NEW ARRC RECOMMENDATIONS FOR LOANS AND SPREAD ADJUSTMENTS IN LIGHT OF LIBOR TRANSITION

On June 30, 2020, the Alternative Reference Rates Committee (ARRC) released a series of updates concerning fallbacks and conventions for new variable rate private student loans and syndicated loans, as well as the results of its supplemental consultation on its cash products spread-adjustment methodology.^[1] The releases should provide further guidance to market participants as they continue to prepare for USD LIBOR’s cessation.

As recommendations, the updates should not be interpreted as binding regulatory standards. Accordingly, market participants are free to consider to what extent they should be adopted and applied, taking into consideration the size and complexity of their institutions and activities, their particular transactions and any governing supervisory or legal policy.

New Variable Rate Private Student Loans: Fallbacks, Spread Adjustments & Conventions

In 2019, the ARRC formed a Consumer Products Working Group to establish guiding principles for restructuring new variable rate private student loans to account for USD LIBOR’s cessation.^[2] On March 27, 2020, the ARRC issued a consultation to determine what type of fallback language and spread adjustment would be best for such products.^[3]

The ARRC’s recommendations are intended to be consistent with its recommendations for other cash products, though consistent with its specific approach to adjustable rate mortgages, it recognizes the need for simple contract language in consumer products.^[4] Its final recommendation is for the fallback language to reference a replacement index recommended by the Board of Governors of the Federal Reserve System, the Federal Reserve Bank of New York, or a committee endorsed or convened by the Board of Governors of the Federal Reserve System or the Federal Reserve Bank of New York. If this is not available, the fallback rate would be determined by the note holder, with possible adjustment to the loan’s margin to account for differences between LIBOR and the replacement index.

Further, the ARRC has concluded that the fallback language for these products should contain (1) a “pre-cessation trigger” that accounts for a public statement by the administrator or the administrator’s regulator of USD LIBOR that the rate is no longer reliable or representative as well as a “permanent cessation trigger” in the event that the USD LIBOR administrator has stopped publicly providing the index and (2) fallback language that references the Secured Overnight Financing Rate (SOFR), which could be based either on averages of SOFR or a SOFR terms rate. The ARRC has further recommended for these products a spread-adjustment to SOFR that is based on a five-year median of the historical difference between USD LIBOR and SOFR with a one-year transition period to the fixed median spread.

Moreover, the ARRC has published recommended conventions for voluntarily use should market participants incorporate SOFR-based fallback language into these products.^[5] The conventions recommend that SOFR-based student loan products (1) reference 30- or 90-day average SOFR, with a monthly or quarterly reset period respectively, (2) determine the rates before the interest period begins and (3) require margin to be set by the lender or originator.

Syndicated Loans: Revised Fallback Language

The ARRC originally published recommended fallback language for syndicated loans in April 2019.^[6] Among other things, those recommendations included (1) both a “hardwired” and “amendment” approach to introducing fallback language into syndicated loan agreements; (2) use of a compounded SOFR in arrears at the second step of the fallback waterfall; and (3) a rigid, SOFR-transaction-based early opt-in trigger for counterparties that elect to apply that fallback language before a USD LIBOR cessation event occurs.

After considering feedback from its working groups and market participants, the ARRC has revised the fallback language for these products. According to the revised recommendations,^[7] (1) the amendment approach should be rejected in favor of the hardwired approach; (2) a daily simple SOFR in arrears should be applied at the second step of the fallback waterfall; and (3) the early opt-in trigger should allow counterparties to bilaterally negotiate the trigger event if the requirement that there be at least five publicly available new or amended syndicated loan facilities referencing a SOFR-based rate is inappropriate.

These recommendations conform to the ARRC’s “best practices” and “2020 objectives” guidance, which anticipated these revisions by June 30, 2020 and currently suggest hardwiring syndicated loan fallback language by no later than September 30, 2020.^[8]

Spread-Adjustment Methodology: The Results of the Supplemental Consultation

On May 6, 2020,^[9] the ARRC issued a supplemental consultation on its recommended five-year historical median spread-adjustment methodology for cash products to resolve technical issues left open by its initial consultation.^[10] In particular, the ARRC sought feedback on two questions: (1) whether the ARRC should adopt the International Swaps and Derivatives Association (ISDA) spread-adjustment “value,” instead of its “methodology,” across the different fallback rates of the same tenor, regardless of the existence of a sufficient rate history for any given tenor; and (2) whether the ARRC should fix its spread adjustments on the same date that ISDA chooses if a pre-cessation trigger event occurs.

After reviewing feedback from the supplemental consultation, the ARRC has concluded that (1) cash products other than consumer products should adopt ISDA’s spread adjustment value across each different fallback rate of the same tenor, and (2) for all cash products, ARRC’s spread-adjustment timing will match ISDA’s timing in the event of a pre-cessation trigger, i.e., when USD LIBOR’s regulator announces that the rate has or will become no longer representative.^[11]

These recommendations will align cash products and derivatives with respect to product valuation and fallback rates in a post-USD LIBOR market environment.

Conclusion

The ARRC’s updated recommendations for student loans, syndicated loans and its spread adjustments should provide the industry with greater clarity as it adapts to USD LIBOR’s likely cessation. The ARRC will continue to distribute recommendations and related information as the LIBOR transition progresses.