LIBOR transition – an agency perspective

Overview

The transition from LIBOR to alternative risk free rates (RFRs) represents one of the biggest changes to the financial services industry, including those providing trust and agency services. There is increasing pressure on market participants from global regulators to take action to address LIBOR transition in both new and legacy transactions. Given the volume of product and processes affected, LIBOR transition will entail considerable work and risk.

This briefing considers the issues arising from LIBOR transaction for agents appointed under Loan Market Association (LMA) based loan agreements.

Recent developments

On 16 January 2020, the Bank of England issued a public statement advising market participants that 2020 is a critical year for LIBOR transition and “firms need to accelerate efforts to ensure they are prepared for LIBOR cessation by end-2021”. At the same time, the UK Working Group on Sterling Risk-Free Reference Rates published a roadmap for LIBOR transition that included (i) ceasing the issuance of cash products linked to sterling LIBOR by end-Q3 2020 and (ii) establishing a framework for the transition of legacy LIBOR products in order to significantly reduce the stock of LIBOR referencing contracts by Q1 2021.

In relation to the legacy LIBOR contracts, any change from LIBOR to RFRs will generally need to be accompanied by a “spread adjustment” to compensate for the fact that RFRs are generally lower than the LIBOR for the same currency. Industry groups have been consulting upon methods by which that could be determined¹. The International Swaps and Derivatives Association (ISDA) published a report on 15 November 2019² summarising responses to its consultation on final parameters for the spread and term adjustments in derivatives fallbacks for key IBORs. The ISDA report found that a majority of respondents preferred the calculation of a spread adjustment to be based on a historical median of the difference between the relevant RFR and LIBOR over a five-year lookback period (as opposed to the alternative option of a historical trimmed mean over a ten-year lookback period). However, recent LMA guidance³ cautions that the historical mean/median approach should be viewed in context and may not be appropriate method for determining an adjustment in forward looking loan documents. The LMA⁴ noted that in the ABP Ports transaction (which was a transition from LIBOR to a SONIA linked floating rate note) the forward market was used to determine the credit adjustment spread. This is possible due to the active SONIA derivatives market. However, it may not be a suitable approach for other risk free rates where the derivatives market is less well established.

Key issues for loan agents

• Operations and systems will need to be updated to accommodate the determination of backward looking compounded risk free risk rates at the end of each interest period (rather than using the relevant LIBOR for the applicable period at the start of the interest period).
• New facilities which reference LIBOR and extend beyond the end of 2021 should now include provisions that envisage an alternative rate applying upon LIBOR ceasing to be available or appropriate (noting that GBP LIBOR should not be used for new deals by end-Q3 2020⁵.
• The typical contractual fallbacks that apply where LIBOR is unavailable in legacy transactions, where included, are generally not designed to deal with the permanent cessation of LIBOR and their use may be problematic and contentious. Legacy LIBOR transactions which extend beyond the end of 2021 are therefore likely to need amendment to either (i) replace LIBOR with a risk free rate and any spread adjustment and/or (ii) include appropriate long term fallbacks that will apply upon LIBOR ceasing to be available or an appropriate benchmark.
• It is likely that any amendments to legacy LIBOR transactions will be requested by lenders, but the standard LMA position is that amendment costs are only paid for by the borrower where the borrower has requested the amendment. It is therefore an open question as to who will pay the costs of any amendments relating to LIBOR transition.
• Related hedging contracts which reference LIBOR will also likely need amendment to avoid creating unintentional mismatches and basis risk between the hedge contract and facility agreement.

Dealing with legacy transactions

Aside from operational issues mentioned above, the main concern for agents will be the amendment or “repapering” of legacy LIBOR transactions.

In most cases, lenders and, to a lesser extent, borrowers can be expected to take the lead in identifying and implementing any changes to legacy transactions. The LMA has released a proposed form of amendments to transition from LIBOR to RFRs, but notably this is silent on the appropriate quantum of spread adjustment.

The main points to note in this context of amending legacy transactions are:

• Any amendment affecting the calculation of interest will usually require all Lender consent⁶, although more recent facilities may include the LMA language⁷ (or a variant thereof) that provides for LIBOR transition related amendments to be approved by the Majority Lenders and the optional inclusion of a “snooze you lose” provision.
• It is unlikely that all transactions affected by LIBOR transition will be amended before the end of 2021, simply because the volume of transactions means that it is not possible to renegotiate every legacy loan agreement.
• If the lender and/or borrower fail to take action or reach agreement, the agent will need to apply the relevant fallback provisions to determine the appropriate rate that should apply upon LIBOR ceasing to be available.

The following paragraphs consider the issues for agents where a legacy transaction is not amended to accommodate LIBOR transition.

LIBOR Fallbacks under LMA facilities

For LMA based facilities⁸, the following provisions will be relevant upon LIBOR being unavailable:

• Screen Rate: The definition of “Screen Rate” may provide that the Lender or Agent may specify another page or service displaying the relevant rate. However, this provision will not provide assistance where LIBOR is replaced by a conceptually different benchmark.
• Market Disruption: Where the Screen Rate is unavailable, the LMA market disruption clause provides for the following waterfall of fallbacks: historic Screen Rates, Reference Banks and cost of funds.

The consensus view is that LMA facilities will ultimately default to the use of the lender’s costs of funds if LIBOR is permanently unavailable. This on the basis that the provision within the definition of “Screen Rate” mentioned above will not apply and use of historic Screen Rates and Reference Banks under the market disruption clause is considered unlikely and/or unworkable⁹.

Issues with the use of costs of funds as a fallback

It is generally acknowledged that “costs of funds” arrangement under the LMA market disruption clause provisions was intended to operate as an emergency short-term solution and not intended to be used indefinitely. The use of cost of funds as a fallback where LIBOR is unavailable for a prolonged period is likely to be problematic for a number of reasons:

• From the agent’s perspective, there will be increased administrative costs if the agent is required to obtain cost of funds from each participating lender for each interest period; these costs may be significant in the case of a syndicated facility where there may be a large number of lenders.
• From the perspective of some lenders, it may be difficult for them to determine their costs of funds and/or their cost of funds may generally be lower than LIBOR such that using cost of funds will put them at an economic disadvantage.
• From the borrower’s perspective, it will lose the protection of an objective benchmark which insulates them from the consequences of an increase in a lender’s cost of funds caused by the deterioration of its credit.

More generally, fallback provisions will vary from contract to contract because the LMA provisions have evolved over time and/or amendments negotiated for specific transactions. This leads to considerable scope for disputes as to how a fallback provision should operate in any specific transaction.

Conclusions

New loan agreements should now accommodate LIBOR transition and/or use the alternative RFRs rather than LIBOR. The LMA has released standard wording for these purposes which should be included in new transactions.

Lenders should take the initiative in amending legacy LIBOR transactions, but agents should not assume that all legacy LIBOR transactions will be amended. The clear concern from an agency perspective is the risk of being faced with a cliff edge of so called “tough legacy” transactions at the end of 2021. With this in mind, agents are recommended to take the following steps to effectively position themselves to deal with legacy LIBOR transactions:

• Establish which transactions are likely to be affected by LIBOR transition and the contractual fallback.¹⁰
• Engage with lenders and borrowers to determine what, if any, action they expect to take in relation to facilities affected by LIBOR transition.
• Develop a strategy to deal with problematic legacy transactions