Immediately after 31 December 2021, LIBOR, the benchmark rate used as a key component of interest, default interest and other calculations in a wide range of contracts, will cease to be published. To ensure that your agreements remain functional and robust, any references to LIBOR in contracts expiring after the end of this year will need to be sense checked and amended where necessary.
With so much to think about and limited time to action these changes, where do you start and how can you plan effectively for the end of LIBOR? In this ThinkHouse session members from our Banking and Finance team explain:
- the new SONIA and other new 'risk free rates' (RFRs) that are replacing LIBOR;
- how RFRs based interest calculations work;
- the operational issues using RFRs might create and what you need to be aware of before amending documents;
- why LIBOR phase out affects both banking and non-banking documents and what you need to think about if you see a LIBOR reference in any contract;
- how to approach and plan your LIBOR re-papering exercise successfully.
Stephan Smoktunowicz: Good morning everyone, a very warm welcome to this Gowling WLG ThinkHouse Session, "Why all in-house counsel need to prepare for the end of LIBOR". My name is Stephan Smoktunowicz, I am a Professional Support Lawyer in the Banking and Finance Team here at Gowling WLG, and I am very pleased to be joined this morning by two Partners from the team, Alasdair McKenzie and Navin Prabhakar, who you will hear from further during the session.
If you are new to ThinkHouse or you are returning, it is very good to see you. In the session we are going to help steer you through what is potentially a very difficult topic.
So what is on the agenda this morning? Well to start with, we are going to set the scene, we are going to talk about LIBOR, the end of it. Why is it ending? Then we are going to move on to what is actually going to replace LIBOR, how is that going to work? Then we are going to think about operational considerations. What do you need to think about as an in-house lawyer operationally when you are having discussions around LIBOR repapering exercises, so that your businesses get it right?
And then the final part of this session, we are going to cover some contractual considerations, looking at banking and non-banking contracts, and also provide you with some practical tips on how to manage the LIBOR transition effectively. We are pleased to say that we will be taking questions during the session, you can use the Q&A function within the webinar to put your questions to us. We will try to answer as many questions as possible at the end of the session. However, if we do not manage that we will reach out to you and try to provide a response after the session.
So to start with... let us set the scene on LIBOR's replacements. What is LIBOR? So LIBOR is an abbreviation for the London InterBank Offered Rate. And that rate is a global benchmark interest rate used predominantly for various financial products. It is also provided in a number of currencies, so UK sterling, US dollar, the euro, the Swiss franc and the Japanese yen.
And the LIBOR rate is provided for a number of periods, different interest periods, and these consist of overnight, one week, one, two, three, six and 12 month rates. These are the most popular rates that we see in the market. And so at the beginning of any interest period that you have interest for you know what that rate is going to be. They are published daily, the LIBOR's rates by an organisation called the Inter-Continental Exchange Benchmark Administrator, and the LIBOR rates are based on submissions by panel banks using Interbank transactional data and expert judgment.
So from an in-house lawyer perspective, what documents is LIBOR used in? And we will talk about banking and non-banking contracts because we are conscious that some of you may not see that many banking contracts in practice but may want to understand where else you are likely to see these.
So from a banking perspective predominantly you will see these in the loan market, in loan agreements with syndicated and bilateral agreements. You will also see reference to LIBOR in hedging and derivative contracts in the Bond market, in bond documentation, in securitisations and securitisations' structures and in other financing agreements and arrangements. So they are predominantly the main banking documents that you will see these used in.
But what if you are not dealing with banking documents? Well you may see LIBOR referenced in inter-company loan agreements, for example. You may see them in other commercial contracts, framework agreements, project contracts. All manner of contracts might have LIBOR references in, either by design or just because it felt good at the time to put a LIBOR interest rate into the contract.
Sale and purchase agreements may have references to LIBOR, whether as an obligation or a right, but also it may appear just generally within an agreement. And also thinking about internal guidance notes, particularly for those of you in the banking and lending community and also customer facing product notes. So a whole wide range of agreements where this could potentially come in to play.
So why is LIBOR actually disappearing? Why is it going? Andrew Bailey, who is now the Governor of the Bank of England, gave a speech in his role at the Financial Conduct Authority back in July 2017. To pick out a quote from that speech, what Andrew Bailey said was that "the absence of active underlying markets raises a serious question about the sustainability of the LIBOR benchmarks that are based upon these markets".
I just want to hone in on those words "the absence of active underlying markets raises a serious question" - so what question was that? I think what Andrew Bailey was trying to say is that LIBOR is effectively no longer a representative of true interbank lending rates, and therefore its use for the past 40 years has really needed to come to an end and be replaced by something else.
And so in terms of thinking about next steps, we need to understand when LIBOR is going to go because we need to know what the end dates are going to be in order to plan for the future and there are a number of dates to think about here. The first key date that is coming down the tracks, pretty quickly, is 31 December 2021 when a number of LIBOR rates will permanently cease to be published.
Also on 30 June 2023, we will see a number of other rates ceasing to be published. We might see some rates moving to what are called "synthetic rates" which I will explain in a moment. But to focus back on this first date, this 31 December date. So what is happening at the end of this year is that LIBOR will disappear for all euro and all Swiss franc LIBOR rates. And then for sterling, for US dollar and for Japanese yen some of the rates will also disappear, so they will no longer be published.
