The transition in financing documentation away from LIBOR benchmark interest rates has been an important topic of discussion over the last few years. In March 2021, the UK Financial Conduct Authority announced the long-anticipated cessation of all LIBOR benchmark settings. These settings will no longer be provided by administrators or will stop being representative as of 1 January 2022 (except for some remaining US dollar settings). This article focuses on the discontinuation of LIBOR, but is also relevant for the discontinuation of EONIA on 3 January 2022 and a potential discontinuation of EURIBOR in the future.
Moving from LIBOR to alternative reference rates takes time and requires a careful process of assessing exposure and discussing this with finance providers. Documentation prepared by the LMA, ISDA, and ICMA can serve as valuable guidance. In this article, we focus on the transition in the context of loans and bonds. However, a similar transition is required for derivatives, and the ISDA has developed fall-back wording to assist in this. Time is running out and borrowers and other market participants should be preparing for the transition now.
LIBOR rates versus risk-free rates
In most instances, LIBOR rates will be replaced by risk-free rates (RFRs). However, there are important differences between these two types of rates, as outlined in our previous In context article on this topic. Most importantly:
- RFRs are overnight rights and do not compensate lenders for making funds available for a longer period of time – this means that an add-on to the RFR (the “adjustment spread”) is required
- LIBOR is forward-looking, whereas RFRs are backward-looking, providing less certainty on borrowing costs. This issue can partly be solved by using the reference rate for a set number of prior days (the “lag or lookback period”, resulting in an observation shift)
- RFRs are currency-specific, while LIBOR is quoted on the same basis for all currencies
- The various publication times for RFRs may lead to operational issues
- RFRs make a distinction between rates for secured and unsecured transactions, which LIBOR does not
In view of these differences, parties cannot simply replace a LIBOR reference by the relevant RFR in their financing arrangements, as this may lead to a commercially different outcome (and operational issues). Instead, a more comprehensive review of the financing documentation and a reset of the pricing mechanics will likely be required in most instances.
For loan documentation, the Loan Market Association (LMA) has published documentation and guidance to assist lenders and borrowers with the move to RFRs.
For new loans, the LMA has published templates for single currency term and revolving facilities agreements referencing the sterling RFR (SONIA) and the US dollar RFR (SOFR), and also a multicurrency term and revolving facilities agreement referencing compounded term rates. These templates contain provisions tailored to the new pricing and the operational changes required as a result of the differences between LIBOR and RFRs that we mentioned earlier.
Parties to new loans in non-sterling currencies that do not want to reference an RFR yet can choose from other options, depending on the level of certainty they want to have on their future RFR settings. A light-touch approach is to opt for an “amendment approach”, where a date is set for the start of negotiations on the RFR terms (with or without pre-agreed high-level terms). However, this only extends the period for reaching a substantive agreement on the post-LIBOR interest benchmark for a short time. Parties that want to hardwire the transitional provisions now may agree to a rate-switch mechanism, which allows the interest settings to switch automatically from LIBOR to the relevant RFR upon a set cessation or pre-cessation trigger event.
Parties to legacy contracts can enter into a separate “reference rate selection agreement”. This sets out the basic commercial terms for the selection of the RFR, and authorises the agent and obligors to determine the necessary amendments to the relevant facility agreement.
Since 31 March 2021, new and refinanced sterling loans that mature after 2021 are no longer available on LIBOR terms. In addition, the possibility to enter into new LIBOR loans in other currencies is expected to cease after 30 June 2021 (for Swiss franc and Japanese yen) or at the end of 2021 (for US dollar and euro). Legacy LIBOR loans for both sterling and other currencies should also transition to alternative reference rates in the coming months, where possible. Hence, over the past months we have seen an increasing use of the new LMA documentation by an ever-growing number of market parties in live transactions.
The bond market has seen a steady rise in issues of new floating rate bonds referencing RFRs over the last two years. The Working Group for Sterling Risk Free Rates has recommended that after 31 March 2021, no sterling LIBOR-linked bonds that mature after 2021 be issued. Issuers of legacy LIBOR-linked bonds need to actively transition to RFRs to maintain control over the economics of their bonds when the relevant LIBOR setting ends. This is also true for legacy bonds that contain fallback provisions, as these are generally not tailored for permanent cessation of the relevant LIBOR setting. However, the vast amount of issued bonds and their wide variety makes a multilateral protocol (as the LMA and the ISDA have prepared) unfeasible. As a result, an active transition has to take place on a bond-by-bond basis and should, in most situations, be achieved via consent solicitation.
Although in live deals, parties already base interest rates on RFRs or include appropriate transition provisions, we have seen little activity in respect of legacy contracts. However, for both borrowers and lenders, it is important that existing financing documentation also becomes geared towards the use of RFRs. To prepare, treasurers are advised to assess their LIBOR exposure, familiarise themselves with RFRs and other alternative rates, and engage with contracting parties on the anticipated process for transitioning. In addition, treasurers may need to raise awareness within their organisation, arrange for system updates where required, and consider potential tax and accounting implications.
As the transition away from LIBOR can be time-consuming and the cessation of many LIBOR settings is fast approaching, it is high time to act.