We here at Seward & Kissel have been receiving numerous questions the past couple of months about banking’s transition away from LIBOR as a benchmark for interest rates as it relates to shipping, and wanted to address in general terms some of the more common and relevant ones in this month’s edition of Simply Speaking. Of course, individual circumstances always vary and relevant contractual language needs to be examined to determine legal rights.
- I have heard for a number of years that LIBOR is going away at some point, but it always felt like a distant future event that may not materialize. Why all of a sudden is there so much news about it?
LIBOR’s eventual demise had been a subject of discussion for quite some time, but there had not been a definitive statement about the timing of its demise. However, on March 5, 2021, LIBOR’s administrator, ICE Benchmark Administration, announced that it would cease publication of most of the LIBOR settings by December 31, 2021 (and the remaining few USD LIBOR settings, including the popular 3-month LIBOR, by June 30, 2023). Under some existing financial contracts, this announcement (and other ensuing announcements by LSTA, LMA and ISDA) constituted a material event that began the process of a transition away from LIBOR and sparked considerable commentary and analysis by general and industry-specific media sources on what is to come.
2. So, the 3-month USD LIBOR isn’t actually going away until June 2023. Why do I need to worry about this now? Can I not deal with it in 2 years when there is more clarity around market practice?
Notwithstanding the availability of certain tenors of LIBOR until June 2023, banks will not issue new loans tied to LIBOR starting next year and likely we will start seeing non-LIBOR-based new loans in the next few months. We expect there is going to be an accelerating industry-wide shift away from LIBOR. And the relevant regulatory authorities are strongly encouraging banks to move away from LIBOR in advance of June 2023, so there could be an early opt-in of SOFR (or another reference rate) depending on the relevant contractual terms.
3. What is the SOFR?
SOFR stands for Secured Overnight Financing Rate and is the current front runner to replace USD LIBOR. SOFR is based on the overnight loans, backed by bond assets, that investors offer to banks in the Treasury repurchase market. The frequency and extensive nature of the repurchase market makes SOFR a far more accurate indicator of borrowing costs in comparison to LIBOR (which is based on estimations rather than data).
4. Does SOFR work like LIBOR where I choose an interest period in advance and the rate is fixed for that duration of time?
Currently, there is no ARRC-recommended forward-looking SOFR term rate that works like LIBOR. The ARRC (Alternative Reference Rate Committee), the Fed-convened committee of industry and regulatory personnel overseeing LIBOR’s transition, has not been able to recommend such a rate yet because trading activity in SOFR derivatives has not been robust enough. It may well be that by the time LIBOR’s transition is well on its way in the next year or so, there will be such a rate (in fact, CME Group has recently announced the launch of a term SOFR reference rate but this is not a rate recommended by the ARRC). At the moment, the calculation of interest based on SOFR is done by other methods, such as using SOFR averages and index data that can be applied either in advance or in arrears.
5. What is “hardwired” fallback language?
“Hardwired” fallback language is one of the primary approaches for loans requiring transition from LIBOR. Hardwired language is built into the original loan agreement so that upon a rate switch trigger event, the loan rate will automatically convert to a new rate either chosen by or acceptable to the parties.
6. What is the ARRC? Are they the definitive authority on USD LIBOR issues?
ARRC is the Alternative Reference Rates Committee. ARRC is a group convened by the Federal Reserve Board and the New York Fed with the specific goal of facilitating a smooth transition from LIBOR. ARRC is the most visible authority on USD LIBOR, but they are joined by other organizations and commentators like the Loan Syndications & Trading Association (“LSTA”).
7. What about the LMA? Do they have a say in the matter? Isn’t LIBOR administered by a U.K. organization?
The LMA is the Loan Market Association, a London-based industry organization which has been an authority in the syndicated loan market in the U.K. and Europe. The ICE Benchmark Administration Limited, regulated by the U.K.’s Financial Conduct Authority, administers and publishes LIBOR, not LMA. Ship finance loans are very often based on LMA form loan agreements, and therefore commonly include LMA recommended fallback provisions. LMA is one of the authorities like ARRC or LSTA that seeks to facilitate a smooth transition from LIBOR when it ends. LMA has provided alternatives to the ARRC recommended fallback provisions, including an LMA version of “hardwired” fallback provisions in the form of a rate switch agreement which enables the switch from an existing rate to an alternative risk-free rate on a pre-agreed date or as of a trigger event date for any currency.
8. Is there a “market” fallback provision that everyone uses? What drafting convention should I follow?
Both legacy and new loan agreements in ship finance commonly use versions of the LMA recommended LIBOR fallback provisions or in the case of U.S.-style documentation, versions of ARRC-recommended or some bespoke “house” language. It is important to note, however, that many of these existing “fallback” provisions, including the widely used LMA recommended LIBOR fallback provisions prior to publication of the form rate switch agreement, require an amendment to the loan documentation to change the reference rate. We recommend that new loan agreements adopt some form of “hardwired” fallback provisions that provide for a change in the reference rate to occur automatically based on certain trigger events without further amendment to the loan documentation.
