LIBOR Fallbacks- Alternative Reference Rates
Insight Douglas J. Schneller · Fred Chang · Q. Scott Kaye · Emma R. Larson · Robert Q. Lee · Suzanne L’Hernault · Lisa-Marie Monsanto · Yaacov P. Silberman · Patrick Maschio · May 20, 2019
LIBOR Fallbacks: What’s Next After LIBOR?
At the end of 2021, the London Interbank Offered Rate (“LIBOR”) may cease as a reference interest rate. For years LIBOR has served as the leading baseline reference interest rate for loans and other financial instruments such as floating rate notes. In order to minimize or avoid loan market uncertainty or disruption after LIBOR ceases, there has been a need for an alternative reference interest rate to LIBOR (i.e. LIBOR fallbacks).
On April 25, 2019, the Alternative Reference Rates Committee (“ARCC”) released its recommended LIBOR “fallback” language for USD loans and floating rate notes. Although some loan agreements include an alternative reference interest rate in the event LIBOR is not available, such alternatives may be expensive for borrowers or may not reflect a lender’s cost of funding.
For syndicated loans, ARRC recommends two different fallback approaches, the “hardwired approach” and the “amendment approach.” Under the hardwired approach, a LIBOR fallback would be included in the original loan agreement. If LIBOR ceases, the loan agreement reference interest rate would switch to either a forward-looking term SOFR or a compounded average of daily SOFRs, in each case plus an adjustment, or spread, reflecting market conditions and the credit risk of the borrower.
Under the amendment approach, lender and borrower would work within a recommended framework to select a successor reference rate plus spread, and amend the loan agreement accordingly. The amendment approach contemplates that the parties will give appropriate consideration to recommendations by relevant governmental bodies or regulators, for example, the Federal Reserve Bank or Federal Reserve Bank of New York, or relevant market conventions.
The ARRC Recommendations include “opt-in” triggers that would allow lenders and borrowers to switch to SOFR before LIBOR becomes unavailable or ceases altogether.
As loan market participants begin contemplating a loan market without LIBOR, they may wish to consider related matters such as their current LIBOR exposure under existing loan agreements; whether the ARRC Recommendations are appropriate for all financial contracts or whether another LIBOR alternative is more sensible; whether and how to update their loan documents to include LIBOR alternatives; and whether their internal systems must be updated for SOFR or other LIBOR alternatives.
 In 2014 as a response to concerns about the reliability and robustness of LIBOR and other term wholesale unsecured bank borrowing rates, the Financial Stability Oversight Council and Financial Stability Board (“FSB”) called for the development of alternative interest rate benchmarks.” ARRC Recommendations Regarding More Robust Fallback Language for New Originations of LIBOR Syndicated Loans, April 25, 2019 (“ARRC Recommendations”), at 2.
 ARRC comprises private-market participants who are important players (including regulators) in markets affected by US dollar (“USD”) LIBOR. ARRC was convened in 2014 by the Federal Reserve Bank and the Federal Reserve Bank of New York to help transition markets from USD LIBOR to an alternative reference interest rate, the Secured Overnight Financing Rate (“SOFR”). “SOFR is a broad measure of the cost of borrowing cash overnight collateralized by U.S. Treasury securities and reflects an economic cost of lending and borrowing relevant to the wide array of market participants active in the financial markets. … However, SOFR is fundamentally different from LIBOR.” ARRC Recommendations at 34.