In this short update, we look at the latest guidance on the use of a forward-looking term rate to replace USD LIBOR primarily in the context of loan products.

On 29 July 2021, the Alternative Reference Rates Committee (ARRC) formally recommended forward-looking term SOFR administered by the CME Group for use in USD financial contracts (Term SOFR). Term SOFR completes the suite of SOFR-based methodologies recommended by the ARRC which includes (i) backward-looking SOFR (i.e. daily simple SOFR in arrears and daily compounded SOFR in arrears) (SOFR in Arrears) and (ii) SOFR averages applied in advance (SOFR Averages).

What is Term SOFR?

Term SOFR is a form of Secured Overnight Financing Rate that parties to business loans may use as a benchmark interest rate. It is a forward-looking rate, meaning that the rate is known in advance of the interest period (as is the case with LIBOR). Term SOFR is calculated with reference to transactions in the derivatives market (SOFR futures and SOFR overnight indexed swaps) and is an expectation of future market movements – the rationale being that if there is sufficient depth and liquidity in this market, there will be limited volatility and actual market movements should be aligned with expectations. Term SOFR is a published screen rate available in 1-, 3- and 6-month tenors.

Comparing Term SOFR with SOFR in Arrears and SOFR Averages

• SOFR in Arrears is a backward-looking overnight rate based on actual transactions. This means that SOFR in Arrears actually tracks what happens to the overnight SOFR rates during the selected period (subject to a “lookback” delay period), however those daily rates are only known at the end of the interest period. In contrast, SOFR Averages and Term SOFR are known prior to the first day of the interest period.
• SOFR Averages are calculated based on historic transactions (as with SOFR in Arrears) and the rate is known in advance of the interest period. The Federal Reserve Bank of New York publishes data for SOFR Averages for 30-, 90- and 180-day tenors. Term SOFR is also a published rate and known in advance of the interest period, however it is a forward-looking rate and expected to reflect future market movements. SOFR Averages are backward-looking, based on the historic rates for the prior equivalent interest period, so does not necessarily reflect the market reality for the upcoming interest period.

ARRC’s recommended conventions – new loans

The ARRC has published conventions and recommended best practices for the use of Term SOFR. As a general principle, the ARRC recommends that SOFR in Arrears and SOFR Averages are used for business loans where possible given their robustness, but ‘supports the use of Term SOFR in areas where use of overnight and averages of SOFR has proven to be difficult’. This is particularly the case where the interest rate needs to be known some time in advance of the interest period and where it may not appropriate to apply a ‘lookback period’ to the relevant rate. In practice, export finance, emerging markets lending, and trade and commodity finance each represent markets with unique challenges where the application of backward-looking risk free rates is less workable and where the use of Term SOFR could present a welcome solution.

Fallbacks

The ARRC recommends that a temporary fallback convention is included in the event that Term SOFR is temporarily unavailable – for example, if Term SOFR has not been published as of 5:00pm New York time on an interest lookback day, the rate will be that published on the relevant administrators’ website for the first preceding US Government Securities Business Day (provided that day is no more than three US Government Securities Business Days prior to such interest lookback day). Alternatively, parties can use interpolation if this is operationally feasible.

Loans using Term SOFR should also include robust, non-temporary fallbacks. Term SOFR itself may also be used as a fallback in loans which use SOFR in Arrears or SOFR Averages. Term SOFR is automatically the first fallback for these loans which follow the ARRC fallback waterfall. For loans based on the LMA documentation, parties may now wish to include Term SOFR as a fallback to the existing interest rate benchmark if Term SOFR is not selected as the day 1 interest rate benchmark.

Lookback

The ARRC recommends a two day lookback (i.e., using the rate published two US Government Securities Business Days prior to the first day of the interest period and held for the entirety of the interest period).

Borrowing notice period

It is recommended that the borrower provides notice of a borrowing request three US Government Securities Business Days prior to the borrowing date.

Daycounts

The ARRC’s recommendation is Actual/360 days for Term SOFR (as is the case with SOFR in Arrears and SOFR Averages) although it is possible to use other day-count fractions (e.g., Actual/365 days).

Business day convention

The Modified Following Business Day convention is recommended, meaning that payments scheduled to be paid on a non-Business Day will be adjusted to the next succeeding business day, unless that business day falls in the next succeeding calendar month, in which case the interest payment date will be the preceding business day. This is consistent with the conventions for SOFR in Arrears and SOFR Averages.

Interest rate floors

The ARRC recommends that interest rate floors apply to Term SOFR.

Rounding

Term SOFR is published to five decimal places and dollar amounts should be calculated to two decimal places. These rounding conventions are aligned with those for SOFR in Arrears and SOFR Averages.

ARRC’s recommended conventions – legacy loans

The ARRC has stated that most of the conventions described above should equally apply to legacy USD LIBOR loans transitioning to Term SOFR – in addition, spread adjustments are likely to be applicable and any floor should apply to the sum of Term SOFR plus the associated spread adjustment.

Use in financing documentation

The legal documentation and operational implementation of Term SOFR (and SOFR Averages) will be similar to those for the use of LIBOR, as they are both based on forward-looking term rates. Parties will need to address any credit adjustment spread and the conventions described above in contractual agreements, but this will be significantly more straightforward than the provisions and operational implementation for the use of SOFR in Arrears which requires extensive calculation methodologies and formulae.

If you would like advice about how Term SOFR might apply to your existing or prospective loan agreements or other financing or factoring products, or any other aspect of LIBOR transition, please contact Jacqueline Bell at jacqueline.bell@dentons.com.