Douglas I. Youngman is a Partner in Holland & Knight's New York office.
Barbara M. Yadley is Associate in Holland & Knight's Tampa office
- The Alternative Reference Rates Committee (ARRC) recently released proposed fallback language for Libor-based floating rate note (FRN) transactions in anticipation of the cessation of Libor in 2021.
- The board of governors of the Federal Reserve System and the Federal Reserve Bank of New York (the Board) has selected the Secured Overnight Financing Rate (SOFR) as a suitable replacement for US Dollar Libor, and began publishing SOFR overnight rates a year ago.
- This Holland & Knight alert summarizes the ARRC's proposal, which is simply suggested contract language and is completely voluntary.
In 2014, as a result of a rate-setting scandal, the board of governors of the Federal Reserve System and the Federal Reserve Bank of New York (the Board) embarked on a program to secure an alternate reference rate for Libor. It ultimately selected the Secured Overnight Financing Rate (SOFR) as a suitable replacement for Libor, and began publishing SOFR overnight rates a year ago. The Board then commissioned the Alternative Reference Rates Committee (ARRC) to develop fallback language for existing and future floating rate note (FRNs) transactions, among other financial structures, that are initially tied to Libor, in anticipation of the end of Libor in 2021. The ARRC noted that many historical transactions do not contain fallback language that contemplates the cessation of Libor as a reliable rate index, and that new FRN transactions also lack a balanced fallback methodology. The goal was to develop contract language that could be adopted today (either in new transactions or by amendment to existing transactions) to avoid the risk of serious market disruption following a Libor cessation.
On April 25, 2019, ARRC released proposed fallback language that could be incorporated into new FRN transactions initially structured as Libor-based FRNs, and for similar existing products by way of amendment before the cessation of Libor occurs. It should be noted that the International Swaps and Derivatives Association (ISDA) is independently developing modifications to its 2006 Definitions of Libor (e.g., USD-LIBOR-BBA), which currently have short-term fallback provisions that are not suitable for the actual demise of the Libor index. ISDA has not yet released its proposed language (which will be rolled out as an amendment to its 2006 Definitions), but it is hoped that the two fallback structures will be similar. However, some basis risk between the two fallback structures is anticipated.
This Holland & Knight alert summarizes ARRC's proposed fallback language for FRNs. This is, in its truest sense, a summary, and reference to the full ARRC report should be made for the definitive terms. The ARRC proposal is simply suggested contract language and is completely voluntary. Market participants are encouraged to make their own independent evaluation and decisions about whether, and to what extent, any of the suggested language is adopted.1
ARRC's proposal is broken down into four distinct segments, namely 1) the trigger events causing the interest rate under the FRNs to switch from Libor to the fallback benchmark, 2) the benchmark rate that will then replace Libor, 3) the applicable adjustments, if any, that will have to be made in the selected fallback benchmark, and finally 4) certain benchmark replacement conforming changes. Each will be discussed briefly below.
As an advance warning, those looking for definitive methodologies for calculating the fallback rate and rate adjustments will be disappointed. ARRC rather chose to use a general reference to selections or recommendations subsequently made by it, or by ISDA or others, or as a final fallback, discretionary decisions made by the issuer based on industry accepted market standards that exist at the time of the fallback trigger. None of these currently exist, and ARRC's or ISDA's determinations could change over time, so this is still work in progress. The proposed language, however, is far better than what is generally in the market today.
Benchmark Transition Events
The trigger event options are divided between the permanent cessation of Libor and precessation triggers before permanent cessation has occurred (collectively referred to in ARRC's proposed language as the Benchmark Transition Event). Parties to a transaction are free to choose between these options, or to make modifications in each category, but should be mindful that their trigger choices could create basis risk if they do not match the trigger event under any underlying hedge transaction.
Cessation. This Benchmark Transition Event will be
deemed to occur if either of the following events occur:
- a) a public statement or publication by the benchmark administrator (ICE Benchmark Administrator currently) that it will permanently or indefinitely cease to provide the benchmark2; or
- b) a public statement or publication by the regulatory supervisor for the administrator (the Financial Conduct Authority or FCA), or the applicable central bank (U.S. Federal Reserve System), or a court with insolvency or resolution authority over the administrator, states that the administrator of the benchmark has ceased or will cease to provide the benchmark permanently or indefinitely3
Trigger. The final Benchmark Transition Event is tied
to FCA's determination that Libor is "no longer
representative." Specifically, the precessation trigger event
will be deemed to occur upon the following event:
- c) a public statement or publication from the regulatory supervisor of the administrator (currently, FCA) announcing that the benchmark is no longer representative
This third trigger is intended to capture a situation where Libor has deteriorated such that it would likely have a significant negative impact on its liquidity or usefulness to market participants or is "no longer representative of the underlying market or economic reality."
