KEY TAKEWAYES FROM THE LIBOR TRANSITION , CAN BE IMPORTANT FOR THE INTERVIW PROCESS

Descriptions

With the expectation that the publication of the London Interbank Offered Rate (LIBOR) will cease by the end of 2021, financial market participants need to be planning the transition of all LIBOR-based exposures to risk-free interest rates in the next six to twelve months. Working groups for the key currencies have identified the proposed benchmark rate for each of those currencies and are developing recommended conventions for the application of those benchmark rates. In addition, proposed legal drafting for the incorporation of those conventions into existing and new transactions is available. We recently advised the lender on one of the first project financings to be done using SONIA from financial close and we are currently advising on a number of other financings using risk free interest rates. In this briefing, we bring together our experience on these transactions to explore some of the challenges arising in the context of financing structures using interest rate hedging?in relation to specific loan interest exposures (as opposed to more generic corporate hedging arrangements), such as project and asset backed finance (as seen in the aviation, real estate and shipping industries).

"Working groups for the key currencies have identified the proposed benchmark rate for each of those currencies and are developing recommended conventions for the application of those benchmark rates."

WHAT IS LIBOR TRANSITION?

“LIBOR transition” is the movement of the financial markets away from using LIBOR as the interest rate benchmark to using alternative “risk free” benchmark rates (“RFRs”).

The background to the use of LIBOR

Since the inception of the syndicated loan market, pricing for loans has been set by reference to the interest rate at which deposits were offered by banks to other prime banks in that market – interbank offered rates or IBORs – with London being the leading market – the London interbank offered rate or LIBOR. This is because in the early days of the loan market banks funded their participations in loans by taking deposits in the interbank market for the relevant currency and tenor (interest period). Published IBORs were based on the panel banks’ submissions of the rates the panel banks considered they?could?be offered in the interbank market when transacting in reasonable market size1. As the loan markets developed, LIBOR was quoted for a wide range of currencies and tenors and, as a result of its ease of use, found its way into a wide range of financial contracts (particularly derivative contracts) and other commercial arrangements as a pricing source.

However, over the years, banks have moved away from funding through the interbank market (it became a theory rather than a practice) and now fund themselves from other sources. New market participants (such as debt funds, insurers and the like) fund themselves from sources other than the interbank market.

The identification of appropriate RFRs

In the UK, the Sterling Risk-Free Reference Rate Working Group (the “Working Group”) has recommended the use of the Sterling Overnight Indexed Average (SONIA) and in the US the Alternative Reference Rate Committee (ARRC) has recommended the use of the Secured Overnight Financing Rate (SOFR) as RFRs to replace sterling and US dollar LIBOR respectively. Similar working groups in the relevant markets have recommended RFRs to replace LIBOR for currencies in those markets: Swiss Average Overnight (SARON) for Swiss Francs, Tokyo Overnight Average Rate (TONAR) for Yen and the Euro short term rate (€STR) for Euros. In this briefing, we will focus on SONIA and SOFR.

• SONIA is administered and published by the Bank of England based on actual transactions and reflecting the average of the interest rates banks pay to borrow sterling overnight from other financial institutions and institutional investors; and
• SOFR is published by the New York Federal Reserve based on transactions in the Treasury repurchase market where banks and investors borrow or lend Treasuries overnight.

An RFR is a different construct to an IBOR. Simply substituting an IBOR for a currency with the chosen RFR for that currency is not an easy or straightforward process because of the way in which the rates are formulated, set and administered.

"Following the investigation of scandals relating to the setting of IBORs arising from the 2008 liquidity crisis, regulators focused on reforming how IBORs were set (by regulating the submission process) and encouraged market participants to consider RFRs."

LIBOR is a “forward-looking” term rate – this means the rate is fixed and known at the start of an interest period. RFRs are “overnight” rates and can only be produced on a backward-looking basis, although work is being done to develop a projected RFR that could be used on a forward-looking basis as a term rate. For now, however, the RFR-based interest rate for a period can only be determined using historical overnight rate data at the end of that period.?The following table summaries the key differences:

For new loan arrangements:

Consider whether these should reference an RFR from the outset. If LIBOR-based, you will still need to consider pre-agreed conversion terms or an agreed process for renegotiation now. If entering into documentation now which contemplates an agreed process for renegotiation, consider how the costs of that renegotiation will be allocated between the parties; from transactions we are seeing now this tends to be a borrower cost. Entering into a fixed rate loan may be an alternative option (although default interest rates would typically reference a rate for calculation).

