SOFR amendments poised to ramp up in Q1 2023

While US dollar (USD) LIBOR has all but vanished from new-issue loans in 2022, the vast majority of the US loan market is comprised of legacy transactions that remain tied to the retiring rate. For every US institutional loan already using SOFR, there are approximately five deals that still need to be transitioned to an alternative interest rate benchmark.¹ With under seven months to go until the end of USD LIBOR based on panel bank submissions, market participants are bracing for an expected flurry of amendment activity in the first half of 2023.

The pace of transition to date has lagged behind initial expectations. One contributing factor is the steep decline in loan market activity in 2022, including incremental financings as well as refinancing and repricing activity, each of which tend to provide a natural opportunity for legacy USD LIBOR loans to transition. In responses to a transition-related survey undertaken by the Alternative Reference Rates Committee ("ARRC"), about half of lenders and borrowers expressed a preference for refinancing outstanding USD LIBOR loans directly into loans with an alternative benchmark.² However, according to LevFin Insights, the volume of refinancing, repricing and dividend recapitalization transactions was down almost 90% year-over-year in 2022.³

Borrowers are also closely scrutinizing the impact of the transition on their all-in loan pricing. Term SOFR is by far the most popular alternative to USD LIBOR. However, while LIBOR is a forward-looking unsecured rate that factors in counterparty credit risk, Term SOFR is derived from a backward-looking secured rate that does not carry any element of credit risk. As a result, Term SOFR has historically tracked lower than USD LIBOR. This gap led to the development of the credit spread adjustment ("CSA"), an additional amount of interest that can be added to Term SOFR in order to counteract any transfer of value resulting solely from the benchmark switch.

However, in 2022, the gap between USD LIBOR and Term SOFR significantly narrowed, with Term SOFR at times exceeding USD LIBOR. In the new-issue market, the result was a general decline in both the amount and prevalence of CSAs. By Q3 2022, most new loans in the US institutional loan market did not include a CSA, and for those that did, the most common CSA was a flat 10 basis points (bps) for all interest periods (or "tenors") of Term SOFR, followed by the so-called "CSA curve" adjustment, being 10 bps, 15 bps and 25 bps for the one-, three- and six-month tenors.⁴ In contrast, the CSAs recommended by the International Swaps and Derivatives Association ("ISDA") and the ARRC are 11.448 bps, 26.161 bps and 42.826 bps for the one-, three- and six-month tenors of Term SOFR, based on the median gap with USD LIBOR over the five-year period preceding March 2021 (when the cessation dates for LIBOR were formally announced).

For credit agreements with amendment-based LIBOR fallback language, use of the ARRC-recommended CSAs is not required and has generally not been observed, however the majority lenders typically have a "negative consent" objection right over the selection of the replacement benchmark rate and CSA.⁵ Though available data is limited, anecdotal evidence suggests most amendment-based transition processes to date have included a flat 10 bps CSA, the CSA curve or no CSA, in keeping with new-issue market trends. In some cases, amendments without a CSA have failed or been withdrawn as a result of lender pushback, forcing the borrowers to relaunch with a flat 10 bps CSA in order to clear the negative consent hurdle.⁶

Meanwhile, those credit agreements that feature the ARRC's "hardwired" fallback language are locked in to using the ARRC-recommended CSAs, whether transitioning after USD LIBOR cessation on June 30, 2023 (the "Cessation Date") or sooner via the "early opt-in" mechanism. Though lenders may argue the ARRC-recommended CSAs are appropriate in light of the historical average difference between USD LIBOR and SOFR, affected borrowers may prefer to hold off for now on the transition to Term SOFR if it could cause their all-in loan pricing to increase overnight.

Charting the Final Course

Without a significant uptick in amendment activity in the near term, process-related concerns will grow as the Cessation Date approaches. The specific parameters for transitioning a LIBOR-based loan facility to an alternative benchmark vary across credit agreements, but all will require sufficient time for the drafting of an amendment document. And the many credit agreements that require parties to agree on the choice of replacement benchmark, negotiate the inclusion of a CSA, and/or obtain affirmative or negative consent from a syndicate of lenders, will consume extra time and bandwidth.