One thing to bear in mind here is that the euro LIBOR rate is separate to a rate called EURIBOR and you may see EURIBOR referenced in contracts. We are expecting EURIBOR to continue for a while beyond 2021, albeit we also expect that rate to be replaced in due course.
The next date, 30 June 2023, we are seeing this US dollar LIBOR rate disappear for overnight and 12 month rates... 12 months tenors only. And that leaves some of the commonly used rates in the market, the one, three and six months' tenors, the sterling LIBOR, the Japanese yen LIBOR and the US dollar LIBOR.
And what is happening is that there has been an acknowledgement in the market that where you have very complicated contractual arrangements it may not be possible to get all the documents amended for the phase-out to happen in time, by this 31 December 2021 deadline. And therefore what is proposed is that for periods from 1 January 2022 the sterling and the Japanese yen LIBOR and for a period from 30 June 2023 for the US dollar one, three and six month tenor rates. And we are going to move to some sort of synthetic rates to help the transition.
But one thing to be aware of here is that there may well be regulations or legislation that actually limits the use and the publication of these synthetic rates to specific circumstances. And therefore, as an in-house lawyer, you should never bank on them being available and we'll have to keep an eye on what happens in the market on that.
So we have seen that LIBOR is going to be phased out. What are the consequences of this? And the big consequence here for all in-house lawyers is that LIBOR references in contracts will, on the whole, need to be amended. As I explained there will be hopefully some dispensation for some tough legacy contracts, complicated arrangements, but the thing to note here is that the parameters are far from settled and therefore we are waiting to see how that develops.
We have already seen active steps taken in the UK market and from Q2 this year LIBOR reference loan agreements no longer exist. All new loan agreements have to be based on the new rates, which I will explain later. And also amendments to existing finance contracts that expire after 2021 are expected to be completed by the end of Q3 this year. So with thousands and thousands of different banking agreements and financial contracts in existence, there is a huge, huge job ahead.
If I can turn to Navin and Alasdair, I guess in terms of the consequences, to what extent have you seen people starting to take active steps on this and if there are hesitancies around that, what are the reasons for that and how has that been overcome? If I can start with Navin first.
Navin Prabhakar: Thanks Stephan and good morning everyone. I will pick up on the lender side if Alasdair wants to cover what we are seeing on the borrower side. I think naturally lenders... when I say lenders, I am mainly referring to clearing back lenders, are keen to transition all of their loan assets across to the new risk free rates as soon as possible, given the deadlines that you have mentioned Stephan.
So I think it is fair to say that in and around Q4 last year, lenders were not seeing much uptake from borrowers to transition across and you can understand that, partly because the various working groups, working on the risk free rates, were still finalising the finer details, but also because the Loan Market Association, so that is the LMA, only had very early exposure drafts of the updated industry recommended form of document so borrowers, and probably lenders, probably wanted to let the dust settle a bit.
But we are at that stage now where the LMA now have recommended forms of drafts for the switch mechanics to the new rates and also for day one risk free rates. The lenders did, or at least should have, sent out letters to all their borrowers notifying them of the upcoming changes and inviting them to get in touch and the clearing lenders we know have dedicated in-house teams that are geared up, ready to talk to borrowers through what LIBOR transition means.
Along with an explanation of the calculations and what this means or what it should mean from an economical perspective, a key message that the Bank of England and various parties are keen to get across is that the objective and the intention here is to ensure that following the transition to new rates, it should be economically neutral for borrowers and Stephan you will come on to explain shortly what that total for the new interest package will comprise of.
Another reason for the delay may have been costs. We have also heard from a couple of lenders that because LIBOR transition is market driven, and not by individual borrowers, that some of them are willing to pick up the costs of implementing the new risk free rates, but with the caveat that so long as the borrower does not seek to renegotiate other parts of the document or the transition language itself. So activity is ramping up, rapidly now, and lenders will be keen to amend documents as quickly as possible. We have heard from one member, they have got over 15,000 loan documents to amend before the end of the year. So early engagement really is critical.
Alasdair McKenzie: Thanks Navin. Yes, I would second that completely. I think it is very much a sort of lender driven process, you know I think the market transition is such a set change in pricing. It certainly is a process that the lenders and finance providers will be driving. They have certainly stepped up a gear or two since the start of the year and that is rightly so as the deadline, if one wants to think of 31 December as a hard deadline comes into the horizon.
And I think a lot of corporates, lest we forget that they have been struggling with all that has been going on in the wider pandemic and the impact that has been having on their business, some positive, some negative. But many business and sponsors have had to recalibrate their businesses over the last 12 months including their finance packages. So I think that has probably had a lag effect on some of the uptake, certainly from what we are seeing, but now lenders are driving the process, they are really reaching out to all their corporates.
I think it is probably different scenarios in certain circumstances, so if you have a club of lenders that are providing to your business, there needs to be symmetry between each of those lenders within the club before they can approach you. If you are borrowing on a unitraunch structure or a more sophisticated structure, then you need to see the interplay between maybe your private credit provider and also maybe your clearer or whoever is providing senior liquidity. So there is definitely some interplay on the lender side before the corporates can engage and then, as Navin said, the market is finding its feet.
