The LMA's draft Sustainability-Linked Loan provisions, explained

Sustainability breaches and declassification events are among the issues covered by the new provisions, write Lucy Jenkins and Martin Bontea-Ungureanu

Understandably, in an environment focussed on the race to net zero, sustainability-linked loans (SLLs) — loans whose "economic characteristics can vary depending on whether the borrower achieves ambitious, material and quantifiable predetermined sustainability performance objectives"¹ — have become increasingly prevalent.

Global sustainable loan issuances increased from just under $40 billion in Q1 2018 to $240 billion in Q4 2021².

An increase in environmental, social and governance (ESG)-related regulations has prompted extension of ESG strategies, corporates and financial institutions have a more persistent focus on sustainable products and SLLs are flexible and can be tailored to work across sectors and amongst borrowers of different sizes.

However, market participants continue to express concerns over consistency of drafting of SLL provisions. In response, on 4 May 2023, the Loan Market Association (LMA) published Draft Provisions for Sustainability-Linked Loans (the Draft SLL Provisions)³.

Overview

The Draft SLL Provisions implement and supplement the concepts outlined in the LMA's Sustainability-Linked Loan Principles (the SLLPs)⁴ and Guidance on Sustainability-Linked Loan Principles⁵.

The LMA stresses⁶ that the Draft SLL Provisions are a starting point and do not reflect a settled market position. That is underlined by extensive drafting notes highlighting the need to consider the suitability of key provisions on a case-by-case basis.

The LMA has also indicated that it will revise the Draft SLL Provisions as the market reacts and a consensus emerges.

Margin ratchet

Upon receipt by the agent of a sustainability compliance certificate, showing which sustainability performance targets (SPTs) relating to certain key performance indicators (KPIs) have been met, the margin will decrease by an agreed amount.

The LMA wording anticipates the highest margin reduction on satisfaction of four SPTs, with that reduction being less as fewer SPTs are satisfied, through to an increase in margin if no SPTs are satisfied (or if only one or two SPTs are met).

In contrast to the LMA's position, the Loan Syndications and Trading Association (LSTA) in its Drafting Guidance for Sustainability Linked-Loans⁷ (the LSTA Guidance) includes a blended ratchet mechanism, whereby the margin varies at different SPT thresholds, with the option to attribute different values to each KPI.

That is generally less common in Europe, but a note in the Draft SLL Provisions does highlight that parties can choose a different pricing adjustment method, including a blended ratchet.

KPIs and reporting

The Draft SLL Provisions include four KPIs, but gives the parties freedom to have less or more, as they see fit. Furthermore, there is flexibility to set KPIs and SPTs at the level of the parent, the borrower or the group as a whole, depending on whether the sustainability strategy is individual or group-wide.

In support of the KPIs and SPTs, the group delivers a sustainability compliance certificate, a sustainability report (prepared by the group) and a verification report (prepared by a third-party reviewer) to the agent at least annually. The intent is for this certificate and these reports to provide sufficient information for lenders to understand whether sustainability requirements have been met.

Sustainability breaches

To incentivise accurate disclosure, a sustainability breach will occur (subject to applicable grace periods) if an obligor doesn't comply with certain key clauses of the Draft SLL Provisions focussing on disclosure of sustainability information (including sustainability-related information supplied by the group to the lenders prior to signing in order to negotiate the SLL).

"Certain borrowers claim in particular that the reporting arrangements of SLLs are onerous and disproportionate to the savings achieved through margin decreases"

A sustainability breach deems no SPTs to have been met for the purposes of the margin ratchet, resulting in a margin increase. In contrast, under the LSTA Guidance, the margin will only increase on failure to deliver a sustainability compliance certificate.

The LMA has noted⁸ that members originally asked for a sustainability breach to also trigger an event of default (subject to a grace period), but this was ultimately omitted because the LMA was of the view that it did not reflect the market, and interestingly the LSTA Guidance is the same in that respect.

Sustainability amendment and declassification events

A sustainability amendment event will occur if any KPI or SPT is adversely affected according to the findings in a verification report or following certain triggers, such as a disposal, acquisition, merger or restructuring.

