July 10, 2018 - Yesterday, the Alternative Reference Rates Committee (ARRC) released its Guiding Principles for more robust LIBOR fallback language in cash product contracts. These voluntary Guiding Principles will be discussed at the ARRC’s Public Roundtable on July 19, 2018. But for those that cannot wait, below we highlight the purpose of these Guiding Principles as well as how they might be used.
As background, in order to minimize systemic risk, the ARRC has been tasked with helping the derivatives and cash markets transition from LIBOR to a new reference rate (most likely SOFR) if LIBOR were discontinued at some point in the future. One of the first steps in reducing systemic risk is to ensure that all new cash instruments – like loans, FRNs and securitizations – have contract language that contemplates what happens if LIBOR ceases.
Unfortunately, before last year, most cash instruments had woefully inadequate LIBOR “fallback” language – in other words, they did not really include a workable long-term replacement if LIBOR were permanently discontinued. This year, most syndicated loans – and a number of other cash products – have begun incorporating more robust LIBOR fallback language in their documents. But the language still could be better. Thus, the voluntary ARRC principles provide guidance in four areas to help practitioners continue developing robust fallback language.
The first set of guiding principles recommends that contract fallback language should start being incorporated now and should evolve as necessary. While little SOFR information is available today, market participants should not wait for perfect clarity before introducing fallback language. Instead, they should at least include flexible fallback language in documents today and, as more information emerges, write tighter and more specific fallback language into the next generation of contracts.
The second set of guiding principles recommends consistency – as appropriate – both within asset classes and between asset classes. Practically, this means that different asset classes ideally would reference the same fallback (preferably SOFR if appropriate), similar triggers (i.e., what event causes the transition from LIBOR to SOFR) and spread adjustments (to recognize that SOFR may be lower than LIBOR). By being relatively consistent, fallback language also should reduce basis risk between products. For example, a loan and an interest rate hedge that protects the loan ideally should transition to a new reference rate the same way.
The third set of guiding principles recognizes that all fallbacks need to be feasible and hopefully will be implemented fairly. So, to begin, it’s important to create a fallback that actually can be implemented (and is more practical that the standard “poll of banks”). It should also be feasible from an operational point of view. And it should be as fair as possible and should try to minimize value transfer. In other words, it is not ideal if one side gets an economic windfall and the other side suffers an economic loss simply due to a transition from LIBOR to SOFR.
The fourth and final set of guiding principles specifically acknowledges the importance of the rate, spread and term structure adoption. While many credit agreements do not explicitly reference a spread adjustment when transitioning from LIBOR to SOFR, the final principals recommend an explicit spread adjustment in order to minimize value transfer. They also recommend that the language around triggers, successor rates, spread adjustments and timing be clear enough to be communicated to borrowers and investors.
These voluntary principles are framing the way in which the ARRC Working Groups are constructing model contract language. So, how do the ARRC principles compare to what is happening in the loan market? As a recent LSTA update noted, at this stage the syndicated loan market has been focusing on flexibility. In particular, market participants have developed a streamlined amendment process to shift to a new reference rate if LIBOR becomes unavailable. In general, the agent (and potentially the borrower) identify that a trigger event has occurred (this is often, but not always, the cessation of LIBOR). The agent (and potentially the borrower) identify a new reference rate. Often the bank group gets a right to object to the new reference rate. So today’s loan transition language emphasizes flexibility; ideally this would transition to a more specific process as more information becomes available about term SOFR and any spread adjustment.
The LSTA is a member of the ARRC and co-chairs the ARRC business loans and CLOs working group. For further information, you can find our Syndicated Loans and LIBOR FAQs on the LSTA website.