The London Interbank Offered Rate (LIBOR) has been the standard floating rate benchmark for debt instruments of all kinds around the world for decades. It is calculated every banking day by polling major banks on their estimated borrowing costs for various currencies and tenors. If your business carries debt, the interest rate on that debt is likely to be linked to LIBOR.  A few years ago, after it came to light that certain banks were effectively manipulating LIBOR, it was announced that LIBOR will cease to be quoted as of the end of 2021.

While the official end of LIBOR is still more than a year away, it is imperative for loan market participants to take action now in order to ensure their loan documentation permits the efficient replacement of LIBOR with another suitable benchmark rate at the appropriate time without disruption.

In 2014, the Federal Reserve commissioned the Alternative Reference Rates Committee (“ARRC”) to recommend a benchmark interest rate to replace LIBOR for U.S. dollar-denominated debt.  ARRC has designed the Secured Overnight Financing Rate (“SOFR”) as the new benchmark.¹  As part of ARRC’s efforts to help financial markets transition away from LIBOR, it published 10 separate releases between Memorial Day and August 2020, in addition to hosting six “SOFR Summer Series” panel discussions on various SOFR topics (which were recorded and can be accessed here). (Note: ARRC is a  group of private-market participants convened by the Federal Reserve Board and Federal Reserve Bank of New York in cooperation with the Consumer Financial Protection Bureau, the Securities Exchange Commission, the U.S. Treasury Department, and other governmental bodies.)

This post will discuss the recommended contractual fallback language for new originations of U.S. dollar-denominated bilateral business loans referencing LIBOR that the AARC released on August 27, 2020,² along with select sections of the July 22, 2020, recommended conventions released by the ARRC related to using the SOFR “in arrears” rates (i.e., calculating interest based on daily SOFR rates published over the course of the relevant interest period and not prior to the start of the interest period) in syndicated business loans conventions.³  These conventions address both new loans originated using SOFR and loans originated under the LIBOR benchmark prior to adoption of the SOFR benchmark.  ARRC eventually recommended a “hardwired” approach pursuant to which the process for replacing LIBOR is essentially spelled out rather than leaving it subject to negotiation of an amendment in due course. ARRC also recommended that, at this point, all new business loans should contain the ARRC Benchmark Replacement Language.  (Note: Of interest, on September 15, 2020, the Loan Syndications & Trading Association issued a SOFR Concept Credit Agreement – Daily Simple SOFR/Daily Compounded SOFR.)⁴

Upcoming Deadlines Recommended by ARRC

• June 30, 2021 – December 31, 2021: The ARRC recommends that, after June 30, 2021, no new business loans using LIBOR and maturing after December 31, 2021, should be originated.
• September 2021: ARRC recommended that issuance of dollar LIBOR securitizations stop by June 2021 and that issuance of LIBOR-based CLOs stop by September 2021.
• Best Practices for Transitioning From LIBOR to SOFR (ARRC Recommended Best Practices for Completing the Transition from LIBOR, ARRC, available here.)
• Third-party technology and operations vendors supporting market participants in the transition should complete all necessary enhancements to support SOFR by the end of 2020; and new U.S. Dollar LIBOR product issuances should stop as soon as commercially possible (e.g., market participants should stop issuing leveraged loans tied to LIBOR by the end of June 2021)
• June 30, 2021 – December 31, 2021: The ARRC recommends that, after June 30, 2021, no new business loans using LIBOR and maturing after December 31, 2021, should be originated.

On July 13, 2020, John Williams, the president of the Federal Reserve Bank of New York, and Andrew Bailey, the governor of the Bank of England, reaffirmed that, despite the COVID-19 pandemic, the end of 2021 deadline for dropping LIBOR would not be extended, and lenders and borrowers should continue their transition plans.

Background

The weaknesses of LIBOR became increasingly evident during the 2008-2009 financial crisis and the following years through numerous examples of LIBOR market manipulation.  Since the financial crisis, LIBOR has widely been criticized due to the declining number of unsecured, wholesale borrowings by banks and banks quoting LIBOR. The declining volume has been further highlighted during the COVID-19 pandemic, as LIBOR rates, and costs for borrowers, spiked upwards during this period.

