The Situation: The Alternative Reference Rates Committee ("ARRC") released market consultations on the securitization and bilateral loan markets on December 7, 2018, concerning potential paths forward for benchmark (e.g., LIBOR) cessation fallbacks.
The Result: The Consultations utilize concepts and language from prior ARRC "cash market" consultations, but in new combinations and with new elements.
Looking Ahead: Responses to the Consultations are due February 5, 2019.
The ARRC has released two market consultations concerning "fallback" mechanisms for the securitization ("Securitization Consultation") and bilateral loan ("Bilateral Loan Consultation" and, together with the Securitization Consultation, "Consultations") markets that are proposed to operate in the event of a temporary or permanent cessation of LIBOR. The Consultations were released on December 7, 2018, and have a response date of February 5, 2019. The ARRC proposes to publish recommended language for new issues only for these markets on the basis of responses to the Consultations.
The Consultations utilize concepts and language from prior ARRC consultations on syndicated loans ("Syndicated Loan Consultation") and floating rate notes ("FRN Consultation") as building blocks, but they include special features to accommodate the unique circumstances and dynamics in the relevant markets. For example, the Securitization Consultation contemplates a "Designated Transaction Representative" to effect many important functions in connection with the LIBOR transition.
The Bilateral Loan Consultation follows the same bifurcated structure (the "amendment" approach and the "hardwired" approach) as the Syndicated Loan Consultation, but for the first time proposes an option for an explicit loan interest rate fallback to prevailing rates and conventions in the derivatives market. This "hedged loan" option is an explicit effort to remove basis risk by tying the interest rate on the loan (or hedged portion of the loan) itself to the interest rate on the related hedging instrument.
This is an innovative approach to resolving the "swap/liability" basis risk that appears to be developing in the syndicated loan, floating rate note, and securitization markets. Based on recent feedback published by the International Swaps and Derivatives Association, Inc. ("ISDA") in connection with its own consultation, ISDA seems likely to adopt "compounded setting in arrears rates" rather than the "forward-looking" rates to which borrowers and lenders have grown accustomed.
Under the Bilateral Loan Consultation's "amendment" approach, the lender has the unilateral right to propose an "amendment" of the credit agreement so as to replace LIBOR with a successor rate and a "spread adjustment" of the lender's choosing. There is optional borrower "negative consent" language, which means that the amendment will be effective as proposed by the lender if the borrower does not object to the proposed amendment within a certain period of time (and if the borrower does object, then the "fallback" will be to an "alternate base rate" until an amendment is otherwise effected). The lender has considerable but not unbounded discretion in selecting the Replacement Benchmark, as due consideration must be given to market conventions and any selection, endorsement, or recommendation by a "Relevant Government Entity" such as the Board of Governors of the Federal Reserve, the Federal Reserve Bank of New York, or the ARRC or any successor committee.
Like their predecessors, each Consultation involves a three-step process: (i) identifying the "Trigger Events" that will lead to the replacement of LIBOR with a successor rate; (ii) selecting or constructing "Replacement Benchmarks" that adequately replicate the term structure of LIBOR; and (iii) selecting an appropriate spread adjustment ("Replacement Benchmark Spread") to compensate the receivers of the replacement floating rate for the loss of the bank credit spread risk that had been inherent in the LIBOR construct.
The following sections lay out the proposed "Trigger Events" under both Consultations and the "waterfalls" for selecting the Replacement Benchmark and "Replacement Benchmark Spreads" under the Securitization Consultation and the Bilateral Loan Consultation's "hardwired" approach.
Both Consultations include the two "ISDA cessation" triggers: (i) an announcement by the LIBOR administrator (currently, ICE Benchmark Administration Limited ("IBA") that it will cease (or has ceased) the publication of LIBOR on a permanent or indefinite basis; or (ii) a similar announcement by the regulatory supervisor (currently, the United Kingdom's Financial Conduct Authority) or an insolvency official for IBA. The Consultations propose three additional "pre-cessation" triggers that were also proposed in the Syndicated Loan Consultation and the FRN Consultation: (i) the nonpublication of LIBOR for five consecutive business days; (ii) an announcement by the LIBOR administrator that it is invoking its "insufficient submissions policy"; and (iii) an announcement by the regulatory supervisor for the LIBOR administrator that LIBOR is "no longer representative or may no longer be used."
The Bilateral Loan Consultation also includes early "opt-in" pre-cessation triggers similar to those under the Syndicated Loan Consultation. The amendment approach permits the lender to commence the amendment process if it determines that new or amended bilateral loans are incorporating a new benchmark rate to replace LIBOR, and a transition under the hardwired approach may be triggered, subject to optional negative consent rights of the borrower, if publicly filed syndicated loans are priced over term SOFR (the Secured Overnight Financing Rate).
