September 2, 2020 - Last week, the ARRC released its refreshed hardwired fallbacks for bilateral loans and a technical support document for SOFR loan conventions. Below, we discuss the criticality of hardwired fallbacks, as well as key differences between bilateral and syndicated loan fallbacks.
A first step in surviving LIBOR is ensuring all your loan agreements – whether syndicated or bilateral – have a mechanism to transition from LIBOR to a replacement rate in a reasonable amount of time. The “amendment” approach to LIBOR fallbacks helps to ensure that a loan has a fallback mechanism (and doesn’t fallback to a Prime-based rate). However, any amendment would be in the queue with thousands of other fallback amendments in the market at the same time. A number of amendments may not pass in a short period of time, leaving borrowers languishing in a Prime-based until their fallback amendment passes. In contrast, the hardwired fallback approach “hardwires” the transition terms at the initiation of the loan, and does not require a voting amendment at LIBOR cessation. Thus, the hardwired fallbacks are likely to be more executable en masse and should not leave borrowers stuck in Prime. For this reason, in June the ARRC released a refreshed hardwired fallback for syndicated loans and recommended that syndicated loans begin using hardwired fallbacks no later than September 30, 2020.
The bilateral hardwired fallbacks generally follow syndicated loans: i) there is a trigger event (LIBOR cessation or LIBOR being declared unrepresentative), upon which, ii) there is a waterfall of replacement rates including (1) Term SOFR + spread adjustment, 2) Daily Simple SOFR + spread adjustment, 3) Lender Selected Rate + spread adjustment).
However, there also are some differences between the bilateral and syndicated loan hardwired fallbacks. First, the bilateral documentation recognizes that there is just one lender and borrower, rather than a number of different counterparties under the syndicated loan fallbacks. Second, the ARRC’s recommended best practice deadline for implementing bilateral hardwired fallbacks was extended to October 31, 2020 to give market participants more time to prepare. (Note that the best practice recommendation for syndicated loans using hardwired fallbacks remains September 30, 2020.) Third, the bilateral fallback language includes a “Hedged Approach”. This approach is only meant to be applicable when a borrower has a perfect hedge on a loan and, in effect, pays a fixed interest rate on the loan because LIBOR and the hedged LIBOR exactly cancel out. In the “hedged fallback” approach, the loan follows the derivative, which in effect would mean falling back to SOFR Compounded in Arrears with all/only the conventions in the derivatives market. As an example, the Hedged Approach would preclude the use of a Forward Looking Term SOFR rate, it would require the use of a lookback with observation shift (as opposed to without observation shift in the hardwired language), a lookback likely would be two days to conform with derivatives, and the borrower would lose any ability to select interest periods. The ARRC concludes by noting “[t]he operational complexities to implementation of the hedged loan approach may be especially challenging, and both lenders and borrowers should ensure that they understand the timing of rate calculations and payments and that both their internal and external systems are able to handle any requirements necessary to implement this approach.”