The Situation: Financial industries around the world are addressing the probable cessation of LIBOR interest rates before 2022 by, among other things, developing language designed to substitute an industry-approved successor rate—most likely to be based on the Secured Overnight Financing Rate ("SOFR") for the U.S. dollar—seamlessly in the event of such a cessation.
The Result: The Alternative Reference Rates Committee (the "ARRC") has recently released its final "fallback language" recommendations for USD-denominated floating rate notes ("FRNs") and syndicated loans. While the recommended language is "final," it leans heavily on future market developments to provide fundamental calculation conventions.
Looking Ahead: We are aware of a number of major financial institutions that have already adopted the ARRC language, and market participants can expect to start seeing the ARRC language in transaction documents at an increasing pace.
Following up on its September market consultations for FRNs and syndicated loans, the ARRC published final recommended fallback language for both products on April 25, 2019. The recommended fallbacks differ in certain notable respects from those proposed in the consultations and reflect elements of both growing industry consensus as well as fundamental differences between the products. Most notably, the final recommended language for syndicated loans (the "Syndicated Loan Language") continues to avail itself of the flexibility and frequency of amendments in that market by continuing to offer two options (the so-called "Amendment (or "wait and see") Approach" and the "Hardwired Approach") for addressing LIBOR transition, while the recommended language for FRNs (the "FRN Language") reflects the greater difficulty in effecting amendments for that product and accordingly adopts an all or nothing "hardwired" approach.
Because it is significantly more straightforward, we address the FRN Language and certain elements it has in common with the Syndicated Loan Language before addressing some of the unique features of the Syndicated Loan Language.
FRN Trigger Events
The FRN Language includes three trigger events, or "Benchmark Transition Events," for when the successor rate is to be adopted. The first two are in substance the same as those contemplated for derivatives: a public statement that LIBOR (or any successor benchmark) will cease permanently or indefinitely by (i) the benchmark administrator (for LIBOR, ICE Benchmark Administration), or (ii) a public sector (or similar) official with authority over the benchmark administrator (for LIBOR, the United Kingdom's Financial Conduct Authority (the "FCA")) or the central bank for the relevant currency. Third, and in contrast to the multiple and inconsistent potential "pre-cessation triggers" in the consultations, market consensus seems to be moving in the direction of a single pre-cessation trigger based on a statement by the FCA (or other regulator) that LIBOR (or other benchmark) is no longer "representative." Under the FRN Language, it is the responsibility of the issuer or its designee to determine if a Benchmark Transition Event has occurred.
The Syndicated Loan Language contains the same triggers as the FRN Language but includes the additional "Early Opt-In Election" discussed below. ISDA has also recently undertaken to further consult the derivatives market at the urging of regulators on the advisability of adding a similar "pre-cessation" trigger to its LIBOR remediation reform efforts. The emerging coalescence around a single "pre-cessation" trigger operates to reduce or eliminate "trigger basis risk," which is the risk that different financial products will "trigger" a rate transition at different times.
FRN Benchmark Replacement Waterfall
The fallback waterfall under the FRN Language contains five stops, with an intervening interpolation "stop" at the top of the waterfall. The waterfall is run once upon the occurrence of a Benchmark Transition Event, and there is no mechanism to move to an earlier stop under the waterfall unless and until another trigger event occurs, even if such a "preferred" option subsequently emerges. The waterfall has also been "future-proofed" to make its provisions applicable equally to the demise of LIBOR and of any replacement rate(s), including SOFR.
The FRN fallback waterfall runs as follows:
- Interpolation between LIBOR (or then-operative fallback rate) tenors
- If LIBOR for a given FRN interest period is unavailable but that period is bracketed by periods for which LIBOR is determinable, LIBOR as "interpolated" on a linear basis between the two would serve as the replacement benchmark.
- Term SOFR plus Benchmark Replacement Adjustment
- In both the FRN Language and Syndicated Loan Language, "Term SOFR" is a placeholder for a forward-looking SOFR-based term rate to be selected or recommended by the ARRC or another "Relevant Governmental Body." Although the ARRC has committed to attempt to endorse a "Term SOFR" rate (subject to sufficient liquidity developing), the ARRC has specifically put the market on notice, most recently and pointedly in its "User's Guide to SOFR" (the "User's Guide"), that there can be no assurance that Term SOFR (or any other forward-looking rate) will be approved by the time of LIBOR cessation (if ever). The User's Guide accordingly admonished market participants not to await the approval of a Term SOFR but to start utilizing Compounded SOFR (discussed below) or other daily SOFR accrual as the primary benchmark rate in amendments and new financings immediately.
