The transition from referring to EURIBOR and LIBOR benchmark interest rates (IBORs) in loan documentation to using risk-free rates (RFRs) has been an important topic of discussion over the last few years. Most borrowers are waiting for clear market guidance before they start the transition process, and they might underestimate the extent and potential impact of the amendments they may have to make. Although forward-looking RFRs may be developed for certain currencies and reformed EURIBOR may remain available, this should not prevent borrowers from taking action. Given the important differences between IBORs and RFRs, the switch requires more than simply referencing an RFR instead of an IBOR. To prepare for the expected discussions with their banks on the transition, borrowers need to assess their IBOR exposure. They should also familiarise themselves with the differences between IBORs and RFRs and what those differences imply. Recently published LMA exposure drafts may assist in this process.

The interest rate for most existing loan agreements is determined by adding a certain margin percentage to an IBOR. Following the FCA's announcements in 2017 and 2018 that borrowers should not count on the widely-used LIBOR remaining available after 2021 and should transition to alternative RFRs, there has been an increased focus on this issue in the market. Working groups for each relevant currency have been tasked with recommending preferred alternative RFRs, identifying transitional issues and solutions, and developing contractual fall-backs. Recommended RFRs include €STR for the euro, SOFR for U.S. dollar and SONIA for pound sterling. Key differences between these RFRs and IBORs are that RFRs will be:

• backward-looking, meaning that the rate applicable to any day is published only on the following business day (T+1), rather than before the interest period (T-1 or T-2). As a result, borrowers will only be able to determine the interest payable at the end of a certain interest period;
• overnight rates, meaning that there will only be an overnight tenor available and the RFRs will not be available for any other tenor. As a result, borrowers will have to decide whether to use a single day's overnight rate, each day's overnight rate or an average of the overnight rates within an interest period as the basis for calculating interest over the interest period; and
• nearly risk-free, meaning that there is no reflection of the bank's credit risk or funding costs, which typically results in a rate that is lower than the currently used IBORs. As a result, to benefit from the RFRs, borrowers will have to renegotiate interest rate structures and the applicable margin.

As a consequence of these RFR characteristics, the transition to RFRs cannot simply be achieved by referencing to the relevant RFR instead of the IBORs, as this may lead to a commercially different outcome. Instead, borrowers will likely be required to amend various clauses of their existing loan agreements that reference IBORs. This will include making certain decisions upfront and negotiating or renegotiating with their lenders on commercial terms as well (for example, on margin and interest rate determination). The foregoing does not only apply to floating-rate loan agreements, but may also be required for fixed-rate loan agreements referring to IBORs; for example, in clauses regarding default interest. In addition, although a reformed version of EURIBOR is expected to remain available after 2021, the times and bases of publication will be different and as such certain additional changes – although to a lesser extent – may be required to EURIBOR-linked loan documentation and operational systems. Borrowers therefore need to prepare for the process of amending their existing loan documentation referencing IBORs. In order to streamline that process, the LMA has published exposure drafts (consultation papers open for comments) of risk free rate facility agreements (23 September 2019) and a reference rate selection agreement (25 October 2019). The suggested reference rate selection agreement can be used as a roadmap to agree on the basic commercial terms for the selection of RFRs. Pursuant to the terms of the agreement the agent and the obligors will be authorised to further determine the actual amendments required in each individual loan agreement. Although the process involves two steps, the LMA expects it to be simpler than obtaining approval for each individual required change to the relevant loan agreement. The suggested risk-free rate facility agreements can provide guidance to borrowers in assessing the required changes and related decisions that have to be taken. So far, most borrowers (in relation to both existing loan documentation with a maturity beyond 3 January 2022 and new credit facilities) have refrained from selecting RFRs, including the relevant wording in their credit facilities and updating their operational systems. Borrowers appear instead to be waiting for clear market guidance, which will presumably come from the banks. To prepare for the inevitable discussions with the banks – expected sometime before the end of 2021 – borrowers should start reviewing existing documentation to identify whether it needs amending. Furthermore, they should start familiarising themselves with the differences between IBORs and RFRs and how these may require changes to their loan documentation and operational systems. The recent exposure drafts published by the LMA could serve as helpful guidance.