A few months ago, the Ice Benchmark Administration and Financial Conduct Authority announced that most tenors of LIBOR would continue to be published through June 30, 2023, rather than the end of 2021 as previously anticipated. Although this delay will be welcomed by many lenders, the Alternative Reference Rates Committee (“ARRC”) continues to emphasize the importance of building in LIBOR transition language into all existing and new contracts as soon as possible.
The ARRC, appointed by the Federal Reserve to study the issue and recommend an alternative benchmark rate to LIBOR, has settled on the Secured Overnight Funding Rate (“SOFR”) published daily by the Federal Reserve Bank of New York as an alternative reference rate to LIBOR. Unlike LIBOR, which is an unsecured rate, SOFR represents the cost of borrowing cash overnight that is collateralized by United States Treasury securities.
The vast majority of bilateral business loans that use LIBOR as a benchmark rate, which have addressed the issue of the pending cessation of LIBOR’s publication, use an “amendment” approach, whereby, upon certain trigger events, the borrower and lender jointly select an alternative rate and spread adjustment. Until a suitable alternative rate can be selected and an amendment to effectuate the necessary changes completed, loans will accrure interest based on the Prime Rate.
Instead, ARRC is recommending that all existing or new bilateral business loans that use LIBOR as a benchmark rate build in a “hard-wired” approach, whereby the change to SOFR is automatically effectuated upon the occurrence of certain specific LIBOR transition events. ARRC’s recommended “hard-wired” language uses the following template:
1. Trigger Events: The “hard-wired” approach has certain trigger events that prompt the initiation of replacement rate: the administrator of LIBOR publicly announcing that LIBOR has ceased or will cease; a public notice by the applicable regulatory supervisor, central bank or resolution authority; a regulatory supervisor publicly disseminating a determination that LIBOR is no longer a representative of the underlying market; or an option whereby the parties can “opt-in” early to SOFR before any of the foregoing trigger events occur, if a specific number (five in the recommended language) of U.S. dollar denominated syndicated or bilateral credit facilities currently outstanding use a SOFR-based rate.
2. Replacement Rate Waterfall:
If available, the first option would be to use Term SOFR. Term SOFR does not exist yet as there is not a robust market for SOFR derivatives, but it would function as a forward-looking rate over a specified tenor, and therefore would function the most like LIBOR.
Next, if Term SOFR is not available, the parties can use Daily Simple SOFR. Daily Simply SOFR is an arrears rate, unlike LIBOR, in that it is a simple average of SOFR over the interest period with a built-in lookback period. Because of this, unlike with LIBOR or Term SOFR, a borrower may not know the exact amount of an interest payment due until a few days before the interest due date when using Daily Simple SOFR.
Finally, if neither rates are available, ARRC recommends the lender select an alternative replacement rate and spread adjustment giving due consideration to market conventions. The borrower may or may not have some input or consent rights in this process. This is in essence a fallback to the “amendment” approach described above.
3. Spread Adjustment Waterfall: Because LIBOR and SOFR are similar, but not identical rates, a spread adjustment is necessary to ensure the lenders’ return is comparable to what they received under LIBOR. The selection is similar to the waterfall above.
First, the waterfall provides for a spread adjustment that is recommended by ARRC.
Next, if ARRC has not selected a spread adjustment by the time LIBOR ceases, it will default to an adjustment recommended by the ISDA. Both ARRC and ISDA have said they intend to publish such adjustments in advance of the cessation of LIBOR.
If neither Term SOFR or Daily Simply SOFR is available, then the lender must select the spread adjustment, giving due consideration to market conventions.
4. Conforming Changes: Even though the approach may be hardwired in, the document may need certain conforming changes that haven’t been addressed by the above, so there is language to permit technical, administrative or operational type changes that the lender decides may be appropriate.
In conclusion, although most tenors of LIBOR will continue to be published to mid-2023, lenders should carefully consider adopting robust fallback language for their new loans, and all extensions or refinancings of existing loans. In response to the LIBOR extension, U.S. bank regulators have strongly recommended that as soon as practicable, and in any event by the end of 2021, lenders either cease entering into new contracts using LIBOR as a reference rate or have robust fallback language that includes a clearly defined alternative reference rate after LIBOR’s discontinuation. Taking into consideration that statement, the trend favoring use of fallback language that either tracks, or comes close to tracking, the hardwired fallback language recommended by ARRC can be expected to continue.
Steven Connor is a partner at Waller. He has extensive experience negotiating and restructuring asset-based and cash flow loans and other credit facilities for lenders, and he advises clients in transactions related to healthcare, manufacturing, consumer products and other industries. Dustin Timblin is of counsel at Waller. He represents banks, financial institutions, specialty lenders, hedge funds, mezzanine lenders, private equity firms, healthcare companies and other borrowers and lenders in complex commercial finance transactions with a focus on the healthcare industry.