Replacement of the current LIBOR regime, in light of various rate setting controversies, has been well-publicised. But what progress has been made in relation to those changes, what is a 'SONIA-based' alternative and are borrowers sleep-walking into the unknown when it comes to documentation? We explain the current state of play.
Where are we now?
There is no guarantee that any LIBOR setting will continue to be published after 2021, as many panel banks are expected to withdraw from making submissions after this date. This has implications not only for transactions executed after 2021, but also for any transactions executed before then referencing LIBOR that will continue to run after 2021.
The markets are acutely aware that any hasty replacement will cause market disruption and uncertainty but there is still no universal agreement what the way forward will be. LIBOR is useful to the markets because it is a forward-looking variable that is ascertainable at a particular point in time, which allows borrowers to plan accordingly and swap as needed. Despite the fact that it consists of a risk premium fiction (term liquidity premium) and is inherently connected to the banks and banking sector that is setting the rate (credit premium), LIBOR adds an element of agreed certainty to an inherently uncertain future.
Yet this is also part of the perceived problem. Any interest rates and similarly LIBOR are man-made concepts that are whatever the market and market participants agree them to be. To avoid manipulation it is suggested that the new reference rate be based on actual transactions and historic data. But this will inevitably render it less suitable to achieve the same forward-looking purpose in the marketplace as LIBOR.
What are the alternatives?
The currently discussed way forward for Sterling is a rate based on SONIA (Sterling Overnight Interbank Average Rate). Currently, SONIA is backwards looking and does not reflect risk premium as it is an overnight rate (so therefore virtually risk free).
This creates operational difficulties for borrowers, who will not know their final redemption sums before the morning of the day of redemption. It also poses a challenge for Agents, who will need to calculate the redemptions, notify the borrower and the syndicate members, and distribute the redemption money to the syndicate all in one day.
A backwards-looking rate also creates operational uncertainty. Averaging historic spread over a period of time will allow the borrowers to carry out some estimate calculations of their forward-looking interest to cover covenants and budget accordingly. But until the final redemption SONIA rate is published, there is no certainty as to what they are expected to repay or roll-over.
Using the overnight rate as the basis also means that repayment profiles would likely change to be in arrears. Moving from a forward-looking to overnight rate therefore represents a conceptual change in how markets currently.
Pricing the risk
A significant global challenge is that different currency rate calculations are based on different methodologies on a secured or unsecured basis and operate differently. The divergence in time of publication between the current LIBOR, SONIA and the other Risk Free Rates (e.g. SOFR and €STER) will require an operational overhaul for the industry. The methodical difference in calculation of LIBOR and SONIA creates a risk of a value transfer between the borrower and the lender that is currently not being discussed or addressed in loan documentation.
It is also not yet agreed whether the swap from LIBOR to SONIA ought to be automatic (e.g. similarly to ISDA protocols) or based on consent of the individual market participants. The current optional LMA wording requires consent of the Agent acting on the instruction of the Majority Lenders and the Obligors. The risk for borrowers is that there will be winners and losers in the way the value transfer is divided, which is currently not covered precisely in the LMA clause. One might speculate that the winners will most likely be the Lenders, as a special interest group, but given public pressure in relation to LIBOR this is not a given.
The successful implementation and use of SONIA will require market-wide adoption. Until this has been resolved, the challenges in providing for life after LIBOR in finance documents are clear, but the market has not yet settled upon how best to provide for that future.
Market participants will be eager to see whether there will be a practical way to come up with a SONIA-derived rate that is forward-looking, or whether bank operations can adapt to a backward looking rate. Uncertainties also remain over how SONIA will interplay with other reference rates in multicurrency facilities and swaps; how the various timing obligations in relation to notices will be set in the facility agreements whether derivatives and bonds markets will take a unified approach with syndicated loan markets; and whether all of this can truly be achieved by the end of 2021.
Interestingly, on 11 June Associated British Ports is reported to have become the first issuer to agree with its bondholders a reference rate switch from LIBOR to SONIA. It is worth mentioning that the bondholders were not paid a fee for their consent to amend the terms of the debt (as they usually would be) and we are told that the flip was structured in such a way as to ensure that the switch from LIBOR plus 2.5% to SONIA plus 2.5% is economically neutral for all sides. With a reported $500bn of bonds worldwide being affected by similar issues, this first reported amendment to documentation will be widely welcomed as a positive first move towards a post-LIBOR world.
Osborne Clarke is a full-service, sector-focussed, international law firm. Our leveraged finance and private equity teams are amongst the most experienced and active across the breadth of the UK mid-market. For further details of our capabilities and experience, to discuss any of the issues raised in this update, or to explore how our team might be able to help you, please contact Laurie, Max or your usual Osborne Clarke contact.