By the end of October 2020, lenders are expected to start taking a “hard-wired” approach to replacing the benchmark interest rate for new loans with LIBOR-based interest rates. This is according to the ARRC Recommended Best Practices Update for Completing the LIBOR Transition, released on September 3, 2020 by the New York Fed Alternative Reference Rates Committee (“ARRC”). The target date for the transition to a hard-wired approach for syndicated loans was September 30, 2020, and the syndicated market has already seen its first implementations of the new language. As the suggested maturity date approaches for bilateral loans, lenders active in this space should be prepared to use the hard-wired approach in their own loan documents. But what is the hard-wired approach and how does it differ from the benchmark alternate language currently found in most bilateral lending documents?
Current Status of Benchmark Replacement Arrangements
First convened in 2014, the objective of the ARRC is to facilitate the transition from LIBOR to the Guaranteed Overnight Funding Rate (“SOFR”) as the benchmark interest rate. The committee has periodically issued recommended contractual language governing this transition for inclusion in supporting documentation for a variety of non-derivative credit products. The ARRC published its first set of recommendations for fallback language in the LIBOR-based Bilateral Commercial Lending Documents in May 2019 (the “2019 Fallback Language”). Fallback Language 2019 featured two alternative approaches to replace LIBOR: the “amendment approach” and the “hard-wired approach”.1
So far, the syndicated and bilateral loan markets have largely favored the amendment approach. The amending approach does not establish in advance what the replacement interest rate will be – instead, it identifies specific triggers for when the loan will stop using LIBOR, establishes a process for simplified modification whereby the lender (in some cases with or without the consent of the borrower)2 may modify loan documents to incorporate an alternative benchmark interest rate, and establish general parameters for how that alternative rate will be selected and implemented. The amendment approach has the advantage of being simple to record in the loan documents and of retaining great flexibility in the choice of a replacement benchmark rate. This flexibility was particularly important given that there was still substantial uncertainty about how SOFR would be operationalized upon adoption of the 2019 fallback language.
A downside of the amendment approach is that it may not produce a truly neutral replacement of the index rate – there may be an opportunity for lenders (or borrowers, in transactions in which the borrower has consent rights on the LIBOR Replacement Amendment) to exploit then prevailing market conditions and trading leverage to force a replacement rate that unfairly favors one party over the other. The amendment approach also presents an operational challenge since, upon transitioning out of LIBOR, the lender would have to separately negotiate and execute changes to the documentation for each of its “amendment” loans simultaneously.
In view of these drawbacks, the ARRC has updated its recommended fallback contractual language on August 27, 2020 (the “2020 fallback language”). The new 2020 fallback language completely abandons the modifying approach and instead exclusively offers the wired approach. As the market is expected to shift to the hard-wired approach, lenders will need to understand how the hard-wired approach will work in their loan documents.
How the wired approach works
Under the hard-wired approach, upon the occurrence of specific trigger events, loan documents will automatically replace LIBOR with a predefined successor interest rate. Due to the continued uncertainty as to which SOFR-based rates will be available at the time of transition, the successor interest rate is determined by going through a cascade of defined successor rates – if the first successor rate specified in the cascade is not available, the second specified successor rate will be used unless it is also unavailable, in which case the specified third successor rate will be used. The hard-wired approach also discusses how the chosen successor rate will be adjusted to provide a neutral replacement for LIBOR, as well as how technical changes can be made to the loan documents to reflect the adoption of the new rate.
The replacement of the interest rate in the hard-wired approach is initiated by one of the many trigger events. “Cessation triggers” correspond to the actual ceasing of LIBOR as a published index rate, as indicated by a public announcement to that effect by the administrator of the LIBOR (the Intercontinental Exchange Benchmark Administration) or specified regulators. . There is also a ‘pre-termination trigger’ in the event that LIBOR is still published but applicable regulators have publicly announced that the quality of the published LIBOR rate has declined to the point that it is no longer representative of the. underlying economy or market. reality. The final trigger is an ‘early opt-in’, which can be activated voluntarily by the lender if the market has already started adopting SOFR-based interest rates even though LIBOR is still available (as measured by the Lender’s determination that a number of unrelated but similar loan transactions have been executed using SOFR).