The trigger events under clauses a) and b) are consistent with ISDA's latest position papers (which have not yet been finalized). Clause c) has not yet been endorsed by ISDA, which raises the basis risk noted above.
The conversion to the benchmark replacement defined in the next section (the Benchmark Replacement) does not necessarily occur on the date any of the Benchmark Transition Events occur. Rather, the Benchmark Replacement Date occurs:
- in the case of clauses a) or b) above, on the later of i) the date of the public statement or publication of information referred to therein and ii) the date on which the administrator of the benchmark permanently or indefinitely ceases to provide the benchmark; or
- in the case of clause c), the date of the public statement or publication of information referred to therein
If a Benchmark Transition Event (described above) occurs, under the ARRC recommendations a new "Benchmark Replacement" will be substituted for Libor on the Benchmark Replacement Date. If the Benchmark Transition Event does not impact all tenors (e.g., one-month Libor, three-month LIBOR, etc.) of Libor and an interpolated Libor rate can be calculated for an impacted tenor based on unaffected Libor tenors, such interpolated rate will be the Benchmark Replacement for the applicable impacted tenor. If such interpolation is not possible, the ARRC recommendations include a waterfall of methodologies for determining the Benchmark Replacement. Under the waterfall, each Benchmark Replacement has two components, namely the Unadjusted Benchmark Replacement and the Benchmark Replacement Adjustment, both of which are briefly described below.
- Term SOFR + Adjustment. The first Unadjusted Benchmark Replacement in the waterfall is Term SOFR. "Term SOFR" means the forward-looking SOFR with a tenor having approximately the same tenor as the Libor rate it is replacing (e.g., one-month SOFR for one-month Libor, three-month SOFR for three-month Libor, etc.) as selected or recommended by the relevant governmental body (here, presumably ARRC). Note here that this rate is intended to be a "forward-looking" rate for a designated tenor and thus, like Libor, is to be set at the beginning of the reset period. Forward-looking SOFR term rates do not currently exist since SOFR is only an overnight rate. However, ARRC's transition plan calls for publication of forward-looking SOFR term rates by the end of 2021. Until those forward-looking SOFR rates are developed in various tenors and endorsed by ARRC, ARRC is recommending a replacement waterfall consisting of four sequential alternatives, as described below.
Compounded SOFR + Adjustment. If a
published forward-looking SOFR for an applicable tenor is not
available at the time of the Benchmark Replacement Date (triggered
by the Benchmark Transition Event described above), the next
fallback is a compounded average of SOFR (Compounded SOFR) plus an
adjustment. The adjustments will be addressed in the next section.
Since the specific compounding methodology has not yet been
identified, the definition is broadly written to reflect
methodologies developed by ARRC or, if ARRC has not published a
methodology, such other methodology subsequently developed by the
issuer using "industry-accepted market practice for U.S.
Dollar denominated floating rate notes at such time." In
either case, this methodology is intended to be backward looking,
meaning that the rate is an average daily compounding rate for each
day within each interest rate period. Thus, unlike LIBOR, the
actual rate will not be known in advance, but accrued interest
could be calculated within any interest rate period at the end of
b) Simple Average SOFR + Adjustment. There currently is no standard methodology for referencing a compounded rate in FRNs, so market participants may prefer to use a simple average of SOFR for this step in the waterfall. The definition of "Simple Average SOFR" is still dependent on conventions subsequently selected or recommended by ARRC, or if that is not available, other conventions selected by the issuer using "industry-accepted market practice for U.S. Dollar denominated floating rate notes at such time." This option can be selected by market participants in lieu of the Compounded SOFR fallback described in clause a) above, so it is technically an alternative to Compounded SOFR and not a separate component of the waterfall.
- Relevant Governmental Body Selected Rate + Adjustment. If, at the time of the Benchmark Transition Event, SOFR has been discontinued and thus the fallback benchmarks in clauses 1) and 2) can't be determined, the next fallback rate is the rate ARRC (or its successor) has selected or recommended, plus the Adjustment. The language here is purposely vague.
