LIBOR Phaseout Implications for Credit Agreements
Few things have generated comparable levels of mental anguish and attention among investors and finance professionals as the looming phase-out of LIBOR as a benchmark interest rate, which takes place by the end of 2021. This phase-out is expected to have far-reaching consequences on corporate loans, derivatives, bonds and other financial instruments around the world and will require thoughtful consideration and preparation by affected parties.
In the US, the Federal Reserve’s Alternative Reference Rates Committee (ARRC) was convened by the Board of Governors of the Federal Reserve System and the Federal Reserve Bank of New York in response to the Financial Conduct Authority’s (FCA) decision to discontinue the use of LIBOR as a benchmark rate. The ARRC was tasked with, among other things, identifying an alternative benchmark rate for US dollar LIBOR and suggesting recommended fallback language for syndicated loan agreements when LIBOR becomes unavailable indefinitely. ARRC’s two suggested approaches for borrowers and lenders to incorporate into their credit agreements are the “hard-wired” approach and the “amendment” approach. Both of these approaches are based on “triggering events”, which are typically defined as specific events known by relevant market stakeholders that prompt the long-term transition from LIBOR to a new alternative benchmark rate such as statements from regulators that prohibit the use of LIBOR or if a material change in LIBOR occurs.
• Under the hard-wired approach, an alternative benchmark rate formulation would be specifically drafted into the credit agreement and would automatically convert the benchmark rate if a triggering event takes place.
• Under the “amendment approach,” the lender(s) and borrower would agree to negotiate an amendment to the credit agreement to replace LIBOR following a triggering event.
To date, most US company credit facilities have included some variation of the amendment approach, essentially “agreeing to agree” at a time down the road when LIBOR is phased out.
The Secured Overnight Financing Rate (SOFR) has been identified by the ARRC as the preferred and most likely successor to LIBOR within the US. SOFR is published by the New York Federal Reserve and represents the general funding condition of the Treasury repurchase agreement (repo) market for secured overnight transactions. Market participants have endorsed SOFR as an alternative to LIBOR but not without highlighting certain deficiencies including the backward-looking nature of the rate and the overnight term. In response to these deficiencies, the ARRC is working to expand SOFR to include forward-looking term rates which are expected to increase overall market utility and SOFR adoption as an alternative rate for LIBOR.
Given the inherent uncertainties associated with the adoption of SOFR as the LIBOR successor rate in the US, market participants have generally adopted a “wait and see” approach and have postponed financial contract amendment discussions until greater clarity is achieved around the appropriate replacement rate.
Stay tuned for further developments on this front.