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SOFR Breakfunding

Simply Speaking
April 29, 2022

SOFR Breakfunding

Example Breakfunding Provision

SOFR Breakage Fee. Upon any prepayment of a SOFR Rate Loan on any day that is not the last day of the relevant Rate Period (regardless of the source of such prepayment and whether voluntary, by acceleration or otherwise), Borrower shall pay an amount (the “SOFR Breakage Fee”), as calculated by Bank, equal to the amount of any losses, expenses and liabilities that Bank may sustain as a result of such payment. Borrower understands, agrees and acknowledges that: (i) Bank does not have any obligation to purchase, sell and/or match funds in connection with the use of the SOFR Rate as a basis for calculating the rate of interest on a SOFR Rate Loan, (ii) the SOFR Rate may be used merely as a reference in determining such rate, and (iii) Borrower has accepted the SOFR Rate as a reasonable and fair basis for calculating the SOFR Breakage Fee and other funding losses incurred by Bank. Borrower further agrees to pay the SOFR Breakage Fee and other funding losses, if any, whether or not the Bank elects to purchase, sell and/or match funds.

What is it and what does it do?

A breakfunding provision is a yield-protection clause that works for the benefit of the lender. It applies when a borrower prepays a loan before the end of an interest period and, as a result of such prepayment, the lender incurs “breakage costs”. These breakage costs may arise for a number of different reasons. The most common reason is that the lender, in making the loan, had borrowed funds for that interest period at, historically, LIBOR (its cost of funds) and, as a result of the prepayment, it no longer has a matching stream of interest from the borrower to service its interest payments. More broadly (and more likely, given that most lenders do not match loans-in to loans-out), the breakage costs are meant to compensate the lender for additional costs it will incur in complying with its risk management policies, e.g., balancing its assets and liabilities.

Why is it important to a lender?

As the loan market transitions itself to SOFR (or other reference rates) as a result of LIBOR’s discontinuation, certain provisions that have historically been included in loan agreements without much negotiation are being revisited. Because LIBOR is calculated on the estimated cost of obtaining an interbank loan, it, by its nature, includes liquidity and credit premiums, i.e., a risk-based rate that approximates a lender’s cost of funds. In contrast, Daily SOFR is considered a “risk free rate” because it is based on the cost of overnight borrowing collateralized by U.S. securities, i.e., little or no risk of loss. SOFR is not meant to represent a lender’s cost of funds.

To date, there is not a market consensus as to whether to include a breakfunding provision for SOFR-based loans. Why? Arguably, a prepayment of a loan based on a Daily SOFR rate means the lender should be able to use those funds in the overnight repurchase market and obtain an equivalent Daily SOFR return, and, at least theoretically, there aren’t any increased costs for the lender.

However, while many loans may allow for short-term interest periods, it is unlikely that there will be a perfect match between the cost of funds being repaid and the cost for the lender redeploying those funds. In addition, there will be a cost associated with the lender adjusting its overall portfolio in accordance with its risk policies because of such prepayment.

Moreover, many SOFR loans today are based on “Term SOFR” rates, which are calculated on the SOFR derivatives markets (as opposed to the treasury repurchase market). These forward-looking rates have different tenors, e.g., one, three and six-months, and are easy for borrowers to adopt into their cash management systems. Because they function like LIBOR rate loans, breakfunding clauses are more relevant.

How does it affect a borrower and get negotiated?

A breakage cost is an obligation of the borrower, and if invoked by the lender, could result in a significant sum to be payable by the borrower (sometimes to their surprise). Lenders have generally retained breakfunding provisions in SOFR loans and these clauses largely follow standard LIBOR breakfunding clauses, which may require a lender to provide an actual calculation of its increased costs, or the lender can, in good faith, certify as to its increased costs. Given the different characteristics of SOFR, as compared to LIBOR, some borrowers have questioned the applicability of the breakage cost and resisted inclusion of such a provision in loan agreements. However, because SOFR loans are still at their infancy, it is difficult to say whether there is market consensus on how breakfunding provisions (as well as other yield protection clauses in a loan agreement) should be treated.


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