Libor Discontinuation: Update for Floating Rate Borrowers
This alert provides a brief summary of a recent development that may impact borrowers that hedge floating rate debt. As discussed in more detail in Holland & Knight's previous alert, the International Swaps and Derivatives Association Inc. (ISDA) published its 2020 IBOR Fallbacks Protocol (the Protocol) and related Amendments to the 2006 ISDA Definitions (the Amendments) in October 2020 to address discontinuation of Libor in the derivatives markets. The Amendments became effective on Jan. 25, 2021.
What Does This Mean?
Starting on Jan. 25, 2021, any new swap or other derivative transactions which reference the 2006 ISDA Definitions will automatically incorporate ISDA's fallback provisions for the replacement of Libor. As a result, upon the occurrence of certain objective trigger events related to the discontinuation of Libor (anticipated to be delayed until June 2023), the floating rate on these new swaps will convert from Libor to ISDA's preferred replacement rate based on compounded Secured Overnight Financing Rate (SOFR) in arrears plus a fixed spread. No amendment or negotiation will be required when Libor goes away.
How Will This Impact Borrowers?
Over the last several years, in anticipation of the impending discontinuation of Libor, most Libor-based loan documents have started to incorporate some form of fallback provisions. The Federal Reserve System and the Federal Reserve Bank of New York jointly created the Alternative Reference Rates Committee (ARRC), which has published a variety of recommended fallback provisions for different types of Libor-linked debt. Unlike the swap market, which has a single, market-wide solution in the form of ISDA's Amendments, the loan market has been much more fragmented, with different banks taking different fallback approaches, even between different sectors and products within the same bank. Even the trigger events have not been uniformly agreed upon. For any given loan, the fallback rate might be left to the discretion of the lender, with or without borrower consent, might be based on SOFR (either a forward-looking term SOFR, a compounded SOFR in arrears (like ISDA's fallback), a simple SOFR in arrears or some other variation of SOFR), or might be based on some other benchmark altogether. When a borrower enters into a new Libor-based loan and intends to hedge that loan with a swap or similar derivative, there may be a disconnect between the fallback rate on the loan and the fallback rate on the swap, as well as the timing of any fallback, creating basis risk and potential increased exposure for the borrower. A borrower who believes that they have effectively converted their Libor-based floating rate to a specific fixed rate through the hedge may find that, once Libor is discontinued, they owe more or less than the fixed rate (which differential may vary from interest period to interest period for the remaining life of the debt). Borrowers, in general, should be aware of the fallback provisions in any new Libor-based loan documents, but now that new swaps are locked into ISDA's fallback mechanism, it is also crucial for borrowers to understand the potential mismatch between the loan and a related swap and the potential basis risk.
Does This Impact Existing Transactions?
No, the updated ISDA Amendments do not automatically apply to existing swap and derivative transactions. As described in Holland & Knight's previous alert, those existing transactions do not include any robust fallback provisions and will need to be bilaterally amended to address Libor discontinuation. ISDA has created the Protocol for that purpose – parties wishing to apply the new fallbacks to their existing transactions can adhere to the Protocol for $500, which will automatically incorporate the new Definitions into those existing transactions with other parties who also adhere. Alternatively, parties may negotiate separate bilateral amendments with their swap counterparties. Borrowers considering entering into the Protocol to address existing transactions may wish to consult with their legal, tax, financial and accounting advisors with respect to adherence to the Protocol.
For more information on how Libor discontinuation could impact your organization, please contact the author. In addition, Holland & Knight can provide advice on other operational and legal issues that may arise with respect to the discontinuation of Libor and the transition to alternative reference rates.
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, and it should not be substituted for legal advice, which relies on a specific factual analysis. Moreover, the laws of each jurisdiction are different and are constantly changing. This information is not intended to create, and receipt of it does not constitute, an attorney-client relationship. If you have specific questions regarding a particular fact situation, we urge you to consult the authors of this publication, your Holland & Knight representative or other competent legal counsel.