March 11, 2020 - There’s been considerable buzz about a “legislative solution” to LIBOR fallbacks. What is it? And is it applicable to syndicated loans? (Short answer: No, but we explain why below.)
On March 6th, the ARRC released its pithily titled “Proposed Legislative Solution to Minimize Legal Uncertainty and Adverse Economic Impact Associated with LIBOR Transition”. Specifically, this is a New York State proposal because it is the jurisdiction governing many commercial transactions and securities. The legislation is meant to address contracts that i) are silentwith respect to what happens when LIBOR ceases (in other words, they literally don’t say what happens and therefore it is not possible to determine the interest rate after LIBOR ceases), ii) fall back to a “LIBOR-based rate” (such as polling for LIBOR or last quoted LIBOR (which would flip a floating rate contract into a fixed rate contract)) or iii) gives a party discretion to select a replacement rate. The ARRC proposes that in those cases, unless parties mutually choose to opt out, the contract would automatically use the recommended benchmark replacement (in i and ii) or give the “determining person” (in iii) cover to select the recommended benchmark replacement. Elegantly, the recommended benchmark replacement is the rate recommended by the FRB, the FRBNY or the ARRC. A grid on p. 5 lays out the key components of the statute and its effects on contractual provisions. The proposed legislation begins on page 13.
As flagged above, syndicated loans generally are not covered this legislation because they ultimately fall back to a Prime-based rate. Specifically, in loans originated prior to 2018, which do not have the new “fallback” language, if LIBOR is not available, these loans eventually convert to a Prime- or Base Rate-based loan. In “amendment fallback” loans, if the amendment to transition to a replacement rate fails, the loan “falls back” to a Prime-based rate until the amendment process is ultimately successful. And in the “hardwired fallback” language, loans fall back to a SOFR based rate; if that fails they use an amendment fallback process; if that fails, they fall back to a Prime-based rate. As the chart on p. 5 shows, contracts falling back to Prime are specifically – and intentionally – not covered.
While loans intentionally are not covered, a number of legacy asset classes with less viable fallbacks could benefit greatly. The proposal estimates that there are approximately $1.8 trillion of LIBOR-based FRNs outstanding. If LIBOR is not available, FRNs that have not incorporated the new ARRC LIBOR fallback language typically would fall back to the last quoted LIBOR. In effect, the floating rate notes become fixed rate ones. This is a clear change from what was intended by the parties and potentially could lead to litigation. Securitizations ($1.8 trillion) without specified fallback language also likely would fall back to last quoted LIBOR. However, securitizations have the added complication that their assets might fall back to a different rate than their liabilities. In contrast, ARRC recommended securitization fallback language specifically attempts to keep securitization assets and liabilities aligned by offering the option of securitization liabilities falling back to whatever rate (probably SOFR) to which a certain percentage of their assets fall back. Adjustable Rate Mortgages (ARMs) ($1.2 trillion) generally allow noteholders to replace the index if LIBOR is no longer available. However, there is no defined standard and a significant degree of discretion. In this case, “discretion” is a bad word; different replacement rates for borrowers could lead to disparate economic outcomes, which could be perceived as “unfair and could, in turn, lead to “disputes”. The legislation addresses the potential market disruption and litigation that silent or inadequate fallback language could create. But, to reiterate, because business loans have a viable ultimate replacement rate, this solution was not meant for them.