Historically, syndicated and bilateral floating rate loans are commonly structured so that, if LIBOR becomes unavailable, the benchmark rate would revert to an alternate base rate (ABR), typically determined as the higher of the federal funds rate plus a spread (usually 50 basis points) or the lead lender or administrative agent’s “prime” rate.  The issue with this approach is that ABR has historically been higher than LIBOR and is, therefore, an unattractive fallback for borrowers.  For this reason, during the past few years, loan agreements have increasingly included language addressing the replacement of LIBOR, although in most cases the language does not provide a very specific road map. and no single approach has been generally accepted in the market.

Historically, syndicated and bilateral floating rate loans have commonly been structured so that, if LIBOR becomes unavailable, the benchmark rate would revert to an alternate base rate (ABR), typically determined as the higher of the federal funds rate plus a spread (usually 50 basis points) or the lead lender or administrative agent’s prime rate.  The issue with this approach is that ABR has historically been higher than LIBOR and is, therefore, an unattractive fallback for borrowers.  For this reason, during the past few years, loan agreements have increasingly included language addressing the replacement of LIBOR, although in most cases the language does not provide a very specific road map and no single approach has been generally accepted in the market.

SOFR Fallback Language

On August 27, 2020, ARRC released updated recommended contractual fallback language for new originations of U.S. dollar-denominated bilateral business loans.⁵ ARRC also released a technical reference document intended to support the previously released syndicated loans conventions. These documents were issued as part of its work to support the transition away from LIBOR and encourage broad voluntary adoption of the ARRC’s recommended alternative reference rate. In line with the ARRC’s best practice recommendations, the refreshed recommendation provides for hardwired fallback provisions.⁶

The goal of ARRC’s recommended fallback language is to create objective replacement triggers and a clear path to the designation of the replacement benchmark for LIBOR and to establish the date on which that fallback rate becomes effective. Thus, in making the replacement of LIBOR operational, ARRC has specified a set of objective, observable trigger events, a successor rate (determined by a waterfall selection), a spread adjustment (also determined by a waterfall selection), and a mechanism for developing “conforming changes” that might be administratively required in connection with the conversion from LIBOR to SOFR.

To the extent market participants continue to enter into LIBOR-based contracts, ARRC recommends and endorses the fallback language and related guidance and believes that financial markets will benefit by adopting a more consistent, transparent, and resilient approach to contractual fallback arrangements for LIBOR. It is important to note that regardless of these recommendations, the extent to which any market participant decides to implement or adopt any suggested contract language is completely voluntary. Therefore, each market participant should make its own independent evaluation and decision about whether, or to what extent, any suggested contract language is adopted.

Two Approaches: Hardwired and the Amendment Approach

There are two approaches identified by the AARC: the hardwired approach and the amendment approach.

The hardwired approach simply states that SOFR plus a spread adjustment will replace LIBOR at an agreed upon time. The amendment approach was much more widely used in loan agreements that contained LIBOR replacement provisions during the past few years, but in light of ARRC’s recent recommendations, the hardwired approach is very likely to gain traction as banks push to avoid the impending disaster of having to amend thousands of loan documents simultaneously and as the methodologies around how SOFR will be adjusted and computed are solidified in the marketplace.

The triggering event in both approaches is typically either an announcement from the benchmark administrator or the administrator’s regulator that it has or will cease to provide the benchmark permanently or a public statement from the administrator’s regulator saying that the benchmark is no longer representative. Once one of these triggering events occurs, the relevant fallback language goes into effect.

Hardwired Approach
The hardwired approach establishes SOFR as the most likely replacement for U.S. dollar-denominated LIBOR while preserving optionality for a different benchmark replacement further down in the waterfall. The updated language includes a set of contractual provisions that identify clear and objective triggers, a successor rate waterfall, and a spread adjustment waterfall and includes the use of daily simple SOFR in arrears, which is the version of SOFR that will be easiest to implement while a forward-looking term rate based on SOFR is still being developed.

Amendment Approach
The amendment approach is a shorter and simpler alternative that provides a streamlined amendment mechanism for the borrower and the agent to negotiate the benchmark replacement and corresponding spread adjustment closer to the time of actual LIBOR cessation. Such a proposed amendment negotiated and agreed between the borrower and the agent will become effective unless objected to by the “required lenders” (typically lenders holding a majority of loans and commitments) under the credit facility.  One of the major problems with the amendment approach, as opposed to the hardwired approach, is that as a practical matter market participants will face enormous (if not insurmountable) challenges with having to agree to amendments of countless documents during a compressed time period if in fact there needs to be a separate negotiation with each borrower in each instance. This process can be completely avoided by following the hardwired approach, which is essentially self-executing.

