On June 18, 2020, the Securities and Exchange Commission’s (the SEC) Office of Compliance Inspections and Examinations (OCIE) published a Risk Alert informing SEC registrants, including registered investment companies and business development companies (collectively, Investment Companies), of its intention to examine such companies to assess their preparedness for the transition away from the London Interbank Offered Rate (LIBOR). The Risk Alert provides a specific list of the considerations and documents that OCIE will use during its examinations.
This Legal Alert will focus on information that is specific to Investment Companies. The Risk Alert provides a roadmap for Investment Companies to assess the impact of the LIBOR transition on their businesses, including loan agreements with their portfolio companies and their credit agreements, and related public disclosure. With the discontinuation of LIBOR expected to occur after December 31, 2021, Investment Companies should consider whether they have taken appropriate steps to prepare for the transition away from LIBOR and what additional steps might be necessary.
LIBOR has been used globally, including in the United States, as a benchmark reference rate for various commercial and financial contracts, including loans. Investment Companies typically use LIBOR as a reference rate in their floating-rate loans extended to portfolio companies. For example, the interest due to the Investment Company pursuant to its loan agreement with a portfolio company will often be calculated using LIBOR. In addition, the terms of an Investment Company’s loans to portfolio companies, or its credit facilities with lenders, may include minimum interest rate floors that are commonly calculated based on LIBOR.
On July 27, 2017, the United Kingdom’s Financial Conduct Authority (the FCA), which regulates LIBOR, announced that it intends to phase out LIBOR by the end of 2021. In response, in the United States, the U.S. Federal Reserve Board and the Federal Reserve Bank of New York, in conjunction with the Alternative Reference Rates Committee (the ARRC), a steering committee comprised of large U.S. financial institutions, began considering replacing U.S. dollar LIBOR with a new index calculated by overnight repurchase agreements, backed by Treasury securities, called the Secured Overnight Financing Rate (SOFR), which the Federal Reserve Bank of New York began publishing in April 2018. In May 2020, the ARRC published a set of best practices to help companies prepare for the transition away from LIBOR to the SOFR index.
In addition, since the announcement of the transition away from LIBOR, the SEC has issued statements regarding LIBOR’s discontinuation. For example, the SEC’s Division of Investment Management urged Investment Companies and investment advisers to consider the impact of LIBOR’s transition on the value of its investments, to begin renegotiating terms of agreements extending beyond 2021 to address the discontinuation of LIBOR, and to disclose tailored risk factors on how the transition away from LIBOR could impact the Investment Company’s investments.1
The FCA has stated that the central assumption that companies cannot rely on LIBOR being published after the end of 2021 has not changed. The FCA, however, acknowledged that the outbreak of the coronavirus (COVID-19) has impacted the timing of many companies’ transition planning, and will continue to assess the impact of the COVID-19 outbreak on interim transition timelines and update the marketplace as soon as possible.
Although LIBOR is expected to cease after 2021, the FCA may make a formal announcement about the timing and the manner of cessation as early as November 2020. Such announcement may include a statement that LIBOR, at a future date, will no longer be representative of the underlying funding markets. If the announcement includes a statement to that effect, a so-called pre-cessation trigger, contractual triggers in instruments could be activated and require parties to no longer use LIBOR as a reference rate as of such future date.
The Risk Alert comes at the heels of OCIE’s 2020 examination priorities that identified preparedness for the expected discontinuation of LIBOR and the transition to an alternative reference rate as an examination priority. Among other things, OCIE will review whether and how the Investment Company has evaluated the potential impact of the LIBOR transition on its (a) business activities, (b) operations, (c) services, and (d) investors. For example, OCIE will review the Investment Company’s transition plans and steps that it has taken to prepare for the LIBOR discontinuation, including, as applicable:
- its exposure to LIBOR-linked contracts that extend past the current expected discontinuation date, including any fallback language incorporated into these contracts;
- its operational readiness, including any enhancements or modifications to systems, controls, processes, and risk or valuation models associated with the transition to a new reference rate or benchmark;
- its disclosures, representations, and/or reporting to investors regarding its efforts to address LIBOR discontinuation and the adoption of alternative reference rates; and
- any potential conflicts of interest associated with the LIBOR discontinuation and the Investment Company adopting alternative reference rates.
The Risk Alert also identifies a specific list of information and documents that may be used in these exams (full list included in Annex A below). Investment Companies should begin organizing and updating, as necessary, information and documents responsive to the list provided by OCIE to be prepared in the event of an examination. This exercise will also assist the Investment Company as it evaluates the full range of operational, economic, and regulatory risks and any shortcoming in its transition plan.
Managing the transition from LIBOR
The transition away LIBOR could have an adverse impact on the market for or value of any LIBOR-indexed debt securities, loans, and other financial obligations or extensions of credit held by or due to Investment Companies. Developing a LIBOR transition plan is therefore critical for Investment Companies to mitigate the impacts of LIBOR’s discontinuation. In light of the SEC’s focus on LIBOR transition preparedness, Investment Companies should take these key steps to prepare for the transition away from LIBOR:
1. Internal Risk Management Assessment Programs: Investment Companies should develop internal risk management and assessment programs to help prepare for and reduce exposure to risks resulting from the transition away from LIBOR, which should:
- develop a strategy to transition portfolios that are LIBOR-indexed; 2
- provide a governance framework with executive officers to oversee the LIBOR transition plan;
- develop a communication strategy with clear objectives to proactively engage, communicate and increase levels of education with regard to the LIBOR transition plan;
- develop a program to evaluate and mitigate risks;
- identify and address financial and non-financial risks associated with the transition to SOFR; and
- consider accounting (including any back-office changes that may be required to effectuate the transition), regulatory and tax reporting concerns resulting from the LIBOR transition.
