Winter is coming, literally. Before winter arrives in most cities across the U.S., though, we'll see the end of the third fiscal quarter of 2020. The September 30, 2020, date is notable for a few reasons for those in the banking and finance industry, and now there's one additional reason to mark the date on the calendar. The Alternative Reference Rates Committee (ARRC) of the Federal Reserve Bank has updated its recommended best practices in connection with the market transition away from LIBOR to provide that all new syndicated commercial loan agreements should incorporate hardwired fallback rates to replace LIBOR by September 30, 2020. (Similarly, the ARRC has adjusted its recommended best practice for new bilateral business loans, to state that those loans should incorporate hardwired fallback rate language by October 31, 2020.) Whether and to what extent market participants will heed the call remains to be seen. For more information, see our recent commentary on the hardwired approach.
This Alert highlights the latest developments in the market transition away from LIBOR, discusses the market response to the ARRC's recommended best practices so far, and details a few reasons that nonbank lenders and asset managers in particular should be focused on the transition and implementing the ARRC recommendations in the near term.
LIBOR Transition – Market Update
Over the last month or so, there has been quite a lot of activity on the LIBOR transition front. Highlights include:
- The ARRC released a request for proposals to be received by October 16, 2020, seeking one or more firms to administer recommended spread adjustments and spread-adjusted Secured Overnight Financing Rates (SOFR) to facilitate contractual fallbacks in loan agreements;
- The ARRC released a request for proposals to be received by October 31, 2020, seeking a potential administrator to calculate and publish forward-looking SOFR term rates as one component of the ARRC's 2020 objectives and the final step in the ARRC's Paced Transition Plan;
- Along with its updated best practices and deadlines, the ARRC released updated recommended contractual fallback language that parties can incorporate into their bilateral loan agreements; and
- The ARRC has released the SOFR Starter Kit, a set of factsheets to inform the public about the transition away from LIBOR to SOFR, the ARRC's recommended alternative reference rate. It includes background on the impetus for the transition and the ARRC's work to select a preferred rate, facts and figures about SOFR and next steps that market participants can take to implement the transition.
The Response to the ARRC Recommendations Thus Far
Overall, the U.S. commercial loan market has adopted a cautious approach to the LIBOR transition. Although many lenders and asset management firms have been adopting some variation of amendment approach language, credit research firm Covenant Review, in an analysis of nearly 300 new and amended commercial loans arranged in the first half of this year, found that zero included the ARRC-recommended hardwired language. However, this trend may change soon. Regulators have recently been stepping up regulatory pressure to push nonbank lenders and asset managers to move forward with preparations for, and faster and more definitive action with respect to, the market transition away from LIBOR. Some of these regulators have highlighted legal and consumer compliance risks associated with inadequate LIBOR fallback language and identified areas of focus for reviews and examinations of LIBOR transition planning and risk mitigation efforts at regulated institutions. The Office of Compliance Inspections and Examinations of the U.S. Securities and Exchange Commission is conducting examinations of entities including asset managers, investment advisors, investment companies and broker-dealers to assess their preparations for the transition away from the LIBOR benchmark to an alternative in loan agreements. Additionally, the Federal Financial Institutions Examination Council, which includes a member of the Fed, the Comptroller of the Currency and Chairman of the Federal Deposit Insurance Corporation, recently encouraged supervised institutions to better prepare for the LIBOR transition and take action against regulated entities who have not yet implemented adequate fallback language in their commercial loan agreements. Given regulators' newly heightened focus on this area, lenders and asset managers are likely to be interacting with regulators even more frequently in the near term than they usually do.
Special Considerations for Nonbank Lenders and Asset Managers
Nearly every financial institution and credit market participant has exposure to LIBOR-denominated contracts and will be affected by the LIBOR transition. That said, the market transition away from LIBOR has particularly weighty implications for lenders and asset managers. In the case of nonbank lenders and many asset managers, they are facing the LIBOR transition at multiple levels. Nonbank lenders and asset managers, including private credit asset management firms, may be party to hundreds or thousands of contracts with borrower counterparties utilizing the LIBOR benchmark that will need to be identified, analyzed and amended to incorporate a replacement benchmark rate prior to the end of 2021. Additionally, these lenders and asset managers (and their private investment funds and affiliates) are often counterparties on numerous contracts for underlying investments (e.g., CLOs, securitizations and derivatives). This structure duplicates the complexity and time involved to address the LIBOR transition. In light of this additional complexity and time involved, it's more important and urgent than ever for lenders and asset managers to consult with knowledgeable counsel on their LIBOR transition approach, interactions with regulators and next steps.
The sands of the hourglass are draining on the LIBOR transition. There are fewer than 500 days until LIBOR's scheduled phaseout. Whether and to what extent credit market participants will heed the most recent ARRC call to action and the impending deadlines remains to be seen. Given the large number of contracts that need to be identified, analyzed and amended before LIBOR is phased out, lenders and asset managers who have not already done so would be well-served to consult with experienced counsel in the near term to start the process and discuss best practices to prepare for and respond to regulators' inquiries and examinations about such parties' preparations for the LIBOR transition.
About Duane Morris
As the end of LIBOR draws closer, Duane Morris' LIBOR Transition Team will continue to monitor developments and issue additional Alerts.
For More Information
If you have any questions about this Alert, please contact Anastasia Kaup, Roger S. Chari, any of the attorneys in our Banking and Finance Group or the attorney in the firm with whom you are regularly in contact.
Disclaimer: This Alert has been prepared and published for informational purposes only and is not offered, nor should be construed, as legal advice. For more information, please see the firm's full disclaimer.