September 24, 2018 - (updated September 25, 2018) – On Monday, the Alternative Reference Rates Committee (ARRC) released two LIBOR fallback consultations – one for syndicated business loans and one for Floating Rate Notes (FRNs). The fallback consultation is the first step toward the ARRC issuing standard recommended fallback language, which should reduce systemic risk and avoid a market dislocation if LIBOR were discontinued. (We think we can all agree that avoiding a market dislocation is a worthy goal!). Below, we offer some background, we detail the syndicated loans consultation, discuss next steps and ask (strongly encourage!) you to share your views.
First, no one should be surprised to hear that LIBOR may be going away. It behooves everyone to prepare for such an eventuality because LIBOR cessation has the potential to disrupt $200 trillion of U.S. dollar LIBOR contracts, including $4 trillion of syndicated loans and $500 billion of CLOs. This would be A Bad Thing.
The first step in preparing for potential LIBOR cessation is to ensure that contracts have robust LIBOR fallback language. In other words, if LIBOR were to cease tomorrow, to what interest rate would your loan or CLO “fall back”? Many syndicated loans would fall back to Prime. Inasmuch as Prime is 5% – well above LIBOR – this could create a financial hardship for borrowers (which also is bad for the lenders that lend to them). Meanwhile, a number of securities fall back to the last reported LIBOR (which is not good for investors that thought they were invested in floating rate products). And some products are simply silent (which may be good for litigators, but probably not so good for the counterparties).
So, it’s very important to improve fallbacks. To address this gap, the ARRC’s Business Loans and CLOs Working Group – co-chaired by the LSTA and ABA – spent the last four months developing better and more robust fallback language. We offer a cliff notes version of the fallback language below, and encourage members to review the consultation itself.
As a foundational matter, one should understand that fallback language comprises four components:
- Trigger: What event precipitates transition from LIBOR to a new reference rate? (An example of a trigger is LIBOR being discontinued.)
- Reference Rate: What is the new reference rate? (For example, for USD LIBOR, the replacement rate will probably be SOFR.)
- Spread adjustment: LIBOR and SOFR are different, so there may need to be a spread adjustment to make the two rates more comparable.
- Amendment process: Some variants of fallback language require amendments and votes to approve them.
In the loan space, two approaches have been proposed by the ARRC. The first is an “amendment approach” that is similar to – but more robust than – the fallback language has been introduced in syndicated loan agreements in the past year. The second is a “hardwired” approach that fixes all decisionmaking at the origination of the credit agreement and does not require any amendments. We drill into each of the approaches (and their pros and cons) below.
Loan Triggers – Mandatory: Both the amendment approach and the hardwired approach use the same five mandatory triggers (p. 7 of the consultation). The first two triggers reference LIBOR cessation, and are intended to match the fallback triggers that ISDA expects to include for derivatives. Specifically, they reference a public statement by the benchmark administrator or its regulator that the benchmark (LIBOR) will no longer be published. The next three loan triggers occur before LIBOR cessation, but are meant to signal an unannounced stop to LIBOR (trigger 3), a material change in the quality of LIBOR (trigger 4), or a shift in the regulatory judgement of the representativeness of LIBOR (trigger 5).
Loan Triggers – Optional: ARRC members recognized that because loans are more amendable than other asset classes, lenders may be able to work down their “inventory” of LIBOR-based loans before cessation. In turn, both loan fallback approaches offer an early “opt-in” trigger to transform LIBOR based loans to SOFR based loans prior to LIBOR cessation. The amendment approach allows the administrative agent or required lenders to determine that new or amended loans are incorporating a LIBOR replacement; an amendment to replace LIBOR with a new rate would be subject to an affirmative majority lender vote. The hardwired approach also allows for an early “opt-in” trigger, which can be triggered if at least two publically available new or amended loans refer to SOFR (plus a spread adjustment). This trigger is subject to an affirmative majority or supermajority vote.
While the triggers are similar for the amendment and hardwired approaches, the rest of the steps are very different (see table on p. 6 of the consultation for a side-by-side comparison).
Amendment Approach: The amendment approach is similar to the LIBOR fallback language that has been appearing in loan documentation since late last year. Upon a trigger event, the administrative agent and borrower may amend the agreement to replace LIBOR with an alternate benchmark rate (which may consider Term SOFR and a spread adjustment), giving due consideration to conventions in the U.S. syndicated loan market. The required lenders would have objection rights for a mandatory trigger (or an affirmative amendment for the opt-in trigger). While this is similar to recent credit agreement language, it is more specific in several respects. First, it explicitly acknowledges the possibility of the replacement rate being SOFR. Second, it specifically acknowledges the potential for a spread adjustment. Third, while some loans do not allow lender objection rights for the rate replacement, this option explicitly allows for it.
Hardwired Approach: The hardwired approach tackles the problem differently, by “hardwiring” all decisions upfront at the origination of the credit agreement. (This is similar to how other asset classes, like FRNs, propose to address fallback language.) After a trigger event has occurred, the hardwired approach immediately looks to a waterfall of potential replacement rates and spread adjustments. The first fallback rate is a forward-looking term SOFR. If that rate does not yet exist, then the hardwired approach looks to compounded SOFR. If that rate does not exist, the hardwired approach next looks to overnight SOFR (which does already exist). In addition, at each stage, the hardwired approach looks to add a “Replacement Benchmark Spread” to make SOFR more comparable to LIBOR. The Replacement Benchmark Spread is either i) the adjustment identified by the relevant governmental body or, ii) if that is not available, then the adjustment selected by ISDA. If, for some reason, it is not possible to identify the replacement rate this way, the hardwired approach then converts to an amendment approach.
Pros and Cons: Neither approach is perfect. There definitely are positives for the amendment approach. First, it relies on loans’ amendment flexibility and does not rely on rates that do not exist today (like term SOFR). But, to be clear, if the market really had to transition all loans – i.e., tens of thousands of loans – from LIBOR to a new reference rate over five days, it simply may not be possible to do it through the amendment approach. Moreover, there likely would be winners and losers depending on the market environment when transition occurred. In a borrower-friendly market, a borrower might be able to extract value from lenders by refusing to include a compensatory spread adjustment when transitioning to a new rate. Conversely, in a lender-friendly market, the lenders might simply choose to stay at “Prime” for an extended period, extracting value from the borrower.
In contrast, by agreeing to terms upfront, the hardwired approach removes the potential for gamesmanship at the point of transition. In addition, because it does not primarily rely on amendments, the hardwired approach should be executable on thousands of documents quickly and simultaneously. However, the hardwired approach also references rates that do not currently exist (like term SOFR), albeit with the “failsafe” that the hardwired approach can always fall back to an amendment approach.
Next steps: The ARRC is seeking feedback on the consultation through November 8, 2018 and invites – encourages! – all market participants to respond. The ARRC working group chairs will be holding educational webcasts and podcasts in the coming weeks to help market participants understand and respond to the consultations. The ARRC intends to publish recommended fallback language on syndicated loans and CLOs around year-end.