Philip Spittal and Andrew Stanfield, Linklaters
This is a time of significant change in the loan markets. New financial products, ongoing banking reforms and documentary change in a fast-evolving market are now a permanent feature of the landscape. This article explores some of the key issues now facing the debt markets.
In July 2017, Andrew Bailey, chief executive of the Financial Conduct Authority (FCA) announced plans to transition away from LIBOR to alternative reference rates by the end of 2021. With the replacement of LIBOR clearly signalled, the market is considering how best to address this major change.
The principal question is what the replacement rate(s) for LIBOR will be. The starting points are the alternative rates identified for certain currencies as part of the Financial Stability Board’s interest rate reform initiative. For example, it is proposed that reformed SONIA be used as an alternative to GBP LIBOR, and the broad US Treasuries repo financing rate be used as an alternative to US-dollar LIBOR.
There are issues, however, in using either of these overnight risk-free rates instead of LIBOR. A new approach would be required to use an overnight rate for the longer interest periods – typically one, three or six months – for which LIBOR is produced. Given the absence of a credit risk premium in the risk-free rates, a new spread would need to be added to the rate, and the calculation and amount of this is not clear-cut. It may be some time, therefore, before these alternative rates can be used outside their originally intended purpose and a transition plan is developed which the market can implement, making the necessary changes to systems and operations.
In the short term, loan documents are likely to continue to refer to LIBOR in the absence of a clear alternative. This will change, but it is currently too early to assess the appropriate approach. Legacy documents referring to LIBOR will require careful analysis in due course as to its interpretation and future use, but it is again too early to assess this.
The green bond and green lending markets are a relatively new phenomenon which has developed over the past 10 years as an alternative financing option. Green loans may be used for general corporate purposes, but the borrower’s “green” credentials demonstrate sustainability. Conversely, green bonds are bonds whose proceeds will be applied exclusively to finance “green” projects.
In the case of green loans, the environmental, social and governance (ESG) rating of a borrower can impact the pricing of the loan. A margin ratchet may be included that provides for a pricing adjustment linked to specified ESG ratings. The ESG rating may be assigned by a third party agency and updated periodically. The agency’s reports will be compiled from publicly available information. Alternatively, the margin may be calculated according to an annual test of specific green performance indicators which are audited as part of the borrower’s financial audit.
Green loans are a relatively new product, and one that may become increasingly popular as the market develops (as has happened with green bonds).
In June 2017, the FCA published new rules banning clauses that restrict an entity’s choice of provider for future primary and market services. This followed the FCA’s study into investment and corporate banking, which concluded that arrangements that restrict the future choice of service provider could inhibit effective competition.
The ban applies to regulated firms that provide primary market services, irrespective of the location of the firm’s client. The core rule is that “a firm must not enter into an agreement in writing with a client that contains a future service restriction”.
The term “future service restriction” means a contractual provision which grants a firm the right to provide future primary market and M&A services, or the right to provide those services before the client is able to accept any offer from a third party to provide those services. The term “primary market and M&A services” refers to services that constitute designated investment business or MiFID business and are either:
The new rules exclude from the ban arrangements included in an agreement to provide a bridging loan where the primary market and M&A services relate only to that bridging loan. The FCA has defined a bridging loan as a loan to provide short-term financing with the commercial intention that it be replaced with another form of financing, such as an equity or debt capital markets issue. The FCA also identified certain non-exhaustive characteristics of bridging loans, including an expressly documented intention that the loan is a short-term financing solution, the loan has a short term (typically less than four years), and the proceeds of future financing are required to be applied in prepayment of the loan.
The new rules apply to agreements entered into from 3 January 2018. The FCA will monitor implementation of the ban and remains open to extending the ban to other wholesale market services if there is evidence that restrictive clauses are being used to the detriment of clients using those services.
Two key Loan Market Association (LMA) documentary developments were announced in 2017: a new designated entity clause in April; and more wide-ranging changes to template facility agreements in July.
The optional designated entity clause is intended to give lenders flexibility in complying with licensing requirements. A lender is permitted to nominate an affiliate to participate in specified utilisations in its place. The affiliate takes on the obligation to lend and right to repayment, while the lender retains the voting rights and other obligations. The clause may assist in some circumstances in light of UK lenders’ potential loss of EU passporting rights, but is unlikely to provide a broad solution to this issue.
The updated LMA investment grade facility agreement has principally been confirmed with relevant provisions of the LMA leveraged facility agreement, itself updated in November 2016. The list of matters requiring all lender consent to amend or waive was expanded, for example, to include the provision restricting changes to the obligors. Representations and undertakings were widened to cover court, arbitral body or agency judgements/orders that might have a material adverse effect. The “know your customer” information obligations now apply where there is a change in status of a holding company of an obligor. A new increase mechanism allows the top company in the group to request that any commitment cancelled pursuant to the illegality or prepayment of single lender provisions be assumed by a replacement lender.
Other changes include updates to reflect IFRS terminology for financial statements, clarification of the scope of the restriction on asset disposals, an option to name specified guarantors not permitted to resign and an alternative permitting any publicly available spot rate of exchange if the agent does not have such a rate. Drafting changes have been made to the tax and jurisdiction clauses, but do not affect their operation, and minor updates have been made to the swingline facility provisions.
IFRS 16 is a new accounting standard for lessees which replaces an existing framework under which lessees categorise leases as either finance leases (which are reported on balance sheet) or operating leases (which are not reported on balance sheet). The new standard applies from 1 January 2019, but early adoption is permitted.
IFRS 16 broadly requires lessees to recognise all leases on their balance sheet, subject to exceptions for short leases (those for 12 months or less) and low value leases (worth less than US$5,000).
The new standard has the potential to impact financial covenants in loan documents, where elements of the financial covenant calculations are drawn from the affected parts of a company’s financial statements. For example, the reclassification of operating lease expenses into depreciation and interest could have the effect of increasing EBITDA, and may therefore prompt consideration of whether it is necessary to adjust any affected definitions or the relevant financial ratios.
In practice, however, the “frozen GAAP” provisions commonly included in facility agreements will help to address many concerns. These require financial statements produced over the life of the facility to be prepared using GAAP as applied at the date of the loan agreement. If there is a change in GAAP, the borrower can deliver financial statements calculated on the new basis, provided it notifies its lenders of the change and its auditors deliver sufficient information to allow the lenders to determine whether the financial covenants have been complied with by reference to GAAP as applied at the date of the facility agreement and to make an accurate comparison between the borrower’s financial position indicated in those financial statements and the borrower’s original financial statements.
The new standard also has the potential to impact other areas of loan documents. For example, the LMA leveraged finance facility agreement has historically included a definition of Finance Lease, which referred to leases that are treated as finance or capital leases. Other LMA facility agreements have used similar descriptions of finance leases in defining “financial indebtedness”. These definitions could be interpreted as having a different scope after IFRS 16 is adopted, impacting provisions in those documents that use those definitions. To address this, the LMA has included optional drafting in these definitions to exclude leases that would have been categorised as operating leases under the pre-IFRS 16 accounting regime. If this is included, the adoption of IFRS 16 should not impact those provisions.
Measures being introduced internationally to address tax structuring in the form of base erosion and profit shifting have the potential to impact loan documents. The new rules are complex, and timing for implementation of certain aspects is currently unclear, but appropriate risk allocation between lenders and borrowers is likely to become an increasingly common point of discussion on transactions.