In July 2020, the Working Group published an updated road map for LIBOR transition, which requires lenders to offer their customers alternative interest rates to LIBOR for new loans from 1 October 2020. For example, alternative rates to LIBOR in sterling loans could include the Sterling Overnight Interbank Average rate or a fixed rate of interest. If a customer nevertheless chooses a LIBOR rate to apply to a loan, rather than an alternative interest rate, the Working Group has made it clear that contractual mechanisms are to be included in their loan documentation that will facilitate LIBOR’s conversion to a suitable RFR before the end of 2021. Although such contractual mechanisms would preferably take the form of pre-agreed conversion terms, it is appreciated that such an arrangement will not always be possible, depending as it does on various operational constraints on market participants. In such instances, an agreed process for renegotiation should be included in the loan documents, together with a timeline for the future transition to conversion terms agreed between the parties.
To aid borrowers and lenders in making this transition, the Loan Market Association (LMA) has recently published the additional documentation set out below. It should be noted that the LMA plans to update this various documentation over time, based on market feedback, and so the information provided here is accurate as at 29 September 2020.
Pre-agreed conversion terms – the Rate Switch Agreement
The LMA has published an exposure draft of a multicurrency term and revolving facilities agreement (Rate Switch Agreement), which incorporates rate switch provisions. Once adopted by parties, the Rate Switch Agreement will enable borrowers and lenders to enter into transactions based on current LIBOR benchmarks that will transition in due course to compounded RFRs.
Key components of the Rate Switch Agreement include:
1. Rate switch provisions
The Rate Switch Agreement contains a new mechanism, the ‘Rate Switch’ clause, which allows the reference rate for a specific currency to change to a compounded RFR by way of the following:
- Rate Switch Trigger Events – are objectively determined events that lead to current benchmarks becoming unsuitable for use or ceasing to exist. A public announcement from a regulatory authority regarding current benchmarks, for example, would constitute a Rate Switch Trigger Event. The occurrence of a Rate Switch Trigger Event will result in the Rate Switch Date, as detailed below. It should be noted that although the Rate Switch Trigger Events are intended to address the same events as the analogous provisions in documentation for other products (for example, ISDA’s derivatives documentation), parties should ensure that where there are interlinked products on transactions, such trigger events should match appropriately to ensure that transition of linked products occurs concurrently.
- Rate Switch Date – is the date on which the change to a compounded RFR will occur, and is triggered by the Rate Switch Trigger Event. While such provisions should contain a ‘backstop’ date to ensure that the transition occurs prior to the end of 2021, they should be adapted to anticipate the levels of operational readiness, which may be unknown at the time of their incorporation into loan documents and should therefore allow for deferrals or limited time extensions.
2. Compounded Reference Rate
The Compounded Reference Rate constitutes two elements: the formulation of the compounded rate and the adjustment spread.
(a) Compounded Rate Terms
The formulation of the compounded rate is based on the Working Group’s calculation methodology convention published in early September 2020. A summary of its key features is set out below.
- Five banking day lookback without observation shift. While the Working Group has made it clear that a lookback with an observation shift is also a viable and robust option, the current Rate Switch Agreement accommodates the lookback only without an observation shift concept (otherwise known as the ‘observation lag convention’). Under the terms of the Rate Switch Agreement, the replacement RFR rate will be derived from the observation period but weighted according to the number of days in an interest period.
- The compounded rate – rather than compounding the balance under the loan documents by applying the compounding rate to the principal and accrued interest on a daily basis, the Rate Switch Agreement compounds the relevant RFR during the interest period and then applies it to the outstanding principal of the loan at the end of the relevant period.
- Non-cumulative rate method – the Rate Switch Agreement adopts the noncumulative compounding methodology that generates a daily-compounded rate with an interest calculation that varies daily. This enables an accurate calculation of accrued interest to be identified at any point in time in order to accommodate prepayments and loan trade settlements rather than a static average relating to an entire interest period.
(b) Credit Adjustment Spread
While over time the economic difference between LIBOR and the relevant RFR may be built directly into the margin, in order to facilitate the transition to an RFR and address the potential transfer of economic value from one party to another as a result of a change of reference rate, the LMA has included an additional component of the interest rate calculation, the “Credit Adjustment Spread”, rather than anticipating changes to be made to the margin.
The Rate Switch Agreement facilitates the specification of the Credit Adjustment Spread as either (a) a methodology/formula that will produce a percentage rate per annum or (b) an agreed percentage rate per annum. It is possible that a methodology specified for a Credit Adjustment Spread may be capable of producing a negative result, and therefore parties may wish to agree to a floor.
For LIBOR loans transitioning to RFRs, the recommendation of the Working Group is that a spread adjustment, based on the historic median between LIBOR and the relevant RFR over a five-year lookback period, in line with the approach adopted by ISDA, is the most appropriate methodology for Credit Adjustment Spreads.
While the approach set out in the Rate Switch Agreement provides a useful framework for transition, many aspects would benefit from variations based on specific lender/borrower requirements, loan specifics, and commercial agreement.
It should also be noted that although concluding pre-agreed conversion terms may not be commercially or operationally possible, it is advised that parties take steps to come as close to agreed conversion terms as possible. In doing so, parties minimise the risk of futile or extended negotiations at a later date.
An agreed process for renegotiation – the Replacement of Screen Rate
If market participants have been unable to agree on terms relating to LIBOR benchmark conversion, such as those detailed in the Rate Switch Agreement, the LMA has published a supplement to the ‘Revised Replacement of Screen Rate Clause’ (the Supplement). The Supplement allows the parties to a transaction to agree to a process of renegotiation, which will be set to occur on a specified future date that must fall prior to 31 December 2021.
The Supplement includes suggested drafting for a ‘Screen Rate Replacement Event’ (Replacement Event). The inclusion of a Replacement Event in loan documentation will act as a trigger event, with a conversion to an RFR only occurring if, at a specified future date, the rate of interest is still determined by reference to the screen rate for LIBOR. Once the Replacement Event occurs, the parties to the transaction will enter into good faith negotiations in order to conclude a replacement benchmark. Although this is a pragmatic alternative to adopting the terms of the Rate Switch Agreement, it will not absolve parties from the need to continue to work to conclude terms well in advance of the specified transition date deadline.
Reed Smith will continue to provide updates as more information becomes available.
Client Alert 2020-563
