July 16, 2019 - A number of global regulators have been warning institutions that i) LIBOR is ceasing, ii) transition plans are critical and iii) it’s (past) time to move on to a new rate. Last Friday the SEC added its voice in a joint eight-page Staff Statement on LIBOR Transition. This is not simply theoretical. After all, when the SEC says that market participants “may want to consider” taking certain actions, most market participants believe that is strong guidance as to what they should/must be doing. Indeed, one well-placed former asset manager observes that the SEC Staff may be laying out a list of questions for their next audit. Ignore this at your own peril!
At a high level, key takeaways include:
- LIBOR as a benchmark is going away
- Ensure that whether you are an issuer, bank, broker-dealer or asset manager, you have analyzed and understand risks and potential mitigants
- For borrowers subject to SEC regulation or Registered Investment Advisors, plan to disclose those potential risks, including in fund prospectuses
- For just about everybody; there may be financial accounting issues that need to be considered and disclosed
Drilling down deeper, the SEC first flagged issues that market participants should (read: must) be reviewing.
Existing contracts: With respect to existing contracts, market participants should be: i) analyzing exposure to contracts ending after 2021, ii) determining the impact of LIBOR cessation on these exposures, including in particular whether there is fallback language, iii) analyzing exposures without fallback language and determining actions to mitigate risk, iv) determining potential replacement rates and any differences with LIBOR, v) determining any impact on hedging strategies, vi) determining if new rate introduces new risks that need to be addressed.
New Contracts: With respect to new contracts, market participants should be i) considering whether they reference an alternative rate (such as SOFR) or ii) if still referencing LIBOR, whether the contracts include effective fallback language. The SEC reminds readers that recommended fallback language has been published for FRNs, syndicated and bilateral loans and securitizations.
Other Business Risks: The SEC “encourages” market participants to identify, evaluate and mitigate other risks that LIBOR transition may have on strategy, products, processes and IT. Market participants may want to consider how IT must change and prudent risk management may necessitate the development of a task force to assess the impact of financial, operational, legal, regulatory, technology and other risks.
Next, each SEC division noted the issues that they are specifically focused on (and, as our ex-manager notes, may ask about in audits).
Investment Management says it is actively monitoring the impact that LIBOR discontinuation will have on investment companies and advisors, particularly those investing in instruments that reference LIBOR, such as bank loans. As the discontinuation of LIBOR could affect the functioning, liquidity and value of these instruments, funds should consider the impact on liquidity of LIBOR instruments, how the instruments are classified and the funds’ liquidity risk management program. Advisors should consider whether these impacts should be disclosed to investors; some funds have begun incorporating tailored risk disclosure on how the transition could affect specific instruments. IM encourages this type of disclosure, and we assume will be looking for this disclosure in connection with new fund registrations as well as updates to prospectuses for existing funds.
Trading and Markets is actively monitoring the impact of LIBOR cessation, noting that the entities they regulate may i) issue LIBOR instruments, ii) own or make markets in LIBOR-based investments, iii) have LIBOR-based hedges, iv) underwrite, place or advise on issuance of LIBOR instruments, v) recommend LIBOR-based securities to investors and vi) have listing and clearing standards that don’t contemplate new benchmarks. Trading and Markets encourages the parties they regulate to analyze these changes in the context of i) business lines, ii) processes, iii) risk management frameworks and iv) clients and consider whether clients and markets should be informed of risks associated with LIBOR cessation. (Our well-placed former manager suggests that loan arrangers review these bullets, use common sense and disclose as appropriate.)
Corporation Finance reminds companies that it is important to keep investors informed about risks and impact of LIBOR cessation. In particular, CorpFin notes that the following disclosures are encouraged: i) companies’ existing and ongoing effectors to evaluate and mitigate risks due to LIBOR discontinuation, ii) explanations around when a company has identified a LIBOR exposure, but cannot yet estimate the impact, iii) how management is assessing whether and in what respects transitioning from LIBOR may affect the company. These disclosures may be both qualitative and quantitative.
The Office of the Chief Accountant noted that the transition from LIBOR could have a significant impact on a company’s accounting. Issues could emerge around the accounting and financial reporting for: i) modifications of terms within debt instruments, ii) hedging, iii) inputs used in valuation models and iv) potential income tax consequences. The OCA (and LSTA, through this recent analysis) reminds market practitioners that FASB and the IASB have been considering and consulting on many of these issues. The reality is that all the financial market regulators are increasingly warning market participants that LIBOR cessation is coming and they must prepare. Banking regulators are asking these questions in their supervisory exams and now the SEC has signaled that it, too, will likely be asking the same questions of the entities it regulates. Lack of knowledge and/or preparation will not be looked upon kindly.