The Situation: The Staffs of the Divisions of Corporation Finance, Investment Management and Trading and Markets ("Divisions") of the U.S. Securities and Exchange Commission ("SEC") and its Office of the Chief Accountant ("OCA") have issued a rare joint statement ("Statement") that corporate issuers, funds, and advisers should consider to be both guidance and a warning regarding the SEC's expectations related to the anticipated cessation of LIBOR after December 31, 2021.
The Result: The Statement provides critical guidance to assist public companies and other registered entities, such as broker-dealers, investment advisers, and investment companies, as they continue to evaluate and proactively address the impact of LIBOR's expected cessation on their portfolios of LIBOR exposures, disclosure obligations, accounting, and back-office technology systems.
Looking Ahead: The financial markets are facing many complex uncertainties as a result of the expected cessation of LIBOR that will need to be addressed during the coming months. Those who work proactively to understand their exposure now will be well-positioned to avoid regulatory scrutiny. And those who take the most thoughtful and sophisticated approaches will likely be able to use this potential market disruption to gain a competitive advantage or obtain favorable economic outcomes for their shareholders and investors.
The Divisions and the OCA released the Statement on July 12, 2019. The Statement echoes and expands upon the "significant risk" LIBOR cessation presents and the substantial work falling upon market participants that SEC Commissioner Clayton highlighted late last year. Although not a formal SEC rule or regulation, and not approved or disapproved by the Commission, the Statement should immediately assume a prominent position at the top of the summer reading list for those in the C-suite, board members, in-house counsel and compliance professionals, internal audit staff, and anyone else involved in risk assessment and the financial reporting and disclosure functions at public companies, registered investment companies and advisers, broker-dealers, and other entities subject to SEC regulation.
We've Been Watching and Advising
In a series of Jones Day publications (e.g., "Bank of England Publishes Discussion Paper on Risk Management Systems for Collateral Referencing LIBOR," "ARRC Publishes Final LIBOR Transition Recommendations for Securitizations and Bilateral Business Loans," "ISDA Forges Ahead with Market Consultations on Critical IBOR Transition Issues," and "Compare and Contrast: SFIG's and ARRC's Differing Approaches to Benchmark Transition in Securitizations"), we have maintained a steady drumbeat on the expected demise of LIBOR by 2022 and the need for financial institutions and counterparties to agreements to focus immediately on transitioning both legacy and future LIBOR-based agreements to alternative interest rates. Multiple industry and country-based working groups have arisen to assist with the transition.
The issue is tectonic in scope: The Statement notes that "[a]n estimated $200 trillion in notional transactions reference USD LIBOR in the cash and derivatives markets with more than $35 trillion extending past 2012." LIBOR benchmark rates impact everything from holders of student loans and mortgages, to small business loans, credit facilities at large public companies, and complex derivative contracts used to hedge a variety of economic risks. Michael Held, General Counsel of the Federal Reserve Bank of New York, has described the potential fallout from LIBOR's cessation as "a DEFCON 1 litigation event."
Key General Considerations and Questions
The Statement is invaluable reading for anyone new to the LIBOR transition issue and for the useful general and Division- and OCA-specific considerations and questions that should be considered now. Some key overarching questions the Staff suggests:
- Are you or your customers exposed to contracts extending past 2021 referencing LIBOR, and are such contracts individually or in the aggregate material?
- Do any effected contracts lack fallback language contemplating a discontinuation of LIBOR and, if so, what proactive renegotiations with counterparties might be required?
- What alternative reference rate—such as the Secured Overnight Financing Rate ("SOFR")—should replace LIBOR in existing contracts?
The Commission Staff encourages all market participants to identify, evaluate and mitigate other potential impacts on their business from any LIBOR termination, such as any effect on strategy, product, processes and information systems. The Staff gives the specific example of ensuring that information technology systems can incorporate new instruments and alternative rates with features different from LIBOR.
SEC Division and OCA-Specific Guidance
Division of Corporation Finance. The Staff of the Division of Corporation Finance not surprisingly emphasizes the need to keep investors informed about the steps public companies have taken or will undertake to identify and mitigate risks related to a transition from LIBOR and the impact on a company, if material. The Division Staff encourages consideration of the following guidance:
- Because LIBOR discontinuation risks may span multiple reporting periods, companies should consider disclosing efforts to date and significant matters yet to be addressed.
- Consider disclosure of a material exposure to LIBOR even if it cannot yet be reasonably estimated or is not yet known.
- Consider disclosure of information used by management and the board in determining how moving from LIBOR to an alternative reference rate may impact the company, including qualitative and, when material, quantitative disclosures, such as the notional value of contracts referencing LIBOR extending past 2021.
Division of Investment Management. Funds and advisers should consider whether any LIBOR cessation impact on investments constitutes risks that should be disclosed to investors. The Division "encourages affected funds to provide investors with tailored risk disclosure that specifically describes the impact of the transition on their holdings."
Division of Trading and Markets. The Staff notes that entities such as broker-dealers may underwrite or make markets in instruments referencing LIBOR or recommend LIBOR-based securities, including to retail investors. Broker-dealers should analyze the impact of these risks and an appropriate response, including whether their clients and the markets should be informed of LIBOR-related risks.
Office of the Chief Accountant. As the OCA Staff notes, interest rate benchmarks can have a pervasive impact on a company's financial reporting, and any related transition from one benchmark to another can similarly have a significant impact on a company's accounting. The OCA Staff also notes the breadth of potential areas impacted by any LIBOR-related rate transition, including modifying terms within debt instruments, hedging activities, the inputs used in valuation models, and potential income tax consequences. The OCA Staff encourages prefiling consultations with the OCA and commends for further reading LIBOR-alternative standard-setting guidance issued by the Financial Accounting Standards Board and the International Accounting Standards Board.
We have been active in thought leadership on the subject through publications and presentations and are actively assisting financial institutions and others in their LIBOR-transition efforts. The Statement is a welcome addition to the growing body of LIBOR-cessation guidance that should be a mandatory read for boards and for those in executive, legal, compliance, risk, accounting, and disclosure functions at public companies and other SEC-registered entities.
Four Key Takeaways
- The Statement provides a "wake-up call" from the SEC on LIBOR cessation that should be a mandatory read for boards and for those in executive, legal, compliance, risk, accounting, and disclosure functions at public companies and other SEC-registered entities.
- With the assistance of outside counsel and appropriate internal personnel, public companies and other SEC-registered entities should be proactively conducting thorough risk impact assessments to determine their financial, commercial, and operational/IT exposure to LIBOR.
- These companies and entities should also be developing remediation plans for LIBOR cessation and preparing, where possible and warranted, to quantify and disclose their LIBOR exposures and the status of any remediation plans in registration statements, prospectuses, and periodic filings and reports under the federal securities laws.
- Market intermediaries such as investment advisers and broker-dealers should exercise caution in recommending LIBOR-related investments to clients and counterparties and should advise them of the risks of such products and the availability of alternatives. They should also expect the matter of LIBOR to become a frequent topic in regulatory examinations in the near future.