Four years after the UK’s Financial Conduct Authority (FCA) announced the impending end of US dollar (USD) LIBOR, LIBOR transition is finally upon us. Regulators and lenders spent much of that time preparing for the substantial changes that the transition will entail, but for the most part borrowers have been left out of the process. As lenders start to approach their borrowers with the proposed alternatives, borrowers are confronted with several choices and potential issues.
When Is USD LIBOR Actually Ending?
New originations of LIBOR loans are expected to cease by December 31, 2021. However, LIBOR loans originated on or prior to that date may generally continue to apply the rate until June 30, 2023, at which point publication of most tenors of USD LIBOR is scheduled to cease permanently. For more information about LIBOR’s cessation, see Practice Note, What’s Market: LIBOR Interest Rate Provisions.
The effect of LIBOR’s cessation depends on the status of borrowers’ loans:
- New loans. On November 30, 2020, the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation, and the Office of the Comptroller of the Currency issued a joint statement encouraging banks to cease entering into new USD LIBOR loans “as soon as practicable and in any event by December 31, 2021.” Given the closeness of that date, some major national banks have already stopped offering new LIBOR loans, and many plan to make the switch in October or November of 2021, comfortably in advance of the deadline.
- New loans after the deadline. Making the transition is not an easy task, and there will probably be lenders that continue to offer LIBOR loans until the last date possible. Some may even continue to issue LIBOR loans after January 1, 2022, if they are not ready. Although the joint statement does not make these loans strictly illegal, lenders will likely face tough regulatory scrutiny. This is not a borrower concern as such. However, borrowers should be aware that these loans may have language allowing the lender to transition the rate to a new benchmark on a condensed timeline or in its sole discretion.
- Existing loans. For LIBOR loans originated on or before December 31, 2021, the FCA announced on March 5, 2021, that USD LIBOR (other than 1-week and 2-month LIBOR) will continue to be published until June 30, 2023. Loans maturing beyond that date will have to transition to a new rate on or before that date. Many single lender loans executed in the past few years allow the lender to replace the rate with another rate and at any time, both of its choosing, sometimes subject to following market practice generally and sometimes not. Loan agreements without this type of language will generally require some level of consent of the borrower to change the rate.
Borrower caution: Banks are generally under guidance to transition existing loans to a replacement rate any time they have to touch a loan agreement, even if it is an unrelated or minor amendment. Although lenders are required to honor LIBOR loan agreements until June 30, 2023, they have regulatory and operational incentives to switch entirely to a different rate before that date. A borrower that needs an amendment before then may find that it has to give up LIBOR or delay its proposed amendment if it wants to keep LIBOR as long as possible.
Have Regulators Picked a Replacement Rate?
Yes, the Secured Overnight Financing Rate (SOFR) has been recommended by the Alternative Reference Rates Committee (ARRC), a group of financial institutions, companies, industry organizations, and other finance market participants convened by the Federal Reserve 0Board and the New York Fed to facilitate an effective transition. Although the ARRC is not strictly a regulatory body, US regulators have accepted the ARRC’s recommendations concerning LIBOR transition.
What Is SOFR?
SOFR is a rate based on the cost of borrowing in the overnight repo market for US government treasury securities. Transactions in this market are secured by the underlying securities. The rate is calculated and published each business day on a volume-weighted basis using transaction level clearing data provided by the Bank of New York Mellon and an affiliate of the Depositary Trust & Clearing Corporation. Unlike the thinly traded LIBOR market, the repo market clears roughly $1 trillion of transactions daily and is thought to be relatively stable.
Can Borrowers Simply Pick SOFR and Be Done?
Not quite. There are several variations of SOFR for borrowers to choose from, depending on the type of loan, including:
- Term SOFR. Leaving aside the back and forth drama this year on whether Term SOFR would or would not be available any time soon, on July 29, 2021, the ARRC formally recommended Term SOFR. For borrowers with loans that are based on 1-month, 3-month, or 6-month LIBOR, Term SOFR operates almost identically, with rates for similar term periods fixed at the beginning of the interest period. Term SOFR is published on each business day by an affiliate of CME Group Inc., which was selected by the ARRC as the administrator of the rate.
