The Replacement of LIBOR By The End of December 2021: Considering Loan Agreements, Swaps And Derivative Contracts

The transition from LIBOR to alternative rates over the next year represents one of the biggest changes to the financial services industry ever. With an estimated $370 trillion of LIBOR related activity globally, covering loans, bonds, derivatives, working capital and trade products, the LIBOR transition will significantly affect how contracts are priced and how risk is managed by market participants, lenders, borrowers and guarantors which use LIBOR as their operating model.

The article provides an overview of the LIBOR transition, including:

• Legal issues to consider as we approach LIBOR discontinuation by the end of 2021
• A five-step process to new loan documentation
• A summary of alternative risk-free rates

For further information and details about how Clyde & Co LLP may be able to assist you worldwide, or to discuss any points in the article, we invite you to contact us using the following email address: LIBOR@clydeco.com

WHAT IS LIBOR?

LIBOR, the London Interbank Offered Rate, is generally still the most referenced short-term interest rate in the world, reflecting the average rate at which major banks can obtain unsecured funding in the London interbank market, in a specified currency and for a particular period. It is still being produced for five currencies (US Dollars, Sterling, Euros, Japanese Yen and Swiss Francs).

LIBOR DISCONTINUATION BY THE END OF 2021

In the aftermath of the global financial crisis of 2007/08, there were widespread allegations of LIBOR manipulation dating back to the 1990s or even earlier. This resulted in significant fines being imposed on several international banks and a loss of confidence amongst market participants in the accuracy and reliability of LIBOR.

Since the crisis, fewer banks have been reporting their rates, which has resulted in a sharp decline in the number of transactions being recorded. Many banks have been discouraged from participating on the panel following concerns over the increased potential for liability, and many only continue to do so as their regulators compel them to.

To combat this trend, LIBOR has leant on "market and transaction data-based expert judgment". The benchmark rate has therefore become increasingly reliant on opinion rather than actual transactions, as originally intended. This development has led to the market becoming insufficiently liquid and has called into question the long-term sustainability of LIBOR.

In July 2017, the FCA announced that, after 2021, it would no longer compel panel banks to make submissions to enable the calculation of LIBOR, and in July 2018, recommended that market participants transition to alternative risk-free rates.

ALTERNATIVE RISK-FREE RATES (RFRs) EXPLAINED

Broadly speaking a RFR is a benchmark rate generally based on overnight deposit rates. As they are derived from a large volume of real observable transactions, they are considered "risk-free".

Although this article focuses on Sterling and US Dollars, the table below provides an overview of the working groups and proposed RFRs across several key jurisdictions in the lending market:

CURRENT INTEREST RATE	PROPOSED ALTERNATIVE RFR	RFR ADMINISTRATOR	SECURED OR UNSECURED	WORKING GROUP
Sterling LIBOR	Sterling Overnight Index Average (SONIA)	Bank of England (BoE)	Unsecured	Working Group on Sterling Risk-Free Rates
US dollar LIBOR	Secured Overnight Financing Rate (SOFR)	Federal Reserve Bank of New York	Secured	Alternative Reference Rates Committee
Swiss franc LIBOR	Swiss Average Rate Overnight (SARON)	SIX Swiss Exchange	Secured	Swiss National Working Group
Japanese yen LIBOR	Tokyo Overnight Average Rate (TONAR)	Bank of Japan	Unsecured	Cross-Industry Committee on Japanese Yen Interest Rate Benchmarks
Euro LIBOR/EONIA	Euro Short-Term Rate (€STR)	European Central Bank (ECB)	Unsecured	Working Group on Euro Risk-Free Rates
EURIBOR	Imminent discontinuation is not envisaged but €STR can be used as an alternative or fall-back rate.
Canadian Dollar Offered Rate (CDOR)	Imminent discontinuation is not envisaged but Canadian Overnight Repo Rate Average (CORRA) can be used as an alternative or fall-back rate.	Bank of Canada took over, as administrator, from Refinitiv Benchmark Services (UK) Limited, on 15 June 2020.	Secured	Canadian Alternative Reference Rate Working Group

ISSUES TO CONSIDER

As they are based on real observable transaction data, RFRs are considered more robust and stable; SONIA, for example, reflects the average interest rate that banks pay to borrow sterling overnight from other institutions. SONIA also tracks the Bank of England Bank Rate very closely, and the compounded rate is relatively stable and predictable.

The nature of these RFRs does, however, raise a number of issues if they are to be used as an alternative to LIBOR in financial instruments. For example:

• BACKWARD-LOOKING RATES: LIBOR is a forward-looking term rate, quoted for various terms (for example, one month, three months and six months). The RFRs are backward-looking overnight rates. This raises difficulties under, say, a loan agreement with interest periods where a quote for LIBOR is taken at the start of the interest period – this is important for cash flow management by the borrower as the interest payable can be calculated in advance. There are currently no forward-looking term rate options for the RFRs.
   
