April 25, 2019 - On April 25th, the Alternative Reference Rates Committee (“ARRC”) released its recommended LIBOR fallback language for U.S. dollar business loans and FRNs. The LSTA, as co-chair of the ARRC Business Loans Working Group, shepherded the process along with Cadwalader and the ABA. Below we explain – in English! – how the fallback language works. For detail-oriented folks, the actual loan fallback language and an extensive explanation is available here.
What is happening with LIBOR? LIBOR, the world’s most important number, may cease after the end of 2021. U.S. dollar LIBOR is the reference rate for nearly $200 trillion contracts, including $4 trillion of U.S. syndicated loans and $600 billion of CLOs. For derivatives, the U.S. dollar replacement for LIBOR will be SOFR, the Secured Overnight Financing Rate. SOFR may also be the successor rate for cash products like loans, CLOs and floating rate notes. Because SOFR is secured and thus expected to be lower than LIBOR, loans that fall back to SOFR will require a spread adjustment to make the successor rate more comparable to LIBOR.
What is the immediate problem with LIBOR cessation? Many existing and newly originated loans and CLOs may be outstanding when LIBOR ceases – and thus it is critical to develop “LIBOR fallback language” in new loans and CLOs.
What is LIBOR fallback language? For loans, this is simply contractual language that answers the question “If LIBOR ceases or is unusable, to what rate would my loan fall back?” Without good fallback language, the answer is likely “Prime”.
What are the components of LIBOR fallback language? Fallback language has two major components. The first is the “trigger”, or the event that initiates a transition from LIBOR to a successor rate. The second component is the “Benchmark Replacement” rate, in other words, the new rate that replaces LIBOR.
What do LIBOR fallbacks for loans generally look like? The ARRC has developed two versions of recommended fallback language for syndicated loans. The first is the “amendment approach”, which is similar to language developed in the loan market in 2018. In this version, a trigger event occurs and then the bank group facilitates a streamlined amendment to replace LIBOR. The second is the “hardwired approach”, which is similar to what is being used in all other cash asset classes. In this approach, fallback language has been “hardwired” into the original credit agreement, so the loan may automatically convert to a successor rate if a trigger event occurs. We discuss each approach in detail below.
What are the “triggers” for loans? To avoid market disruption, cash products like loans, FRNs and CLOs generally attempt to have the same triggers so that a transition would happen simultaneously for all products. Loans have three triggers. The first two are “cessation” triggers, and state that either i) the benchmark administrator (like ICE Benchmark Administration) or ii) the administrator’s regulator (currently the UK’s Financial Conduct Authority) has announced the administrator has or will cease to provide the benchmark permanently. The third trigger is a public statement from the LIBOR administrator’s regulator saying that the Benchmark is no longer representative. Once one of these triggers occurs, then the fallback language moves to replace LIBOR with a successor rate.
How does the Amendment Approach work? Once a trigger occurs, the borrower and administrative agent select a successor rate and a spread adjustment, in both cases giving due consideration to a recommendation by the Relevant Governmental Body (likely the Federal Reserve Board or FRBNY) or relevant market convention. Next, there is an amendment by negative consent, which means “Required Lenders” (typically a majority) have five days in which to object to the successor rate and spread. If they do not object, the successor rate and spread are implemented.
How does the Hardwired Approach work? Once a trigger occurs, the “hardwired approach” first looks to replace LIBOR with forward-looking term SOFR plus a spread adjustment. If that does not exists, the “hardwired approach” next looks to replace LIBOR with a compounded average of daily SOFRs plus a spread adjustment. If that too doesn’t exist, then the “hardwired approach” essentially falls back to the amendment approach.
What is the “spread adjustment”? Because SOFR is secured and expected to be lower than LIBOR, fallbacks to SOFR will need a spread adjustment to make it more comparable to LIBOR. The “hardwired approach” fallback language first suggests a spread adjustment selected or recommended by the Relevant Governmental Body. If that doesn’t exist, it will apply the spread adjustment used by ISDA in their fallback language. In the “amendment approach”, the borrower and the administrative agent select the spread adjustment, giving due consideration to a recommendation by the Relevant Governmental Body or relevant market convention.
Which fallback rate is “better”? Both approaches have pros and cons. The “amendment approach” takes advantage of loans’ flexibility and also does not lock market participants into a rate (like Term SOFR) that does not exist yet. However, the amendment approach may be subject to gamesmanship depending on the economic environment when the transition occurs. Moreover, if thousands of loan documents need to be transitioned simultaneously, the “amendment approach” might simply not be workable. In contrast, because the terms are predetermined, the “hardwired approach” is not subject to gamesmanship and should be executable en masse at LIBOR cessation. However, it does require market participants to agree to a rate (like Term SOFR) that does not exist today. For these reasons, it is possible the market will continue to use the “amendment approach” as a transitional method until there is more clarity on the attributes of Term SOFR.
Can loans switch to SOFR before LIBOR ceases or is unrepresentative? Yes! The ARRC has also recommended “Opt-In” triggers in case parties to a credit agreement want to switch to SOFR before LIBOR ceases or is unusable. For the “hardwired approach”, once the agent or borrower can identify that a certain number of loans have used Term SOFR (plus a spread adjustment), then the agent, required lenders and borrower can elect to switch to Term SOFR by affirmative vote. In the “amendment approach”, the agent or required lenders can determine that loans are being executed or amended to incorporate or adopt a successor rate and can elect to switch to a successor rate. This rate is then selected by the borrower and agent and accepted by an affirmative vote of the required lenders.
What else needs to be considered? Agents likely will need to make technical or operational conforming changes to implement the replacement of LIBOR. This is expressly considered in the fallback language. In addition, before executing fallback language, market practitioners should review their loan systems to ensure the fallback language will be able to be operationalized upon the fallback being executed.
Need more information? The LSTA is a member of the ARRC, co-chairs the ARRC’s BLWG and the BLWG’s Operations Sub-Group. For more information, contact firstname.lastname@example.org, email@example.com or firstname.lastname@example.org.