- Daily Simple SOFR. Until Term SOFR was recommended, Daily Simple SOFR was set to be the primary SOFR option used in loans. Operationally, Daily Simple SOFR is much like the prime rate or base rate used in loans. It fluctuates daily, and the interest due is not known until the end of the interest period. Daily Simple SOFR is currently published each business day on the website of the New York Fed.
- Average SOFR. Before Term SOFR became available, the New York Fed tried to create a rate with fixed interest rate periods similar to LIBOR by calculating compounded averages of SOFR. The word similar above is highlighted since Average SOFR has some significant differences from LIBOR. The interest periods are 30- day, 90-day and 180-day rather than 1-month, 3-month and 6-month, since calculating a true monthly average of SOFR is extraordinarily complex. More importantly, although the rate is known at the beginning of the interest period, it is calculated based on interest rate data for the 30-, 90-, or 180-day period immediately prior to the interest period (for example, the actual rate for the last 30 day period will be used for the next 30 day period). It is not a forward looking rate like LIBOR. Still, in the absence of Term SOFR, Average SOFR provides a certain level of predictability for borrowers.
- Compounded SOFR in Arrears. This rate combines features of both Daily Simple SOFR and Average SOFR. Computationally, it is virtually identical to Average SOFR. The rate is compounded on a daily basis for the preceding 30-, 90-, or 180-day period. However, the lookback period used is the actual current interest period. This solves the problem of using stale interest rate data from before the start of the interest period as the actual rates for each day in the current interest period are used. However, this comes at a price. The rate is not known until the end of the interest period. For borrowers that want to be able to plan for their interest rate expense, this rate does not allow for that.
- Compounded SOFR in Arrears is still a significant rate, since it is the variation of SOFR that was chosen by the International Swaps and Derivatives Association, Inc. (ISDA®) as the replacement rate for LIBOR interest rate swaps. For real estate borrowers that highly value the ability to hedge their interest rate exposure as closely as possible, choosing Compounded SOFR in Arrears for the loan may have certain advantages despite the downsides.
Do Lenders Have to Offer a SOFR Replacement Rate Since That Is the Only Rate Recommended by Regulators?
No. Subject to regulatory scrutiny, lenders are free to offer any replacement rate they want. In the absence of clear market consensus, some lenders early on contemplated falling back to traditional alternative rates, such as the Wall Street Journal prime rate or the overnight federal funds rate. Other market participants have seen the landmark move away from LIBOR as an opportunity to be more creative and invent new interest rate replacements much in the way the New York Fed developed SOFR. There are several of these rates being offered in the market, but the two that have garnered the most attention so far are Ameribor and BSBY. These rates are known as credit sensitive rates (CSRs).
- Ameribor. Described by its founder as “the most boring benchmark in America” due to its relative lack of volatility, Ameribor is the brainchild of Richard Sandor, a pioneer of the first interest rate futures contract on the Chicago Board of Trade with decades of business, finance, and academic experience. Ameribor is calculated as a weighted average of the daily transactions in the overnight unsecured loan market on the American Financial Exchange (AFX), a self-regulated exchange formed by Sandor in 2015. The AFX has more than 200 members representing approximately 25% of all US banks. As of June 25, 2020, the cumulative volume of the transactions on AFX since 2015 had reached $1 trillion. Ameribor is available for several term periods, including the popular 1-month and 3-month fixed terms, similar to LIBOR.
- BSBY. If Ameribor is the response of smaller, regional banks to the perceived inadequacies of SOFR, BSBY is the response of large institutional banks. Short for the Bloomberg Short-Term Bank Yield Index, BSBY is a proprietary index launched by Bloomberg on October 15, 2020, and made available for use by licensees on March 8, 2021. BSBY is a rate based on unsecured, private commercial paper, certificate of deposit, USD bank deposit, and short-term bank bond transactions. Compared to SOFR, transaction volume is in the single digit billions of dollars daily, sometimes reaching only a small fraction of that number. BSBY is reported each business day at 8:00 a.m. Eastern Time to subscribers on their Bloomberg terminals in overnight, 1-month, 3-month, 6-month, and 12-month tenors. The first American alternative rate syndicated loan was actually a BSBY loan agented by Bank of America on May 14, 2021, rather than a SOFR syndicated loan (which did not happen until September 8, 2021).
