/>iDespite the continuing widespread fallout from the coronavirus pandemic, international and US financial regulators and financial industry working groups have recently reiterated that December 31, 2021, remains the anticipated cessation of the London Interbank Offered Rate (LIBOR). In view of this, efforts to prepare for the transition from LIBOR remain paramount in order to avoid widespread disruption to financial markets, products, and participants. This memorandum summarizes this recent guidance and various suggested best practices to aid and advance a smooth transition from LIBOR in advance of the end of 2021.
LIBOR is the most widely used reference rate for a variety of financial products, including syndicated and non-syndicated loans, consumer loans such as mortgages and student loans, and variable rate notes. It is estimated that US dollar LIBOR is the reference rate for as much as $200 trillion in various products.[1]
In a March 2020 statement, the Financial Conduct Authority of the United Kingdom (FCA), the primary regulatory body for LIBOR, reiterated its assumption that LIBOR publication will cease at the end of 2021 notwithstanding the coronavirus pandemic.[2] The FCA’s statement urged market participants to refocus their efforts on transitioning away from LIBOR so as to avoid undue financial hardships and potential market upheaval.
Nevertheless, despite the anticipated end of LIBOR, some recent developments reveal that transition efforts may not be as widespread as necessary. For example, when the Federal Reserve Bank released details of its Main Street Lending Program in April 2020, the initial term sheets for these loans denoted the Secured Overnight Financing Rate (SOFR) as the reference interest rate. However, the Federal Reserve Bank quickly reversed the adoption of SOFR when it issued revised term sheets for the Main Street Lending Program a few weeks later.[3] These revised term sheets reverted to US dollar LIBOR as the reference rate. The quick reversal likely resulted from strenuous pushback from possible participants in the program who are unprepared or unable to adequately calculate SOFR.
Alternative Reference Rates Committee 2020 Objectives and Best Practices
In view of these developments, and in an effort to more aggressively advance preparations for a LIBOR transition, the Alternative Reference Rates Committee (ARRC), convened by the Federal Reserve Board and the Federal Reserve Bank of New York, identified several objectives to be achieved prior to the end of 2020, together with several best practices with target milestones.
ARRC’s six primary objectives for year-end 2020 are:
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Developing and promoting widespread use of fallback language for use in various financial products;
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Supporting expanded use and adoption of SOFR as the preferred replacement for US dollar LIBOR;
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Creating tools to assist market infrastructure upgrades necessary to support SOFR;
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Developing new fallback language for use in student loans referencing LIBOR;
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Assisting tax, legal, accounting, and other regulatory bodies in assessing the various impacts resulting from LIBOR transition and adoption of SOFR; and
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Continuing aggressive outreach and education efforts concerning LIBOR transition, including seeking potential legislative remedies to minimize unnecessary upheaval.[4]
To further these objectives, ARRC also suggests several best practices for market participants to adopt by certain target milestones. These best practices are as follows:
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As of September 30, 2020, all new business loans referencing US dollar LIBOR (which ARRC defines as nonconsumer loans with maturities after December 31, 2021), including renewals and refinancings, should include “hardwired” fallback language using daily SOFR as the replacement rate.
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Third-party technology and other operational vendors (such as booking, trading, valuation, settlement, and accounting systems) should complete enhancements necessary to support SOFR calculations by September 30, 2020.
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New issuances of business loans referencing US dollar LIBOR should cease as of June 30, 2020.
