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“You’ll never stop me loving you” - Transitioning from LIBOR to SONIA

  • United Kingdom
  • Banking and finance
  • Restructuring and insolvency

10-11-2020

Welcome to our series of thought leadership articles on some of the ‘Hot Topics’ affecting borrowers.

Introduction

Even before 1980s pop princess Sonia burst onto the scene, LIBOR (the London InterBank Offered Rate) was the interest rate benchmark of choice for most UK Corporate borrowers. Unfortunately however, since the financial crisis in 2008, overnight lending between Banks now very rarely happens and despite still supporting over £300 trillion of financial instruments globally, LIBOR has recently been argued to be no more than informed guesswork.

As such, the UK is currently in the midst of transitioning to the SONIA benchmark (the Sterling OverNight Index Average), which is an overnight, “risk-free” rate,  produced daily by the Bank of England, based on actual sterling overnight transactions.

Deadlines are approaching

From now, borrowers can take out either LIBOR or SONIA based loans (or Base Rate and fixed rate loans in certain instances for smaller amounts). The Working Group on Sterling Risk-Free Reference Rates (the “Working Group”) recommended that, after the end of Q3 2020, LIBOR referencing in loan agreements (both new and re-financed) should include clear contractual arrangements to facilitate conversion to SONIA (or an alternative rate) ahead of the end of December 2021) either:

  • through pre-agreed conversion terms (a ‘switch’ mechanism); or
  • via an agreed process for renegotiation.

Furthermore after the end of March 2021, the Working Group’s recommendation is that no new LIBOR loans (maturing after the end of 2021) should be made available to borrowers.

What happens on 31 December 2021?

LIBOR is set by a panel of banks. Those banks have agreed to make LIBOR submissions until the end of 2021. After that point, the Financial Conduct Authority (“FCA”) will no longer compel banks to make LIBOR submissions. Whilst it is not impossible that LIBOR submissions could continue, they will no longer be supported by the FCA (LIBOR’s regulator). We therefore need to work on the assumption that LIBOR, as we know it, will cease to be a reliable benchmark rate at the end of 2021.

So should I move on from LIBOR now?

Whilst many lenders and borrowers are ready to use risk-free rates now, there still remains some clarity required from certain key market participants. On the basis that the market position is not entirely settled, borrowers and lenders alike are therefore seeking alternatives – given the nature of the markets over the last 8 months, it is hardly surprising that parties would exercise caution.

Including pre-agreed conversion terms (a switch mechanism) in new and refinanced loan agreements provides an element of certainty and may be a good interim option. A switch mechanism will provide for the loan to transition from LIBOR to an alternative rate on a future date or trigger event. This allows the parties to continue to use LIBOR while preparing practically for a switch to an alternative rate. In theory, the loan agreement will not require any future amendment in respect of LIBOR transition, providing as much legal and commercial certainty as is possible for the parties (with the added comfort that there will be an opportunity to amend the terms if any of the conventions need to be revisited).

Where the parties are neither able to move to a risk free rate now nor pre-agree terms for a switch to a risk-free rate, they could, as an alternative, include an agreed process for renegotiation. The LMA has provided drafting for this option, but acknowledge the clear down-side of this approach, in that it will require further amendment to loan agreements in 2021 to reflect the outcome of those negotiations (and there is a risk that negotiations could be inconclusive).  

Given the uncertainty of market conditions, some FDs/CFOs might cringe at the idea of re-opening key commercial terms in their documents next year.  To try to manage this, the LMA has also proposed a compromise position, where a process for renegotiation can be agreed now, along with some of the terms for the conversion.  This has the benefit of cutting down the scope/risk of future negotiations by agreeing as many of the terms as possible upfront.   In practice we would not expect the relevant amendments to documents to be complex, but there is a balance to be struck between taking control of the process now,  or deferring until such time as there is greater understanding of the practical implications and collective/market approach.

