If your business carries debt, the interest rate on that debt is likely to be linked to the London Interbank Offered Rate (LIBOR). LIBOR has been the standard benchmark rate for a variety of financial products since the early 1980s.
Following the LIBOR-manipulation scandals that came to light in 2012, regulators announced that what is often referred to as the "world's most important number," underpinning an estimated $350 trillion in contracts globally,1 will likely be phased out by 2021.
This article discusses syndicated loan market recommendations for implementing a replacement benchmark interest rate from the Alternative Reference Rates Committee (ARRC), a group of private-market participants convened to help ensure a successful transition away from LIBOR, and provides practical tips for borrowers to prepare their business for the transition.
SOFR to the Rescue
The ARRC has identified the Secured Overnight Financing Rate (SOFR) as the preferred alternative benchmark rate for U.S. dollar LIBOR transactions. SOFR is a broad measure of the cost of borrowing cash overnight collateralized by U.S. Treasury securities in the repurchase market, and represents what is considered to be the nearly risk-free rate of borrowing. The SOFR rate is published each day at 8 a.m. ET by the Federal Reserve Bank of New York.
While the underlying market feeding into the LIBOR rate is small, mostly hidden from public view and handled exclusively by major global banks, a large range of observable transactions underlie the SOFR. Daily SOFR volumes reliably remain between $700 billion and $800 billion, and regularly exceed $1 trillion, making it a transparent rate that is representative of the current market across a broad range of participants, including money market funds, asset managers, corporates, insurance companies, securities lenders and pension funds. It is therefore far more protected from attempts at manipulation than LIBOR and is not at risk of ceasing to exist in the future.
However, many difficulties remain on the road to SOFR implementation. In most existing and newly inked contracts, the fallback rate after LIBOR ceases to exist is the prime rate (also referred to as the base rate or reference rate), which is the interest rate charged by banks to their most creditworthy customers and is nearly always more expensive for borrowers than LIBOR. To worsen matters, in transactions with more than one debt holder, changes to the interest rate generally require the consent of every debt holder, making alterations to the fallback rate difficult. Finally, since SOFR is a secured rate for loans outstanding for only a day, it tends to be lower than LIBOR rates. As a result, loans that do find a way to make the switch to SOFR will require an interest rate spread adjustment to keep overall loan costs comparable to those using LIBOR.
The Market's Response
The ARRC has developed two approaches to dealing with the LIBOR transition to SOFR in syndicated loans.2 The first is the "amendment approach," in which a streamlined process for a future amendment to replace LIBOR is agreed to in advance. The second is the "hardwired approach," which is consistent with the approach being used in other cash asset classes, and simply states that SOFR plus a spread adjustment will replace LIBOR at an agreed upon time. The amendment approach is being utilized almost universally now, but the hardwired approach is very likely to gain traction as banks push to avoid the impending disaster of having to amend thousands of loan documents simultaneously, and as the methodologies around how SOFR will be adjusted and computed are solidified in the marketplace.
The triggering event in both approaches is typically either an announcement from the benchmark administrator or the administrator's regulator that it has or will cease to provide the benchmark permanently, or a public statement from the administrator's regulator saying that the benchmark is no longer representative. Once one of these triggering events occurs, the relevant fallback language springs into action.
In the amendment approach, the borrower and the administrative agent select a successor rate and a spread adjustment, giving due consideration to relevant market conventions and the guidance of relevant governmental bodies. This selection can be overridden if a majority of lenders step forward and object. If they do not affirmatively object to the proposal within five days, the suggested successor rate and spread is implemented automatically. In a small minority of loans, no lender consent is required for the amendment, or a majority of lenders must affirmatively approve the amendment.
The hardwired approach first looks to replace LIBOR with a forward-looking term SOFR (a rate based on SOFR that is being developed but does not yet exist), and next looks to a compounded daily average SOFR, in each case plus a spread adjustment. If neither rate is available, then the hardwired approach falls back to the amendment approach. The spread adjustment is determined by looking first to a spread adjustment selected or recommended by a relevant government body. If this is unavailable, the spread adjustment used by the International Swaps and Derivatives Association (ISDA) will be applied, which is a measure of historic median/mean of SOFR versus LIBOR.
