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15 November 2019
What will the syndicate loan market do without LIBOR?
In 2017 the FCA announced that LIBOR would be phased out and now we understand that the benchmark rate will be discontinued in 2021. This might feel a long time away but given that some expect the movement away from LIBOR to have a bigger impact than Sarbanes-Oxely, MIFID II or any other regulatory change seen recently, you probably need to start devoting time and resource to this if you haven’t done so already.
A few alternative rates have positioned themselves to take up the mantle but there are a number of issues that need to be considered and a few of these issues relate specifically for capital markets and debt fund administrators. Stephen McKenna, Director, Product Development – Private Debt & Capital Market highlights key issues and explores what questions administrators should be asking at this stage.
Where to start with reviewing your documentation
Firstly, do you know which transactions include reference to LIBOR and have you started to speak to your clients, arrangers and/or investment managers about this? If they do refer to the benchmark, what does your current documentation state? Do you have a fall back rate or the ability to replace the reference rate if it is not available or do you need to amend your documentation? If you do need to make an amendment to the legal documentation, does this constitute a trigger event or have any further repercussions? Some documentation might include the cessation of a benchmark as a force majeure event and frustrate the contract, if you do not have a sophisticated electronic document management system, it might be an opportunity to get one, otherwise, this in itself might be a significant process.
Collaboration at an industry level to find a solution
There is a lot of work going on by lots of bodies and organisations to ensure a smooth transition. The LMA is working with the market, trade associations and the regulators on the transition, although there is no obvious alternative to LIBOR for the syndicated loan market. In fact, the major challenge that LMA and LSTA are facing is the change from a term forward looking reference to an overnight risk-free backward looking rate. It does not only affect the screen rate, but the overall operational mechanics of the interest calculation and rate fixing.
The International Swaps and Derivatives Association (ISDA) has launched two consultations on benchmark fallbacks. The first consultation covers adjustments that would apply to fallback rates in the event certain IBORs are permanently discontinued, and the second relates to pre-cessation issues for LIBOR and certain other IBORs. Comments for both consultations are due by 12 July 2019.
New rates gain momentum
The use of the proposed new rates has started to gather momentum but new issuances is less of a concern. From a zero base this time last year, Sterling Overnight Index Average (SONIA) linked Floating Rate Note (FRN) issuance now dominates sterling floating rate financials issuance and there is clear momentum towards using the compounded SONIA rate across bond markets. We have also seen the first SONIA linked securitisations issued, therefore, the real focus needs to be existing transactions that are still going to be here in 2021 and beyond.
At the moment the LMA template Facility Agreement, for all types of floating rate facilities, includes the Screen Rate as LIBOR, failing that the Interpolated Screen Rate and failing that the Reference Bank Rate. At a first glance this appears to now require amendments given the fallback options also rely on LIBOR or a form there of. More importantly, the mechanics of the fixing of interest rates and interest periods should also be amended, as, as of today, the backwards looking alternative rates require that the fixing of rates is made in arrears, i.e., at the end of the period of interest. Amending commercial terms of facility agreements can be a long drawn out process since there is no industry wide alternative at present.
It is unlikely that a Trustee would use its discretion to amend the benchmark rate used and the interest calculation mechanics, and therefore will need direction, indemnification or risk relying on existing fallback provisions. Edwin Schooling Latter from the FCA stated during a speech to the ISDA annual legal forum that “We think that the best and smoothest transition from LIBOR will be one in which contracts that reference LIBOR are replaced or amended before fallback provisions are triggered”.
What rate do you look to use instead of LIBOR?
The five front runners, SOFR, ESTER, SONIA, SARON and TONAR are all overnight rates, thus backward looking rates. LIBOR was forward looking. Two of these are secured three are unsecured, LIBOR is an unsecured rate and at the moment none of the options provide a term rate. All the options are risk free rates (RFR), whilst LIBOR forward looking rates include the cost of making longer-term funds available. LIBOR has seven term rates and most of our documentation is going to include one of these variations. Three month LIBOR plus margin for example. As a result, how do we take a historic overnight rate and convert it into a forward looking term rate to satisfy our existing loans? Compounded overnight rate or historic average are a couple of suggestions but that is not really the purpose of this article.
For capital market transactions there could be added complexity. For example, hypothetically we have a repack transaction that has issued floating notes, three month EURIBOR plus margin, and has entered into a swap transaction where they receive three month EURIBOR plus margin from the counterparty in order to be able to satisfy their obligations to the noteholders. In this scenario you potentially need to negotiate and amend the terms of the note instrument with the noteholders, probably via the clearing systems and you need to negotiate the swap agreement with the swap counterparty and make sure that these match so that you can continue to fulfill your obligations. In most cases the swap counterparty will be the arranger who will be motivated to make sure this works but that might not always be the case and in any event, it still involves two lots of approvals and amendments so time is of the essence.
Once terms have been agreed and documents have been amended there are different considerations to resolve. One of these would be financial reporting and system updates. How do your systems currently work? Do they pick up LIBOR automatically and feed into your general ledger. Will you be able to do the same for the agreed replacement rate and will additional controls be required to make sure this works? Last Wednesday, the Financial Accounting Standards Board (FASB) tentatively decided to provide accounting relief for modifications to contracts as a result of ongoing reference rate reform efforts. Institutions should read and understand the details of the proposal, which are expected to be issued later this year, and take the opportunity to provide comments to the FASB
Time is money
Another consideration for this issue is cost. As discussed, the process for amending existing transactional documentation could be difficult and time consuming. Which in turn could also make it an expensive one. For loans governed by LMA terms these costs will be borne by the borrowers. For capital market transactions amendment costs would usually be paid by the Arrangers through a fees and expenses agreement and reimbursed or through the transaction cash flows which would mean that the Noteholders directly or indirectly pick up the bill. If it becomes a protracted process, there is merit in collapsing the structure and starting again through a clean new issuance.
On that basis a further alternative is that a form of LIBOR continues to operate in some capacity for existing contracts. Edwin Schooling Latter talked about how the benchmark regulations allow an administrator to continue to publish an unrepresentative rate for a reasonable period of time. We should potentially not rule out some contracts ambling on with a defunct benchmark rate.
Commitment from the industry
Although a high profile issue, it appears from a number of industry experts and surveys that the vast majority of organisations are yet to really commit to a LIBOR action plan. This seems to especially be the case on the buy side with sell side performing a little better. As a result, it is an opportunity for service providers to raise these points with their clients, assist with the action plan, add value and help negotiate what is likely to be a difficult and timely process for everybody.