The Loan Market Association (LMA) earlier this week published new drafts of two facilities agreements referencing the risk-free-rates that are designed to replace LIBOR, as well as a commentary on the documents.
There is a new sterling facilities agreement based on SONIA (Sterling Over Night Index Average), and a new dollar facilities agreement based on SOFR (Secured Overnight Financing Rate). The drafts are described as "exposure drafts" rather than recommended forms and contain a number of blank placeholders and optional provisions. The LMA state that there is insufficient market practice or infrastructure at this time to publish recommended forms of the facilities agreements. The drafts have been produced to act as a focal point for lenders to consider some of the structuring issues that arise when trying to develop syndicated loans based on the new risk free rates. The comments below relate to the sterling SONIA facilities agreement (although many of the issues are common to the dollar SOFR agreement).
The sterling document uses a backward-looking compounded average of SONIA with a "lag" structure. SONIA for any given interest period is calculated for a slightly different period (the "Observation Period") which begins a few days before the start of the interest period and ends a few days before the last day of the interest period. The interest payment is therefore known a few days before the end of the interest period. SONIA derives from a rate provided by an information provider (the Primary Screen Rate), failing which it is calculated by the facility agent using agreed methodology (the Fallback Compounded Rate).
The commentary flags up a number of the issues that need to be resolved in the drafts, these include:
- Currently there is no Primary Screen Rate available, and the methodology for calculating the Fallback Compounded Rate is not specified in the drafts because there is no established market practice on this.
- The concepts of "Interest Period" and "Observation Period" are defined by reference to a number of business days, and so public holidays could result in those periods containing a different number of days which would affect the rate produced for that interest period. An alternative definition of "Observation Period" allows users to specify which types of days are included but then the definition becomes less straightforward.
- The length of the lag period is not specified and parties will need to agree on this. A longer lag period gives more certainty on how much interest is payable/receivable but a shorter period will better reflect the latest movements in the rate.
- SONIA is typically lower than LIBOR and may not accurately reflect lenders' cost of funds over an interest period. This differential could be addressed via an increase in margin, or via a separate element of the interest formula. The draft contains two options for calculating interest, either interest = SONIA + margin or interest = SONIA + margin + an "Adjusted Reference Rate" intended to represent cost of funds. The Adjusted Reference Rate is based on an adjustment spread specified in a schedule which has been left blank in the draft, and so the means of calculating this will need to be agreed by parties if this option is used.
- The break costs concept is optional in the draft. Whereas break costs are included in a LIBOR facilities agreement to reflect the assumption that lenders have match funded their commitments for each interest period and will have to pay interest on such funding for the entire period, for SONIA loans they may instead obtain funding on an overnight basis meaning that the concept of break costs is not relevant. Where the break costs concept is included, the drafting would need to be amended from that contained in the other LMA facilities agreements because at the point of any repayment or prepayment, the amount of interest the lender would have received for that interest period will not be known.
- The market disruption provisions are also optional. These provisions kick in where lenders report that the benchmark does not reflect the cost to them of funding a loan, and as such would only apply where the interest formula includes an identifiable cost of funds element (e.g. the Adjusted Reference Rate mentioned at 4 above). Even where the cost of funds element has been adopted, it may not be commercially acceptable to include the market disruption provisions.
The new drafts are obviously in their infancy and much work is still to be done before we see them included in syndicated loan documents, however their publication should lead to lenders beginning to discuss and agree a common position on the various structuring issues, included those mentioned above.