While the market has largely made the switch to SOFR for purposes of determining interest rates, market standards for related terms and provisions are still developing. For example, a consensus has not yet been reached on the question of whether market disruption provisions are necessary or appropriate in a term SOFR-based transaction. The Loan Syndications and Trading Association (LSTA) itself notes in its concept term SOFR credit agreement that this is an ongoing discussion point in the market. The emergence of a consensus on this point may have been slowed by the relative dearth of floating rate transactions this year, as borrowers have raced to fix interest rates in a rising interest rate environment. Some borrowers argue against the inclusion of market disruption provisions in SOFR-based transactions on the basis that, unlike LIBOR, SOFR is not intended to represent lenders’ actual cost of funds. LIBOR was a forward-looking measure of banks’ unsecured cost of funds, based on quotations from a relatively small number of individual panel banks that accounted for the creditworthiness of institutions. It was accordingly susceptible to market distortions, which required market disruption provisions to ensure that banks could charge interest at least equal to their actual cost of funds if LIBOR became unrepresentative at a particular time, even if in practice these provisions were rarely if ever invoked.
SOFR, by contrast, is a so-called “risk-free rate,” which excludes by design the credit standing of banks from the more objective measure of the average rate on all overnight transactions. It is therefore less susceptible to manipulation than LIBOR, and also less likely to be unrepresentative of the broader market. That said, lenders may prefer to retain market disruption provisions, particularly where a loan is transitioning from LIBOR to SOFR, and a credit adjustment spread is included in the interest rate, as this spread is typically based on the median average difference between LIBOR and SOFR over the previous five years, thereby linking the rate to LIBOR and its cost of funds approach. In new SOFR-based loans, particularly those without a specific credit adjustment spread, the argument in favor of market disruption provisions is, at this early stage, largely based on precedent from LIBOR transactions and can be expected to evolve over time.
Break costs are another area where a market standard approach is still emerging in new SOFR-based loans. Breakage in both floating rate and notional fixed rate LIBOR deals historically included funding breakage based on LIBOR breakage. LIBOR breakage was initially predicated on the idea that banks match fund their loans in the interbank market for the duration of each interest period. This became more theory than reality over time as banks gradually stopped match funding and LIBOR breakage became a proxy for compensating banks for their funding breakage and/or internal treasury costs associated with prepayment events. SOFR-based loans are not dependent on or in any way tied to match funding in the interbank market, and while some have argued against the merits of SOFR-based breakage on this basis, banks can still be expected to incur broken funding costs based on their internal funding arrangements and the costs associated with redeploying funds. We therefore expect that breakage indemnities will continue to be commonplace in post-LIBOR financings. However, the shape and form of such indemnities can be expected to evolve to reflect the different foundations of LIBOR in SOFR. There may be additional flexibility in notional fixed rate transactions, where we have seen some lenders agree to limit breakage to notional swap breakage and to forego additional SOFR-based breakage, presumably because the notional swap breakage adequately compensates them for the costs they expect to incur in connection with a prepayment. The approach may vary from bank to bank depending on their funding sources, funding costs and policy requirements.
Another point to note in relation to interest rate hedges (real and notional) is that care should be taken to ensure that the form of SOFR being hedged matches the form of SOFR used in the underlying loan. Meaning, if the relevant loan is based on term SOFR, then the relevant interest rate swap should contemplate the swap of floating rate term SOFR for fixed rate term SOFR, and swap breakage should be calculated based on a term SOFR hedge. This may sound obvious, but it’s worth clarifying this point in the documentation since the International Swaps and Derivatives Association (ISDA) and the Alternative Reference Rates Committee (ARRC) have recommended that SOFR compounded in arrears be used as the replacement for LIBOR in derivatives markets. Parties are free to choose what form of SOFR to use in their swaps, and the ARRC has acknowledged that term SOFR derivatives are appropriate for end-user facing derivatives intended to hedge loans that reference term SOFR. But, absent specification, it is possible that a bank could hedge the interest rate for a term SOFR loan with a swap based on SOFR compounded in arrears, which could potentially result in a mismatch and breakage costs that are higher than necessary.
