By now almost everyone knows that the world of interest rate benchmarks is going to change. Certain existing dominant and long-used inter-bank offered rates (IBORs) such as EURIBOR and LIBOR are likely to be restructured or may disappear all together as a result of new regulation and market forces. New alternative 'risk-free rates' (RFRs) that will replace the old IBORs have been identified or are being developed by a number of working groups for the financial markets that will be affected.
In many instances, existing interest rate fallback provisions included in standard loan documentation do not anticipate a permanent cessation of an applicable reference rate. This creates legal uncertainty. To address this problem, new standard fallback provisions are being prepared by financial market organisations such as the Loan Market Association (LMA) and the International Swaps and Derivatives Association (ISDA). For additional background on the transition from IBORs to RFRs and the new fallback provisions proposed by ISDA, I refer to my previous article about ISDA's consultation on benchmark fallback provisions. This article is about the new fallback provisions that have recently been published by the U.S. Alternative Reference Rates Committee (ARRC).
Against the backdrop of the transition from IBORs to RFRs, the ARRC was convened by the Board of Governors of the Federal Reserve System and the Federal Reserve Bank of New York in 2014. The ARRC's mandate includes identifying an alternative RFR for (U.S. Dollar) LIBOR, creating an implementation plan to support voluntary adoption of such new RFR and identifying best practices for contract robustness in the interest rate market. The ARRC has selected the Secured Overnight Financing Rate (SOFR) as the alternative rate of (U.S. Dollar) LIBOR. In addition, it has set out a Paced Transition Plan with respect to the adoption of SOFR in the derivatives market.
ARRC consultations on fallback provisions
With a view to reduce risk of serious market disruption following a LIBOR cessation, the ARRC has published Guiding Principles for More Robust LIBOR Fallback Contract Language in Cash Products in July 2018. Following these principles, the ARRC published market consultations on contractual fallback language for four types of cash (non-derivative) products: floating rate notes, syndicated business loans, bilateral business loans and securitizations. In an ideal world, the transition from LIBOR to SOFR will pass smoothly given that appropriate fallback provisions are written into all new contracts whereas existing contracts will have been amended to include such fallback provisions. However, the reality is different. Lots of existing contracts continue to reference LIBOR and lots of new contracts are still entered into without appropriate fallback provisions. The fallback provisions proposed by the ARRC for floating rate notes, syndicated business loans, bilateral business loans and securitizations have in common that they reference SOFR as the applicable rate following a cessation of LIBOR or other trigger event, such as LIBOR being declared no longer representative. Because of the differences between LIBOR (which is an unsecured term rate) and SOFR (which is a secured overnight rate), the proposed fallback provisions provide for an adjustment to make SOFR more like LIBOR and to avoid any unjustified transfer of economic value. Ideally, the proposed fallback provisions would reference a forward-looking term rate to replace LIBOR, but no such forward-looking term rate based on SOFR exists yet.
Recommended fallback language for LIBOR-referenced U.S. Dollar-denominated syndicated business loans
Consistent with the results of its consultations, the ARRC is now publishing recommended fallback language for each of the four types of products. The ARRC is recommending market participants to incorporate the fallback language in new and existing contracts now without waiting until a forward-looking SOFR term rate comes into existence. The recommended fallback language for syndicated business loans was published last week on 25 April 2019 with the recommended fallback language for other types of products expected to follow in the next months. The recommendations of ARRC for syndicated business loans actually include two sets of fallback language, one being referred to as the "hardwired approach" fallback language and the other being referred to as the "amendment approach" fallback language. The hardwired approach fallback language provides for the automatic replacement of an existing reference to LIBOR by the first available rate that is taken from a waterfall of alternative rates upon a so-called "Benchmark Transition Event". By contrast, the amendment approach fallback language provides for a contractual framework that allows the borrower and the administrative agent to amend the existing loan agreement to replace LIBOR with a replacement benchmark following a Benchmark Replacement Event. The amendment will be deemed to have been accepted by the lenders unless a percentage of them has sent the administrative agent a notice of objection within a certain time. In many aspects, the amendment approach resembles the revised Replacement of Screen Rate clause that was published by the LMA in May 2018 and subsequently updated in October of that year, albeit that amendment under the latter requires a majority lender decision.
