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Documenting SOFR Loans: 8 Things for Borrowers to Think About
Although the borrower community has been actively involved in the negotiation of fallback provisions, borrowers in the United States have not had much of an opportunity to express their views on documentation for SOFR-priced loans
Bankers, lawyers and others involved in the loan markets transition from LIBOR to another reference rate have spent much of the past two years thinking about and drafting fallback provisions-the section of a loan agreement that describes what happens if LIBOR is not available. Now that the likely disappearance of LIBOR is less than a year and a half away, and the Alternative Reference Rates Committee (ARRC) has identified the Secured Overnight Financing Rate (SOFR) as the likely successor to US dollar LIBOR, market participants are spending more time thinking about how to document loans that provide for interest accruing at a rate based on SOFR.
Here is a list of things that may be proposed by borrowers in the negotiation of a SOFR credit agreement and, in a syndicated financing, ong lenders:
- There are a handful of precedent deals, including credit facilities for Royal Dutch Shell plc and British American Tobacco. 1 Their utility in preparing documentation in the United States is limited since they are governed by English law; they are somewhat dated (from , respectively); and, instead of providing for SOFR pricing at the outset, each has a so-called “switch mechanism” providing for a change in pricing from US dollar LIBOR to SOFR in the future. 2
- The LSTA has prepared various draft “concept documents”-model credit agreements (governed by New York law) that provide for loans priced at a rate based on SOFR. The most recent of these forms includes provisions for loans bearing interest at daily simple SOFR (the “Draft Simple SOFR Credit Agreement”). 3 Insofar as we know, these models have not yet been used for actual SOFR financings. Similarly, the LMA has prepared an exposure draft (governed by English law) of a compounded SOFR-based US dollar term and revolving facilities agreement. 4
- On , the ARRC published revised recommendations for fallback language in syndicated credit agreements (the “Refreshed Hard-wired Recommendations”). The revised recommendations provide solely for the “hard-wired” approach (and eliminate the “amendment approach” as an alternative). 5 Although this language provides for the automatic replacement of LIBOR with SOFR, it also acknowledges that “conforming changes” will need to be made to implement that replacement.
- The ARRC has also published a note on SOFR “In Arrears” Conventions for Syndicated Business Loans. 6 This note discusses mechanical issues that must be addressed in documentation for SOFR loans (and, for many of the issues, the ARRC does not make a recommendation on how it should be resolved).
1. Eliminate term SOFR from waterfall The first level of the waterfall in the Refreshed Hard-wired Recommendations is term SOFR. 7 Although there appears to be a strong preference by some banks for term SOFR (rather than daily SOFR), it is possible that some borrowers and lenders may prefer daily SOFR (the second level of the waterfall) since interest rate hedges (both for existing LIBOR hedges when they fall back and for new SOFR hedges) will likely be based on daily SOFR and not term SOFR. Those borrowers and lenders may fear potential basis risk and may want to eliminate the term SOFR level from the waterfall of possible fallback rates. 8 Other borrowers may well prefer to keep term SOFR as the first level of the waterfall (if term SOFR is in fact available) since its use will enable the parties to determine at the beginning of an interest period the exact amount of interest that will be payable at the end of the interest period-a determination that will not be possible for interest accruing at a rate based on daily SOFR in arrears (the second level of the waterfall in the Refreshed Hard-wired Recommendations).