- The Board of Governors of the Federal Reserve System and the Federal Reserve Bank of New York convened the Alternative Reference Rates Committee (ARRC) in 2014 to develop an alternative rate and conversion methodology for the U.S. dollar (USD) London Interbank Offered Rate (Libor).
- After receiving market input on numerous occasions, it released its initial recommended Libor fallback language for bilateral business loans on May 30, 2019 (the Initial Release), and recently issued a significant rewrite of the Initial Release on Aug. 27, 2020 (the 2020 Release).
- This Holland & Knight alert is a brief overview of the more significant provisions of the hardwired approach set forth in the 2020 Release as it pertains to the initial conversion from USD Libor to Secured Overnight Financing Rate (SOFR).
- As was the case in the Initial Release, the fallback language in the 2020 Release is recommended but completely voluntary.
The Board of Governors of the Federal Reserve System and the Federal Reserve Bank of New York convened the Alternative Reference Rates Committee (ARRC) in 2014 to develop an alternative rate and conversion methodology for the U.S. dollar (USD) London Interbank Offered Rate (Libor). After receiving market input on numerous occasions, it released its initial recommended Libor fallback language for bilateral business loans on May 30, 2019 (the Initial Release), and recently issued a significant rewrite of the Initial Release on Aug. 27, 2020 (the 2020 Release). As was the case in the Initial Release, the fallback language in the 2020 Release is recommended but completely voluntary.
The Initial Release contained three separate fallback approaches, namely 1) the "amendment approach," providing great flexibility to establish a fallback rate based on general market standards but that, if negative consent rights are granted to the borrower, would require both parties to agree, 2) the "hardwired approach," having more definitive language about the new rate structure and, for the most part, obviating the need to seek further consent to replace the Libor rate, and 3) the "hedged loan approach," providing language to ensure that a loan and related hedge convert to the same replacement rate to avoid basis risk. The 2020 Release no longer contemplates that the amendment approach will be used, and has clarified and delineated specific terms of the hardwired approach, including designating iterations of the Secured Overnight Financing Rate (SOFR) in the fallback rate waterfall. The recommended fallback language is intended to apply to new originations of bilateral business loans initially referencing Libor.
This Holland & Knight alert briefly highlights the architecture of the 2020 Release's full text, which includes a background section in Part I, specific recommended fallback language in Part II and a user's guide in Part III.
This alert is an overview of the more significant provisions of the hardwired approach set forth in the 2020 Release as it pertains to the initial conversion from USD Libor to SOFR. It does not address provisions in the 2020 Release for subsequent benchmark fallbacks if SOFR ceases to be available, nor does it address the hedged loan approach. Parties with hedged loans are encouraged to discuss with their advisors the relative benefits of the hardwired approach described herein versus the hedged loan approach set forth in more detail in the 2020 Release. This alert is not intended to be a comprehensive review of the relatively complex provisions embedded in the recommended language, or the implications thereof, and thus reference to the 2020 Release should be made for greater detail and clarity. In several instances, the actual text of the 2020 Release is copied or paraphrased.
Components of Fallback Language
The goal of the ARRC's recommended fallback language is to create objective replacement triggers and a clear path to the designation of the replacement benchmark for Libor and to establish the date on which that fallback rate becomes effective. Thus, in making the replacement of Libor operational, ARRC has specified a set of objective, observable trigger events, a successor rate (determined by a waterfall selection), a spread adjustment (also determined by a waterfall selection), and a mechanism for developing "conforming changes" that might be administratively required in connection with the conversion from Libor to SOFR.
