With the end of LIBOR, the secondary debt trading sector needs new terms and conditions. Our distressed debt and debt trading team examines how the Loan Market Association amended its documents to introduce risk-free benchmarks.
- What changes have been made to late payment compensation under STCs?
- Two new checkbox options: exclude credit adjustment spread and apply a zero floor
- The new default rate can be straightforward, but only if the parties agree on everything in advance
The Loan Market Association (LMA) recently released revised documentation on secondary debt transactions that will apply to bank debt transactions entered into on or after January 4, 2022. The LMA’s standard terms and conditions for troubled business transactions ( STC) and LMA trade confirmation remain largely the same, but key revisions have been made to language regarding deferred settlement clearing for Risk Free Reference Rates (RFRs). These changes were necessitated by the shift from the London Interbank Offered Rate (LIBOR) in the corporate syndicated loan market to RFRs (such as the Average Overnight Sterling Index (SONIA) applicable in the UK market. sterling and the guaranteed overnight funding rate (SOFR) applicable in the US dollar market).
Changes to Deferred Settlement Compensation Under CTS
Under the STCs, unless the parties expressly agree otherwise, the deferred settlement fee begins to run during the delay period, which, for au pair transactions, is the transaction date plus 10 working days ( T + 10) and, for transactions in difficulty, is the transaction date plus 20 working days (T + 20). Historically, the cost of carry rate applicable during the delay period was based on the 1 month Interbank Offered Rate (IBOR) for the currency concerned. As noted in the revised LMA User Guide, this cost of carry approach is no longer adequate for syndicated credit facilities that have moved from using IBOR to RFR.1
Under section 11.1 (a) of the updated STCs, if interest accrues on the part traded under a credit agreement by reference to an IBOR rate, the cost of carry should be calculated in the same way. than historically by averaging the IBOR rate applicable to 1 month. currency during the delay period. If the corresponding 1-month IBOR is no longer available, the cost of carry rate will be the simple daily risk-free rate for that currency.
Loans based on RFR
Under Article 11.2 (a) of the updated STCs, the default cost of carry rate for negotiated parties bearing interest under a credit agreement on an RFR basis is now a simple daily risk-free rate. .2 For such transactions, the cost of carry is calculated by averaging the simple daily risk-free rate over the delay period. In addition, a credit adjustment spread (CAS) equal to the CAS payable under the credit agreement must be added to the daily risk-free rate, unless the CAS is not payable under the credit agreement or the parties specify in the confirmation that the CAS does not apply. .
The default simple daily risk-free rate is not mandatory, and parties may specify that a composite index, such as a SONIA composite index, will be used for cost of carry purposes instead of a risk-free rate. simple everyday. If the parties choose to use a composite index, this choice must be detailed in the confirmation with the applicable index for each currency. Due to the operational complexities and capacity limitations of the electronic settlement platform that generate prices for market participants, we expect the majority of LMA bank debt transactions to follow the risk-free rate convention. simple daily default for the carry cost calculation for RFR-based loans.
The compensation provisions for deferred settlement in STCs also cover situations in which the accrued interest on assets purchased under the credit agreement passes during the delay period from the IBOR base to the RFR base. If this occurs, compensation for deferred settlement will be based on the current 1-month IBOR rate methodology for each day during the delay period during which the purchased assets are subject to an IBOR rate and for the remainder of the period of arrears will be payable on the basis of the new Simple Daily RFR (plus the Credit Adjustment Spread, if applicable).
Very useful examples on how to calculate deferred compensation in relation to the new risk-free rate methodology have been added to the appendix of the revised AML User Guide. In addition to understanding the new methodology, for anyone looking to better understand how deferred compensation is calculated in general, reviewing such examples will be an informative learning tool.
LMA transaction confirmation (bank debt)
Other terms of trade
The major revisions to the confirmation can be found in the Other Trade Terms (OTOT) section.3 Under this section, parties, as before, can choose to waive deferred compensation, but now have two new checkbox options to select from that will affect the economics of commerce.