9. If USD is my loan currency, should I follow the fallback language recommended by the ARRC, even though my loan is governed by English law?
There is no “requirement” to follow one drafting convention over the other. The ARRC, LMA or LSTA does not have supervisory authority and cannot compel a private party into specific contractual terms. English law governed loan agreements in ship finance are often based on the LMA form loan agreement and have generally used versions of the LMA recommended LIBOR “amendment” fallback provisions, rather than the ARRC recommended language. As the end of LIBOR approaches, parties should consider utilizing “hardwired” fallback language in new loan agreements and amending legacy loan agreements to incorporate “hardwired” fallback provisions. These “hardwired” fallback provisions can be based on the ARRC recommended “hardwired” fallback language, the LMA rate switch agreement, or other “hardwired” fallback provisions mutually agreed by the parties. For consistency in style and defined terms, there may be some logic to follow the same drafting conventions, as opposed to incorporating language from another convention.
10. What is the difference between the LMA fallback language and the ARRC fallback language?
Key differences between the LMA rate switch agreement and the ARRC “hardwired” fallback language include:
- The trigger for the change of reference rate. The LMA rate switch agreement provides for the change of reference rate to occur by a specified date. The ARRC “hardwired” fallback language provides for the discontinuation or unavailability of all available tenors of LIBOR as the trigger event.
- The spread adjustment. The LMA rate switch agreement includes spread adjustments as options for the parties to include as necessary. The ARRC “hardwired” fallback language includes specified spread adjustments for common tenors.
- The applicable SOFR formulation. The LMA rate switch agreement uses the daily non-cumulative compounded SOFR plus any agreed spread adjustment. The ARRC “hardwired” fallback language provides for a waterfall of SOFR formulations beginning with forward term SOFR plus spread adjustment, and if this is not available then daily simple SOFR (unless parties agree to compounded SOFR) plus spread adjustment, and if this is not available then a rate selected by the parties plus spread adjustment.
11. If I am an agent in a syndicated loan, are there any issues I should be aware of?
As mentioned, the March 5 announcement by IBA and the subsequent announcement by other industry organization constituted a material event, which may have triggered a notice requirement on the part of an administrative agent. Depending on the terms of the contract, there may be other notice requirements as LIBOR transition gets under way.
In part due to the substantial uncertainty regarding the LIBOR transition mechanics, many legacy loan agreements in ship finance do not include “hardwired” fallback provisions and require that the parties amend the loan documents to provide for a change in the reference rate, consistent with the LMA recommendations prior to the LMA providing rate switch agreement terms. Agents will need to commence the process of implementing amendments depending on the terms of the contract.
Agents and security trustees should also be mindful of the potential need to file amendments to their ship mortgages in connection with the change in the reference rate. See question 14 below for further discussion.
12. I heard recently that New York has passed a law that solves the LIBOR issue. Does that mean all contracts will automatically default to SOFR when the time comes? Do I then need to do anything about LIBOR?
New York State has passed legislation that by operation of law replaces LIBOR with a recommended benchmark replacement on the relevant LIBOR replacement date. While this new law provides important safeguards, it should not be viewed as a cure-all for all things LIBOR-related but rather as a backstop. First, the law does not affect contract governed by laws other than New York. Second, it does not override any contractual fallback provision that may be contained in the relevant contract. Third, it does not address individual circumstances where parties may want to negotiate for specific terms of the transition away from LIBOR.
13. What about swaps? Do I need to do anything with interest rate swaps when I amend my loan agreement?
As a general matter, any derivative instrument that is intended to hedge risk associated with an underlying loan needs to sync up with the underlying loan. ISDA has issued a fallbacks protocol for amending legacy swaps and has also issued template amendment agreements to assist in the transition. However, the ISDA fallbacks applicable to any derivative hedge should be assessed carefully to ensure that any change to the loan agreement relating to LIBOR will be reflected in the related derivative instrument.
14. If I amend my loan agreement in anticipation of LIBOR’s transition, do I need to amend my ship mortgage?
A ship mortgage is governed by the law of the jurisdiction in which the ship is flagged, so the answer would be jurisdiction-specific. As far as U.S. law is concerned (and the same considerations may be given to U.S.-influenced jurisdictions like the Marshall Islands and Liberia), there is no “hard and fast” rule. A mortgage is intended as a notice to the world that a mortgagee has a security interest in the relevant asset. It needs to include sufficient information to allow a third party to ascertain the nature of the mortgagee’s security interest, and such information must not be misleading. Therefore, a determination to amend a mortgage when there is a change in the underlying terms of the loan is highly fact-specific. As relating to LIBOR, whether amendments will be required is an open question and would depend on the facts of each case. LIBOR’s transition being a staggered process – that is, many contracts are being amended now to provide for a fallback but the actual replacement of LIBOR is not to happen until later – also poses a question as to the timing of any such mortgage amendment. We at Seward & Kissel are happy to discuss any individual circumstance under which a mortgage may (or may not) need to be amended as a result of LIBOR’s transition.