The Securitization Consultation adds two additional pre-cessation triggers. The first occurs when the "Asset Replacement Percentage" (which measures the proportion of underlying assets that have been modified to bear interest at the "Replacement Benchmark") exceeds "%" (with the brackets indicating an ability to be adjusted to suit the needs of particular transactions). This represents a (somewhat imprecise) attempt to maintain a transaction's cash flows in greater alignment than otherwise when assets are converting to SOFR rates and the vehicle has issued unremediated LIBOR liabilities.
The second provides the Designated Transaction Representative the ability to accelerate the Benchmark Replacement Date by up to 30 days upon giving 30 days' advance notice to the securityholders. The Designated Transaction Representative must also represent that the acceleration "will facilitate an orderly transition of the transaction to the Replacement Benchmark."
The first two steps in the waterfall for selecting the Replacement Benchmark under the Bilateral Loan Consultation's "hardwired" approach and under the Securitization Consultation are identical: (i) "Term SOFR" (which is defined as a forward-looking term SOFR rate that has been selected, endorsed, or recommended by the relevant governmental body), with any necessary interpolation on a linear basis; and (ii) "Compounded SOFR," which means daily SOFR compounded over the relevant tenor at the beginning or end of an interest period.
Under the Bilateral Loan Consultation's "hardwired" approach, if the lender determines neither of these to be available, then (much like under the "amendment" approach) the lender can propose an amendment to the borrower selecting an alternate rate of interest.
The Consultation is soliciting feedback regarding the level of discretion afforded to the lender in selecting the rate, including whether it must afford due consideration to market practice and the recommendations of the relevant governmental body or provide the borrower with "negative consent" rights.
If Term SOFR and Compounded SOFR cannot be determined under the Securitization Consultation, the waterfall continues as follows: (iii) such other alternate rate as is selected, endorsed, or recommended by the relevant governmental body; and (iv) to whatever the applicable fallback is under the ISDA definitions ("ISDA Fallback Rate"). This fourth stop on the waterfall comes with a wrinkle, however. The fifth and final stage in the waterfall is triggered upon (a) the inability to determine the ISDA Fallback Rate; or (b) upon the determination of the Designated Transaction Representative that the ISDA Fallback Rate is not a then-applicable industry-accepted successor rate for securitizations. The Designated Transaction Representative may (if the ISDA Fallback Rate is unavailable) and must (if the ISDA Fallback Rate is not an "industry-accepted successor rate") propose an industry-accepted successor rate (which must include a "spread adjustment") for securitization issues at that time.
The Securitization Consultation offers alternative language for securityholders to approve or veto such proposal(s) by the Designated Transaction Representative, and, in the absence of an effective amendment, the relevant securities will bear interest ("Interim Benchmark") at: (i) the last valid fixing of the applicable Replacement Benchmark in cases where the ISDA Fallback Rate is unavailable; and (ii) at the ISDA Fallback Rate in cases where the Designated Transaction Representative has nonetheless determined the ISDA Fallback Rate not to be an "industry-standard successor rate" for securitizations at the relevant time.
For their Replacement Benchmark Spread, both the "hardwired" approach of the Bilateral Loan Consultation and the Securitization Consultation primarily rely upon a successor rate that has been selected, endorsed, or recommended by the relevant governmental authority. Each also has a fallback to the "ISDA Spread Adjustment" applicable to the ISDA Fallback Rate under the ISDA definitions. The Securitization Consultation (like the "hardwired" approach under the Syndicated Loan Consultation) stops there, while the "hardwired" approach in the Bilateral Loan Consultation permits the lender to select a Replacement Benchmark Spread in its sole discretion, with the usual optional caveats concerning "due consideration" of market developments and recommendations of the relevant governmental body.
Three Key Takeaways
The ARRC Consultations relate to proposed recommended language for new issues only; "legacy" issues will need to be amended to accommodate the potential demise of LIBOR in accordance with the amendment provisions generally applicable to interest rate amendments (which often require 100 percent consent of the lenders/bondholders).
Both Consultations rely heavily on "Term SOFR" and "Replacement Benchmark Spreads," which do not as yet (and conceivably may not ever) exist; however, the Bilateral Loan Consultation contains language specifically designed to eliminate swap/loan basis risk that may become useful in other contexts and markets.
The Securitization Consultation attempts to accommodate varying paces at which underlying assets are converted to SOFR or other post-LIBOR rates, but much work remains to understand consumer receivables and the parameters that would be applicable to converting them from a LIBOR basis to a SOFR or other post-LIBOR basis.