November 23, 2020 - There is good news – and some modest bad news – on the LIBOR front. As has been discussed (ad nauseum?) in these pages, LIBOR cessation is coming and thousands of credit agreements will need to transition from LIBOR to a replacement rate.
This is a daunting task, but is easier using “hardwired” LIBOR fallbacks. Hardwired fallbacks say that when LIBOR ceases, the loan falls back first to Term SOFR + spread adjustment; if Term SOFR does not yet exist, the loan falls back to Simple SOFR + spread adjustments. The economics and mechanics are clear, are set out in advance, and do not require negotiation.
The good news: The ARRC set September 30, 2020 as the goal for using hardwired fallbacks in new loans – and lenders and borrowers increasing are using them. A recent Covenant Review article calculated that, of the 43 loans in the CS Index that were amended or originated in October, more than 30% used “hardwired” fallbacks. This good news and we hope that the trend accelerates as hardwireds become mainstream.
But there’s bad news too. Even if new loans start using hardwired fallbacks, most credit agreements have been using the “amendment” fallback approach, whereby: 1) the agent and borrower determine that LIBOR has ceased/will ceased or is non-representative; 2) the borrower and agent identify a replacement rate (and potentially a spread adjustment); and 3) the required lenders typically have 5 days to object to the rate. If the amendment fails, the loan flips to a Prime-based rate until a fallback amendment clears. The concept of doing tens of thousands of such amendments around LIBOR cessation is…daunting. In addition, it is not clear that the large sponsor community is accepting (yet) of hardwired fallbacks, potentially thinking that they will somehow get a better rate than the market standard SOFR+spread adjustment. What we have heard from banks is that SOFR+spread adjustment will almost assuredly be the market norm, and thus, relying on the “amendment” approach just locks in the downside optionality of falling back to Prime if the amendment fails.