In concept, the regulators have been supportive of having multiple replacement rates. The ARRC is the Alternative Reference “Rates” Committee, not “Rate” Committee. In remarks before the Financial Stability Oversight Council (FSOC) on June 11, 2021, Acting Comptroller of the Currency Michael Hsu noted that a bank’s replacement rate selections should be “appropriate for the bank’s products, funding needs, and operational capacities.” Randal Quarles, vice chair for supervision of the Board of Governors of the Federal Reserve System, gave more specific guidance that “lenders and borrowers are free to choose the rate they wish to use to replace LIBOR.”
Regulators have also expressed caution and concern about CSRs. In the same statement, Randal Quarles urged borrowers to “ensure that they understand how their chosen reference rate is constructed” and to “make sure they are aware of any fragilities associated with that rate.” Secretary of the Treasury Janet Yellen also expressed concern to the FSOC generally about “alternative rates that lack sufficient underlying transaction volumes.”
Gary Gensler, chair of the Securities and Exchange Commission, has been more blunt in his criticism and unabashedly outspoken in calling out BSBY by name. Among other points, he notes that at the start of the COVID pandemic in the spring of 2020, the commercial paper lending market virtually evaporated for about five weeks. No market means no liquidity means no rate. In Gensler’s colorful imagery, this lack of resiliency to market stress is “the same emperor” that had no clothes as LIBOR during the 2008 financial crisis.
Are These CSRs Better for Borrowers Than SOFR?
Possibly, but it will depend on how lenders price loans and how the rates perform in the future.
Many medium-sized banks like Ameribor. A key advantage of Ameribor for many regional, mid-size, and community banks is that it better represents their actual funding costs as compared to SOFR. These banks typically do not have large holdings of US government securities and do not have access to the treasury repo market that underlies SOFR. Unlike LIBOR, where very few banks actually borrowed in the London interbank market, member banks can and do borrow funds in the AFX for their operational needs. This allows member banks to align more closely the interest income they receive on their loans with their costs of obtaining the funds to lend.
At the same time, many large banks like BSBY. Unlike smaller banks, big banks often hold US treasury securities. Nonetheless, the treasury repo market is not usually their primary source of obtaining new funds to lend. The commercial paper, bank deposit, and bank bond markets are more likely sources.
Big bank, small bank, Ameribor and BSBY, the common thread that ties them together is the unsecured nature of the underlying rate. Key issues to consider include:
- That LIBOR is unsecured. LIBOR is based on unsecured transactions in the London interbank market. Although it is a bit subjective, LIBOR has a credit sensitive component.
- What credit sensitivity is. A lender that makes a loan on an unsecured basis has to account for the risk (however small) that the borrower will default at some point during the course of the loan and the lender will not recover the full amount of its loan. The treasury repo transactions upon which SOFR is based are fully secured by the most liquid, creditworthy collateral, and they are generally overnight loans. SOFR is therefore called a “risk free rate” (RFR).
- How credit sensitivity affects rates. A loan that is fully secured should be relatively stable in good times and bad. Correspondingly, the rate of interest should not need to rise and fall dramatically in times of market stress. For an unsecured loan, market stress can be a factor that increases the likelihood that the borrower will default. An interest rate that compensates the lender for this increased risk will likely fluctuate and rise more rapidly in response to a changing market. During times of great market stress like the 2008 financial crisis, there might even be a flight of capital to more stable secured loans, which can push the interest rate on these loans lower, just at the time the risk on unsecured loans is the highest. If a lender is obtaining liquidity in the interbank or commercial paper market on an unsecured basis and its cost to obtain funds rises dramatically while the interest it earns on loans to borrowers only goes up gradually, the lender could be negatively impacted.
Should a Borrower Care About the Interest Rate Mismatch?
Everything else being equal, no. SOFR should be better for borrowers than competing CSRs, particularly in a rising rate environment as is currently anticipated. However, loan terms are not always equal.
On April 27, 2021, the Association for Financial Professionals, the National Association of Corporate Treasurers, and the US Chamber of Commerce joined in a letter addressed to regulators touting the virtues of SOFR. The letter points to the volatility and unreliability of “LIBOR and other credit-sensitive rates during times of financial market stress, when transaction volumes shrink while rates spike up, causing a spiral of increasing unreliability.” When they asked the question “would you prefer to borrow using alternatives based on SOFR or potential credit-sensitive rates that could move up like LIBOR has done in times of economic stress?”, roughly 85% of borrowers chose SOFR. The question is more than a bit leading, but the message behind it is telling. With the participation of the letter writers on the ARRC, the SOFR rate selected by the ARRC is quite favorable to borrowers.