Alternative benchmark interest rate cascade
Following a trigger event, the benchmark interest rate will automatically be replaced by the first of the following alternatives (in the following order) which can be determined by the lender: (1) Term SOFR, (2) Daily Simple SOFR, and (3) an alternative benchmark rate chosen by the lender. “Term SOFR” is the SOFR-based term rate for the applicable interest period chosen by the ARRC or its successors. If no selection has taken place at this time, the next alternative, “Daily Simple SOFR”, will be used.3 The simple daily SOFR is the daily retrospective rate determined from the overnight Treasury repo market applied against the principal overdue for each day of the interest period. The overnight SOFR rate is currently available, but if for some reason it cannot be determined at the time of transition, the cascade switches to another benchmark selected by the lender. Optional provisions included in the Fallback Language 2020 may be inserted to require the lender to select the alternative rate based on ARRC recommendations or market custom then in effect, and to provide the borrower with certain consent rights. on the selected rate.
The cascade described above is based on the stock provision in the 2020 fallback language. However, there is some discussion in the guidelines about alternative steps (such as “SOFR compound daily” or “SOFR average”) which can be included in the cascade to suit particular lenders or transactions.
Spread adjustment cascade
After selecting a replacement benchmark interest rate, the hard-wired approach then seeks to establish a spread adjustment to increase or decrease the successor rate to match the equivalent LIBOR rate. If Term SOFR or Daily Simple SOFR will serve as the replacement benchmark interest rate, there is another cascade of alternative spread adjustments: (1) the spread adjustment selected by the ARRC or its successor, then (2) ) the spread adjustment selected by the ISDA. If, instead, the alternative benchmark rate determined by the lender was selected, the lender also selects the spread adjustment.
The hard-wired approach is designed to mechanically produce an alternative benchmark interest rate without the need for further negotiations by the parties. However, after the determination of the new rate, there will likely be minor technical, administrative or operational changes to certain provisions of the loan documents necessary to allow administration of the new rate. Fallback Language 2020 allows the lender to make these changes in accordance with the loan agreement unilaterally at or after the transition to the new rate.
As we move closer to the LIBOR phase-out expected at the end of 2021, it will become increasingly essential for lenders to implement effective LIBOR replacement provisions in their documents to ensure a smooth transition. smooth and predictable. Current ARRC guidelines suggest that the wired approach is the preferred approach to achieve this goal, and we should expect the wired approach to be widely adopted in the market.
As we expect the new LIBOR-based loans created in the last quarter of 2020 and throughout 2021 will increasingly favor a hard-wired approach to replacing LIBOR, an interesting question every lender will need to consider. is whether to modify its existing loans to install wired LIBOR. replacement provision. Many institutions have already invested considerable energy in updating their operational loan documentation to include an alternative provision based on an amendment approach, and in some cases (particularly those where the lender is already entitled one-sided to select the replacement index rate), they may prefer to continue relying on the modification approach without the expense and difficulty of modifying documents again to put in the wired approach. We will be monitoring this area closely to see if a market consensus emerges. The two sets of ARRC fallback languages discussed here also include a “covered loan approach” intended to be used for transactions where the interest rate is fully hedged against a derivative using the recommended benchmark alternate language promulgated by the ‘International Swaps and Derivatives Association (“ISDA”). The ISDA definitions that will be used in derivative contracts are slightly different, and the hedged loan approach adjusts the wording of the proposed fallback contract to align with the ISDA approach. The current approach to covered loans defined in the Fallback Language 2020 is fundamentally similar to the hardwired approach, rather than an amendment approach, and therefore the discussion below on how the hardwired approach works is still generally applicable to the current approach to covered loans.  The Fallback Language 2019 provides options for both a unilateral lender modification right (whereby the lender can modify the loan document to implement the alternative interest rate chosen by the lender without further consent from the lender. ‘borrower) or, alternatively, a “negative consent” approach to the rider (whereby the lender offers a rider implementing the replacement interest rate chosen by the lender that does not automatically come into effect unless the lender borrower does not object within five to ten working days). We have also seen wordings of this provision in the market calling on the borrower and lender to negotiate and mutually agree on an amendment to replace the index rate.  The 2020 fallback language use of the simple daily SOFR as the second step in the cascade is a change from the 2019 fallback wired approach, which used the compound SOFR in this position.