Stroock Special Bulletin
“The Guiding Principles: Why to Start Incorporating LIBOR Fallback Language Into Your Debt Documents Now”
On July 9, 2018, the Alternative Reference Rates Committee (“ARRC”) released the ARRC Guiding Principles for More Robust LIBOR Fallback Contract Language in Cash Products (the “Guiding Principles”). The Guiding Principles aim to assist market participants with crafting contract language in newly issued cash products, like loan agreements, to account for the future cessation of LIBOR.
BackgroundIn 2014, the ARRC was created by the Board of Governors of the Federal Reserve System and the Federal Reserve Bank of New York to, among other things, aid in the transition from LIBOR to an alternative rate. Principally tasked with finding an alternative reference rate, the ARRC identified the Secured Overnight Financing Rate (“SOFR”) as a best practice alternative rate. Thereafter, the ARRC issued the Paced Transition Plan, which offered guidelines and timetables to effectuate and encourage the adoption of SOFR as a replacement reference rate.
In March of 2018 the ARRC was reconvened to assist in the continued implementation of the Paced Transition Plan. On March 7, 2018, the ARRC announced that it was working to assist market participants currently using USD LIBOR to consider (i) a transition to an alternative rate and (ii) to address the risks associated with existing contracts that (a) contain language that does not fully address the possibility that LIBOR might cease to exist and (b) do not include appropriate alternatives to LIBOR.
The Shift to More Robust LIBOR Fallback LanguageAccording to the Loan Syndications and Trading Association’s weekly review issued on July 13, 2018, many of the cash instruments issued prior to 2017 contain either no LIBOR fallback language or have fallback LIBOR language that is unworkable in the long term.
Over the last year, however, there has been a shift in the syndicated loan market to include more robust, workable LIBOR fallback language in contracts.
The Guiding PrinciplesThe Guiding Principles issued by the ARRC offer general advice in four areas and are currently voluntary in nature.
The first Guiding Principle is that market participants should not wait to begin incorporating more robust LIBOR fallback language into contracts. This means initially including flexible fallback language to minimize litigation risk until (i) more information around the replacement rate is available and (ii) specific alternative language is developed.
The second Guiding Principle is that the LIBOR fallback language or the alternative rates deployed should be consistent across asset classes and liabilities. The ARRC suggests that the best way to attain consistency is to utilize SOFR, or a benchmark based on SOFR, where appropriate.
The third Guiding Principle is that the fallback language for determining successor rates should be based on observable facts, should be feasible to implement from an operational perspective and should minimize value transfer. The ARRC says that the language should “go beyond the standard poll of banks that appears in many legacy documents’ fallback provisions.” Such language should also contemplate the potential cessation of the successor rate.
The fourth and final Guiding Principle is that replacement contract language should provide clear and precise triggers for when spread and rate adjustments are to be applied. The language should provide adequate protections for the parties responsible for making determinations and should be clear enough to be communicated to those parties relying on the contract.
The ARRC RoundtableOn July 19, 2018, the ARRC hosted a public roundtable at the Federal Reserve Bank of New York in New York City, which was composed of several panel discussions. The roundtable provided a forum to discuss the four Guiding Principles along with more detailed ways to implement alternative rate fallback language into contracts. Topics included the Guiding Principles, floating rate notes, business loans and securitizations. For additional information, including presentation materials, please visit the ARRC’s website.
In his opening remarks at the ARRC roundtable, Randal K. Quarles, vice chairman for supervision of the Board of Governors of the Federal Reserve System, noted that “it was clear that the market needed to develop alternatives in case the worst happened, and this was the reason that we convened the ARRC four years ago . . . it is important that we find ways to make it as easy as possible to use SOFR because the risks to LIBOR are, at this stage, quite considerable.”
Fallback Language for Floating Rate Notes and Syndicated Business LoansOn September 24, 2018, the ARRC released LIBOR fallback language for floating rate notes (the “Notes Consultation”) and syndicated business loans (the “Syndicated Loan Consultation”) for public comment, which can be viewed here and here. The ARRC had requested that comments be provided to the ARRC no later than November 8, 2018.
The ARRC provides varying approaches under the Notes Consultation and the Syndicated Loan Consultation in the event LIBOR is no longer usable. The approach under the Notes Consultation identifies various “triggers” — or events that signal the transition away from LIBOR to a new reference rate — and provides a waterfall for determining which rate would replace LIBOR in various situations and how spread adjustments would be calculated.
The Syndicated Loan Consultation provides two approaches: the hardwired approach and the amendment approach (the latter of which has been employed in many syndicated deals over the past year). Under the hardwired approach, the underlying agreement includes a specific SOFR-based rate and a spread adjustment that would be implemented in the event LIBOR was no longer viable. Under this approach, the borrower(s) and lender(s) would not be able to modify the replacement rate designated or take advantage of current market conditions to capture value, to the extent applicable. Conversely, under the amendment approach, an amendment mechanism is built into the underlying agreement so that a replacement benchmark could be negotiated and implemented when needed. The amendment approach is thought to be similar to the current LIBOR replacement language used today.
ConclusionsWhen possible, market participants should try to build LIBOR fallback language into their agreements in new transactions to avoid confusion and potential litigation in the future. While the hardwired approach may not be widely used yet, the amendment approach is a good option for a more palatable mechanism to address the future cessation of LIBOR.
For More InformationAlex Cota: 212.806.5531; [email protected]
Lucas Charleston: 212.806.5419; [email protected]
Alon Goldberger: 212.806.5429; [email protected]
Elizabeth Loonam: 212.806.5997; [email protected]
Marni Isaacson: 212.806.6549; [email protected]
?This article is for general information purposes only. It is not intended as legal advice, and you should not consider it as such.