Up until recently, savvy borrowers seeking to learn more about SOFR and how it will impact their multi-year loans nearing renewal have received relatively little guidance from their lenders. The transition has already required a massive effort for lenders, and for many borrowers, the operational, technological, accounting, tax and legal compliance and documentation tasks are just beginning. The borrower organizations above expressed real concerns that “by the time the banks have fully prepared transition materials and processes, the [nonfinancial corporate borrowers] awaiting that information would have little to no time” to accomplish these tasks. Unfortunately, that time is now, and many lenders are still just getting up to speed themselves, not to mention borrowers. While some lenders still offer LIBOR loans, some lenders have begun only offering SOFR loans, and by January 1, 2021, this will be all lenders. Borrowers need to get themselves educated and prepared fast.
Borrower caution: Not all loans have equal terms. In theory, if two loans, one SOFR and one Ameribor or BSBY, are priced to have the same interest rate, then they should have roughly the same rate (at least to start). Everything else being equal, the SOFR loan should be less volatile and less likely to spike up dramatically in a rising rate or stressful market. However, adjusting rates in this manner is not an exact science, and banks may not be inclined to try.
Construction of an Interest Rate
A typical interest rate on a loan has two components, which are:
- The interest rate benchmark used (for example, SOFR, Ameribor, or BSBY).
- An interest rate margin.
The benchmark represents (at least nominally) the lender’s cost of obtaining the funds to lend to the borrower. The interest rate margin roughly represents the lender’s cost of being in business and making the loan, including its real estate, payroll, anticipated risks relating to the loan, and expected profit. If the interest rate benchmark is not credit sensitive, then the lender has to account for the risk of a rising cost of obtaining or maintaining funds over the term of the loan in the interest rate margin.
For example, if both SOFR and Ameribor happen to be the same rate at closing and a lender believes that over time Ameribor will rise 0.25% more than SOFR will, the lender may price the interest rate margin on a SOFR loan 0.25% higher than the interest rate margin for a comparable Ameribor loan. At closing, the Ameribor loan would be cheaper for the borrower, but with a higher risk that the rate will increase over time. If a lender prefers Ameribor since the rate aligns more comfortably with its operations, it may even offer the Ameribor loan at a discount, for example, 0.35% lower than a comparable SOFR loan.
Will a Borrower’s Interest Rate Go Up Due to the Transition?
In theory, no. However, depending on the time of transition, the rate may temporarily be higher. Borrowers should consider:
- What is the ARRC SOFR spread adjustment? After consultation with market participants to promote consistency and uniformity, the loan market and the swap market decided to use the same methodology for determining how to price a loan that is transitioning from LIBOR to SOFR. In broad terms, the market decided to compare the performance of LIBOR and SOFR over the immediately preceding five-year period ending on March 5, 2021, to determine, on average, how much LIBOR and SOFR vary from each other. These spread adjustments for USD LIBOR are 0.11448% for a 1-month interest period, 0.26161% for a 3-month interest period, and 0.42826% for a 6-month interest period. As an example, a loan that is currently priced at LIBOR plus 1.50% for 1, 3 and 6 month LIBOR should be transitioned to SOFR plus 1.61448%, 1.76161%, and 1.92826% for 1, 3 and 6 month SOFR interest periods respectively. This generally reflects that the longer the interest period, the greater the difference between an RFR like SOFR and a CSR like LIBOR.
- Do these spread adjustments apply to all loans? No, the spread adjustments above only apply to existing LIBOR loans that are transitioning to SOFR. Lenders are free to price new SOFR loans with whatever spread adjustment compared to LIBOR they choose. For that matter, lenders are not strictly required to apply the spread adjustments above to transitioning LIBOR loans (with some lenders rounding the adjustments to 0.10% and 0.25% for 1 and 3 month interest periods, or perhaps even using the 1-month adjustment for both 1 and 3 month interest periods). Although LIBOR and SOFR will both be reported in the market until June 30, 2023, ultimately LIBOR will cease and SOFR has to stand on its own as a rate. Nonetheless, a lender varying materially from the agreed spread adjustments should raise a red flag for borrowers. Borrowers are also free to negotiate lower spread adjustments (or no spread adjustment) with their lenders. Anecdotally, many are doing so.