- The "Benchmark Replacement Adjustment" (discussed further below) is an element common to all stops on the FRN fallback waterfall (other than the interpolation "stop") and, in slightly different form, the "Hardwired Approach" fallback waterfall for syndicated loans.
- Compounded SOFR plus Benchmark Replacement Adjustment
- The FRN Language dictates that any SOFR compounding will be in arrears. In an acknowledgement that no consensus methodology specifics for calculating Compounded SOFR has yet developed, the FRN Language specifies that Compounded SOFR will be calculated in accordance with the conventions for "lookback" and/or "suspension" periods and other technical matters as recommended by the ARRC or another Relevant Governmental Body or, if Compounded SOFR cannot be determined on the basis of the foregoing, then in accordance with conventions selected by the issuer "giving due consideration to any industry-accepted market practice." The User's Guide explains some of the detailed options, mechanisms, and other conventions that could be employed for calculating Compounded SOFR.
- Compounded SOFR in arrears is also the rate ISDA plans to use as the primary fallback to LIBOR. The ARRC recommends removing the "Term SOFR" item from the waterfall when cohesion with hedging instruments is paramount.
- The FRN Language also includes a "simple" averaging formulation as an alternative to Compounded SOFR for market participants that are not readily capable of performing compound calculations.
- Rate Endorsed by Relevant Governmental Body plus Benchmark Replacement Adjustment
- Because SOFR already exists and it is already possible to average SOFR over various interest periods to derive compound or simple SOFR in arrears, the remaining fallbacks cater to the situation in which SOFR is no longer being published. Because the ARRC selected SOFR as the primary fallback rate for LIBOR, one can anticipate that the ARRC or a similar industry body would be convened to select SOFR's successor.
- The "ISDA Fallback Rate" plus Benchmark Replacement Adjustment
- This stop refers to the SOFR fallbacks under the yet-to-be-finalized revisions to the "2006 ISDA Definitions" (which are regularly "supplemented"). The proposed fallbacks currently contemplate the Overnight Bank Funding Rate, which is published by the Federal Reserve Bank of New York, and the "effective fed funds" rate or range midpoint targeted by the Federal Reserve's Open Market Committee.
- The FRN Language also contains a variant to allow parties to "skip over" the ISDA Fallback Rate.
- Issuer Determination plus Benchmark Replacement Adjustment
- The final stop on the FRN fallback waterfall is for the issuer (or a designee) to select an alternative reference rate "giving due consideration to any industry-accepted rate of interest as a replacement for the then-current Benchmark."
FRN Benchmark Replacement Adjustment
The Benchmark Replacement Adjustment, under both the FRN Language and the Hardwired Approach for syndicated loans, is necessary to equalize the (nearly) risk-free SOFR rate with LIBOR, which implicitly incorporates a bank credit risk spread. Thus far, ISDA is the farthest along among industry groups in developing a means for calculating this "spread adjustment" and intends to compare the forward curves for SOFR and LIBOR for each tenor on each day during an extended period (five or 10 years) and to use the mean or median spread between the two to fix the spread adjustment for each tenor permanently.
The Benchmark Replacement Adjustment waterfall under the FRN Language operates identically no matter which fallback is selected under the FRN fallback waterfall. The spread adjustment waterfall runs as follows: (i) the spread adjustment selected or recommended by the ARRC or another Relevant Governmental Body; (ii) the spread adjustment as determined under the 2006 ISDA Definitions; and (iii) the spread adjustment selected by the issuer (or a designee) "giving due consideration to any industry-accepted spread adjustment."
Syndicated Loan Trigger Events
The Syndicated Loan Language includes the same three Benchmark Transition Events as the FRN Language. Recognizing that time may be needed to amend an extensive number of credit agreements, in the case of preannounced LIBOR cessation the Amendment Approach suggests a window (up to 90 days) prior to the actual LIBOR transition date in which amendments can take place.
The Syndicated Loan Language also provides an "Early Opt-In Election" to implement replacement rate provisions based on market developments prior to the occurrence of a Benchmark Transition Event upon an agreement among the borrower, the agent and the Required Lenders. There are slight differences in this opt-in trigger between the Hardwired Approach and the Amendment Approach, with the Hardwired Approach applying a more objective trigger tied to a minimum amount of deals using Term SOFR being executed.