Whilst from a legal perspective, any of the above options are viable, many borrowers coming to the market are currently favouring the certainty of either day one SONIA (or other risk-free rates), or agreeing a switch mechanism. In any event, it would not be advisable for borrowers to leave the decision until too close to the impending deadline; instead they should give themselves and their legal counsel plenty of time to consider the necessary changes and any peculiarities of the borrower’s situation or relevant documentation.

What happens if I don’t do anything?

A good question –  one possibility is that your LIBOR-linked contract could be classified as ‘tough legacy’. By tough legacy we are referring to contracts (extending beyond the end of 2021) that are unable to convert to an alternative reference rate or be amended to include fallback provisions.  This could include:

  • Derivatives: Both derivatives contracts where amendment is not agreed (the ISDA IBOR Fallback Protocol is voluntary), or hedging that forms part of a more complex structure and so, even though the hedging itself can be amended, it relates to another contract that is not easily amended.
  • Bonds: Bonds with a large investor base.  The more people that are required to consent, the higher the risk that not everyone will do so.
  • Loans: Some syndicated loans may have a large number of lenders making any amendment process a more difficult, time consuming, and costly task. The market has made a move towards Majority Lender consent for amendments related to the transition of rates, but some loans may still require all Lender consent.

The risk of not taking action is that either:

  • the decision will be taken out of your hands and left to the FCA.   The FCA will have enhanced powers to manage tough legacy contracts by way of a wind-down synthetic LIBOR (bringing with it potential issues for non-sterling or multi-currency facilities, in the event that currency jurisdictions don’t take a coordinated approach); or
  • you may be left with inappropriate fallbacks, never intended for the permanent cessation of LIBOR (for example, costs of funds provisions, which are especially onerous on borrowers). These fallbacks may not kick-in until the permanent cessation of LIBOR, which could leave you in a tricky situation if LIBOR still exists, but is found to no longer be representative, when it becomes unregulated after 31 December 2021.

What will the move away from LIBOR mean cost wise?

SONIA is not a like for like replacement for LIBOR. Unlike LIBOR which is fixed in advance for a set period (e.g. 3 months), SONIA is an overnight rate, measured on each day over the interest period to produce a final (compounded) interest rate at the end. There are a number of tools (some of which are free) to help businesses to calculate interest payments linked to compounded SONIA.

Some participants in the sterling loan markets are still holding out hope for a look-forward ‘term SONIA’.  This seems a likely development in 2021, but it’s worth noting that regulators have made it clear that they expect the use of any ‘term SONIA’ to be limited in the loan market given the risk of falling back into the same bad habits that have applied to LIBOR.

Banks are currently awaiting detailed guidance from governing bodies and working groups on how to adjust their own credit spreads, but a guiding principle is that the comparison ultimately should be ‘economically neutral’ for borrowers. Pending this clarity, it is possible that there may be differences between lenders around spread adjustments, e.g. some may look to incorporate this into the margin, whereas others favour keeping it separate. Additionally, compounding methodology, prepayment terms and interest periods may vary between lenders.

What about other currencies?

LIBOR is available for Sterling, Euros, Swiss francs, Japanese yen and US dollars. Each of those currency jurisdictions is going through its own transition process equivalent (but not identical) to the rise of SONIA in the UK. In addition, other IBORs are undergoing (or have completed) reforms. Borrowers need to think about the different currency exposures that they have, and consider and take advice on the position for each of those currencies.

What do I need to do now?

Whilst some may ‘never stop loving’ LIBOR, it will, as we know it, shortly be disappearing. Now is the time to discuss with your lender how you will switch your lending contract away from LIBOR, but at the same time, it is worth considering where additional exposures to LIBOR may lie. Whilst this could include hedging contracts and deposit facilities which your bank may also be able to help you with, it may include contracts as varied as leases, pension schemes, commercial contracts (e.g. rate-linked late payment terms) and, even cycle to work schemes.