Key takeaways
- Unlike the 2019 version of the ARRC fallback provisions for syndicated loans, the 2020 version does not include an “amendment approach” fallback option, but instead only a hardwired fallback.
- The ARRC is recommending as a best practice that all new originations of USD LIBOR syndicated loans include hardwired fallback provisions no later than September 30, 2020.
- The second step of the benchmark replacement waterfall is now set at daily simple SOFR, rather than compounded SOFR in arrears.
- Market participants should be aware that
- an IOSCO-compliant forward term rate based on SOFR appears unlikely to exist prior to the end of 2021; and
- any LIBOR replacement for syndicated loans will most probably be a backward-looking rate based on overnight SOFR.
In depth
On June 30, 2020, the Alternative Reference Rates Committee (ARRC) published updated recommendations regarding more robust fallback language for new originations of US Dollar-denominated LIBOR syndicated loans.[1] These recommendations replace fallback language for syndicated loans recommended by the ARRC in April 2019.
Unlike the 2019 version of the ARRC fallback language for syndicated loans, the 2020 version does not include an “amendment approach” fallback option, but includes only a hardwired fallback.
The new fallback provisions are consistent with the ARRC’s recommended best practices for LIBOR transition published in May 2020.[2] Among other things, the ARRC is recommending as a best practice that all new originations of USD LIBOR business loans should include ARRC-recommended (or substantially similar) hardwired fallback language as soon as possible, but in no event later than September 30, 2020. This recommendation is in part intended to mitigate systemic risk by reducing the number of contracts that might need to be amended upon LIBOR’s cessation or being declared unrepresentative of financial reality. At the transaction level, borrowers and lenders should take seriously the risk that a large volume of LIBOR contracts without hardwired fallbacks in the system may make it quite difficult to amend such parties’ own LIBOR contracts in the period immediately preceding a fallback trigger event in the absence of a hardwired fallback. The new fallback language contains one significant change from the 2019 hardwired fallback. The second step of the benchmark replacement waterfall is now set at daily simple SOFR, rather than compounded SOFR in arrears. The first step of the waterfall is Term SOFR (defined as the forward-looking term rate based on SOFR “that is selected or recommended by the Relevant Governmental Body”). Because Term SOFR does not yet exist, step two (daily simple SOFR) is currently the most likely landing spot in the waterfall.
The ISDA fallbacks for USD LIBOR will use compounded SOFR in arrears. The ARRC states that parties may reasonably choose to use compounded SOFR in arrears rather than daily simple SOFR at this step, to align with hedges or for other reasons. However, lenders may resist borrowers wanting to use compounded SOFR, given that many financial institutions prefer daily simple SOFR, for the reasons noted below.
To justify the change to daily simple SOFR in the waterfall, the ARRC stated that there was little difference between daily simple SOFR and compounded SOFR in arrears, making it possible to hedge daily simple SOFR with compounded SOFR in arrears.[3]
The choice of daily simple SOFR reflects the preference of the ARRC’s Business Loans Working Group. The ARRC stated that daily simple SOFR had already been incorporated into the operational systems of many financial institutions and reduced operational risk for lenders when compared to compounded SOFR in arrears. The ARRC further explained that, since calculating compounded interest in arrears is difficult when the principal amount of a loan does not remain constant over a given period, daily simple SOFR posed fewer challenges for financial institutions in dealing with syndicated loans, where intra-period payments are routinely made. In addition, the ARRC pointed to differences between loans and ISDA swaps, which will use compounded SOFR as a fallback. The ARRC explained that, because loans have fluctuating principal amounts, compounded SOFR in arrears as used in loan products would likely have different conventions than those used by ISDA, which would create differences between the two products even if both used compounded SOFR in arrears.
The updated recommendations also revise the mechanics of an Early Opt-in Election in that Required Lenders are given a negative consent right, rather than an affirmative consent right.
