IN BRIEF

  • After years of transition efforts, the benchmark interest rate for nearly all commercial loans for the past 40 years (LIBOR) has been phased out and replaced in most agreements with a new benchmark rate (SOFR) that results in all-in borrowing costs that are in line with LIBOR.
  • Some commercial loan agreements without SOFR-based fallback provisions, however, may revert to a prime or base rate if LIBOR is unavailable, leading to increased loan costs.
  • Companies should review their commercial loan agreements and any other payment obligations with interest accrual provisions to determine the effect of the LIBOR cessation on their interest rate. If LIBOR's unavailability has resulted in a prime or base rate benchmark instead of SOFR, borrowers should promptly reach out to counterparties to amend the agreement.

The London Interbank Offered Rate (LIBOR) officially ceased to be published on June 30, 2023. The change comes after almost 40 years of LIBOR serving as the principal benchmark rate for trillions of dollars of various financial contracts, including loans, bonds, derivatives and mortgages, among others. For some unwary borrowers, the end of LIBOR could result in increases in their all-in borrowing costs during a time of already challenging interest rate increases.

LIBOR transition preparations have been ongoing for years, resulting in a largely smooth, efficient and uneventful transition to a benchmark based on the Secured Overnight Financing Rate (SOFR).1 Efforts spearheaded by the Alternative Reference Rates Committee (ARRC) resulted in various automatic or streamlined fallbacks to SOFR. For LIBOR loans without adequate contractual benchmark replacement provisions, the Adjustable Interest Rate (LIBOR) Act stepped into the void to mandate a SOFR-based replacement.2 The net result is that LIBOR has been replaced in many commercial loan contracts by a SOFR-based benchmark with all-in borrowing costs that have (thus far) remained consistent with LIBOR or have been slightly more favorable for borrowers.3

Prime Rate Fallbacks Could Increase Borrower Loan Costs

Despite these preparations and legislative actions, there remains a contingent of corporate borrowers that have fallen (back) into the cracks. In many loan documents, LIBOR cessation results in a fallback to a rate based on the prime rate, also known as the base rate or reference rate, which, while based on the rate banks give to their best, most creditworthy corporate customers, has historically been more expensive than LIBOR. Because the LIBOR Act is generally inapplicable for loan documents containing contractual fallback language that clearly specifies a replacement rate, the prime rate will become the controlling benchmark under these agreements. A recent estimate stated that approximately 8% of leveraged loans could fall back to the prime rate upon the cessation of LIBOR if action is not taken.4 Although public data on the topic is limited, the percentage of loans falling back to the prime rate in the venture debt and middle-market spaces is likely to be far higher. Note that while beyond the scope of this article, similar considerations may be implicated by fixed-to-floating-rate preferred stock or floating-rate senior notes, depending on the specific features of those instruments.

Because the prime rate tends to be more expensive for borrowers than SOFR after inclusion of applicable margins, borrowers with agreements that fall back to the prime rate will begin paying significantly higher interest after their next rate reset date following the LIBOR cessation. This higher rate will remain applicable until borrowers are able to refinance or amend agreements to implement a replacement rate. Borrowers who delay the amendment process may experience increased credit pressure amid already high interest rates, which can be particularly problematic for borrowers facing liquidity concerns. Furthermore, borrowers with syndicated debt facilities may face a difficult amendment process, as the consent of each debt holder is generally required to alter the applicable interest rate. It is therefore important for borrowers with prime fallback rates to begin the amendment process promptly if they have not already done so.

In Switch to SOFR, Be Mindful of Spread Adjustments

Borrowers making the switch from prime to SOFR should pay close attention to the spread adjustment proposed in connection with the SOFR-based replacement rate. In March 2021, the ARRC released recommended spread adjustments of approximately 12, 26 and 43 basis points applicable to one-, three- and six-month Term SOFR, respectively.5 These spread adjustments are meant to cause Term SOFR to more closely mimic historic LIBOR run rates. The amount of the adjustment is largely negotiable, however, and is only fixed for contracts that have adopted "hardwired" fallback language automatically incorporating the ARRC's recommendations at the time of LIBOR cessation.

Contrary to the ARRC recommendations, the current market standard for Term SOFR spread adjustments is either (i) a flat adjustment of 10 basis points across one-, three- and six-month tenors or (ii) an adjustment of 10, 15 and 25 basis points applicable to one-, three- and six-month Term SOFR, respectively.6 Borrowers negotiating replacement rate amendments should therefore resist attempts to set spread adjustments in accordance with the ARRC's recommended values to avoid taking on additional credit costs and instead push for a flat spread adjustment of 10 basis points across one-, three- and six-month tenors.

The Takeaway

With the June 30, 2023 LIBOR deadline well past, borrowers should carefully review all financial contracts, including credit agreements, to determine the effect of the LIBOR cessation on applicable benchmark interest rates. If the agreement does not contain fallback language addressing the applicable interest rate in the event of LIBOR's unavailability, consider reaching out to legal counsel to determine whether the LIBOR Act applies. If the agreement falls back to a prime, base or reference rate, reach out to legal counsel or counterparties to begin the process of amending financial contracts to minimize unnecessary monetary losses. Borrowers should expect their lenders to implement a new benchmark rate based on the Term SOFR rate and should push for a flat spread adjustment of 10 basis points across one-, three- and six-month tenors.

Footnotes

1. See Chalyse Robinson & Nathan J. Moore, Prepare Your Business for the End of LIBOR, WILMERHALE (August 20, 2019), https://www.wilmerhale.com/en/insights/client-alerts/20190820-prepare-your-business-for-the-end-of-libor.

2. See Board of Governors of the Federal Reserve System, Federal Reserve Board Adopts Final Rule That Implements Adjustable Interest Rate (LIBOR) Act by Identifying Benchmark Rates Based on SOFR (Secured Overnight Financing Rate) That Will Replace LIBOR in Certain Financial Contracts After June 30, 2023, FED. RSRV. (December 16, 2022), https://www.federalreserve.gov/newsevents/pressreleases/bcreg20221216a.htm; see also 12 C.F.R. § 253 (2023).

3. See Sven Klinger & Olav Syrstad, Does SOFR-linked Debt Cost Borrowers More Than LIBOR-Linked Debt? (Norges Bank Research Working Paper, May 25, 2023), https://www.norges-bank.no/contentassets/4c30d6a7361740a1838e5a761971cffe/wp-7-2023-sofr.pdf?v=06/16/2023151415; see also Harriet Clarfelt & Kate Duguid, Over $1tn of Risky US Loans Shackled to LIBOR as Deadline Looms, FIN. TIMES (February 27, 2023), https://www.ft.com/content/1e8adb6d-10ac-4cc2-9d30-97c41150832f.

4. See LIBOR Cessation Could Pressure Funding Costs for Some LL Issuers, FITCH RATINGS (April 10, 2023), https://www.fitchratings.com/site/pr/10230011.

5. See Summary of the ARRC's Fallback Recommendations, ARRC (October 6, 2021), https://www.newyorkfed.org/medialibrary/Microsites/arrc/files/2021/spread-adjustments-narrative-oct-6-2021.

6. See Theodore Basta, Christian Alfred Fundo, Jeffrey A Nagle and Tess Claudia Virmani, The Loan Product in the SOFR World: Perspectives of Administrative Agents, Arrangers and Lenders in a Post-LIBOR World, ABA BUS. L. SECTION (July 15, 2022), https://www.americanbar.org/groups/business_law/resources/business-law-today/2022-august/the-loan-product/.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.