Of note, the most recent ARRC releases no longer contemplate that the amendment approach will be used and have clarified specific terms of the hardwired approach, including designating iterations of the SOFR in the fallback rate waterfall. The recommended fallback language is intended to apply to new originations of bilateral business loans initially referencing LIBOR.

Parties with hedged loans are encouraged to discuss with their advisers the relative benefits of the hardwired approach versus the hedged loan approach set forth in more detail in the ARRC Releases.

ARRC Releases SOFR “In Arrears” Conventions for Syndicated Business Loans

On July 22, 2020, ARRC released recommended conventions related to using SOFR “in arrears” (i.e., calculating interest based on daily SOFR rates published over the course of the relevant interest period and not prior to the start of the interest period) in syndicated business loans (the “Conventions”).⁷ The Conventions are generally applicable to both simple SOFR and compounded SOFR structures, which allow for daily calculation of interest accruals in arrears and address new loans that are originated using SOFR as well as legacy loans that have fallback provisions from LIBOR to SOFR when LIBOR has ceased or is declared to be no longer representative.

With respect to newly issued SOFR loans, ARRC acknowledges that syndicated loans may be based on either compound or simple interest and recommends the following specific conventions:

1. Business day lookback with no observation shift;
2. Interest compounded on all SIFMA government securities market business days or simple interest used for all days, with the preceding business day’s rate applied over weekends or holidays;
3. Actual/360 days used for day count;
4. “Modified Following Business Day Convention” (i.e., a non-business day payment date will be adjusted to the next succeeding business day unless that day falls in the next calendar month, in which case the payment date will be the preceding business day);
5. SOFR interest rate rounded to five decimal points and dollar amounts rounded to two decimal points;
6. Interest rate floors calculated daily;
7. Interest calculated on each lender’s share of principal that day and, if a lender sells out of the loan completely, they are owed interest during the time they held part of the loan which will not be paid until the end of the relevant interest period;
8. Utility of a SOFR Index for syndicated business loan may be limited, given the specific conventions recommended; and
9. Language for compensating lenders for funding losses may be used.

Conclusion

Our takeaway from various regulators regarding the LIBOR transition is that senior managements, boards of directors, and market participants must remain vigilant as LIBOR cessation approaches.

The various best practices and objectives identified by the ARRC serve as helpful guideposts to ensure as smooth a transition as possible and to avoid any undue financial upheaval as momentum continues to build toward the cessation of LIBOR in 2021.

ENDNOTES

¹ SOFR is a broad measure of the cost of borrowing cash overnight collateralized by U.S. Treasury securities in the repurchase market and represents what is considered to be the nearly risk-free rate of borrowing. The SOFR rate is published each day at 8 a.m. ET by the Federal Reserve Bank of New York.

²AARC Updated Final Recommended Business Loans Fallback Language, available here  (New York Federal Reserve). (August 27, 2020).

³“SOFR “In Arrears” Conventions for Syndicated Business Loans,” available here (New York Federal Reserve).

⁴ Blacklined Version of SOFR Concept Credit Agreement – Daily Simple SOFR/Daily Compounded SOFR (Loan Syndications and Trading Association (LSTA) (September 2020).

⁵ AARC Updated Final Recommended Business Loans Fallback Language, available here  (New York Federal Reserve). (August 27, 2020).

⁶ ARRC Recommended Best Practices for Completing the Transition from LIBOR dated March 27, 2020 are available here.  https://www.newyorkfed.org/medialibrary/Microsites/arrc/files/2020/ARRC-Best-Practices.pdf.  See also, AARC Recommendations Regarding More Robust Fallback Language for new Originations of LIBOR Syndicated Loans, available here, (June 30, 2020). See also, ARRC Press Release on Supplemental Spread-Adjustment Consultation (June 30, 2020).

⁷ See footnote 1 above.

This post comes to us from Merrill Stone, a partner in the law firm of Kelley, Drye & Warren LLP.