USD LIBOR Reform

ARRC recommendation

It is expected that as from 30 June 2023, the ICE Benchmark Administration (IBA), responsible for overseeing LIBOR, will cease to publish USD LIBOR rates. Market parties will therefore need to use alternative benchmark interest rates for USD denominated loans and other financial products that currently use LIBOR.

On 21 July 2021, the US based Alternative Reference Rates Committee (ARRC), a group of private-market participants convened by various US financial market authorities to help ensure a successful transition from USD LIBOR to a more robust reference rate, formally announced its support for forward-looking Secured Overnight Financing Rate term rates (SOFR Term Rates) produced by the CME Group as an alternative to USD LIBOR rates used in bilateral or syndicated commercial loans.

The SOFR Term Rates are in addition to the already recommended "in arrears" SOFR rates and the SOFR Averages (Applied in Advance) rate. An important difference between The SOFR Term Rate and the SOFR Averages (Applied in Advance) rate, is that the SOFR Term Rate is a real term rate. The SOFR Averages (Applied in Advance) rate are averages that reflect the overnight SOFR rates from the prior period, but these rates can be transparently applied in advance of the upcoming interest period.

The ARRC commented that the SOFR Term Rates will be especially helpful for the business loans market (particularly multi-lender facilities, middle market loans, and trade finance loans) where transitioning from LIBOR to an overnight rate has been difficult.

Practice

The Financial Times reported on 13 September 2021 that Bank of America had launched the first leveraged loan with an interest rate that is based on SOFR Term Rates. Apparently, the terms of the loan provide that the interest rate will from the end of 2021 be based on SOFR Term Rates if possible from an administrative perspective, or otherwise on the daily SOFR rate. 

One of the issues perceived by market participants with the originally recommended SOFR based interest rates was that, in contract to LIBOR rates, they were backward rather than forward looking. This change had a considerable impact on the treasury operations of borrowers and lenders, since the amount of interest payable on a loan could not be predicted in advance of an interest period.  It is expected that, by introducing SOFR Term Rates as well as the SOFR Averages (Applied in Advance) rate, this will no longer be a reason to postpone the move to SOFR based interest rates.

Recommended rates

Two different forms of SOFR term rates are recommended by the ARRC: SOFR Averages (Applied in Advance) and SOFR Term Rates. The differences between the rates are that they are provided by two different reference sources and reflect two different time periods.

SOFR Averages (Applied in Advance)

The SOFR Averages for 30, 90 and 180 days are published by the Federal Reserve Bank of New York (FRBNY). ARRC recommends the use of 30-day average for all tenor periods, as the shorter observation period ensures a more current rate. The publication of SOFR Averages follows the FRBNY publication schedule of SOFR. SOFR Averages are based on number of calendar days rather than number of months, i.e., 30/90/180 days; however, a SOFR Average rate can still be used for interest payment periods based on number of months, for example by using the 30 days SOFR Average for an interest period of one month.

SOFR Term Rate

The CME Group Benchmark Administration Ltd currently publishes one-month, three-month and six-month Term SOFR Rates. CME's SOFR Term Rates will be calculated for each day the FRBNY calculates and publishes SOFR.

Conventions

The ARRC has also published conventions for the use of SOFR term rates in bilateral and syndicated commercial loans, which are broadly similar for both term rates.

It recommends the inclusion of a temporary fallback convention be included in the event that either the SOFR Averages or Term SOFR (or the relevant tenor thereof) are not published for a short time. It furthermore recommends using the rate published two US Government Securities Business Days prior to the first day of the interest period and that such rate is then held for the entirety of the interest period. This is similar to the LIBOR convention today. The recommended day count fraction for both rates is Actual/360 days. It is further recommended to use the "Modified Following Business Day" convention.

Given that the move from LIBOR rates to a risk free rate, such as SOFR, may result in a credit spread adjustment for legacy loans, the ARCC recommends to use a static spread adjustment recommended by either the ARRC or ISDA for the appropriate tenor. Such spread adjustment is the published five-year historical median difference between LIBOR and SOFR and were set on 5 March 2021. The spread adjustment would be applied to Term SOFR or SOFR Averages (if selected as the fallback rate) and would follow the LIBOR tenor.

Further action

Although the availability of a forward-looking USD term interest rate is an important step, market parties with legacy loans still face a number of challenges as a result of the LIBOR transition. These include for example:

• The inclusion of interest rate provisions in loan documentation that reflect the new benchmark rate, its conventions and fall-backs.
• The need for credit spread adjustment due to the different risk profile of the benchmark rate.
• Identification of "linked" financial products (such as derivatives) and mitigating the risk of mismatches as a result of the use of different benchmarks and credit spread adjustments.

Market parties should not underestimate the time and effort it will take to ensure that legacy financial products will be properly prepared for the LIBOR cessation. For example, the consent of parties may be required for any changes that are to be made to the transaction documentation. Even where the documentation already provides for alternative benchmarks, action will still need to be taken to implement the changes. Furthermore, discussions can arise about the interpretation and application of the transition provisions included in the transaction documentation, for example in the context of linked products or the timing of the transition.