July 13, 2020 - On Monday, the LSTA circulated to the Primary Market Committee a final draft of our concept credit agreement describing a term loan referencing daily simple SOFR or daily compounded SOFR (“compound the balance” approach). A blackline against the LSTA’s LIBOR referencing Investment Grade term loan form is available here.
Background
The ARRC published an updated recommendation for LIBOR fallback language syndicated loans on June 30th. The updated recommendation only provides updated hardwired fallback language which is consistent with the ARRC’s best practice that syndicated loans include hardwired fallback language in new loan originations by the end of 3Q20. (Click here for a summary of the updated recommendation.) The ARRC Business Loans Working Group worked diligently to develop the updated language, building on months of ARRC Business Loan Working Group discussions on how SOFR will be implemented in the loan market. The result of that work has been to modify the replacement rate waterfall that would come into effect following a trigger event – the first step is Term SOFR, and if that is not available (which it is not currently), then Daily Simple SOFR (instead of the compounded average of SOFR found in the April 2019 recommendation) so that both the first and second step of the waterfall are already operationalized. However, it is important to note that Daily Compounded SOFR is provided as an alternative step of the waterfall in the User’s Guide (see pp. 21-22 of the recommendation).
The concept credit agreement serves to support the use of hardwired fallback language, and hopefully ease the transition to new originations of SOFR-referenced loans, by offering an illustrative example of a Daily Simple SOFR loan (or Daily Compounded SOFR loan). Members are encouraged to keep in mind that the concept document does not purport to represent or set any standard market practice. It has been developed simply as a tool to further familiarize market participants with replacement benchmark alternatives, in this case Daily Simple SOFR and Daily Compounded SOFR, which will hopefully further assist each institution with its own transition planning.
Daily Simple SOFR
After considered discussion among market participants and systems providers, it is clear that loan facilities will need to accrue interest on a daily basis. The concept credit agreement provides for a daily SOFR loan, i.e. interest accrues based on SOFR for each day of the interest period, with a lookback with no observation shift (of an number of days for parties to determine). As a daily rate loan, interest accrues on a real-time basis (i.e. “in arrears”) so the amount of interest owed by the borrower would not be known until the end of the period without the use of a convention, like a lookback, that permits certainty as to the interest amount before the interest payment is due. A lookback simply shifts backwards the period of time that the rates are observed. For a daily rate loan, any applicable “interest period” would only represent the applicable payment period for interest, e.g. monthly or quarterly, and for that reason there is no need for a borrower to have the option of electing different “interest periods” as they do in LIBOR loans (or other term rate loans). Relatedly, in the absence of such optionality, it is operationally easier for interest to be paid on scheduled payment dates (like ABR loans). The concept document reflects this approach to “Daily Simple SOFR” loans (or “Daily Compounded SOFR” loans).
Daily Compounded SOFR – “Compound the Balance”
While interest will need to accrue on a daily basis, interest can accrue on a simple basis (described above) or a compounded basis. To that end, alternative drafting is included for a loan referencing “Daily Compounded SOFR.” It is important to note that the drafting provided in this concept document illustrates the “compound the balance” approach in which the overnight SOFR rate is multiplied by outstanding principal and unpaid accrued SOFR interest (collectively, the balance). Compounding is only applicable on Business Days and solely with respect to SOFR (not margin, i.e. the “Applicable Rate”). The operative provision for this compounding mechanism, found in Section 2.09(d), sets forth that interest will be applied on a daily basis based upon (x) the outstanding principal amount of the loan as of that day plus (y) the accrued, unpaid interest on the loan attributable to “Daily Compounded SOFR” (and not the Applicable Rate) as of the immediately preceding Business Day.
The “compound the balance” approach is only one of two compounding approaches which are being discussed in the ARRC Business Loans Working Group. The second approach is to “compound the rate” which applies a calculated rate of daily compounded interest to principal outstanding. This method accurately compounds interest when principal is unchanged within an interest period or, if principal is paid down, when any accompanying interest is paid down at the same time. The application of this approach to loans is complicated because loans often have intraperiod principal fluctuations (whether through prepayments or trading) and it may be that this approach is best expressed by a formula. The approach will be illustrated in a separate concept document (based on an updated version of the February 26th draft of the compounded SOFR in arrears concept document).
Transition to Term SOFR
Member feedback supported including an option for an automatic transition to Term SOFR if an ARRC recommended Term SOFR were to exist and be available for use in syndicated loans. Sample language providing for that transition has been included in brackets and highlighted in blue. Member feedback also reflected the careful consideration needed before market participants include an automatic transition to Term SOFR. As set out in Footnote 2, parties should weigh the potential benefits as well as the operational risks of shifting to Term SOFR and be aware of the potential disruption to existing hedging arrangements that a transition could cause. Moreover, as an alternative to an automatic transition to Term SOFR, parties may also consider whether such a transition is more appropriate as an “opt-in option” which could be accomplished through modifying the “Early Opt-in Election” mechanism.
Next Steps
The final version of this concept document will be circulated to membership shortly after the ARRC recommended conventions for business loans are published (expected by the end of July). For a blackline against the March version, please click here.
A final draft of the compounded SOFR (“compound the rate” approach) concept document will also be circulated to the Primary Market Committee in due course.
For further information, please contact Tess Virmani.
