What are the principal features of the draft facilities agreements based on compounded SONIA and SOFR published by the LMA?

What are the principal features of the draft facilities agreements based on compounded SONIA and SOFR published by the LMA?

The Loan Market Association (LMA) has published draft facilities agreements based on compounded SONIA and compounded SOFR. This News Analysis looks at the background to the publication of the documents and provides an overview of the draft provisions and issues raised.

What have the LMA published and why?

On 23 September 2019, the LMA published exposure drafts of compounded risk-free rate facility agreements for sterling and US dollars (the ‘Exposure Drafts’). The Exposure Drafts have been prepared by LMA in order to assist the market to prepare for the transition away from LIBOR to risk-free rates (RFRs).

The current lack of a suitable forward-looking term rate and the likely preference of some market participants for a product based on compounded risk-free rates mean that development of a lending product and documentation based on compounded RFRs is an important step in the transition.

The main purpose of the Exposure Drafts is to facilitate awareness and consideration of some of the structuring issues that have emerged by framing them in their documentary context.

Alongside the Exposure Drafts themselves, the LMA has published a detailed commentary document. This discusses the key areas of difference between the standard LMA Primary Documents and the Exposure Drafts. For each area identified, the commentary sets out the following:

  • the background issues relating to that area 
  • the framework adopted in relation to that area in the Exposure Drafts, and 
  • a summary of some key commercial issues in relation to that area for market participants considering the structuring of syndicated loans referencing SOFR or SONIA

What are the principal features of the Exposure Drafts?

The Exposure Drafts are structured as single currency US dollar/ Sterling denominated term and revolving facilities agreements.

Instead of interest for any given interest period being based on Sterling/US dollar LIBOR (as in existing standard form documentation), interest is determined by reference to a compounded average of SONIA/SOFR (as applicable).

That compounded average of SONIA/SOFR is calculated on an in arrear basis over an observation period starting before the start of, and ending before the end of, that Interest Period.

The significant differences between LIBOR and the RFRs, SONIA and SOFR, mean that the interest rate provisions in the Exposure Drafts differ significantly from those in the standard LMA Primary Documents. An overview of the key differences is provided in the section below.

How do the interest provisions differ from those in the existing LMA standard form facilities agreements?

Construction of the interest rate benchmark

Instead of LIBOR, the Exposure Drafts contemplate use of a compounded average of the relevant RFR—this reflects the current use of a compounded average in the bond market as well as feedback from the loan market.

The Exposure Drafts provide that the compounded average RFR initially falls to be determined by reference to an externally produced compounded average of that RFR made available by an information provider (referred to as the Primary Screen Rate). However, if there is no such externally produced rate, the compounded average RFR is determined by the facility agent calculating the rate in accordance with a specified calculation methodology (referred to as the Fallback Compounded Rate).

There is currently no Primary Screen Rate published so any loan based on SONIA or SOFR would need to use the Fallback Compounded Rate.

Period over which the interest rate benchmark is constructed to ensure advance notice of payment

RFRs are backward looking. Therefore, a mechanism is needed to provide the borrower with some visibility as to how much it will need to pay at the end of the interest period. The Exposure Drafts adopt the ‘lag’ structure. In brief, this means that the rate for any particular interest period is calculated by reference to an overlapping observation period which starts a specified number of days before the first day of the interest period and ends a specified number of days before the last day of that interest period.

Constituent elements of the interest rate calculation

Pricing in transactions based on RFRs must cater for the fact that RFRs are typically lower than LIBOR. The rate differential can either be addressed by an increased margin or by using an adjustment spread to add to the margin.

The Exposure Drafts therefore provide two possible options for the constituent elements. The first is the compounded average RFR plus a margin. The second is an approximation of the lenders’ cost of funds plus a margin. If the latter option is used, the approximate cost of funds would be calculated using the compounded average RFR, plus a margin, plus an adjustment spread to make up the shortfall.

Fallback provisions

The primary fallback in the Exposure Drafts is to central bank rates. Unlike in the standard LMA Primary Documents, fallbacks to historic rates and quotations provided by a panel of reference banks are not used since these have not proved particularly workable or popular. The use of cost of funds as an ultimate fallback is retained as an option.

