In Part 1 of this series, we discussed the circumstances that have led to the planned phase-out of the London Inter-bank Offered Rate, commonly referred to as “LIBOR”. In this part of the series, we will discuss the proposed replacement rate referred to as the Secured Overnight Financing Rate (“SOFR”).
SOFR was established by the Federal Reserve Bank of New York and is recommended by the Alternative Reference Rate Committee (“ARRC”) - the committee tasked with addressing various concerns pertaining to the LIBOR phase-out and the rate to replace LIBOR. SOFR is calculated by measuring the cost of overnight borrowings through bilateral repurchasing agreement transactions collateralized with U.S. Treasuries. A notable difference between SOFR and LIBOR that all parties would be well-advised to anticipate the difference in the spread. In particular, because SOFR is collateralized and, therefore, less risky than the unsecured LIBOR, the spread will vary between the two rates. When implementing the alternative rate (i.e., SOFR), this variation will need to be accounted for in the modification of any agreement.
Despite the perceived security of the SOFR rate compared to that of LIBOR, a common criticism of the rate is that, given its nature as an overnight rate, it is going to be much more volatile from day to day. In response, the Federal Reserve Bank of New York has reassured prospective users that use of the daily averages will alleviate the issues of volatility. Nevertheless, there are proposals, particularly by the Structured Finance Industry Group, to implement a “forward-looking term SOFR” to address this issue. Such a rate would be based on market expectations of a SOFR over an upcoming accrual period. This development should be monitored as we approach 2021.
In next part of this Series, we will discuss the proposed language recommended by ARRC for use in loan documentation to smooth the transition to SOFR. In the meantime, if you would like additional information about the LIBOR phase out, please contact the attorneys in Parker McCay’s Corporate Department at any time.
The content of this post is for informational purposes only and should not be construed as legal advice or legal opinion. You should consult a lawyer concerning your specific situation and any specific legal question you may have.