Benchmark Transition Event
The hardwired approach fallback language and the amendment approach fallback language have in common that they are triggered upon the occurrence of a "Benchmark Transition Event". In summary, a Benchmark Transition Event is a situation in which one or more of the following events has occurred with respect to LIBOR: (i) a public statement from the administrator of LIBOR that it, or a competent regulatory supervisor or court announcing that the administrator, has ceased or will cease to publish LIBOR, without a successor administrator being available to continue to publish LIBOR; or (ii) a public statement from a competent regulatory supervisor that LIBOR is no longer representative.
Hardwired approach fallback language waterfall
As indicated above, the hardwired approach fallback language includes a waterfall that references a number of alternative reference rates in a specific order. The first of those alternative reference rates that can be determined by the administrative agent as of the benchmark fallback date will automatically replace LIBOR as the reference rate for the relevant contract. The order of the alternative reference rates is: (i) the sum of "Term SOFR" and the "Benchmark Replacement Adjustment"; (ii) the sum of "Compounded SOFR" and the Benchmark Replacement Adjustment; (iii) the sum of an alternative rate selected by the borrower and the administrative agent and the Benchmark Replacement Adjustment. The Benchmark Replacement Adjustment is a spread adjustment as published for the relevant interest period by a competent governmental body or, if no such adjustment spread can be determined, the spread adjustment that would apply to the fallback rate for a derivative transaction referencing the fallback provisions as included in the 2006 ISDA Definitions upon an index cessation event with respect to U.S. Dollar LIBOR for a corresponding tenor. The term "Term SOFR" is used to describe the forward-looking SOFR term rate that has been selected or recommended by the competent governmental body. As discussed above, no forward-looking SOFR term rate is currently in existence. The term "Compounded SOFR" is used as a definition of the compounded average of SOFRs for the corresponding tenor. As those SOFRs are published during a current term, the Compounded SOFR rate for such term can only be determined when the term has ended. This makes Compounded SOFR a backward-looking rate, which is considered less attractive than the forward-looking nature of existing IBORs. If no Term SOFR or Compounded SOFR can be determined, the borrower and the administrative agent may determine an alternative reference rate. In doing so, they must give due consideration to any selection or recommendation of a replacement rate or the mechanism for determining such rate by the competent governmental body or any then-prevailing market convention for determining such rate at such time.
Divergence from the ISDA Fallback language
Although the ARRC has made efforts to ensure general consistency between markets, there are two areas in which the recommended fallback language published by the ARRC will potentially diverge from the new fallback language to be included in the 2006 ISDA Defnitions. The first area relates to the fallback triggers. It is not yet clear what circumstances will trigger the replacement of a reference rate with respect to a derivative contract to which the 2006 ISDA Definitions apply. In particular, it is uncertain whether the ISDA fallback provisions will provide for a so-called pre-cessation event, such as an announcement from a regulatory supervisor that LIBOR is no longer representative. Unless the trigger events referenced in both sets of fallback provisions are aligned, there will be considerable risk that existing references to LIBOR in cash products will not be replaced simultaneously with the replacement of LIBOR references in derivative products. The second area in which the ARRC fallback language diverges from the fallback language proposed by ISDA is the primary fallback rate. As discussed above, the primary fallback rate referenced in the hardwired approach fallback language recommended by the ARRC is Term SOFR (which currently does not exist). By contrast, the primary fallback rate proposed by ISDA is based on an average of the SOFRs for the published during the relevant term and compounded in arrears. Given the results of its fallback language consultation, it is highly unlikely that ISDA will move to include Term SOFR as a fallback rate. Such difference would result in potential mismatches between cash and derivatives products. For this reason, a user of interest rate derivative transactions that are entered into to hedge an interest rate exposure under a floating rate loan should consider to include the amendment approach fallback language in the loan agreement rather than the hardwired approach fallback language.
The ARRC is the first working group that produces recommended fallback provisions for syndicated loans that include language based on a hardwired approach. In doing so, it has set an example for the working groups of other jurisdictions, including the UK Working Group on Sterling Risk Free Reference Rates and the Working Group on Euro Risk-Free Rates. It will be interesting to witness whether these working groups will also publish recommended fallback language and, if so, if that language will be based on a hardwired approach or an amendment approach and if it will resemble the example set by the ARRC. Finally, I wonder if we can expect the LMA to follow with the publication of a hardwired approach alternative to its revised and updated Replacement of Screen Rate clause for LMA-based loan agreements. I believe that the time is ripe.