- How could the rate end up higher? On average, over the five-year test period, 1-month SOFR was 0.11448% lower than 1-month LIBOR, 3-month SOFR was 0.26161% lower than 3-month LIBOR, and so on. However, both LIBOR and SOFR are dynamic rates that fluctuate daily. In September 2021, 1-month SOFR was only about 0.03% lower than 1-month LIBOR, 3-month SOFR was only about 0.08% lower than 3-month LIBOR, and 6-month SOFR was about 0.10% lower than 6-month LIBOR. Adding the ARRC spread adjustment to SOFR now would result in a higher interest rate (about 0.08448%, 0.18161%, and 0.32826% higher respectively). Interest rates are historically low right now, so it is not surprising that LIBOR is closer to SOFR than the five-year average. As rates are generally expected to rise in coming years, the difference between secured SOFR and unsecured LIBOR should more closely match the average ARRC spread adjustment. Still, a borrower that is able to should consider delaying the transition of its loan from LIBOR to SOFR until the spread difference is closer to the average to take advantage of the lower LIBOR rate.
- Are there comparable Ameribor and BSBY spread adjustments? No. Since these are proprietary rates of the AFX and Bloomberg, there is no market agreed standard for comparing them to LIBOR, SOFR, or other rates. Some lenders in the market are pricing BSBY loans with no spread adjustment compared to LIBOR, since both of these rates are CSRs and are thus expected to rise and fall in a similar manner. This lack of a spread adjustment makes BSBY a simpler rate for borrowers to understand and accept, even though a RFR with a fixed spread adjustment may be better for them in the long run in a rising rate environment.
Will Borrowers Be Able to Swap Their Interest Rate Exposure on the New Replacement Rates?
Generally yes, interest rate swaps should be more broadly available soon for all three rates mentioned above. Existing swaps should be transitioned at or around the time that the loan is transitioned to a replacement rate. However, borrowers should be aware that the availability of swaps depends on a liquid swap market, and a liquid swap market depends on volume. The lack of SOFR swap volume early on almost derailed Term SOFR. Due to market and regulator initiatives, SOFR swap volume is virtually guaranteed to grow into a robust market. The picture for Ameribor and BSBY swaps is not so clear. The markets are developing. On September 8, 2021, CME Group announced that BSBY futures are now live and trading on the exchange, with BSBY swap clearing to come on November 15, 2021. Development of these markets for Ameribor and BSBY will be crucial. A small, illiquid market may not allow for efficient swap pricing, potentially driving up the relative cost to borrowers of choosing these rates.
Will the Transition Cause Adverse Tax Consequences to Borrowers?
Based on proposed tax regulations, probably not for SOFR, but unclear for transitions of existing loans to Ameribor or BSBY. A detailed analysis of the proposed regulations and revenue procedures is beyond the scope of this Article, and the regulations and guidance can change. A few points are highlighted below. Borrowers should consult with their tax advisors on their particular situations.
- General Rule. Under Treasury Regulations §1.1001-3, the modification of a loan agreement or note is treated for federal income tax purposes as the exchange of the original debt loan agreement or note for a modified loan agreement or note if the modification is “significant.” This deemed exchange is a taxable event that mayvresult in gain or loss for the holder/creditor, cancellationvof indebtedness income for the issuer/debtor, and/or the unintended creation of original issue discount. A “modification” is generally any alteration of a legal right or obligation under a debt instrument, whether evidenced by an express agreement (oral or written), conduct of the parties, or otherwise.
- Proposed Safe Harbor Guidance. On October 9, 2019, the Treasury Department and the IRS released proposed regulations at 84 Fed. Reg. 54,068 (Proposed Regulations) to offer guidance on the tax implications of LIBOR transition. That was followed on October 9, 2020, by Revenue Procedure 2020-44 (Revenue Procedure). However, the Treasury Department and the IRS have stated that they anticipate that the Proposed Regulations and Revenue Procedure will minimize potential financial disruption and facilitate the market’s adjustment to the termination of LIBOR in a cost-efficient manner.
