June 30th has passed and one-, three- and six-month USD LIBOR settings have ceased to be published. As confirmed by the FCA on 3 April 2023, the ICE Benchmark Administration (IBA) has begun publishing non-representative “synthetic USD LIBOR” rates for these settings using an alternative methodology. The methodology is based on the Term SOFR published by the Chicago Mercantile Exchange (this is known as the “CME Terms SOFR”) plus the relevant spread adjustment (being the spread that is published by Bloomberg for the purpose of the ISDA 2020 IBOR Fallbacks Protocol on 5 March 2021). The FCA has compelled the IBA to continue publication of synthetic USD LIBOR until 30 September 2024.
So, what happens now to USD LIBOR legacy contracts that have not already transitioned to alternative base rates?
Whether a USD LIBOR loan will transition to the relevant synthetic LIBOR depends on the governing law of the underlying contract and the specific contractual provisions. Some jurisdictions, such as the US and the UK, have adopted legislation to provide targeted solutions for the transition of tough legacy contracts.
The US Adjustable Interest Rate (LIBOR) Act (“LIBOR Act”) covers those US law-governed contracts that do not have viable fallbacks to USD LIBOR. The LIBOR Act identifies three situations in which LIBOR will be replaced by the replacement rate identified by the Federal Reserve Board (the “Board”). These three scenarios are: (i) where the legacy contract does not contain fallback provisions; (ii) where the fallback provisions do not identify a specific replacement rate (or where a specific replacement rate is identified, it is based on LIBOR) or do not identify a sole determining person (or where such person is identified, the person is required to conduct a poll or survey to determine the replacement rate), or (iii) where such determining person has not selected a replacement rate. In all other situations, depending on the contractual provisions, either the contractually agreed replacement rate or synthetic LIBOR will apply.
The UK Benchmarks Regulation allows English law-governed LIBOR based contracts that include no fallback provisions to use synthetic LIBOR. By design, synthetic LIBOR and the Board selected rate under the LIBOR Act are calculated using the same methodology. To do away with or minimize the need for amendments to those legacy contracts to which synthetic LIBOR applies, synthetic LIBOR rates are being published on the same page as LIBOR. As a result, no further action is required to transition these loans so long as the definition of LIBOR in the contract points to the relevant page.
In the case of contracts governed by laws other than a US law or English law, applicable LIBOR transition legislation in that jurisdiction should be considered. In the absence of any such legislation, the rate to be applied will depend on the contractual provisions. The Financial Conduct Authority does not prohibit the use of synthetic LIBOR by parties to legacy contracts that are not governed by English law.
Supplement 70 to the 2006 ISDA Definitions (“Fallback Supplement”) provides for a replacement rate that comprises a term adjusted SOFR compounded in arrears for the relevant period plus the relevant credit adjustment spread as fixed on 5 March 2021 (“ISDA CAS”).
An important issue in non-recourse financings is the potential for basis risk arising from mismatches in the hedging position. For instance, if there is no proactive contractual amendment to the loan documentation, the typical fallback rate for US law and English law governed contracts is CME Term SOFR plus ISDA CAS as noted above. Parties may also choose to transition to compounded risk-free rates adopting the LMA or APLMA approach. In both these instances, relying on the ISDA fallback protocols will not result in a ‘perfect’ hedge as lookback periods differ between the ISDA fallbacks and the provisions adopted under the LMA/APLMA forms. It is also possible that a mismatch occurs because the loan has been proactively transitioned to a replacement rate at a different time from when the hedging agreements are transitioned. For the hedging agreements to serve their purposes in non-recourse financings, it is important to limit the mismatch between the interest rate mechanism in the loan documentation and the floating rate determination in the hedging agreements. That said, we appreciate some lenders and borrowers may be comfortable with a slight mismatch from an accounting and a cost perspective.
The manner in which a hedge transition is documented will depend on the approach taken by the parties with respect to the underlying rates as well as the timing of the transition. Contracts entered into on or after 25 January 2021 automatically incorporate the Fallback Supplement and need no further action. For legacy contracts, the documentation will vary depending on whether one or both parties decide to adhere to the ISDA Fallback Protocol or whether the parties desire to choose a bespoke rate that more closely aligns with the replacement rate for the underlying loan.
Parties may adopt diverse approaches to transitioning from LIBOR in hedging agreements. In our experience, in addition to dealing with the mechanism available for transitioning, a key challenge is to formulate positions that are acceptable to all parties in multi-source financings.