December 14, 2021

SEC staff speaks up on LIBOR transition

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Cooley LLP

Last week, the SEC staff issued a new statement on the LIBOR transition. LIBOR, the London Interbank Offered Rate, is a widely used reference rate calculated based on estimates submitted by banks of their own borrowing costs. LIBOR has been used extensively as a benchmark reference for short-term interest rates for various commercial and financial contracts—including interest rate swaps and other derivatives, as well as floating rate mortgages and corporate debt. In 2012, the revelation of the LIBOR rigging scandals made clear that the benchmark was susceptible to manipulation, and British regulators decided to phase it out at the end of 2021. The staff statement addresses a wide variety of issues for various market participants, but central for many public companies is the discussion of applicable disclosure obligations with respect to the transition away from LIBOR.

As described in the staff statement, on March 5, 2021, LIBOR’s regulator announced that “the publication of the one-week and two-month USD LIBOR maturities and non-USD LIBOR maturities will cease immediately after December 31, 2021, with the remaining USD LIBOR maturities ceasing immediately after June 30, 2023.” In the U.S., the Secured Overnight Financing Rate (SOFR) has been identified as the preferred alternative rate. SOFR 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.”

SideBar

In these remarks to the Alternative Reference Rates Committee’s SOFR Symposium in September, SEC Chair Gary Gensler discussed LIBOR and supported the move to the SOFR as an alternative. Gensler’s substantial familiarity with LIBOR dates, at least, to his time as head of the CFTC, when he oversaw numerous enforcement actions related to LIBOR manipulation. According to Gensler,

“LIBOR had gotten to be so popular that it was embedded in hundreds of trillions of dollars of financial contracts around the world. Loans, derivatives, mortgages, and even supplier arrangements referenced LIBOR. In reality, though, in good times there was very little lending of unsecured term loans between banks—in London, or anywhere else for that matter. In stressed times, even that small market went away. Long before the 2008 crisis, it largely had dried up. Banks simply were not making term loans to other banks without getting some collateral in return. Because few transactions underpinned LIBOR, the people responsible for determining this benchmark tended to use their own judgment in setting it. That was not the only challenge. On top of that, LIBOR was easy to game. The dedicated staff at the CFTC did a remarkable job uncovering many cases of manipulative conduct involving LIBOR at large banks. Finally, somebody had pointed out that the emperor had no clothes.”

Gensler believes that SOFR, “which is based on a nearly trillion-dollar market, is a preferable alternative rate.” Although many regulators have advocated the use of SOFR as an alternative, as reported in this article by Bloomberg, some traders think SOFR is not a good solution because it “will do a poor job hedging risks in turbulent times.” According to one trader cited in the article, SOFR is “‘a great product as long as credit spreads remain static. The time it really falls apart is in a crisis.’”

In the statement, the staff stresses the importance of keeping investors informed about the company’s “progress toward LIBOR risk identification and mitigation, and the anticipated impact on the company, if material.” Disclosure related to the discontinuation of LIBOR may be required under current rules, including rules related to risk factors, MD&A, board risk oversight and financial statements. The staff encourages companies to provide “detailed and specific disclosure, rather than general statements about the progress of the company’s transition efforts to date.” Specifically, companies should provide “qualitative disclosures and, when material, quantitative disclosures, such as the notional value of contracts referencing LIBOR and extending past December 31, 2021 or June 30, 2023, as applicable, to provide context for the status of the company’s transition efforts and the related risks.”

One potential issue might be the adequacy of fallback provisions. “Fallback” language refers to language in documentation for LIBOR-linked securities “intended to provide an alternative reference rate or otherwise address a permanent cessation of LIBOR.” If there is no fallback language in the documentation or the language is not “robust” (e.g., it contemplates only a temporary cessation of LIBOR), those securities will likely be materially affected when the rate is discontinued. The statement indicates that newer issuances of LIBOR-linked securities are more likely to contain adequate fallback language, such as language that provides “interest rate provisions that will function upon discontinuation of LIBOR and promotes consistency in defining key terms such as benchmark transition events, benchmark replacement, and benchmark replacement adjustments.” The statement notes that recent New York state legislation, which would apply to contracts that are governed by New York state law, “effectively codified the use of SOFR as the alternative in the absence of another chosen replacement rate.” Nevertheless, “because no replacement rate is a perfect match for LIBOR, even when the transaction documents contain robust fallback language, the value of LIBOR-linked securities—and consequently their potential returns—may experience material changes upon LIBOR’s discontinuation.”

The statement advises that companies facing “material risk related to outstanding debt with inadequate fallback provisions should consider disclosing how much debt will be outstanding after the relevant cessation date and the steps the company is taking [to] address the situation, such as renegotiating contracts or refinancing the obligations. To the extent that a company has or is taking steps to identify and assess LIBOR exposure and mitigate material risks or potential impacts of the transition, the company should consider providing investors insight into what the company has done, what steps remain, and the timeline for further efforts.”

SideBar

By a vote of 415 to 9—really—the House has passed the “Adjustable Interest Rate (LIBOR) Act of 2021.” A vote like that in the House would seem to suggest that the bill may actually pass in the Senate, but there’s a hitch. According to Bloomberg, Republican Senator Pat Toomey “had a concern the bill will coerce business to use specific rates.” How widespread that view is remains to be seen. The bill is intended to “establish a clear and uniform process, on a nationwide basis, for replacing LIBOR in existing contracts the terms of which do not provide for the use of a clearly defined or practicable replacement benchmark rate, without affecting the ability of parties to use any appropriate benchmark rate in new contracts.” In addition, the bill is designed to “preclude litigation related to existing contracts the terms of which do not provide for the use of a clearly defined or practicable replacement benchmark rate.” Under the bill, in the event the documentation does not provide for a fallback or replacement rate provision in effect when LIBOR is retired, or a replacement rate is not selected by an authorized person under the contract, the bill provides for a transition to a replacement rate selected by the Fed Board of Governors. The bill also provides for “conforming changes to these contracts, the continuity of these contracts, and a safe harbor to protect against liability.” According to Bloomberg, the bill would protect $16 trillion of deals that would otherwise be unable to transition.

The staff statement observes that companies often provide disclosure about the LIBOR transition as part of risk factors, recent developments, MD&A and/or quantitative and qualitative disclosures about market risk. Where the disclosure is responsive to different rule requirements and appears in multiple locations, the staff recommends that companies consider providing a cross-reference or summary “so an investor has a complete and clear view of the company’s plan for the discontinuation of LIBOR, the status of the company’s efforts, and the related risks and impacts.” The staff expects disclosures to evolve over time. The statement also encourages companies to review the July 2019 Staff Statement for more information about disclosure in the context of the LIBOR transition and its potential impact on their businesses. (See this PubCo post.)

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DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.