The 2020 Release contemplates three objective, easily observable trigger events that precipitate the transition away from Libor. Briefly summarized, they are:
- a public statement or publication of information by the Intercontinental Exchange (ICE) Benchmark Administration (IBA) that it has ceased or will cease to provide all available tenors of Libor (or a published component used in the calculation thereof), permanently or indefinitely, or
- a public statement or publication of information by the Financial Conduct Authority (FCA), the Board of Governors of the Federal Reserve System, the Federal Reserve Bank of New York, among others, which states that the administrator of Libor (or such component) has ceased or will cease to provide all available tenors of Libor (or such component) permanently or indefinitely, or
- a public statement or publication of information by FCA announcing that all available tenors of Libor are no longer representative (that is, that Libor has deteriorated such that it would likely have a significant negative impact on its liquidity and usefulness to market participants)
The 2020 Release also offers a fourth, optional, trigger event referred to as the "early opt-in," which, if employed, has two components, namely:
- a determination by the lender that at least [five] publicly available currently outstanding U.S. dollar-denominated syndicated or bilateral credit facilities at such time contain (as a result of amendment or as originally executed) a SOFR-based rate as a benchmark rate, and
- the election by the lender to trigger a fallback from USD Libor and the provision by the lender of written notice of such election to the borrower
This provision, of course, gives the lender the right to convert to SOFR once a sufficient number of publicly disclosed SOFR-based syndicated or bilateral credit facilities have been executed in the market, evidencing general market acceptance of the new rate. The number five in Clause 1 above is bracketed and, according to the 2020 Release, is subject to negotiation between the parties. The 2020 Release notes that lenders may wish to grant borrowers the right to object to the lender's designation of this early trigger event within a short time frame after notice, and if such an objection is timely made, the lender's "early opt-in" election would cease to be a trigger event.
Under the ARRC-recommended hardwired fallback language for bilateral business loans, if a trigger event and its related effective date occur, all references to Libor will be replaced throughout the documentation with the "Benchmark Replacement." The 2020 Release contains a waterfall to determine the particular Benchmark Replacement to be used. The table below displays the waterfall:
|Benchmark Replacement Waterfall|
|Step 1: Term SOFR + Adjustment|
|Step 2: Daily Simple SOFR + Adjustment|
|Step 3: Lender Selected Rate + Adjustment|
It is important to note that the replacement rate will be the first rate in the waterfall that is in effect as of the effective date of the trigger event (this date is referred to as the "Benchmark Replacement Date").1 The availability of each step in the waterfall is not reevaluated at a later point in time, so if on the Benchmark Replacement Date, Term SOFR in Step 1 is not published and available at that time, Daily Simple SOFR would be designated as the Replacement Benchmark for the remaining term of the contract.
Term SOFR. "Term SOFR" is defined as the forward-looking term rate based on SOFR that is selected or recommended by the Relevant Governmental Body. The "Relevant Governmental Body" means the Board of Governors of the Federal Reserve System or the Federal Reserve Bank of New York, or a committee officially endorsed or convened by the Board of Governors of the Federal Reserve System or the Federal Reserve Bank of New York (e.g., the ARRC), or any successor thereto. The definition provides that "Term SOFR" relates to the "Corresponding Tenor"2 (meaning a period equivalent to the Libor tenor as elected and then effective under the credit agreement, e.g., one-month SOFR, three-month SOFR, etc.) as of the applicable Reference Time (meaning, for each interest setting under the credit agreement, the time and day that the rate for the next interest rate period is determined). Note that each option in the waterfall includes a "Benchmark Replacement Adjustment" described below.
Term SOFR is not currently being published and may not exist on the effective date of the trigger event, though the ARRC has recently solicited proposals for a vendor to begin calculating and publishing forward-looking SOFR term rates. The related Request for Proposals indicates that the winning vendor should be prepared to begin publishing term rates by June 30, 2021.
Daily Simple SOFR. The second alternative benchmark fallback in the waterfall is the sum of: a) Daily Simple SOFR and b) the related Benchmark Replacement Adjustment. Libor is a forward-looking rate where the rate is set at the beginning of each interest period. SOFR is an overnight rate, published the following day, which would have to be calculated "in arrears" by observing the daily resets over a specified interest period and thus will not be known until the end of the interest rate period. In order to allow lenders to provide advance notice of the amount due at the end of each interest period, the 2020 Release proposes that a "lookback" period be specified in the definition. A lookback shifts backward the period of time that the rates are observed for purposes of this calculation. Using that methodology, ARRC gives the following example:
"Assume a 30-day Daily Simple SOFR loan with a five business day lookback starts on Wednesday, April 1st. The first SOFR rate applicable to the loan was SOFR for Wednesday, March 25th (five business days before the start of the interest period). This process of taking the daily rates would continue for the next twenty-nine days with the last day looking to the SOFR rate for Thursday, April 23rd (five business days before the end of the interest period on April 30th)."
