Term SOFR and Term SONIA: A Return to Term Reference Rates in European Fund Financing Transactions?

Now that the dust has (almost!) settled on issues relating to LIBOR cessation in fund financing transactions (and the lending markets more generally), we are increasingly seeing market participants turning their attention to the rates now being used for financing transactions involving currencies which were previously funded on the basis of LIBOR.

One of the key differences between term reference rates (such as LIBOR) and the risk-free reference rates (whether on a "simple, daily" or a "compounded" basis) is that lending which is based on a term reference rate gives the involved parties certainty as to the amount of interest which will be payable for an interest period from the outset of that interest period (or very shortly thereafter).  Conversely, in a transaction funded on the basis of a risk-free reference rate, the interest bill for an interest period can only be calculated shortly before the end of that interest period. 

In the context of fund financing transactions, this is something which is especially relevant — particularly where payment on the debt is to be made from the proceeds of a capital call against investors.  Market approaches have converged on using a five-business day "lookback period" as the standard approach for risk-free reference rate lending — this means that the final interest bill can only be calculated with certainty a maximum of five business days ahead of the end of the interest period.  This five-business day period is shorter than the typical notice period which fund managers are required to give their investors on making a capital call — and, therefore, in these circumstances, fund managers are potentially having to call capital from investors to make payments on debt without knowing the precise amount of the interest bill.

US dollar

There has, to date, been a difference in approaches used in the US and European markets for US dollar-based lending.  This is nothing new, and the lending markets have always operated somewhat differently on each side of the Atlantic.  In Europe, much of the approach to date has been as a result of participants wanting to treat US dollar lending and sterling lending in the same way (given that they have been equally affected by the cessation of LIBOR and for administrative and documentary ease), whereas the US domestic market has been less tied to equivalent developments in the European markets for sterling-based lending.

US market

In the US market, there was an initial preference for the use of a "daily simple" SOFR lending basis over compounded SOFR in arrears due to perceived difficulties in using a compounded rate in products subject to prepayment and secondary trading.  That preference quickly moved towards favouring Term SOFR as the basis for US dollar lending, supported by Term SOFR being formally recommended by the Alternative Reference Rates Committee ("ARRC") in July 2021¹ and by Term SOFR being selected as a "Board-selected benchmark replacement" (with related safe-harbour protections from associated litigation) for select categories of contracts in the Federal Reserve Board's July 2022 notice of proposed rulemaking,² which, when final, will implement the March 2022 Adjustable Interest Rate (LIBOR) Act.³  Note that the ARRC's best practices include a recommendation that, as a general principle, "market participants use overnight SOFR and SOFR averages given their robustness"; this is tempered by further guidance that "the ARRC supports the use of SOFR Term Rate in addition to other forms of SOFR for business loan activity—particularly multi-lender facilities, middle market loans, and trade finance  loans—where transitioning from LIBOR to an overnight rate has been difficult and where use of  a term rate could be helpful in addressing such difficulties".⁴  While the ARRC's pronouncements do not constitute supervisory guidance, and US regulators have been clear in stating that market participants are free to use any robust reference rate that they choose, the developments described above appear to have resulted in a general convergence towards the use of Term SOFR in the US lending markets.  As a result, the Loan Syndications and Trading Association has published several concept credit agreements based on Term SOFR, as well as other SOFR variants, in order to provide some clarity to market participants in terms of suggested drafting that can be used for these transactions.  Readers should note that the ARRC does not support the use of Term SOFR in securitisation transactions that are not based on underlying Term SOFR assets nor in the derivatives markets (though given that most fund financing transactions do not use associated interest rate hedging a discussion on those points is outside the scope of this Legal Update).

European market

In the European market, up until recently, much of the approach taken with respect to US dollar lending has followed the equivalent approach being taken in relation to sterling lending.  Although the recommendations of the Working Group on Sterling Risk-Free Reference Rates ("£RFR Working Group") only apply in respect of sterling lending, the general market approach has been to follow the recommendations for sterling lending in the context of other currencies which were formerly financed on the basis of LIBOR (e.g. US dollar and Swiss franc).  This is likely in part due to the weight which the European lending markets place on the Loan Market Association's ("LMA") recommended form of documentation which uses the same approach as used for sterling (being based on SONIA compounded in arrears) in the context of other currencies.  Consequently, US dollar lending in the European markets has, to date, largely been undertaken on the basis of SOFR compounded in arrears.   For market participants, this has had the added benefit of conforming the approach taken between sterling and US dollar lending.

However, the £RFR Working Group's recommendations are generally limited to sterling-based lending — at the September 2021 meeting the £RFR Working Group noted that "the ARRC's recommended best practice for term SOFR would be relevant for US dollar business in London" and that in multi-currency facilities, "guidance should be followed for each currency respectively".⁵

Accordingly, there is no regulatory impediment to market participants in the European markets seeking to finance US dollar transactions on the basis of Term SOFR — though some further speedbumps exist which participants will need to overcome before a wholesale rollout of Term SOFR is possible.

