We’re in the Endgame Now: Recommended LIBOR Replacement Language ReleasedMay 2019
The London Interbank Offered Rate (LIBOR) is an interest rate index that is widely used in financial documents and commercial agreements. As described in our prior alert, the U.K.’s Financial Conduct Authority announced in 2017 that it plans to phase out LIBOR by 2021. Following this announcement, in an effort to minimize market disruption, the U.S. Federal Reserve Board and Federal Reserve Bank of New York convened the Alternative Reference Rates Committee (ARRC), comprised of private-market participants, to study this issue, identify alternative reference rates, and create an implementation plan. On April 25, 2019, the ARRC released recommended language to include in contracts for syndicated loans and LIBOR floating rate bonds, and encouraged market participants to begin using the new language in contracts. In the accompanying statement, Tom Wipf, Chairman of the ARRC, said, “It’s no longer a question of if – but when – LIBOR will become unusable, yet most contracts referencing it don’t adequately account for this eventuality.”
The ARRC recommends the use of the Secured Overnight Financing Rate (SOFR) as an alternative reference rate to replace LIBOR. Because SOFR is secured by U.S. Treasuries, and LIBOR is unsecured, SOFR reflects less risk and is expected to be lower than LIBOR. In order to preserve the economic terms of a LIBOR-based contract upon a shift to SOFR, the spread will need to be adjusted to account for the difference in the underlying rates. The difference between the two rates will vary, but for example, if SOFR is .50% less than LIBOR, a contract for interest at a rate of LIBOR plus 3% would need to be changed to SOFR plus 3.5% to be economically equivalent.
Parties should begin to include “fallback language,” which takes effect if LIBOR becomes unavailable, in their contracts for syndicated loans and LIBOR floating rate bonds. The recommended fallback language specifies what events will trigger the replacement of LIBOR and an adjustment to the applicable spread to make the new rate more economically equivalent to LIBOR. For syndicated loans, the ARRC recommends using one of two approaches: the “hardwired” approach or the “amendment approach.” In the hardwired approach, the contract will specify which SOFR-based successor rate will apply and what the adjustment to the spread will be. In the amendment approach, a specific rate is not provided, but the contract will instead provide a process for negotiating a replacement rate in the future and amending the contract at that time. For LIBOR floating rate bonds, the recommended language includes a process for determining a specific replacement rate, similar to the hardwired approach for syndicated loans.
The ARRC plans to provide fallback language for bilateral (non-syndicated) business loans and securitizations soon.
Derivative products such as interest rate swaps do not currently contain LIBOR replacement language. The International Swaps and Derivatives Association (ISDA), the trade organization for the derivatives market, is expected to eventually develop its own replacement language using SOFR to include in its standard documents.