For both existing financings that require amendment and new financings:

i) Manage the transition of interest rate hedging arrangements and the corresponding loan arrangements in parallel. In particular, consider aligning:

a) whether to amend or close out any interest rate hedging;

b) timing of the switch to an RFR;

c) the RFRs applicable under the loan and the interest rate hedging;

d) the conventions around that RFR, such as term or in arrears, compound or simple, cumulative or non-cumulative, duration look-back period, with or without observation shift; and

e) the fallbacks if the RFR ceases to be available, whether temporarily or permanently.

ii) Manage the transition of different currency facilities in parallel, considering many of the same points as outlined above too. For multicurrency facilities where some currencies can continue on term rates and others use “in arrears” rates, particular consideration will have to be given to the transition between currencies;

iii) Many lenders will have a position on whether certain provisions typical of a LIBOR-based loan will apply and if so, with what modifications but to the extent that they have not or different lenders within a lending syndicate take different view, consider the applicability of provisions such as:

a) “Cost of funds” as the ultimate fallback arrangement;

b) Interest rate floors;

c) Compounding (or not) of the adjustment spread;

d) Market disruption;

e) Break costs;

f) Intra-period prepayments and loan transfers and the timing of the payment of accrued interest; and

g) Pro rata settlement of interest.

We are advising lenders and borrowers on their approach to LIBOR transition for documenting amendments to existing transactions and new transactions going forward, including documenting new transactions referencing RFRs with both pre-agreed conversion terms and an agreed process for renegotiation. Please contact one of the authors or your usual WFW contact if you would like to discuss LIBOR transition and its impact on your financing arrangements.

Important Appendix from processing point of view: Key Provisions for Daily Simple SOFR Loan Facility with Lookback (No Observation Shift)1 Interest Amount:

Interest Amount: For SOFR loans, the amount of interest accrued and payable on the loans for any day will be equal to the product of (i) the outstanding principal amount of the loans on such day multiplied by (ii) (a) the Rate of Interest for such day divided by (b) 360.

Rate of Interest: The Benchmark plus the Applicable Margin.?

Benchmark: For SOFR loans, the benchmark is Daily Simple SOFR.?

Applicable Margin: The margin is [plus]/[minus] ___ basis points per annum

Interest Payment Dates: The last business day of each [March, June, September and December][calendar month] and the Maturity Date.

U.S. Government Securities Business Day: Any day except for (i) a Saturday, (ii) a Sunday or (iii) a day on which the Securities Industry and Financial Markets Association recommends that the fixed income departments of its members be closed for the entire day for purposes of trading in United States government securities.

Day count convention: Actual/360

Floor: ___%.2

SOFR: means, with respect to any U.S. Government Securities Business Day, a rate per annum equal to the secured overnight financing rate for such U.S. Government Securities Business Day, as such rate appears on the SOFR Administrator’s Website on the immediately succeeding U.S. Government Securities Business Day.3

where:

“SOFR Administrator” means the Federal Reserve Bank of New York (or a successor administrator of the secured overnight financing rate). “SOFR Administrator’s Website” means the website of the Federal Reserve Bank of New York, currently at https://www.newyorkfed.org, or any successor source for the secured overnight financing rate identified as such by the SOFR Administrator from time to time

Daily Simple SOFR: means, for any day (a “SOFR Interest Day”), an interest rate per annum equal to the greater of (a) SOFR for the day that is [five] U.S. Government Securities Business Days4 prior to (i) if such SOFR Interest Day is a U.S. Government Securities Business Day, such SOFR Interest Day or (ii) if such SOFR Interest Day is not a U.S. Government Securities Business Day, the U.S. Government Securities Business Day immediately preceding such SOFR Interest Day and (b) the Floor. Any change in?Daily Simple SOFR due to a change in SOFR shall be effective from and including the effective date of such change in SOFR without notice to the borrower. Borrowing Requests: Notice of each SOFR borrowing must be received by the Administrative Agent or Lender, as applicable, not later than [11:00 a.m.] ([New York City time]) [five] 5 business days prior to the date of the requested borrowing. Prepayment Notices: Notice of a voluntary prepayment must be received by the Administrative Agent or Lender, as applicable, not later than [11:00 a.m.] ([New York City time]) [five]6 business days before the date of prepayment.

Interest Calc process can be like below-

The daily interest accrual under the Compound Balance approach is simply calculated by applying the appropriate day’s SOFR rate to outstanding principal and accrued unpaid interest:

AFETCTED INTRUMENTS BY THE LIBOR TRANSITIONS EVENT

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