|Footnotes for this article are available at the end of this page.
By the end of October 2020, lenders should begin adopting a “hardwired” approach to replacing the benchmark interest rate for new loan originations with LIBOR-based interest rates. That’s according to the updated ARRC Recommended Best Practices for Completing the Transition from LIBOR published on September 3, 2020 by the New York Fed’s Alternative Reference Rates Committee (“ARRC”). The target date for transitioning to a hardwired approach for syndicated loans was September 30, 2020, and the syndicated market has already seen its first implementations of the new language. As the suggested deadline approaches for bilateral loans, lenders active in this space should prepare to use the hardwired approach in their own loan documents. But what is the hardwired approach, and how is it different from the benchmark replacement language featured in most bilateral loan documents now?
Current State of Benchmark Replacement Provisions
First convened in 2014, ARRC’s purpose is to facilitate the transition from LIBOR to the secured overnight financing rate (“SOFR”) as a benchmark interest rate. The committee has periodically published recommended contract language governing that transition for inclusion in the documentation supporting a variety of non-derivative credit products. ARRC published its first set of recommendations for fallback language in LIBOR-based bilateral business loan documents in May of 2019 (the “2019 Fallback Language”). The 2019 Fallback Language featured two alternative approaches to replacing LIBOR: the “amendment approach” and the “hardwired approach”.1
Up until now, both the syndicated and bilateral loan markets have largely favored the amendment approach. The amendment approach does not establish in advance what the replacement interest rate will be – instead it identifies specific triggers for when the loan will stop using LIBOR, establishes a streamlined amendment process by which the lender (in some cases with or without the consent of the borrower)2 can amend the loan documents to incorporate a replacement benchmark interest rate, and establishes broad parameters for how that replacement rate will be selected and implemented. The amendment approach has the advantages of being simple to write into loan documents and preserving great flexibility in selecting a replacement benchmark rate. This flexibility was particularly important given that there was still substantial uncertainty around how SOFR would be operationalized at the time the 2019 Fallback Language was adopted.
A disadvantage of the amendment approach is that it may not produce a truly neutral replacement of the index rate – there may be an opportunity for lenders (or borrowers, in transactions in which the borrower has consent rights over the LIBOR-replacement amendment) to exploit then-current market conditions and negotiating leverage to force a replacement rate that unfairly favors one party over the other. The amendment approach also presents an operational challenge since, upon the transition away from LIBOR, the lender would have to separately negotiate and execute amendments to the documentation for each and every one of its “amendment approach” loans simultaneously.
With these disadvantages in mind, ARRC updated its recommended fallback contract language on August 27, 2020 (the “2020 Fallback Language”). The new 2020 Fallback Language drops the amendment approach entirely, and instead exclusively features the hardwired approach. As the market is expected to shift to the hardwired approach, lenders will need to understand how the hardwired approach will function in their loan documents.
How the Hardwired Approach Works
Under the hardwired approach, upon the occurrence of specific trigger events the loan documents will automatically replace LIBOR with a pre-defined successor interest rate. Because of lingering uncertainty about which SOFR-based rates will be available at the time of transition, the successor interest rate is determined by moving through a waterfall of defined successor rates – if the first specified successor rate in the waterfall is unavailable, the second specified successor rate will be used unless it too is unavailable, in which case the third specified successor rate will be used. The hardwired approach also addresses how the chosen successor rate will be adjusted to provide a neutral replacement for LIBOR, plus how technical changes can be made to the loan documents to reflect the adoption of the new rate.
The interest rate replacement in the hardwired approach is initiated by one of several trigger events. “Permanent cessation triggers” correspond to the actual cessation of LIBOR as a published index rate, as shown by a public announcement to that effect by either LIBOR’s administrator (the Intercontinental Exchange Benchmark Administration) or specified regulators. There is also a “pre-cessation trigger” in the event that LIBOR is still being published but the applicable regulators have publicly announced that the quality of the published LIBOR rate has diminished to the point that it is no longer representative of underlying economic or market reality. The final trigger is an “early opt-in”, which can be voluntarily activated by the lender if the market has already started to shift to SOFR-based interest rates even though LIBOR is still available (as measured by the lender’s determination that a certain number of unrelated but similar loan transactions have been executed using SOFR).
