Oh How Will We Measure When the Ruler is Uncertain: More Observations on the LIBOR Saga

At the end of May, I wrote a piece titled “‘Measure for Measure’ LIBOR, SOFR, and the U.S. DOLLAR.  ICE BANK YIELD INDEX”.  As noted there, the U.S. Board of Governors of the Federal Reserve System (“FRB”) in 2014 created the Alternative Rates Reference Committee (“ARRC”) to develop alternatives to LIBOR.  ARRC has responded to that charge and proposed a series of other reference rates for U.S. dollar LIBOR – denominated financings.

Under the ARRC proposals, there are four occurrences that would indicate a cessation of the ability to use LIBOR as the reference rate for interest calculations.  These occurrences, which mark when LIBOR either is no longer published or is no longer representative, are termed “Benchmark Transition Events.”  The first two are i) a permanent cessation of LIBOR, and ii) the activation of LIBOR triggers in the International Swaps and Derivatives Association (“ISDA”) 2018 Consultation.  These two require that either the LIBOR Administrator (currently ICE Benchmark Administration), the LIBOR regulatory supervisor of the LIBOR Administrator (currently the UK Financial Conduct Authority), the FRB (as the central bank for U.S. dollar denominated LIBOR), or a bankruptcy/resolution official or court with jurisdiction over the administration of LIBOR “state or publicize” that LIBOR has actually ceased or is expected to cease.  These two Benchmark Transition Events will result in changing the reference rate on financings on the date LIBOR ceases to be published: the “Benchmark Replacement Date.”

ARRC also has added two pre-cessation triggers.  They are i) if the regulatory supervisor for the LIBOR administrator issues a statement or publication that LIBOR “is no longer representative,” and ii) if the percentage of assets indexed to LIBOR exceeds a preset limit of the percentage of outstanding principal balance of all relevant assets.

ARRC has noted that ISDA may adopt one or more pre-cessation triggers at variance with ARRC’s. This could result in disarray in capital markets, especially as hedged positions may turn out not to be hedged as intended.  The ISDA has itself recognized the risk.  In a June 10, 2019 release, Scott O’Malia, the CEO of ISDA, stated:

Simply put, a change in the reference rate could cause a breakdown of some of . . . . [hedge accounting] relationships resulting in an immediate impact on profit and loss (P&L) statements.

The subsequent balance sheet volatility would not reflect the economic or risk position of the company – despite having a hedge in place to offset risk; the mark-to-market gains and losses on the derivatives hedge could start having to be recognized in the P&L, while the gains and losses on the instrument being hedged would not.

Mr. O’Malia goes on to cite both the Financial Accounting Standards Board (“FASB”) and the International Accounting Standard Board as “looking to put in place solutions.”  The release does not otherwise signal any particular choices of pre-cessation triggers.

The ARRC proposals for benchmark rate changes offer two approaches: one, the so-called “hardwire” change, would fully replace LIBOR immediately; the second, a so-called “Benchmark Replacement Waterfall,” would replace the reference rate in steps. In either case these ARRC proposals will require careful adjustment of the relevant provisions in existing financing documents.  A late June 2019 article in The Wall Street Journal noted that LIBOR “underpins an estimated $200 trillion of transactions” (Thursday, June 20, 2019 p. B10 Col 1).

There has, however, been an indication of at least one substantial accommodation to the potential tidal wave of changes wrought by the cessation of LIBOR.  The FASB on June 19, 2019, announced that it had tentatively decided that financing agreements that met certain criteria would not be viewed as terminated and replaced, just because of a change in the benchmark rate.  Rather the financing agreement could be accounted for as a continuation of that agreement.  This would apply to loans, debts, leases, securitization, and other arrangements.  This FASB proposal still will have to be incorporated in a rule amendment, which must first be published for public comment.  However, the FASB is confident the amended rule will be in place before LIBOR ceases in 2021.

Still not fully addressed by ARRC, ISDA, or any of the interested parties is whether the Secured Overnight Financing Rate (“SOFR”) will be the only (or even the most dominant) reference rate for calculating borrowers’ obligations. So please “stay tuned”; this could get very interesting.