On Friday, October 23, 2020, the International Swaps and Derivatives Association (ISDA) published the ISDA 2020 IBOR Fallbacks Protocol (the Fallbacks Protocol) and Amendments to the 2006 ISDA Definitions (the Amendments). These two initiatives create a streamlined approach for derivatives market participants to prepare for the end of the London Interbank Offered Rate (LIBOR), without the need for a bilateral amendment to each and every one of their LIBOR-based derivatives contracts.
Broadly speaking, the Fallbacks Protocol and Amendments are intended to solve one big problem: how will parties determine which index will apply in a LIBOR-based derivatives transaction when LIBOR goes away at the end of 2021? Because trillions of dollars’ worth of derivatives transactions do not contemplate the end of LIBOR, ISDA published the Fallbacks Protocol and Amendment as an efficient mechanism for market participants to insert terms in their existing and future derivatives transactions, stating when and how LIBOR will be replaced. The Amendment and the Fallbacks Protocol will both go into effect on January 25, 2021, with the Amendment applying to derivatives transactions executed on and after that date, and the Fallbacks Protocol applying to derivatives transactions executed prior to that date.
These FAQs are intended to help our bank clients (i) understand the impact and timing of the Fallbacks Protocol and Amendments, (ii) determine which steps to take to adopt the Fallbacks Protocol and Amendments, and (iii) communicate with bank customers about the upcoming LIBOR transition. This is a high-level overview of the Fallbacks Protocol and Amendments, and are not intended to be a comprehensive analysis.
1. Amendments to the 2006 ISDA Definitions
What do the Amendments Do?
The Amendments to the 2006 ISDA Definitions amend the definitions of each of the interbank offered rates, including USD-LIBOR, to account for the discontinuance of LIBOR upon the occurrence of an Index Cessation Event (defined below). Once an Index Cessation Event occurs, derivatives market participants are on notice that USD-LIBOR will be replaced by a term-adjusted version of the Secured Overnight Financing Rate (SOFR) plus a relevant spread, as published by Bloomberg Index Services, effective as of the Index Cessation Effective Date (defined below).
An “Index Cessation Event” means: (i) the Intercontinental Exchange (ICE) has announced that it will cease publishing LIBOR, (ii) the UK Financial Conduct Authority ( FCA) or another relevant financial regulator has announced that ICE will cease publishing LIBOR, or (iii) the FCA has determined that LIBOR is or no longer will be representative of the underlying market or economic reality that LIBOR is intended to measure, and such determination is made by the FCA in recognition of the fact that it will be a trigger for LIBOR fallback terms going into effect. The “Index Cessation Effective Date” means the date on which LIBOR is no longer published, or the date on which LIBOR is determined to be non-representative.
Said more succinctly, the effect of the Amendments is that for LIBOR-based derivatives contracts executed on and after January 25, 2021 that incorporate the 2006 ISDA Definitions, LIBOR will automatically be replaced by term-adjusted SOFR plus a spread when ICE permanently stops publishing LIBOR, or when LIBOR is deemed to be “non-representative” by the FCA.
Do I Need to Do Anything In Order for the Amendments to be Effective?
The Amendments will go into effect on January 25, 2021, and any derivatives transactions executed on that date forward that incorporate the 2006 ISDA Definitions will include the Amendments and therefore the appropriate fallback terms.
For our bank clients that rely on ISDA documents drafted by our firm, our standard ISDA document sets incorporate the 2006 ISDA Definitions by reference. Therefore, the Amendments will apply automatically to any such clients’ derivatives transactions executed on or after January 25, 2021, without any further action needed.
2. The ISDA 2020 IBOR Fallbacks Protocol
What Does the Fallbacks Protocol Do?
The Fallbacks Protocol, when effective and if adhered to by two counterparties, will insert the appropriate LIBOR fallback terms (the same as those in the Amendments) into all Protocol Covered Documents. “Protocol Covered Documents” include all confirmations, ISDA Master Agreements and Credit Support Documents entered into by two adhering parties that (i) incorporate the 2006 ISDA Definitions, (ii) reference LIBOR, and (iii) have an effective date or trade date prior to January 25, 2021.
In other words, the Fallbacks Protocol has the same effect as the Amendments (inserting LIBOR fallback terms into derivatives contracts that reference the 2006 ISDA Definitions), but applies retroactively, to derivatives contracts that were already executed prior to January 25, 2021.
Importantly, the Fallbacks Protocol will obviate the need for any two adhering parties to bilaterally negotiate and amend every one of their already-existing LIBOR-based derivatives contracts.
For our bank clients that rely on ISDA documents drafted by our firm, these all incorporate the 2006 ISDA Definitions by reference and therefore, if your bank adheres to the Fallbacks Protocol, LIBOR fallback terms will automatically be inserted into all of your LIBOR-based derivatives transactions executed prior to January 25, 2021 with every one of your counterparties that has also adhered to the Fallbacks Protocol. However, if a customer does not adhere to the Fallbacks Protocol, then you will need to enter into a bilateral amendment with that customer to adopt the Fallbacks Protocol.
Do I Need to Adhere to the Fallbacks Protocol?
There is no regulatory or other requirement for market participants to adhere to the Fallbacks Protocol. This is an optional solution created by ISDA, so that derivatives market participants have a streamlined means of amending their existing LIBOR-based transactions, and do not need to bilaterally amend each one.
