Last updated: January 24, 2019
Over the past year and a half, market participants have experienced a significant amount of change related to the upcoming transition away from the use of LIBOR. While LIBOR transition preparations have been long underway, the recent initiatives were brought to the surface on July 27, 2017, when the U.K.’s Financial Conduct Authority (FCA) announced that banks would no longer be compelled by the FCA to support LIBOR past the end of 2021. Although the FCA’s position is seemingly straightforward, other factors complicate this outlook. First, the administrator for the LIBOR Benchmark, ICE Benchmarks Administration (ICE), has said it will continue to publish LIBOR after 2021. Additionally, the EU Benchmarks Regulation (BMR) is scheduled to become effective on January 1, 2020. The BMR provides that all financial benchmarks used within the European Union, including third country benchmarks, must be formally approved by EU authorities.
However, despite these additional complications, regulators have signaled that continued reliance on LIBOR could present a systemic risk. According to the regulators, this systemic risk exists because LIBOR continues to suffer from a lack of real transactions underpinning it and, beginning in 2022, many banks may drop out of the LIBOR submission pool, further undermining LIBOR as a benchmark.
The threat of banks no longer making submissions after December 31, 2021 means that regulators will likely continue to push market participants, particularly large banks, to transition away from LIBOR. However, the December 31, 2021 date provides a relatively short timeframe for transitioning to LIBOR alternatives. Moreover, the massive amount of economic activity tied to LIBOR creates the potential for significant value transfers between buy-side and sell-side participants if not handled correctly.
While regulators have been working with industry stakeholders since at least 2014 to develop a uniform approach to the phase-out of LIBOR, given the complexities involved, regulators and the industry have not yet identified a consensus approach. Chatham has been participating in these efforts by engaging with regulators and participating in International Swaps and Derivatives Association (ISDA) and the Alternative Reference Rates Committee (ARRC) working groups.
The amount of economic activity tied to LIBOR and the complexity of transitioning away from it means that the transition to alternative rates needs to begin well before December 31, 2021. A critical part of that transition will involve reviewing and updating LIBOR language in loan and derivative documentation. To prepare for the likely transition, Chatham has outlined important factors to consider in loan documentation when grappling with the future unavailability of LIBOR.
Review of LIBOR-related terms
In commercial loan documentation, LIBOR is typically defined by reference to a specific Fixings Screen at a certain time (e.g., Bloomberg Office ICE LIBOR Fixings Screen LIBOR01 Page at 11:00 a.m., London time). While typical LIBOR definitions will include a fallback to request quotes from polling banks if the Fixings Screen is not available, were LIBOR to be temporarily or permanently discontinued, polling may not be a viable fallback option. As a result, market participants are encouraged to incorporate more robust fallback mechanisms into their loan documentation.
- Polling language should be reviewed carefully: Even if polling language is incorporated into the LIBOR definition of the loan agreement, additional fallbacks should be considered to account for the permanent cessation of LIBOR.
Once the LIBOR definition has been reviewed, the next step is to determine how the loan agreement addresses the potential unavailability of LIBOR. These unavailability clauses dictate the scenarios when the fallback provisions in the loan agreement are triggered and are commonly referred to as the “triggers”. As discussed further below, these triggers fall into two general categories: flexible and objective. There are benefits associated with each category, and market participants generally incorporate a combination of flexible and objective triggers into their loan documentation. Typically, the LIBOR unavailability triggers will be found as a subsection within the Interest Rate section of a loan agreement.
- LIBOR unavailability should be addressed: If the temporary or permanent cessation of LIBOR is not specifically addressed in a loan agreement, it is advisable to incorporate language addressing the unavailability of LIBOR in the loan agreement.
- If flexibility and alignment with the market are priorities, flexible triggers should be considered: Many market participants prefer to have the ability to potentially move to a substitute rate before LIBOR is permanently discontinued. As recommended by the ARRC, it may be preferable for loan agreements to contain pre-cessation triggers, such as conversion to a substitute rate being based on when the conversion of similar loans in the same market is happening.
- If certainty is a concern, LIBOR unavailability should be triggered by objective, verifiable criteria: Common objective LIBOR unavailability triggers include: 1) LIBOR permanently ceases to be published (e.g., the LIBOR administrator announces its indefinite discontinuation); 2) LIBOR is unavailable (e.g., banks are not providing LIBOR quotes); or 3) LIBOR is illegal. Unavailability provisions should be triggered by objective criteria. Triggers based on subjective criteria (e.g., “lender in its sole and absolute discretion shall have determined that LIBOR is no longer available”) should be avoided.
- Alignment with derivatives should be considered: If market participants are hedging loans with derivatives, they should take into consideration any potential mismatch in timing between the triggering of LIBOR unavailability provisions in their loan agreements versus in their related derivatives documentation.
It is critical to determine the substitute rate selected in the event of the unavailability of LIBOR. To date, there is no market consensus regarding a standard substitute rate definition. A common formulation of the substitute rate language is to include language that contemplates where LIBOR unavailability provisions are triggered, LIBOR first to fall back to either PRIME or Fed Funds, unless and until the substitute rate defined in the loan agreement is available. Different substitute rate definitions are possible, and regulatory and industry efforts to provide a standard substitute rate definition are ongoing. Considerations for the substitute rate definition include:
- Flexibility and alignment with the market are priorities for some market participants in choosing a substitute rate: Some market participants prefer to keep substitute rate definitions as broad as possible, providing flexibility in loan agreements to allow whatever fallback rates are ultimately adopted by the marketplace to be effectively incorporated into the loan agreement.