• DIFFERENT RFRs PER CURRENCY: LIBOR is quoted for different currencies. The RFRs are currency-specific. Different RFRs will have to be used for different currencies.
  Some RFRs are secured rates, and others, unsecured rates. This issue may cause difficulties under the mechanics of, say, multi-currency loans or cross-currency swaps.
  RFRs for different currencies may be published at different times of the day and by different methodologies. LIBOR is currently published for each currency and tenor combination at 11:55 am London time on each applicable London business day. Therefore the mechanics of financial contracts will have to cater for these variations.
   
• BANK CREDIT RISK: LIBOR is quoted to include bank credit risk. It also incorporates a liquidity premium contingent on the relevant term. The RFRs (being overnight rates based on actual transactions) do not include these elements. Accordingly, an RFR is likely to be a lower rate than LIBOR, potentially leaving a pricing gap which may need to be captured under a financial instrument by another means or by agreeing a spread adjustment.
   
• LEGACY AGREEMENTS: As the cessation deadline approaches, the risks associated with relying on agreements referencing LIBOR are increasing. Once LIBOR ceases, this may lead to volatility as the calculation of LIBOR will be based on even fewer transactions.
   
• INTEREST RATE HEDGING ISSUES: Attention will need to be paid to interest rate hedges to ensure the same benchmark is used for the loan and swap. There may be a risk of mismatched payments where different conventions are used to calculate the RFR for the loan and the swap, or the derivatives market and loan market transition at different times, in each case affecting borrower cashflow and presenting accounting issues.
   
• TIME IS RUNNING OUT: It is well known that the transition demands time and resources. This means engaging lenders, legal experts and system providers. We recommend that clients (borrowers, lenders and system providers) make the transition as soon as possible. During this year, we have assisted clients with implementing such successful transitions.

A: LOAN AGREEMENTS

A FIVE-STEP PROCESS

As part of the transition process, in line with guidance provided by the Working Group on Sterling Risk-Free Reference Rates, parties will be expected to take the following steps:

STEP 1: Review the outstanding loan for LIBOR referencing loans (including multi-currency loans containing a LIBOR option).

• Is it a bilateral or syndicated loan? Larger syndicated loans will require more transition time.
   
• What are the fall-back provisions in the loan agreement? Existing fall-backs in loan agreements are likely to only be for short-term, temporary use.
   
• What level of consent is required to make amendments? Is majority lender consent or any other third party consent (i.e. guarantors, security parties) required?
   
• What is the currency of the loan? Calculations of the new RFRs are not consistent across the various currencies, which may mean that successive amendments are required as the alternative RFRs become available.
   
• Consider alignment with hedging agreements.
   
• Consider potential new reporting requirements under IFRS (details of which are beyond the scope of this article).
   

STEP 2: Identify the alternative RFR to be used for each loan.

It is worth mentioning that an option being considered by Working Groups is a backward compounding of RFRs in arrears with a lag mechanism. Compounding in arrears involves aggregating overnight rates over a period to derive an interest payable at the end of the period. Such final interest payment is known a few days before it becomes payable.

STEP 3: Understand how the alternative RFR will be calculated, and how to calculate any economic difference between LIBOR and the selected RFR.

STEP 4: Consider whether treasury management and loan systems and operations can accommodate the alternative RFRs.

STEP 5: Document the transition of the loans.

All parties should undertake appropriate due diligence on any changes that are proposed.

DOCUMENTING THE TRANSITION

In order to facilitate a successful transition from LIBOR to RFRs by the end of 2021, the Working Group on Sterling Risk-Free Rates advocates the following roadmap to document amendments to loan agreements maturing after the end of 2021:

Loan Agreements maturing after the end of 2021	End of Q3 2020 to end of Q1 2021	End Q1 2021 to end of 2021	2021 onwards
Existing LIBOR referencing loan agreements		Must be amended to be based on RFR (unless a switch mechanism has already been included)	Should now be based on an RFR following amendment exercise in previous period.
Existing LIBOR referencing loan agreements being amended or replaced due to a refinancing	Must (i) be amended to be based on an RFR or (ii) include provisions to assist with conversion to an RFR, for example a switch mechanism.	Must be amended to be based on an RFR (unless a switch mechanism has already been included).	Should now be based on an RFR following amendment exercise in previous period.
New loan agreements	Must (i) be based on an RFR or (ii) include provisions to assist conversion to an RFR, for example a switch mechanism.	Must be based on an RFR.	Must be based on an RFR.

Therefore:

(a) each new loan agreement should be documented to incorporate the chosen RFR or include, where possible a switch mechanism to an RFR; and

(b) legacy loan agreement (i.e. a loan agreement which extends beyond 2021) should be amended by an amendment agreement to either incorporate the chosen RFR or, include where possible a switch mechanism to an RFR.

