You may recall that, at the end of last year, SEC Chair Jay Clayton and Corp Fin Chief Accountant Kyle Moffatt were warning at various conferences about some of the risks the SEC was monitoring, among them the LIBOR phase-out, which is expected to occur in 2021. LIBOR, the London Interbank Offered Rate, is calculated based on estimates submitted by banks of their own borrowing costs. In 2012, the revelation of LIBOR rigging scandals made clear that the benchmark was susceptible to manipulation, and British regulators decided to phase it out. In one speech, Clayton reported that, according to the Fed, "in the cash and derivatives markets, there are approximately $200 trillion in notional transactions referencing U.S. Dollar LIBOR and... more than $35 trillion will not mature by the end of 2021." Clayton indicated that an alternative reference rate, the Secured Overnight Financing Rate, or "SOFR," has been proposed by the Alternative Reference Rates Committee; nevertheless, there remain significant uncertainties surrounding the transition. (See this PubCo post.) And those uncertainties surrounding LIBOR and SOFR may be leading companies and others to delay addressing the issue until everything is finally settled. Perhaps with that in mind, on Friday evening, the SEC staff published a Statement that "encourages market participants to proactively manage their transition away from LIBOR." And, in the press release announcing the publication, Clayton drew "particular attention to the staff's observation: 'For many market participants, waiting until all open questions have been answered to begin this important work likely could prove to be too late to accomplish the challenging task required.'"
As discussed in the WSJ, some of the uncertainty may have been triggered by volatility related to the SOFR benchmark. According to the article, the "cost to borrow cash overnight spiked late last year in part of the market for repurchase agreements, where lenders such as money-market funds make short-term loans to bond brokers, often using government debt as collateral....That has investors and bankers paying close attention to developments in this obscure yet vital part of the debt market, because repo trades are a key component of a new borrowing benchmark designed by the Federal Reserve Bank of New York. That benchmark, called SOFR, for the secured overnight financing rate, is considered the leading candidate to replace the fading London interbank offered rate, now used in setting interest rates on hundreds of trillions in debt....If SOFR proves unusually volatile or hard to predict, it would diminish the benchmark's appeal to companies that are considering tying their borrowing costs to it, adding uncertainty to the market's search for a suitable Libor alternative." The ARRC is "planning to use trading data from the markets for futures and swaps to develop pricing models that they expect will make borrowers and investors more comfortable using SOFR as a benchmark for longer-term securities. Overnight repo rates can often be volatile, but the underlying reasons for and timing of many of those swings 'are well-known and predictable,' according to an explanation about SOFR on the website maintained by ARRC. When averaged over time, Treasury repo rates are less volatile than U.S. dollar Libor, the statement said."
And, further reflecting the uncertainty, in April, MarketWatch suggested that LIBOR may be getting a "second life." That's because "the market hasn't warmed up to the new rate." According to a bank executive in charge of interest rate strategy, "the transition to a new benchmark interest rate 'has not gone swimmingly. I would characterize the state of transition [to SOFR] amongst our clients as being in the state of paralysis....They know Libor might go away. They know there is a need to take action. But they are unsure about what to do'....With so much uncertainty, no one is doing anything," he said. While the Fed Vice Chair was urging the private sector to accelerate its efforts to transition away from LIBOR, others were apparently entertaining the possibility that LIBOR "may not end." Said one economist, "'There is some chance we're going to wake up in 2022 and the Libor universe won't have completely imploded'...." The market might ultimately demand multiple reference rates, he speculated.
Given that, at least in some quarters, action related to the transition seems to be stalled, the new staff Statement reminds readers that the "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 risks associated with this discontinuation and transition will be exacerbated if the work necessary to effect an orderly transition to an alternative reference rate is not completed in a timely manner." The Statement also observes that market participants should consider that other reference rates may be undergoing transitions and examine their exposures to these other rates as well.
According to the Statement, SOFR, identified by the ARRC as its "preferred alternative rate for USD LIBOR," is a "measure of the cost of borrowing cash overnight, collateralized by U.S. Treasury securities, and is based on directly observable U.S. Treasury-backed repurchase transactions. This is a liquid market with daily volumes regularly in excess of $800 billion." The Statement indicates, however, that the SEC does not endorse any particular reference rate. Nevertheless, the staff recognizes that some market participants are considering other USD reference rates and the staff is monitoring whether the use of multiple rates could, to use a term of art, gum up the works.
Existing contracts. In the Statement, with regard to actually managing the transition away from LIBOR, the staff advises companies to first identify contracts that extend past 2021 to determine if there are any interest rate provisions that reference LIBOR. These provisions may not have contemplated the discontinuation of LIBOR and their interpretation may create uncertainty or disagreement. The staff advises that companies consider the following questions:
- "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 to mitigate risk, such as proactive renegotiations with counterparties to address the contractual uncertainty?