This example provides the borrower with five business days' notice of the amount due for each interest period. It should also be noted that ARRC's definition allows the lenders significant discretion in revising this convention to make Daily SOFR work for them administratively.
Lender Selected Rate. If the Benchmark Replacement cannot be determined under Step 1 or 2, the third and final step specified in the "Benchmark Replacement" waterfall is:
the sum of: (a) the alternate benchmark rate that has been selected by the Lender as the replacement for the then-current Benchmark for the applicable Corresponding Tenor [giving due consideration to (i) any selection or recommendation of a replacement benchmark rate or the mechanism for determining such a benchmark rate by the Relevant Governmental Body or (ii) any evolving or then-prevailing market convention for determining a benchmark rate as a replacement for the then-current Benchmark for U.S. dollar-denominated syndicated or bilateral credit facilities at such time]3 and (b) the related Benchmark Replacement Adjustment
This final step of the waterfall provides a last resort for selecting a Benchmark Replacement, giving the lender the ability to select the fallback rate if, for some reason, neither Term SOFR nor Daily Simple SOFR can be determined at the time of the fallback. The recommended language, without the bracketed provisions, gives the lender the broadest discretion in selecting the replacement rate. If the parties incorporate the bracketed provisions, the lender is required to give due consideration to the rate or mechanism selected or recommended by the Federal Reserve or the ARRC, or to any evolving or then-prevailing market convention for determining interest rates in U.S. dollar syndicated or bilateral credit facilities. This bracketed language mirrors the parameters that the ARRC had recommended in the amendment approach contained in its earlier set of recommendations.
The borrower's ability to consent to a replacement rate or early opt-in will be determined by the parties' agreed-upon terms, as the ARRC's recommendations include various bracketed provisions providing for differing levels of consent rights.
The ARRC's guidance notes provide for two additional potential steps in the waterfall, which may be agreed upon to replace one or more of the standard waterfall steps. The first of these additional options is Daily Compounded SOFR, which is similar to Daily Simple SOFR in that it is calculated in arrears based on overnight SOFR resets during the observation period, but differs from Daily Simple SOFR in that it is calculated on a compounded basis. The second optional fallback is Compounded SOFR in Advance. Compounded SOFR in Advance is similar to Daily Compounded SOFR, in that it is based on compounded daily SOFR resets in arrears for a specific tenor (e.g., 30, 90 or 180 days), but is used as a forward-looking rate, set at the beginning of a calculation period, rather than in arrears at the end of the calculation period.
Benchmark Replacement Adjustment
Because Libor is a forward-looking rate incorporating credit risk and SOFR is an overnight risk-free rate, the market has generally determined that when converting a Libor loan to SOFR, a spread adjustment will be required to make the rate levels more comparable. ARRC has proposed the following waterfall to determine what the spread adjustment should be upon the transition from LIBOR to SOFR. As discussed below, the spread adjustment becomes fixed as of the Benchmark Replacement Date:
|Benchmark Replacement Adjustment Waterfall|
|Step 1: ARRC Selected Adjustment|
|Step 2: ISDA Fallback Adjustment|
|Step 3: Lender Selected Adjustment|
ARRC Selected Adjustment
The first step of the adjustment waterfall is the spread adjustment to SOFR recommended by ARRC for the applicable tenor of Libor set forth in the underlying credit agreement. ARRC's spread adjustment methodology will be based on a historical median over a five-year lookback period calculating the difference (spread) between USD Libor and SOFR. ARRC's five-year median spread adjustment methodology will match the methodology recommended by the International Swaps and Derivatives Association (ISDA) for derivatives, and ARRC has determined that, with respect to business loans, its recommended spread adjustments will match those of ISDA with respect to derivatives. ARRC intends to engage an administrator to publish its recommended spread adjustments on a daily basis.