The intention is to bring the borrower and lenders back to the negotiating table to agree amendments to the calculation methodology, KPIs, SPTs, or other provisions of the loan document to take account of such adverse impacts. If the parties cannot reach agreement within a certain time following a sustainability amendment event, on the instruction of the lenders or majority lenders, the agent can "declassify" the facility, removing its title of "sustainability-linked" and disapplying the sustainability-linked margin adjustment. The borrower will also not be able to reference the loan or any borrowing thereunder as "sustainability-linked".

The LMA notes⁹ that market participants had differing views on which events should trigger a sustainability amendment event, and that ultimately the LMA sought to strike a balance between including events which participants agreed should lead to re-negotiation whilst leaving discretion for parties to include their own triggers. Other than a change in law and regulation trigger, the LSTA Guidance includes the potential for similar provisions only as a footnote, leaving them entirely to the parties' discretion. The LMA apparently decided against including the same law and regulation trigger on the basis that many market participants may not be in favour of it.

Apparently, the LMA also heard significant debate as to whether a declassification event should be automatic following a failure to agree amendments, but the Draft SLL Provisions requires it to be actioned by the agent (acting on the lenders' or majority lenders' instructions). We understand LMA members also sought a margin increase following a declassification event, but the LMA decided to instead disapply the margin ratchet (removing any possibility of a decrease). Interestingly, the LSTA Guidance does not include a declassification event or place such publicity restrictions on the borrower.

Additional protections

Market participants may also consider protections not contemplated by the Draft SLL Provisions. For example, if a revised sustainability compliance certificate is prepared and submitted following an initial error and it is found that a higher margin should have applied for the applicable SLL reference period, the borrower will have to pay the difference to the agent, but the Draft SLL Provisions do not extend to the opposing scenario, meaning the borrower will not see the benefit of a set-off or return of interest paid where it is shown that a lower margin should have applied during that period.

In a similar vein, borrowers could look for their SLL provisions to allow reclassification of a loan as "sustainability-linked" if agreement on amendments is reached after a declassification event (which is not currently envisaged by the Draft SLL Provisions).

Issues for the market

As SLLs continue to gain prominence in the loan market, a distinction is being made between market participants who need SLLs to access finance, and those for whom SLLs are merely preferable. It remains to be seen whether borrowers for whom SLLs are unattractive will find it more difficult to access finance going forward. Certain borrowers claim in particular that the reporting arrangements of SLLs are onerous and disproportionate to the savings achieved through margin decreases.

Other borrowers are hesitant to enter into SLLs before the ESG regulatory landscape has been fully developed and is clearer, to avoid inconsistent obligations across SLLs and limit time and money invested seeking to understand how obligations (e.g. methods of reporting) might change in the future.

"To incentivise accurate disclosure, a sustainability breach will occur (subject to applicable grace periods) if an obligor doesn't comply with certain key clauses of the Draft SLL Provisions focussing on disclosure of sustainability information"

Another challenge for market participants is measuring and reporting KPI and ESG performance. KPIs included in the SLL Draft Provisions require detailed consideration and work on the group's part to determine (amongst other things) who is responsible for them, how they are calculated, what data is needed and whether it is readily available, where that data is located and whether it is of a satisfactory quality. In many instances, because KPIs require data which may not have been collected until recently, there may be issues with the quality of it and borrowers may as a consequence have to reconstruct or obtain data from external providers. Data collectors' and providers' inputs are unverified and can also be inconsistent, which can lead to data quality issues.

Even once KPI data collection is operational, there may be challenges in processing that data and sharing it with lenders in a satisfactory way.

Conclusion

As detailed above, the Draft SLL Provisions are simple yet comprehensive, and provide a clear documentary framework for market participants. There is no doubt that they will result in more consistency across documentation.

What will be of real interest, however, is to see how rapidly and how extensively these draft provisions are personalized and particularized by participants as these provisions are adopted and this fast-developing product spreads across the market.

Lucy Jenkins is finance partner and Martin Bontea-Ungureanu is finance associate at Vinson & Elkins.