In an earlier blog we set out the basics of how the transition from LIBOR to SONIA would be effected. The matter has become more pressing as since October 2020 Banks have been providing detailed drafting to document the proposed transition and it was announced on 5 March 2021 that LIBOR as currently calculated would no longer be available from 1 January 2022. We examine some key issues below:
Although other periods are possible, LIBOR has generally been offered to the sector for periods of one, three or occasionally six months with longer periods incorporating an increasing premium to compensate for loss of funds and credit risk over those future terms. As an overnight rate based on past data, SONIA is effectively a risk free rate (RFR) which will be lower than LIBOR.
For new loans this is likely to be reflected in a higher margin than would be offered under LIBOR; for existing loans which transition to SONIA this will, in the absence of other factors, be effected by retaining the existing margin but adding a spread based either on LIBOR – SONIA swap rates or alternatively a comparison of the difference between LIBOR and SONIA over an agreed period.
Looking back not forward
As noted, LIBOR is based on a subjective decision by Banks about the rate they could borrow funds over a set period which, for all its drawbacks, at least fixes a rate at the outset of an interest period allowing the borrower to know how much they will have to pay at the end. Being based on past transactions however, SONIA will not be calculable until the interest period has ended when it becomes immediately due.
In order to resolve this it is proposed that interest payable at the end of the interest period will be based on SONIA rates from a period (e.g. five business days) prior to the start of the interest period until the same number of business days prior to its end. As and when RSLs transition to SONIA, RSL’s will have to adapt their existing systems to reflect these arrangements and early consideration should be given as to how that will be implemented.
Which Screen Rate?
The SONIA rate over a period will be calculated by compounding daily rates in line with a formula set out in the Agreement and shown on a publicly available screen selected by the Lender. Unlike LIBOR there is likely to be more than one such screen rate - there have been queries as to whether this may result in different rates being charged to different borrowers dependant not simply on margin, but on which screen rate the Lender selects and comfort should be sought on that point when negotiating transition documentation.
Action to be taken
We understand that some funders are writing to their customers asking whether they wish to amend their facility documentation to transition from LIBOR to SONIA now rather rely on such fall-back provisions as the documentation may contain when LIBOR ceases to be available on 31 December 2021 (e.g. Lender’s cost of funds as stated by them etc.). Inevitably such provisions will vary depending on the funder (s) involved and, more importantly perhaps, when the documentation was entered into. In addition many will have been designed to cover a short temporary failure rather than a permanent cessation and in other cases there may not be any fall-back provisions at all.
In order to resolve this, it is proposed that legislation be put in place to enable FCA to set a benchmark (“synthetic LIBOR”) where there is genuinely no realistic ability to renegotiate or amend the contract. However, as UK Finance have pointed out in their Guide to LIBOR Discontinuation (at pages 22/23), FCA and other Regulators expect this to be limited to agreements that cannot be transitioned, renegotiated or amended prior to the date when LIBOR expires.
It also seems likely that even where such a benchmark is available it will only be so for a limited period and it is not immediately obvious how a Scottish RSL would justify being within this category – particularly when FCA have made clear in a Statement on the subject that “those who can amend their contracts so that they move away from LIBOR at or before this point,(i.e. LIBOR discontinuation date) should do so”
Whilst certain aspects of the transition still needs to be finalised, there are steps RSLs can take to make the process easier well in advance of LIBOR’s replacement at the end of this year including a review of their current loan documentation to examine whether it contains any ‘fall-back’ provisions and if not (or if these are likely to be inappropriate) contacting their lender(s) to discuss.
Should you or anyone in your organisation require assistance with this or have any questions about the LIBOR transition process our team would be happy to assist.