On 29 July 2021, the US Alternative Reference Rates Committee (“ARRC”) announced that it formally recommended CME Group’s forward-looking Secured Overnight Financing Rate (“SOFR”) term rates (“CME Term SOFR Reference Rates” or “Term SOFR”) for adoption by market participants. This recommendation marks a milestone in the transition away from U.S. dollar (“USD”) London Interbank Offered Rate (“LIBOR”). In light of the Hong Kong Monetary Authority (“HKMA”) requirements that authorized institutions in Hong Kong shall cease entering into new LIBOR contracts after 31 December 2021 (the “HKMA Requirement”), this article will focus on discussing how Term SOFR can be applied as an alternative interest rate benchmarks in the business loan market.
For further information on the transition away from LIBOR in general, please refer to our newsletter published in September 2020: “Transition away from LIBOR”.
CME Term SOFR Reference Rates
Currently, the CME Term SOFR Reference Rates are the only forward-looking term rates endorsed by the Federal Reserve Bank of New York (“FRBNY”) and ARRC. CME Term SOFR Reference Rates is a daily set of forward-looking interest rate estimates, calculated and published for 1-month, 3-month and 6-month tenors, by the Chicago Mercantile Exchange based on market expectations implied by the SOFR derivatives market. CME Term SOFR Reference Rates will be calculated for each day that FRBNY calculates and publishes SOFR, i.e. any day except for a Saturday, Sunday or a day on which the Securities Industry and Financial Markets Association recommends that the fixed income departments of its members be closed for the entire day for purposes of trading in US government securities (“US Government Securities Business Day”). They are published on the webpage of CME Group Benchmark Administration Limited and are available to licensees via CME DataMine, CME’s Market Data Platform (MDP) channel 261, and data redistribution partners such as Bloomberg and Refinitiv.
While ARRC continues to recommend as a general principle that market participants use overnight SOFR and SOFR averages given their robustness, ARRC also supports the use of Term SOFR for business loan activity, particularly multi-lender facilities, middle market loans, and trade finance loans, where adapting to an overnight rate could be more difficult and the use of a term rate could be helpful in addressing such difficulties.
ARRC, however, does not support the use of Term SOFR for the vast majority of the derivative markets, particularly the trading of Term SOFR derivatives in the interdealer market because such activity could undermine trading activity in the underlying overnight SOFR derivatives that are needed to construct Term SOFR itself and could, thereby, compromise the robustness of the rate and its corresponding utility to market participants. ARRC recommended that any use of Term SOFR derivatives be limited to end-user facing derivatives intended to hedge cash products that reference Term SOFR. Such end-user refers to a direct party or guarantor to a new Term SOFR business loan or securitization linked to Term SOFR assets, or to a legacy LIBOR product that has converted to Term SOFR through contractual fallback language or legislation.
Use of Term SOFR in business loan activity
Term SOFR, similar to LIBOR, is a forward-looking interest rate (as opposed to SOFR which is a backward-looking interest rate) which facilities interest rate fixing of a loan at the beginning of an interest period and for the calculation of daily interest accruals. The ARRC’s recommended conventions for the use of Term SOFR are similar to existing market practices for using USD LIBOR in business loan activity.
On 21 July 2021, ARRC published the Forward Looking Term SOFR and SOFR Averages (Applied in Advance) Conventions for Syndicated and Bilateral Business Loans (“Term SOFR Business Loan Conventions”) which sets out the following recommended conventions for using Term SOFR in the business loans market:
New SOFR loans
1.Holiday and weekend convention: The recommended convention is for holiday/weekends to be any day that is not a US Government Securities Business Day.
2.Interest lookback/quotation day: Similar to the LIBOR convention today, the recommended convention is to use the rate published two US Government Securities Business Days prior to the first day of the interest period and held for the entirety of the interest period.
