Executive Summary

• Nearly five years after the "end of LIBOR" was first announced, LIBOR transition is definitively in full swing in the U.S. loan market.
• LIBOR transition may seem mundane, but it has brought to the fore many mechanical, pricing, and operative provisions in loan documentation that previously were rarely given much attention.
• Despite regulatory pressure, new reference rate recommendations, and form language published by established industry organizations, interest rate provisions post-LIBOR in the U.S. loan market have been anything but uniform.
• With market participants selecting new reference rates, determining credit spread adjustments, and adopting other pricing and interest rate terms, nearly all interest rate-related terms are up for negotiation in non-LIBOR-based credit facilities.

LIBOR Transition Background

Many market participants may be hard-pressed to recall a time before LIBOR. The British Bankers’ Association launched LIBOR in 1986 for U.S. Dollars, British Pounds Sterling and Japanese Yen. In short order, LIBOR became the market standard reference rate in U.S.-law governed credit agreements and other financial contracts. However, in recent years, LIBOR became the subject of several scandals and criminal cases where, allegedly, financial professionals and others had manipulated LIBOR for personal financial gains.

As a result, in July 2017, the United Kingdom’s Financial Conduct Authority announced it would no longer require publication of LIBOR, effectively resulting in the cessation of LIBOR. Between 2017 and now, loan market participants, regulators and lawmakers worked together to prepare for “LIBOR transition”. In the U.S., the Alternative Reference Rate Committee (ARRC) selected the secured overnight financing rate (SOFR) as the replacement rate for USD LIBOR, and preparations began to develop interest rate conventions, methodologies, reporting, etc. for the various SOFR-based rates recommended for different financial contracts. Credit agreements began to incorporate LIBOR fallback provisions to specify the mechanics to replace LIBOR with a new reference rate and, over time (at least in some credit facilities), to include a hardwired waterfall of replacement rates to automatically replace LIBOR upon the occurrence of specified triggering events.

On March 5, 2021, the ICE Benchmark Administration and Financial Conduct Authority issued statements (the ICE / FCA Announcements) regarding the discontinuation of LIBOR. These statements detailed the date(s) when various LIBOR tenors would cease publication (most at the end of 2021) and urged market participants to ramp up LIBOR transition efforts. A few months later -- in July 2021 -- the ARRC formally endorsed Term SOFR to replace USD LIBOR for syndicated and bilateral business loans. Nonetheless, most deals in the U.S. loan market continued to use LIBOR as a reference rate well into 3Q21. It was only in 4Q21 that USD LIBOR transition accelerated, likely prompted by a looming year-end deadline both from (1) the Federal Reserve requiring that supervised institutions (such as regulated banks) cease entering into “new contracts” based on the LIBOR and (2) the end of publication of all tenors of CHF, GBP, Euro & JPY LIBOR and the one-week and 2-month tenors of USD LIBOR. According to S&P’s Leveraged Commentary and Data, by the end of January 2022, almost all new issuances in the syndicated loan market (i.e., over 98%) were SOFR-based. Other than incorporating a SOFR-based reference rate, interest rate related terms in such SOFR-based credit facilities have varied extensively.

1. To CSA, or Not to CSA

   When SOFR was announced as the replacement rate for USD LIBOR, there were concerns about whether it would be a truly comparable replacement. Historically, USD LIBOR was higher than SOFR, such that using SOFR in its stead would result in a lower interest rate and effective yield. While some borrowers may have welcomed this change, to address concerns about this differential, the ARRC indicated SOFR would need to include a credit adjustment spread (or CSA) such that the applicable SOFR-based rate plus the related CSA would approximate the replaced USD LIBOR for a comparable tenor.

   The ARRC recommended using a five-year historical median approach (calculated based on the difference between LIBOR and SOFR over this period), which initially prompted little to no objection from loan market participants. Market participants anticipated CSAs would be determined (and become fixed) once all USD LIBOR tenors ceased publication. Instead, following the ICE / FCA Announcements on March 5, 2021, Bloomberg published fixed CSAs using this methodology for the 5-year period preceding that date.

   Reception of the “Bloomberg fixed” CSAs was mixed at best. Some suggested using the date of the IBA / FCA Announcements (March 5, 2021) as the date of determination was artificial, particularly with USD LIBOR continuing publications for all tenors through the end of 2021 (and for most tenors through June 30, 2023). As SOFR and LIBOR became much closer in quantum throughout the rest of 2021, others (borrowers and sponsors in particular) worried using these values would increase borrowing costs. At certain points, SOFR-based rates that included the Bloomberg fixed CSAs were nearly double the corresponding USD LIBOR rate. To offset this disparity in borrowing costs, some deals in the syndicated loan market began to include lower fixed CSAs (most often, 10 basis points (bps) for one-month interest periods, 15 bps for 3-months, and 25 bps for 6 months, respectively). In short order, CSAs were being negotiated in most SOFR-based deals.

