Use of the term SOFR in the business loan market

introduction

On July 29, 2021, the American Alternative Benchmark Rates Committee (“ARRC“) announced that it formally recommends CME Group’s guaranteed overnight rate (“SOFR“) forward rate (“SOFR Reference Rate CME Term” Where “SOFR term”) For adoption by market players. This recommendation marks an important step in the transition of the US dollar (“USD”) London Interbank Offered Rate (“LIBOR“). In light of the Hong Kong Monetary Authority (“HKMA“) the requirement that authorized institutions in Hong Kong cease entering into new LIBOR contracts after December 31, 2021 (the”HKMA requirement“), this article will focus on how the term SOFR can be applied as an alternative benchmark for interest rates in the business loan market.

For more information on the transition out of LIBOR in general, please refer to our newsletter published in September 2020: “Transition away from LIBOR”.

CME SOFR term Reference rate

At present, the SOFR CME forward benchmark rates are the only forward-looking forward rates approved by the Federal Reserve Bank of New York (“FRBNY”) And ARRC. The SOFR CME Forward Reference Rates are a daily set of forward-looking interest rate estimates, calculated and published for 1-month, 3-month and 6-month terms, by the Chicago Mercantile Exchange based on market expectations. involved in the SOFR derivatives market. The CME Term SOFR reference rates will be calculated for each day on which FRBNY calculates and publishes the SOFR, that is to say any day except a Saturday, a Sunday or a day when the Securities Industry and Financial Markets Association recommends closing the bond departments of its members. throughout the day for trading in US government securities (“U.S. Government Securities Business Day“). They are published on the CME Group Benchmark Administration Limited webpage and are available to licensees through CME DataMine, CME’s Market Data Platform (MDP) Channel 261, and data redistribution partners such as Bloomberg and Refinitiv.

While the ARRC continues to recommend as a general principle that market participants use the day-to-day SOFR and SOFR averages given their robustness, the ARRC also supports the use of the term SOFR for corporate lending activities, especially multi-lender facilities, middle market loans and trade finance loans, where adjusting to an overnight rate might be more difficult and the use of a forward rate might be useful to resolve these difficulties.

The ARRC, however, does not support the use of the term SOFR for the vast majority of derivative markets, especially the trading of SOFR futures derivatives in the inter-professional market, as such activity could adversely affect trading activity on the underlying overnight SOFR derivatives which are necessary to construct the SOFR term itself and could, therefore, compromise the robustness of the rate and its corresponding utility to market participants. The ARRC recommended that any use of SOFR futures derivatives be limited to end-user derivatives intended to hedge treasury products referencing SOFR futures. Such end-user refers to a direct party or guarantor of a new SOFR commercial loan or new Term SOFR securitization linked to SOFR Term assets, or a legacy LIBOR product that has been converted to SOFR Term by the bias of language or legislation of contractual fallback.

Use of the term SOFR in business credit activity

The SOFR term, similar to LIBOR, is a forward-looking interest rate (as opposed to SOFR which is a retrospective interest rate) that sets the interest rate on a loan at the start of a loan period. interest and for the calculation of accrued daily interest. The conventions recommended by the ARRC for the use of the term SOFR are similar to existing market practices for the use of USD LIBOR in business lending activities.

On July 21, 2021, the ARRC published the SOFR prospective duration agreements and SOFR averages (applied in advance) for syndicated and bilateral commercial loans (“SOFR commercial term loan agreements”) Which sets out the following recommended conventions for the use of Term SOFR in the business lending market:

New SOFR loans

1.Holiday and weekend convention: The recommended convention is that statutory holidays / weekends be any day that is not a business day for US government securities.

2.Retrospective of interest / listing day: Similar to the LIBOR convention today, the recommended convention is to use the rate published two business days for US government securities before the first day of the interest period and held throughout the interest period.

