LIBOR Transition: What? Why? When? How?23 November 2020

For both existing financings referencing LIBOR and new transactions, the first step is to understand the differences between the recommendations of the various working groups and how to reconcile them in the context of the specific transaction. In relation to existing transactions and new transactions that are not RFR-based from the outset, the additional point to address is the timing of the transition of that particular loan (sometimes referred to as the “switch”).

Working group recommendations

Market participants and industry groups have been refining how RFRs may operate in the loan and derivatives markets and the market conventions which will need to be adopted to facilitate this: the basis for compounding (rate vs balance), cumulative or non-cumulative interest, length of look-back period (generally a short period allowing payment certainty for borrowers when using an in-arrears rate), inclusion (or not) of an observation shift (where the RFR for each day during the interest period is weighted according to the observation period and not the relevant interest period) and rounding conventions, amongst others. It should be noted that all working groups recognise that their recommendations may not be the most appropriate outcome for every transaction and parties are free to use amended or alternative mechanisms.

In September 2020, the Working Group published recommendations that SONIA should be calculated using a non-cumulative compounded in arrears² methodology (with conventions for how that should operate) using a five banking day look-back without an observation shift. This aligns in some respects with the approach recommended by the ARRC for SOFR.

The ARRC recommends the use of a term SOFR, with simple daily SOFR (using a five banking day look-back without an observation shift) as the initial fallback should that not be available.

As contemplated in the ISDA 2020 IBOR Fallbacks Protocol, with effect from 25 January 2021 derivatives transactions governed by ISDA documentation and in place on or before that date between adherent parties will incorporate the IBOR Fallbacks Supplement and await, from that point, the occurrence of a cessation event triggering the replacement provisions.

The following table compares, at a high level, the recommended conventions of the Working Group, ISDA and the ARRC.

Documentation

The ARRC has published wording that market participants may want to use in amending existing facility agreements, or in preparing documentation for new financings, that reflects the ARRC’s recommendations but does leave a number of important factors for the agent or lender to decide unilaterally at the time of the switch and amend the document to reflect.

As noted above, ISDA has published a protocol enabling parties adhering to it to automatically apply a supplementary set of provisions to transactions covered by the protocol which introduce a switch mechanism to the ISDA recommendations. They will also automatically apply, unless excluded, to all new derivatives transactions governed by ISDA documentation entered into after 25 January 2021.

The Loan Market Association, working with the Working Group, has produced exposure drafts (i.e., for discussion but not formally recommended) that reflect the Working Group’s proposals for sterling LIBOR, and developing additional mechanisms and drafting consistent with that. Those drafts include similar proposed wording for other currencies based on the Working Group’s recommendations for sterling but does not reflect the conventions recommended by the separate working groups for those other currencies such as those published by the ARRC in July 2020 in relation to SOFR transactions.

The existence of these various sets of drafting will be helpful to parties in preparing documentation, whether for amendment or new transactions. However, as can be seen from the comparison table above, it will be important to tailor the suggested drafting to align the different parts of the transaction, whether across currencies or with hedging products, as well as to fit the specific transaction.

Market fragmentation

Market practice for using published screen rates for LIBOR (and associated fallbacks in the absence of a screen rate) is straightforward and transparent (even if the setting of the rate is not).

At least until the market develops further, given the number of different RFR conventions available and the suitability of those conventions to different lending institutions and transaction structures, we anticipate that parties will agree to calculate RFRs in different ways for bilateral financings and across different lending syndicates (depending on the presence of interest rate hedging specific to the loan, the nature of the lender and the identity of the facility agent or calculation agent). For borrowers with loan arrangements with different lenders, this may mean tracking and paying different rates for the same RFR. In addition, for multicurrency borrowings the RFR for each currency is likely to be calculated in a different way, in particular if a mix of term and in arrears rates are used. Loan documentation is going to become longer and more complex.

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.

This article was authored by London Partners Richard Hughes, Daisy East and Rob McBride, and Professional Support Lawyers Elaine Ashplant and Sarah Tighe.