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In those circumstances where a loan party has the contractual right to select a replacement rate for LIBOR, the party with such right should disclose to the counterparties the selected replacement rate, together with any spread adjustment methodology, at least six months prior to the date that such replacement rate is intended to become effective.[5]
SOFR Fallback Language
ARRC issued recommended “hardwired” fallback language for syndicated loans on June 30, 2020.[6] This language identifies daily SOFR as the preferred replacement rate for LIBOR (at least until a “term,” or “forward-looking,” SOFR is widely available). The adoption of a “hardwired” fallback replacement rate — one in which the replacement rate is explicitly identified and automatically becomes effective upon a triggering event — will avoid unnecessary delays resulting from seeking amendments to existing language. The Loan Syndications and Trading Association (LSTA) has also released several iterations of conventional loan language for consideration by lenders and borrowers in, both syndicated and non-syndicated products using daily SOFR as the reference rate.[7] Both ARRC and the LSTA view SOFR as the most appropriate replacement rate for LIBOR because it is a combination of three (3) daily US Treasury repo rates.
There are currently two drawbacks to using SOFR: (i) it is calculated daily and therefore not currently widely available or determinable in advance; and (ii) it does not contain any inherent spread adjustment methodology. While it is anticipated that widespread adoption of SOFR will allow for calculating SOFR “in advance” (and that it will function more closely to LIBOR), ARRC’s default fallback language provides for daily SOFR as the interim replacement rate.[8] Daily SOFR is calculated by pulling the SOFR for each day of an interest period and accruing (but not compounding) it with the prior day’s SOFR. This method of calculation is very similar to the calculation of daily LIBOR or Prime, and ARRC anticipates that such familiarity may ease the necessary operations to calculate the daily SOFR. The parties can also adopt a spread adjustment mechanism as part of the SOFR calculation.
Other Regulatory Developments
Recent actions and statements from several other regulatory agencies also reiterate the urgency of preparing for LIBOR transition.
Federal Financial Institutions Examination Council Joint Statement on Managing the LIBOR Transition
In July, 2020, the Federal Financial Institutions Examination Council (FFIEC)[9] issued a “Joint Statement on Managing the LIBOR Transition.”[10] The Joint Statement highlights several categories of potential risks to financial institutions of all sizes from the cessation of LIBOR publication, and re-asserts the critical importance of implementing robust risk management processes. In the Joint Statement, the FFIEC urges financial institutions to conduct a robust review of their portfolios and products to identify and quantify the LIBOR exposure they may face. It reiterates that only once the nature of an institution’s risk exposure is fully identified can it properly adapt risk mitigation strategies commensurate with the institution’s size and complexity. Some of the risks identified include: financial, valuation, and model risk related to LIBOR transition; consumer-protection risks; third party vendor readiness; and potential litigation and reputational risk.
In its Joint Statement, the FFIEC also recommends implementing contractual fallback language where needed to close any gaps between current language that fails to address a permanent cessation of LIBOR publication, and to avoid entering into new contracts or issuing financial products using LIBOR as the reference rate. The FFIEC notes that inadequate fallback language poses not only legal risks, but could be considered a safety and soundness risk as well. The potential impacts to consumers – the clients and customers of a financial institution – should also be kept in view. Various types of consumer financial products may reference LIBOR, including adjustable-rate mortgages, home equity lines of credit, student loans, credit cards, and personal loans. Institutions should undertake measures necessary to adequately disclose to its customers and clients the risks posed by the transition from LIBOR, and adequately communicate any necessary changes made to the terms of their products in advance of the cessation of LIBOR publication. The FFIEC notes that in some circumstances, an institution may be legally required to make disclosures to a customer regarding any changed in a reference rate, and to assist them in understanding how the change impacts their contractual principal and interest payments, annual interest calculations, and other terms.
Finally, the FFIEC’s Joint Statement discusses the heightened supervisory focus in 2020 and 2021 on assessing institutions’ risk mitigation processes and LIBOR transition efforts. Institutions should expect to be asked during regularly scheduled examinations and monitoring about preparation efforts underway to transition from LIBOR. Specifically, institutions will be asked to discuss their transition plan with milestones and key completion dates; assessment of LIBOR exposure, including possible scenario testing or legal reviews; use of contractual fallback language; assessing the impact to the institution’s customers and its communication plans; necessary updates to the institution’s policies, processes, and internal control systems; and progress reporting to the institution’s board of directors and senior management, and their oversight of the LIBOR transition processes. The evaluation of an institution’s preparations and risk mitigation strategies by the supervisory agencies will be tailored to the size and complexity of the institution, as well as to the extent of the institution’s LIBOR exposure.
