The Securities and Exchange Commission (SEC) has identified key risks that the looming Libor transition poses to market participants. Corporate treasury and finance professionals should take note.
MAJOR MARKET RISKS
In a joint statement, the staffs of the Division of Corporation Finance, the Division of Investment Management, the Division of Trading and Markets, and the Office of the Chief Accountant warned of the potential impacts if Libor either stops publication in 2022 or is degraded to the point where it is no longer seen as a benchmark rate. As a result, the SEC urges regulators and market participants to implement alternative reference rates ahead of deadline to stave off any market disruptions.
The SEC added that the risks posed to public companies will be exacerbated if the necessary prep work for an orderly transition isn’t completed in a timely fashion. As such, the Commission said it is “actively monitoring” how market participants address these risks.
Market participants need to identify existing contracts that extend past 2021 to determine their exposure to Libor. Many contracts have interest rate provisions referencing the rate that didn’t take into account its potential discontinuation when they were drafted. As a result, there may be discrepancies over how contracts should be interpreted. Conversely, even if contractual interpretation is clear, the adjustment still may not be consistent with expectations of affected parties.
Since these types of issues can be difficult to fix, the SEC recommends market participants get to work now. For example, corporates should do their best to determine what effect a Libor discontinuation would have on the operation of existing contracts, what alternative rate might replace Libor in such contracts, and whether said alternative rate might introduce new risks altogether.
Lawton B. Way, partner with Hunton Andrews Kurth LLP, noted that many businesses are not addressing these contracts now because they feel they still have plenty of time. He encourages them to do so, because 2022 will be here before you know it. “I don’t think many companies are actually doing this,” he said. “The window has been out there for a while, but I don’t think companies are acting very quickly to take these projects on.”
For new contracts, the SEC recommends participants reference an alternative reference rate to Libor, such as the Secured Overnight Financing Rate (SOFR). If they still opt to use Libor, then it would be wise to include effective fallback language in the event that Libor does go away. The Alternative Reference Rates Committee (ARRC) published recommended fallback language for new issuances of floating rate notes, syndicated loans, bilateral business loans, and securitizations. And the International Swaps and Derivatives Association (ISDA) is currently developing robust fallback language for derivatives contracts.
Fortunately, this does seem to be happening overall. “New contracts are generally picking up the language of what to do if Libor goes away,” Way said. “But contracts that are older than a couple years likely don’t have that in.”
OTHER BUSINESS RISKS
The SEC noted that an impact assessment of Libor’s end extends beyond mitigation efforts related to contracts; there may be other consequences on corporates’ strategy, products, processes, and information systems. For example, treasury teams should ensure that their systems are set up to incorporate new instruments and rates with features that differ from Libor. Depending on the corporate’s market exposure to Libor, it may be necessary to establish a task force to assess the potential impact.
The SEC also offered specific guidance on how the Libor transition could impact groups regulated by the four divisions.
Division of Corporation Finance
Investors will need to be kept in the loop about the probable discontinuation of Libor, and that includes disclosing risk factors, management’s discussion and analysis, board risk oversight, and financial statements. A few factors to keep in mind:
- The evaluation and mitigation of risks related to the Libor transition may span several reporting periods.
- A company may identify an exposure but cannot reasonably estimate the expected impact. This assessment should still be disclosed to investors.
- Any disclosures that allow investors to “see through the eyes of management” are likely the most useful. This could include sharing information that management and the board use to assess and monitor how moving to an alternative rate could affect company performance.
The SEC noted that companies in the real estate, banking and insurance industries are the ones most frequently providing Libor transition disclosures. Additionally, the agency has found that the larger the organization, the more likely it is to disclose risks related to Libor’s end.
Office of the Chief Accountant
Moving to a new benchmark rate can severely impact financial reporting and accounting for debt instruments, hedging activities, inputs used in valuation models, and potential income tax consequences. As such, the OCA urges constituents to participate in the standard-setting process with the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB).
Division of Investment Management
The Libor transition could have a major impact on investment companies and advisers, particularly those that invest in instruments that reference Libor. If Libor is discontinued, it could affect the functioning, liquidity and value of instruments like floating rate debt, bank loans, Libor-linked derivatives, and certain asset-backed securities. Even funds that do not invest in Libor-linked instruments could nevertheless feel an impact.
Division of Trading and Markets
The discontinuation of Libor may also impact broker-dealers, central counterparties and exchanges. The division asks that these entities assess how the change could affect their business, systems, models, processes, risk management frameworks, and clients, and respond accordingly.
The SEC welcomes comments from market participants on Libor discontinuation. Corporates may find it beneficial to share the issues and challenges they are facing with the agency.
Way noted that many corporates may be waiting to act because they want to see if the market comes to a consensus on what to do about Libor. “That’s slowly emerging but I don’t think it’s emerged yet,” he said. “There’s been a lot of talk [from regulators] that ‘the end is near,’ but we’re not seeing a lot of action yet. But we’re encouraging people to start taking inventory of their contracts, to identify which ones you’re going to need to amend or renegotiate.”
The Libor transition has far-reaching implications for corporate treasury and finance. For more insights, be sure to visit AFP’s Libor Transition Guide. And also check out the Treasury Management and Capital Markets and Investments tracks at AFP 2019, which each feature sessions on Libor.