3.Temporary unavailability of Term SOFR: ARRC suggested a temporary fallback convention be included in the event that Term SOFR (or the relevant tenor thereof) are not published for a short period of time. Such a convention may be the functional equivalent of: “If as of [5:00 p.m. (New York time)] on any interest lookback day, the SOFR Average or Term SOFR has not been published by the relevant administrator or on the relevant administrator’s website, then the rate used will be that as published by the relevant administrator or on the relevant administrator’s website for the first preceding US Government Securities Business Day for which such rate was published on such administrator’s website so long as such first preceding US Government Securities Business Day is not more than three US Government Securities Business Days prior to such interest lookback day”.
4.Borrowing notice period: The recommendation is for the borrower to provide notice of a borrowing request three US Government Securities Business Days prior to the borrowing date similar to the LIBOR convention today. Bilateral loans may have more flexibility in borrowing notice periods.
5.Daycounts: The recommended convention is Actual/360 days for Term SOFR, which is the standard convention in the US money markets.
6.Business day convention: It is recommended for Term SOFR to follow the “Modified Following Business Day” convention which means that payments that are scheduled to be paid on a day falling on a non-business Day will be adjusted to the next succeeding business day, unless that business day falls in the next succeeding calendar month, in which case the interest payment date will be the preceding business day.
7.Compensation for loss: Credit agreements may include language that compensates lenders for funding losses such as those sustained due to an intra-period prepayment, conversions or continuations or the failure to make borrowings or payments when due or scheduled.
8.Interest rate floors: It is recommended that any interest rate floor applies to Term SOFR for new loans.
9.Rounding: Similar to LIBOR today, Term SOFR are published to five decimal places and dollar amounts can be calculated to two decimal places.
10.Fallback: Market participants are recommended to include robust and workable fallback language, such as the updated recommended fallback languages for syndicated and bilateral business loans published by ARRC on June 30, 2020 and 27 August 2020 respectively or the supplemental recommendation for business loans published on 25 March 2021.
Conversion of legacy LIBOR loans to SOFR loans
At LIBOR cessation or upon LIBOR being declared to be no longer representative, many business loans are expected to convert from LIBOR to SOFR according to their respective fallback languages. If a legacy LIBOR loan falls back to Term SOFR, most of the conventions for Term SOFR discussed in the New SOFR Loans section above would be applicable, save that a spread adjustment for neutralizing the economic effect of the conversion shall be added to the fallback rate and the application of a floor would apply to the resulting Term SOFR plus the related spread adjustment. Such spread adjustment for legacy LIBOR loans would be separate from and in addition to the loan’s original contractual margin.
According to the Term SOFR Business Loan Conventions, ARRC recommended that legacy LIBOR loans that convert from LIBOR to a SOFR-based rate shall use a static spread adjustment recommended by either the ARRC or ISDA, i.e. the published five-year historical median difference between LIBOR and SOFR. The applicable spread adjustment would follow the original LIBOR tenor for the legacy LIBOR loan and apply to Term SOFR (e.g. 3M LIBOR to 3M Term SOFR). Market participants can refer to the spread adjustments set on 5 March 2021 which are available here for ease of use.
If a legacy LIBOR credit agreement which contains an interest rate floor converts to Term SOFR, ARRC recommended that such interest rate floor shall apply to Term SOFR plus the associated spread adjustment as recommended by the ARRC.
In view of forthcoming cessation of LIBOR and the HKMA Requirement, market participants in Hong Kong will need to reference alternative interest rate benchmarks in new loan contracts from 1 January 2022 onwards. While the ARRC’s formal recommendation for the adoption of the CME Term SOFR Reference Rates provides market participants with an essential tool for transitioning away from the USD LIBOR, they should also keep themselves abreast of the latest development and use of forward-looking term rates in respect of risk-free rates for currencies other than USD. Considering the complexity and diversity of alternative reference rates involved in the transition, market participants should seek advice from accounting, financial, information technology in addition to legal and compliance professionals in assessing the consequences in such areas and other operational issues where necessary.