- Certainty and predictability may be priorities for other market participants: Market participants that are more concerned with having certainty upfront about what the substitute rate will be may prefer substitute rate definitions that cite a specific rate, index, or the future determination of a substitute rate by a specific committee or organization.
- Alignment with derivatives should be considered: To reduce the likelihood of a mismatch between the loan’s fallback and the fallback of the derivative product hedging that loan, a fallback referencing the commercially accepted rate endorsed by both the industry and ISDA should be included.
- Substitute rates may be defined in different ways and in different places within loan agreements: Substitute rates may be included with the LIBOR unavailability trigger language or within the definitions section of a loan, and they may be under a number of different names, including “Alternate Index”, “Alternative Index”, “Replacement Rate”, and “Substitute Rate”.
Loan Spread Adjustment
Market participants should review any spread adjustments contained within a loan agreement. A common refrain from many industry participants and government officials is that there should be little to no value transfer arising solely from the transition from LIBOR to the replacement rate. Spread adjustments are one mechanism to reduce the amount of value transfer associated with the LIBOR transition. At issue is that LIBOR, SOFR, and other proposed replacement rates are not directly comparable. There are two primary causes of this incomparability. First, LIBOR is an unsecured reference rate that incorporates a level of credit risk whereas SOFR is a secured, overnight rate that is seen as “risk-free”. Second, LIBOR is most commonly quoted using a term structure (e.g., one-month, three-month, six-month) whereas SOFR is an overnight rate and a term structure does not currently exist for SOFR.
As the market has begun contemplating LIBOR transition in its loan documentation, one development is that many loan agreements have begun including loan spread adjustments. These adjustments are typically a one-time adjustment to the spread when the substitute rate is triggered based on the spot difference between LIBOR and the substitute rate. For example, if the substitute rate is triggered and, at that time, LIBOR is 1.25% and SOFR is 1.00%, then the borrower spread would increase by 25 basis points (0.25%). Additionally, many spread adjustment clauses will include a floor in the adjustment. This floor language provides that the spread adjustment cannot be a negative number, meaning that the borrower’s spread will only go up or remain the same and will never go down due to the spread adjustment. Even where a floor is not included in the spread adjustment and the substitute rate results in a reduced basis between LIBOR and the substitute rate over the remaining term of the loan, there could still be an increased borrowing cost once the cost of the loan spread adjustment is added into the equation. To avoid or at least minimize value transfer, a loan agreement’s spread adjustment needs to be reviewed to see how it would change the economics of a transaction in the event of LIBOR unavailability, including whether a floor is included in the spread adjustment.
- Alternatives to the spot-spread methodology should be considered: Loan documentation may include a spot-spread adjustment methodology; however, Chatham would advise clients to carefully consider this method before agreeing to it due to the observed volatility between LIBOR and SOFR. As illustrated in the graph below, when using the spot-spread methodology, variations in SOFR create the potential for significant value transfer solely because of the selection of an arbitrary calibration date. As evident in the ISDA consultation fallback results, many market participants favor a historical mean/median methodology which captures the cyclical nature of markets and, over time, reverts to the mean. It is important to note however that SOFR only has been published since April 2018 and therefore data used to calculate historic mean/median is currently limited and as markets continue to evolve, the mean/median data observed in that data may ultimately change between today and the date LIBOR is discontinued.
Lender Required Hedging Provisions
Consideration should be given to how provisions requiring hedging are drafted in a loan agreement. Clients swapping floating rate loans may want to carefully consider or take steps to ensure that the fallback language in the loan and the derivative match exactly. Two possible techniques are (1) to align the fallback in the loan to match the fallback language in the hedge documentation, or (2) to attempt to negotiate bilateral provisions in the swap confirmation that match the loan. If there is a mismatch in the fallback language between the loan agreement and the hedge documentation, the potential for a mismatch between the rate or index used in the loan agreement versus that used in the hedge in the event of LIBOR unavailability must be considered. Using interest rate caps as another example, provisions that define items like a required strike price/rate as a fixed number based on a LIBOR index should be reviewed. To avoid a potential mismatch, the cap’s strike price should be relative to the index used to calculate interest in the loan. For example, hedging requirements could be tied to the level of debt service coverage required in the loan agreement rather than a specific number. Other terms that may be desirable are those that allow for an existing hedge to be amended to reflect the substitute rate, rather than the hedging agreement being required to be completely replaced.
In addition to reviewing any lender-required hedging provisions, consideration also should be given to any additional amendments that may need to be made to the loan agreement. The general structure of certain terms within the loan agreement are based upon the assumption that the reference rate will have a term structure associated with it (e.g., having the rate set at the beginning of the term period). Transitioning to a reference rate that has an overnight structure may require certain amendments to conform the other terms in the agreement to an overnight structure. Consideration should be given to any additional amendments that may need to be made to modify these existing terms so that they are compliant with an overnight reference rate.
These are some of the issues that should be considered as market participants prepare for the unavailability of LIBOR and the resulting impact on loans and derivatives. It is not meant to be an exhaustive list, but rather to provide a sense of the complexities in loan documentation related to the unavailability of LIBOR.