Overview of the new LMA Draft SLL Provisions
On 4 May 2023, the Loan Market Association (LMA) published Draft Provisions for Sustainability-Linked Loans (the LMA Draft Provisions)1. This follows the publication of the Loan Syndications & Trading Association (LSTA)’s Drafting Guidance for Sustainability-Linked Loans on 17 February 2023 (the LSTA Drafting Guidance) and the publication of Asia Pacific Loan Market Association (APLMA)’s Term Sheet (with sustainability-linked loan appendix) on 27 September 2022 (APLMA Term Sheet).
Sustainability-linked loans (SLLs) are, as we explained in our previous article, any type of loan for which the economic characteristics vary depending on whether a borrower achieves ambitious, material and quantifiable predetermined sustainability performance objectives. There is a wide world of loans where the economic characteristics of a loan are linked to sustainability performance objectives or have terms requiring the provision of sustainability information.
The LMA Draft Provisions are intended to be used in conjunction with the LMA’s senior multicurrency term and revolving facilities agreement for leveraged acquisition finance transactions (senior / mezzanine) and can be adapted for use with the LMA’s other recommended forms of facility agreement. The LMA Draft Provisions are aligned with the LMA/LSTA/APLMA Sustainability-Linked Loan Principles (SLLPs) as published on 23 February 2023 and aim to reflect current market practice and provide a drafting framework to be used by parties in the negotiation of SLL provisions. The LMA Draft Provisions contain extensive drafting notes for parties to understand the rationale and background to the draft terms as well as providing points to consider when drafting SLL provisions. Given the increased popularity of SLLs, the market has developed rapidly and this development is expected to continue. The LMA intends that the LMA Draft Provisions will evolve to keep pace with the market.
Each of the LMA Draft Provisions, LSTA Drafting Guidance and APLMA Term Sheet have been drafted to align with the SLLPs, although we note that they were not published simultaneously (the LMA Draft Provisions were published after the publication of the most recent iteration of the SLLPs). It is also of note that the APLMA Term Sheet is in term sheet form, so does not have the same level of drafting detail and perhaps includes a greater level of optionality and flexibility. While each set of provisions conforms to the SLLPs, we expect that each association has also been guided by what it sees as the prevailing market practices in its respective region in how to incorporate the SLLPs into a loan agreement (as determined through engagement with its members), and accordingly there are some significant differences between the three sets of provisions.
We note that the drafting is not mandatory and parties are free to agree the terms which suit them best whilst still aligning with the SLLPs.
Comparison of the LMA Draft Provisions, LSTA Drafting Guidance and APLMA Term Sheet
Below we set out the main differences between the LMA Draft Provisions, LSTA Drafting Guidance and APLMA Term Sheet.
Takeaways
There are a few points which are evident from a comparison of the three sets of model terms:
- The drafting notes are important. They add helpful background and explanation relating to the terms which have been included and some which have not.
- Currently, information undertakings and the consequences of failing to comply with the core sustainability provisions of the agreement do not result in an event of default, although the delineation of “sustainability provisions” will likely be a point of some debate. We will need to watch this space to see whether the regulators provide more guidance on these points in respect of both disclosure and consequence, through voluntary guidance or greenwashing rules. We may see the event of default carve-outs further limited or removed entirely, but for the moment, the consequential rights of acceleration and cross default implications seem to be felt to be too significant a consequence and too much of a disincentive for borrowers to enter into a sustainability-linked loan structure.
- We see “ESG controversies” included in the APLMA Term Sheet but not in the other model terms – that is, an adverse ESG event that may not be relevant to the KPIs being measured but nonetheless has a significant adverse ESG or reputational impact. There has been a turn towards good due diligence rather than looking to ESG controversies of late. There may still be a place for ESG controversies being included in the information covenants but controversies reflect what has gone wrong whereas the focus now is on governance which will prevent controversies before they happen.
- The drafting notes in the LMA Draft Provisions recommend that the relevant calculation methodologies for the KPIs are incorporated into the loan agreement itself. While there are advantages to having the calculation methodologies clearly set out on the face of the facilities agreement, in practice it could prove challenging to ensure that the methodologies are accurately reflected and it is likely that input would be needed from an ESG consultant or other party involved in developing them, as applicable.
- There is a difference of approach in respect of sleeping SLLs (that is, loan agreements which have the mechanics for SLLs but do not have the relevant commercial ESG terms, such as KPIs and targets, included). Only the LSTA Drafting Guidance includes drafting for future SLLs. This flexibility is often something which market participants are keen to include as it can take time to complete the ESG diligence process and analyse and determine applicable, relevant and ambitious KPIs and targets, and it may well not be possible for this to be carried out in a measured way ahead of signing the loan agreement in the context of a financing of an acquisition or other event-driven process (and allows for implementation without needing the consent of all lenders). However, the latest form of guidance to the SLLP states that this sleeping SLL structure should only be used “in exceptional instances, for example on deals where time is pressured and the borrower already has a clear sustainability strategy in place”, and in any event with all KPIs and targets set no later than 12 months after origination. What is clear though, is that until the SLL provisions are “woken up” (i.e. the KPIs and targets have been set and the loan is classified as sustainability-linked), the loan should not be used in a lender’s calculation towards net zero or sustainability targets.
Recent developments – FCA oversight in the SLL market – a thorny thicket?
The SLLPs and the model terms reviewed above clearly set helpful standards and provide a useful drafting base for market participants to execute SLL transactions. However, whilst sustainability-linked financing products are recognised by regulatory authorities as key enablers to delivering a market-led transition to a more sustainable economy, it is clear that regulators have ongoing concerns about credibility. Greenwashing is a particular concern, but also whether this product is actually moving the dial, even if no-one is seeking to gain from a ‘greensheen’: key questions remain to be answered as to whether performance targets are ambitious enough and relevant to the core of the business? Is the margin ratchet meaningful in the context of the interest rate to incentivise action? Are default consequences like ‘negative publicity’ going to lessen over time as failure to meet performance targets becomes more commonplace? Is the product genuinely aligned to leverage a broader sustainability strategy or just an ineffective add on?
Throughout March and April 2023, the FCA engaged the market stakeholders to better understand the functioning of the sustainable loans market and to determine whether regulatory intervention was necessary. On 29 June 2023, it wrote to stakeholders outlining its concerns about SLLs. It found that the market has grown rapidly over the last 5 years and that there are a number of weaknesses that may limit more widespread adoption and growth of SLLs, including credibility, market integrity and greenwashing concerns. It suggested that the Transition Plan Taskforce framework for credible corporate transition planning, which is due to be finalised later this year, could inform the design of more credible and robust performance targets and KPIs for SLLs. The FCA also noted that lenders need to be cognisant of potential conflicts of interest for lenders keen to promote their sustainability credentials, potentially having aligned rewards to volume, which might encourage the acceptance of weaker performance targets and KPIs in order to generate business and appear competitive. Despite the misgivings, the FCA stated that it has no current plans to introduce regulatory standards or a code of conduct for this market, but that it will reconsider this if it considers that the market needs it and indicated that the LMA’s updated SLLPs may be helpful to provide additional stringency required.
Next steps
We will continue to watch the market to observe how the LMA Draft Provisions are used on a transaction by transaction basis, recognising that many financial institutions will already have template terms that they will use for each transaction and different policies and procedures that they will need to meet in respect of ESG.
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