In 2014, as a result of a rate-setting scandal, the board of governors of the Federal Reserve System and the Federal Reserve Bank of New York (the Board) embarked on a program to secure an alternate reference rate for Libor. It ultimately selected the Secured Overnight Financing Rate (SOFR) as a suitable replacement for Libor, and began publishing SOFR overnight rates a year ago. The Board then commissioned the Alternative Reference Rates Committee (ARRC) to develop fallback language for existing and future floating rate note (FRNs) transactions, among other financial structures, that are initially tied to Libor, in anticipation of the end of Libor in 2021. The ARRC noted that many historical transactions do not contain fallback language that contemplates the cessation of Libor as a reliable rate index, and that new FRN transactions also lack a balanced fallback methodology. The goal was to develop contract language that could be adopted today (either in new transactions or by amendment to existing transactions) to avoid the risk of serious market disruption following a Libor cessation.
On April 25, 2019, ARRC released proposed fallback language that could be incorporated into new FRN transactions initially structured as Libor-based FRNs, and for similar existing products by way of amendment before the cessation of Libor occurs. It should be noted that the International Swaps and Derivatives Association (ISDA) is independently developing modifications to its 2006 Definitions of Libor (e.g., USD-LIBOR-BBA), which currently have short-term fallback provisions that are not suitable for the actual demise of the Libor index. ISDA has not yet released its proposed language (which will be rolled out as an amendment to its 2006 Definitions), but it is hoped that the two fallback structures will be similar. However, some basis risk between the two fallback structures is anticipated.
This Holland & Knight alert summarizes ARRC's proposed fallback language for FRNs. This is, in its truest sense, a summary, and reference to the full ARRC report should be made for the definitive terms. The ARRC proposal is simply suggested contract language and is completely voluntary. Market participants are encouraged to make their own independent evaluation and decisions about whether, and to what extent, any of the suggested language is adopted.1
ARRC's proposal is broken down into four distinct segments, namely 1) the trigger events causing the interest rate under the FRNs to switch from Libor to the fallback benchmark, 2) the benchmark rate that will then replace Libor, 3) the applicable adjustments, if any, that will have to be made in the selected fallback benchmark, and finally 4) certain benchmark replacement conforming changes. Each will be discussed briefly below.
As an advance warning, those looking for definitive methodologies for calculating the fallback rate and rate adjustments will be disappointed. ARRC rather chose to use a general reference to selections or recommendations subsequently made by it, or by ISDA or others, or as a final fallback, discretionary decisions made by the issuer based on industry accepted market standards that exist at the time of the fallback trigger. None of these currently exist, and ARRC's or ISDA's determinations could change over time, so this is still work in progress. The proposed language, however, is far better than what is generally in the market today.
The trigger event options are divided between the permanent cessation of Libor and precessation triggers before permanent cessation has occurred (collectively referred to in ARRC's proposed language as the Benchmark Transition Event). Parties to a transaction are free to choose between these options, or to make modifications in each category, but should be mindful that their trigger choices could create basis risk if they do not match the trigger event under any underlying hedge transaction.
This third trigger is intended to capture a situation where Libor has deteriorated such that it would likely have a significant negative impact on its liquidity or usefulness to market participants or is "no longer representative of the underlying market or economic reality."
The trigger events under clauses a) and b) are consistent with ISDA's latest position papers (which have not yet been finalized). Clause c) has not yet been endorsed by ISDA, which raises the basis risk noted above.
The conversion to the benchmark replacement defined in the next section (the Benchmark Replacement) does not necessarily occur on the date any of the Benchmark Transition Events occur. Rather, the Benchmark Replacement Date occurs:
If a Benchmark Transition Event (described above) occurs, under the ARRC recommendations a new "Benchmark Replacement" will be substituted for Libor on the Benchmark Replacement Date. If the Benchmark Transition Event does not impact all tenors (e.g., one-month Libor, three-month LIBOR, etc.) of Libor and an interpolated Libor rate can be calculated for an impacted tenor based on unaffected Libor tenors, such interpolated rate will be the Benchmark Replacement for the applicable impacted tenor. If such interpolation is not possible, the ARRC recommendations include a waterfall of methodologies for determining the Benchmark Replacement. Under the waterfall, each Benchmark Replacement has two components, namely the Unadjusted Benchmark Replacement and the Benchmark Replacement Adjustment, both of which are briefly described below.
There are at least two fundamental differences between Libor rates and SOFR. First, Libor is quoted in various tenors, while SOFR currently is solely an overnight rate. Also, Libor is based on unsecured transactions that include the price of bank credit risk. SOFR, on the other hand, is a risk-free rate that does not include a bank credit risk component. Thus, ARRC's fallback language contemplates a rate adjustment to account for these differences. At least until SOFR is quoted for different tenors, the adjustment will be different for the applicable tenor of the Libor rate SOFR is to replace.
As of the date of ARRC's release, the methodologies for rate adjustments have not been developed, although it is clearly a goal of ARRC to develop them. Thus, ARRC has proposed a fallback waterfall similar to the structure used in the Benchmark Replacement discussed above. There are three components to this waterfall:
In addition to the Benchmark Replacement Adjustments, the issuer is entitled to make technical, administrative or operational changes in the underlying documents that the issuer decides may be appropriate to reflect the adoption of a Benchmark Replacement, provided that it does so in a manner substantially consistent with market practice. These changes might include changes in the definition of Interest Period, the timing and frequency of determining rates and making interest payments, addressing terms unique to Libor-based loans such as illegality, increased costs and breakage fees, and other administrative matters.
1 As a drafting note, "issuer" used herein refers to the issuer of the FRNs. ARRC's language refers to the "issuer or its designee," so market participants would be free to designate someone other than the issuer (e.g., an administrative agent or other third party) to make the discretionary decisions referred to below.
2 Benchmark is defined in the release initially as Libor, and after the occurrence of a Benchmark Transition Event, the Benchmark Replacement referred to below.
3 In both clauses a) and b), the Benchmark Transition Event will not occur if a successor administrator has been selected to continue providing the benchmark.
4 Note that ISDA's current definition of USD-SOFR-Compound uses the historical "compound" method rather than a forward-looking term rate, as proposed by ARRC to be the first fallback. ISDA's Libor fallback definition has not been developed but is expected to use the same "compound" methodology rather than a forward-looking rate, so market participants who intend to hedge the floating rate risk under FRNs will need to consider the basis risk of selecting Term SOFR or Simple Average SOFR rather than Compounded SOFR.
Information contained in this alert is for the general education and knowledge of our readers. It is not designed to be, and should not be used as, the sole source of information when analyzing and resolving a legal problem. Moreover, the laws of each jurisdiction are different and are constantly changing. If you have specific questions regarding a particular fact situation, we urge you to consult competent legal counsel.
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