LIBOR Transition: Wisdom for Global Capital Markets

LIBOR, the reference rate for determining interest on over $200 trillion of financings worldwide, terminates on December 31, 2021. How will interest be determined after that?

On July 12, 2019, the SEC Staff published a major and unusual joint statement on “LIBOR Transition.” The Divisions of Corporation Finance, Investment Management, and Trading and Markets, together with the Office of the Chief Accountant, issued a seven-page, single-spaced statement.

Staff Statement on LIBOR Transition

That statement notes:

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 SEC Staff then goes on to stress the importance of “… the work necessary to effect an orderly transition to an alternative reference rate…” [emphasis added]. The statement adds, “[t]he Commission does not endorse the use of any particular reference rates, noting that the Alternative Reference Rate Committee (“ARRC”) prefers the Standard Overnight Financing Rate (“SOFR”), but some market participants are also considering other U.S. dollar reference rates for certain instruments.” See my blog “Measure for Measure: LIBOR, SOFR, and the U.S. Dollar ICE Bank Yield Index.”

The SEC Statement does not directly address the impact of the end of LIBOR on other than U.S. capital markets, but the concerns raised by the Staff apply equally to non-U.S. public companies whose shares or American Depository Receipts are traded on U.S. equity markets. Moreover, the end of LIBOR has potential material consequences for public companies listed on exchanges in London, Paris, Frankfurt, Tokyo, Singapore, Hong Kong, and elsewhere.

In addition, the transition from LIBOR in global capital markets may involve switching to a reference rate other than SOFR, which will add to the complexity of financial disclosures.

The Staff then identifies particular areas to which affected market participants should give attention:

Existing Contracts

After noting that parties to a contract may disagree about how to handle the discontinuance of LIBOR (noting as an example that a floating rate obligation might become a fixed-rate one), the Staff poses six questions:

1. Do you or your customers have contracts that extend beyond 2021 and reference LIBOR?
2. For each of those contracts, what happens when LIBOR ends?
3. Do you need to take action now, either because the contract does not have fallback language or because the fallback will not work (so that you need to negotiate revisions now)?
4. What alternative reference rate will work for you and what impact will the change have on financial results?
5. Have you hedged floating rate obligations with derivatives referencing LIBOR? How will the end of LIBOR affect those hedges?
6. Will the change to an alternative reference rate introduce new risks (e.g., different behavior in hedging capital costs)?

New contracts

All new contracts extending past 2021 should have an alternative reference rate built into them. The Staff notes the availability of fallback language recommended by ARRC that is intended to function when LIBOR ends. The Staff also draws attention to the ongoing industry effort led by the International Swaps and Derivatives Association to implement “robust fallback language for derivative contracts.” See also my blog “Oh How Will We Measure When the Ruler is Uncertain: More Observations on the LIBOR Saga.”

Other Risks

The Staff urges market participants to “identify, evaluate, and mitigate” other risks, such as those affecting strategy, products, processes, and information systems – noting as an example that participants should be certain that their information technology systems can deal with new instruments, reference ratio, conversions, and hedges.

Financial Reporting

• The Staff notes that public companies must disclose risks and their possible financial impact. The end of LIBOR may affect more than one reporting period. Current planning to deal with that event and any material exposures should be disclosed, particularly in the real estate, banking and insurance industries. This evaluation must also take into account risks involving counterparties.
• Investment companies and investment advisers dealing with and/or recommending instruments using LIBOR as a reference rate (such as floating rate debt, bank loans, LIBOR-based derivatives, and some asset-backed securities) should consider how the end of LIBOR will impact the functioning, liquidity, and value of these investments. Investment companies, in particular, must assess how the end of LIBOR will affect their liquidity risk management programs, to assure that they remain in compliance with Rule 22e-4 under the Investment Company Act of 1940.
• Closed-end funds, Business Development Companies (“BDC”), and Fintech companies that engage in direct lending may need to renegotiate contracts extending beyond 2021.
  Broker-dealers, central counterparties, and exchanges will have to address the issuance, valuation, trading, and using derivatives tied to LIBOR to determine whether the instruments will work as intended and, in the case of broker-dealers, whether the sale to an investor is not only suitable but also in the best interest of that investor.
• Finally, accounting for the possible variants in financial results due to a change in reference rate is a key disclosure concern of the Staff.

So it may be safely said that the way in which things, especially financial things, are measured is material. Hence, the SEC calls those affected by the end of LIBOR to account.