The staffs of the Securities and Exchange Commission’s Division of Corporation Finance, Division of Investment Management (IM Division), Division of Trading and Markets, and Office of Chief Accountant (collectively, Staff) on July 12, 2019 issued a statement relating to the expected cessation after 2021 of publication of the ICE LIBOR (LIBOR) reference rate.1 LIBOR is used extensively around the globe as a benchmark for determining interest rates in financial transactions, adjustable-rate financial products, and derivatives. In its statement, the Staff emphasized the responsibility of market participants, including (among others) investment companies, investment advisers on behalf of their clients, broker-dealers, banks and insurance companies, to prepare to transition from LIBOR to one or more alternative reference rates in order to minimize risk as well as potential negative impacts on shareholders and clients.
The Staff’s statement discusses the importance of market participants preparing for the discontinuation of LIBOR, including: (i) analyzing existing and future contracts that may be affected and the risks such discontinuation may pose to market participants; (ii) encouraging market participants to proactively deal with amending or replacing existing contracts if necessary, and ensuring that future contracts provide for an effective transition in a timely manner to an alternative reference rate; (iii) encouraging market participants to put appropriate policies, procedures and operating systems in place in connection with LIBOR transition; and (iv) providing adequate disclosure to investors and shareholders regarding potential risks with respect to, and impacts of, LIBOR cessation and transition. Further, several SEC divisions highlighted the impacts that LIBOR discontinuation could be expected to present with respect to companies’ financial statements.
LIBOR represents the average interest rate at which a panel of large international banks could obtain unsecured financing from one another for a given future period of time in a specific currency, and is determined based on data reported by such banks to ICE Benchmark Administration (IBA), the LIBOR administrator. LIBOR is published by the IBA each business day for seven maturities (i.e., for overnight or up to 12-month borrowings) in five currencies, such that there are 35 LIBOR rates published each business day. The Federal Reserve Bank of New York estimates that $200 trillion in transactions reference U.S. dollar (USD) LIBOR, with more than $35 trillion in transactions extending beyond 2021.2
Currently, a panel of large international banks provides the applicable data to the IBA, enabling the IBA to publish the 35 daily LIBOR rates, subject to oversight by the UK Financial Conduct Authority (FCA). Representatives of the FCA have stated that these banks have agreed to voluntarily continue submitting the relevant data through 2021. However, due to the absence of an active market for unsecured term lending to banks (the market that LIBOR rates are designed to measure), the FCA has determined not to compel such banks to voluntarily provide this information after 2021.3 As a result, it is expected that banks will no longer provide the necessary data to the IBA, and that LIBOR will cease publication or will no longer be sufficiently robust to be representative of its underlying market. In such circumstances, LIBOR would cease to be an effective reference rate for financial transactions and other contractual arrangements.
In response to the expected discontinuation of LIBOR, the Federal Reserve Board and the Federal Reserve Bank of New York formed the Alternative Reference Rates Committee (ARRC), a U.S. working group of private-sector representatives and financial regulators, to recommend an alternative reference rate to USD LIBOR. Similarly, financial regulators in the UK, the European Union, Japan and Switzerland have formed working groups with the aim of recommending alternatives to the LIBOR rates denominated in their local currencies. The ARRC has recommended the Secured Overnight Financing Rate (SOFR) together with a spread adjustment, as appropriate in the particular market, as its preferred alternative reference rate for USD LIBOR. SOFR represents the average interest rate to borrow cash overnight collateralized by U.S. Treasury securities, and is based primarily on recent U.S. Treasury-backed repurchase transactions. The Staff made clear, however, that the SEC “does not endorse the use of any particular reference rate.”
Staff Guidance on Existing Contracts Extending Beyond 2021
The Staff emphasized the importance for market participants to identify existing contracts extending beyond 2021 and to determine whether such contracts include references to LIBOR. The Staff noted that some legacy contracts referencing LIBOR might not include any reference to its discontinuation, or might not include a LIBOR fallback specifying the reference rate that would replace LIBOR, or how or when such replacement reference rate would be determined. The absence of sufficient LIBOR fallback language is likely to result in uncertainty and potential disagreement as to the interpretation of these legacy contracts. The Staff also noted that market participants should evaluate how an alternative reference rate could impact their contractual arrangements, including whether the alternative reference rate would need to be adjusted to “maintain the anticipated economic terms” of the existing contracts. Further, the Staff suggested that market participants assess the potential impact that the discontinuation of LIBOR could have on their strategies to hedge floating-rate investments or obligations with respect to their derivative contracts that reference LIBOR.
Staff Guidance on New Contracts
The Staff noted that, with respect to new contracts, market participants should consider whether it is preferable to include references to alternative reference rates rather than continuing to include references to LIBOR. In the event that market participants continue to reference LIBOR in new contracts, the Staff emphasized the importance of including appropriate fallback language to address future LIBOR discontinuation, in order to avoid the issues discussed above with respect to existing contracts extending beyond 2021. The Staff noted that the “ARRC has published recommended fallback language for new issuances of floating rate notes, syndicated loans, bilateral business loans, and securitizations.” In addition, the Staff noted that the International Swaps and Derivatives Association (ISDA) is working to adopt standard fallback language that would be included in all derivatives contracts entered into using ISDA documentation.4
Staff Guidance on Other Business Risks
The Staff encouraged market participants to address potential risks they could encounter as a result of the discontinuation of LIBOR (i.e., along with economic risks, the ability of information technology to incorporate new instruments and reference rates that differ from LIBOR). The Staff noted that each market participant should evaluate its individual exposure to LIBOR and develop appropriate policies and procedures to address such risks. Further, the Staff explained that the ARRC is evaluating additional issues (including operational matters), and market participants should monitor any guidance issued by the ARRC on these issues.