- What alternative reference rate (for example, 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?"
As discussed in this PubCo post, for public companies that have floating rate obligations tied to LIBOR, Clayton warned, a significant risk is "how to manage the transition from LIBOR to a new rate such as SOFR, particularly with respect to those existing contracts that will still be outstanding at the end of 2021." As reported in Compliance Week, according to a BDO partner, the "transition is not as simple as swapping out a new rate for an old one....While LIBOR is a rate banks use to lend among themselves, SOFR is a secured overnight rate. Credit risk is embedded in LIBOR, but not in SOFR, he says. 'There's going to have to be some negotiation for the credit spread that was implicit in LIBOR....That will take some time.'" (See this PubCo post.)
New contracts. The staff also suggests that, for new contracts, companies consider referencing an alternative rate or include fallback language. The Statement notes that the ARRC has fallback language for specific contexts, which offers the benefit of consistency. ISDA has also been developing fallback language.
Other consequences. The Statement also advises that companies consider other potential consequences of the discontinuation of LIBOR, such as the impact on strategy, products, processes and information systems, for example, whether IT systems "are able to incorporate new instruments and rates with features that differ from LIBOR." Those facing a significant impact may want to establish a "task force to assess the impact of financial, operational, legal, regulatory, technology, and other risks." Various ARRC working groups are also considering other issues.
The Statement also includes specific guidance from various relevant SEC Divisions, including Corp Fin and the OCA.
Corp Fin. Corp Fin observes that disclosure regarding the expected discontinuation of LIBOR may be required under existing rules related to risk factors, MD&A, board risk oversight and financial statements. In the Statement, Corp Fin advises companies to "keep investors informed about the progress toward risk identification and mitigation, and the anticipated impact on the company, if material." To help companies assess the appropriateness of disclosures, Corp Fin provides the following guidance:
- "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."
Corp Fin notes that, so far, LIBOR transition disclosure is most common in the real estate, banking and insurance industries, and also more prevalent among larger companies. However, Corp Fin cautions, "for every contract held by one of these companies providing disclosure, there is a counterparty that may not yet be aware of the risks it faces or the actions needed to mitigate those risks. We therefore encourage every company, if it has not already done so, to begin planning for this important transition."
Office of Chief Accountant. The OCA is monitoring potential financial reporting issues that might arise in connection with any transition from LIBOR to an alternative benchmark rate, such as accounting and financial reporting for "modifications of terms within debt instruments; hedging activities; inputs used in valuation models; and potential income tax consequences." OCA is encouraging ongoing discussion and is available for related pre-filing consultations. In addition, the statement notes that the OCA staff has previously provided views on the impact of the LIBOR transition on hedge accounting. (See the SideBar below.)
With regard to standard-setting, the FASB and the IASB are both addressing hedge accounting issues, as well as other potential accounting and reporting implications relating to the expected discontinuation of LIBOR.
In remarks before the 2018 AICPA Conference on Current SEC and PCAOB Developments, Professional Accounting Fellow Rahim M. Ismail advised that FASB has implemented one change that allows SOFR to be designated as a benchmark interest rate and has a current project to consider and implement other changes to GAAP that might be required to facilitate the transition. And the SEC has so far been relatively accommodating. Ismail also provided an update on a stakeholder consultation regarding the impact of the LIBOR transition on the stakeholder's existing cash flow hedge accounting related to variable rate debt instruments. Under these instruments, the hedged item was LIBOR-based interest payments. The stakeholder had two questions that—caution—were deep in the accounting weeds:
Probable of occurring. For hedge accounting to be applicable, "the forecasted transaction being hedged, in this case the LIBOR based interest payments, has to be probable of occurring." The stakeholder asked whether companies could continue to assert that cash flow hedges were "probable of occurring" where the hedged item was LIBOR-based interest payments for variable rate debt with terms that extended beyond the LIBOR transition date. The staff did not object to the stakeholder's view that "hedge documentation involving LIBOR based cash flows implicitly considers the rate that would replace LIBOR, thereby allowing an entity to continue to assert that the hedged item is probable of occurring."
Highly effective. For hedge accounting to be applicable, "a hedge must be assessed as highly effective both on a prospective and retrospective basis." The stakeholder asked whether and how the expected LIBOR transition would affect the assessment of the effectiveness of a cash flow hedge of LIBOR-based variable rate debt. The staff did not object to the stakeholder's view that, "as part of its assessment of hedge effectiveness, an entity could consider an expectation that anticipated changes to LIBOR will impact both the hedged item (e.g., forecasted interest payments on debt) as well as the hedging instrument (e.g., interest rate swap). The stakeholder further asserted that in light of this expectation, the anticipated transition away from LIBOR in and of itself would not impact the effectiveness of the hedge." (See this PubCo post.)
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