Joyce Frost, Partner
The declaration that the Federal Reserve convened Alternative Reference Rates Committee (ARRC) to eliminate the age-old London Interbank Offered Rate (LIBOR) in 2017 brought about a disruption in the financial realm. What catalyzed the decision was the “LIBOR scandal” that came to light in 2012. To this end, ARRC has recommended Secured Overnight Financing Rate (SOFR) as a new benchmark for dollar-denominated contracts in 2017. As opposed to LIBOR, SOFR relies on transaction data and does not incorporate built-in credit risk component.
Until LIBOR phases out, which is expected to occur by the end of 2021, it will coexist in the financial markets with SOFR. However, some in the financial sector are wary about the LIBOR transition, since LIBOR serves as a benchmark for trillions of dollars of debt and derivatives. Switching LIBOR-based markets to the alternative benchmark is going to be daunting for a plethora of reasons. “Nearly every lender in this country has LIBOR-based loans, and internal systems and the loan agreements themselves will need to be changed accordingly to accommodate the LIBOR transition. Between now and the end of 2021, there is an enormous amount of work that needs to be done,” says Joyce Frost, Co-Founder and Partner of New York-based Riverside Risk Advisors. “Despite the impact that COVID19 is having on the financial markets, regulators remain firm on the December 31, 2021 deadline”.
The LIBOR transition also presents a particularly complicated situation for borrowers whose current LIBOR fallback in credit agreements is Base Rate (i.e., Prime). With the Base Rate typically 200 to 300 basis points higher than LIBOR, borrowers with LIBOR-based loans will be hit hard with increased interest expense. To illustrate, for a $100 million loan, the increased interest expense can be upwards of $250,000 per month, which will continue until the credit agreement can be amended and new language can replace existing fallback provisions.
The fallback to Base Rate also gives rise to moral hazard risk for the lender who is enjoying this benefit.
We have been working closely with clients to ensure that they avoid the base rate fallback as much as possible during the transition
There can also be other sources of LIBOR risk within a company that may not be as obvious, and certain contracts may not have any fallback language at all. In addition to providing its clients with expert advice for managing and hedging their interest rate, currency, and equity risk, Riverside is assisting companies during the LIBOR transition phase. The company has been working with its clients and counsel to put forward ARRC-recommended language in the credit agreements with a few important modifications. The proposed ARRC language aims to eliminate operational and other risks by offering consistent definitions and contractual language across the financial markets; however, it includes the fallback to Base Rate. “The most significant risk for most borrowers stemming from the LIBOR transition is the Prime rate fallback issue, which can and should be avoided by all constituents,” says Joyce.
Riverside is helping clients by offering a whole transition services package. Riverside helps identify the sources of exposure to LIBOR through a comprehensive diagnostic questionnaire, quantifies the risk and its potential impact, and will assist in negotiating any changes to LIBOR-based debt or derivatives. Riverside is partnering with Scissero, a UK-based AI firm, to utilize natural language processing technology for retrieving sensitive parts of a financing or credit agreement and creating a suggested amendment that can be reviewed by counsel. The results will be increased efficiency, reduced time frame to amend agreements and a reduction in legal costs.
Leveraging decades of experience in negotiating, structuring, trading, and executing various LIBOR-based derivative transactions, Riverside professionals are addressing the risks and working with clients to ensure a seamless transition from LIBOR to SOFR