Some of the mechanics that Stephan will come and touch on, they are really at a fledging stage and so the hesitancy that one might be seeing from the borrower side is understandable. No-one really wants to be first to dive in and potentially not get the best deal they could do, when there is still a little bit of time before the deadline.
Stephan: Thank you both. I think that is why it is important, certainly for us as a law firm and for the lawyer in the street to try and educate the market around this. Which brings us very neatly onto the new rates. What are these new rates? These replacement rates for LIBOR? How are they going to work? How are they going to fit into contracts? Can you just slot the new rate in? We are going to spend the second part of this session exploring all of this.
So to begin with, let us talk about what the new risk free rates are. And what you will hear in the market are terminology around the words "risk free rates" and "RFR", these words are used pretty interchangeably,so what are these new risk free rates? So for each of the currencies we have a risk free rate. So for sterling, that rate is a rate called SONIA and that is published by the Bank of England. In the US for the US dollar, US dollar LIBOR is replaced by a rate called SOFR. For Swiss franc LIBOR that LIBOR rate is now replaced by a rate called SARON. For the euro, we will have a rate called €STR and in Japan, for the Japanese yen, the LIBOR rate will be replaced by a rate called TONAR.
And Navin, if I could turn to you again in terms of basic level understanding of risk free rates, why is it important for in-house lawyers to get a basic good grasp of what these are?
Navin: Yes, as you have already sort of alluded to, Stephan, you know this does not just affect loan agreements, so there are a lot of other commercial agreements out there that reference LIBOR. So even if you do not have exposure as in-house Counsel to the financing arrangements of your company or your group then it could affect you in other ways. I also think it is important in terms of raising awareness to the extent required, managing... informing internal stakeholders. You know, most of your Finance Directors, CFOs, Treasury Teams, they will all be aware of the LIBOR transitions, so they will know "the why" and "the when", however, they may not know "the how".
So the intention of today is to really give you the background, some of the theory and some of the drafting principles and we do appreciate that some of this will be new to some of you and for others, it will be about consolidating existing knowledge. But, hopefully you will all take something away from this session. It is to arm you to be able to have those internal conversations, to start to assess the size of the task for your businesses, which we can support you with. But also really to evaluate, when is the best time to implement any changes in line with your company's treasury strategy.
Stephan: Thanks Navin. Alasdair do you have anything to add to that?
Alasdair: No only to restress the fundamental step change so that when people are saying "what is all the fuss about?" I think one cannot underestimate the question marks that have been raised over the old rate and how it operated and then how many more players and participants have been involved in creating the new rate.
So whereas formerly you would maybe have one access screen point, a number of banks giving the rates in various currencies and that would produce your LIBOR number. Now you are looking at different institutions, government institutions, some of them are independent institutions and they are co-ordinating the rates between themselves, so it is far more of an international and concerted effort and therefore being familiar with the jargon and the interplay and how that all feeds back into the documentation that is relevant to your business is very, very important.
You may have funded or borrowed in dollars or in sterling, all under LIBOR, from now on and certainly once these changes all come through, you will have different rates applicable to each of those currencies and that is a very major change in the way the market operates.
Stephan: Absolutely. So it is going to be important to think about how LIBOR works and what this looks like in a contract so that in-house counsel can make a decision as to whether or not they want to use the new risk free rates in non-banking contracts, but also banking contracts too. So we will talk through these steps over the next few slides.
And we are going to concentrate on SONIA, the SONIA rate because that is the one we are most likely to see in the UK, and ask how that differs to the sterling LIBOR rates that currently exist. So sterling LIBOR is what we call "a forward looking rate" - what does that mean? Well it means on any given date you get a rate for a future period of time. So if I want to borrow for say one week as a bank, I would get a one week sterling LIBOR rate. If I wanted to borrow for a month or three months then I would get the equivalent one month or three month LIBOR rate.
So it is always looking forward, I know what my interest is going to be at that date. And so, for example, if we looked at three month sterling LIBOR on 8 April that rate was 0.0850% and, as we mentioned earlier, this rate is published by reference to bank submissions based on their expert judgement and knowledge of the market. But if we compare the SONIA rate, how does that look in comparison? Well rather than being forward looking it is actually something that we call "backward looking", it is a backward looking rate and you will hear this word "backward looking rate" used a lot.
And what that means is, rather than looking forward, it means that if you took the SONIA rate published today, that would be the average overnight rate for the previous business day, so we are looking backwards in time. And so if we looked at the SONIA rate on 8 April that was 0.0483% as published by the Bank of England based on actual transactions it had been notified of in the market. And what you start to see is a picture of the divergence in these two rates, so the sterling LIBOR rate is 0.0850%, the SONIA rate 0.0483% and clearly if you put the same rates into a contract you are going to get a significantly different economic result. So something needs to give in terms of the drafting that you use in contracts.
So let us try and explain this, but the key point here to bear in mind is that the SONIA or the RFR rate that goes into your contract has to go through a different calculation for it to work. So let us look at an interest calculation that would have been typical using LIBOR. How would that have worked? Let us try and look at this and when you use this example let us take a two year loan facility. It is going to have four equal interest periods of six months with interest payable at the end of each of those six month interest periods. And the interest rates per annum for each of those interest periods will be a margin, let us call it 2% plus the applicable six month LIBOR.
