The federal appropriations bill that passed the U.S. House and Senate in March 2022 included a provision that finally codified what will happen with contracts reliant on the London interbank offered rate, or LIBOR. The law finds that:
- LIBOR is used as a benchmark rate in more than $200,000,000,000,000 worth of contracts worldwide.
- A significant number of existing contracts that reference LIBOR do not provide for the use of a clearly defined or practicable replacement benchmark rate when LIBOR is discontinued.
- The cessation of LIBOR could result in disruptive litigation related to existing contracts that do not … clearly define … [a] replacement benchmark rate.
And it stipulates that, in general, on the LIBOR replacement date, all contracts that are not consumer loans and that use LIBOR as a reference rate—and do not provide either a specific fallback benchmark rate or a specific person responsible for determining the replacement rate—will switch from LIBOR to a benchmark selected by the Federal Reserve Board of Governors. That Fed-selected replacement rate is the secured overnight financing rate (SOFR) with respect to LIBOR contracts that are not consumer loans.
To understand what this means for corporate debt and other business contracts, Treasury & Risk spoke with Amy McDaniel Williams, a partner in the structured finance and securitization practice at law firm Hunton Andrews Kurth LLP who helps clients draft purchase agreements, bilateral credit agreements, and securitization contracts.
Treasury & Risk: Thank you, Amy, for taking the time to speak with us. I assume that for new contracts, companies are selecting benchmark rates other than LIBOR.
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Amy McDaniel Williams: Yes. Across all the types of contracts I work on, companies are switching to alternative benchmarks—typically SOFR. The challenge has been figuring out what should happen with the legacy loans or credit agreements that still reference LIBOR.
T&R: And companies have a year to figure this out, right?
AMW: Right. We now know for sure that LIBOR will go away after June 30, 2023. Corporate treasuries have been working on this, but they really need to intensify their efforts to make sure everything is transitioned by that time, at the latest.
The biggest concern recently has been around securitized debt. Those agreements don't have an easy and obvious way to transition, since the trust agreement might say that a change requires a 100 percent vote. As a practical matter, going out and getting every lender to sign onto the shift from LIBOR to SOFR might be hard, if not impossible.
The legislation passed in March was designed to solve this issue.
T&R: So, tell me about the legislation.
AMW: Clearly, Congress wanted to help ensure a smooth transition that does not upset contractual agreements which are currently working. So, they determined that any loan or security which is set up to flip to something like the prime rate as a fallback will just do that when LIBOR goes away. If there are parties that don't want that outcome, they have the chance to undertake amendments to the agreement, to ensure that everybody's expectations are met.
But with respect to contracts where the fallback is some other rate tied to LIBOR, or some process that involves asking banks what LIBOR rate they are offering—which just wouldn't work—this law enables those contracts to shift to whatever rate the Federal Reserve adopts with regulations coming out by September of this year. That rate is very likely to be SOFR.
T&R: If a company is OK with all its contracts rolling over automatically to SOFR, is there anything the treasury and finance groups should be doing right now?
AMW: Well, first of all, they should make sure they are really OK with rolling over to SOFR. Companies that are borrowers and aren't the calculation agent for the rates on their bilateral and syndicated loans need to understand what the change will mean for their contracts when June 30, 2023, arrives.
T&R: What, specifically, do many companies not understand?
AMW: Well, LIBOR and SOFR aren't the same. To make SOFR comparable to LIBOR, the ARRC [the Fed's Alternative Reference Rates Committee] recommends adding a credit spread adjustment.
But using a credit spread adjustment complicates calculations of a loan's interest rate. Today, your rate might be LIBOR plus 500 basis points, whereas tomorrow you're going to have to convert to SOFR plus a credit spread adjustment plus 500 basis points.
The credit spread adjustment also adds complexity in another area: LIBOR contracts typically have a floor of 0 percent, because there have been situations where LIBOR has gone negative and the loan contracts keep the loan's interest rate from moving below zero. But how would a floor like that work when applied to SOFR? Would the loan be unable to use a negative number for just plain SOFR, or could SOFR itself be negative but the sum of SOFR plus that credit spread couldn't be?
T&R: So, how is the credit spread adjustment determined?
AMW: For contracts that can't be switched by amendment, whose new interest rates will be determined by the legislation passed in March, the ARRC picked a credit spread adjustment last March, based on data going back five years.
However, for contracts that borrowers and lenders will be able to amend, the credit spread adjustment is one element of the negotiations. At the end of last year, when interest rates were really low, the spread wasn't very big because SOFR and LIBOR were both close to zero—there wasn't a lot of difference between them.
But as prevailing interest rates go up, the spread between the two reference rates will likely get bigger. For one-month LIBOR to one-month term SOFR, for example, the spread has grown from 4 to 13 basis points. Locking in today's spreads gives borrowers an incentive to go ahead and get the amendments to their loan contracts finalized.
T&R: So, what do corporate treasury teams need to do before they can make this transition?
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Read McDaniel Williams' response in part 2 of this article, which will publish next week.
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