LOAN MARKET ASSOCIATION EXPOSURE DRAFTS

To assist with the transition, the Loan Market Association (LMA) has published a number of "exposure drafts" of their precedent documents. This includes:

(a) a draft multicurrency term and revolving facilities agreement incorporating rate switch provisions and term sheet for multicurrency term and revolving facilities agreements incorporating rate switch provisions to satisfy the working group's recommendations that contractual arrangements should comprise pre-agreed conversion terms;

(b) draft replacement of screen rate wording, which is predominantly suited for insertion into bilateral loan agreements and provides that the parties will agree amendments (with the consent of obligors and the lender(s)) to the loan agreement to incorporate an RFR to satisfy the working group's recommendation that contractual arrangements should comprise agreed process for renegotiation; and

(c) a draft Reference Rate Selection Agreement for use when transitioning syndicated loans whereby all parties agree the key commercial terms, but then delegate authority to the facility agent and obligors to make the necessary changes. This is particularly useful when any majority lender consent threshold is high and, therefore, impractical for making amendments where majority lender consent would otherwise be required.

OTHER DOCUMENTARY CONSIDERATIONS

In addition to considering the appropriate RFR to be chosen, and how to incorporate it into the loan agreement, parties will need to consider a number of other terms in the loan agreements, for example:

• Interest periods;
• Fall-back provisions;
• Application of any break costs;
• Aligning notice periods for prepayments with the lookback periods, to address mismatch risks
• Market disruption provisions; and
• Any additional forward looking debt service of interest coverage projections.

As part of the transition process, there are also likely to be additional conditions precedent for such transition to be met:

• Legal opinions;
• Board resolutions;
• Security documentation review (if applicable);
• Guarantee confirmations (if applicable);
• Hedging documentation; and
• Other conditions precedent as may be required.

B: SWAPS AND DERIVATIVE CONTRACTS

Whether it is an interest rate swap agreement, a cross-currency swap agreement or another hedging arrangement, the existing fall-back provisions in such hedging agreements should be reviewed.

If a derivative contract incorporates LIBOR, then it will need to deal with a transition to an alternative RFR.

ISDA DOCUMENTATION - ISDA 2020 IBOR FALL-BACKS SUPPLEMENT AND PROTOCOL

On 23 October 2020, ISDA (International Swaps and Derivatives Association) published:

• An IBOR Fallbacks Protocol (the Protocol); and
• An ISDA Fallbacks Supplement to the 2006 ISDA Definitions (the Supplement).

The Supplement and the Protocol are voluntary, and market participants may opt to use different fallback rates, if either preferred or required. The Protocol and the Supplement provide robust fallback provisions to be applied upon the permanent cessation of IBOR or any pre-cessation of LIBOR announcement.

On the assumption that the parties use ISDA documentation, we have summarised the main points to note ahead of the transition:

DOCUMENTATION AMENDMENTS	It is recommended that market participants amend their existing ISDA Master Agreements and other derivative contracts to incorporate new RFRs. The Supplement amends the 2006 Definitions to incorporate certain RFRs and terms necessary to implement the new RFR.
LEGACY CONTRACTS	For contracts that are already in place, the parties may enter into the Protocol to incorporate the fallback RFRs.
AUTOMATIC INCORPORATION OF TERMS INTO THE CONTRACT	Market participants should access the Protocols section of the ISDA website, enter the required information and pay the applicable fee. An adherence letter is to be signed and uploaded into the protocol system. Once approved and accepted by ISDA, the adhering party will receive an email confirmation of their adherence to the protocol and the contract will incorporate the new fallback RFRs, avoiding the need for any separate negotiation and agreement between those parties.
EFFECTIVE DATE	The Supplement and the amendments made by the Protocol take effect on 25 January 2021 and will apply upon the cessation of IBOR (or any pre-cessation of LIBOR announcement).
CALCULATING RFRs	The RFRs selected by ISDA are overnight, risk-free rates. Two adjustments are made to the RFRs to function as fallbacks for their corresponding IBORs and, effectively, to arrive at a "compound" RFR, similar to that considered above: a "term" adjustment that accounts for the different maturities used for IBOR rates (for example, three months or twelve months); and a "spread adjustment" that accounts for the risk premium reflected in IBORs but not RFRs. Such adjustments are included in the Supplement and Protocol.

NON-ISDA DOCUMENTATION

For parties that do not use ISDA documentation, each legacy contract should be re-negotiated to incorporate the new fallback RFRs (or any other applicable rate if the RFR is not appropriate).

IMPACT OF THE COVID-19 PANDEMIC ON THE TRANSITION

On 1 July 2020, the Financial Stability Board confirmed that, whilst acknowledging temporary disruptions and delays due to the pandemic, all jurisdictions should continue to ensure that their transition programmes enable them to transition to LIBOR alternatives before the end of 2021.

FURTHER INFORMATION

For further information and details about how Clyde & Co LLP may be able to assist you worldwide, or to discuss any points in the article, we invite you to contact us using the following email address: LIBOR@clydeco.com.