Let us try and think visually, how does that actually look in an agreement? So what you would have is a loan facility of two years in length; you would have four interest periods, each of six months; you would have this constant margin of 2% throughout the whole of those two years, each of those four interest periods. But for each interest period what you would do is, you would look at the screen rate, published rate for LIBOR at the end of the first interest period and apply it for the first period. You would do that again for the second interest period, i.e. at the start of the second six months you would take the LIBOR rate for that period and the same for the third interest period and then the fourth interest period. So effectively what you have are four different calculations that you do throughout the life of that two year facility to calculate your interest, so relatively straightforward.
But how does that compare when you look at a rate like SONIA? And let us take that same two year loan and those four equal interest periods of six months and again interest payable at the end of each interest period. So rather than LIBOR being used and being calculated for each interest period, what happens here when you use SONIA is that the interest rate per annum for every day of every interest period is still going to be your margin of 2% but, rather than using LIBOR, we use something called the compounded reference rate instead. And this is the key thing when you are looking at these risk free rates, like SONIA and how you get them into contracts.
So let us do a visualisation on screen of how this looks. Let us build this up for you. So again we have this loan facility of two years in length, so exactly the same as we saw before. We still have our four interest periods, six months each, interest repayable at the end of each of those interest periods. We still have our nice constant margin of 2% throughout the life of the two year facility.
But here is where it changes, the compounded reference rates are the rates that are going to replace LIBOR has to be ascertained daily rather than the start of each interest period. So through each six month interest period you are having to do a daily calculation to work out what your daily rate is that you have to apply. And so the upshot here is that because this rate is ascertained daily rather than at the beginning of each interest period, the drafting of the interest calculation language is going to be significantly different when using SONIA or a risk free rate than when you use LIBOR.
So when we are looking at banking transactions and thinking about the methodologies that are building up in the banking market, when we are looking at non-banking transactions as an in-house lawyer we are thinking "actually do I want to use that methodology or do I want to use something else?" and we will come on to that shortly.
So what is this new compounded reference rate? Again you will need to understand or have a basic understanding of how that works. So as a reminder we have a new interest rate per annum for each day in each interest period. We set that as a margin, for example 2% plus this new compounded reference rate. And that compounded reference rate is then split into two key components.
The first component is the daily non-cumulative compounded RFR rate. That is really a bit of a mouthful, so let us make that simple - let us call that the 'daily rate' and then added to that is something called the credit adjustment spread. So we need to know what the daily rate and the credit adjustment spread actually are to understand how it works in a contract. So let us take the daily rate first and to calculate the daily rate, this is derived from the new RFR rate, for example SONIA, but it is done so by a set of three calculations. So we are not just looking at a nice simple LIBOR calculation for these purposes. What we are looking at is a set of three calculations.
What actually happens is that we take these risk free rates, the SONIA rates, and we have to do a calculation, we have annualise, cumulate and compound the rate to start with and then, with the result of that, we have to do another calculation, we have to unannualise it. And then we have got another calculation, we have got to uncumulate it, so we have three different steps and these are backed up by different formulae. And what we will be providing, after the session, is some additional materials to explain this in more detail, but for these purposes we will try and keep this relatively simple.
So one daily rate, three steps to calculate it. Then we have to think about adding the credit adjustment spread to that, so what is that? So this is really an additional margin percentage to reflect that there is a difference in the way that LIBOR and the risk rate, for example SONIA are calculated and this is something that we are starting to see and have seen in finance agreements.
So a good point to pause with that information on the screen. Alasdair, if I can come to you, what are the key things that in-house lawyers need to understand about these mechanics when they are having conversations with Finance Directors, CEOs, external parties - where would you start?
Alasdair: Yes, it is always a tricky one. I think the three sort of fundamentals are... first of all the mechanics are completely different to LIBOR, so just a massive step change away. It is look back rather than look forward and that is really really key. So you are approaching your interest determination in a very different way and, as Navin said earlier, the ultimate aim here is there is economic neutrality in the end number, the end amount of cash one might have to pay if you boil it down to a practical level, but the mechanics are completely different.
So in a conversation with a Finance Director one might say "well with LIBOR I knew exactly how much interest I was going to be charged at the start of my interest period, I can build that into my cash flow model, that is not a problem". Is that a problem now? Well, in theory, you do not know exactly down to the pence and the pound how much you will have to pay at the end of the interest period. However, there should be certainty that it will be within the band width that you have seen over the last 18-24 months of whatever LIBOR rates you have been paying on your various facilities or products. So that certainty should be in there but there is definitely the mechanic that actually we will not be able to clarify the specific cash amount until we get much nearer to the interest payment date, albeit it builds on a daily basis.
Secondly, of course, there is the mechanic itself. There is a lot of jargon in there, a lot of terminology, so I would say a key thing is that maybe you do not need to understand every single minute detail, depending on your role and how you interplay with it within your business, but you certainly want to be familiar with the key terms, specifically the daily rate and what sits behind it, the three stages to producing the ultimate daily rate and also the separate item of the credit adjustment spread.
