Financing documents have long included provision for circumstances in which IBOR was not available, however, those provisions were primarily intended for a short term disruption to IBOR, not for a longer term discontinuation of IBORs.
Generally, the fallback provisions that apply in a syndicated loan agreement where the relevant IBOR is not available, work as follows:
- initially, the first step is for the facility agent to obtain a range of quotes from a (usually pre-determined or selected) group of reference banks of their borrowing rates in the interbank markets. The average of these rates is then used as the replacement benchmark. However, banks already generally refuse to act as reference banks and in the circumstances where IBOR has been discontinued then, (in the absence of regulator compulsion) it seems unlikely that banks would be willing to provide such rates.
- the final fallback is by reference to each lender’s self-determined cost of funds, with the benchmark rate then either set as the weighted average of those rates, or individually for each lender. Clearly for large syndicates it is likely to be impractical (for borrowers and facility agents) to administer lenders’ individual costs of funds and therefore interest payments.
Usually, if such IBOR disruption provisions are invoked, there is an obligation on the parties to negotiate for a period of time to find a suitable replacement reference rate. However, any changes to the reference rate require the borrower and all lenders to consent to any changes- which in a large syndicate may be impractical (or in certain circumstances impossible).1 It was in this context that some industry associations introduced additional fallback language to deal with the situation where IBOR was discontinued.
In Europe, the LMA has introduced recommended wording to deal with the replacement of various IBORs.
The proposed clause operates only upon the occurrence of a trigger event or, alternatively, any time where the parties wish to provide for the use of a replacement benchmark rate. The trigger events include the following:
- events related to the cessation of the relevant IBOR;
- the relevant IBOR is to be calculated on the basis of reduced submissions;
- the parties determine that that the relevant IBOR is no longer appropriate for the purposes of calculating interest.
On the happening of the relevant event, the requisite lender consent level to deal with amendments to the interest rate are reduced to a majority lender level (in Europe generally 66 2/3%).
This follows what is known as the “amendment approach”, simply allowing for a lower lender consent threshold, rather than providing for specific fallbacks that apply automatically on the occurrence of a trigger event (the “hardwired approach”). The advantage of the amendment approach for markets, such as the loan market, for which no consensus has been reached on the replacement of IBORs, is that it allows flexibility to follow that market consensus once determined. The disadvantage is that borrowers may be stuck with the cost of funds alternative because of lender paralysis or disagreement.
The ARRC in the United States proposed two alternative clauses – one taking the amendment approach and one taking the hardwired approach. The hardwired approach refers to term reference rates and spread adjustments issued by the ARRC, or failing that, ISDA.2
The ARRC has prepared draft New York state legislation to provide that if there are no appropriate fallbacks, the rate automatically switches to RFR. The proposed legislation would (1) prohibit a party from refusing to perform its contractual obligation or declaring a breach of contract due to the discontinuance of IBOR or the use of the proposed recommended replacement rate; (2) establish that the recommended benchmark is a commercially reasonable replacement and substantial equivalent and (3) provide safety from litigation for the use of the replacement rate. The legislation would (1) override existing fallback language that falls back to a IBOR based rate or requires polling for IBOR or other IBORS and includes the recommended replacement as the IBOR fallback where there is no existing fallback. Parties may mutually opt out of the application of the legislation at any time. However, it is uncertain whether this would be enforceable outside the US and it would only cover New York law contracts.
In October 2019 the LMA published a further exposure draft reference rate selection agreement (the Draft Reference Rate Selection Agreement) for the transition of legacy transactions to risk free rates, the purpose of which is to facilitate awareness of documentary mechanics and some of the issues that will need to be determined when transitioning legacy syndicated loan transactions. By contrast to the derivatives market, the syndicated loans market does not have a protocol system such as ISDA to document amendments to agreements due to the multilateral nature of the financing arrangements. Each facility agreement which references IBOR has to be amended to refer to the new benchmark. Under the Draft Reference Rate Selection Agreement, the parties would agree the basic commercial terms for the selection of the applicable alternative reference rate(s) and then authorise the agent and the obligors to determine the necessary amendments to the relevant facility agreement in accordance with the terms set out in the Draft Reference Rate Selection Agreement. The proposed Draft Reference Rate Selection Agreement should streamline the process of agreement to such amendments. This document is to be read and reviewed in conjunction with the Exposure Drafts.
The derivatives market has led other markets in developing fallbacks for IBORs with, two main initiatives – (i) the Benchmarks Supplement (largely a stop-gap and mainly introduced to comply with regulation) and (ii) the actual development of fallback rates to replace IBORs.
First, largely in response to the EU Benchmarks Regulation and the requirement under Article 28(2) for robust fallbacks in certain contracts (including listed bonds and traded derivatives) ISDA published the Benchmarks Supplement and related Benchmarks Supplement Protocol in 2018. The Benchmarks Supplement Protocol allows parties to amend legacy transactions in addition to new transactions.
