The London Interbank Offered Rate (LIBOR) has been used extensively as a reference rate across a broad spectrum of financial products and instruments for decades. With potential exposure to LIBOR estimated to be more than $400 trillion, questions naturally arose following the Financial Conduct Authority’s announcement that it would not compel banks to submit LIBOR quotations after 2021. The impact of this change reverberates across industries ranging from insurance and financial services to real estate, infrastructure, and innumerable other sectors.
The Alternative Reference Rates Committee (ARRC), working with the International Swaps and Derivatives Association (ISDA), has issued guidance with respect to the transition from LIBOR to the “secured overnight financing rate” (SOFR) with respect to a significant number of financial instruments, including Adjustable Rate Mortgages, Floating Rate Notes, Securitizations, Variable Rate Private Student Loans and Bilateral Business Loans (the “Loan Instruments”).
To facilitate the transition from LIBOR to SOFR, ISDA issued proposed amendments to the definitions of “floating rate options” in the 2006 ISDA Definitions. The proposed amendments include fallbacks that would apply upon the permanent discontinuation of LIBOR and upon a “non-representative” determination for LIBOR (i.e., a determination that even if LIBOR is being quoted, it no longer represents an accurate market-based rate).
In order to opt into the application of the referenced amendment, parties will be required to execute a “protocol” adopting the revised floating rate definitions. Once two counterparties have opted into the protocol, the amended floating rate option (i.e., the floating rate option with the fallback) will be automatically included in all transactions that incorporate the 2006 ISDA Definitions that are entered into on or after the date of the Supplement (i.e., the date that the 2006 ISDA Definitions are amended).
Transactions entered into prior to the date of the Supplement (so-called “legacy derivative contracts”) will continue to be based on the 2006 ISDA Definitions as they existed before they were amended pursuant to the Supplement, and therefore will not include the amended floating rate option with the fallback (such transactions, “Legacy Swap Transactions”). ISDA has published a variety of articles recommending the most practical approach to implementing the transition to SOFR from LIBOR for a majority of Loan Instruments. It is anticipated that all of the Loan Instruments (with the exception of bilateral Loan Agreements) will adopt a standardized approach to the adjustment of the related ISDA swap transaction to align the pricing adjustment in the Loan Instrument to the pricing of the swap.
As a complicating factor, legislative proposals from the United Kingdom (with respect to UK-based transactions) and the State of New York (with respect to US transactions) are now under consideration. These proposals would give effect, by operation of law, to the automatic conversion from LIBOR to SOFR together with a “spread adjustment” to preserve the original economics of the transaction. Note that no such legislation is being proposed at the US federal level.
Swap Transactions that are tied to the specific terms of a bilateral Loan Agreement (“Bilateral Legacy Swap Transactions”) have been negotiated on a bilateral basis and are tied to the specific terms of the related loan facilities. As such, Bilateral Legacy Swap Transactions do not lend themselves to conversion to SOFR by way of a generic “protocol”, nor by operation of law. Such Bilateral Legacy Swap Transactions are concentrated in the real estate and infrastructure sectors. The regional lenders who finance such transactions will also be impacted, not only with respect to the individual swap transactions, but also with respect to any portfolio hedging that may be in effect.
Future articles and alerts from Barton’s dedicated, multidisciplinary team will analyze the issues highlighted above in greater detail and supply practical guidance from various perspectives. In the interim, please feel free to contact the author of this article, Justine Clark, or any of the other members of Barton’s LIBOR Sunset Team: Christopher McNamara and Michael Ward.