April 26, 2023 - Last Friday, the ARRC released Updated Term SOFR Best Practice Recommendations. The announcement was good news for the continued availability of Term SOFR hedges, but it also creates potential risk for institutional term loans if they are determined to be securities. We decode the statement below.
Background: Most of the Updated Recommendations pertain to hedging Term SOFR. When the ARRC first released Term SOFR Best Practice Recommendations – and the CME enshrined them in their Term SOFR licensing agreement – the scope of use for Term SOFR for derivatives was very narrow. This is because Term SOFR is derived from futures contracts on Daily SOFR. The ARRC fears that if too much Term SOFR is used in the system, it could hollow out Daily SOFR and destabilize the rate.
Term SOFR Hedges: Under the original Recommendations, end users – such as companies borrowing under Term SOFR loan agreements – could hedge their risk. And lenders to those companies that provided the hedge could in turn hedge with a dealer. But that is where it stopped. Dealers were not allowed to swap out of that Term SOFR risk and an interdealer Term SOFR derivatives market was not permitted. This created a large build-up of Term SOFR risk at dealers that they couldn’t lay off and some were approaching their risk limits. Moreover, Term SOFR hedge demand is expected to increase materially when LIBOR ceases and loans fall back to Term SOFR. All told, this suggested that Term SOFR hedges might not be available – at any price – which hurts borrowers. (We direct readers that want more detail to a TD “Market Musings” article that discusses the issue in detail.)
The Updated Recommendations sought to reduce this problem. In effect, it now permits dealers to enter into Term SOFR-SOFR basis swaps with any non-dealer market participant. The hope is that this will draw parties like hedge funds, asset managers, pension funds and bank treasurers into the market on the other side of the Term SOFR-SOFR basis market at the appropriate price. Ideally, this eases the build up of one-way risk at the dealers and supports the continued availability of Term SOFR hedges. This is a welcome expansion. But another development was less welcome.
Term SOFR, TLBs and the Kirschner Case: Though a compromise on Term SOFR swap usage was expected, the Updated Recommendations also offered up a surprise. Curiously, they create an interesting intersection between Term SOFR use and the question at issue in the Kirchner case (covered in detail last week) – are term loan Bs securities? Let’s unpack that.
The Updated Recommendations include a definition of “business loan” to better distinguish business loans (which can use Term SOFR) from intercompany loans (which cannot use Term SOFR). The definition is designed to be broad enough to capture the different flavors of business lending. Of most relevance to LSTA members, the definition includes “a loan or other extension of credit that is primarily for business or commercial purposes and includes but is not limited to, whether or not syndicated to banks or other financial entities in each case: commercial loans; corporate loans; middle market loans”. All good, right? Well, the definition does not end there – it also explicitly excludes certain instruments from being a “business loan”. These exclusions are generally intuitive, but one exception may prove significant and limiting in the future. The definition of “business loan” excludes any publicly offered security or security offered under rule 144A. It would also exclude any non-144A private security unless it is “a loan or other extension of credit or the functional equivalent of a loan or other extension of credit that is primarily for business or commercial purposes of the type described above in the definition of Business Loan.” If term loan Bs were subject to the securities laws, presumably rule 144A offerings would be an exemption market participants would rely on. That could be complicated by the Updated Recommendations’ different treatment of 144A securities than other private securities. The rationale for this distinction is not immediately clear, but the accompanying footnote does suggest it is intentional. Furthermore, the Updated Recommendations expressly contemplate future material changes to the statutory, regulatory, or jurisprudential treatment of business loans. Footnote 5 states that if a material change were to occur, it would be appropriate to reconsider the Business Loan definition and, specifically recommends that the official sector, or an appropriate body of stakeholders working with them, further consider whether Term SOFR should continue to be referenced in new business loans. Will there be anybody interested in this role? Who knows, but this is yet one more reason to hope that the court in the Kirschner case does not find term loan Bs to be securities.