SEC Risk Alert. On June 18, 2020, the SEC’s Office of Compliance Inspections and Examinations (OCIE) issued a Risk Alert identifying LIBOR transition preparedness as an examination priority in 2020 for certain registrants, including investment advisers, broker-dealers, investment companies, municipal advisers, transfer agents, and clearing agencies.[11] The alert states that LIBOR transition may constitute a “material risk” to certain registrants and/or their clients from their exposure to possible disruption from any transition from LIBOR and a failure to adequately prepare for such a transition. An appendix to the Alert contains a list of 20 potential documents or types of information OCIE may request to assess a registrant’s preparations related to LIBOR. As a result, both financial institutions and other market participants should have a clear and robust internal program with defined deadlines to aid the preparation for LIBOR cessation. Part of this internal program should include a clear governance framework with one or more senior executives with accountability to the board of directors and a widespread means of identifying risks associated with the transition from LIBOR. Other considerations that require monitoring are the accounting and tax consequences of the transition from LIBOR.
Credit Sensitivity Group Workshops. In late winter 2020, the Federal Reserve System, the Office of the Comptroller of the Currency, and the Federal Deposit Insurance Corporation combined forces to create the Credit Sensitivity Group (CSG) aimed at easing concerns raised by regional banks over potential operational turbulence they may face from the cessation of LIBOR and the use of SOFR.[12] To date, however, CSG has met only once and has not yet issued any definitive guidance aimed at easing the concerns of the regional banks.
Conclusion
The message from various regulatory and industry leaders regarding LIBOR transition is clear: boards of directors, senior management, and various market participants must keep their collective eye on the ball as LIBOR cessation approaches. The various best practices and objectives identified by industry leaders, primarily ARRC, can serve as helpful guideposts to ensure as smooth a transition as possible and to avoid any undue financial upheaval as momentum continues to build toward the cessation of LIBOR in 2021.
Footnotes
[1] Transition from LIBOR, Alternative Reference Rates Committee, available here.
[2] Impact of the coronavirus on firms’ LIBOR transition plans, FCA, March 25, 2020, available here. The FCA issued further guidance on April 29, 2020, reiterating the anticipated cessation of LIBOR. Further statement from the RFRWG on the impact of Coronavirus on the timeline for firms’ LIBOR transition plans, FCA, April 29, 2020, available here.
[3] Federal Reserve announces it is expanding the scope and eligibility for the Main Street Lending Program, Federal Reserve Bank, April 30, 2020, available here.
[4] 2020 Objectives, ARRC, available here.
[5] ARRC Recommended Best Practices for Completing the Transition from LIBOR, ARRC, available here.
[6] ARRC Recommendations Regarding More Robust Fallback Language for New Originations of LIBOR Syndicated Loans, ARRC, June 30, 2020, available here.
[7] These forms are available to LSTA members only.
[8] ARRC Recommended Best Practices for Completing the Transition from LIBOR, ARRC, available here.
[9] The FFIEC is composed of: (1) a member of the Board of Governors of the Federal Reserve System (FRB); (2) the Director of the Bureau of Consumer Financial Protection; (3) the Chairman of the of the Federal Deposit Insurance Corporation (FDIC); (4) the Chairman of the National Credit Union Administration (NCUA); (5) the Comptroller of the Currency; and (6) the Chairman of the State Liaison Committee.
[10] FFIEC Joint Statement on Managing LIBOR Transition available here.
[11 Examination Initiative: LIBOR Transition Preparedness, Securities and Exchange Commission, Office of Compliance Inspections and Examinations, June 18, 2020, available here.
[12] Transition from LIBOR: Credit Sensitivity Group Workshops, Federal Reserve Bank of New York, July 22, 2020, available here.
