In its ongoing effort to facilitate the transition to a new benchmark for floating-rate financial transactions, the Alternative Reference Rates committee (ARRC) recently recommended a method for using the secured overnight funding rate (SOFR) for intercompany loans. Treasury executives should discuss the language and how to address the issue most effectively with colleagues across their companies’ finance departments, if they haven’t already.
Jenifer Herdin, vice president, corporate treasury at apparel company PVH Corp., and a member of the ARRC’s Nonfinancial Corporate Working Group (NCWG), said the recommendations provide a strong starting point.
“My plan is to share the recommendations with our legal, tax and accounting teams and form a consensus before we draft the changes to our loan conventions,” Herdin said.
In its paper published Jan. 29, the ARRC says that “the consensus recommendation of the NCWG is that SOFR-based intercompany loans use the 30- or 90-day average SOFR set in advance, with a monthly, quarterly, semi-annual, annual, or other reset period as is determined appropriate by the firm.”
The ARRC goes on to note the benefits of using those SOFR terms for intercompany loans compared to current U.S. dollar (USD) Libor. Benefits include robustness, since SOFR is generated from transactions in the gigantic overnight repo market, and the New York Federal Reserve producing the rates in a way that is easily communicated and accessed by global authorities and the private sector. Plus, they can be used within the current system for intercompany loans and do not necessitate significant changes to implement.
The paper provides a complete description of conventions to adopt SOFR for intercompany loans, although it emphasizes that they do not “constitute binding rules or regulatory guidance,” and that market participants must decide what is most appropriate for their specific companies.
One potentially significant challenge that treasury may want to confront early on, Herdin said, is whether the regulators of counterparties located in jurisdictions outside the U.S. deem SOFR as an acceptable arm’s length benchmark rate. Another early step is to take inventory of all loans that rely on not just USD Libor but all interbank offering rates (IBORs) and determine when each will be phased out.
“It may be a good time to clean up loans that may no longer be necessary,” she said.
Corporate finance should also ensure that whatever system it uses to calculate intercompany interest will be able to accept the new benchmarks. Once finance has listed the company’s impacted intercompany loans, Herdin said, it must determine if the loans can be settled before Libor expires as a benchmark, or if they require amendments to implement language to fall back to a replacement rate.
The ARRC recommends that the fallback language use a spread adjustment that it recommended for business loans for the appropriate tenor, such as three-month Libor to three-month SOFR. That adjustment is the published five-year historical median difference between Libor and SOFR.
David Bowman, senior associate director at the Federal Reserve Board and the lead staff liaison with the ARRC, noted that the ARRC’s recommended spread adjustments match those developed by the International Swaps and Derivatives Association (ISDA) to be used for derivatives. He added that those spread adjustments have also been used in the recommendations by ARRC-like national working groups in other jurisdictions.
“ISDA’s spread adjustments have been widely recognized,” he noted, “And they will be used to convert hundreds of trillions of dollars’ worth of financial instruments. They form a sound basis for transitioning intercompany loans from Libor to SOFR.”
Currently, regulators have proposed extending USD Libor for legacy transactions to June 30, 2023, giving companies more time to perform that analysis, although they still anticipate new transactions to be priced over a Libor-replacement rate by the end of this year.
“It would be a good time to start working with your tax, legal and accounting [departments] to update them on SOFR and the implications for intercompany loans and other debt instruments,” Herdin said, adding that most companies will likely want to focus on transitioning external debt before intercompany loans.
For more insights on the transition away from Libor, download the AFP Treasury in Practice Guide: Making Preparations for a Post-Libor World.