Finally, it’s worth highlighting that the new SOFR-based loans generally include SOFR fallback language, which would come into play if term SOFR were to be discontinued at a future date. The LSTA model agreements provide that the benchmark replacement for a term SOFR loan should be determined based on a waterfall, whereby the fallback is the first alternative in the waterfall that can be determined by the agent. The first fallback in the LSTA waterfall is daily simple SOFR plus a spread adjustment, and the second is the alternative benchmark agreed between the agent and the borrower having due regard for (i) any recommendation by financial regulators regarding a replacement benchmark rate, or (ii) any then evolving or prevailing market conventions (in each case plus a spread adjustment). Most new term SOFR loans are following the LSTA recommendation, though we do occasionally see banks ask for alternative fallback rates, such as the federal funds rate plus a margin (generally 25 – 50 basis points) and Bloomberg Short-Term Bank Yield Index (BSBY), among others.
Amendments to Existing LIBOR-Based Transactions
Existing financing transactions have not been as quick to switch over to SOFR as new transactions. In our experience, market participants have been waiting for market standards to emerge in new SOFR transactions as well as in LIBOR to SOFR amendments. That said, it’s clear that most if not all parties are now turning their mind to the task of amending their LIBOR transactions, and we expect to see a flurry of these amendments in the coming months.
When it comes to aircraft leases, LIBOR most frequently needs to be replaced in the default rate definition. We have seen default rates in new leases refer to the U.S. prime rate, term SOFR or a specified fixed rate instead of LIBOR. Existing leases may reference LIBOR in other provisions as well, such as floating rate rent calculations, make whole provisions and breakage calculations, and any LIBOR references in such provisions should generally be replaced with references to term SOFR. Existing leases which reference LIBOR in any way should be amended prior to June 2023. We are not generally seeing widespread lease amendments to this effect at this stage, but we are increasingly seeing aircraft purchasers looking to amend LIBOR references in connection with the acquisition of a leased aircraft.
With the June 2023 discontinuation of LIBOR just around the corner, lenders, borrowers, lessors and lessees alike will soon need to start discussions on their LIBOR amendments.
U.S. Adjustable Interest Rate (LIBOR) Act
While it’s certainly preferable for parties to come to a commercial agreement on the terms for the switch from LIBOR to SOFR, Congress has passed legislation to address the fate of those transactions which are not or cannot be amended prior to the discontinuation of SOFR.
On March 15, 2021, the Adjustable Interest Rate (LIBOR) Act (the Act) was signed into law by President Biden. The purpose of the Act is to “establish a clear and uniform process, on a nationwide basis, for replacing LIBOR in existing contracts the terms of which do not provide for the use of a clearly defined or practicable replacement benchmark rate.” (Section 2(1) of the Act.) The Act preempts applicable state laws and applies to LIBOR-based contracts regardless of the governing state law of the relevant contract. The Act acknowledges that given the sheer volume of existing LIBOR-based contracts (estimated to be in excess of $200 trillion), there will undoubtedly be a material number of contracts which, for any number of reasons, are not amended to provide for a LIBOR fallback. The Act acknowledges that this situation creates uncertainty and the potential for disputes and litigation around the post-LIBOR operation of these contracts.
