September 16, 2020 - This summer has seen a number of tools added to the LIBOR transition toolbox, such as the Updated ARRC Hardwired Fallback Language (“Hardwired Fallback Language”) and the ARRC’s Recommended Conventions for Syndicated Loans (“ARRC Conventions”), and now there is one more – the “Daily Simple SOFR” Concept Credit Agreement.
What is the Concept Credit Agreement?
The concept credit agreement is an illustrative example of a Daily Simple SOFR referencing credit agreement. It has been developed as an educational tool to support the use of hardwired fallback language and hopefully ease the transition to new originations of SOFR-referenced loans. It is important to bear in mind that this concept document does not purport to represent or set any standard market practice. Given that Daily Simple SOFR loans have not yet been executed, there is no market practice to reflect. Instead, the concept document uses familiar ABR-style provisions and incorporates the ARRC Conventions to offer an example of a SOFR loan.
Why Daily Simple SOFR?
The ARRC recently published Hardwired Fallback Language, developed by the ARRC Business Loans Working Group, which included a critical modification to the benchmark replacement waterfall that is effective following a trigger event – the first step, Term SOFR, is unchanged, but Daily Simple SOFR has replaced the compounded average of SOFR as the second step of the waterfall. It is important that the first two steps in the waterfall are practicable for syndicated loans. Term SOFR does not yet exist as a reference rate, but it is an operational analog of LIBOR so requires little change to conventions and systems. We have learned however that loan facilities will need to accrue interest on a daily basis so an average of SOFR (which is only known at the end of the interest period) is not implementable. Furthermore, compounding on a daily basis is complicated for syndicated loans due to routine intra-period principal fluctuations (whether through prepayments or trading) and represents the greatest departure from current practice (click here for more information). Given that Daily Simple SOFR is the straightforward option and included in the Hardwired Fallback Language, Daily Simple SOFR makes sense as the starting point.
What are the Notable Features of the Concept Credit Agreement?
Interest Accruals: As a daily rate loan, interest accrues on a real-time basis (i.e. “in arrears”) so the amount of interest owed by the borrower would not be known until the end of the period without the use of a convention that permits certainty as to the interest amount before the interest payment is due.
Use of a Lookback: In accordance with the ARRC Conventions, the concept document includes a lookback with no observation shift to build in breathing room for invoicing and payment. A lookback simply shifts backwards the period of time that the rates are observed.
No “Interest Period”: For a daily rate loan, any applicable “interest period” only represents the applicable payment period for interest, e.g. monthly or quarterly, and therefore there is no need for a borrower to have the option of electing different “interest periods” as they do in LIBOR loans (or other term rate loans). Relatedly, in the absence of such optionality, it is operationally easier for interest to be paid on scheduled payment dates (like ABR loans).
Transition to Term SOFR: Member feedback supported including an option for a hardwired transition to Term SOFR if an ARRC recommended Term SOFR were to exist in the future. It is important that parties weigh the potential benefits as well as the operational and potential hedging risks of shifting to Term SOFR.
What’s Next in the Series?
We intend to develop concept credit agreements reflecting all four of the methodologies set forth in the ARRC Conventions. To that end, we have built in to this concept document alternative drafting illustrating a “Daily Compounded SOFR” loan using the “compound the balance” approach. Under this approach, the overnight SOFR rate is multiplied by outstanding principal and unpaid accrued SOFR interest (collectively, the balance). Compounding is only applicable on Business Days and solely with respect to SOFR (not margin, i.e. the “Applicable Rate”). Because both Daily Simple SOFR and this compounding approach apply the daily SOFR rate (the former to principal and the latter to the balance) they are mechanically similar. In contrast, both “compound the rate” methodologies apply a calculated rate of daily compounded interest to principal and are highly conventions dependent. A separate Daily Compounded SOFR (“compound the rate”) concept document is in development.
We will continue to monitor developments in the implementation of Daily Simple SOFR and will update this concept document, if necessary, to reflect any future evolution. Click here for a blackline of the concept document against the LSTA’s form of term loan.