LIBOR Transition: Do Recent Credit Agreements “Adequately and Fairly” Reflect the ARRC’s Fallback Provisions?
What is the issue?
Two years after Andrew Bailey’s speech that appeared to announce the end of LIBOR, regulators in the U.S. and the U.K. continue efforts to persuade market participants that LIBOR will no longer be available after 2021. In the U.S., the Alternative Reference Rates Committee (ARRC), a group of private-market and public-sector participants, was convened by the Federal Reserve Board and the New York Fed to help ensure a successful transition from U.S. dollar LIBOR to a more robust reference rate. The ARRC has now recommended a new alternative rate, the Secured Overnight Financing Rate (SOFR).
While the ARRC is strongly advising market participants to stop using LIBOR and start using SOFR, it recognized that LIBOR-linked instruments continue to be used. In order to mitigate the disruptions related to the transition away from LIBOR, the ARRC published (in April and May of 2019) recommended fallback provisions for various cash (i.e., non-derivatives) products, including syndicated loans and bilateral business loans.
The ARRC’s recommended fallback provisions generally provide LIBOR replacement procedures following one of several triggering events. Such triggers include, for example, an announcement that LIBOR has ceased or will cease to be published, or that it is “no longer representative.” The fallback provisions mainly follow two alternative approaches: a “hardwire approach,” which incorporates a pre-determined waterfall of replacement options, and an “amendment approach,” under which the new rate will be determined at the appropriate time.
While the loan markets have yet to adopt SOFR as a replacement benchmark to LIBOR, lenders and borrowers have started using the ARRC’s fallback provisions or variations thereof in credit agreements. However, in almost all cases credit agreements continue to contain other standard provisions that arguably are inconsistent with the ARRC provisions and should be removed.
These provisions typically suspend a lender’s obligation to “make or maintain” LIBOR-based loans under a credit agreement when the lender (or a majority of the lenders or the administrative agent) determines that LIBOR no longer “adequately and fairly” (or similar language) reflects the lender’s cost of funding (referred to here as the “cost of funding provision”). Such suspension results in the borrower’s inability to borrow funds based on LIBOR and shifting borrowing to an alternative rate, such as the Prime Rate, which could be more expensive for the borrower. Further, in some cases the consequence might be an obligation to repay the loan or convert it to a different rate under the agreement. The cost of funding provision would arguably enable a lender to circumvent the LIBOR fallback provisions by opportunistically ceasing to make and maintain LIBOR loans.
LIBOR was born 50 years ago as a novel way to make syndicated loans using a variable rate with inflation on the rise. The rate was recalculated periodically based on the cost of funds of the lending banks. This may explain the inclusion in credit agreements of a provision tying the use of LIBOR-based loans to the cost of funding. As LIBOR became hugely popular (there are $200 trillion of financial products tied to U.S. dollar LIBOR today), this provision became standard.
However, in recent years LIBOR became increasingly disconnected from its underlying market of unsecured interbank lending. That market today is very thin. For example, a recent estimated daily volume of three-month wholesale funding transactions by major global banks was approximately $500 million, very low compared to the $200 trillion mentioned above or to over $1 trillion of daily volume in the market underlying SOFR in recent months.
Indeed, that dwindling underlying market is one of the main reasons that LIBOR is ending. Put simply, and in the words of Andrew Hauser, Executive Director, Markets, of the Bank of England, “LIBOR … no longer accurately measures banks’ true cost of funding.”
Practical Implications -- Borrowers’ Perspective
In these circumstances, can a lender determine, at any time—and even immediately after signing—that it will no longer use LIBOR under the credit facility since it no longer adequately and fairly reflects its cost of funding? Such a determination would give a lender a free option under the agreement to abandon LIBOR at any time (and possibly switch to the Prime Rate or a different rate), without triggering a benchmark replacement process.
Borrowers may not fully understand the implication of this right, and they may not want to agree to a provision in a credit agreement that could result in an unexpected switch to a higher interest rate. And even if this is less likely to occur on “day one,” since LIBOR’s underlying market continues to weaken it would be easier for lenders to use this option as time goes by, and much earlier than borrowers may have anticipated based on the ARRC provisions.
It should be noted that the ARRC-recommended fallback provisions afford lenders a right to make an “early opt-in election,” triggering the benchmark replacement procedure, which lenders can use early in the LIBOR transition process. Since the ARRC contemplated an early trigger as part of its fallback provisions, a right to suspend the use of LIBOR early under the cost of funding provision without a replacement process included in the credit agreement seems to be contrary to the intent behind the fallback provisions.
Practical Implications -- Lenders’ Perspective
From the lenders’ perspective, the cost of funding provision could be useful in their LIBOR transition efforts. For example, under the ARRC-recommended fallback provisions for syndicated loans (as part of the “amendment approach”), the use of a replacement benchmark requires the borrower’s agreement. If the parties fail to agree, the cost of funding provision could be used to suspend the lenders’ obligation to make LIBOR-based loans even if LIBOR is still available at that time. However, as noted, the ARRC’s intention seems to have been to address any such concern through the fallback provisions, not through a “back door” approach.
More importantly, and while this goes beyond the scope of this article, lenders may find the cost of funding provision useful in “legacy” loan documents that do not contain any or adequate fallback provisions. Legacy instruments that did not contemplate a permanent cessation of LIBOR remain one of the most difficult obstacles in LIBOR transition. As lenders assess their options in addressing such instruments, provisions that allow a lender to suspend LIBOR lending if LIBOR does not reflect the cost of funding for the lender should be identified and considered as part of the LIBOR transition plan.
Lenders and borrowers do not have to use the ARRC’s recommended fallback provisions. But if they choose to do so, they should not only add those provisions, but also remove other inconsistent provisions. In our view, a provision that enables a lender to suspend LIBOR-based lending when it determines that LIBOR “no longer adequately and fairly reflects the cost to the lenders” is one such provision.
 The other products are floating rate notes and securitizations.
 A third alternative is a “hedge loan” approach, proposed for bilateral business loans.
 Based on our survey of credit agreements filed publicly after April 25, 2019, the date on which the ARRC published the recommended fallback language for LIBOR syndicated loans.
 While lenders would be expected to utilize such a right across their entire portfolio rather than on a case-by-case basis, borrowers may nevertheless be disadvantaged by such an action.
 As noted by Andrew Bailey in his 2017 speech: “data from IBA and from central banks indicate that there are relatively few eligible term borrowing transactions by any large banks – i.e. these banks receive few loans or deposits of a twelve, six or even three month term from other banks or eligible corporate depositors… The absence of active underlying markets raises a serious question about the sustainability of the LIBOR benchmarks that are based upon these markets.”
And as noted by IOSCO in a statement on July 31, 2019: “The issue with LIBOR is that the underlying market LIBOR seeks to measure, i.e. the market for unsecured, wholesale funding, has dwindled substantially, as banks no longer tend to borrow on such a basis.”
 In a speech on June 27, 2019, in London.
 Interestingly, the “amendment approach” fallback provisions recommended by the ARRC for bilateral business loans do not require such consent, although an optional negative consent of the borrower is proposed by the ARRC for the parties’ consideration.