The Situation: SFIG's LIBOR Task Force has released the first of a planned series of "green papers" on benchmark transition in the US securitization market.
The Result: The Green Paper contains proposed recommendations that differ in certain ways from the ARRC Consultation on the same topic.
Looking Ahead: Feedback to the ARRC Consultation is due February 5, which should inform the SFIG in future iterations of the Green Paper, which are intended to culminate in a "White Paper."
The LIBOR Task Force ("Task Force") of the Structured Finance Industry Group ("SFIG") released its "Green Paper, First Edition, A Set of Recommended Best Practices for LIBOR Benchmark Transition," on December 14, 2018, exactly one week after the Alternative Reference Rates Committee ("ARRC") released its market consultation ("AARC Consultation") on the same topic. As the Green Paper frankly acknowledges, and notwithstanding SFIG's role as co-chairman of the ARRC's Securitization Working Group, the Task Force's recommendations ultimately "may differ" from ARRC's recommendations. The purpose of this Commentary is to identify and summarize the subtle but potentially important distinctions between the current recommendations of the Task Force and those of ARRC Securitization Working Group.
The Green Paper Process
The Task Force's mission is to develop a set of "industry-recognized best practices" in the securitization markets for managing the expected transition away from LIBOR to rates based upon "(nearly) risk-free rates" ("RFRs"), which in the case of the U.S. dollar appears likely to be the "Secured Overnight Financing Rate" or "SOFR."
The Green Paper itself is the first of an envisioned series of publications recommending best practices, and is designed to be iterative in nature as the market develops and issues arise or are revisited. SFIG foresees the evolution of its green paper(s) into a "white paper," which may differ from prior green paper iterations and will itself be subject to further review and modification as warranted by market developments. The Green Paper also acknowledges the myriad but as yet largely unexplored complexities of benchmark transition under consumer receivables.
Like the ARRC Consultation, the Green Paper is directed at "new" transactions only, although the Green Paper hints that future iterations may cover "legacy" transactions. The Green Paper also adopts the conventional "three step" approach to RFR transition (i.e., identification of "trigger events" and determining a new RFR rate and "credit spread adjustment"). The Green Paper, however, differs from the ARRC Consultation in potentially important ways and is peppered with concerns of trustees and other deal parties over who will bear responsibility for monitoring the occurrence of a trigger event and determining and calculating successor rates.
The first four "Benchmark Discontinuance Events" outlined in the Green Paper conform to those that appear in the ARRC Consultation. The first two consist of the two "ISDA cessation events" (i.e., an announcement by the benchmark administrator that it has ceased or will cease to publish the applicable benchmark or an announcement by the regulator or insolvency official for the administrator that it has ceased or will cease to publish the applicable benchmark). There are also benchmark discontinuance events for non-publication of LIBOR for five business days and the date on which the asset replacement percentage (i.e., the portion of the underlying assets originally denominated in LIBOR that have converted from LIBOR) exceeds 50 percent.
Paragraph 5 of the definition of benchmark discontinuance event is unique to the Green Paper. It consists of a statement by the benchmark administrator or its regulator that the applicable benchmark is "no longer representative or may no longer be used as a benchmark reference rate in new transactions." This appears to be an amalgam of clauses 4 and 5 in the ARRC Consultation but expands upon the narrow reference in the ARRC Consultation to the invocation by the administrator of its policy on insufficient submissions.
The Green Paper contemplates that the "Sponsor/Servicer/Independent Third Party" will have the ability to accelerate the transition date only upon an ISDA cessation event, whereas the ARRC Consultation contemplates that the "Designated Transaction Representative" will have this ability upon the occurrence of any benchmark discontinuance event.
Like the ARRC Consultation, the Green Paper recommends no "early opt-in" feature based on the existence of other transactions in the market being issued with comparable fallback language. However, the Green Paper notes the existence of this feature in the CLO market and specifically requests comment for future iterations as to whether this feature should be extended to other market segments.
Replacement Base Rates
The operation of the "waterfall" for selecting the replacement base rate operates quite differently under the Green Paper as opposed to the ARRC Consultation, although the first fallback under both is the "Relevant Tenor SOFR" (or "term SOFR") that has been selected, endorsed or recommended by the relevant governmental sponsor.
Where the next fallback under the ARRC Consultation was a form of compounded SOFR (either set in advance or in arrears), the Green Paper offers up alternatives based upon compounded SOFR or average SOFR, each set in advance of a given interest period.
The next fallback does not appear in the ARRC Consultation and consists of the spot or "Overnight" SOFR rate as of the commencement of each interest period and remaining fixed throughout that interest period. A noteworthy feature of the Green Paper is that the check for term SOFR is to be run quarterly when the replacement base rate for the time being is being determined by means of compounded/average or Overnight SOFR.
The Green Paper also requests feedback on whether Overnight SOFR is implicitly duplicative of compounded/average SOFR. We would expect most market participants to respond "yes", but only in the context of advance determinations of compounded/average SOFR.
The Green Paper and ARRC Consultation converge again with the next two fallbacks, which relate to the alternate, substitute or successor rate selected, endorsed or recommended by the relevant government sponsor and the fallback rate defined under the ISDA Definitions (which will be the "compounded setting in arrears rate").
If the entire waterfall is exhausted, the rate under both the Green Paper and the ARRC Consultation will remain fixed at the last benchmark fixing until one of the fallbacks becomes available.
Moreover, if the replacement benchmark is the ISDA fallback, the "Sponsor" (or other entity to be determined) has the right to propose a "Substitute Replacement Rate" (inclusive of any credit spread adjustment, as detailed below), which will become the replacement rate upon various permutations for noteholder approval/negative consent etc. This is similar to the right of the "Designated Transaction Representative" under the ARRC Consultation, except that there is no requirement for a determination that the ISDA fallback is "not an industry-accepted rate" under the Green Paper.
Credit Spread Adjustment
As already noted, both the Green Paper and the ARRC Consultation contain an additional component in the fallback for the credit spread that had been implicit in LIBOR but will cease to exist in an RFR environment. Under the Green Paper, the "Replacement Floating Rate Spread" will be the "base rate modifier . . . selected, endorsed or recommended by the relevant governmental sponsor" in all replacement base rate scenarios other than the ISDA fallback scenario, in which case the replacement floating rate spread will be the credit spread adjustment recommended by ISDA. This differs from the ARRC Consultation in which these two "Replacement Benchmark Spreads" were treated as serial fallbacks that are applicable in all cases.
Regardless of whether a replacement floating rate spread is determined pursuant to the foregoing, the "Sponsor" (or other entity to be determined) has the right to propose a "Substitute Spread," which will become the replacement floating rate spread upon various options for noteholder approval/negative consent etc. Pending implementation of the substitute spread, the replacement floating rate spread will be determined in accordance with the relevant governmental sponsor base rate modifier or the ISDA credit spread adjustment as applicable, and if the relevant fallback credit spread adjustment is not capable of determination, the replacement floating rate spread will be deemed to be zero.
Three Key Takeaways
- There are subtle but potentially important distinctions between the ARRC Consultation and the Green Paper that the structured finance industry will need to consider during the expected transition away from LIBOR approaches.
- Future Green Paper iterations may converge toward or diverge further from the ARRC Consultation as SFIG constituents further explore and attempt to address their occasionally competing interests.
- Future iterations may also delve into "legacy" transactions and the largely unexplored LIBOR transition implications for securitizations that contain consumer receivables.