I think the most common question I am getting at the moment is "where is the market on the credit adjustment spread?" I could name five different lenders who do five different things and that is the tricky thing that you will all be facing at the moment... there is no one central, this is hard and fast as to how credit adjustment will fit into our documentation. So those are probably the key mechanical things to have in your mind, in your internal and external discussions.
Stephan: Sure, and I guess getting all parties on the same page on this is going to be really important. Navin, anything to add on what Alasdair has said there?
Navin: Yes, no I think it is absolutely right on credit adjustment spread, it does depend from lender to lender and even from borrower to borrower. By way of example of sort of the four recent deals that I have executed, they had three different clearing bank lenders and there was no credit adjustment spread, and that may well be because the whole commercial terms are being revisited and it was baked into the overall margin.
But, you know, we have also seen that a fixed credit adjustment spread that will apply, depending on the interest period being chosen. So you do need to seek clarity, or the FD does, from lenders in terms of how that credit adjustment spread is made up. Has a part of it been baked into the margin? These are the kind of questions that need to be asked.
But coming back to the question, as Alasdair said, the definitions and the formulae that sit behind all of this are complicated and we would not expect you to have necessarily an intimate knowledge in this. But the one thing to be aware of is timescales, you need to consider how all of this fits in with your finance and treasury strategy. So if you are about to amend or extend your facilities, then your lenders will want to put you on the new risk free rates and if you are not ready to move to that right now, then perhaps consider delaying any material amendments. You know there is always an option of putting a switch date into the document so that LIBOR continues now and you switch across to the new risk free rate on or before 31 December. So it is really about having that conversation with your Finance Team to see what sort of fits in best for your business.
But I would also say there are also some really good slides available from the Bank of England, you know apart from ours of course, that set out the background to all of this which may be more appropriate for colleagues with a finance rather than a legal background and we will include that in the pack that we will distribute after this session.
Stephan: Yes, absolutely, and that will show some example calculations so people can understand how that would work with an almost a real life situation. So there are some key points, thanks Navin, thanks Alasdair. Some key points to flesh out here. You cannot really just delete an existing reference to LIBOR in a contract and write SONIA or RFR in its place. It is really not going to work.
And there are standard wording formally in the market for this daily rate calculation and whilst there might be some slight divergence on that, essentially the market is trying to get to the same place in using that. So, do have a look at our accompanying materials pack when we send that through and if you have any questions feel free to get in touch.
So we have seen how the calculation works. Let us think about the appropriateness of these calculations for all types of contracts, banking and non-banking contracts. So we have seen the mechanics and calculations for interest rates are very complex, lots of stages to jump through, and so perhaps avoid using these rates where there is a simpler alternative that works better for you.
And I have been asked if I can come back to you both, Navin in terms of banking contracts, Alasdair - non-banking contracts. What alternative rates are you seeing being used in banking and non-banking contracts, Navin?
Navin: The risk free rate or LIBOR is not always going to be the most appropriate rate to use and if you go back to sort of Q4 of last year, we did see some lenders taking what, at the time, was the easier option of switching either to a fixed rate or tracking the Bank of England base rate and you can understand why they did that, because of the whole uncertainty in the market. And what are these new risk rates and back to Alasdair's point, "why we want to be the first ones doing that" borrowers were thinking.
But some lenders, they also look at debt sizes as the thresholds. So, for example, if the bank debt is sub £10 million or if the loan is documented on bank standard documents then you may well see a fixed rate or sort of Bank of England linked overall interest package. But more recently we have heard of lenders are now having to give an option of fixed rate or SONIA or the relevant risk free rate, even on smaller loans which are given by standard terms and conditions. So you will probably start to see more of that coming through into sort of the more standard bank documents.
Stephan: Thank you. And Alasdair on non-banking contracts and I guess some of it might depend on whether or not you are trying to pass through a rate, so for example if you have borrowed based on SONIA and you want to put that into a inter-company loan arrangement, historically if you have used LIBOR to match a LIBOR based banking contract. But generally what are your thoughts?
Alasdair: For some documents I have seen it is actually quite a headache because they were passing through LIBOR rates which will now become far more complex because an overarching or underlying documents and agreements are having to transition to SONIA in one area, SOFR in another area. So the general trend is try to move to fixed rates wherever possible or seek other re-cutting of economic terms, whether you are moving some of the return into fees or you are repricing based on other measures.
So, for example, the HMRC for sterling denominated liabilities publishes a rate but that changes far less frequently and tends to run per tax year. So there are options out there but it is a bit of a headache, but the key thing is just diligencing where those references are in your non-direct finance documents and then just thinking those through as to what the best option is for your business.
Stephan: Sure, thanks. So there is a bit of comfort for in-house lawyers. There are alternatives that you can look to but ultimately it may depend on whether you are trying to pass through funding risk through various contracts.
What you may also see being talked about in the market are alternative forward looking rates. So for example, there is a SONIA forward looking rate which is similar to LIBOR i.e. it looks at a future you can ascertain at a rate on today's date for a future period of time. But these rates, it is important to stress, are somewhat in early stages and therefore the working group that has been set up to deal with all this in the UK has emphasised that to get this LIBOR transition exercise done by the end of the year, we really have to stick with these backward looking SONIA rates as much as we can. So they may come into play down the line in years to come, but for the time being we are very much focussed on this with the backward looking rates.