ISDA Selected Adjustment
If ARRC's selected adjustment is not available on the Benchmark Replacement Date, the second step in the waterfall is the spread adjustment applicable to fallbacks for derivatives that ISDA will implement for Libor-based swaps in its definitions. As described above, ISDA's spread adjustment will be based on the median over the five-year lookback period preceding the Benchmark Replacement Date of the historical differences between each relevant tenor of Libor and SOFR, compounded over each corresponding period. ISDA has engaged Bloomberg to publish these adjustments on each business day on an indicative basis until the occurrence of a trigger event, at which time each spread adjustment for each tenor of Libor will become fixed.
Lender Selected Adjustment
If the successor Benchmark Rate is selected by the lender in the third step in the benchmark replacement waterfall, the recommendations require that the lender also select a Benchmark Replacement Adjustment. Similar to the language of the third step in the Benchmark Replacement waterfall, the recommended language, without the bracketed provisions, gives the lender the broadest discretion in selecting the Benchmark Replacement Adjustment. If the parties incorporate the bracketed provisions, however, the lender is required to give due consideration to the spread adjustment or mechanism selected or recommended by the Federal Reserve or the ARRC or to any evolving or then-prevailing market convention for determining spread adjustments in U.S. dollar syndicated or bilateral credit facilities. As with the Benchmark Replacement terms, this bracketed language mirrors the parameters that the ARRC had recommended in the amendment approach contained in its earlier set of recommendations.
Effective Time for Setting Benchmark Replacement Adjustment
If the parties agree to incorporate the concept of the "early opt-in," and the lender elects to exercise such "early opt-in" (which may or may not require the borrower's consent, depending on the terms agreed to by the parties), the spread adjustment will be determined by reference to the published indicative rates at the time the early opt-in election becomes effective and updated thereafter at the beginning of every interest period, subject to the lookback described above, and will apply for the duration of that interest period until the applicable spread adjustment becomes static as described above, at which time the static spread adjustment will apply over the remaining term of the transaction. This mechanism ensures that parties that elect an "early opt-in" will eventually be subject to the same fallback rates and adjustments as if they had waited until a mandatory fallback trigger occurred.
Although the hardwired waterfall seeks to limit the lender's discretion in determining the basic fallback rate and spread adjustment, the ARRC recommendations provide the lender with discretion to make certain conforming "Benchmark Replacement Conforming Changes" (which may include technical, administrative or operational changes) that it deems appropriate or necessary in order to implement and administer the successor rate. Pursuant to the recommended language, such conforming changes may include, by way of example, changes to certain definitions relating to the interest period, business days and alternative base rates, and changes to "the timing and frequency of determining rates and making payments of interest, timing of borrowing requests or prepayment, conversion or continuation notices, length of lookback periods, the applicability of breakage provisions and other technical, administrative, or operational matters," in each case that the lender decides "may be appropriate to reflect the adoption and implementation of such Benchmark Replacement and to permit the administration thereof by the Lender in a manner substantially consistent with market practice." The related guidance notes that some of these conforming changes may be required well after the Benchmark Replacement Date, as conventions continue to evolve over time.
Lender's Discretionary Determinations
The recommended language of the 2020 Release seeks to set specific standards for decisions and determinations that are within the discretion of the lender. In each case, any determination, decision or election, including "any determination with respect to a tenor, rate or adjustment or of the occurrence or non-occurrence of an event, circumstance or date and any decision to take or refrain from taking any action or any selection" will be deemed to be "conclusive and binding absent manifest error and may be made in its sole discretion" and without borrower consent except where expressly required. This language grants the lender wide latitude in making such determinations and broadly protects the lender from the borrower's objection.
"Hedged Loan Approach" to Fallback Language
As noted earlier, the 2020 Release offers the hedged loan approach as alternative language for those parties to existing credit agreements who have hedged, or wish to hedge, the floating rate applicable to loans made thereunder. The hedged loan approach is beyond the scope of this summary, and such parties are encouraged to discuss the appropriate approach with their advisors.
