On August 7, 2020, the Alternative Reference Rate Committee of the U.S. Federal Reserve (the “ARRC”) released a three-part “SOFR Starter Kit.” The first two parts[1] provide a history of the events that led to the replacement of the London Inter Bank Offered Rate (“LIBOR”), the choice of the Secured Overnight Financing Rate (“SOFR”) as its replacement for U.S. dollar LIBOR-based financial contracts, and how SOFR compares with LIBOR.
It is part three that brings together the numerous resources that the ARRC has published to implement its key recommendations, including links to its Best Practices (revised on September 7 to anticipate the imminent release of ISDA’s IBOR Fallback Protocol), syndicated loan conventions[2], refreshed recommended business loans fallback language[3], and an internal systems transition guide.
With lenders encouraged to cease using LIBOR in new loan originations not later than June 30, 2021—fewer than 280 days from now—and to adopt, well in advance of December 31, 2021, hardwired fallback language in LIBOR-based contracts entered or amended prior to that date, the time to act is NOW. We offer our view of a few of the more critical ARRC recommendations that lenders and borrowers should implement immediately if they have not already.
- Lenders adopting SOFR as their chosen replacement benchmark should determine whether they will use compounded SOFR, which more accurately (but not substantially) reflects the time value of money and may allow more accurate hedging, or simple SOFR, which is operationally easier to implement. They also must decide related mechanical issues that will affect the documentation of such loans, including the use of lookbacks, observation shifts, and interest rate floors, and the inclusion of customary yield protection provisions.[4]
- Stop referencing LIBOR as the interest rate benchmark in new loan originations. To the extent new LIBOR-based loans continue to be originated, include hardwired fallbacks in related loan agreements and, to the extent practicable, amend legacy loan agreements to incorporate hardwired fallbacks. Although public records indicate that only four credit agreements, representing three unique borrowers and administrative agents, have implemented the ARRC’s refreshed hardwired fallback language since it was introduced in June 2020, we understand that several lenders have mandated its use going forward and we expect to see significant adoption during the fourth quarter of 2020.
- Identify and implement operating system changes required to support alternative reference rates, including the sourcing and calculation of such rates.
- Develop a detailed understanding of the loans in your portfolio that will need to be amended, including differing fallback language and required negative consent action time frames, and the related regulatory notices required to be given under relevant federal and state laws in connection with payment modifications.
- To the extent hedging is an important part of your loan management program, understand and be prepared to adhere to the ISDA IBOR Fallback Protocol upon publication, and preferably during the “in escrow” period prior to effectiveness.
- Understand and begin to plan for the new accounting, tax, and regulatory reporting requirements that will apply after transition.
[1] https://www.newyorkfed.org/medialibrary/Microsites/arrc/files/2020/ARRC_Factsheet_1.pdf and https://www.newyorkfed.org/medialibrary/Microsites/arrc/files/2020/ARRC_Factsheet_2.pdf.
[2] https://www.newyorkfed.org/medialibrary/Microsites/arrc/files/2020/ARRC_SOFR_Synd_Loan_Conventions.pdf and related https://www.newyorkfed.org/medialibrary/Microsites/arrc/files/2020/ARRC-Syndicated-Loan-Conventions-Technical-Appendices.pdf.
[3] https://www.newyorkfed.org/medialibrary/Microsites/arrc/files/2020/Updated-Final-Recommended-Language-June-30-2020.pdf for syndicated loans and https://www.newyorkfed.org/medialibrary/Microsites/arrc/files/2019/Bilateral_Business_Loans_Fallback.pdf for bilateral loans.
[4] See our recent Legal Update, SOFR Loan Documentation: 8 Things for Borrowers to Think About, at https://www.mayerbrown.com/-/media/files/perspectives-events/publications/2020/08/sofr-loan-documentation-8-things-for-borrowers-to-think-about.pdf, for a more detailed discussion of these issues.