The New York Federal Reserve Bank (the “Fed”) has worked for years to promote an alternative reference rate to replace US Dollar LIBOR (“LIBOR”) in floating rate debt instruments. Those plans were fast-tracked and expanded in 2017 after the Chief Executive of the U.K.’s Financial Conduct Authority warned market participants that they should not rely on the continued existence of LIBOR post 2021, after which the FCA will no longer compel panel banks to make submissions to the LIBOR administrator.
On September 24, 2018, the Alternative Reference Rate Committee (“ARRC”), a committee organized by the Fed, released its “Consultation Regarding More Robust LIBOR Fallback Contract Language for New Originations of LIBOR Syndicated Business Loans” for public comment. The Consultation proposes contractual language that can be inserted into U.S. syndicated loan agreements in order to replace LIBOR as the reference rate for syndicated loans in the market.
Public comments indicate a moderate amount of engagement from the global lending community but only limited engagement from companies that borrow in the leveraged lending market and their financial sponsors. As the calendar turns, borrowers and sponsors should know and track the following key issues.
The Secured Overnight Financing Rate (“SOFR”) is ARRC’s preferred rate to replace LIBOR. SOFR is a reference rate established by the Fed and has been published since March 2018. SOFR is the average rate of the cost of borrowing cash overnight collateralized by US Treasury securities. ARRC prefers SOFR to other rates primarily because the volume of transactions reflected in SOFR exceeds other proposed replacement rates and because SOFR is used by a wider array of market participants. This means, ARRC believes, that SOFR is more reflective of general borrowing costs and less prone to manipulation.
SOFR is different than LIBOR, however, in at least two ways that are important to borrowers:
- SOFR is a lower rate than LIBOR. SOFR is a secured rate and does not have a term risk component. Both factors contribute to SOFR running at a rate lower than LIBOR. A transition to SOFR under existing documentation will likely require an additional interest rate adjustment to account for the lower SOFR rate. A fair method to determine the amount of such an adjustment will ultimately be determined by market practice. Borrowers will need to negotiate deal-by-deal the size of any additional rate adjustment.
- SOFR may be more volatile than LIBOR. Although SOFR increased steadily over the course of 2018, the rate spiked at the end of each of the second and third quarters due to increased demand for overnight cash transactions as companies managed cash before end of quarter debt payments. Investors should closely consider how and when SOFR is calculated.
Always be prepared (to amend)!
Most U.S. syndicated loan agreements have provisions that apply when LIBOR can no longer be calculated. The interest rate defaults to a “Base Rate” calculation, which is typically the higher of a reference bank’s prime rate and the federal funds effective rate. This interest rate tends to be higher than LIBOR and most margins are determined with LIBOR in mind, so a requirement to maintain loans in Base Rate leads to an inefficient outcome for the borrower. Base Rate was intended to apply only as a stopgap for temporary disruptions in the LIBOR market, not a permanent switch in the reference rate.
In contrast, the Consultation’s proposed language permanently changes the loan agreement’s reference rate after a “transition event” occurs. If parties propose this approach, borrowers should closely watch the following key terms:
- Any party can trigger a transition. Delivery of a notice from the borrower, the lender agent or a majority of lenders in a loan facility can trigger the process for changing the reference rate. The notice simply needs to confirm either that an administrator of LIBOR has publicly announced the cessation of its publication of LIBOR or that parties to other syndicated loans have adopted a new rate to replace LIBOR. Borrowers should consider whether the right to trigger a transition should be limited to the borrower and/or agent, or subject to external events that are more objectively determined.
- Parties can either hardwire SOFR as the replacement rate or agree to agree later on a new reference rate. The Consultation provides both options. In the “hardwire” approach, there is a hierarchy of reference rate calculation alternatives that will automatically apply after a transition event. Each hierarchy rate is based on SOFR (e.g., one of the following: a forward-looking “term SOFR” based on SOFR derivatives, a compounded average of historical SOFR over a selected term or interpolated SOFR based on term SOFR for longer and shorter terms). The hardwire approach also includes a replacement rate spread adjustment tied to a rate recommended by the Fed or otherwise adopted by ISDA for derivative transactions. In the “amendment” approach, parties will look to market practice and agree both a reference rate and a spread adjustment upon the occurrence of a transition event. Borrowers should consider amending existing loan agreements with their preferred approach over the next couple of years.
Coming soon to a transaction near you in 2019…
There are many other issues important to borrowers that have yet to be addressed by ARRC, the Consultation or the use of SOFR as a replacement rate. These issues will need to be addressed over the next two years before LIBOR ceases to be published. Some of these issues are:
- The Consultation proposes language for syndicated loan transactions only. ARRC has promised proposed language for bilateral facilities in the next year. Other working groups are considering reference rate replacement language for floating rate notes and swap contracts. Borrowers outside the syndicated loan market will need to consider whether SOFR and the language proposed in the consultations is right for these debt facilities.
- Replacement reference rates in multicurrency facilities is still an open question. The Consultation was drafted for use in facilities that provide borrowings in U.S. Dollars. Loan markets around the world that have relied on an interbank offered rate are each considering the most viable replacement and multicurrency facilities will need to consider the applicable trigger events and amendment process for each lending currency. Borrowers of multicurrency facilities should be prepared to negotiate replacement provisions for other currencies.
- Swap contracts will use SOFR but will have a different replacement regime. ISDA has engaged in a similar market consultation process for replacing the reference rate in hedging agreements. Although the proposed solution for swap contracts uses SOFR as the reference rate, the method of calculation based on published SOFR may lead to different results under the Consultation and ISDA’s proposed language. Because of the daylight between these approaches, interest rates may become imperfectly hedged when reference rates are calculated different between a syndicated loan and the swap contracts that hedge interest under them. Borrowers should take particular care to ensure that reference rate replacement language in loan agreements and swap agreements align with their hedging expectations.
For discussion of the transition process in the UK, see our blog https://transactions.freshfields.com/post/102f281/time-is-running-out-for-libor.