July 3, 2023

SLLs: Recent oversight developments and comparing the LMA, LSTA and APLMA approaches

Nathan Cooper, Emily Julier, Louise Leung, Oliver Shafe, Bryony Widdup

Hogan Lovells

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The LMA published its Draft Provisions for Sustainability-Linked Loans on 4 May 2023, following on from the updated the Sustainability Linked Loan Principles published in February 2023. In this article, we take an in depth look at the suggested model terms, market guidance and recent FCA perspectives on these products, and compare with the US and Asia-Pacific markets, including the LSTA Drafting Guidance published on 17 February 2023 and APLMA Term Sheet (with sustainability-linked loan appendix) published on 27 September 2022.

Overview of the new LMA Draft SLL Provisions

On 4 May 2023, the Loan Market Association (LMA) published Draft Provisions for Sustainability-Linked Loans (the LMA Draft Provisions)¹. This follows the publication of the Loan Syndications & Trading Association (LSTA)’s Drafting Guidance for Sustainability-Linked Loans on 17 February 2023 (the LSTA Drafting Guidance) and the publication of Asia Pacific Loan Market Association (APLMA)’s Term Sheet (with sustainability-linked loan appendix) on 27 September 2022 (APLMA Term Sheet).

Sustainability-linked loans (SLLs) are, as we explained in our previous article, any type of loan for which the economic characteristics vary depending on whether a borrower achieves ambitious, material and quantifiable predetermined sustainability performance objectives. There is a wide world of loans where the economic characteristics of a loan are linked to sustainability performance objectives or have terms requiring the provision of sustainability information.

The LMA Draft Provisions are intended to be used in conjunction with the LMA’s senior multicurrency term and revolving facilities agreement for leveraged acquisition finance transactions (senior / mezzanine) and can be adapted for use with the LMA’s other recommended forms of facility agreement. The LMA Draft Provisions are aligned with the LMA/LSTA/APLMA Sustainability-Linked Loan Principles (SLLPs) as published on 23 February 2023 and aim to reflect current market practice and provide a drafting framework to be used by parties in the negotiation of SLL provisions. The LMA Draft Provisions contain extensive drafting notes for parties to understand the rationale and background to the draft terms as well as providing points to consider when drafting SLL provisions. Given the increased popularity of SLLs, the market has developed rapidly and this development is expected to continue. The LMA intends that the LMA Draft Provisions will evolve to keep pace with the market.

Each of the LMA Draft Provisions, LSTA Drafting Guidance and APLMA Term Sheet have been drafted to align with the SLLPs, although we note that they were not published simultaneously (the LMA Draft Provisions were published after the publication of the most recent iteration of the SLLPs). It is also of note that the APLMA Term Sheet is in term sheet form, so does not have the same level of drafting detail and perhaps includes a greater level of optionality and flexibility. While each set of provisions conforms to the SLLPs, we expect that each association has also been guided by what it sees as the prevailing market practices in its respective region in how to incorporate the SLLPs into a loan agreement (as determined through engagement with its members), and accordingly there are some significant differences between the three sets of provisions.

We note that the drafting is not mandatory and parties are free to agree the terms which suit them best whilst still aligning with the SLLPs.

Comparison of the LMA Draft Provisions, LSTA Drafting Guidance and APLMA Term Sheet

Below we set out the main differences between the LMA Draft Provisions, LSTA Drafting Guidance and APLMA Term Sheet.