3.Temporary unavailability of the SOFR Term: ARRC suggested that a temporary back-up agreement be included in the event that the term SOFR (or relevant content thereof) is not published for a short period of time. Such a convention can be the functional equivalent of: “If from [5:00 p.m. (New York time)] on an interest analysis day, the average SOFR or forward SOFR has not been published by the administrator concerned or on the website of the administrator concerned, the rate used will be that published by the relevant administrator or on the relevant administrator’s website for the first preceding period. The business day for U.S. Government securities for which that rate was posted on that administrator’s website, provided that the first business day for U.S. government securities before the first business day for U.S. government securities does not exceed three days of US government securities prior to that interest retrospection day ”.

4.Borrowing notice period: Borrowers are recommended to notify their loan request three business days before the loan date, similar to today’s LIBOR agreement. Bilateral loans can have more flexibility in loan notice periods.

5.Number of days: The recommended convention is Real / 360 days for the SOFR term, which is the standard convention in the US money markets.

6.Business day: It is recommended that the term SOFR follow the “Modified Next Business Day” convention, which means that payments due on a day falling on a non-business day will be adjusted to the next business day, unless that business day falls. in the following calendar month, in which case the interest payment date will be the previous business day.

7.Compensation for loss: Credit agreements may include wording that compensates lenders for funding losses such as those incurred due to intra-period prepayment, conversions or continuations, or the inability to borrow or pay off loans. payments when due or expected.

8.Interest rate floors: It is recommended that any floor interest rate apply to the SOFR term for new loans.

9.Round: Similar to LIBOR today, SOFR terms are published with five decimal places and dollar amounts can be calculated with two decimal places.

ten.Withdraw: Market participants are recommended to include a strong and practical fallback language, such as the updated Recommended Fallback Languages ​​for Syndicated and Bilateral Business Lending released by ARRC on June 30, 2020 and August 27, 2020 respectively or the additional recommendation for business loans published on March 25, 2021.

Converting old LIBOR loans to SOFR loans

Upon termination of LIBOR or when LIBOR is declared unrepresentative, many business loans are expected to switch from LIBOR to SOFR depending on their respective fallback languages. If a legacy LIBOR loan reverts to the SOFR term, most of the conventions for the SOFR term described in the New SOFR Loans section above would apply, except for a spread adjustment to neutralize the economic effect of the conversion will be added to the rollback rate. and the application of a floor would apply to the resulting SOFR Term plus the corresponding spread adjustment. Such a spread adjustment for legacy LIBOR loans would be separate and additional to the loan’s initial contractual margin.

(a) Gap adjustment

According to SOFR commercial term loan agreements, the ARRC recommended that legacy LIBOR loans converted from LIBOR at a rate based on SOFR use a static spread adjustment recommended by the ARRC or ISDA, that is – that is, the historical median difference published over five years between LIBOR and SOFR. The applicable spread adjustment would follow the original LIBOR term for the old LIBOR loan and apply to the SOFR term (eg 3M LIBOR to 3M SOFR term). Market participants can refer to the spread adjustments set on March 5, 2021 which are available here for ease of use.

(b) Floors

If an old LIBOR credit contract that contains a floor interest rate is converted to a SOFR term, the ARRC recommended that this floor interest rate apply to the SOFR term plus the associated spread adjustment as recommended by the ARRC.

Conclusion

Given the upcoming shutdown of LIBOR and the HKMA requirement, market participants in Hong Kong will need to reference alternative benchmark interest rates in new loan contracts from January 1, 2022. While ARRC’s formal recommendation for the adoption of SOFR CME futures benchmarks provides market participants with an essential tool to move away from USD LIBOR, they should also keep abreast of the latest developments and usage forward rates with respect to risk-free rates for currencies other than USD. Given the complexity and diversity of the alternative benchmarks involved in the transition, market participants should seek advice from accounting, finance and IT professionals as well as legal professionals. and compliance to assess the consequences in these and other operational matters, if applicable.

Priscilla C. Carnegie