- Qualified Rate Test. Section 1.1001-6(a) of the Proposed Regulations generally provides that altering the terms of a debt instrument or non-debt contract to replace LIBOR with a “qualified rate” would not result in a tax realization event under Section 1001 of the federal tax code or related sections of the treasury regulations. This treatment also applies to “associated alterations” that are both associated with and reasonably necessary to adopt the alternative rate. Based on the definition of “qualified rate” in Section 1.1001-6(b) of the Proposed Regulations, it is not clear whether Ameribor or BSBY would be a “qualified rate” for transition of existing legacy loans.
- Rate Comparison and Arm’s Length Safe Harbors. The Proposed Regulations provide a further safe harbor if the historic average of the replacement rate does not differ from the historic average of LIBOR by more than 25 basis points on the date of the modification. In addition, there is a safe harbor if unrelated parties determine that the fair market value of the debt instrument or non-debt contract before the modification is substantially equivalent to the fair market value after the modification based on bona fide, arm’s length negotiations.
Borrower caution: The Proposed Regulations and Revenue Procedure only apply to LIBOR transition. If an amendment includes other changes that might independently trigger tax liability, those changes have to be evaluated separately for tax consequences.
Will Borrowers Have to Pay for LIBOR Transition?
It depends. Many loan agreements say that the borrower pays for all amendments. Although not expressly premised on the assumption that the borrower requested the amendment or benefits from it, that is the usual rationale. In this case, neither the lender nor the borrower wanted the change. It instead was imposed by regulators at great cost to lenders.
Many lenders are trying to do the right thing by their borrowers and not charge for the amendment or charge only a nominal fee that does not reflect the true cost of documenting the change, if the only reason for the amendment is to change the rate and the borrower does not try to negotiate the changes. If other unrelated amendments are being done at the same time, then it is likely that the lender will charge the borrower for these amendments and also include the costs of adding the LIBOR transition amendments. Furthermore, if a borrower chooses to negotiate the standard LIBOR transition amendment offered by the lender, the lender may charge the out-of-pocket costs of outside counsel to negotiate the changes. If an amendment contains market transition pricing and other reasonable terms, there should not be a need for significant borrower pushback.
What Are the Most Common LIBOR Transition Issues Borrowers Are Negotiating?
Timing of transition, spread adjustment, and the amount of lender discretion.
Given the short amount of time that borrowers have getvup to speed on the changes that will be involved in the transition, the longer they can delay, the better. SOFR (or Ameribor, BSBY or another CSR) is the future, but that future is unclear at this point. If a legacy loan is not set to mature for several months or years and the borrower does not have a pressing need to request an amendment that would trigger a transition in the rate, there is no rush to switch. SOFR may be a better rate in the long run, but the ARRC-agreed spread adjustment for legacy loans is not favorable to borrowers right now. For new originations or legacy loans transitioning on or before December 31, 2021,
lenders are strongly discouraging LIBOR, but they are not strictly prohibited from making or continuing LIBOR loans.
Where the “market” ends up on the amount of the spread adjustment to transition from LIBOR to SOFR or CSRs remains a significant open question that will become clearer as loans are negotiated and closed. Most loans closing now are unreported private deals, and in the few publicly available deals, the actual spread pricing is sometimes blanked out. Legacy loans with ARRC hardwired language will apply the ARRC-agreed adjustments. There will also be new originations with no pre-set adjustments and market pressure from strong borrowers to reduce or eliminate any such adjustment. Legacy loans following an amendment approach that is supposed to be negotiated by lenders and borrowers using “market” customs will likely vary between these extremes until the practice becomes more settled.
Although the ARRC strongly recommends, and lenders favor, use of a “hardwired” approach with a pre-agreed waterfall of replacement rates, some loans are still being negotiated with “amendment” approach language where the lender and the borrower have to agree on the replacement. Particularly in bilateral loans, lenders are taking control of the transition process, with the ability to make conforming changes for the new rate in their sole discretion. Many borrowers may not have negotiating leverage to counter such provisions, but those that do are trying to make it a more consensual process, or at least temper the lender’s discretion by terms of reasonableness and market practice.
What If a Borrower Does Not Agree to Replace LIBOR?
