Loan Agreement Market Disruption Clauses to be Invoked only as a Last Resort

In response to recent reports that some banks are considering invoking the Market Disruption clause commonly found in loan agreements, the Association of Corporate Treasurers (ACT) believes that this should be a last resort and implemented only after certain other steps are taken.

The ACT would only expect the Market Disruption clause to be invoked if banks generally are experiencing exceptional difficulty in raising funds in the interbank market or are paying materially more for interbank deposits than the displayed screen rates for LIBOR or EURIBOR. In these circumstances the clause enables banks to increase the rates charged to borrowers so that they reflect the actual cost of funds to banks.

The displayed screen rates for LIBOR and EURIBOR should, however, even in current market conditions reflect the panel banks’ average costs of wholesale funds. An individual bank might pay a little more or less. Clearly, banks contributing rates to the LIBOR or EURIBOR panels should be unlikely to be in the position of paying significantly more.

It seems, however, that in the current market conditions the data being provided by banks for the purposes of calculating the displayed screen rates for LIBOR and EURIBOR is not in all cases reflecting the true cost of funds. If this is correct, it means that banks are not providing good information and, as a result, they are triggering a situation in which the Market Disruption clause is likely to be invoked, thus enabling banks to abandon the transparent system of displayed screen rates and instead to charge borrowers interest rates based on the individual cost of funds of each bank. This is a highly opaque and cumbersome way to calculate interest on major loans.

If banks are not making proper inputs the British Bankers Association/the European Banking Federation (www.fbe.be) and ACI-The Financial Markets Association (www.aciforex.com) should take the matter up with the affected banks. The ACT believes that it is essential that the reason for the screen rates not being reflective of market rates is investigated before banks seek to use these circumstances as a reason for abandoning the established method of charging LIBOR- or EURIBOR-based interest.

The inconsistent behaviour of some banks in the current market is demonstrated by the fact that ACT members have recently noted that some banks are reluctant to accept term deposits in wholesale markets and bid well below the published LIBOR rates at the same time as they are offering high rates to retail depositors.

To the extent it may help in the current market conditions, the ACT would also encourage banks, as part of their banking relationship with borrowers, to provide guidance to borrowers, where appropriate through agent banks, regarding optimum interest periods for a new drawdown or a roll-over. It may be that, in the current market conditions, banks and borrowers should be working together in using interest periods other than the commonly provided one, three or six months. If banks prefer to quote for one week or even two-day interest periods, since greater liquidity currently exists at the shorter maturities, then discussions should be taking place with borrowers to see if this is a better way, in some cases, to calculate interest. In many cases this approach will require the consent of all banks in a syndicate as well as the borrower and it may not be appropriate in cases where the borrower has hedging or other arrangements which it may wish to continue to match. Borrowers will also need to consider the cash flow impact of using such shorter interest periods. In some cases, however, it may be beneficial to banks and borrowers and, in these cases, consideration should be given to using it.

In any circumstances, a strong relationship between the bank and the corporate borrower is crucial.

Enquiries

For further information, please visit the ACT Press Room.

Notes for Editors

Many corporate loan agreements are based on documentation published by the Loan Market Association (www.loan-market-assoc.com) with the support of the British Bankers Association and the ACT. While the ACT supports the idea of a common base, the template documentation is open for negotiation. The ACT publishes a guide for borrowers to help them in negotiating the specific wordings with their lenders.

Extracts from

• The ACT’s Guide to the Loan Market Association Documentation for Investment-Grade Borrowers, 1 June 2007.

LIBOR - Clause 9.1: Calculation of interest

...“LIBOR” is defined as the applicable Screen Rate, and, if that is not available, the average of the rates quoted by the Reference Banks, rounded up to four decimal places, even though the Screen Rate rounds up to five decimal places; rounding is conventionally upwards in loan documentation. The definition of “EURIBOR” is very similar, though the Screen Rate provided by the Banking Federation of the EU shows rounding only to 3 decimal places.

...BBA LIBOR (including BBA EURO LIBOR) is the official rate of the BBA. It is calculated from the quotations of a panel of banks selected by the BBA for each relevant currency and period.... Now it is compiled for the BBA by Reuters, and published by Reuters and others. A similar process applies for EURIBOR, which is the official rate for the Banking Federation of the EU.

Market disruption
Clause 11.1: Absence of quotations

The Screen Rate may not be available, if for example there is a significant technological problem. In that case, the Agent calculates the average of the rates quoted by the Reference Banks (see the definitions of LIBOR and EURIBOR). The Agreement assumes there will be 3 Reference Banks (see the definition). Clause 11.1 provides that if one Reference Bank does not quote, the rate will be the average of the quotes provided by the other two. Borrowers may not feel that in these circumstances the rate would be representative of the market. One solution is to appoint four Reference Banks, so that Clause 11.1 applies where there are three (or two) quotations.

Clause 11.2: Market Disruption

If the Screen Rate is not available and insufficient Reference Banks provide a quotation (see above), or if significant Lenders (usually Lenders whose participations in a Loan aggregate 33% or 50%) say that their cost of obtaining matched funding in the relevant market would be higher than LIBOR or EURIBOR, there will be a “Market Disruption Event”. In that case, each Lender has to notify its actual cost of funding (selecting its source reasonably), and the Margin and the Mandatory Cost will be added to that cost to determine the interest payable to that Lender.

Clause 11.3: Alternative basis of interest or funding

As soon as a Market Disruption Event occurs, either the Agent or the Borrower can require the parties to enter into negotiations, for up to 30 days, to try to agree another way of determining the interest rate. Unless and until another basis for determination is agreed, the rate will continue to be based on the actual cost of funding for the Lenders, as explained above.

Mandatory costs
Schedule 4

UK mandatory costs

There are two categories of costs applicable to Lenders with a Facility Office in the UK: reserve asset costs and supervisory fees.

...Borrowers will be sensitive to the selection of the Reference Banks. … Reference Banks which are “incoming firms” with large MELs[] are likely to quote a lower rate than UK Reference Banks with smaller MELs.

[Comment: many borrowers will have negotiated concessions in respect of mandatory costs and, in any case, it is commonly not the practice of banks to charge them.]

Reference banks

Reference banks are appointed by the Agent in consultation with the borrower.