SOFR: Coming in for Landing

In line with industry guidance, (i) any new contracts that were entered into on or prior to December 31, 2021, should have either used a reference rate other than LIBOR or have included robust fallback language indicating a clearly defined alternative reference rate (“Alternative Rate”) that would apply after LIBOR’s discontinuation and (ii) any new contracts that were entered into post December 31, 2021, should have used a reference rate other than LIBOR.

Based on industry reports, such guidance has largely been followed, but the issue of legacy LIBOR transactions with maturities after June 30, 2023 remains.

Thankfully, we have a clearer picture now on how the post-LIBOR landscape will look and have set out below a brief summary of the current positions being adopted:

1. Preferred Alternative Rates: The Alternative Reference Rates Committee (“ARRC”) has made it clear that it considers Term SOFR to be the preferred variant to replace LIBOR, and Term SOFR is indeed the variant most often seen in the market — although there has been some divergence with some parties opting to use both Term SOFR and Daily Simple SOFR, while others have opted for Daily Simple SOFR.

2. LSTA Approach: Given that the Loan Syndications and Trading Association (“LSTA”) is the co-chair of ARRC, it is unsurprising that it has also adopted the Term SOFR concept loan (i.e., a forward looking term SOFR), rather than the Loan Market Association (“LMA”) approach seen in the UK, which adopted a Sterling Over Night Index Average (“SONIA”) compounded in arrears that does not permit the parties to know the rate in advance. Similar to the approach taken in the LMA documentation, LSTA has not provided a CAS (as defined below) convention, leaving market participants free to negotiate. 

3. Credit Adjustment Spreads (“CAS”): Most loan parties have been including credit adjustment spreads in their SOFR-based loans and leases in order to bridge the gap between the LIBOR rate and the SOFR rate, given that SOFR does not include a credit premium. A variety of spreads have been used including:
   1. a flat 0.10% adjustment spread applicable to all Term SOFR tenors; and
   2. a spread adjustment of varying basis points across several different tenors (0.10% / 0.15% / 0.25% across one-month / three-month / six-month Term SOFR tenors).

There has been a divergence in practice in respect of the CAS, as some participants have maintained the traditional two part pricing [SOFR + Margin] with the CAS baked into the Margin, whereas others prefer the three part pricing model [SOFR + CAS + MARGIN] as adopted by the International Swaps and Derivatives Association (ISDA). In the lending market, the determination of the CAS really comes down to the preference of the administrative agent and what their current systems are able to support.

4. Options outside of SOFR: Reference rates like the Bloomberg Short-Term Bank Yield Index (“BSBY”) and the American Interbank Offered Rate (“Ameribor”) are unsecured rates (unlike SOFR, which is a secured rate), which by definition carry high levels of risk. BSBY and Ameribor therefore provide for a generally higher rate of return, and these rates are also being used by certain participants. They believe that these rates better reflect a lender’s funding costs and account for the risks from the perspective of a short term lender. However, their usage is mostly limited to smaller national banks, as well as community banks.

Implications on the Aviation Leasing Industry

While financiers will likely take the lead in replacing LIBOR in their financing arrangements, the cessation of LIBOR will impact the aviation leasing industry in other ways. For example, amendments will be required:

1. to operating lease agreements for any default rate provisions based on LIBOR;
2. to existing operating lease agreements with floating rate rentals based on LIBOR;
3. to new operating lease agreements that calculate monthly rentals based on LIBOR; and
4. any hedging agreements using LIBOR.

In particular, we would highlight the following:

1. operating lessors will need to ensure that they have sufficient capabilities to undertake the calculations associated with the Alternative Rates;
2. while operating lessors will have greater flexibility to formulate their own contractual fallback provisions so that it works for their operation, this cannot be done in a vacuum, and consideration must be given to any linked financing or hedging arrangements to ensure that there are no inconsistencies between them that may cause significant payment mismatches; and
3. particularly in today’s environment, airlines may not feel compelled to link the lease rate terms to the changes made to the related financings; depending on the jurisdiction of their domestic currency, they may still be formulating their LIBOR transition policy (e.g., the Euro Interbank Offered Rate (“Euribor”)), which could also result in further payment mismatches.

Potential implications on doing nothing?

On July 19, 2022, the Federal Reserve Board invited comment on a proposed regulation that provides default rules for certain contracts that use the LIBOR reference rate. The proposal implements the Adjustable Interest Rate (LIBOR) Act, which Congress enacted earlier this year.

In response to the planned end of LIBOR, Congress enacted the LIBOR Act to provide a uniform, nationwide solution for replacing references to LIBOR in existing contracts without adequate fallback provisions.

Consistent with the law, the proposal would replace references to LIBOR in certain contracts with the applicable Board-selected replacement rate after June 30, 2023 (a.k.a. SOFR). The contracts include those governed by domestic law that do not mature before LIBOR ends and that lack adequate fallback provisions.

For example, if implemented, this would mean that if you have an operating lease (i) governed by U.S. law (e.g., New York law), (ii) with default rate provisions based on LIBOR, (iii) that will continue past the June 30, 2023 deadline, and (iv) no action is taken to adopt an Alternative Rate, then SOFR will automatically be applied to such calculations post June 30, 2023.

In summary, the cessation date is fast approaching, but market positions have been solidified in respect of the Alternative Rate and CAS choices, which eliminates much of the uncertainty, thus making an orderly transition achievable with some pre-planning.

Please reach out to Kim Dalrymple for more details on the above topic or if you have any other queries.