2. Existing Contracts: Investment Companies should review all contracts that extend beyond 2021 and reference LIBOR to determine the impact of a discontinuation of, or transition from, LIBOR. To the extent a contract specifies that one or more parties will select a replacement rate at their discretion, the determining party should disclose their planned selection at least six months prior to the date that the replacement rate will become effective.
3. New Contracts: Investment Companies should consider LIBOR’s discontinuation when entering into new contracts which reference LIBOR and should, at minimum, specify an alternative reference rate and include robust fallback language if the contracting parties decide to reference LIBOR.
4. Risk Assessment: Investment Companies should identify, evaluate and mitigate certain consequences that the discontinuation of LIBOR may have on their business, including on strategy, processes and information systems, and any litigation risk.
5. Disclosure Obligations: Investment Companies should review their LIBOR disclosure in all SEC filings, particularly in risk factors and the MD&A. Investment Companies should provide tailored disclosure regarding risks associated with the transition away from LIBOR, its efforts to prepare for LIBOR’s discontinuation and information used by management and the board of directors to assess how the transition away from LIBOR may affect its business and operations.
6. Third-Party Technology and Service Providers: To the extent an Investment Company relies on third-party technology and operations vendors, it should make sure that such third-party service provider completes all necessary enhancement to support SOFR by the end of 2020.
OCIE Sample Request List
- Information regarding registrant’s organizational structure and business lines, particularly regarding the individuals, positions, departments, and operations that may be impacted by discontinuation of LIBOR transition and transition to an alternative rate (collectively, the LIBOR Transition).
- Information regarding any individuals or groups (e.g., internal committees, working groups, or transition teams) assigned responsibility to oversee or manage the effects of the LIBOR Transition on the registrant, including information regarding the frequency of any meetings on this topic and whether minutes are kept.
- The identity of any third parties registrant has utilized or plans to utilize to assess the impact of the LIBOR Transition on the firm or its clients, customers, or investors (collectively, investors).
- Documentation or descriptions of any analysis performed to identify contracts or obligations held and/or issued by registrant or its investors that may be affected by the LIBOR Transition and any remediation plans thereof.
- Documentation or descriptions of any performance composites or performance advertising that use a benchmark that could potentially be affected by the LIBOR Transition and any remediation plans thereof.
- Information regarding any investors whose fee structure (e.g., performance-based fees) or performance reporting (e.g., use of LIBOR-linked benchmark) could potentially be affected by the LIBOR Transition.
- Any written assessments, strategic plans (including remediation plans, as applicable), roadmaps, or timelines prepared by or for registrant regarding preparation for the LIBOR Transition, including the consideration of alternative reference rates.
- Documentation of any risk management matrices or risk inventories of registrant that reference the LIBOR Transition, including a description of any LIBOR Transition-related vulnerabilities or exposure covered by the matrix or inventory.
- Documentation or descriptions of any analysis performed to identify LIBOR-based risk or valuation models used by registrant, including information regarding changes that may be needed to account for a new reference rate, if any.
- Materials referencing the LIBOR Transition provided to registrant’s board of directors, any committee of the board of directors, any board member, the board or board member(s) of any investors, or the board, legislative body or member(s) thereof of any municipal entity or obligated person client, if applicable, or equivalent governing bodies or offices, if registrant is not organized as a corporation.
- Information regarding any third-party vendors registrant uses that may be impacted by the LIBOR Transition, including the services provided (e.g., back office) and how the vendor may be impacted.
- Information regarding any LIBOR-linked contracts or obligations that extend past the current expected discontinuation date that are held and/or issued by registrant, including the implications and impact of any incorporated fallback language.
- Information regarding any LIBOR-linked contracts or obligations that extend past the current expected discontinuation date that are held and/or issued by registrant’s investors, including the implications and impact of any incorporated fallback language.
- Information regarding any contracts or obligations held and/or issued by registrant, or its investors, that reference a rate identified as an alternative to LIBOR (e.g., SOFR).
- Information regarding any changes made or planned to be made to registrant’s information technology systems (e.g., accounting, investor reporting, risk, valuation or trading) to accommodate the LIBOR Transition, including any changes to accommodate new instruments/contracts and rates with features that differ from LIBOR.
- Disclosures provided in registrant’s filings with the Commission and/or to investors (e.g., in prospectuses) about the LIBOR Transition, including fallback language for LIBOR instruments, as applicable, during the period of January 2019 to the present.
- Any guidance provided by registrant to employees or supervised persons concerning recommendations to investors to purchase, sell, or enter into LIBOR-linked instruments or contracts that extend past the current expected discontinuation date, reviews of portfolios containing such instruments, or the underwriting of new instruments referencing LIBOR, if applicable.
- Any guidance provided by registrant to employees or supervised persons regarding the provision of advice to issuers of new LIBOR-linked instruments.
- Any guidance provided by registrant to employees or supervised persons regarding the provision of advice to clients regarding the replacement of LIBOR in outstanding contracts or obligations with an appropriate alternative reference rate.
- Any implemented or planned changes to compliance procedures, controls, or surveillance systems designed to monitor for LIBOR-linked instruments or contracts recommended or sold to clients.
1 For more information regarding the SEC’s guidance, see this previous Eversheds Sutherland legal alert.
2 The ARRC Recommended Best Practices for Completing the Transition from LIBOR includes a schedule of recommended deadlines by which companies should stop using LIBOR for new products with maturities after December 31, 2021.