	*LMA Draft Provisions*	*LSTA Drafting Guidance*	*APLMA Term Sheet*
Margin ratchet mechanism	A ‘sliding scale’ approach based on a number of key performance indicators (KPIs) (four are included but for illustrative purposes only). The margin is adjusted by reference to the number of KPIs for which the performance target has been achieved in each year. The footnotes emphasise that the mechanism should be considered on a case by case basis and that alternative approaches may be adopted (such as the ‘blended’ mechanism set out in the LSTA Drafting Guidance). The drafting contemplates a two-way adjustment where poor performance results in a margin premium (for example achieving none of the targets or the target under one KPI) and meeting specified targets results in a margin discount.	A ‘blended’ approach based on a number of KPIs (two KPIs for illustrative purposes): each KPI has a target and a threshold for each year. A reduction is applied for each target achieved, an increase applied for each threshold not met, and no adjustment is made if performance falls in the range between the target and threshold. The overall margin discount or premium is then calculated by aggregating the adjustments across the KPIs. An option is included to apply the adjustment to commitment fees as well as the margin.	Two example mechanisms are set out (using six KPIs for illustrative purposes), both of which are ‘blended’ approaches that include both a target and threshold for each KPI and each reference period. The first example sets out a grid specifying the overall discount or premium based on the number of targets achieved and thresholds not met; the second example is similar to the LSTA Drafting Guidance approach, where an increase and reduction is set out for each KPI (allowing flexibility for different weightings). The margin will be rebased each year on a specific date, so any adjustment mentioned above applies to the base margin, not to the margin as previously adjusted.
Declassification provisions	No exhaustive list of declassification events, flexibility for parties to decide as there is a lack of consensus in market and still developing. The margin adjustment is disapplied on declassification. No automatic declassification – requires lender instruction.	Not included in the main body, however an example provision is suggested in a footnote, which applies where the KPIs or targets need to be adjusted and cannot be agreed. This contemplates a margin premium for a specified period (after expiry of the initial rendez-vous period), followed by disapplication of the margin adjustment. Under this example wording, declassification is automatic if agreement cannot be reached after a certain period.	Suggested declassification events set out, including failure to deliver sustainability performance certificate or to report on KPI(s), misrepresentation in any sustainability performance certificate, [material] ESG controversy, failure to reach an agreement during the rendez-vous period (see below) and the facility no longer being aligned with the core components of the SLLPs. The example wording suggests [majority lenders’] instructions to declassify following a declassification event.
Publicity following declassification event	The companies in the borrower group must not make disclosures referencing the facility as “sustainability-linked”. We note that this does not include any backward-looking provisions requiring obligors to remove all previous references to “sustainability-linked”. As noted in the “Events of Default” row below, this obligation is not a “sustainability provision” and therefore breach could result in an event of default. The drafting notes recognise that the market varies in approach to restrictions on publicity, disclosure and reporting following declassification.	In the example wording included as a footnote, no party to the facility agreement may make public or private representations or description of the facility as a sustainability-linked loan. This restriction extends to both the borrower group and the finance parties, and is not backward-looking.	Suggested wording is forward and backward-looking, requiring the obligors, with effect from the declassification date, to cease to make any representation in all internal and external communications, marketing, and/or publication that the facility is a sustainability-linked loan and also to ensure that all materials, publication and information published by any member of the borrower group no longer refer to the facility as a sustainability-linked loan. Optional wording is also included to extend the restriction to finance parties.
Conditions precedent	None included, on the basis that the documents and evidence required as conditions precedent will be for the parties to agree on a transaction.	Suggested inclusion of a statement from the external reviewer that sustainability-linked loan provisions comply with the SLLPs (that is, a second party opinion).	Drafting suggestions include a sustainable finance framework, a second party opinion confirming alignment of the facility with the SLLPs and assessing the meaningfulness, credibility and ambition on the performance targets, and an initial certificate setting out the company/group’s performance in respect of the baseline KPIs for a certain preceding period.
Level of lender consent	The level of lender consent required is not prescribed, with optionality throughout for all lender and “Majority Lender” approval (that is, lenders with commitments representing more than 66 2/3% of the total commitments under LMA form). As noted in the drafting notes, this reflects that there is not yet market consensus on consent levels.	Increases in the size of the margin adjustment require the consent of all affected lenders. Option to include clarifying language that changes to KPI definitions and Sustainability Table can be amended by just “Required Lenders” (that is, lenders with commitments representing more than 50% of the total commitments under LSTA form).	Optionality provided for all lender and Majority Lender consent throughout, reflecting the lack of market standard.
Events of Default	Breach of a “Sustainability Provision” and misrepresentation relating to “Sustainability Information” are carved out of the events of default. Breach of a Sustainability Provision instead can result in the sustainability targets being deemed not to have been met. “Sustainability Provisions” cover the information requirements and rendez-vous clause. Notably though they do not extend to the margin adjustment clause, the indemnity in favour of the sustainability coordinator or declassification and the related publicity undertaking, and as such breach of those provisions could result in an event of default.	Breach of sustainability provisions, including failure to provide sustainability reporting is expressly not an event of default (but would result in margin adjustment being set as a positive value. If a notice is given that a sustainability certificate was materially inaccurate, there is no backwards looking default, but additional amounts, if applicable, would become payable (and such failure to pay the additional amounts is an event of default).	Little detail is prescribed, on the basis that there is no established market standard as to what constitutes a sustainability-related event of default, which shall be determined as is relevant to the company/group on a transaction by transaction basis, with reference to the interplay between the events of default generally and the sustainability-linked loan provisions.
Rendez-vous clause	The provisions provide for a period for the parties to enter into good faith negotiations to agree revised KPIs, targets and/or other changes to the sustainability provisions following a “Sustainability Amendment Event”. The specified events are non-exhaustive and include acquisitions, disposals or other transactions that impact the KPIs or targets, and changes in calculation methodologies or applicable standards that impact the KPIs and targets.	No ‘rendez-vous’ clause is included in the main body of the provisions, but the drafting notes include an example clause. The example clause includes acquisitions and disposals (and other similar transactions) and relevant changes in law as the events that trigger the requirement to negotiate adjusted KPIs and targets. The drafting notes state that it is not intended that modification of the provisions related to KPIs and targets become standard practice absent circumstances such as an acquisition or disposal of assets or regulatory changes.	A list of example “Sustainability Review Events” are set out, including changes in respect of methodology or measurement of targets, targets being inappropriate, failure to deliver or misrepresentation in a sustainability performance certificate, lack of alignment of the facility with SLLPs, acquisitions, mergers, disposals and lack of meaningfulness/ ambition in KPIs and/or targets.
Sleeping SLLs	There are no provisions that contemplate setting the KPIs and targets at a later stage.	Wording is included for future implementation of sustainability adjustments, which requires final signoff by only the Required Lenders and not all lenders. The drafting notes clarify that certain limited circumstances may warrant the inclusion of so-called “sleeping SLL” provisions for a limited post-closing period (suggested to be no more than 12 months).	Not referenced.

