Uncertainty remains regarding benchmark rate transition
01 October 2019
Banking law & finance
Until now, the financial sector has relied on the daily fixed interbank offered rates like EURIBOR, LIBOR and EONIA (IBORs). Loan agreements based on standard loan documentation for (syndicated) corporate loans, such as the loan agreements based on the formats of the Loan Markets Association (LMA), include interest rate fallback provisions based on these IBORS. Unfortunately, these IBORs are likely to be restructured or may no longer be available in the near future following decreased market activity in the past years. For example, the United Kingdom Financial Conduct Authority stated that market participants should not rely on LIBOR being available after 2021. As to EURIBOR, the LMA noted that EURIBOR looks set to continue being published for the foreseeable future.
The Dutch regulators, the Netherlands Authority for the Financial Markets (Autoriteit Financiële Markten) and the Dutch Central Bank (De Nederlandsche Bank), are also aware of the benchmark rate transition and, in that context, circulated a questionnaire to banks, insurers and pension funds in the Netherlands in April 2019. Based on the input provided on that questionnaire, the Dutch regulators published a document on 25 September 2019. In that document, the Dutch regulators (among other things) state that Dutch market parties consider the risks associated with the transition as significant. The regulators have formulated several best practices that could be taken into account by the relevant market parties. One of the best practices is that alternatives to the IBORs should be identified and that these alternatives should already be applied, if possible.
Alternative risk free rates (RFRs) are proposed or are being developed by various working groups (such as the U.S. Alternative Reference Rates Committee (ARRC), the Bank of England Working Group on Sterling Risk-Free Reference Rates (the Sterling Working Group) and the Working Group on Euro Risk-Free Rates (the Euro Working Group)). The ARRC proposed that the Secured Overnight Financing Rate (SOFR) should be used as an alternative for (US-dollar) LIBOR in respect of (among others) (syndicated) corporate loans. The Sterling Working Group and the Euro Working Group identified the Sterling Overnight Index Average (SONIA), respectively the Euro Short-Term Rate (€STR) as an alternative for the relevant IBOR.
These RFRs are daily published overnight rates and are based on reliable underlying market transactions and should better represent the underlying economic reality. However, the RFRs are overnight rates, whilst the IBORs are term rates. As there are currently no term rate RFRs available, the RFRs need to be adjusted in order to make them comparable with the IBORs. In addition, the RFRs are not equivalent to the IBORs they replace. As a result, a transfer of economic value could take place. The average difference between the relevant IBOR and the relevant RFR (adjusted to make it comparable to a term rate) should therefore be considered. Currently, each of the ARRC, the Sterling Working Group and the Euro Working Group is working on developing a term rate based on the RFR but it is uncertain whether such forward-looking rates will be available on time.
As a result of the IBORs ceasing to exist or being replaced by RFRs such as the SOFR, the SONIA and the €STR, the interest rate fallback provisions as included in the standard loan documentation will no longer suffice as these provisions often do not address the situation in which the IBORs themselves are no longer available and do not anticipate the usage of the RFRs. Consequently, standard loan documentation currently in place will, in the near future, contain a void. This will result in legal uncertainty for the parties involved which is undesirable. To address this problem, new standard interest rate fallback provisions are (being) developed by multiple organizations such as the ARRC and the LMA.
On 25 April 2019, the ARRC already published the recommended fallback language for syndicated corporate loans and recommends to incorporate this language in new and existing contracts without waiting until a SOFR term rate comes into existence. The published fallback language provides for two sets: a “hardwired approach” fallback language and an “amendment approach” fallback language. The hardwired fallback language entails that the reference to LIBOR is automatically replaced by another rate using a waterfall-mechanism upon the occurrence of a so-called Benchmark Transition Event. The amendment fallback language entails a contractual arrangement that allows the parties to amend the existing loan agreement to replace LIBOR with a replacement benchmark following a so-called Benchmark Replacement Event.
The LMA reported recently that there is still no obvious available alternative based on RFRs to the IBORs for the syndicated loan market and it has not yet seen any RFR-linked syndicated loans (while admitting it has seen a RFR-linked bilateral loan). The LMA itself has published a revised version of its replacement of screen rate clause on 7 August 2019 that provides a mechanism for loan agreements referencing to LIBOR to transition to RFRs through an amendment approach. The relevant parties can choose whether the provisions of the clause operate only upon the occurrence of a trigger event (a Screen Rate Replacement Event) or at any time where the parties wish to provide for the use of a replacement benchmark rate. The clause entails that amendments to replace the screen rate will include adjusting the pricing to reduce or eliminate, to the extent reasonably practicable, any transfer of economic value as a result of the application of a replacement benchmark. The clause also contemplates that if any adjustment or method for calculating any adjustment has been formally designated, nominated or recommended by the Relevant Nominating Body, the adjustment will be determined on the basis of that designation, nomination or recommendation. In addition, the LMA is working on documentation for RFR based facilities (including updated and RFR based fallback language) and on a form of reference rate selection agreement which can be entered into by parties to an existing LMA-based facility agreement in order to streamline the amendment process. The LMA stated that further updates will be provided by the LMA once further developed.
As a party that is a party to or will become a party to an IBOR-based loan agreement, it is relevant to consider what to do with the IBOR-based loan agreement, respectively whether to already use a RFR as a benchmark rate for a new loan agreement or to wait for a RFR term rate. Unfortunately, these questions are difficult to answer. There is currently no market practice in dealing with these matters. The best practices as set out by the Dutch regulators may provide some guidance in this regard. In each case, a key point to consider in these matters is the pricing issue as a result of the transfer of economic value.