Exclude the CAS from the cost of transport?
The first of these new checkbox options is the ability to exclude the credit adjustment gap for cost of carry purposes. In deciding whether or not to exclude CASs for cost of carry purposes, each party should be aware that a CAS is typically used to reconcile the economic differences between IBORs and RFRs, which, in turn, aims to limit the transfer of value between parties during the transition to RFRs. However, parties shouldn’t take this at face value because although LIBOR is credit sensitive (unlike SONIA and other RFRs), it still evolves alongside other RFRs, such as SOFR. Thus, when a transaction involves a CAS, the parties should carefully consider the applicable IBOR and RFR trends to determine whether the inclusion of the CAS for cost of carry purposes is in fact limiting the transfer of value between the parties. In practice, end buyers will prefer to exclude the CAS from the calculation as this will reduce the cost of carry owed to the seller for the delay period. Market participants should specify at the time of trade whether CAS will be excluded from cost of carry calculations.
Does a zero floor apply?
The second new checkbox option is the application of a “zero floor” for transportation cost purposes. By checking the zero-floor box, the parties ensure that the cost of carry cannot be a negative number and therefore payable by the seller to the buyer. As stated in footnote 3 of the new confirmation, if accepted, “a floor of zero will apply to the cost of transport rate when calculated for RFR currencies on the basis of a Daily RFR (and a compound RFR) before adding CAS if applicable and for IBOR rate currencies based on a relevant IBOR rate. The zero floor checkbox could prove to be a point of contention between the parties. Naturally, sellers will prefer to have a floor of zero as this ensures that they will not have to pay buyers in situations where the cost of carry calculation results in a negative number. On the other hand, buyers will prefer the absence of a zero floor, which will allow them to reap the benefits of a negative interest environment.4 In order to avoid such disputes, the parties must determine at the time of the transaction whether a floor of zero applies when calculating the cost of carry.
Other changes – Default interest by virtue of participation in the AML
The transition from IBORs to RFRs also required the LMA to change the way provisions for default interest are calculated in the LMA’s standard participation agreements. Prior to the revised negotiating documents, default interest owed either by a grantor to a participant or by a participant to a grantor for late payments was equal to 2%. more the relevant interbank market for demand deposits offered by the main banks in the applicable currency and for an amount equal to the outstanding balance. According to updated LMA participation negotiating documents, default interest will now equal 2% more the rate at which the liable party could obtain by depositing with a leading bank an amount equal to the outstanding balance.5
Take away food
Buyers and sellers should be aware that the default cost of carry rate for negotiated interest-bearing portions of a credit agreement on an RFR basis is now a simple daily risk-free rate. Along with this new default rate, it is possible to exclude the CAS or apply a zero floor for the purposes of the cost of transport. Since the exclusion of the CAS and the applicability of the zero floor have economic impacts on both the buyer and the seller, these choices must be agreed upon at the time of trade. Otherwise, these economic elections can become contentious and delay the settlement of open trades.
1 Secondary debt negotiation documentation (by and in difficulty) – User Guide at 10, LMA (January 4, 2022), https://www.lma.eu.com/documents-guidelines/documents.
3 LMA transaction confirmation (bank debt) in section 14, LMA (January 4, 2022), https://www.lma.eu.com/documents-guidelines/documents.
4 Since the global financial crisis between mid-2007 and early 2009, several central banks around the world, including the European Central Bank, have added the use of negative policy rates to their toolkits. Sweden’s central bank, in July 2009, was the first to drop one of its key rates into negative territory. The European Central Bank introduced its negative interest rate policy in 2014. Negative interest rates have been in place for almost eight years in the euro area, and markets expect such rates to be in place. up for the foreseeable future. Grégory Claeys, “What are the effects of the ECB’s negative interest rate policy?”At 8-9, Policy Department for Economic, Scientific and Quality of Life Policies (June 2021).
5 LMA Master Funded Participation Agreement (Par / Distressed) in section 4.5, LMA (January 4, 2022), https://www.lma.eu.com/documents-guidelines/documents.