August 15, 2019 - There is good news – and less good news – on LIBOR fallback language in cash products like loans, FRNs and CLOs. On the good news front, it looks like most cash products are now including fallback language in new deals. This is critical because many instruments will be outstanding when LIBOR ends after 2021, and if they don’t have good fallback language, there could be contract frustration (and litigation). However, on the less-good-news front, the fallback language is not always consistent (which may lead to a lot of work to determine exactly how each instrument would fall back) or workable en masse (which may lead to traffic jams as everyone tries to amend their deals at the same time). We discuss the fallback status of FRNs and loans below. (And we’d gently remind readers that several CLOs have gone “hardwired”, per LCD and Covenant Review).
Legacy FRNs – those issued prior to fallback language being developed – may have been in the worst spot. In general, pre-2018 FRNs did not conceive of a world without LIBOR. In turn, if LIBOR ceased to be quoted, FRNs would generally remain at last quoted LIBOR, effectively turning a floating rate instrument into a fixed rate one. Because bonds are not easily amended, that is where a number of legacy FRNs may end up.
However, the newest FRNs may have jumped from being in the worst spot to potentially being in the best one. Precisely because they have so little amendment flexibility, FRNs have generally embraced the ARRC’s hardwired fallback language that was released in April 2019. In the FRN hardwired approach, if LIBOR ceases (or is determined to be non-representative) after 2021, new FRNs will automatically convert to a replacement rate. This is first defined as forward looking term SOFR plus a spread adjustment; if that does not exist, then compounded SOFR plus a spread adjustment. (There are further steps down the waterfall, but as compounded SOFR exists today and a spread adjustment will be published by ISDA around year-end 2019, we might assume we can stop at this stage of the waterfall.) Why are FRNs in the best spot today? Covenant Review analyzed 40 publicly traded FRNs issued in June and July to check on the adoption of the ARRC fallback language. Twenty-five – or approximately two-thirds – used a version of the ARRC’s hardwired fallback language. Good for FRNs.
Meanwhile loans, which were first out of the gate with fallback language in 2017, now “lag behind other asset classes” in adopting consistent ARRC language, Covenant Review writes. The specifics: Of the 66 new and amended leveraged loans issued in June and July, only 11% used ARRC amendment fallback language, 86% used pre-ARRC amendment fallback language and 3% used no fallback language. (And none used hardwired fallbacks.)
So, there are positives and negatives here. On the positive side, fallback uptake has been extensive in loans. PLC writes that 97% of the publicly filed deals they reviewed in 2018 and 2019 had fallback language. In addition, we had heard that some sponsors were pushing to strip the negative consent rights from the required lenders (an action we believe does not balance the interests of borrowers and lenders). However, the statistics indicate this stripping behavior is rarer than anecdotes suggest. Covenant Review analyzed 57 deals from June and July that used “pre-ARRC” amendment fallback language. Of those 57 loans, six – all of which were sponsored – had no negative consent language and one had affirmative consent language. Of the remaining 50, 38 were sponsored and 12 were not sponsored; all 50 had negative consent language (see COW). Thus, we’d suggest the narrative that “negative consent rights are going away” is exaggerated. We believe fairness dictates maintaining the negative consent right so that all parties have the opportunity to participate in the selection of a successor rate.
While it is good that “fair” fallback language is going into most loan documents, there are two potential problems to consider in this pre-ARRC amendment strategy. First, in contrast to the “hardwired” approach, amendment fallbacks may be hard to execute for tens of thousands of outstanding loans simultaneously at LIBOR cessation. (That said, issuing loans on SOFR before LIBOR cessation will help with this “inventory” problem.) Second, if loans continue to use bespoke “house” amendment fallback language, lenders may not know the fallback variations in each document. Thus, unlike ARRC fallbacks, each loan may have to be analyzed separately to understand exactly how the fallback would work upon LIBOR cessation. Ultimately, most lenders and borrowers might see the “house” amendment approach as a stopgap as they develop more information and certainty on SOFR; they might do the next deal using a hardwired approach. Finally, we’d point out that SOFR is being published and ISDA plans to publish their spread adjustment around year-end 2019. So more information and certainty is coming!