More Urgency Required
LIBOR transition has been a hot topic for regulators this summer. The U.S. Securities and Exchange Commission's Division of Corporate Finance, Division of Investment Management, Division of Trading and Markets, and Office of the Chief Accountant (the Divisions) issued a public statement on LIBOR Transition on July 12, 2019, which stated that the "risks associated with this discontinuation and transition will be exacerbated if the work necessary to effect an orderly transition to an alternative reference rate is not completed in a timely manner,"3 and warned that "the Commission staff is actively monitoring the extent to which market participants are identifying and addressing these risks." At a LIBOR gathering hosted by the Securities Industry and Financial Markets Association on July 15, 2019, Federal Reserve Bank of New York President Williams requested more urgency from market participants in replacing LIBOR.
Six Steps to Prepare Your Business
Savvy business leaders will take the initiative and get out in front of the issue now to mitigate potential risks. Consider taking the following six steps to prepare your business for the end of LIBOR.
1. Assign responsibility. Start by forming a committee with senior management oversight to take accountability for addressing the issue.
2. Take inventory. Review current contracts to identify (a) where there is exposure to LIBOR, (b) what the fallback provision is (if any) for the scenario where LIBOR becomes unavailable and (c) how amendments to the benchmark interest rate are handled. Do not limit the inquiry to third-party debt instruments. Intercompany loans, long-term leases and procurement contracts, among others, may have a LIBOR component. It is also useful to flag agreements with exposure to LIBOR that do not extend beyond 2021 in case these agreements are extended in the future.
3. Identify and mitigate any other potential consequences. Evaluate the use of LIBOR in your individual circumstances and identify other potential consequences of LIBOR transition on your products, operations, information systems or otherwise. If you are a public company, you should also consider your disclosure obligations and whether any changes should be made to risk management policies, including establishing a task force if there will be significant impact.4
4. Educate internal stakeholders. Educate all key stakeholders within the business (treasury, tax, legal, procurement teams, etc.) to ensure all relevant business implications are dealt with appropriately and in a timely manner. Make sure all team members with signatory authority for new agreements are considering this issue with all new contracts and including effective fallback language.
5. Stay current on market and regulatory developments. Keep your eye out for articles in the press, and sign up for a "Secured Overnight Funding Rate" Google alert to monitor the web for interesting new content. In addition, consider keeping tabs on the industry groups that are tackling the details of the transition and the milestones to be met along the way:
a. Sign up for email alerts from the ARRC, the key group of decision makers guiding the transition from LIBOR to SOFR for floating rate notes, syndicated business loans, bilateral business loans and securitizations.
b. Find current guidance from ISDA on fallback language for swaps and derivative contracts.
c. Get more detailed LIBOR transition news, market trends and resources as they relate to syndicated business loans from The Loan Syndications and Trading Association.
d. Subscribe to the Structured Finance Association newsletter to stay up to date on SOFR guidance in the securitization industry.
e. Keep informed of any relevant FASB Accounting Standards Updates for any changes relating to your financial reporting.
6. Engage counterparties. Reach out to your legal counsel or directly to counterparties to discuss the issue and begin the amendment process, if necessary.
1. Report, ICE Benchmark Administration, March 2016.
3. The Divisions cited Randal K. Quarles, vice chair for supervision, Federal Reserve Board, and chair of the Financial Stability Board (June 3, 2019): "With only two and a half years of further guaranteed stability for LIBOR, the transition should begin happening in earnest. I believe that the [Alternative Reference Rates Committee] has chosen the most viable path forward and that most will benefit from following it, but regardless of how you choose to transition, beginning that transition now would be consistent with prudent risk management and the duty that you owe to your shareholders and clients."
4. See the Divisions public statement on LIBOR Transition on July 12, 2019.
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.