The Alternatives Reference Rates Committee's (ARRC) suggestions for addressing the discontinuation of LIBOR leave some risk to borrowers and lenders with respect to loan repricing, according to Fitch Ratings.

As anticipated, the ARRC has recently published a consultation that includes proposed LIBOR fallback language for syndicated loan agreements. The proposed language was drafted with the goal of avoiding market disruption associated with the expected phase-out of LIBOR in 2021. The ARRC provides two different versions of new fallback language: the "amendment approach" and the "hardwired approach." Although both varieties address the necessity of revisions to credit margins in order to maintain bargained-for loan prices, repricing risks remain.

The "amendment" approach is similar to the LIBOR replacement language as currently drafted in syndicated credit agreements. It still requires a negotiation and amendment process among borrowers and loan parties if and when LIBOR is phased out. Notably, however, the ARRC version now explicitly requires that the renegotiations of a new base rate include negotiating a "replacement benchmark spread" to compensate for disparities between LIBOR and newly negotiated rates such as SOFR. Currently employed fallback versions simply provide for the renegotiations of a base rate "and related changes."

Although the ARRC amendment approach is helpful in highlighting the need to address corresponding changes in credit margins, the requirement to renegotiate such margins on an ad hoc basis may provide lenders an advantage in a rising interest rate environment. As highlighted in our previous publication (Syndicated Loan Repricing Likely with LIBOR Phase-Out), lenders who retain consent rights may attempt to leverage rising interest rate environments and object to any proposed interest rate that does not reflect the rising market rate. Fitch observes that the ARRC amendment approach does not require that lender objections to proposed replacement spreads be made only in good faith. Such good faith limitations, as provided in The Good Year Tire & Rubber Co.'s (BB/Stable) second-lien credit agreement, may prevent lenders from taking advantage of a higher interest rate environment by limiting objections to those that ensure a market rate return.

Beyond addressing the necessity to renegotiate credit spreads, the ARRC amendment approach also explicitly provides lenders with consent rights to the newly negotiated base rate and replacement spread. This is far superior to the fallback provision currently contained in The Stars Group (B+/Stable) credit agreement, where the administrative agent and the borrower retain the sole right to negotiate a LIBOR replacement and required lenders cannot object to the renegotiated base rate (or spread). Fitch notes that credit agreements where lenders are not granted any consent rights with respect to LIBOR replacement rates are atypical.

With respect to the ARRC hardwired approach, the proposed language provides for a preselected alternative base-rate (e.g., SOFR) along with a replacement benchmark spread to become effective upon a LIBOR phase-out. Notably, although the hardwired approach would not require amendments to the credit documents at the time LIBOR becomes unavailable, currently outstanding credit agreements would need to be amended prior to any LIBOR termination in order to include the hardwired mechanism into the terms of the credit agreement. Accordingly, at least with respect to currently operative credit agreements, the inclusion of hardwired language would necessitate some degree of renegotiation at the time of incorporation of the new fallback provision.

Unlike the amendment approach, the replacement benchmark spread under the hardwired approach would not be the result of a renegotiation. Rather, the hardwired approach envisions that either a governmental body - such as the Federal Reserve Board - or ISDA would publish or endorse a recommended spread to be added to the preselected base rate (e.g., SOFR), which would account for the run-rate differential between LIBOR and the applicable replacement rate.

However, Fitch notes that it is unlikely that any replacement rate - even with appropriate credit spread adjustments - can sufficiently mirror the true nature and economic temperament of an alternative existing base rate such as LIBOR. For example, SOFR, which the hardwired approach expects to function as a replacement benchmark rate, is expected to stay flat (or potentially tighten) in periods of credit stress. LIBOR on the other hand has historically widened during periods of severe credit stress. Thus, although a credit spread adjustment to SOFR may successfully replicate LIBOR at a single point-in-time, it is virtually impossible to replicate the yield profile provided by LIBOR by applying a one-off fixed credit spread adjustment.

Accordingly, Fitch continues to expect some degree of loan repricing if and when LIBOR ceases to exist. To the extent loan repricing results in higher interest expenses, such a shift will add additional pressure to speculative-grade issuers with significant unhedged variable-rate debt, already large interest burdens, limited to negative FCF, and secularly-challenged business models. Repricing resulting in lower interest expenses may provide critical headroom for similarly situated borrowers. Thus, at least with respect to certain issuers, repricing has the potential to materially affect credit quality and ultimately, ratings.