When we last blogged in January about what borrowers can do to prepare for a potential cessation of the London interbank offered rate (“LIBOR”), there was a lot of uncertainty surrounding whether LIBOR would actually be replaced, what that replacement would be, and whether the market would have sufficient time to react. Due to this uncertainty, we advised taking a “wait-and-see” approach with respect to borrowers reaching out to affirmatively modify their existing loan documents that reference a LIBOR rate to include LIBOR fallback language, except in the cases where borrowers were already in the process of negotiating an amendment for other reasons. Although there has been some significant movement in both the development of LIBOR fallback language and the determination of the replacement rate since our last blog post, there has not yet been enough movement for us to change our advice at this time.
ARRC FALLBACK LANGUAGE
One major development since our last blog post is the publication by the Alternative Reference Rates Committee (the “ARRC”) of its Consultation Regarding More Robust LIBOR Fallback Contract Language for New Originations of LIBOR Syndicated Business Loans (the “Consultation”) on September 24, 2018. As noted in our last blog post, the ARRC was established in 2014 by the Board of Governors of the Federal Reserve System and the Federal Reserve Bank of New York for the purpose of recommending a LIBOR alternative, identifying best practices for contract sturdiness in the interest rate market, and creating a plan to implement the new reference rate. In the Consultation, the ARRC offered two general proposals for sample LIBOR fallback language and asked market participants for their commentary up until November 8, 2018. The LIBOR fallback language was developed by a working group of the ARRC co-chaired by the Loan Syndications and Trading Association (“LSTA”), a highly influential trade group in the syndicated loan market, which gives it a lot of credibility in the marketplace.
Although the fallback language is not yet finalized, even in its current unfinished state, it provides some valuable guidance for borrowers who are currently involved in negotiations over either a new credit agreement or an amendment to their existing credit agreement. At a high level, the Consultation takes two basic approaches to LIBOR fallback language, the amendment approach and the hardwired approach, each of which is discussed below. Please note that the Consultation also discusses the different consent requirements under the amendment approach and hardwired approach, which are not addressed in this article.
THE AMENDMENT APPROACH
The amendment approach provides a streamlined mechanic for negotiating a replacement to LIBOR and a replacement LIBOR spread upon the occurrence of a “trigger event.” A trigger event is essentially an action that gives rise to the conversion from LIBOR to a new reference rate. Under the amendment approach, a trigger event is basically either (i) a public statement that LIBOR will fail to be published, or the actual failure of LIBOR to be published (a “Benchmark Discontinuance Event”), or (ii) a determination by the administrative agent or required lenders that new or amended loans are incorporating a new rate to replace LIBOR. If either of these trigger events occur, the Borrower and the administrative agent may amend the agreement to replace LIBOR with an alternate benchmark rate (including a replacement benchmark spread), in each case giving due consideration to then-existing market convention and endorsements or recommendations by relevant governmental bodies such as the Federal Reserve Board, the Federal Reserve Bank of New York or a committee convened by either or both of them (each a “Relevant Governmental Body”).
As you can see from the above, the amendment approach is flexible in many respects, which is positive in some ways and negative in others. On the positive side, it allows for LIBOR language to be amended if other lenders are incorporating a rate other than LIBOR, which could be well before the time, if any, that LIBOR becomes unavailable. This gives borrowers and lenders the flexibility to get well ahead of the LIBOR issue if they desire. Additionally, the amendment approach does not automatically replace LIBOR with a fixed replacement rate such as the Secured Overnight Financing Rate (“SOFR”), the alternative replacement rate selected by the ARRC. Instead, it gives borrowers and lenders the ability to choose both the replacement rate and the applicable spread. On the negative side, the ARRC pointed out in the Consultation that it may not be practicable to use the amendment approach if thousands of loans must be amended simultaneously due to a potential LIBOR cessation. Moreover, this added flexibility comes at the price of allowing the lender or borrower to “game” an amendment depending on whether the credit market is then lender-friendly or borrower-friendly. In a lender-friendly market, the lenders could block a proposed rate and force the borrowers into a higher interest rate (such as the alternate base rate). In a borrower-friendly market, the borrowers could block any proposed spread to the replacement rate. Although the hardwired approach addresses these concerns, it has its pros and cons as well, which are discussed below.
THE HARDWIRED APPROACH
As suggested by its name, under the hardwired approach the LIBOR replacement language is hardwired into the agreement, which is obviously much less flexible than the amendment approach. Similar to the amendment approach, the replacement language also becomes effective upon the occurrence of a trigger event, which is either (i) a Benchmark Discontinuance Event, or (ii) an agreed upon number of outstanding publicly filed syndicated loans being priced over term SOFR plus a replacement benchmark spread. If either of these trigger events occur, LIBOR is automatically replaced in accordance with a waterfall approach where the first available option is chosen from the following: first (1) Term SOFR, or, if not available for the appropriate tenor, interpolated SOFR, then (2) Compounded SOFR, then (3) Overnight SOFR, then (4) a rate chosen giving due consideration to then-existing market convention and endorsements or recommendations by any Relevant Governmental Body. In addition, the existing LIBOR spread is automatically replaced by a spread adjustment, or method of calculating a spread adjustment, that has been selected, endorsed or recommended by the Relevant Governmental Body or, if not available, the spread adjustment or method of calculating the spread adjustment is selected by the International Swaps and Derivatives Association, Inc.
Like the amendment approach, the hardwired approach has its pros and cons. On the pro side, it provides borrowers and lenders with the certainty that if and when LIBOR is discontinued, it is highly likely that some version of SOFR will be inserted as a replacement rate with a market replacement spread. On the con side, as of now SOFR is only being quoted as an overnight rate, so it is currently unclear what the actual replacement to LIBOR (and the replacement spread) will look like if LIBOR is discontinued. That being said, the ARRC has said that part of its transition plan for implementing SOFR will include the development of multiple forward rates, so it is likely that the waterfall will be fully populated well before LIBOR’s potential cessation.
In summary, although the ARRC has made great strides in drafting LIBOR fallback language, at the current time we do not think it is far enough along to advise borrowers to proactively request amendments to their existing credit agreements with LIBOR-based loans. However, if a borrower is currently involved in an amendment or a new credit, we still recommend that they consider including either the amendment approach or the hardwired approach in its current form. Although neither approach is perfect, both are preferable to the option of automatically defaulting to the alternate base rate.