The Alternative Reference Rates Committee (“ARRC”) released its recommended LIBOR fallback language for floating rate notes, syndicated and bilateral business loans, and securitizations that reference LIBOR.[1] The ARRC’s recommended fallback language seeks to minimize the risk of significant market disruption following the end of LIBOR. Below we discuss the background behind the cessation of LIBOR, the ARRC’s suggested fallback language, and recommended next steps.

What is LIBOR?

The London Interbank Offered Rate (“LIBOR”) is an interest rate that measures the interest rates at which banks and other financial institutions borrow from one another. The rate is calculated daily based on quoted rates submitted by a panel of banks to the ICE Benchmark Administration and is applied over the term of an interest period – typically, 1, 2, 3, 6 or 12 months.

Why is LIBOR going away?

For decades, LIBOR has been the widely used and globally accepted interest rate benchmark found in many financial instruments, including loan agreements, swap agreements and securitizations. However, in recent years, LIBOR has been criticized for its susceptibility to market-manipulation. Banks collectively have paid billions of dollars in penalties for their involvement in schemes to influence LIBOR. In July 2017, Andrew Bailey, the CEO of the United Kingdom’s Financial Conduct Authority (“FCA”), announced that the FCA would no longer sustain LIBOR after the end of 2021. In the wake of this announcement, the ARRC, tasked with identifying an alternative reference rate for LIBOR, recommended the Secured Overnight Financing Rate (“SOFR”) as the successor rate.

What is SOFR?       

SOFR is the measure of the cost of borrowing overnight collateralized by US Treasury securities. It is thought of as a riskless rate and is overnight. With SOFR as a basis, the ARRC is developing a rate, generally known as “Term SOFR”, to prospectively measure the cost of borrowing for a longer term. It is anticipated that “Term SOFR” will provide index rates for various periods in a manner similar to  the current interest periods for LIBOR.  Since SOFR is a riskless rate, it is anticipated that SOFR will be less than LIBOR thereby necessitating a spread adjustment for loans originally priced using LIBOR.

Current Developments

While the ARRC recommends drafting new agreements and amending existing agreements to reference rates other than LIBOR, the ARRC also recognizes the unlikelihood of agreements ceasing to reference LIBOR altogether until we have transitioned away from LIBOR. As such, on April 25, 2019, the ARRC released two versions of recommended fallback language for cash (non-derivative) products.

• “Amendment Approach” Fallback Language[2]. In this version, upon the occurrence of a triggering event[3], the parties may amend the agreement to replace LIBOR with an alternative rate. While any loan may be amended with the consent of all parties, typically amendments regarding interest rates and spreads require the consent of all lenders. The “amendment approach” provides a more streamlined approach.  In its basic form, the “amendment approach” requires only the agreement of the Borrower and Agent, with negative consent rights afforded to the majority lenders.

The amendment approach does not designate a successor to LIBOR, allowing the flexibility to adopt an alternative market convention if  “Term SOFR” does not materialize or is not widely accepted. The amendment approach allows the parties to select both a successor rate and a spread adjustment.  Lenders, in particular, will need to track each loan that contains this “amendment approach” fallback language and amend accordingly at the time of a trigger event.

• “Hardwired Approach” Fallback Language[4]. In this version, upon the occurrence of a triggering event, the successor rate to LIBOR will have been predetermined. Unlike the “amendment approach”, the parties agree to an alternative rate at the time the agreement is entered into. The fallback language the ARRC recommends under this approach replaces LIBOR with forward-looking SOFR plus a spread adjustment. If forward-looking SOFR does not exist, then LIBOR will be replaced with a compounded average of daily SOFRs plus a spread adjustment. If this is also not available, then the “hardwired approach” will revert to the “amendment approach”. This approach may be desirable if the parties wish to agree on a successor rate at the time the loan agreement is signed. Unlike the “amendment approach”, the parties will not be able to take advantage of future market conditions when determining a successor rate. While implementing the “hardwired approach” will be a smoother transition (since the loans will revert to the successor rate automatically without further amendments by the parties), this approach also requires the parties to agree to a successor rate that does not exist today (e.g., forward-looking SOFR).

Given that SOFR is still being developed, we do not anticipate that the “hardwired approach” will be adopted except in cases where the underlying documents are not easily amended (such as publicly issued floating rate notes). The “amendment approach”, which is essentially an agreement to agree, will continue to be the preferred method until there is further clarity around if and when “Term SOFR”, or an alternative, is developed.

Considerations and Key Takeaways

For existing transactions that reference LIBOR, categorize those transactions into those that mature or terminate before and after the cessation of LIBOR at the end of 2021. For transactions that mature or terminate after 2021, (1) consider employing either the “amendment approach” fallback language or the “hardwired approach” fallback language, and (2) determine whether there are any additional obligations tied to LIBOR (e.g., swap obligation based on LIBOR).

For prospective transactions being entered into between now and 2021, carefully consider the choice of reference rate. If LIBOR is to be used, incorporate the “amendment approach” fallback language or the “hardwired approach” fallback language.

Nelson Mullins attorneys will continue to monitor developments set forth by the ARRC and across the market.

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