Undeterred by the COVID-19 Pandemic, ARRC Publishes on April 8, 2020 a Methodology for Addressing Differences between LIBOR and SOFR

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On April 8, 2020, the Alternative Reference Rate Committee (“ARRC”) agreed to align itself with the International Swaps and Derivatives Association, Inc. (“ISDA”), in recommending to the market a “spread adjustment” methodology for use in U.S. Dollar-denominated financial instruments.

Both ARRC and ISDA previously solicited comments from practitioners in markets for certain loans and over-the-counter (“OTC”) derivatives, with an eye towards addressing the reality that replacing the London Interbank Offered Rate (“LIBOR”) with the Secured Overnight Financing Rate (“SOFR”) will change the economics of financial instruments referencing LIBOR.

With the upcoming discontinuation of LIBOR after 2021 (which has been confirmed by English authorities as an event scheduled to take place at the end of 2021 notwithstanding the global COVID-19 pandemic, according to a recent press release issued by the Financial Conduct Authority*), parties cannot simply replace LIBOR with SOFR, a median of rates that market participants pay for overnight, collateralized loans, because the benchmarks are fundamentally different. LIBOR and SOFR are neither identical in terms of their inputs and component parts nor do they measure the same risk over an identical period of time. While both LIBOR and SOFR are intended to reflect short-term borrowing costs, SOFR is a daily, collateralized overnight rate, whereas LIBOR incorporates the judgment of a panel of bankers for the cost of credit for certain periods of time, typically greater than 24-hours (while LIBOR is a benchmark for calculating payments on the spot or overnight, or even during a period of one week, it typically is used in financial instruments for periods of one, two, three, six, or 12 months).

For these reasons it has always been contemplated that an “add-on” feature would be necessary in benchmark transitioning from LIBOR to SOFR. That feature is known as “the spread” (which differs from even a further “add-on,” which lenders may impose on a borrower given the credit profile of that borrower).

Without the use of a spread to account for differences between LIBOR and SOFR, the economics of financial instruments referencing LIBOR (e.g., interest rate payments required by the terms of a commercial mortgage referencing LIBOR) will be different if the benchmark is SOFR as opposed to LIBOR. In fact, over the past five years LIBOR and SOFR have not been identical and the recommended spread adjustment methodology is designed to address differences in these two benchmarks.

For certain cash products (e.g., commercial mortgage and other loans) as well as for over-the-counter derivatives (e.g., interest rate swaps accompanying certain commercial mortgages, for example), ARRC and ISDA, as of April 8, 2020, both recommend a “historical mean-median approach” which directs market participants to determine the historical mean-median differential between LIBOR and SOFR over a period of time: five years.

While the methodology recommended by ARRC on April 8, 2020, and previously by ISDA, is to be voluntarily adopted by market participants, it is hoped that widespread use of the spread adjustment methodology will minimize the difference between LIBOR and SOFR in both loans and OTC derivatives once LIBOR is discontinued after 2021.

As for next steps, we expect further developments and announcements by ARRC and ISDA as the markets for both loans and OTC derivatives continue to address legacy documentation referencing LIBOR, while executing new transaction documentation with replacement language.

We expect that ARRC will release detailed guidance for how the historical mean-median approach will in practice be used for inputting a spread into reference rate calculations for commercial and other loans.

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*“Impact of the Coronavirus on Firms’ LIBOR Transition Plans,” Financial Conduct Authority, Mar. 25, 2020 (“The FCA [Financial Conduct Authority], Bank of England and members of the Working Group on Sterling Risk-Free Reference Rates have discussed the impact of the coronavirus on firms’ LIBOR transition plans over the coming months. The central assumption that firms cannot rely on LIBOR being published after the end of 2021 has not changed and should remain the target date for all firms to meet.”).

These materials have been prepared by Seyfarth Shaw LLP for informational purposes only and do not constitute legal advice.