- ISDA Fallback Rate + Adjustment. If, at the time of the Benchmark Transition Event, none of the earlier fallback options exist (meaning that SOFR has been discontinued), the next fallback is the "ISDA Fallback Rate," which is defined to mean the rate that would apply for derivatives transactions referencing the ISDA definitions to be effective upon the occurrence of an index cessation date with respect to SOFR. Presumably, that fallback rate will, at least in part, reference the ISDA Definition of "USD-SOFR-Compound" released last year.4 This definition contains its own waterfall of available rate options if SOFR ceases to exist, along with methodology for calculations. Of course, this reference would encompass any amendments ISDA makes in this definition, unless the market participants elect to freeze the definition as of the date of the Benchmark Transition Event. It is unclear how this would work if the market participants have otherwise elected the Simple Average SOFR in lieu of the Compounded SOFR.
- Issuer Selected Rate + Adjustment. If, at the time of the Benchmark Transition Event, none of the previous fallback methodologies work, the final bucket in the waterfall is the alternate rate selected by the issuer as the replacement for the then-current benchmark for the applicable corresponding tenor that gives due consideration to any industry-accepted rate of interest as a replacement for the then-current benchmark for U.S. dollar-denominated floating rate notes at such time. The ARRC recommendations permit market participants who believe the ISDA Fallback Rate is not an industry-accepted rate to skip clause 4) of the waterfall and go directly to the final fallback methodology referred to in this clause 5).
Benchmark Replacement Adjustments
There are at least two fundamental differences between Libor rates and SOFR. First, Libor is quoted in various tenors, while SOFR currently is solely an overnight rate. Also, Libor is based on unsecured transactions that include the price of bank credit risk. SOFR, on the other hand, is a risk-free rate that does not include a bank credit risk component. Thus, ARRC's fallback language contemplates a rate adjustment to account for these differences. At least until SOFR is quoted for different tenors, the adjustment will be different for the applicable tenor of the Libor rate SOFR is to replace.
As of the date of ARRC's release, the methodologies for rate adjustments have not been developed, although it is clearly a goal of ARRC to develop them. Thus, ARRC has proposed a fallback waterfall similar to the structure used in the Benchmark Replacement discussed above. There are three components to this waterfall:
- ARRC Selected Adjustment. This adjustment is defined to mean the spread adjustment or methodology (which could be positive or negative) that has been selected or recommended by ARRC for the applicable Unadjusted Benchmark Replacement. Presumably different spread adjustments or methodologies will be developed for different tenors of the Libor rate it replaces.
- ISDA Fallback Adjustment. If ARRC adjustments are not available at the time of a Benchmark Transition Event, the next stop in the waterfall is the ISDA adjustments applicable to fallbacks for derivatives that ISDA implements in its definitions. This will only be used if the Unadjusted Benchmark Replacement (in this case SOFR) is equivalent to the ISDA Fallback Rate described above. As discussed above under Benchmark Replacements, USD-SOFR-Compound starts out using SOFR as the applicable rate, but shifts into other rate methodologies if SOFR is not available. So this option is only applicable if SOFR is available, and becomes inapplicable if other rates in the USD-SOFR-Compound definition have kicked in.
- Issuer Selected Adjustment. If ARRC has not published its adjustment methodology by the time a Benchmark Transition Event has occurred, and USD-SOFR-Compound is no longer applicable, the last bucket in the waterfall is the adjustment methodology selected by the issuer of the FRN, giving due consideration to any market-accepted conventions for such spread adjustment for U.S. dollar-denominated floating rate notes at the time.
Benchmark Replacement Conforming Changes
In addition to the Benchmark Replacement Adjustments, the issuer is entitled to make technical, administrative or operational changes in the underlying documents that the issuer decides may be appropriate to reflect the adoption of a Benchmark Replacement, provided that it does so in a manner substantially consistent with market practice. These changes might include changes in the definition of Interest Period, the timing and frequency of determining rates and making interest payments, addressing terms unique to Libor-based loans such as illegality, increased costs and breakage fees, and other administrative matters.
1 As a drafting note, "issuer" used herein refers to the issuer of the FRNs. ARRC's language refers to the "issuer or its designee," so market participants would be free to designate someone other than the issuer (e.g., an administrative agent or other third party) to make the discretionary decisions referred to below.
2 Benchmark is defined in the release initially as Libor, and after the occurrence of a Benchmark Transition Event, the Benchmark Replacement referred to below.
3 In both clauses a) and b), the Benchmark Transition Event will not occur if a successor administrator has been selected to continue providing the benchmark.
4 Note that ISDA's current definition of USD-SOFR-Compound uses the historical "compound" method rather than a forward-looking term rate, as proposed by ARRC to be the first fallback. ISDA's Libor fallback definition has not been developed but is expected to use the same "compound" methodology rather than a forward-looking rate, so market participants who intend to hedge the floating rate risk under FRNs will need to consider the basis risk of selecting Term SOFR or Simple Average SOFR rather than Compounded SOFR.
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.