What are the latest developments in the transition away from LIBOR? David Osborne, Dominic Pearson, Louise Mor and Elaine Ashplant of law firm Watson Farley & Williams LLP consider the most relevant announcements.
The IBA, the benchmark administrator for LIBOR, was consulting on the future of USD LIBOR with a view to it continuing until the end of June 2023.
On 5 March 2021, the Financial Conduct Authority (FCA) confirmed that this would be the case except for the quoted tenors for one week and two months which will cease to be published at the end of 2021. The remaining tenors will continue to be published at least until the end of June 2023 with the FCA considering whether to require IBA to publish a synthetic form of one-month, three-month and six-month USD LIBOR settings for a further period after that date to assist with Tough Legacy Contracts. However, new use of any synthetic LIBOR by UK-regulated firms in regulated financial instruments will be prohibited and continued use by regulated firms in legacy financial instruments will also be subject to FCA restrictions.
In the US, the Federal Reserve Board, the Office of the Comptroller of the Currency, and the Federal Deposit Insurance Corporation have issued supervisory guidance encouraging banks to “cease entering into new contracts that use US Dollar LIBOR as a reference rate as soon as practicable and in any event by December 31, 2021”.
However, the ARRC has confirmed that it will not be able to recommend a SOFR term rate by mid-2021 and has encouraged market participants to continue to transition from LIBOR using the tools available now (such as SOFR averages and index data that can be applied in advance or in arrears) rather than wait for a forward-looking term rate for new contracts. As a SOFR term rate is the first option in the ARRC Hardwired Fallback Language, this is clearly something the loan market has been hoping for. However, in the UK, regulators are not keen on reliance on forward-looking term rates as they are seen as more vulnerable to manipulation. Notwithstanding its announcement, the most recent version of the ARRC Hardwired Fallback Language still refers to the SOFR term rate as the initial fallback.
Documenting transition has also become slightly more settled as the LMA has now published its multi-currency rate switch agreements as recommended forms rather than as exposure drafts, as well as publishing recommended forms of day one RFR-based facility agreements. However, although intended to be used for other LIBOR currencies, including US Dollars, all the mechanics follow the recommendations of the Sterling working group and therefore diverge from the recommendations of the ARRC. Moreover, the commercial issues left unaddressed in the exposure drafts (such as break costs, market disruption, cost of funds and some rounding conventions) remain to be agreed by the parties.
Not to be outdone, the LSTA has published a multi-currency facility agreement as a concept document that includes day one RFR-based facilities that use the ARRC’s preferred option of simple SOFR as opposed to the LMA’s compounded rate. It also contemplates a future switch to a SOFR term rate when available, again reflecting the ARRC approach.
Staying in New York, the New York State governor, Andrew Cuomo has signed LIBOR legislation proposed by the ARRC to address the issue of some legacy contracts referencing USD LIBOR, which should facilitate a change to an alternative rate on the discontinuance of USD LIBOR. As a New York law, it may, however, be of limited assistance in relation to contracts governed by other laws.
Consequences of the FCA announcement
LMA screen rate replacement wording: Where the optional LMA screen rate replacement event definition forming part of this wording has been included in facility agreements, the FCA’s announcement on 5 March will constitute such an event where the most recent LMA optional wording for the definition (published 21 October 2020) was used. However, earlier versions do not include, as a screen rate replacement event, a statement that LIBOR has or will cease to be representative of the underlying market or economic reality that it was intended to measure and instead simply refer to discontinuance of LIBOR. This creates uncertainty, owing to the fact that a synthetic version is likely to continue to be published, albeit regulated lenders might not be permitted to use it. That said, the LMA wording simply facilitates amendment with the option of an agreement by majority lenders rather than all lenders plus a ‘snooze you lose’ option to address the risk of non-responsive lenders. In many asset finance deals, the syndicates are small and the inclusion of the use of the definition was also optional. Many deals since late August 2020 also include the LMA Optional Backstop and therefore are not wholly dependent on a screen rate replacement event having occurred since this will operate to trigger negotiations and any changes to syndicate voting.
ARRC wording: The ARRC has confirmed that the FCA’s announcement on 5 March will constitute a “Benchmark Transition Event” for all USD LIBOR settings. However, this does not trigger an immediate transition to a SOFR-based rate under ARRC Hardwired Fallback Language but will start the process to agree a new rate under the ARRC Benchmark Replacement Amendment Language. Actual transition under ARRC Hardwired Fallback Language is based upon the “Benchmark Replacement Date,” which is expected to be on or immediately after the dates the relevant LIBOR tenors or settings stop being published, (so 31 December 2021 for 1 week and 2 month USD LIBOR, and 30 June 2023 for overnight, one-month, three-month, six-month, and 12-month USD LIBOR) depending on the options selected such as an earlier backstop date or not switching if not all tenors/settings stop being published.
