Three Key Points

  • It is becoming increasingly clear that the Secured Overnight Financing Rate (SOFR) will be the preferred replacement benchmark rate to succeed LIBOR.
  • LIBOR fallback language (preferably “hardwired” fallback language) should be incorporated into any new LIBOR cash products (e., loans). The Alternative Reference Rate Committee (ARRC)—a group of private-market participants convened by the Federal Reserve Board and Federal Reserve Bank of New York—and the Loan Syndications and Trading Association (LSTA) have both published example fallback language referencing SOFR, with revised language to come from each soon.
  • Market participants need to start preparing now for the phase-out of LIBOR to reduce the risk of serious market disruption following LIBOR cessation.

Overview of Best Practices for Transitioning from LIBOR to SOFR

On May 27, the ARRC published its recommended best practices to assist market participants as they prepare for the cessation of LIBOR. With 19 months left until LIBOR could become unusable, the ARRC’s best practices are intended to help market participants’ transition away from LIBOR in a way that will minimize market disruption and support a smooth transition through the broad voluntary adoption of SOFR, which is ARRC’s recommended replacement benchmark rate.

The ARRC’s recommended guidance is:

Market participants should incorporate LIBOR fallback language into any new LIBOR cash products as soon as possible.

The ARRC’s recommended fallback language includes two alternatives:

  • The “amendment” approach, which contemplates the parties selecting a replacement benchmark rate and spread adjustment, with an amendment implementing the changes.
  • The “hardwired” approach, in which parties agree at the onset to a replacement benchmark rate and spread adjustment, determined by a waterfall of portions. For new business loans, the ARRC recommends that loan agreements incorporate “hardwired” fallback language no later than September 30, 2020.
Vendors should begin preparing to support SOFR.

As the ARRC has previously noted, third-party technology and operations vendors should complete all necessary enhancements to support SOFR by the end of 2020.

Market participants should stop using LIBOR as the benchmark rate in new LIBOR cash products.

The ARRC recommends that new use of LIBOR should stop, with timing depending on specific circumstances in each cash product market. For business loans, the ARRC recommends that participants cease the new use of LIBOR by June 30, 2021.

Market participants should determine and disclose their LIBOR replacement rate.

For contracts specifying that a party will select a replacement benchmark rate at its discretion following a LIBOR transition event, the determining party should disclose its planned selection to relevant parties at least six months before the date that such replacement benchmark rate would become effective.

Practical Takeaways for Institutions Transitioning from LIBOR to SOFR

While a Covenant Review study earlier this year found that in the fourth quarter of 2019 no new issue or amended institutional loans (including repricings) used the ARRC’s “hardwired” approach (and only 33% used the ARRC’s “amendment” approach),  we predict that the “hardwired” approach will be used more regularly, and likely will be standardized, as the industry narrows the focus to a single replacement benchmark rate (i.e., SOFR) and recognizes the operational risks posed by the “amendment” approach.

To the extent parties have not selected a specific replacement benchmark rate in their respective agreements or have otherwise followed the “amendment” approach, the parties should start conversations this year regarding the process to amend their agreements, especially if the agreement, absent an amendment, flips to a base rate index when LIBOR is discontinued.

If you have any questions about the transition away from LIBOR to SOFR and its impact on your business, please contact the author.