That said, we expect the vast majority of derivatives market participants to adhere to the Fallbacks Protocol. Dealer banks (with whom many of our regional and community bank clients enter into offsetting or “upstream” interest rate swaps) will likely require their customers to adhere. And, even if a bank has no pressure or requirement to adhere, it is still the most efficient way to amend existing LIBOR-based transactions, without having to individually negotiate amendments with each counterparty. Unless a bank prefers an alternative replacement rate to SOFR (such as Prime or Ameribor), has a small number of outstanding LIBOR-based transactions and customers, has customers who refuse to adopt the Fallbacks Protocol, or has certain other unique circumstances, adhering to the Fallbacks Protocol is likely the best approach.
What if My Customers Don’t Adhere to the Fallbacks Protocol?
To the extent that a bank customer refuses to adhere to the Fallbacks Protocol, the bank will need to bilaterally amend each of the LIBOR-based derivatives transactions that it entered into with that customer at any time prior to January 25, 2021. We expect a number of our bank clients to opt into the bilateral amendment approach where customers refuse to adopt the Fallbacks Protocol, or in certain other limited circumstances. Our firm has prepared a simple form amendment that our bank clients can use with these customers, which incorporates the terms of the Amendments and Fallbacks Protocol, as in effect on January 25, 2021, into these derivatives contracts. Please see our contact information below to discuss next steps.
How do I Adhere to the Fallbacks Protocol?
In order to adhere to the Fallbacks Protocol, you must access the “Protocols” section of the ISDA website, enter the relevant information in order to populate a form Adherence Letter, and submit any applicable fee. The Protocol is open to the public and you do not need to be an ISDA member to adhere to it. The adhering party must sign the Adherence Letter, submit it to ISDA via the Protocol section of its website, and then it will receive an e-mail confirmation from ISDA that the adhering party has officially adhered to the Protocol. ISDA will publish all signed Adherence Letters on its website for all adhering parties to view. The effective date of the Protocol will be January 25, 2021, meaning that the Protocol will apply to all Protocol Covered Documents (defined above) executed prior to that date between any two adhering parties.
3. Next Steps
What happens between now and January 25, 2021?
Derivatives market participants that plan to adhere to the Fallbacks Protocol should do so prior to January 25, 2021, so that when the Fallbacks Protocol goes into effect on that date, it will immediately apply to all Protocol Covered Documents executed with other adhering parties. To the extent that you have not familiarized yourself with SOFR, the USD-LIBOR replacement rate, this is a good time to do so.
As noted above certain bank customers may not adhere to the Fallbacks Protocol, and therefore you may also need to bilaterally amend certain LIBOR-based derivatives contracts that are already executed. This can be accomplished with a simple amendment, and we are working with many of our bank clients to get these executed on and shortly after January 25, 2021, to ensure that ISDA’s fallback terms are inserted into the appropriate derivatives contracts without relying on the Fallbacks Protocol.
For derivatives transactions executed between October 23, 2020 and January 25, 2021 (in other words, after the Amendments and Fallback Protocol were published but before they go into effect), it may also be appropriate to incorporate the terms of the Amendment or Fallbacks Protocol “as published on October 23, 2020,” despite the fact that they are not yet effective. This is not necessary, but some derivatives market participants are considering this approach, to ensure that new derivatives transactions executed during this “limbo” time period have the appropriate fallback terms. To the extent a bank is entering into bilateral amendments with its customers in lieu of relying on the Fallbacks Protocol, this will also obviate the need for the parties to amend any LIBOR-based derivatives contracts executed during this time period.
How Can I Prepare My Customers?
If you have not already discussed the LIBOR transition with your bank’s customers, now is the time. We have prepared additional FAQs for our bank clients, which explain what LIBOR is, why it is going away, what SOFR is, and how LIBOR will be replaced with SOFR eventually. This document is a great starting point for discussion.
Do I need to do anything else?
Yes! Even after you have adhered to the Fallbacks Protocol, the Amendments are in effect, and you have bilaterally incorporated fallback terms into all of your derivatives contracts (as needed), there are two additional steps that all derivatives market participants need to take:
Loan Documentation. The Amendments and Fallbacks Protocol published by ISDA apply to derivatives contracts only. Unfortunately, no such streamlined approach exists for loan documentation, which makes up a substantial portion of the universe of LIBOR-based contracts. Loan documentation will also need the appropriate LIBOR fallback terms inserted, and to the extent there is a derivative instrument executed in connection with such loan, the fallback terms will need to work in tandem with ISDA’s fallback terms so that the variable rate in the derivatives and loan documents are the same. As with derivatives contracts, the LIBOR fallback terms will need to be inserted in new loan documents, and previously executed loan documents will need to be amended. We have model fallback terms and a form amendment to address these issues, and are working with our clients to ensure that this process runs smoothly.
Amendment to Reflect the Replacement Rate. The Fallbacks Protocol and Amendments describe how a replacement rate will be determined, but do not result in the new rate being explicitly stated in derivatives documents. Upon the occurrence of an Index Cessation Effective Date, USD-LIBOR will be replaced with term-adjusted SOFR plus a spread, in accordance with the Amendments and Fallbacks Protocol. However, at that time and as a matter of best practices, derivatives market participants should enter into a simple bilateral amendment to evidence the actual interest rate, so that there is no uncertainty about the rate and replacement timing. Our firm has a form amendment that our bank clients can rely on to accomplish this last step.
Please contact Alec Fraser, Cheryl Isaac, or your regular Michael Best attorney if you would like to discuss further.
 In addition to LIBOR, the Amendments and Fallbacks Protocol include fallback terms for a variety of other financial benchmarks that are based on interbank lending markets in other world financial markets. These FAQs are limited to a discussion of USD-LIBOR, which is most relevant to our clients.