ISDA Fallbacks: For USD interest rate hedging based on ISDA forms, the FCA’s announcement constitutes an index cessation event under the IBOR Fallbacks Supplement and the ISDA 2020 IBOR Fallbacks Protocol for all 35 LIBOR settings. Therefore, for those Master Agreements relating to a USD LIBOR swap that incorporate the most recent form of the 2006 ISDA definitions, unless there is other drafting to the contrary, the interest rate will be calculated as per the ISDA fallbacks after 30 June 2023 (so term adjusted SOFR in arrears plus Spread Adjustment with two business day lookback). The announcement also triggered the fixing of the fallback Spread Adjustments for all tenors in each LIBOR currency. These have now been published by Bloomberg and are based on the median over a five-year period of the historical differences between the IBOR in the relevant tenor and the relevant RFR compounded over each corresponding period. Such rates are used not only for ISDA fallback purposes but for some Spread Adjustments in the ARRC Hardwired Fallback Language as well as for the Credit Adjustment Spread in other RFR-based facility agreements.
What does this all mean when documenting new asset finance deals?
In both ship and aviation finance using LMA-based agreements, lenders still seem to be adopting different approaches. Some are continuing to use the LMA Screen Rate Replacement Wording (deleting references to the optional definition of screen rate replacement event as it has now occurred). Where the LMA Optional Backstop is included to trigger a negotiation to change the rate during the life of the facility, attitudes differ between lenders as to the choice of date. Some lenders have reported they are coming under pressure from their regulators to switch away from LIBOR by the end of 2021 so are looking to retain dates within this year. Others, however, seem happy to push transition out much further, agreeing that negotiations to amend the benchmark can start on selected dates in 2022 or early 2023.
We are increasingly seeing requests to include a switch to SOFR using the wording from the LMA Rate Switch Agreement, adapted for US Dollar-only facilities. Again, there is divergence on when the switch will occur. As one of the triggers for the switch from LIBOR to an RFR in the LMA wording includes the discontinuance of any published LIBOR tenor or time period, the discontinuance of one-week and two-month USD LIBOR at the end of this year will result in the switch occurring at the end of 2021 unless the LMA wording is amended. Some lenders are retaining the LMA wording, preparing for a switch after 31 December 2021, whereas others contemplate not switching before the end of June 2023. Others are adopting a middle way, using a backstop date to ensure a switch happens some time towards the end of 2022 or early 2023, by which time the market should be more settled.
For ship finance, using a rate switch agreement now has the advantage that, when the switch occurs, no amendments to the facility agreement should be necessary so there is no risk that a mortgage addendum will need to be filed. Whilst the requirement for mortgage addenda is not universally applicable, it is, for example, advised for many amendments where the relevant ship mortgage is registered with one of the three principal ship registries (Marshall Islands, Liberia and Panama).
For aviation and rail finance, further security filings are unlikely to be required in any event, although that may depend on local law requirements where filings have been made. The LMA form of rate switch agreement has the added advantage of permitting a degree of flexibility should market methodology change slightly as it permits the terms to be tweaked by way of supplement rather than amendment.
In loans using LMA drafting we are currently seeing few requests to incorporate ARRC Hardwired Fallback Language but it is being included in New York law governed facilities, including those tracking the LSTA form. Those lenders that do request it tend to be in the US; however, given the strong ties in aviation finance to the New York loan market, this might become a more universal trend in the sector. We are also not yet seeing loans documented based on day one SOFR although, again, that is likely to become increasingly common as we move through the year.
There also seems to be no appetite to base interest calculation of syndicated facilities on SOFR Averages or SOFR Index Data as was suggested by the ARRC. The SOFR Averages are compounded averages of SOFR over rolling 30-, 90-, and 180-calendar day periods. By contrast, the SOFR Index measures the cumulative impact of compounding SOFR on a unit of investment over time, with the initial value set to 1.00000000 on 2 April 2018, the first value date of SOFR. The SOFR Index value reflects the effect of compounding SOFR each business day and allows the calculation of compounded SOFR averages over custom time periods. Both are published by the Federal Reserve Bank of New York. Whilst both could be used as a basis for, for example, a default rate in an aircraft lease or a charter party, neither rate reflects how banks (and ISDA) calculate interest based on SOFR (for example SOFR averages do not necessarily start or finish on a business day and neither apply a zero floor) and the rates provided by the SOFR Averages relate to periods in the past, all of which no doubt explains why they are not being used in loan financings.
What does this all mean for existing asset finance deals?
Where existing deals are being amended for other reasons, some lenders are discussing the option of a substantial amendment to incorporate a rate switch. This is being resisted by some borrowers, sometimes because of timing/expense, or otherwise because they are not yet comfortable with SOFR and its method of calculation or because there is not yet a ‘market’ position. However, at the very least, lenders are reviewing the replacement screen rate provisions in their facility agreements. Some lenders are also looking to amend all their USD-based asset finance facilities to switch away from USD LIBOR before the end of the year. Again, in ship finance, any such exercise is likely to involve the filing of mortgage supplements where that would be required or prudent under the law of the relevant flag, but this is less likely in the context of aviation or rail.