Takeaways

There are a few points which are evident from a comparison of the three sets of model terms:

The drafting notes are important. They add helpful background and explanation relating to the terms which have been included and some which have not.
Currently, information undertakings and the consequences of failing to comply with the core sustainability provisions of the agreement do not result in an event of default, although the delineation of “sustainability provisions” will likely be a point of some debate. We will need to watch this space to see whether the regulators provide more guidance on these points in respect of both disclosure and consequence, through voluntary guidance or greenwashing rules. We may see the event of default carve-outs further limited or removed entirely, but for the moment, the consequential rights of acceleration and cross default implications seem to be felt to be too significant a consequence and too much of a disincentive for borrowers to enter into a sustainability-linked loan structure.
We see “ESG controversies” included in the APLMA Term Sheet but not in the other model terms – that is, an adverse ESG event that may not be relevant to the KPIs being measured but nonetheless has a significant adverse ESG or reputational impact. There has been a turn towards good due diligence rather than looking to ESG controversies of late. There may still be a place for ESG controversies being included in the information covenants but controversies reflect what has gone wrong whereas the focus now is on governance which will prevent controversies before they happen.
The drafting notes in the LMA Draft Provisions recommend that the relevant calculation methodologies for the KPIs are incorporated into the loan agreement itself. While there are advantages to having the calculation methodologies clearly set out on the face of the facilities agreement, in practice it could prove challenging to ensure that the methodologies are accurately reflected and it is likely that input would be needed from an ESG consultant or other party involved in developing them, as applicable.
There is a difference of approach in respect of sleeping SLLs (that is, loan agreements which have the mechanics for SLLs but do not have the relevant commercial ESG terms, such as KPIs and targets, included). Only the LSTA Drafting Guidance includes drafting for future SLLs. This flexibility is often something which market participants are keen to include as it can take time to complete the ESG diligence process and analyse and determine applicable, relevant and ambitious KPIs and targets, and it may well not be possible for this to be carried out in a measured way ahead of signing the loan agreement in the context of a financing of an acquisition or other event-driven process (and allows for implementation without needing the consent of all lenders). However, the latest form of guidance to the SLLP states that this sleeping SLL structure should only be used “in exceptional instances, for example on deals where time is pressured and the borrower already has a clear sustainability strategy in place”, and in any event with all KPIs and targets set no later than 12 months after origination. What is clear though, is that until the SLL provisions are “woken up” (i.e. the KPIs and targets have been set and the loan is classified as sustainability-linked), the loan should not be used in a lender’s calculation towards net zero or sustainability targets.

Recent developments – FCA oversight in the SLL market – a thorny thicket?

The SLLPs and the model terms reviewed above clearly set helpful standards and provide a useful drafting base for market participants to execute SLL transactions. However, whilst sustainability-linked financing products are recognised by regulatory authorities as key enablers to delivering a market-led transition to a more sustainable economy, it is clear that regulators have ongoing concerns about credibility. Greenwashing is a particular concern, but also whether this product is actually moving the dial, even if no-one is seeking to gain from a ‘greensheen’: key questions remain to be answered as to whether performance targets are ambitious enough and relevant to the core of the business? Is the margin ratchet meaningful in the context of the interest rate to incentivise action? Are default consequences like ‘negative publicity’ going to lessen over time as failure to meet performance targets becomes more commonplace? Is the product genuinely aligned to leverage a broader sustainability strategy or just an ineffective add on?

Throughout March and April 2023, the FCA engaged the market stakeholders to better understand the functioning of the sustainable loans market and to determine whether regulatory intervention was necessary. On 29 June 2023, it wrote to stakeholders outlining its concerns about SLLs. It found that the market has grown rapidly over the last 5 years and that there are a number of weaknesses that may limit more widespread adoption and growth of SLLs, including credibility, market integrity and greenwashing concerns. It suggested that the Transition Plan Taskforce framework for credible corporate transition planning, which is due to be finalised later this year, could inform the design of more credible and robust performance targets and KPIs for SLLs. The FCA also noted that lenders need to be cognisant of potential conflicts of interest for lenders keen to promote their sustainability credentials, potentially having aligned rewards to volume, which might encourage the acceptance of weaker performance targets and KPIs in order to generate business and appear competitive. Despite the misgivings, the FCA stated that it has no current plans to introduce regulatory standards or a code of conduct for this market, but that it will reconsider this if it considers that the market needs it and indicated that the LMA’s updated SLLPs may be helpful to provide additional stringency required.

Next steps

We will continue to watch the market to observe how the LMA Draft Provisions are used on a transaction by transaction basis, recognising that many financial institutions will already have template terms that they will use for each transaction and different policies and procedures that they will need to meet in respect of ESG.

References

1 The LMA Draft Provisions can be accessed by LMA members via the LMA website.

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DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.