The updated fallback refines the ability of the administrative agent to deal with circumstances where one or more tenors of a benchmark, but not all of them, may be unavailable or declared unrepresentative. The administrative agent will be able to remove the affected tenors as interest periods (with the possibility of later reinstating them, if the circumstances leading to removal no longer exist thereafter).[4]
At this point, it is uncertain whether the market will move decisively towards hardwired fallbacks over the next three months. Changing over to hardwired fallbacks for all new USD LIBOR syndicated loan originations by the end of September is an ambitious goal, particularly since, as the ARRC notes, to date “syndicated loan facilities incorporating the ‘hardwired approach’ generally have not been seen.” Most syndicated loans have used an amendment approach fallback.
Among other reasons for the lack of hardwired fallbacks in syndicated loans to date, borrowers and lenders may have been uncomfortable with hardwired fallbacks, instead wanting the ability to consent to changes in the interest rate upon a trigger event. However, in addition to the risk of potential difficulty in effecting an amendment following a trigger event for the systemic reasons described above, market participants should recognize that the amendment approach has significant practical limitations. Credit agreements often provide that, following a trigger event, LIBOR will become unavailable as a pricing option, and that outstanding LIBOR loans will convert to base rate or cost of funds pricing until an amendment is agreed to, which may render the borrower’s consent rights to an amendment cold comfort. Further, a variant of the ARRC’s recommended amendment approach provisions commonly seen in the market purports to preclude lenders from objecting to a LIBOR replacement amendment (other than to the spread adjustment) if the replacement rate for LIBOR is a SOFR-Based Rate (often defined to include SOFR, a forward term SOFR recommended by a Relevant Governmental Body or compounded SOFR). However, an administrative agent or a borrower may face practical difficulty in policing such a restriction. Market participants should assess the value of any consent rights afforded by the amendment approach in light of these limitations.
Market participants may also have avoided locking in a different fallback rate, hoping that an IOSCO-compliant forward term rate for SOFR would emerge prior to the occurrence of a LIBOR trigger event. As noted above, such a forward term rate would fill in the first step of the waterfall in the ARRC hardwired fallback. Although the ARRC’s Paced Transition Plan from 2017 had set a goal that a forward term SOFR rate would be developed by the second half of 2021, the lack of sufficient liquidity in SOFR markets makes it very unlikely that this goal will be achieved by the end of 2021 (and even less likely that this will happen by September 30, 2020). Although an IOSCO-compliant forward term rate for SOFR may exist at some point in the future after LIBOR’s expected cessation at the end of 2021,[5] until such time market participants should steel themselves that any LIBOR replacement for syndicated loans will very likely be a backward-looking rate based on overnight SOFR.
Syndicated loan originations with pricing based on SOFR have been quite rare to date. Nonetheless, market participants should consider whether new originations should be priced based on SOFR in arrears, since a new USD LIBOR loan that contains a hardwired fallback will by definition only bear interest at LIBOR temporarily and will very probably convert to SOFR in arrears no later than the end of 2021. Regulators and working groups have urged market participants to actively transition from LIBOR to risk-free rates, and not to rely on fallbacks as their principal means of transition. However, market conventions for the pricing mechanics of SOFR in arrears have not yet been settled (such conventions would likely be handled in the ARRC fallback language by means of Benchmark Conforming Changes). Borrowers and lenders may be able to move past the more familiar LIBOR and reliance on fallbacks when there is market acceptance of these conventions.
[1] ARRC, Recommendations Regarding More Robust Fallback Language for New Originations of LIBOR Syndicated Loans.
[2] ARRC Recommended Best Practices for Completing the Transition from LIBOR.
[3]The differences between compounded and daily simple SOFR are explained in A User’s Guide to SOFR, published by the ARRC in April 2019.
[4] The Financial Conduct Authority’s (FCA) statement on LIBOR contractual triggers (11 November 2019) contemplates that the FCA may announce a contractual triggers that only affects certain tenors of LIBOR (or some, but not all, LIBOR currencies).
[5] The ARRC has said that it intends to endorse a forward term rate for SOFR, if a consensus can be reached among its members that a robust, IOSCO-compliant term benchmark that meets appropriate criteria set by the ARRC can be produced. However, it has cautioned that the production and timing of such a rate cannot be guaranteed..