Credit agreements that include "hardwired" fallback language developed by the ARRC will be the easiest to transition away from LIBOR. Though hardwired fallback provisions do not obviate the need for an amendment document, they lock in the choice of successor benchmark (typically Term SOFR as published by CME Group) and the ARRC-recommended CSAs. For syndicated loans with hardwired fallback language, the borrower and administrative agent may elect to trigger an "early opt-in" to replace USD LIBOR prior to the Cessation Date, subject to the negative consent of the majority lenders. Otherwise, the credit agreement will flip to the chosen successor benchmark automatically after the Cessation Date. In either case, the administrative agent will need to prepare an amendment to implement the technical, administrative and operational "conforming changes" required to facilitate use of the new benchmark. The ARRC's hardwired fallback language provides that such an amendment will become effective without further action or consent of any other party.⁷

Only about a third of outstanding credit agreements include hardwired fallback language.⁸ For the rest, a more onerous process will be necessary. Most of this pool of credit agreements will include amendment-based fallback provisions that follow either the ARRC's "amendment approach" form or similar language that originated prior to development of the ARRC forms. In either case, such credit agreements typically require the administrative agent and borrower to agree on a successor benchmark (and CSA, if any) giving "due consideration" to evolving/prevailing market conventions and/or recommendations made by applicable regulatory authorities. The majority lenders are typically granted a negative consent right, and if they do not object to the amendment within a specified timeframe (usually five business days), the rate switch becomes effective.⁹

Most examples of non-ARRC amendment-based fallback language do not dictate the timing of the transition process. But for credit agreements that include the ARRC's "amendment approach" form language, transitioning earlier than a date specified in the agreement (usually 90 days prior to USD LIBOR cessation, or April 1, 2023) requires affirmative consent from the majority lenders. Since obtaining such consent will not be feasible in many cases, this means there are already a substantial number of credit agreements that effectively will not be able to transition until Q2 2023.

If most other legacy loans wait until then to transition, volume-related risks could compound. Agent banks and their back-office staff might struggle to handle the flood of simultaneous amendment processes. Lenders could be overwhelmed by amendments requiring review and objection/consent determinations within overlapping five business day periods. Borrowers may encounter objections to amendments that do not include CSAs (or CSAs that are deemed insufficient), especially if time is running short and the failure to replace USD LIBOR before the Cessation Date means their loans will flip to the more costly "alternative base rate" (which in this scenario would typically be the greater of (i) the prime rate and (ii) the effective federal funds rate plus 0.50%).

One tool that may become increasingly relied upon as the Cessation Date nears is the set of generic SOFR amendment forms published by the Loan Syndications and Trading Association ("LSTA"), which were designed to "serve as a blunt tool to remediate legacy contracts en masse".¹⁰ The forms operate as a one-size-fits-all overlay, basically deeming the USD LIBOR provisions in the existing credit agreement to be overridden by the SOFR provisions in the forms. The most significant downside to this approach is that the credit agreement remains LIBOR-based on its face, and has to be read together with the separate amendment document for the SOFR mechanics, as opposed to the more popular, but time-consuming, approach of preparing a "redline" version of the credit agreement integrating all of the changes necessary to migrate from USD LIBOR to Term SOFR. But given the minimal tailoring required when using these forms, the resulting ease, speed and efficiency of execution cannot be matched by a traditional "surgical" amendment, and may outweigh the disadvantages as transition volume increases.

LIBOR Lingers On

Though most legacy USD LIBOR loans are expected to transition to an alternative benchmark by the Cessation Date, there are some situations in which use of USD LIBOR could continue into the second half of 2023 or beyond.

One example is tied to the way interest periods operate. Most benchmark transition amendments are drafted such that, with respect to any outstanding loans, USD LIBOR is not replaced until the next interest period reset date. This approach eliminates the potential incurrence of breakage costs and the need to calculate and pay accrued interest for a partial period. As a result, loans already outstanding on the Cessation Date will typically continue to bear interest based on USD LIBOR for the duration of the then-current interest period(s). Parties could potentially use this feature strategically to push out their transition date, by choosing a lengthy interest period prior to the Cessation Date.¹¹ However, a risk with this approach is that new loans (e.g. under a revolving or delayed draw facility) might only be available using the costlier "alternate base rate" until USD LIBOR is replaced.

Another example arises from the anticipated publication of "synthetic" USD LIBOR after the Cessation Date. The UK's Financial Conduct Authority ("FCA"), which oversees ICE Benchmark Administration in its role as the administrator of LIBOR, compelled the temporary publication of GBP and JPY LIBOR for certain tenors on a synthetic basis after the traditional, bank panel-based versions of those benchmarks ceased in December 2021. The goal of this effort was to allow "tough legacy" contracts—those which lacked a clear path to transition away from GBP and JPY LIBOR—to function following cessation, providing more time for such contracts to find a solution or roll off in accordance with their terms.

In late November 2022, the FCA indicated that they also intend to compel the publication of USD LIBOR on a synthetic basis through September 2024. Assuming this plan is confirmed, synthetic USD LIBOR would be based on the sum of Term SOFR and the CSAs recommended by ISDA and the ARRC, which is effectively the same result as a benchmark transition pursuant to ARRC hardwired fallback language.

