Podcast: LIBOR Cessation Update
In this Ropes & Gray podcast, Alyson Gal, Milap Patel and Jill Kalish Levy discuss recent developments in the long-awaited LIBOR cessation. In particular, our attorneys analyze the rationale and impact behind its newly announced bifurcated rollout.
Jill Kalish Levy: Hello, and thank you for joining us today for this Ropes & Gray podcast. My name is Jill Kalish Levy and I am a knowledge management counsel in the finance group at Ropes & Gray. I have with me here today, Alyson Gal, a partner in the finance group, and Milap Patel, who is counsel in the finance group. We are here to talk about the current state of play in the world of LIBOR cessation and help everybody get up-to-speed on what is happening right now. Milap, would you like to share some background about the recent developments to get us started?
Milap Patel: Sure, Jill, I would be happy to do so. The move away from LIBOR has been creeping towards us somewhat slowly since the United Kingdom’s Financial Conduct Authority—otherwise referred to as the FCA—announced back in 2017 that this was going to happen. However, it took a very significant step forward on March 5th of this year. On that day, the FCA and the ICE Benchmark Administration confirmed the timing of LIBOR cessation, so that market participants now know with certainty when the end of LIBOR will actually be. The lack of certain timing has likely been a key factor in parties not moving with great speed to address this imminent event. The hope now is that the market will focus on LIBOR cessation in anticipation of the dates that have been set.
Jill Kalish Levy: That makes sense. Milap, I believe the timing for LIBOR cessation will now be phased, which was not originally the plan. Is that your understanding as well?
Milap Patel: That’s right, Jill. Originally, all of LIBOR was scheduled to become unavailable at the same time, but that is not the case anymore. With respect to USD LIBOR, 1-week and 2-month USD LIBOR will not be available after the end of this year, but all other USD LIBOR settings will continue until the middle of June 2023 and will be available for LIBOR-based debt agreements entered into before the end of this year. For all other forms of LIBOR (such as GBP, EUR, CHF, and JPY), LIBOR will cease to be published after December 31 of this year.
Milap Patel: It was based on a number of factors. I believe the reality was that various regulators did not think the market as a whole would be ready to move off LIBOR completely at the end of this year. The idea is that new loans will hopefully begin to be issued using LIBOR’s presumptive replacement, the Secured Overnight Funding Rate—otherwise known as SOFR—during the second half of this year. Those initial issuances will hopefully help to iron out any kinks or concerns and establish a SOFR market, and then legacy contracts will follow.
Jill Kalish Levy: I would agree with that assessment, Milap. The other reason for the bifurcated timing was to allow more time for the LIBOR legislation proposed by the Alternative Reference Rate Committee—or the ARRC—to pass in New York and potentially other jurisdictions as well. The legislation had been submitted last spring, but the timing for its passage and enactment were delayed due to COVID. Allowing legacy contracts to use LIBOR for a longer amount of time gives more time for the legislation to be available to act as a safe harbor for those tough contracts that don’t contemplate the end of LIBOR and can’t be easily amended.
Alyson Gal: Yes, I had heard that the ARRC legislation had passed. I have also heard that it is expected to be challenged on various grounds, including being in conflict with the Trust Indenture Act and potentially presenting some constitutional issues since the legislation modifies contracts without the consent or participation of any of the contract parties.
Jill Kalish Levy: Yes, there was a good deal of discussion in the market about those potential challenges. We’ll need to wait and see if anybody actually brings them to court, and if so, how a judge will handle them. In any case, having USD LIBOR for longer definitely permits more time for all of that to be sorted out. But Milap, does the new timing mean that existing LIBOR-based contracts will really continue to live on LIBOR for another two years?
Milap Patel: Well, no one really knows how this exactly will play out, but we do know that most financial institutions and many of our clients have expressed a desire to have all of their portfolio on one reference rate. So, we have to assume that once SOFR originations get rolling, banks and funds are going to want to move everything they hold from LIBOR to SOFR. I think we can envision a scenario in which there is an initial round of SOFR-based issuances, and then, once it picks up speed, the rest of the market will move over.
Alyson Gal: That sounds like a more workable plan than having everything tied to LIBOR switching to SOFR at the same time. What has the impact of all of this been on loan documentation? I know the ARRC had originally proposed fallback language in both an “amendment-style” approach and a “hardwired” approach, the former of which would require borrower and lender consent, and the latter of which allows the agent to move the credit off LIBOR unilaterally. What is happening now with those provisions?
Milap Patel: That’s correct, Alyson. The original fallback language proposed by the ARRC in 2019 did have those two iterations of “amendment-style” vs. “hardwire-style.” The ARRC published updated language in June 2020, but they only updated the “hardwired” version so as to encourage its adoption. Along with its other announcements made on March 5th, the Federal Reserve made clear that all loan agreements should have the “robust” fallback language by the second half of this year. The term “robust” has been interpreted to mean “hardwired.” Since those announcements, pretty much every syndicated lender has been pressing for adoption of the hardwired approach in both new deals and amendments to existing deals. We have even seen an increase in hardwired language in the direct lending world. I think we will only see more of the hardwired approach as each week brings us closer to the end of the year.
Jill Kalish Levy: I agree with you again, Milap. So at this point, what are some of the main sticking points of the hardwired language that parties are negotiating given the new pressure to adopt it?
Milap Patel: Borrowers try to restore some of their consent rights that the hardwired approach does not provide for them, such as consent rights over the determination of whether it is time to move off of LIBOR and in respect of changes to be made to the agreement to effect that transition. The other major negotiated issue is the addition of what have been called the “flip forward” provisions. Those provisions allow the loan to adopt Term SOFR if and when it comes available at some point in the future. Term SOFR is expected to be a forward-looking rate based upon a term curve, and would allow borrowers to know and lock in an interest rate for a specific term at the beginning of such term, just like LIBOR does.
