The deadline is looming. Neil Waller and Shivana Sood examine the implications of an interest rate switch.
The Bank of England and the Financial Conduct Authority have advised that the discontinuation of LIBOR and transition to SONIA (being the Sterling Overnight Index Average) must be completed by 31 December 2021. PFI contracts are affected by the transition and the issues which local authorities should monitor going forward, bearing in mind in particular the updated IPA guidance issued earlier this month.
The key difference to be aware of between LIBOR and SONIA is that LIBOR is a forward-looking interest rate meaning that the rate of interest is known at the start of an interest period.
Conversely, SONIA is based on actual historic transactions, and so the interest rate is not determined until just before the end of an interest period. SONIA is considered less volatile than LIBOR and is a risk-free rate because no bank credit risk is included.
IPA Guidance
The Infrastructure and Projects Authority (IPA) published an updated guidance note on 11 October in respect of the effect of the transition on PFI contracts.
The main points to note are:
- The switch from LIBOR to SONIA may constitute a change in law under the PFI contract, but it should not constitute a qualifying change in law, or a compensation event or relief event. The obligations and liabilities of the procuring authority should therefore not change on account of the transition.
- The transition may fall under the definition of a refinance under the finance documents. However, there should not be any refinance gain, or loss, as any gain will be countered by equivalent losses under existing swap arrangements and there will be administrative costs incurred in dealing with the switch.
- A refinancing event may crystalize liabilities of the project special purpose vehicle (SPV) under its existing swap arrangements. This could potentially (although unlikely) threaten the solvency of the SPV. The procuring authority should be made aware of this as soon as possible. There should be further guidance issued by the IPA in respect of these implications later this year.
- The FCA is considering more direct interest benchmark substitutes for markets with so-called “tough legacy” contracts (those do not have a realistic prospect of being amended or renegotiated before the discontinuation of LIBOR). A market consultation to determine whether PFI contracts are “tough legacy” is ongoing and, if they are, SPV costs associated with switching to SONIA may reduce. The FCA have indicated that any such benchmarks would be published for a maximum of 10 years so the switch may just be delayed.
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While the consequences of the transition do not have huge ramifications for local authorities, the key takeaway from the guidance note is that councils should be aware of the transition and should engage with SPVs to ensure they have a plan in place.
However, local authorities should not direct a course of action to the SPV to avoid taking on any liabilities and should not contribute to the SPV’s costs in dealing with the transition.
Loan Documentation Changes
Loan documentation will need to be amended to account for the change in interest rates calculated and payable by reference to SONIA and not LIBOR (as well as related hedging arrangements). Aside from the administrative and legal costs involved in dealing with these amendments, there could also be implications arising from how the mechanics of the loan documentation may change.
Specifically, there could be amendments to the timing and testing of covenants to account for the fact that the rate of interest payable in accordance with SONIA is only known at the end of the testing period whereas the rate of interest by reference to LIBOR is known in advance of the testing period. This is likely to be applicable to loans which are not 100% hedged.
The model for calculating finance costs for compounded rate loans will need to be updated to replace references to LIBOR with the use of SONIA. Economic assumptions in the model may also need updating and adjusting accordingly.
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The timing of delivery of reports and information may need changing due to interest costs not being known until near the end of the interest period. It may be helpful for the SPV to keep a note of all such changes to the delivery of information to ensure no new deadlines are missed.
The impact of the transition from LIBOR to SONIA on procuring authorities should be minimal although it is useful for councils to be aware of the transition and the points highlighted above. The IPA will continue to update their guidance and so authorities should keep an eye out for any new information they share on the transition.
Neil Waller is a partner, and Shivana Sood a solicitor, at law firm Trowers and Hamlins.
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