Since synthetic rates are not based on panel bank submissions, they are inherently not "representative" of the interbank lending market. While many credit agreements (including those with ARRC fallback language) provide for the replacement of LIBOR if and when it is no longer representative, some lack this trigger even though they contain otherwise workable fallback provisions. Such credit agreements may not require or even permit the replacement of USD LIBOR so long as a rate continues to be published on the source screen, regardless of calculation methodology. Therefore, if and for so long as synthetic USD LIBOR is published, these credit agreements may continue to rely on that rate after the Cessation Date. The language of each individual credit agreement will need to be carefully checked to determine whether synthetic USD LIBOR may have an impact.

Legislation and the Loan Market

The Adjustable Interest Rate (LIBOR) Act ("LIBOR Act"), which was signed into federal law in March 2022, is not expected to have a meaningful impact on the US business loan market. Generally, the LIBOR Act will only impose a switch to Term SOFR on those LIBOR-based contracts that would otherwise be rendered inoperable following the Cessation Date. The vast majority of US credit agreements for business loans will not meet this standard. This is because those credit agreements that lack LIBOR fallback provisions will generally still provide for the use of an "alternate base rate" in the event USD LIBOR is unavailable. And for those credit agreements that contain LIBOR replacement provisions without a representativeness-based trigger, they can continue to function by referencing synthetic USD LIBOR until its cessation, and then transition to a non-LIBOR benchmark if they haven't rolled off in the interim.

However, use of synthetic USD LIBOR in such cases could still be blocked by regulation. The LIBOR Act tasked the Board of Governors of the Federal Reserve System ("FRB") with establishing rules to carry out the purpose of the legislation. Though these rules remain in development as of December 2022, the FRB has indicated that they are considering making a rule to impose Term SOFR on credit agreements that would otherwise reference synthetic USD LIBOR following the Cessation Date.¹² Such a rule may face resistance from some market participants. The LSTA submitted a comment letter to the FRB on the matter, taking the position that such a rule would have the effect of capturing credit agreements that had been intentionally left out of the scope of the LIBOR Act. Per the LSTA, this kind of intervention "could create additional risk, ambiguity, and disruption in the business loan markets".¹³

While the role of synthetic USD LIBOR and the impact of the FRB's regulations remains to be seen, it is only a relatively small portion of legacy loans in the US loan market that will be affected by these considerations. Most legacy USD LIBOR credit agreements in the US loan market provide a clear path to transition to an alternative benchmark before or soon after the Cessation Date. But this is still no easy task for the loan market. Between amendment drafting and negotiation, managing affirmative and negative consent processes with lenders, and adhering to variable timing and back-office requirements, market participants will have much to juggle in the coming months.

_{1 Credit Suisse Leveraged Loan Index; LevFin Insights.
2 Alternative Reference Rates Committee, "Loan Remediation Survey Results" (October 13, 2022).
3 LevFin Insights, "Insight: Investors hone in on CSAs—or lack thereof—as negative consent amendments roll in" (September 15, 2022).
4 LevFin Insights.
5 Certain credit agreements may instead require affirmative consent from the majority lenders. This is often the case in credit agreements where a passive, third party administrative agent has been appointed, particularly in the context of private credit and direct lending transactions.
6 LevFin Insights, "Ensemble Health’s negative consent SOFR amendment passes with 10 bps CSA" (November 2, 2022); LevFin Insights, "National Seating & Mobility’s SOFR amendment clears with 10 bps CSA" (September 21, 2022); LevFin Insights, "Insight: Investors hone in on CSAs—or lack thereof—as negative consent amendments roll in" (September 15, 2022).
7 As noted above, certain credit agreements, particularly where a passive, third party administrative agent has been appointed, may instead require affirmative consent from the majority lenders for exercise of the early opt-in election and/or a conforming changes amendment.
8 LSTA, "Are you ready…for the end of LIBOR?" (October 13, 2022).
9 As noted above, certain credit agreements, particularly where a passive, third party administrative agent has been appointed, may instead require affirmative consent from the majority lenders in this scenario.
10 LSTA, "Spotlight on LIBOR remediation tools" (October 18, 2022).
11 Most US credit agreements allow the borrower to select either 1, 3 or 6 month USD LIBOR interest periods, plus 12 months if agreed by all relevant lenders.
12 Board of Governors of the Federal Reserve System, "Regulation Implementing the Adjustable Interest Rate (LIBOR) Act – Notice of proposed rulemaking" (12 CFR Part 253) (July 27, 2022).
13 Board of Governors of the Federal Reserve System, "Regulation Implementing the Adjustable Interest Rate (LIBOR) Act – Notice of proposed rulemaking" (12 CFR Part 253) (July 27, 2022).}

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