Role of break costs and assumed funding practice

Break costs are included in the standard LMA Primary Documents as the assumption is that the lenders are funding the loan through matched borrowings of their own. The extent to which break costs are still relevant is likely to depend on the funding practices adopted in relation to syndicated loans referencing RFRs. Break costs provisions in the Exposure Drafts are therefore drafted as optional and the definition is left blank.

Role of market disruption provisions

These are included as optional.

Why have these been published as Exposure Drafts rather than recommended documents?

There are still a number of points and issues outstanding which need to be discussed and addressed before the documents are ready for widespread use. The aim of publishing the documents at this stage is principally to get feedback.

As an example, one key obstacle is that there is no externally produced compounded average of either SONIA or SOFR. This means that the RFR would need to be determined by the facility agent using a calculation methodology. The commentary paper notes, however, that this would be greatly facilitated by the provision by a third party of a calculation tool, capable of calculating a compounded average RFR over any period pursuant to a transparent and consistent calculation methodology. There is currently no such tool. In addition, before any such tool is likely to be developed, the loan market would need to form a consensus around certain questions such as how to cater for weekends and public holidays when a rate isn’t published and the applicable rounding convention.

There has been doubt in the market for a long time that backwards looking rates are suitable for the market as, unlike with forward looking term rates, the borrower will not know how much it must pay at the end of the interest period until the end of the interest period. While the lag mechanism attempts to go some way towards addressing this, it may not give many borrowers sufficient visibility—feedback from the market is required as to whether the lag mechanism would generally work for borrowers.

Another point raised relates to break costs. It is not certain whether they are still appropriate or how they should be calculated given that they evolved as a way of estimating losses on matched term funding. In particular, the amount of interest a lender would have received (used to calculate break costs in the Primary Documents) is not ascertainable at the time the prepayment is made because RFRs are backwards looking. If they are no longer appropriate to cater for loss of interest on matched funds, could lenders’ other commercial interests be protected by way of break costs (eg administration costs)?

These issues, and the many others raised in the commentary document, are likely to require consideration and consensus from the market.

What should market participants consider in the context of a compounded SONIA or SOFR based loan?

The commentary paper highlights a number of points that market participants might like to consider before embarking on a loan based on a compounded RFR.

Considerations include:

  • whether market participants will be able to provide syndicated loans referencing RFRs in the absence of a screen-based compounded average of the relevant RFR or a recognised and consistent compounding methodology across the relevant currencies and markets and/or the provision of a recognised and accepted calculation tool reflecting that methodology

  • whether the lag mechanism will provide the borrower with enough advance notice of their payment obligations and if so how long the lag should be

  • if the preference is to price the facilities based on an approximation of cost of funds, ie the compounded average RFR, plus margin, plus adjustment spread, how the adjustment spread should be calculated

  • whether the use of a central bank rate as the principal fallback in the case of unavailability of the relevant RFR is commercially acceptable and if so, how should any variation between the central bank rate and the RFR be catered for

  • whether the cost of funds mechanism should be used as a fallback if there is no central bank rate

  • whether break costs are appropriate and if so how they should be quantified

  • whether the inclusion of market disruption provisions is still appropriate

What are the next steps?

The LMA is requesting feedback from the market on the issues discussed in the commentary document, in particular feedback arising from experiences relating to the issues on transactions. Any feedback should be sent to lma@lma.eu.com and headed ‘Market feedback on Exposure Drafts of Compounded RFR Facilities Agreement.

Some of the issues raised are being looked at by the various LIBOR transition working groups. As an example, the Working Group on Sterling Risk Free Rates is planning to issue a consultation on adjustment spreads in the loan market.

In addition, the LMA is in the process of preparing amendment documentation to assist market participants who wish to transition existing deals from LIBOR to RFRs in amending their documentation.

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About the author:

Miranda is a solicitor specialising in leveraged and acquisition finance. She trained at Hogan Lovells International LLP and qualified into the international banking and finance team. During her time at Hogan Lovells she worked on a variety of domestic and cross-border transactions, acting for both borrowers and lenders. She also experienced secondments to Barclays Bank PLC and Kaupthing Bank hf.