulators in each of the relevant jurisdictions for the main currencies for which LIBOR is quoted, and industry bodies" (paragraph 6 of the paper referred to in footnote 9 below).
[3] https://www.fca.org.uk/news/speeches/libor-transition-and-contractual-fallbacks
[4] Referenced in footnote 1 above.
[5] http://www.fsb.org/2014/07/r_140722/
[6] https://www.bankofengland.co.uk/-/media/boe/files/markets/benchmarks/rfr-timeline-with-milestones.pdf?la=en&hash=93421F3ADFF423707AA0D430980751E3BEA23A05
https://www.bankofengland.co.uk/-/media/boe/files/markets/benchmarks/libor-transition-and-development-of-a-term-rate-based-on-sonia.pdf?la=en&hash=27A2CF8298A8FD9EDE3E76B653BD5101F2F99E7E
https://www.newyorkfed.org/medialibrary/Microsites/arrc/files/ARRC-progress-timeline.pdf
http://www.fsb.org/2017/10/reforming-major-interest-rate-benchmarks-4/
https://www.afme.eu/en/reports/publications/ibor-global-benchmark-survey-2018-transition-roadmap/
[7] https://www.fca.org.uk/news/speeches/the-future-of-libor
[8] https://www.newyorkfed.org/medialibrary/Microsites/arrc/files/2018/ARRC-Syndicated-Business-Loans-Consultation.pdf
[9] See paragraph 24 of "New and legacy transactions referencing Sterling LIBOR" (https://www.bankofengland.co.uk/-/media/boe/files/markets/benchmarks/new-and-legacy-loan-transactions-referencing-sterling-libor); LMA letter of 21 November 2018 responding to ARRC consultation regarding more robust LIBOR contract language for new originations of LIBOR syndicated business loans (https://www.newyorkfed.org/medialibrary/Microsites/arrc/files/syndicated-business-loans/Loan-Market-Association.pdf).
[10] "LIBOR: banks don’t want to be calculation agents" (IFLR, 28 November 2018).
[11] Please see footnote 9.
[12] https://www.bankofengland.co.uk/-/media/boe/files/markets/benchmarks/term-sonia-reference-rates-consultation-summary-of-responses.pdf?la=en&hash=CFD2AB11A3156B31CB15030962ECA9987BEFCED8
https://www.newyorkfed.org/medialibrary/Microsites/arrc/files/ARRC-faq.pdf
[13] http://www.fsb.org/2018/07/interest-rate-benchmark-reform-overnight-risk-free-rates-and-term-rates/
https://www.bankofengland.co.uk/-/media/boe/files/markets/benchmarks/libor-transition-and-development-of-a-term-rate-based-on-sonia.pdf?la=en&hash=27A2CF8298A8FD9EDE3E76B653BD5101F2F99E7E
[14] Regulation (EU) 2016/1011 - https://eur-lex.europa.eu/legal-content/EN/TXT/?uri=CELEX%3A32016R1011
[15] http://www.legislation.gov.uk/ukdsi/2019/9780111179208
[16] For example, Intercontinental Benchmark Administration (ICE) the current administrator of LIBOR claims to have already developed a workable forward looking SONIA-derived term rate – see https://www.theice.com/publicdocs/futures/Bank_Yield_Index_WP.pdf . The RFRWG recently invited proposals from prospective benchmark administrators: https://www.bankofengland.co.uk/-/media/boe/files/markets/benchmarks/libor-transition-and-development-of-a-term-rate-based-on-sonia.pdf?la=en&hash=27A2CF8298A8FD9EDE3E76B653BD5101F2F99E7E
[17] https://www.bankofengland.co.uk/-/media/boe/files/markets/benchmarks/what-you-need-to-know-about-libor-transition.pdf?la=en&hash=C1AF77CC308280CF84794D152005A3635546A850;
https://www.bankofengland.co.uk/-/media/boe/files/markets/benchmarks/infrastructure-and-systems-preliminary-priority-list.pdf?la=en&hash=BED990A60D1565B805E1931C992C407BAAB50F22;
https://www.newyorkfed.org/medialibrary/microsites/arrc/files/2017/October-31-2017-ARRC-minutes.pdf;
See page 35 of https://www.isda.org/2018/06/25/ibor-global-benchmark-transition-report/.
[18] https://www.fca.org.uk/publication/correspondence/dear-ceo-letter-transition-from-libor-banks.pdf
[19] Compare https://www.isda.org/a/OqrEE/IBOR-Transition-Report.pdf and https://www.jcragroup.com/wp-content/uploads/2018/07/JCRA_Libor-to-SONIA_survey-results.pdf.
[20] https://icmsa.org/wp-content/uploads/2018/10/Minutes-of-LIBOR-Trade-Association-Meeting-10-September-2018.pdf
[21] See note 7 above.
[22] See note 3 above.
[23] Commission Delegated Regulation (EU) 2018/67 which sets out relevant criteria but in the context of a different Article, refers to agreements/instruments which "do not provide for a substitute benchmark or do not contain rules on how such a substitute benchmark shall be determined or any other appropriate contingency measures".
[24] Article 11(4).
[25] Replicated in the Exit SI.