From a documentary perspective, the LMA published an exposure draft facilities agreement (the "single currency term and revolving facilities agreement incorporating Term SOFR for use in developing market jurisdictions") in October 2021 and followed this up with an equivalent document for use in investment grade transactions (the "multicurrency term and revolving facilities agreement incorporating a letter of credit facility and backward-looking compounded rates and forward-looking term rates with Term SOFR and rate switch provisions (with option for lookback without or with observation shift)") in October 2022.  While the two documents use different drafting approaches, the content relating to the application of Term SOFR to loans is the same (though the investment grade document provides for greater optionality in respect of fallbacks (in the event of an unavailability of a Term SOFR rate) than the developing markets document).  These documents are exposure drafts rather than recommended forms issued by the LMA and, as such, are intended as a starting point for consideration rather than setting out a final, recommended position.  The expectation is that these documents will be upgraded from exposure draft to recommended form (with necessary updates) once market participants have undertaken sufficient transactions referencing Term SOFR and have come to a general consensus on key provisions (as the LMA's approach is that its recommended forms reflect established market practices).

One of the key points which the LMA exposure drafts flag for consideration by market participants relates to fallbacks in the event that an appropriate Term SOFR rate is not available.  On this point, it is important to note that the shortest tenor for which Term SOFR is published is one month.  On that basis, it will not be possible for a Term SOFR rate to be computed by way of interpolation of two Term SOFR rates for a period which is shorter than one month.  The LMA exposure drafts acknowledge this by allowing for interpolation by reference to the overnight SOFR rate (i.e., not a Term SOFR rate but the regular SOFR rate) and the one-month Term SOFR rate, but this is not a perfect solution as it requires interpolation based on two rates which are not calculated on the same basis.  Further detail on this point is set out in the LMA commentary on the Term SOFR exposure drafts (Term SOFR commentary, October 2022).

Therefore, while use of Term SOFR in the European market may be possible from a regulatory perspective, there are certain issues which market participants will need to address and get comfortable with before routinely using Term SOFR on live transactions.   As we see more and more Term SOFR-based transactions executed in Europe, these issues will undoubtedly resolve themselves, and, therefore, we are expecting that the approach in the European markets will eventually converge with that being followed in the US, such that Term SOFR will become the "standard" funding rate used in US dollar fund financing transactions.

Sterling

Due to progress in relation to Term SOFR, we are increasingly fielding queries from market participants on the use of "Term SONIA" for sterling-based lending.   A wholesale return to term reference rates is, however, not expected.  The £RFR Working Group has made it clear that SONIA compounded in arrears should be the primary vehicle for sterling-based lending following LIBOR cessation, and there is a concern that a "Term SONIA" rate becoming too widely used could subject it to the same structural vulnerabilities as those associated with LIBOR and which led to its discontinuation.⁶ The £RFR Working Group did identify certain areas where use of a rate such as Term SONIA may be appropriate:

• Smaller corporate, wealth and retail clients, for whom simplicity and/or payment certainty is a key factor (though the £RFR Working Group noted that other alternative rates (including, but not limited to the Bank of England base rate) may be more appropriate here);
• Trade & Working Capital, such as supply chain finance and receivable facilities which require a term rate or equivalent to calculate forward discounted cash flows to price the value of assets into the future;
• Export finance/Emerging markets, where borrowers typically require much more time to make payments of interest and principal payments; and
• Islamic facilities, which can pay variable rates of return, so long as the variable element is pre-determined.

The views of the £RFR Working Group summarised above have also been followed by the FICC Markets Standards Board in formulating its Standard on use of Term SONIA reference rates, published in July 2021.⁷  While fund financing transactions may share certain hallmarks with the above (e.g. in relation to payment certainty and length of time needed to arrange for funds to be in place to make interest payments), we expect that, given the extremely limited appetite of the £RFR Working Group and UK financial regulators generally for usage of Term SONIA, it will not see widespread (if any) use in fund financing transactions, given its absence from the specifically identified potential use cases, and these transactions will continue to be based on a compounded SONIA reference rate as is currently the case.

¹ "ARRC Formally Recommends Term SOFR", 29 July 2021: https://www.newyorkfed.org/medialibrary/Microsites/arrc/files/2021/ARRC_Press_Release_Term_SOFR.pdf

² Regulation Implementing the Adjustable Interest Rate (LIBOR) Act, 19 July 2022: https://www.federalreserve.gov/newsevents/pressreleases/files/bcreg20220719a1.pdf

³ Division U – Adjustable Interest Rate (LIBOR) Act, signed into law 15 March 2022: https://www.congress.gov/117/bills/hr2471/BILLS-117hr2471enr.pdf

⁴ "ARRC Best Practice Recommendations Related to Scope of Use of the Term Rate", updated 27 August 2021: https://www.newyorkfed.org/medialibrary/Microsites/arrc/files/2021/ARRC_Scope_of_Use.pdf

⁵ "Minutes of the Working Group on Sterling Risk-Free Reference Rates - September 2021": https://www.bankofengland.co.uk/minutes/2021/september/rfr-september-2021

⁶ "Use Cases of Benchmark Rates: Compounded in Arrears, Term Rate and Further Alternatives", January 2020: https://www.bankofengland.co.uk/-/media/boe/files/markets/benchmarks/rfr/use-cases-of-benchmark-rates-compounded-in-arrears-term-rate-and-further-alternatives.pdf

⁷ "Standard on use of Term SONIA reference rates", July 2021: https://fmsb.com/wp-content/uploads/2021/07/Standard-on-use-of-Term-SONIA-reference-rates_FINAL.pdf