IM Division Guidance5
- The IM Division provided division-specific guidance that highlighted certain risks that may impact public and private investment companies (collectively, funds) and investment advisers that invest in certain assets tied to LIBOR, “such as floating rate debt, bank loans, LIBOR-linked derivatives, and certain assetbacked securities.” The IM Division noted that:
- If these assets do not contain the appropriate fallback language, the discontinuation of LIBOR could impact the liquidity and value of the investments, which in turn could affect funds’ liquidity classification with respect to the fund’s liquidity risk management program pursuant to Rule 22e‑4 under the Investment Company Act of 1940.
- Closed-end funds and business development companies engaged in direct lending, whose loans reference LIBOR and extend beyond 2021, may need to renegotiate such contracts.
- Funds should consider whether any of the exemptive orders on which they rely (notably, interfund lending orders) reference LIBOR in the terms or conditions of such relief.
- Funds and investment advisers should consider adding any appropriate disclosure to investors related to the discontinuation of LIBOR and its potential impact.
- Funds should provide tailored risk disclosure to investors describing the impact of the transition on their holdings, rather than more generic disclosure.6
- Investment advisers should consider the potential impact of LIBOR discontinuation when recommending or monitoring investments in instruments that reference LIBOR and extend beyond 2021.
Guidance from the Office of the Chief Accountant
The Office of the Chief Accountant (OCA) also highlighted certain issues that the transition away from LIBOR could have on a company’s financial reporting and accounting, including with respect to: “modifications of terms within debt instruments”; “hedging activities”; “inputs used in valuation models”; and “potential income tax consequences.” The OCA noted that industry standard setters, including the Financial Accounting Standards Board (FASB), have begun to consider the potential impact on accounting and reporting as a result of the discontinuation of LIBOR. The OCA further noted that the International Accounting Standards Board (IASB) published an Exposure Draft, Interest Rate Benchmark Reform, which addresses various hedge accounting issues resulting from the replacement of a benchmark.7 The OCA encouraged active engagement with FASB and IASB to aid those organizations in the standard-setting process.
Additional Practical Considerations
The exercise of determining whether an alternative reference rate would need to be adjusted to “maintain the anticipated economic terms” of existing contracts is a significant and important undertaking. Contracts referencing the LIBOR rates will not necessarily produce the same economic results as those referencing the anticipated replacement risk-free rates (RFRs). As discussed above, LIBOR rates are “forward-looking” in nature, as they represent the average interest rate at which a panel of large international banks could obtain unsecured financing over various future periods of time or “tenors,” while the proposed RFRs such as SOFR are necessarily “backward-looking” in that they are based on transactions that have already occurred. In addition, LIBOR rates take into account bank credit-risk premiums and other factors whereas the RFRs do not do so. Adjustments will need to be made to the RFRs when used in various contracts (e.g., swap agreements, loans and asset-backed securities) in order to achieve a similar economic result. This will be especially important for derivative contracts currently used to hedge specific exposures.8
Following formal consultation with the swaps industry,9 ISDA reported that its protocol for existing contracts will include adjustments to the RFRs based on a compounded “setting-in-arrears-rate” approach to address the difference in tenors, as well as a historical mean/median approach to address the difference in risk premiums.10 However, the ISDA protocol will apply only to existing contracts at time of protocol adherence, not all LIBOR rates were addressed in the ISDA consultation, and the adjustments will not necessarily address all market participants’ hedging concerns. Therefore, market participants will need to study the ISDA protocol and plan ahead.
For assets such as floating rate debt, bank loans, mortgage loans and asset-backed securities, some market participants have begun to adopt fallback language based on the recommendations of the ARRC. For securitizations, the ARRC recommends that fallback language be “hardwired” into contracts to replace LIBOR upon the occurrence of a “benchmark transition event,” with the alternative reference rate based on a prioritized waterfall of options. Such alternative reference rate would be a floating rate benchmark derived from SOFR, with a spread adjustment to account for the differences between LIBOR (an unsecured forward-looking term rate reflecting relevant bank credit-risk premiums) and SOFR (an overnight backward-looking rate determined in the U.S. Treasury secured repo market). With respect to loans, however, many market participants are including fallback language that is not “hardwired,” but requires that the loan be amended to provide for an alternative reference rate upon the occurrence of a LIBOR transition event. Under these circumstances, securitization market participants are concerned about a mismatch between (i) the alternative reference rate applicable to the underlying assets and the timing of any such transition by amendment, and (ii) the alternative reference rate applicable to the asset-backed securities collateralized by such underlying assets based on a hardwired approach.
The Staff emphasized the time-sensitivity and importance for market participants to review their risk exposures with respect to the discontinuation of LIBOR and encouraged market participants to proactively address these risks. The sense of urgency the Staff expressed is consistent with sentiments expressed by other U.S. and international financial regulators.