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The Board of Governors of the Federal Reserve System and the Federal Reserve Bank of New York convened the Alternative Reference Rates Committee (ARRC) in 2014 in order to, among other things, identify the best practices for establishing an alternative reference rate in replacement of U.S. dollar LIBOR. In June 2017, the ARRC announced its identification of the Secured Overnight Financing Rate (SOFR) as its preferred rate to replace USD LIBOR.1 On July 9, 2018, the ARRC published a set of guiding principles for the development of fallback language to be inserted into credit agreements (and other financial contracts for cash products) to ensure that such contracts continue to be effective in the event LIBOR ceases to be published.2
Guiding Principle #1: Contract Language Evolution and Moving from Discretion to Specificity
The first guiding principle stresses the importance of incorporating fallback language into credit agreements now without waiting until such time when the “absolutely most robust language possible has been identified”. The ARRC recommends an iterative approach to drafting fallback language. While the fallback language inserted into credit agreements today may provide for a high level of flexibility and/or discretion, such language should continue to evolve to leave less ambiguity over time.
Guiding Principle #2: Consistency between Asset Classes as Appropriate
The second guiding principle provides that fallback language “should bear resemblance to contract language in other asset classes and liabilities”. In the lending context, this would be of particular interest to a borrower that has hedged its floating rate loan via an interest rate swap, cap or other derivative. The fallback language provided for in the credit agreement and the underlying derivatives documentation should be largely consistent. In the event of a material inconsistency, a borrower could be faced with a situation where the interest rate on its loan and associated derivative are no longer correlated as intended.
Guiding Principle #3: Feasibility and Fairness of Implementation
The ARRC is very focused on minimizing “value transfer”, i.e. the situation where a shift from LIBOR to a successor rate results in a windfall to one contract party at the expense of the other. The ARRC notes that fallback language “should be based on observable, objective facts and rules set forth in the contract” and “should go beyond the standard poll of banks that appears in many legacy documents’ fallback provisions”. The ARRC also recommends that fallback language contemplate future disruptions, such as the potential cessation of SOFR or any other replacement rate.
Guiding Principle #4: Rate, Spread and Term Structure Adoption
The ARRC recommends that fallback language “explicitly allow for a spread adjustment to minimize valuation changes”. As noted in this firm’s earlier article on this topic, Market Update: The Transition from LIBOR to SOFR: “LIBOR is based on the rate that banks charge one another for short-term loans on an unsecured basis. Accordingly, LIBOR includes a risk premium to capture the underlying credit risk of entering into an interbank lending transaction on an unsecured basis. By contrast, SOFR is based on transactions that are secured by Treasury securities.”3 The spread adjustment recommended by the ARRC is intended to account for the lack of the “credit risk” component in SOFR that is already incorporated into LIBOR. We note that many credit agreements currently being entered into do not provide for an explicit spread adjustment. Language providing for an explicit spread adjustment as recommended by the ARRC should develop as market participants continue to transition from the current flexible/discretionary fallback language towards a more specific, objective solution.
We note that the ARRC guidelines are voluntary in nature and are not binding upon participants in the lending marketplace. That said, the ARRC is composed of representatives from virtually every major commercial bank, along with the Loan Syndications and Trading Association (LSTA). Accordingly, we expect that the ARRC guidelines will be influential in shaping the development of credit agreement fallback language in the coming months (and years) as we approach LIBOR’s expected phase-out by 2021.