Jill Kalish Levy: I see. It will be a big transition for lenders and borrowers to not know the rate at the beginning of the interest period.
Alyson Gal: It definitely will, and I hear from many clients that it is causing a good deal of consternation because LIBOR operates so differently than SOFR. The other distinction between the two reference rates is that SOFR does not reflect the cost of funds as LIBOR does. That’s another major difference between them and the reason we need a spread adjustment in order to make SOFR look more like LIBOR. Milap, is anybody talking about alternatives to the various versions of SOFR? I know people were discussing that at the beginning of this process.
Milap Patel: In fact, the LSTA just recently printed a Market Advisory which provides a rider to the ARRC hardwired language, which would include the ability to move to a “credit-sensitive-rate” once it becomes available—otherwise referred to as a CSR. Apparently, there are at least four other reference rates being developed for use that do reflect the cost of funds and the LSTA is sanctioning the inclusion of such rates as options in the fallback provisions.
Jill Kalish Levy: It sounds as though even though much of the market has coalesced around SOFR as a replacement for LIBOR, there are still some parties who are looking for other options.
Milap Patel: That's right, Jill. There have been factions all along that have insisted that SOFR is too different from LIBOR to replace it, and those voices have apparently not diminished with time.
Alyson Gal: So what does all that mean for a transition that is so imminent, Milap?
Milap Patel: It is hard to know. We believe the majority of the market will eventually be on SOFR, but time will tell. The first step is for syndicated debt to be issued using SOFR and the corresponding SOFR spread adjustment to calculate the interest rate. Once that starts to happen, hopefully it will have a domino effect and other credits will follow suit. If that can happen, things will become clearer and more standardized pretty quickly, and thus, we will be closer to having this transition behind us.
Alyson Gal: It sounds like the loan market has some work to do before this is over. Can you talk a bit about what’s been happening in the world of derivatives as far as LIBOR is concerned? Where are ISDA-governed contracts in this process?
Milap Patel: Sure. In the world of swaps and hedges, things are a bit simpler and it would seem, less contentious. Unlike loans, where parties to loan agreements are negotiating and incorporating a wide-range of fallback language, the fallback language in the ISDA world was
standardized and set forth in a supplement to the 2006 ISDA Definitions and the ISDA 2020 IBOR Fallbacks Protocol. The Supplement took effect on January 25th of this year and amends the terms of new transactions entered into from that date that incorporate the 2006 ISDA Definitions. The Protocol amends the terms of legacy transactions entered into prior to that date that incorporate the Definitions, but only if both parties to the applicable transaction have adhered to the Protocol. ISDA has also published bilateral templates that may be used to customize the application of the changes covered by the Protocol and the Supplement, by adding additional provisions and tailoring the scope of agreements covered. As a result of the announcements, the transition for all over-the-counter derivative contracts that reference USD LIBOR that have been amended by the Protocol and also for all over-the-counter derivative contracts that were entered into after January 25, 2021 that incorporate the 2006 ISDA Definitions, is expected to happen on July 1, 2023. That date obviously syncs up with the final date of LIBOR availability for loans.
Alyson Gal: It's a great fact that the ISDA market has made so much progress on this issue. But my understanding is that there are still a number of disconnects between the world of swaps and hedges and the world of loans in respect of LIBOR cessation. Have you heard that as well?
Milap Patel: Yes, that is correct. There are a few issues that still require better understanding, and potentially, resolution. One issue is that ISDA-governed products that adhere to the Protocol will use SOFR Compounded in Arrears, which loans do not use. Loans may use Daily Simple SOFR, or perhaps in the future, Term SOFR, or maybe even one of the CSRs that I described earlier, but they are not expected to use SOFR Compounded in Arrears. The impact of loans using one version of SOFR, and swaps and hedges of those loans using another version of SOFR remains to be seen, although I should mention that the ARRC and others have stated that the impact of such difference is expected to be minimal.
Jill Kalish Levy: I had heard about that as well. The other issue is timing. Loans have the ability to opt in to SOFR (or another replacement rate) before June 2023, but the Protocol does not offer that flexibility. That could create a scenario where loans transition to a different reference rate, but the swaps and hedges of those loans do not transition at the same time. It seems as though that would be very challenging to administer, and in nobody’s benefit.
Alyson Gal: So what can borrowers do to try to get ahead of these potential problems as between their loans and their swaps and hedges?
Jill Kalish Levy: I wish we had a clearer answer, but this is all still developing. I would say it’s very important for borrowers to initiate and maintain dialogue with their lenders and swap and hedge providers about the internal plans that those counterparties have for LIBOR cessation and the expected impact on those contracts. Borrowers should especially focus on doing that in the context of any loans which have terms that actually require them to swap or hedge the debt.
Milap Patel: That is all correct, Jill. There are differences in how various asset classes are managing the end of LIBOR, which is something the markets and the ARRC are still grappling with. As the end of the year approaches, conversations about these issues and hopefully resolution of these issues should be expected to accelerate, so that ideally, we will come to a good outcome for all (or most) market participants.
Alyson Gal: I echo that optimism, Milap. Thank you both for all of this very helpful information. It is great to stay current about this very dynamic topic. For more information on the topics that we’ve discussed or other topics of interest to the finance community, please visit our website, www.ropesgray.com. And of course, if we can help you navigate any of the topics we've discussed, please don't hesitate to get in touch. You can also subscribe and listen to this series wherever you regularly listen to podcasts, including on Apple, Google and Spotify. Thanks again for listening.