   As of April 2022 (based on proprietary tracking of publicly disclosed SOFR-based credit facilities), most SOFR-based, U.S. law governed credit facilities (i.e., over 75%) include negotiated alternative spread adjustments. Most often, the alternative CSA is 10 bps for all tenors (~40% of all such deals and over 1/2 of those with alternative CSAs), followed by CSAs of 10/15/25 bps for 1/3/6 month tenors (~25% of all deals and ~1/3 of those with alternative CSAs). The CSA may be set forth specifically or incorporated into the margin. When the CSA is embedded in the margin, it is fixed for all tenors and may be less subject to negotiation. An ever growing (albeit small) proportion of such credit facilities include no CSA, or at least no CSA for one or more tranches of debt thereunder. Some deals also include a “CSA MFN”, which requires the CSA to be automatically reduced if a sufficient number of comparable credit facilities in the market have a lower CSA or do not incorporate any CSA for the SOFR-based benchmark rate.

2. Could SOFR Suffer the Same Fate as LIBOR?

   SOFR, and the other non-U.S. selected replacement rates for impacted interbank offering rates (or IBORs), are often referred to as “risk free rates” (RFRs). RFRs are typically published, supervised and administered (at least in part) by a governmental entity in the applicable jurisdiction. As such, RFRs are thought to be less likely subject to manipulation, and by extension, prohibition.

   Due to these differences between IBORs and RFRs, market participants began to rethink certain interest rate-related provisions that had previously been treated as boilerplate and were most often dependent on the lead lender’s / agent bank’s form. Terms such as increased costs and capital adequacy, which typically require borrowers to compensate lenders for any increased costs due to changes in law or reserve requirements that existed for IBORs, were sometimes modified to address differences in the nature of SOFR as compared to LIBOR (and, in some cases, borrowers and sponsors pushed for them to be removed entirely). Some borrowers and sponsors also looked to remove, or at least limit, illegality provisions (that generally allow any lender to suspend lending based upon a reference rate if that lender provides a notice that it has become illegal for the lender to do so) suggesting such provisions would be unnecessary given the ostensibly low-risk of such government published rates becoming legally prohibited. In most RFR-based, U.S. law governed credit facilities, these terms have largely remained (sometimes in slightly altered forms), as many financing sources require such protections and the additional obligations on the loan parties are limited to the occurrence of specified events.

   Breakage provisions may be the exception to the above, as these have been limited in certain RFR-based credit facilities. These terms usually require borrowers to reimburse or indemnify lenders for any costs, losses and expenses related to certain events that disrupt or “break” loan funding or interest periods. Sometimes these terms require borrowers to make the lenders whole for any interest that would have been payable (whether including LIBOR plus the margin or just LIBOR to reimburse lenders for interbank borrowing expenses incurred) had the borrower not made an early voluntary prepayment. Thus, some deals incorporating daily or compounded rates (which unlike term rates cannot be known in advance of the interest period) limit these to costs and expenses only or make breakage provisions only applicable to term rate-based borrowings.

3. What’s Next for SOFR

   Over the next fifteen or so months while USD LIBOR continues to be published, market participants should expect a continued flurry of LIBOR transition amendments and non-LIBOR based new issuances in the U.S. loan market. It is likely SOFR-based issuances will accelerate, particularly in bank-led deals. As Term SOFR adoption increases in the U.S. loan market, fears about its robustness and whether it can be operationalized seem to be dissipating. Regulated banks also appear focused on making the switch from LIBOR now that the Federal Reserve’s 2021 year-end deadline to cease LIBOR-based issuances has passed. For non-bank lenders, there does not yet seem to be the same push to discontinue LIBOR usage. Such alternative lenders may be waiting to take the proverbial leap (and avoid making multiple post-LIBOR transitions to new benchmarks or subsequent amendments to adapt other interest rate related terms) until the market settles a bit on preferred replacement rates, credit spread adjustments, mechanics, etc. Given limited Securities & Exchange Commission (SEC) guidance on active USD LIBOR transition issued to date, registered private debt fund lenders may instead be assessing their portfolios and preparing for LIBOR transition.

   Even with increased issuances of SOFR loans, 2022 will probably not mark the end of USD LIBOR loans. Regulated banks continue to shift away from USD LIBOR in new issuances, and the number of SOFR loans has increased. However, consensus as to preferred replacement rates, spread adjustments, methodologies, and mechanics may continue to congeal and cause USD LIBOR loans to continue through 2022, particularly given the variety of lenders that typically participate in broadly syndicated credit facilities and secondary trading activities. Whether or not market participants ever all get on the same page about LIBOR transition, LIBOR transition will eventually be effected across the U.S. loan market—even if it takes until June 30, 2023, when all remaining tenors of USD LIBOR are slated to cease publication.