The market is still very uncertain but there is an increasing acceptance of SOFR and the new methods of calculating interest based on this rate. We are starting to see lenders developing positions on the various options for calculation in the LMA drafting such as whether or not to include observation shift, what to do about commercial issues such as break costs, market disruption and the level of Credit Adjustment Spread. Of course, in a syndicate, different lenders might have different positions. These are, of course, issues which we are very happy to discuss.
The authors of this report are Watson Farley & Williams LLP partners David Osborne, Dominic Pearson, Louise Mor and professional support lawyer Elaine Ashplant.
ARRC The Alternative Reference Rate Committee was set up in the US to find an alternative to USD LIBOR.
ARRC Hardwired Fallback Language Wording recommended by the ARRC to be included in facility agreements to implement a transition away from USD LIBOR using a Hardwired Approach. It provides for transition to several alternative fallback rates, depending on what is available at the time of transition with the Agent authorised to make conforming changes to the facility agreement regarding the mechanics to operate the facility based on the relevant rate. The most recent version was published on 25 March 2021.
ARRC Benchmark Replacement Amendment Language Alternative wording recommended by the ARRC to be included in facility agreements to implement a transition away from USD LIBOR. It provides for the parties to negotiate and agree a replacement benchmark.
IBA ICE Benchmark Association Limited, the benchmark administrator for LIBOR.
Compounded Rate The method of calculation for interest-based on an RFR favoured by the Sterling working group and reflected in the LMA RFR-based agreements whereby the daily rate is compounded each business day and applied daily with each day’s interest added together during the interest period.
Credit Adjustment Spread (Spread Adjustment) An additional percentage element which can be added to SOFR to reflect the fact that historically SOFR is lower than LIBOR (owing mainly to the fact that SOFR is a secured overnight rate as opposed to LIBOR which is a forward-looking term rate that includes a premium for the term/credit risk). This is referred to in the ISDA fallbacks and in the ARRC wording simply as spread adjustment and in the LMA wording as credit adjustment spread.
FCA The Financial Conduct Authority, one of the financial services regulators in the UK, including of IBA.
Hardwired Approach Including in an agreement a switch mechanism from LIBOR to an RFR, either completely, as contemplated in the LMA Rate Switch Agreement or simply the headline rates, leaving the details to be added via amendment at the time of the switch, as per the ARRC Hardwired Fallback Language.
LMA The Loan Market Association, a trade group that exists to enhance the development and running of the primary and secondary syndicated loan markets in Europe, the Middle East and Africa.
LMA Optional Backstop Supplemental wording suggested by the LMA in August 2020 to be included in the LMA Screen Rate Replacement Wording whereby the parties agree to start negotiations to replace LIBOR as the benchmark if LIBOR is still being used by a specified date. It includes a further option to set out details of the replacement benchmark in a separate schedule and will also trigger any agreed changes to syndicate voting in relation to amendments to implement the replacement.
LMA Rate Switch Agreement Formerly the most recently published LMA exposure draft but now a recommended form using a Hardwired Approach consisting of a multicurrency facility which provides for benchmarks to switch away from LIBOR to agreed new RFR rates without the need for further amendments.
LMA Screen Rate Replacement Wording Originally published in 2018 and recently supplemented by two further suggested additions (one being the LMA Optional Backstop), this provides a framework for syndicated facilities to be amended to implement the replacement of LIBOR with an alternative benchmark but leaves it to the parties to agree the nature and operation of the alternative.
LSTA The Loan Syndications and Trading Association, a trade group that exists to enhance the development and running of the North American syndicated loan market.
RFR Risk-free rate, named as such because they are based on real transactions and therefore considered less vulnerable to manipulation. All those under consideration as the replacement benchmarks for LIBOR are overnight rates.
Simple SOFR The method of calculation for interest based on an RFR favoured by the ARRC whereby the daily rate is applied to the loan daily and each day’s interest added together during the interest period.
SOFR Secured Overnight Financing Rate. As the name suggests, unlike LIBOR, it is based on secured as opposed to unsecured transactions, namely the cost of borrowing cash overnight collateralised by Treasury securities, (admin: The Federal Reserve Bank of New York).
SOFR Term Rate A forward-looking rate based on SOFR, likely to be based on SOFR-linked interest rate derivative products which will be published daily for set tenors/settings in a similar way to LIBOR. SONIA term rates have been developed and are published by both IBA and Refinitiv.
Tough Legacy Contracts A term used by the FCA to refer to contracts that have no realistic ability to be renegotiated or amended to transition to an alternative benchmark.