So that has had a look at the new risk rates, how they work, what the calculations look like, some considerations for when you are looking at contracts. What about operationally? What do you need to think about when you are talking to internal stakeholders? And there is a fair bit to think about here so we will just go through this on the next couple of slides.
The first one is your systems. So if you are going to put SONIA into a contract where you want to check your calculations using SONIA or a risk free rate, your systems will need to be able to handle and check those calculations and more over they will need to be able to check them as actually documented in your contracts. And what your contracts might also have, and banking documents typically will do, are fall-back rates. So, for example, if the SONIA is not published for any reason or there is a systems failure, a fall-back rate to say Bank of England base rate or similar rate instead. So operationally you will need to be able to handle both the principal rate you are using but also any back-up rate.
The next thing to think about is, what if I cannot? What if I do not really want to handle all these calculations? Do I need someone else to do this for me? And particularly I think for people who are handling loans and having to do calculations around loans or other financial products. Consideration might be needed around whether or not you need some kind of calculation agents to do that or not. If you can get your systems in place to deal with that then that is probably going to be more straightforward because you do not have to worry about having to handle someone else. But certainly if you are becoming overwhelmed by this, if you have not had much time to get this through, it may be useful as a temporary stop gap or as something you use.
Also think about what calculations you are actually responsible for producing. If you are a lender, a facility agent, they will be clear in your documentation but in commercial contracts it might not be so clearly defined and you might need to think about that. And that is going to be particularly important in terms of liability. What happens if you get the calculation wrong? Do you want to incur any liability for that? So thinking not only about responsibility but also liability and carving out liability where you need to, is going to be important.
The other thing to think about and something that we might not necessarily think about at day one is that "well if I am dealing with another party and they are calculating an interest rate based on a new risk free rate, can they actually handle that?" Have they got the systems in place. So that is a useful conversation to have up front just to make sure that everybody is set up okay.
And the other thing to consider is that there are calculator tools available, we have put some of the links to these in the materials that we will provide after the session. And I would point out some pros and cons of this. Obviously free to use tools are good, you can just plug in numbers and you will get to the interest calculation that you need to, but it is important to think about a few things.
The first thing is that the official SONIA rate is published by the Bank of England and the Bank of England will then licence out the ability to publish that rate to official counterparties so, for example, the current administrator of the LIBOR rate is expected to and has actually started to publish some SONIA rates. But that needs to flow through your agreement, your agreement needs to say which screen rate you are actually looking at. So that is going to be important.
The other thing is that where the publication of rates is licenced out, what you may see are parties thinking "well, I know we have got different types of contracts that use certain types of methodologies, we can get to an answer on what the overall interest rate is quickly using different calculator tools". So some of these are emerging in the market and the thing I would say about these is they are very useful to get to the calculation number quickly.
But again if that calculation is wrong, for any reason, you have got to think "well, did I actually take the rate from the official source, from the Bank of England source, from the daily SONIA rate? Is there a liability here for me, if I get it wrong?" So just a note of caution if you are going to use those kind of tools. So there are some operational considerations.
And moving on to the final part of this session, we want to focus on contractual considerations for you and provide you with some tips on how to manage the process and we are going to split the contractual considerations into both banking documents and non-banking documents and then provide some tips around the whole part of that.
So let us start with banking and finance agreements and key considerations. So we have mentioned there is a new calculation and potentially you need to put the new calculation into the agreement in a way that it switches on a specific date. And you may say have a loan agreement and you might have something like an interest rate swap agreement and your business might have that. And the question there is "well, do they match?" Does the RFR calculation and your switch date actually match and Navin, why is that important? Why have people got to think about, not just the new rate, but actually when it switches and how it applies in different types of finance agreements?
Navin: I think on that question the phrase that kind of springs to mind is that you cannot compare apples with pears. It is extremely important that when you have multiple debt instruments to ensure that you are working off the same rates in all of them. A lot of finance documents do talk to each other. So having references to sort of risk free rates in one product and LIBOR in another linked product will lead to a mismatch. So it is really important to consider your debt documents as a whole and not look at them individually in Silo. So it really is important that you have the same rates that apply to each product.
Stephan: Thank you. And now we move to the question of guarantees and security. I think what we are seeing at the moment is lenders looking at this and thinking "do the amendments to facilitate a switch to SONIA or risk free rates... does the existing guarantee and security actually cover those amendments and Alasdair, why is it important? Why are lenders focussing on this so much?
Alasdair: Well the key here really is around contractual certainty and the fact that most security documents and the like are always looking through to the primary debt obligations and what is in, what we would call in legal speak, what is the purview of the security? And the idea is that it is covering the initial debt and also the interest that has accrued on top of course. When your interest mechanic changes fundamentally, the question for the lender then is, "are you fundamentally moving beyond that which was initially captured or intended to be captured by the security or the guarantee?" A cautious lender may say "well actually we have moved beyond, we need fresh security and fresh guarantees" which of course brings an extra level of complexity and work that needs to be done as part of the switch process.