Benchmark Replacement Waterfall – Hardwired Approach
Like the FRN fallback waterfall, the fallback waterfall under the Hardwired Approach for syndicated loans is "future-proofed" and applies both to LIBOR cessation and to cessation of any replacement rate(s), including SOFR. However, the waterfall has only three (as opposed to the five under the FRN Language) stops, with an interim stop between Term SOFR and Compounded SOFR, and runs as follows:
- Term SOFR plus Benchmark Replacement Adjustment (discussed above)
- Next Available Term SOFR plus Benchmark Replacement Adjustment
With Next Available Term SOFR, if Term SOFR for the existing tenor does not exist, the agent has the ability to apply a shorter Term SOFR, if available, without having to proceed to Compounded SOFR. This interim stop (not found in the FRN Language) allows the agent to use the longest existing Term SOFR that is shorter than a given tenor (plus that tenor's corresponding Benchmark Replacement Adjustment). This is a change from the consultation, which had proposed interpolation, and was meant to address concern from the market that agents could face operational challenges with interpolation.
- Compounded SOFR plus Benchmark Replacement Adjustment
- As with FRNs, no market-standard methodology for calculating Compounded SOFR currently exists in the syndicated loan market, so the recommended language allows for then existing market convention to direct the determination of Compounded SOFR. This involves a two-step analysis that first looks to any recommendations or selections by the ARRC as to rate, methodology, and/or conventions and, if none then exist, then to those determined by the agent that are consistent with at least [five] publicly available syndicated loans. Reflecting a growing market preference, the language specifically contemplates compounding in arrears with a lookback or lockout period, but unlike the FRN Language, it does not rule out the use of in advance compounding. It also acknowledges that there may be a preference to reference a simple (instead of compounded) average of SOFRs and provides for alternative language that can be used in place of "Compounded SOFR."
- Borrower and Agent Selected Rate plus Benchmark Replacement Adjustment
- This last stop in the waterfall allows for the agent and the borrower to determine the replacement rate and any related spread adjustment based on then existing market convention. Once selected, the Required Lenders have a negative consent right. If the Required Lenders object to the selected rate and adjustments, the amendment process will continue until the Required Lenders no longer object. This last stop represents roughly where the Amendment Approach commences.
Benchmark Replacement Adjustment – Hardwired Approach
The Benchmark Replacement Adjustment under the Hardwired Approach (unlike the FRN Language) is dependent on the then-applicable Benchmark Replacement. This operates as follows:
- If the Benchmark Replacement is Term SOFR, Next Available Term SOFR, or Compounded SOFR, the spread adjustment selected by the ARRC or another Relevant Governmental Body, or (if not available) the spread adjustment as determined under the 2006 ISDA Definitions, applies.
- If the Benchmark Replacement is a Borrower and Agent Selected Rate, then a spread adjustment selected by the agent and the borrower "giving due consideration" to (i) any adjustment selected by the ARRC or other Relevant Governmental Body or (ii) any "evolving or then-prevailing market convention for determining a spread adjustment" for syndicated loans applies.
Amendment Approach for Syndicated Loans
Under the Amendment Approach, the borrower and agent select the Benchmark Replacement and the Benchmark Replacement Adjustment after giving due consideration to (i) any rate and adjustment selected by the ARRC or another Relevant Governmental Body or (ii) any "evolving or then-prevailing market convention" for syndicated loans. The rates elected by the borrower and agent become effective upon negative consent of the Required Lenders upon a Benchmark Transition Event and upon affirmative consent of the Required Lenders upon an Early Opt-In Election.
The Amendment Approach generally follows the "LIBOR replacement" language that is currently being used in the syndicated loan market but with a few material differences. The fallback language includes more specific trigger events as noted above and, although not prescribed, makes express reference to Term SOFR plus credit spread adjustment as the probable replacement rate. Consistent with current market language but unlike the FRN and Hardwired Approach language, it does not address any future reference rates that might exist and applies solely to the replacement of LIBOR and not SOFR or other replacement rates (i.e., it is not "future-proofed").
Four Key Takeaways
- The FRN Language and the Syndicated Loan Language are, at a high level, broadly aligned but with significant differences in detail, most notably in the existence of the Amendment Approach under the Syndicated Loan Language.
- The timing and substance of the ARRC's recommendations reflect a balance between providing the market specific language it can start using immediately and accommodating the future development of highly technical details such as the conventions for calculating Compounded SOFR.
- While Term SOFR remains the "first choice" under both waterfalls, the ARRC has recently begun to admonish market participants not to await the approval of a Term SOFR but to start utilizing Compounded SOFR or other daily SOFR accrual as the primary benchmark rate in amendments and new financings immediately. Compounded SOFR (in arrears), moreover, still has the maximum potential to cohere with developing conventions for derivatives and enable "perfect" hedging.
- Notably, the ARRC's recommended language includes cessation and pre-cessation triggers that are consistent with ISDA's still-in-process consultations to mitigate potential "trigger basis risk.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.