Earlier this month, staff of the Securities and Exchange Commission (SEC) published guidance that encourages market participants to move away from LIBOR (the Staff Statement).1 The interest benchmark rate is expected to disappear after December 31, 2021, when panel banks are no longer required to submit quotes that are used to determine the rate.2 The benchmark is set to disappear because the underlying market that LIBOR seeks to measure, unsecured wholesale term lending to banks, is no longer sufficiently active. The largest classes of instruments referencing LIBOR are over-the-counter and exchange-traded derivatives. A large proportion of syndicated loans and floating rate bonds and notes also reference LIBOR, and a large volume of securitized products, including Retail and Commercial Mortgage-Backed Securities, Asset-Backed Securities and Collateralized Debt Obligations are linked to LIBOR.3 Accordingly, many products, including floating rate notes, loans, transaction financing, investments and insurance products, that reference LIBOR, will be impacted by the transition away from LIBOR and such transition will impact a broad range of issuers, lenders, borrowers, investors, derivatives counterparties, as well as their advisers and intermediaries.
The Staff Statement encourages market participants, including public companies, investment advisers, investment companies and broker-dealers, to commence or carry on the following two action items: appropriate disclosures of material exposure to LIBOR and the type of activities that market participants should engage in to manage such risk. Despite many unanswered questions about LIBOR’s demise, including whether it will actually happen, and the transition to alternative reference rates, “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."4
Appropriate disclosures of material exposure to LIBOR
The Staff Statement points to a number of existing rules or regulations that may require disclosure related to the expected discontinuation of LIBOR, including in the sections of public disclosure documents related to (i) risk factors, (ii) management’s discussion and analysis of financial condition and results of operations, (iii) risk oversight, and (iv) financial statements.
The Staff Statement provides specific details on the disclosures that market participants should consider and includes a non-exhaustive list of disclosures that may be required under existing rules or regulations:
- Item 105 of Regulation S-K and Item 3.D of Form 20-F, which requires the disclosure of risk factors that are specific to the company or its industry and make an offering speculative or one of high risk;
- Item 303 of Regulation S-K and Item 5 of Form 20-F, which requires a discussion of the financial condition, changes in financial condition and results of operations, including the causes of material changes;
- Item 407(h) of Regulation S-K, which requires a description of the board leadership structure and its role in risk oversight; and
- Financial reporting requirements, such as those set by the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB).5
Additionally, the Staff Statement provides guidance regarding disclosures that companies should consider when informing investors about the anticipated material impact LIBOR’s discontinuation may have on the company. Such disclosures include:
- A disclosure of the status of company efforts to date, and any significant matters that the company will address during future reporting periods;
- A disclosure of the fact that the company has determined that a material exposure to LIBOR exists, but that it cannot yet predict the expected impact of such exposure; and
- A disclosure of information that is used by management and the board of the company to determine the impact the transition away from LIBOR may have on the company, i.e., the notional value of legacy contracts referencing LIBOR.
In the Staff Statement, the SEC’s Division of Investment Management specifically addresses closed-end funds and business development companies, noting those funds “that engage in direct lending may need to renegotiate the terms of contracts extending past 2021 that do not address the discontinuation of LIBOR. In addition, funds that have received exemptive orders that reference LIBOR … should consider evaluating possible implications for terms and conditions of their relief.”6
The type of activities that market participants should engage in to manage such risk
If you have not already done so, the first step to tackle LIBOR’s demise within your company is to identify the company’s total exposure, if any, to outstanding instruments or other obligations referencing LIBOR that continue beyond December 31, 2021. To understand the effect of the discontinuation of LIBOR, each contract needs to be evaluated to determine whether it anticipates a permanent, expected discontinuation of LIBOR, and if so, whether such fallback provisions continue to be practicable, i.e., some provisions that anticipate the permanent cessation of LIBOR, a floating rate, may fall back to a fixed rate. If no such provisions were anticipated by the parties when entering into a contract, incurring an obligation, or matching an instrument, amendments to incorporate fallback language may be necessary to mitigate unforeseeable risks when LIBOR ceases to exist. Separately, the fallback itself should be considered as part of the exposure determination. In the US, the fallback rate identified by the Alternative Reference Rate Committee (ARRC) as the risk-free alternative to US dollar LIBOR is the Secured Overnight Financing Rate (SOFR), but other USD reference rates are also being considered.
Going forward, market participants should also consider whether to include fallbacks in new contracts, obligations, or instruments that reference LIBOR, to minimize exposure to LIBOR between now and the end of 2021. Such fallbacks for certain types of new instruments, including for floating rate notes, syndicated loans, bilateral business loans and securitizations, have been developed by various committees of the ARRC, of which the SEC is an ex officio member.7 Fallbacks for derivatives documentation referencing LIBOR are being developed by the International Swaps and Derivatives Association (ISDA), which is currently reviewing comments that it received on its Supplemental Consultation on Spread and Term Adjustments for Fallbacks in Derivatives Referencing USD LIBOR, CDOR and HIBOR and Certain Aspects of Fallbacks for Derivatives Referencing SOR, which closed on July 12, 2019.8 Any amendments as a result of the Consultation are expected to apply to legacy contracts via a protocol.
In addition to amending legal documents to include one or more fallbacks to alternative reference rates, other business parts may be impacted by the cessation of LIBOR. Accordingly, market participants should evaluate and, to the extent possible, mitigate the impact that the discontinuation of LIBOR may have on their strategy, products, processes, models and information systems, which may include financial, operational, regulatory, technology, client outreach, and other risks.
Although it may be impossible to anticipate the impact that the cessation of LIBOR will have on your company, you should not wait to engage in evaluation of your company’s exposure to LIBOR, risk management and disclosure efforts.
1 Staff Statement on LIBOR Transition, Public Statement, July 12, 2019, available at https://www.sec.gov/news/public-statement/libor-transition.
2 A general overview of the potential cessation of LIBOR is available at https://us.eversheds-sutherland.com/NewsCommentary/Legal-Alerts/213747/Legal-Alert-December-31-2021-changes-to-the-London-Interbank-Offered-Rate-LIBOR-are-comingwill-you-be-ready.
3 For more information on the potential cessation of LIBOR, please see https://us.eversheds-sutherland.com/NewsCommentary/Legal-Alerts/213747/Legal-Alert-December-31-2021-changes-to-the-London-Interbank-Offered-Rate-LIBOR-are-comingwill-you-be-ready.
4 SEC Chairman Jay Clayton, SEC Staff Publishes Statement Highlighting Risks for Market Participants to Consider As They Transition Away from LIBOR, Press Release, July 12, 2019, available at https://www.sec.gov/news/press-release/2019-129.
5 Notes 16-19 of the Staff Statement cite the relevant provisions.
6 Staff Statement.
7 For a full list of the ARRC members, see https://www.newyorkfed.org/arrc/about#members.
8 The Consultation is available at https://www.isda.org/a/n6tME/Supplemental-Consultation-on-USD-LIBOR-CDOR-HIBOR-and-SOR.pdf; ISDA also published a Consultation relating to pre-cessation issues for LIBOR and certain other IBORs, which is available at https://www.isda.org/a/md6ME/FINAL-Pre-cessation-issues-Consultation.pdf.