Stephan: Sure. Thank you. And I guess coupled on top of guarantees and security we often see where there are multiple funding arrangements so, if your business has different funding lines, you may well see inter-creditor arrangements governing those. And so a point of focus for lenders and parties to inter-creditor arrangements is going to be "is there going to be a need for a consent to deal with these amendments to accommodate SONIA rates. So that is an important thing. So that is why you may see your business coming to you and saying "I have got a request to get a consent here, what does that mean?"
The other thing that is an integral part of most financier agreements are financial covenants because these test the ability of a business to be able to meet its debt and interest payments. And so the question here is "do they work with the new rates? Can they be complied with?" Navin, what are you seeing on that? What do you think is important for in-house Counsel? Who would these conversations normally be had with?
Navin: Yes, I think it is a mixture of two roles here. One is a legal functionality and one is the Finance Team. You know if we go back to my earlier point, the intention here is that neither party should be out of pocket and it should be economically mutual. So if that is the case and the working assumption that everybody is working to then the answer is "there should not be any effect on financial covenants". You know, if you take for example the interest cover, the financial covenant, right? The definition of how you make that up includes finance charges. So if the overall interest does not or is not supposed to change then the financial covenants should not be affected.
However, what we would say and recommend is that Finance Teams closely monitor this and keep an eye on this right from the start. Particularly the first few quarters or however often your financial covenants are calculated. To build up a picture of how those covenants are affected, if at all, and if they are then, how are we going to put that right? How do the definitions of the covenant... how the definitions that build up the financial covenants and the financial covenant numbers themselves, how will they need to be adjusted? And that is when the in-house role or the external lawyer's role comes into making those amendments to make sure that borrowers are not penalised. Because that should not be the case, you know borrowers should not be penalised solely as a result of switching to a new rate.
Stephan: Thank you. So a fair bit to think about there on banking and finance agreements. The other important thing is just remembering to keep up to date on latest market conventions. As I mentioned earlier, I touched on the fact that for the euro rate, €STR, we are going to see a switch probably from euro LIBOR to the use of EURIBOR for the time being, if it is not there already. But how that pans out is likely to be seen over the next few months and so we will see more market conventions coming around the euro risk free rate. But keeping on top of market conventions will be really important when you are looking at banking and finance agreements.
And so let us look at other commercial agreements too. So the key things here... we are thinking about where LIBOR is going to be used. So it could be in an interest clause; you might see it in a default interest clause; or a late payment clause; or it could be in some other calculation; or another reference. And I guess the key question here is not just "is LIBOR used?" but does it actually affect an obligational right? And Alasdair, is that a fair question? I mean if it does not affect a right or obligation then do in-house Counsel really need to worry?
Alasdair: I think the start point is, you diligence your documents, you find out if there is a LIBOR reference in them and for each of those it is very much, almost a common sense approach, that for the time being... you know at this point in time LIBOR is still there and yes there may be synthetic rates applicable in the coming months, even years, but there is no certainty around that. So you are looking at an end point where that mechanic will cease to operate and in which case there is a question around validity, there is a question around the impact it would have on an obligation.
Can you be obliged to make a payment when the rate you are setting it against does not exist, it is no longer accessible. Arguably not. That can be terrible if you are a lender, it could also put you in a tricky position if you are a borrower, but then you have got back to back arrangements where you are passing money on, you are pushing it through group companies that may operate slightly independently within your structure. So it is definitely one where there is thought and consideration needed.
Stephan: Sure and on that one, how has in-house Counsel sort of trip over themselves and do work they do not need to as well. So that is a good one to focus on. As is thinking about what are the contractual contract that you are looking at actually inter-relates with. If you have got a contract that says LIBOR and it is going to affect an obligation right, you know what other agreements are referenced in that contract? Do you need consent or a waiver to make amendments to that underlying contract? So same kinds of considerations that we saw for banking documents.
And then I guess for guarantees and security we are looking at whether the guarantee or security will cover the amendments, whether we need confirmations and whether we need new securities and guarantees and, Navin, these are essentially the same questions that we are seeing for banking deals, is it not.
Navin: Yes, absolutely. You have to look at each of these on a case by case basis. Go back and look at "what were the intended guaranteed obligations, what were the intended secured liabilities" with what you are doing now. Will that still be covered? So it is back to what Alasdair was saying about considering it on a case by case basis to understand "will those still continue to guarantee and secure obligations"?
Stephan: Sure, thanks. And I am thinking about what should I amend reference to LIBOR to? We have talked already this morning about whether to use the new risk free rate but it may be more appropriate to use a more fixed rate, Central Bank rate or some other kind of margin. But also what is the risk if you do not amend the contract. You have a commercial contract, it has LIBOR in it, it affects the LIBOR obligation, it is a material contract. What is the risk if you do not do anything?
Well potentially you have got an interest clause that might not be enforceable because the LIBOR rates are not going to be published so you will have no source of reference by which to calculate your LIBOR rate in a contract. The other thing is misrepresentation, which is a really important point. Often commercial agreements or rights under them are sold to third parties whether under business sale agreements or arrangements like invoice discounting, invoice finance. And, there again, if the interest payments are important under those arrangements and the ability to get those interest payments are important, potentially if you have not changed LIBOR rate to something else, whether it is SONIA or a fixed rate, or whatever you want to choose, then potentially, if the agreement is unenforceable, you may also have misrepresentational difficulties. So really important.
