The LIBOR Sunset Series: Notes on the US LIBOR transition
The London interbank offered rate for US Dollars (“LIBOR”), which forms the basis of the majority of US Dollar floating interest rate financial instruments, will commence being phased out at the end of 2021 and replaced with the Secured Overnight Financing Rate (“SOFR”). In the LIBOR Sunset Series, Freshfields’ finance experts answer frequently asked questions about the transition.
FAQ 2: How are regulators proposing companies transition their debt arrangements?
Although large corporate debt arrangements have been excluded from legislative fixes (see FAQ 1 here), regulators have provided a mountain of guidance to large corporate borrowers and their lenders on the transition away from LIBOR. In particular, the Alternative Reference Rate Committee (“ARRC”), the group organized by the Federal Reserve Bank of New York, identified SOFR as the right reference rate replacement and has proposed language for lenders and borrowers to use in their contracts to provide for a smooth(er) transition. ARRC’s proposed language varies somewhat by product – including floating rate notes, syndicated loans, bilateral loans and certain derivative instruments – and the language has been tweaked over time taking into account market feedback for each product. That said, by the beginning of this year, the language appears to have settled, and ARRC has indicated it expects its so-called “hardwired” approach to be adopted in all debt arrangements going forward.
The wiring under the hardwired approach is conceptually simple, but in practice the contractual sausage-making resulted in several pages of dense drafting. Our cheat sheet, available here, boils it down in simple terms. The most important points for CFO’s, treasurers and others working in treasury departments to understand are:
- The Trigger: On March 5, 2021, both IBA and the FCA made announcements setting June 2023 as the dates that LIBOR would cease or no longer be representative for most LIBOR tenors (see here and our guidance). ARRC has confirmed that a trigger event has occurred under its hardwired language, so parties may begin to identify the appropriate replacement rate and conforming changes. This is why lenders and/or administrative agents may send you a notice about this. The important thing is that the triggers simply put parties on notice about transition timing – nothing really changes until closer to the transition date, which as of now looks to be first half of 2023 for most LIBOR tenors.
- The Waterfall – Term SOFR: For bilateral and syndicated loan facilities, the recommended replacement rate is a Term SOFR rate, which is a SOFR rate projected for a future period (e.g., 1 month, 3 months, 6 months) derived from interest rate futures contracts. ARRC determined this is the best replacement based on market feedback because operationally this is closest to LIBOR. The only problem with this recommended rate – not a small one -- is that it is not available for general use yet. It is still in a beta testing phase. ARRC expects it will begin to be published for market us in the middle of 2021, and there remains a chance that ARRC may either determine that the futures market from which the rate is derived is not deep enough to be trustworthy or that it should not be widely adopted for another reason. Given that new bilateral and syndicated loan facilities are no longer supposed to use LIBOR as a reference rate after the end of 2021, there are hopes that an easily quoted Term SOFR will be available before the end of the year.
- The Waterfall – Daily Simple SOFR: If Term SOFR is not available, then the replacement rate will be Daily Simple SOFR, which is SOFR calculated on a daily basis by reference to the rate published two to five days prior (i.e., on a look-back date). This will allow the amount of interest owing on a loan to be determined on any particular date, but it will not allow the amount of interest that will be owed at the end of an interest period to be known until fairly close to the date interest is due. (Note: there is a third level to the waterfall, where the borrower and the agent agree to another rate but given Daily Simple SOFR exists it appears unlikely this “fallback” will be needed.)
- The Adjustment: Whether it is Term SOFR or Daily Simple SOFR, the replacement rate will need to be adjusted to ensure that it is economically equivalent to LIBOR. A fundamental tenet of LIBOR transition for all parties has been to ensure that the transition to SOFR is economically neutral. This means that the transition should result in about the same overall interest rate that parties expected the borrower to pay. ARRC expects to publish a recommended adjustment based on the five-year median spread between LIBOR and SOFR. If the ARRC recommended adjustment is not available for some reason, then the adjustment will default to the ISDA recommendation for USD LIBOR swap contracts (which is now available here). (Note: once again, there is a third level to this waterfall, where the borrower and the agent mutually agree to an adjustment, but once again given that the ISDA adjustment exists it appears unlike they will need to agree to this.) Any floor that is applicable to LIBOR as a reference rate will continue to apply to the new rate (SOFR-based reference rate plus the adjustment).
- The Plumbing: ARRC language hardwires a replacement rate but does not deal with every change needed for a loan agreement to transition to the SOFR benchmark. Consequently, there will still need to be certain operational decisions agreed (known as “Benchmark Replacement Conforming Changes”). The ARRC hardwired language permits the agent to make these changes to the document without consent from other parties. These changes should be limited to only those items that are required to administer the new rate, such as eliminating references to LIBOR in the definitions of Business Day or Interest Period, for example. The changes should be consistent with what other agents in the loan market are doing (or, if not consistent, then your agent should explain why they are reasonably necessary). Many of these changes will depend on whether Term SOFR is available to be used (if so, there will be far fewer operational changes). Best to check in with your counsel and your agent late summer this year to see if they have a good sense yet what changes will be needed.
- The New Beginning: ARRC language provides that the transition will not occur until the actual date on which LIBOR ceases. Many parties have agreed in their loan agreements that this will be a certain number of days before the actual cessation (90 days is typical) to give everyone more time to iron the kinks out. You should check your loan agreement and mark your calendar now. The ARRC hardwired language does allow the borrower and agent to begin using a SOFR based interest rate earlier than actual cessation, as long as a pre-agreed upon number of deals in the market are actually using SOFR.
There are probably two bigger-picture points to keep in mind about the ARRC hardwired approach. First, for all its density, the language does the bare minimum to make SOFR a functional reference rate in existing loan agreements in an attempt to make the transition as smooth as possible. It does not do away with legacy concepts like breakage costs, illegality provisions and even the concept of an interest period, which are all concepts of bygone eras in which banks actually funded loans by borrowing from an interbank lending market (the “I” and “B” of LIBOR). Second, the reference rate waterfall that prioritizes Term SOFR and Daily Simple SOFR is unique to the New York syndicated loan market. This is driven by market feedback that prioritized the needs of secondary market traders to settle trades by reference to a forward-looking rate or a simple daily rate. Debt agreements in other markets, including those following London’s Loan Market Association (“LMA”) recommendations, prioritize reference rates compounded in arrears rather than on a daily basis.
In further notes, we will explore in more detail how ARRC hardwired language deviates from the LMA approach and the potential consequences of this deviation for both the New York and London markets, as well as the thorny issuing facing borrowers under multicurrency facilities.