The automatic fallback provision of the Act takes affect after June 30, 2023, (the day on which the ARRC has announced that all tenors of LIBOR will permanently cease to be published), unless the Board of Governors of the Federal Reserve System (the Board) determines that any LIBOR tenor will cease to be published or representative on a different date. The Act applies to LIBOR contracts (both loans and leases), which either (a) contain no fallback provisions which are not based on LIBOR, or (b) contain fallback provisions that identify neither (i) a specific benchmark replacement, or (ii) a so-called “Determining Person” with the authority to determine the benchmark replacement. Many early LIBOR fallback provisions in aviation financings were essentially agreements between the borrower and the agent to agree on an appropriate fallback at a future date. These contracts will come within the ambit of the Act if no agreement is reached by the parties prior to June 30, 2023. On the other hand, contracts which give the agent the discretion to select and implement a benchmark replacement (without requiring borrower consent) will generally not come within the scope of the Act, unless the agent fails to select a benchmark replacement by June 30, 2023. The Act does not alter the impact of any pre-existing caps, floors or spread adjustments to which the LIBOR-based rate had been subject. The Act also doesn’t override any applicable federal consumer financial laws that require creditors to notify borrowers of changes in terms. Regardless of applicable laws, it is certainly good commercial practice to notify borrowers of any changes in commercial terms, particularly those as fundamental as the applicable interest rate.
On June 30, 2023, the applicable benchmark in LIBOR-based contracts to which the Act applies will, by operation of law, become the SOFR-based benchmark replacement which is identified by the Board. This will include a spread adjustment, which is prescribed by the Act, based on the tenor of the applicable interest period (0.11448 percent for 1-month LIBOR, 0.26161 percent for 3-month LIBOR, 0.42826 percent for 6-month LIBOR and 0.71513 percent for 12-month LIBOR).
The Act does not include any further specifics regarding the nature of the SOFR-based rate but contemplates the issuance of regulations by the Board regarding the same and regarding any conforming changes required to be made to affected LIBOR contracts. This past July, the Board published a proposed regulation and invited public comments thereon. While the final regulation has yet to be issued, the proposal is instructive, and we expect the final regulation will follow it closely.
The proposed Board regulation contemplates the use of CME-administered term SOFR for the relevant tenor plus the applicable tenor spread adjustment specified in the Act for cash transactions that are not consumer loans or covered Government-Sponsored Enterprises (GSE) contracts (a category which most if not all aviation finance and leasing transactions will fall into). This is not surprising given that CME term SOFR has already been recommended by financial regulators as a replacement for LIBOR in financing transactions and market participants have already begun transitioning to this new benchmark.
With respect to derivatives transactions, the Board has proposed to select the approach to LIBOR replacement set forth in the ISDA 2020 IBOR Fallbacks Protocol (being (i) SOFR, compounded in arrears for the appropriate tenor, plus (ii) a spread adjustment for the appropriate tenor (with the stated spread adjustments in the ISDA protocol being identical to those in the Act). The intent of this selection is to avoid disruption to derivatives markets’ existing efforts to transition away from LIBOR, which the Board considers to be progressing well. While this makes sense for derivatives more generally, this could result in a mismatch for borrowers as the operation of the Act could result in the interest rate in a loan transaction being converted to term SOFR and a related hedge being converted to SOFR compounded in arrears, resulting in a mismatch and potentially higher breakage costs in the event of a prepayment. Borrowers with interest rate hedges in place should take this into consideration and endeavor to amend their loans and hedges before June 2023 to avoid this potential mismatch being implemented by operation of law.
With respect to proposed conforming changes, the proposed regulation at this time simply provides that references to LIBOR in LIBOR contracts be replaced with the proposed Board-selected benchmark replacement, without any modification of other contractual provisions.
After years of discussion and planning, the transition to SOFR is now upon us. The market has made meaningful progress this year and new market standards are emerging in SOFR-based aviation financing and leasing transactions. Parties should now move quickly to amend their LIBOR-based facilities well in advance of the June 2023 discontinuation of LIBOR. Recent new SOFR financings and model agreements provided by the LSTA provide useful guidance and model language in this regard. While there are still a few areas where market consensus has yet to develop, on the fundamentals of interest rate calculation and determination, the market is quite unified. The LIBOR to SOFR amendment process should therefore be a relatively painless one. Of course, if for commercial or procedural reasons this is not possible, the U.S. Adjustable Interest Rate (LIBOR) Act should help smooth the transition for LIBOR-based financing and leasing transactions.