So quite a lot to think about commercially. Also think about the other knock on issues: accounting issues; tax issues; and take appropriate professional advice and encourage your key stakeholders to do so. Which brings us on to the final bit of the session and what we thought was, we would provide ten quick tips, key actions to think about when you are doing your LIBOR transition planning.
So to start with, think about which contracts reference LIBOR and expire after the important deadline of 31 December 2021. Also have a look at those that reference IBOR as well, you might see other rates creeping in and you might want to do some forward planning about things like EURIBOR potentially as well.
Then think about filtering it into document type, so loan agreements; hedging trade; finance supplies, sale and purchase agreements; different types of contracts. And I would say that to do this exercise of identifying where you have got LIBOR and to do the filtering, if you do have contract review technology available in-house, that is a good starting point. If not, do come and speak to us, we do have that technology available and it is something that we have been helping many businesses with.
Also have a think about establishing which documents each contract interplays with in each case, what other contracts feed off this and thinking about your key counterparties. Where is the key risk? Where are the key parties you need to engage with? And that will enable you to think about what are my key contracts? What really matters? Do I need any amendments, waivers or consents? And actually if I have got security or guarantees, is that affected?
And then that allows you to flow into the bottom five points. And the first one of those is engaging early as we have seen already and that includes in all relevant jurisdictions, so if you have got cross border aspects, thinking about that.
Establishing some kind of plan for taking your documents amendment process forward and also agreeing costs on that. Agreeing what you are going to pay might be tricky, but engaging in conversation early will be important.
Think about getting some heads of terms. As we have seen it is important to try and break down these calculations into simple commercial terms so that we understand them and that is going to help drive any drafting when you are looking at amendment processes.
And also consider your changes to internal systems. We mentioned earlier operational considerations to make sure that implementation is smooth.
And finally to finalise and execute amendments.
And there you have a ten step process that will help you. Navin, Alasdair, 30 seconds each, just a very quick tip, if you were starting up a LIBOR planning strategy from scratch, what would be your key point? I will start with Alasdair and then go to Navin.
Alasdair: Well communication. I think I would definitely say communication, both internally within your business, communicating, understanding exactly where LIBOR or other pricing benchmarks pervades and cuts across your documents, whether they are finance documents or commercial it does not matter. You need to communicate with the relevant teams that would have those documents and then bring that knowledge together and then communicate with your third parties and to understand what their minimum requirements are. Lenders, banks, private credit - they all have minimum requirements at the moment and they will therefore be sort of held and holding you, as a business, to certain of those benchmarks. So you need to just communicate and start that discussion as early as possible.
Navin: Timescales, you know you need to think how this fits in with your wider financing strategy, okay. Do not leave it until Q4, particularly if your business if very busy around Christmas. As lenders become busy over the next few months, you know amending lots of different loan agreements, their turnaround times might be slower. So it just reinforces the message, get on top of this as soon as you can.
Stephan: Wonderful. Thank you. So eight months, three days, counting. It is goodbye to LIBOR, it is hello SONIA and others and looking at the key messages to transition successfully. Prepare now. We have a couple of minutes for questions, I am just going to have a look at the Q&A. I think we have a lot of questions. Thank you everyone who has sent them through. We are unfortunately not going to have time to look at all of those, so we will reach out to you.
But I want to pick up on one key thing that has come through and if I can give just a minute to you each, Navin and Alasdair on this, couple of questions. What is the best way of managing costs? And also how long is a typical re-papering exercise going to take an in-house lawyer to do. If I can start with Alasdair on costs and perhaps pick up with Navin on the second point.
Alasdair: Costs, that is a tricky one. So as Navin touched on earlier in the presentation, quite a few clearing banks are already reaching out and offering to pick up the cost if this is a one-off tweak to your financing documentation. It is hard to give a specific number because different banks are taking different approaches but, certainly, if you are looking to tie this in with other amends, then of course the more you do, the more costly it becomes. But provided that there is the term sheet and you have a structured process the costs should not be sort of significant in the grand scheme of things. But, yes, very hard to say, there is no sort of one hard and fast "oh it is a standard market price at the moment". I am afraid that just is not the case.
Stephan: Sure. And Navin on documentation in terms of typical length, I guess it is going to differ for banking and non-banking contracts.
Navin: Yes, it will do. You have to look at it on a case by case basis. But just to give you a more recent example, we did a sterling loan based on a LMA document, 11 group companies. It took about three weeks but that... a lot of sort of commercial points were being renegotiated so you can do it quicker than that. It does depend if you are looking at multiple currencies, because that will take longer to implement and, as you say, if there are commercial agreements involved they are more bespoke and they will take a little bit longer to factor in.
So, yes, it very much depends on the nature of the deal.
Stephan: Sure, thank you both. That is it for questions. We will reach out to those who we have not been able to get to but it just leaves me to say thank you to Navin, thank you to Alasdair and, more importantly, thank you to everyone who has joined us this morning for this Webinar. We hope you have found it useful. Feel free to reach out to us after the session and we will send through those additional materials to you for you to have a look at, at your leisure. Good to see you all. Hope you can join us on the next ThinkHouse session, but for now goodbye.
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