A borrower should review its loan documents carefully to see what rights it has, if any, relating to LIBOR transition. The language varies greatly from loan to loan:
- Hardwired Approach. Many loan agreements that have been originated or amended in recent years provide for a mechanism to replace LIBOR. Some agreements follow what is called a “hardwired approach” in which the first rate that is available in a specified waterfall at the time of transition will be used. The order of priority in these loans is usually Term SOFR, followed by Daily Simple SOFR, and sometimes by a rate to be agreed or chosen by the lender. Since Term SOFR is generally available at this point, the agreed replacement under these loan agreements would be Term SOFR without any further consent of the borrower. However, the details of implementing the new rate could be subject to challenge by the borrower if they are not reasonable.For example, the lender might require a longer notice period to request SOFR loans, increase the minimum borrowing amount, or make other changes that limit its use.
- Amendment Approach. Alternatively, recent loan agreements might apply what is called an “amendment approach,” which provides a process under which the borrower and the lender will select a replacement rate. These provisions often apply neutral criteria for selecting the replacement rate, such as giving due consideration to the replacement rate being used in the relevant loan market, or by the lender generally in its loans to similarly situated borrowers, and that this rate must be administratively feasible for the lender to implement. A borrower may have more leeway to challenge a proposed rate under this type of provision since it is not as specific as the hardwired approach. Nonetheless, a borrower would have to show that the replacement does not satisfy the specified criteria or is otherwise implemented unfairly.
- Lender discretion. Many recent loans, especially smaller single lender loans, provide that the lender can unilaterally select the replacement rate and make corresponding amendments to the loan agreement without further consent of the borrower simply by giving notice. The language sometimes provides neutral criteria for the lender to follow to select the replacement rate along the lines of the amendment approach and sometimes not. A borrower would have to show that the lender abused its discretion unfairly in implementing a new rate.
- Borrower caution: Fallback to Prime. Most loan agreements of the type described above and many loan agreements executed or last amended prior to the advent of LIBOR transition contain an additional lender protection. If LIBOR is unavailable, then the rate switches to the prime rate or base rate. Whether this means the Wall Street Journal prime rate, the overnight federal funds rate, or something else is not relevant. The key point is that the built-in fallback rate is usually quite a bit higher than the LIBOR rate. A borrower can challenge the replacement rate offered by the lender, but it will often be better than the prime rate or other fallback, and during the time the borrower challenges the new rate, that inflated fallback rate, plus potentially default rate interest, may apply to the loan.
- No contractual fallbacks. If a loan agreement does not have any interest rate fallback of any kind, lenders must consider whether the borrower can stop paying interest when LIBOR ceases permanently since there is no interest rate. It’s a relatively small portion of outstanding loans that have no fallback whatsoever, but it poses a conundrum to lenders. On the one hand, a deal is a deal, and the lender arguably drafted the loan agreement poorly. On the other hand, the spirit of the deal was always that some amount of interest would accrue on the loan.
- Legislative solutions. The ARRC evaluated the issues posed by so-called “tough legacy” loan agreements and came up with a solution, which was to draft legislation to mandate a replacement by operation of law. So far, this has been easier said than done. On March 24, 2021, the New York legislature passed Senate Bill 297B/Assembly Bill 164B substantially in the form drafted by the ARRC. Alabama followed suit the next month, but that has been it so far. A large percentage of commercial loan agreements are governed by New York law, but people do loans in other states too. On the national level, although the ARRC legislation was approved by the House Committee on Financial Services on July 30, 2021, it hasn’t passed the full House yet, and the Senate banking committee was just holding hearings on November 2, 2021. The details of the ARRC legislation are beyond the scope of this Article, but it should not come as a surprise that the only replacement rate mentioned in it is SOFR.
- Timing of transition. Even if the lender is given the right to select the replacement rate (either contractually or by statute) and it is not worthwhile for the borrower to challenge the rate, the borrower may still be able to influence when the replacement rate goes into effect. Most agreements with LIBOR replacement language provide that the date of the rate change will not be until the end of LIBOR (that is, June 30, 2023) or an early opt-in date agreed upon by the lender and the borrower. Unless the lender has the right to change the rate by giving notice, the borrower can at least delay the new rate until the actual end of LIBOR. As discussed above, the LIBOR rate may be lower than the replacement rate, and the borrower should be able to get the full benefit of that bargain as long as it can.
LIBOR transition is coming whether anyone really wanted it or not. On the whole, the change should not have a dramatic impact on borrowers. With some careful planning, the change can be a positive one for borrowers, or at least a non-event.
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