Replacement Benchmark Interest Rate Waterfall
Following a trigger event, the benchmark interest rate will be automatically replaced by the first of the following alternatives (in the following order) that can be determined by the lender: (1) Term SOFR, (2) Daily Simple SOFR, and (3) an alternative benchmark rate selected by the lender. “Term SOFR” is the forward-looking SOFR-based term rate for the applicable interest period selected by ARRC or its successors. If no such selection has occurred at the time, then the next alternative, “Daily Simple SOFR”, will be used.3 Daily Simple SOFR is the daily backwards-looking rate determined from the prior day’s overnight treasury repo market applied against the outstanding principal for each day of the interest period. The overnight SOFR rate is currently available, but if for some reason it cannot be determined at the time of transition the waterfall moves on to an alternative benchmark selected by the lender. Optional provisions included in the 2020 Fallback Language can be inserted to require the lender to select the alternative rate based on then-current ARRC recommendations or market custom, and to provide the borrower certain consent rights over the selected rate.
The waterfall described above is based on the stock provision in the 2020 Fallback Language. However, there is some discussion in the guidelines about alternative steps (such as “Daily Compounded SOFR” or “SOFR Average”) that can be included in the waterfall to suit particular lenders or transactions.
Spread Adjustment Waterfall
Having selected a replacement benchmark interest rate, the hardwired approach then seeks to establish a spread adjustment to increase or decrease the successor rate to match the equivalent LIBOR rate. If Term SOFR or Daily Simple SOFR will serve as the replacement benchmark interest rate, there is another waterfall of alternative spread adjustments: (1) the spread adjustment selected by ARRC or its successor, then (2) the spread adjustment selected by ISDA. If instead the lender-determined alternative benchmark rate was selected, the lender also selects the spread adjustment.
The hardwired approach is designed to mechanically produce a replacement benchmark interest rate without the need for further negotiation by the parties. However, following the determination of the new rate there will likely be minor technical, administrative or operational changes to some provisions of the loan documents required to accommodate the administration of the new rate. The 2020 Fallback Language authorizes the lender to make these conforming changes to the loan agreement unilaterally at or following the transition to the new rate.
As we move closer to the anticipated phase out of LIBOR at the end of 2021, it will become increasingly critical for lenders to implement effective LIBOR replacement provisions in their documents to ensure a smooth and predictable transition. Current guidance from ARRC suggests that the hardwired approach is the preferred approach to achieving this goal, and we should expect to see the hardwired approach become broadly adopted across the market.
While we expect new LIBOR-based loans originated in the last quarter of 2020 and throughout 2021 to increasingly favor a hardwired approach to LIBOR replacement, one interesting question each lender will have to consider is whether to amend its existing loans to install a hardwired LIBOR-replacement provision. Many institutions have already invested considerable energy updating their operative loan documentation to include an amendment approach-based replacement provision, and in some cases (especially those in which the lender already has the unilateral right to select the replacement index rate) they may prefer to continue to rely on the amendment approach without the expense and difficulty of amending the documents again to put in the hardwired approach. We will be monitoring this area closely to see if a market consensus emerges.
 Both sets of ARRC fallback language discussed here also include a “hedged loan approach” intended to be used for transactions where the interest rate is fully hedged against a derivative utilizing the recommended benchmark replacement language promulgated by the International Swaps and Derivatives Association (“ISDA”). The ISDA definitions that will be used in derivative contracts are slightly different, and the hedged loan approach adjusts the proposed fallback contract language to align with the ISDA approach. The current hedged loan approach set out in the 2020 Fallback Language is fundamentally similar to the hardwired approach, rather than an amendment approach, and so the discussion below of how the hardwired approach functions is still generally applicable to the current hedged loan approach.
 The 2019 Fallback Language offers options for both a unilateral amendment right for the lender (whereby the lender can amend the loan document to implement the replacement interest rate selected by lender without further consent from borrower) or, alternatively, a “negative consent” approach to the amendment (whereby the lender proposes an amendment implementing the replacement interest rate selected by lender which automatically takes effect only if the borrower does not then object within five to ten business days). We have also seen formulations of this provision in the market calling for the borrower and lender to mutually negotiate and agree on an amendment replacing the index rate.
 The 2020 Fallback Language’s use of Daily Simple SOFR as the second step in the waterfall is a change from the hardwired approach in the 2019 Fallback Language, which used Compounded SOFR in this position.