Companies need to ensure that they are prepared for the end of LIBOR. Internal reviews must be carried out at the earliest possible opportunity and appropriate systems should be put in place.
-From the end of 2021, financial institutions will no longer be required to publish LIBOR rates. It is critical that companies consider the impact of the transition on their businesses as soon as possible.
-Thorough internal audits must be carried out to ensure that companies are aware of the requirements and that suitable processes and systems are in place.
-There is a tendency for corporate borrowers to rely on their lenders to lead the charge. However, companies and financial institutions alike need to ensure that they are ready.
The Financial Stability Board (FSB) published a global transition roadmap for LIBOR on 16 October 2020. Among other things, it highlights that firms should have already identified and assessed all LIBOR exposures and agreed on a project plan to transition in advance of the end of 2021. It also highlights that firms should have established formalised plans to amend legacy contracts by mid-2021 where this can be done and have implemented systems for allowing transitions. This aligns with LMA advice in respect of loan documentation, which requires parties to include clear contractual arrangements dealing with the LIBOR transition in all new and re-financed LIBOR-referencing loan products from the end of Q3 2020.
There are a few reports of SOFR and SONIA syndicated loans (with top FTSE companies leading the charge) and bilateral loans using risk-free rates (RFRs), but these are still a minority in the market and this needs to be addressed. Further clarifications with regard to some best practices are awaited, but this should not prevent companies from progressing their LIBOR transition.
In order to comply with this timetable, corporates need to prioritise general contractual reviews in addition to a review of their internal systems, so as to assess and know their exposure to LIBOR. Clearly, there needs to be a review of bonds and loan documents but also of commercial agreements referencing default interest rates linked to LIBOR as well as any other LIBOR dependencies outside of commercial contracts. These may include the use of LIBOR in financial modelling, discounting and performance metrics. Further, supporting systems and processes will need to be updated, including treasury management and accounting processes, and alternative solutions and infrastructure offerings will need to be considered. Technological and legal updates need to be made at the same time.
As such, corporate borrowers cannot assume that their lenders will lead the charge in all relevant instances.
Where a corporate borrower has numerous commercial contracts with third parties, the updating process may be reasonably straightforward in terms of the amendments to be made, but this will involve interaction with all relevant counterparties, and may need to be considered carefully to avoid opening doors to any unwanted renegotiation of contractual terms. In order to ensure that all contracts can be transitioned away from LIBOR, plans need to be formalised and actioned before mid-2021 to allow for such contracts to be amended (where the counterparties agree).
If corporate borrowers have standard form contracts, these will also need to be updated such that new business will be able to continue past the end of 2021 without further amendment, and that for any standard form contracts entered into from the beginning of 2022, the correct reference rates are referred to.
According to a recent white paper by Acuiti, only about 30% of financial service providers (banks, hedge funds, proprietary trading firms) declare that they are ready to go in relation to the shift to RFRs with respect to their loan issuance businesses. On this basis, corporate borrowers should also take the initiative to raise the LIBOR transition with their relationship banks if the topic is not yet being discussed to encourage progress towards the LIBOR transition in good time.
For LIBOR-denominated debt, contracts have to date focused on two basic approaches: (1) an “agreed process for renegotiation” that provides a mechanism for borrowers and lenders to negotiate a replacement rate by means of an amendment to a debt contract in the future, failing which the cost of funds would apply, and (2) a “hardwired approach” which allows either for the document to include pre-agreed conversion terms, or a replacement rate to be provided upfront. Of course, the former has a fundamental drawback in that each contract with such provisions will need to be reconsidered by the relevant parties once LIBOR is no longer available. Assessing which methodology has been included in contracts to date will be an integral part of a corporate’s risk assessment.
If documents already contain fallbacks specifying the rate that will apply in the event that LIBOR is not published, this is usually intended to deal with a short-term LIBOR issue rather than its replacement. Industry reports have concluded that financial firms do not expect to accept these fallbacks on an ongoing basis across all financial instruments and instead expect these to be renegotiated. Therefore, updating legacy fallback language also needs to be included as part of the review, planning and updating process.
For any corporate with bank debt with a maturity after 2021, it is also worth considering whether to move to an RFR loan. The Working Group on Sterling Risk-Free Rates published the results of its consultation in September 2020, which aligned the recommended position with the Alternative Reference Rates Committee (ARRC) in the U.S., and there is now a market recommendation which corporates can refer to as the likely market preference for SONIA loans. This includes:
using SONIA compounded in arrears methodology, which means that the market will compound the rate of interest rather than the balance, following ISDA’s methodology for compound RFRs;
applying the lookback without observation shift convention (or observation lag convention), whereby the SONIA rate is derived from the observation period, with a standard period being five business days, but weighted according to the days in the interest period; and
applying a floor to each daily interest rate before compounding.
A further consideration for corporate borrowers is whether to include a credit spread adjustment to ensure that the economic terms are comparable to a previously existing facility (which the exposure drafts, such as those produced by the LMA) leave open for commercial consideration. These may be helpful in the first instance to ensure comparability between loans though they add a degree of calculation complexity.
Whether considering the risk assessment in relation to exposure to LIBOR or the drafting changes to be implemented when all parties are getting comfortable with the proposals and recommendations, it is clear that there is still a lot of work to be done prior to the end of 2021. However, preparation will ensure that the risks associated with an abrupt end of LIBOR or the event that LIBOR becomes unrepresentative or volatile before LIBOR ends, can be avoided, and that adequate timing and consideration is given to the new contractual terms to apply.