December 9, 2021 - by Meredith Coffey. In recent months, SEC Chairman Gary Gensler fulminated (here and here) against LIBOR and certain Credit Sensitive Rate replacements and, in an ARRC SOFR Symposium interview, said that LIBOR must end and that there would be no extensions.
While it’s fair to say we know the Chairman’s views, what is the SEC staff thinking? Now we may know that too. On December 7th, the SEC issued “Staff Statement on LIBOR Transition – Key Considerations for Market Participants,” which was intended to remind “investment professionals of their obligations when recommending LIBOR-linked securities and to remind companies and issuers of asset-backed securities of their disclosure obligations related to the LIBOR transition.”
The SEC discussed a number of issues, with a particular focus on i) the appropriate disclosures (including disclosure around the effect of LIBOR transition on customers with existing holdings of LIBOR-linked instruments); ii) the impact that LIBOR transition may have on valuation; and iii) the significant operational complexities that LIBOR transition may introduce. The SEC also warned that LIBOR – and replacement rates – may face changes in market liquidity and trading volumes in the transition. In addition, the Agency observed that some contracts do not have robust fallback language and even those that do still may see economic impacts upon transition.
The SEC divided its guidance into a number of areas: in addition to specific guidance for broker-dealers (which we are not covering here), the Agency addressed i) investment advisers’ legal obligations when recommending or providing advice regarding LIBOR-linked investments; ii) considerations for funds and investment advisers related to disclosure, valuation, and operational issues; and iii) companies’ and asset backed securities issuers’ disclosure obligations related to the LIBOR transition.
When it comes to investment advisors, the SEC reiterated that advisors “have a fiduciary duty under the Advisers Act to act in their clients’ best interest, including duties of care and loyalty.” For registered investment advisors and BDCs, the SEC focused first on disclosure. The Agency commented that “[i]f a fund invests a significant portion of its assets in LIBOR-linked investments, it should disclose any principal risks related to the potential cessation of LIBOR, as well as the anticipated impact (and expected timing of that impact) on those investments, including with respect to volatility, value, and liquidity.”
Next, the SEC reminded investment companies of the impact of LIBOR cessation on valuation procedures, noting that, “[a]dvisers, funds and fund boards should be mindful of any valuation risk and impacts to valuation inputs and assumptions associated with LIBOR and the transition.”
The Agency turned to conflicts of interest, saying that funds and advisors should manage transition-related conflicts of interest, including, for example, by considering their disclosure and other legal obligations relating to performance fees. The SEC noted that performance fees may be tied to hurdle rates; to the extent that a hurdle rate changes – or becomes easier to achieve – in transition, that should be disclosed.
Finally, the SEC reiterated the substantial operational complexities that LIBOR transition may bring. (Note: The LSTA has worked extensively for three years with market participants to address operational challenges of LIBOR transition. While the adoption of Term SOFR for USD contracts may mitigate much of the complexity, some complexity remains in the form of items like the CSA. In addition, other currencies such as Sterling will not be adopting a term rate for leveraged loans, so entities may need to be able to operationalize different types of replacement rates.)
The SEC also offered “Disclosure Considerations for Companies and Asset Backed Securities Issuers” (and earlier referenced CLOs as an example of a securitization). After discussing disclosure requirements for companies, the Agency added that “[i]ssuers of registered asset-backed securities also should consider relevant disclosure requirements under Regulation AB, as well as appropriate disclosures regarding the potential impacts of the LIBOR transition on investors in those securities.” Finally, the SEC noted that it welcomed discussion on this issue and asked market participants to share their issues and challenges.