The replacement of the London Inter-bank Offered Rate (“LIBOR”) in contracts evidencing loan, derivative and other transactions with maturities extending beyond 2021 is a massive undertaking involving legal and compliance teams within companies operating in virtually every industry throughout the world.
A leader in that undertaking is the Alternative Reference Rates Committee (“ARRC”), which began its reference rate reform initiatives when it initially met on November 17, 2014. ARRC, sponsored by the Federal Reserve Board and the Federal Reserve Bank of New York, formally endorsed on June 22, 2017 the Secured Overnight Financing Rate (“SOFR”) as its preferred benchmark to replace U.S. dollar denominated (“USD”) LIBOR as a basis for calculations in certain transactions. SOFR, a benchmark based on overnight U.S. Treasury repo trade activity, was first published on April 3, 2018 by the Federal Reserve Bank of New York.
In the global economy, $370 trillion in instruments denominated in various currencies are based on LIBOR1, and USD LIBOR is a primary interest rate benchmark for loans and derivatives.2 Whereas other monetary authorities and regulators in leading markets throughout the world are developing new benchmarks for market acceptance, the central goal of ARRC is to develop a strategy to move a significant portion of loan (and derivative) documentation from instruments referencing USD LIBOR to a more robust alternative rate.3
On September 24, 2018, ARRC published proposed benchmark replacement fallback language (the “ARRC Fallback Language”) for floating rate notes and syndicated business loans as part of a consultation in which ARRC also posed specific questions directed to market participants concerning the formulation of the ARRC Fallback Language. ARRC has requested comments by November 8, 2018.
The ARRC Fallback Language is intended to be a starting point in the finalization of language for certain loans, with the goal of assuring that contracts which reference USD LIBOR continue to be effective in the event that LIBOR is discontinued after 2021 or is no longer an accepted benchmark.
Parties may want to examine their existing, applicable loans to determine whether the ARRC Fallback Language (or language having a similar effect) will effectively replace USD LIBOR benchmark language in loan documentation. In the event that interest rate risk relating to those loans is hedged beyond 2021 by means of swaps, caps or other derivatives with USD LIBOR benchmark language, parties may also consider amending existing hedge documentation in tandem with related loan documentation
Whereas ARRC has convened since 2014 for purposes of replacing USD LIBOR language with substitute language for loans, the international trade association for over-the-counter (“OTC”) derivatives (such as caps and swaps), the International Swaps and Derivatives Association, Inc. (“ISDA”), has similarly undertaken hedge documentation revision efforts for the past several years. ISDA is developing a protocol to enable parties to existing executed caps, swaps and other OTC derivatives (with maturities beyond 2021) that reference USD LIBOR to join (i.e., “adhere”) a future LIBOR protocol for purposes of automatically amending with USD LIBOR replacement language any such existing derivatives documentation between adhering parties. This replacement language for derivatives continues to be developed by an ISDA working group. While ISDA is primarily focusing on definitional amendments within derivative documentation and ARRC has proposed ARRC Fallback language for loan documentation, both ISDA and ARRC are concerned with the consistency of benchmark language in all documentation and mechanics for most efficiently amending existing documentation referencing USD LIBOR.
In the process of considering whether loan and hedge modifications will be necessary, transaction participants should also consider whether the ARRC Fallback Language (and/or any similar language used in transaction documents) adequately anticipates the development of forward-looking term-based rates based upon on SOFR (along with market-approved calibrating adjustments to those rates to account for the differences in character between USD LIBOR and SOFR) that do not yet exist.
The September 24, 2018 release of ARRC Fallback Language is part of ARRC’s “Paced Transition Plan.” Following an internal survey in late 2017, ARRC convened to determine dates by which ARRC could feasibly implement steps towards the replacement of contract language referencing USD LIBOR, including the goal of developing forward-looking term rates based upon SOFR.
Early milestones in the Paced Transition Plan included the execution of futures contracts referencing SOFR. ARRC initially intended for SOFR futures to be traded by the end of 2018. The largest derivatives exchange and clearinghouse in the world, CME Group, through its affiliate Chicago Mercantile Exchange Inc., operates a deep, liquid SOFR-based futures market and SOFR futures have successfully traded there since May 7, 2018. The ARRC benchmark replacement effort is today ahead of schedule.
November 8, 2018 Comment Deadline
As previously highlighted, ARRC is presently seeking comments and feedback with respect to proposed approaches and questions set forth in connection with the ARRC Fallback Language. Comments are to be transmitted electronically to the ARRC Secretariat for receipt on or before November 8, 2018.
While the proposed ARRC Fallback Language is intended to be tailored to each specific product, the ARRC Fallback Language provides a baseline for (a) describing the “trigger events” which start the transition from USD LIBOR to a new reference rate; (b) instituting a “waterfall” mechanic for specifying the priority of unadjusted rates that would, subject to the calibration described in clause (c) below, replace USD LIBOR; and (c) instituting a similar waterfall mechanic for purposes of specifying the priority of adjustments in calibrating “spread” that would be applied to the replacement rate due to differences between USD LIBOR (which is an unsecured, term-based rate) and SOFR (which is an overnight, secured and nearly risk-free rate).
October 2018 Action Items
The release of the ARRC Fallback Language on September 24, 2018 marks the start of a public comment period during which ARRC will work closely with market participants to answer questions and provide insight into the expected post-USD LIBOR benchmark world. Lenders, borrowers, derivative counterparties and other market participants should inventory existing documentation referencing USD LIBOR for possible amendment (whether by an ISDA benchmark protocol or otherwise), and new documentation should take into consideration the anticipated discontinuation of USD LIBOR after 2021.
On the legal, compliance and operational fronts, the inventory of documentation based on USD LIBOR should also include an evaluation of what changes, other than amending existing documentation and/or adjusting documentation for new transactions, should be undertaken, including the possible need to rework computer systems that may be hardwired to make calculations based on USD LIBOR.
The focus today should be not only on benchmark language in credit facility documentation but also on the related interest rate management documentation (which may include ISDA Master Agreements and accompanying schedules and trade confirmations evidencing caps, swaps or other OTC derivatives), as the adjustment of benchmark language in loan documentation without the simultaneous adjustment to related derivative documentation -- if any -- may result in inconsistent contracts. Given this reality, ARRC working groups developed the ARRC Fallback Language for loans in such a way as to be consistent with the approach for USD LIBOR replacement language in hedges currently being developed by ISDA.