General Considerations/Scope of Recommendation
The 2020 Release notes that the recommended fallback language stated therein is not intended to address every aspect of a credit agreement that would be impacted by the fallback to a replacement rate. For example, the 2020 Release acknowledges that SOFR may not be reflective of a particular bank's internal funding costs, which could presumably impact such a bank's willingness to hardwire a fallback to a SOFR-based rate. In addition, the 2020 Release mentions a number of common provisions in credit agreements, such as break-funding, increased costs and illegality, which were developed based on Libor funding mechanisms and that may need to be reevaluated for interest rates other than Libor. The lender's ability to make Benchmark Replacement Conforming Changes, as described above, is intended to address these types of provisions, which may result in substantive changes to the terms of a credit agreement.
1. It should be noted that ARRC's recommended fallback rates in the hardwired waterfall do not match those being developed by the International Swaps and Derivatives Association Inc. (ISDA) for use in derivatives transactions. ISDA has determined that the standard fallback for USD Libor for derivatives will be compounded SOFR in arrears plus a spread adjustment. Thus, if a borrower intends to hedge the floating rate under their credit agreements, it may wish to consult with its advisors regarding the use of the hedged loan approach rather than the hardwired approach, to ensure that the loan and related swap fall back to the same rate, avoiding basis risk for the borrower. Otherwise, the hardwired approach may result in a mismatch between the loan and the hedge. For reference, ISDA has engaged Bloomberg to publish, on a daily basis, indicative fallback rates for each tenor of USD Libor based on ISDA's compounded SOFR in arrears methodology.
2. The refreshed "hardwired approach" fallback language for bilateral loans contains references to three related terms: "Interest Period," "Available Tenor" and "Corresponding Tenor." These terms and concepts appear throughout the 2020 Release and are described and defined therein as follows:
Interest Period: For a USD Libor bilateral loan facility, the interest rate on LIBOR loans is fixed for discrete periods, referred to as "Interest Periods," and these "Interest Periods" correspond to the tenors of USD Libor that are most commonly used. For many Libor loans, the borrower selects the length of its desired Interest Period for a loan at its option. "Interest Period" would refer to any concrete period pursuant to which a benchmark is calculated for a loan (or portion thereof) (e.g., an Interest Period from April 1-April 30).
Available Tenor: "Available Tenor" refers to all of the tenors, or payment periods if the successor rate is a daily rate, available under the credit agreement with respect to the Benchmark. For example, a USD Libor facility may have Available Tenors of one month, three months and six months. The Available Tenor for a daily rate would be determined based upon the period during which interest is required to be paid (e.g., a Daily Simple SOFR loan may be payable once every month or once every three months, which would result in Available Tenors for such facility of one month and three months). Available Tenor is distinguishable from Interest Period because Available Tenor refers to the available tenors and Interest Period refers to the actual period applicable to such loan.
The definition of "Available Tenor" is set forth below:
... as of any date of determination and with respect to the then-current Benchmark, as applicable, any tenor for such Benchmark or payment period for interest calculated with reference to such Benchmark, as applicable, that is or may be used for determining the length of an Interest Period pursuant to this Agreement as of such date and not including, for the avoidance of doubt, any tenor for such Benchmark that is then-removed from the definition of "Interest Period" pursuant to clause (d) of this Section titled "Benchmark Replacement Setting."
Corresponding Tenor: "Corresponding Tenor" is used to link tenors from one Benchmark to tenors of a Benchmark Replacement, and is drafted to account for minor differences that may occur as a result of a transition. For example, the Corresponding Tenor for one-month USD Libor may be a 30-day SOFR-based rate.
The definition of "Corresponding Tenor" is set forth below:
with respect to any Available Tenor means, as applicable, either a tenor (including overnight) or an interest payment period having approximately the same length (disregarding business day adjustment) as such Available Tenor.
3. The 2020 Release notes that, "in the "hardwired approach," a number of provisions are bracketed. Bracketed language provides alternate approaches, for example, to the circumstances in which a borrower will have a right to withhold consent to actions initiated by the lender, such as the lender's election of an Early Opt-in trigger described below. The inclusion or exclusion of any of the bracketed language, as with all decisions concerning use of the ARRC's fallback recommendations, is a decision to be made by the parties to the loan transaction. Though the ARRC has sought to develop recommendations that market participants can use broadly in preparing for the transition to a new rate benchmark, the inclusion of these bracketed choices reflects the significant diversity of transaction terms in the bilateral business loan market."
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.