What is happening?
Since our article on the topic in the December 2020 edition of Legalflyer (link), there have been further developments in the retirement of LIBOR. On March 5, 2021, the UK’s Financial Conduct Authority (as regulator of ICE Benchmark Administration, which publishes LIBOR) announced that:
- As from December 31, 2021 LIBOR will either cease to be provided or will no longer be representative for US Dollars in 1 week and 2 month tenors and for GBP, euro, Swiss Francs and Yen in any tenor; and
- As from June 30, 2023 LIBOR will either cease to be provided or will no longer be representative for all remaining US Dollar tenors (i.e. overnight, 1 month, 3 month, 6 month and 12 month US Dollar LIBOR tenors).
Why does it matter?
Although LIBOR will still be published for the most popular USD tenors until Q2 2023, regulators have re-emphasized the need for new and refinanced transactions to no longer reference LIBOR and to prepare for legacy LIBOR deals to transition to new benchmarks.
As aircraft are a US Dollar asset, the most important risk-free rate for the aviation industry is the Secured Overnight Financing Rate (SOFR), the risk-free rate identified for US Dollars. The Alternative Reference Rates Committee of the Federal Reserve Bank of New York (ARRC) has stated that new US Dollar LIBOR lending should cease by end of Q2 2021, with the Federal Reserve Board issuing supervisory guidance to US banks “cease entering into new contracts that use USD LIBOR as a reference rate as soon as practicable and in any event by December 31, 2021”. The approach taken by other regulators may vary between jurisdictions, but these statements will be persuasive.
What does this mean for financing documentation?
We will increasingly start to see US Dollar lending referencing SOFR from the outset for new and refinanced facilities.
In the short term, fallback provisions, which pre-agree a mechanism for a loan facility to transition from LIBOR to SOFR on a future date, may be used, after which regulators are likely to require parties to use SOFR from the outset.
The drafting approach taken varies between markets. In the London and European markets, the Loan Market Association (LMA) ‘switch clause’ is widely used – this drafting provides more certainty for a borrower as all of the terms of transition are agreed upfront in the clause.
Whereas, in the US market, use of the ARRC recommended “hard wired approach” wording as incorporated into the Loan Syndications and Trading Association’s (LSTA) precedent facility agreements is widespread amongst US-regulated banks. This drafting pre-determines the selected rate calculation method for SOFR by reference to a waterfall and leaves the lenders with more flexibility to make “Benchmark Conforming Changes” (being the changes required to ensure that the new rate works within the context of the loan facility).
The FCA’s announcement of March 5 may have triggered certain consequences in existing finance documentation depending on the drafting formulation used.
- Existing Loan Documentation (based on LMA wording): It is likely that the FCA announcement triggered a “Screen Rate Replacement Event”. The usual consequence of this is that the consent threshold in the loan agreement to agree to a change of benchmark is reduced from all lender consent to Majority Lenders. In documentation including a rate switch clause, it is also likely that the FCA announcement constituted a Rate Switch Trigger Event. The usual consequence of this is that the Agent may be required to notify the Borrower that the Rate Switch Trigger Event has occurred, however the actual switch to a compounded in arrears risk free rate for a LIBOR currency would usually occur upon the cessation of the rate or upon it ceasing to be representative with respect to a quoted tenor of LIBOR for that currency or as otherwise agreed between the parties. However, parties may wish to check documentation that refers to these terms to see if any other contractual consequences arise.
- Existing Loan Documentation (using the ARRC’s “hard wired” approach): Note that the FCA announcement amounted to a “Benchmark Transition Event” under the ARRC wording, thereby setting the future date on which transition will occur to the replacement rate, provided the parties have not elected to transition earlier under the “Early Opt-In Election”. (After the announcement, the wording was updated to reflect that this event has already occurred). The ARRC’s recommended spread adjustments were set on the same date as ISDA’s spread adjustments – see below.
- International Swaps & Derivatives Association (ISDA) Swaps: This announcement by the FCA also constituted an Index Cessation Event under ISDA’s 2006 Definitions as updated by the ISDA IBOR Benchmarks Supplement and Protocol. This had the effect of fixing the credit adjustment spread based on the historical median approach for the purposes of relevant ISDA documentation. Please visit our "IBOR transition – are you prepared" website for further details.
What should I be doing?
- Avoid use of LIBOR: New and refinanced transactions will increasingly use risk free rates from the outset with the LMA's ‘Switch clauses’ and the LSTA's 'hard-wired approach' wording now only available for use in the short term, depending on where lenders are regulated. In addition, the use of LIBOR should be avoided in clauses such as operating lease default rate provisions where there is no connection to any underlying financing. We can advise on suitable alternatives.
- Audit existing financings which reference LIBOR:
- Borrowers and lenders alike should identify any existing LIBOR referencing documentation that extends beyond Q4 2021/Q2 2023, as applicable.
- Interlinking financial products such as a hedging agreement or a limited recourse loan and lease structure are likely to need to transition at the same time and on the same basis. This is particularly the case for interest rate hedging, as a mismatch could cause basis risk.
- Note that references to LIBOR will not only be found in loan documentation, but also, for example, in the formula for calculating floating rate rentals in operating leases and in default rate provisions.
- Parties should establish whether any consents or approvals, including regulatory approvals, would be required to change a benchmark and the required time to allow for this.
- Familiarise yourself with the terminology and concepts:
Parties will need to familiarise themselves with SOFR, the different methodologies which can be used to calculate SOFR for use in loan agreements and the terminology involved, bearing in mind the differing approaches across different markets.
If you would like to find out more about the latest developments of LIBOR transition, please visit our "IBOR transition – are you prepared" website.