On July 12, the staffs of the Division of Corporation Finance, Division of Investment Management, Division of Trading and Markets, and Office of the Chief Accountant (the “Staffs”) of the Securities and Exchange Commission issued a statement (the “Statement”) highlighting risks for market participants to consider as they transition away from Libor. The Staffs noted that it is expected that private-sector banks currently reporting information used to set Libor will stop doing so after 2021 when their current reporting commitment ends, which could either cause Libor to stop publication immediately or cause Libor’s regulator to determine that its quality has degraded to the degree that Libor is no longer representative of its underlying market.
The Staffs further noted that the expected discontinuation of Libor could have a significant impact on the financial markets and may present a material risk for certain market participants, including public companies, investment advisers, investment companies and broker-dealers.
The highlights of the Statement are set forth below (a full copy of the Statement may be found here).
The Staffs encourage market participants who have not already done so to begin the process of identifying existing contracts that extend past 2021 to determine their exposure to Libor. In particular, the Staffs encourage market participants to consider questions along the lines of the following:
- Do you have or are you or your customers exposed to any contracts extending past 2021 that reference Libor? For companies considering disclosure obligations and risk management policies, are these contracts, individually or in the aggregate, material?
- For each contract identified, what effect will the discontinuation of Libor have on the operation of the contract?
- For contracts with no fallback language in the event Libor is unavailable, or with fallback language that does not contemplate the expected permanent discontinuation of Libor, do you need to take actions, such as proactive renegotiations with counterparties, to mitigate the risk of contractual uncertainty?
- What alternative reference rate — for example, the Secured Overnight Financing Rate (SOFR) — might replace Libor in existing contracts? Are there fundamental differences between Libor and the alternative reference rate — such as the extent of or absence of counterparty credit risk — that could impact the profitability or costs associated with the identified contracts? Does the alternative reference rate need to be adjusted (by the addition of a spread, for example) to maintain the anticipated economic terms of existing contracts?
- For derivative contracts referencing Libor that are utilized to hedge floating-rate investments or obligations, what effect will the discontinuation of Libor have on the effectiveness of the company’s hedging strategy?
- Does use of an alternative reference rate introduce new risks that need to be addressed? For example, if you have relied on Libor in pricing assets as a natural hedge against increases in costs of capital or funding, will the new rate behave similarly? If not, what actions should be taken to mitigate this new risk?
The Staffs also recommend that market participants consider whether contracts entered into in the future should reference an alternative rate to Libor (such as SOFR) or, if such contracts reference Libor, include effective fallback language. The Alternative Reference Rate Committee (Arrc) has published recommended fallback language for new issuances of floating-rate notes, syndicated loans, bilateral business loans and securitizations.
Other Business Risks
The Staffs encourage market participants to also identify, evaluate and mitigate other consequences the discontinuation of Libor may have on their business, such as on strategy, products, processes and information systems. For example, market participants may wish to ensure that their information technology systems are able to incorporate new instruments and rates with features that differ from Libor’s.
The federal securities laws are designed in part to elicit disclosure of timely, comprehensive and accurate information about risks and events that a reasonable investor would consider important to an investment decision. In the Statement, the staff of the Division of Corporation Finance (DCF) identifies a number of existing rules or regulations that may require disclosure related to the expected discontinuation of Libor, including rules and regulations related to disclosure of risk factors, management’s discussion and analysis, board risk oversight, and financial statements.
In deciding what disclosures are relevant and appropriate, the staff of the DCF encourages companies to consider the following:
- The evaluation and mitigation of risks related to the expected discontinuation of Libor may span several reporting periods. Consider disclosing the status of company efforts to date and the significant matters yet to be addressed.
- When a company has identified a material exposure to Libor but does not yet know or cannot yet reasonably estimate the expected impact, consider disclosing that fact.
- Disclosures that allow investors to see this issue through the eyes of management are likely to be the most useful for investors. This may entail sharing information used by management and the board in assessing and monitoring how transitioning from Libor to an alternative reference rate may affect the company. This could include qualitative disclosures and, when material, quantitative disclosures, such as the notional value of contracts referencing Libor and extending past 2021.
In addition, the staff of the Office of the Chief Accountant (OCA) notes that an interest rate benchmark can have a pervasive impact on a company’s financial reporting. Transitioning from one benchmark rate to another benchmark rate can also have a significant impact on a company’s accounting. The staff of the OCA is actively monitoring the activities underway among preparers and auditors of financial statements; standards setters, such as the Financial Accounting Standards Board (FASB); and other regulators, to address financial reporting issues that might arise in connection with any transition from Libor to an alternative benchmark rate.
The staff of the OCA notes that these issues could span a number of areas, including, for example, the accounting and financial reporting for:
- Modifications of terms within debt instruments
- Hedging activities
- Inputs used in valuation models
- Potential income tax consequences