While the Benchmarks Supplement (and related Protocol) do not provide specific IBOR fallbacks, they do provide for a waterfall of replacement methodologies that are more robust than the existing fallback of quotes from reference banks in the legacy ISDA documentation (which was a short-term solution and not likely something that would be workable in the event of a permanent discontinuation of an IBOR). The Benchmarks Supplement (and related Protocol) provide that the fallback rate will in first instance be the specific rate agreed by the parties (this anticipates a further supplement and protocol once the fallback rates are commercially agreed – see below) and failing that, a further waterfall that would include a rate nominated by the relevant regulator.
We have not seen widespread adherence to the Benchmarks Supplement Protocol but we have seen these sorts of fallbacks included in some new derivatives agreements and also bond documentation where a requirement for robust fallbacks is mandated by EU law.
In September 2019, ISDA launched its [hoped] final consultation on its proposed approach to term and spread adjustments for derivatives fallback language. It is expected that the fallback rates will be a compounded RFR over the relevant term plus a spread (to reflect the bank credit risk implicit in an IBOR rate) determined using a 5 or 10 year look-back/comparison between the RFR and IBOR and a mean or median.
It is contemplated that these fallbacks, once agreed, would be implemented into new transactions by virtue of forming a supplement to the 2006 Definitions; and into legacy transactions by way of protocol. Where the Benchmarks Supplement forms part of an agreement, these new rates would slot into the Benchmarks Supplement as the primary fallback rate to be used.
It was initially expected that a Supplement to the 2006 Definitions and a related Protocol would be finalised in 2019 and become effective in early 2020. Drafts of both of these documents have already been circulated and are the subject of discussion. Bloomberg was appointed in the summer of 2019 as the vendor that will calculate and publish the fallback rates. The Protocol will amend references to IBORs in transactions incorporating the 2000 and the 2006 Definitions, as well as other references that Parties may have included in their ISDA Master Agreements and CDAs, though the exact scope of the Protocol is still under consideration.
In February, ISDA announced that it would re-consult on how to implement the pre-cessation fallbacks to determine whether pre-cessation fallbacks should be linked with permanent cessation fallbacks as standard language in the amended 2006 ISDA Definitions and in a single protocol, with no optionality.
The deadline for responses to the consultation is late March, and ISDA hope to publish the results and next steps for implementing permanent cessation and pre-cessation fall backs in late April/early May 2020, with the “big bang” effective day for the amendments and protocol following no earlier than the end of August/September.
In the meantime, ISDA is working with Bloomberg to publish indicative spread calculations and all-in fallback rates during the first half of 2020 to help facilitate operational readiness for fallback implementation.
On 18 December 2019 ISDA launched a supplemental consultation on spread and term adjustments for EUROLIBOR and EURIBOR. The feedback was published on 24 February 2020 and the overwhelming majority of respondents agreed with an implementation based on the “compounded setting in arrears rate approach with a backward-shift adjustment” and a spread adjustment based on “historical median over a five year lookback period” for fallbacks.
On 13 January, ISDA published a set of IBOR Fallback Rate Adjustments FAQs, which address issues arising from key adjustments that market participants will need to make if fallbacks to risk-free rates are to take effect in contracts that originally referenced IBOR.
In February 2020, ISDA published a research note, Adoption of Risk-Free Rates Major Developments in 2020 looking at major upcoming development in 2020, including the publication of new benchmark fallbacks for derivatives contracts.
The fallback to a cessation of an IBOR under legacy bond documentation tends to be (i) first, quotes from reference banks; failing which (ii) the last relevant fixing of the floating rate. This raises serious issues about bondholders effectively being stuck with a fixed rate bond (possibly at a low interest rate) for the term of a bond when they had purchased a floating rate instrument. Many older bond documents do not even include risk factors addressing this eventuality.
More recent bond documentation has been more robust in including risk factors and fallback methodologies. These methodologies vary but are often in line with the waterfall set out in the Benchmarks Supplement discussed above. Some documents give the Issuer or Calculation Agent the ability to unilaterally amend the rate to follow new market standards.
A problem with bonds (that does not exist in the derivatives market, for example) is the potential difficulty in amending legacy documents. In general, a consent solicitation process would be required, whereby in addition to agreement from the Issuer, a relevant majority of bondholders (typically 2/3 in Europe) agree to the change. In the US market, the threshold of bondholders requiring consent is often 100 per cent.
In May 2019, we saw the first instance of an IBOR-linked bond changed to an overnight rate by way of a consent solicitation process when Associated British Ports amended its floating rate notes to reference compounded daily SONIA plus a margin. See our Law-Now article for more information.
Even in the case of consenting bondholders, the process for consent solicitation is relatively burdensome from an administration perspective, and is likely to be a challenging exercise for the market, when multiplied over thousands of bond issuances.
The Sterling Working Group published a note3 in January 2020 advising market participants to transition the SONIA CIA before the fallbacks are triggered and listing some considerations and lessons learnt from previous consent solicitations.
1There could be “zombie lenders” in a syndicate which, for various reasons (insolvency, constitutional restrictions or the fund reaching its end of life) cannot consent to any changes.
3 see https://www.bankofengland.co.uk/-/media/boe/files/markets/benchmarks/rfr/lessons-learned-from-recent-conversations-of-legacy-libor-contracts.pdf?la=en&hash=F7369B04468DEE1B54CE4C2B42F2D0DC1D0E06B1