LIBOR is considered one of the most widely used and important interest rates in finance, upon which trillions of dollars rest. And its expected phaseout after 2021 could result in massive business and market disruptions for companies, auditors and other market and financial reporting participants, unless mitigating action is taken. Are you ready for the LIBOR transition?
In July 2019, SEC Staff issued Staff Statement on LIBOR Transition (available on Thomson Reuters Checkpoint), calling attention to the need for companies, investment advisers, broker-dealers, auditors, preparers, regulators and other market and financial reporting participants to take action to avoid major business and market disruptions resulting from the expected discontinuation of the London Interbank Offered Rate (LIBOR) after 2021.
LIBOR and its significance
To put into perspective the significance of LIBOR coming to an end, this rate is a longstanding global benchmark interest rate that’s determined and published daily based on the representations of certain large, international banks regarding their estimates of what they would be charged if they were to borrow from other banks. It’s used for various commercial and financial contracts, and it’s calculated for five different currencies (U.S. dollar (USD), British pound sterling, euro, Japanese yen and Swiss franc) and for seven borrowing periods ranging from overnight to one year.
In the derivatives market, LIBOR is used as a reference rate that helps standardize financial contracts with floating rate terms and, as a result, USD LIBOR alone is referenced in approximately $200 trillion of outstanding derivative financial products. LIBOR use, however, isn’t limited to the derivatives market as you might think. Many corporate and municipal bonds and loans are LIBOR-based. And financial institutions use LIBOR as a reference rate for variable-rate commercial and consumer loans, the most common being home mortgages, auto loans, student loans and credit cards. Also, some financial institutions set deposit rates based on a spread from LIBOR. Still others have hedging structures based on LIBOR. It takes no stretch of the imagination to see the far-reaching impact of LIBOR and how its sudden discontinuation could leave unprepared market and financial reporting participants with virtually worthless contracts, organizational models, information systems and applications, potentially wrecking financial stability.
News of LIBOR’s downfall came several years after the LIBOR scandal—an event peaking in 2008 in which a number of financial institutions were accused of fixing LIBOR rates. Banks were found to have reported artificially low or high interest rates for profit. Naturally, this suggested to the banking industry that LIBOR was neither reliable nor sustainable. As a result, regulators around the world have ramped up their supervision of benchmarks and are looking to replace LIBOR with alternative reference rates that are more representative of the market and are harder to manipulate. To that end, in the U.S., the Federal Reserve Board and the Federal Reserve Bank of New York created the Alternative Reference Rate Committee (ARRC), and in 2017, the ARRC announced that it had identified the Secured Overnight Financing Rate (SOFR) as its replacement for USD LIBOR.
Though the SEC doesn’t endorse any particular alternative reference rate, its Staff is urging market and financial reporting participants to understand and mitigate the risks related to the LIBOR transition in areas such as IT, accounting, corporate governance, compliance and internal controls. This is especially so since any change to the scope of the LIBOR phaseout would likely bring challenges, such that playing catch-up could be dangerous, particularly for those market and financial reporting participants who haven’t begun any sort of sound planning. What follows is a call to action that focuses on two of these participants—companies and auditors—and encourages them to chart their course for the transition away from LIBOR.
Navigating the LIBOR transition: Companies
Existing contract risks
If you haven’t done so already, you should begin identifying existing contracts that extend beyond 2021, such as financial instruments, credit agreements, and customer, vendor and employee agreements, so that you can evaluate their exposure to LIBOR. Granted, some legacy contracts contain contingency language that’s triggered if LIBOR becomes unavailable. However, unavailability and complete withdrawal aren’t the same, and in many cases, legacy contracts contain interest rate provisions tied to LIBOR that, when drafted, didn’t envision its permanent phaseout, leading to potential uncertainty in contract interpretation. And then there are circumstances where the contract interpretation is clear, but the adjustment may not be in line with parties’ expectations, like in the case of a variable-rate mortgage changing to a benchmark rate that is considerably higher or the language allowing for a change in reference rate but not a change in the spread over the reference rate. Resolving these types of issues can be very time-consuming, which is why you can’t afford to be passive.
What follows are some of the concerns that you ought to consider as you try to grasp and ease the risks related to the LIBOR transition:
- Whether you have, or are exposed to, any contracts referencing LIBOR that extend beyond 2021 and if so, the effect of the discontinuation of LIBOR on your operations for each of those contracts.
- Whether actions need to be taken to mitigate risks in the case of contracts with no fallback language for when LIBOR is unavailable or in the case of contracts with fallback language that doesn’t contemplate the expected phaseout of LIBOR, such as renegotiating with counterparties to address contractual uncertainty.
- The alternative reference rate that might replace LIBOR in existing contracts; whether there are fundamental differences between that alternative reference rate and LIBOR that could impact profitability or costs; and whether the alternative reference rate needs to be adjusted to maintain the expected economic terms of existing contracts.
- The effect of the discontinuation of LIBOR on a company’s hedging strategy in the case of derivative contracts referencing LIBOR that are used to hedge floating-rate investments or obligations.
- Whether use of an alternative reference rate introduces new risks and if so, the actions to be taken to mitigate those risks.
New contract risks
You should also consider whether contracts entered into in the future should reference SOFR or another alternative rate to LIBOR or, instead, reference LIBOR but include fallback language that lessens the impact of its loss of liquidity and/or change in value as the date approaches when it will no longer be updated. The ARRC has published recommended fallback language for floating rate notes and other new issuances, in each case looking to provide interest rate provisions that’ll function upon the expected termination of USD LIBOR and promote consistency in the definition of key terms, such as “benchmark transition events,” “benchmark replacement” and “benchmark replacement adjustments.”
Other business risks
Let’s not forget about LIBOR phaseout risks beyond those related to existing or new contracts. In this regard, you’re encouraged to identify, evaluate and mitigate other consequences that the discontinuation of LIBOR may have on your business, such as on strategy, products, processes and information systems. For example, you may seek to future-proof your IT systems by making sure that you can incorporate new instruments and rates with features that differ from LIBOR. You may also find it worthwhile to establish task forces that assess the impact of financial, operational, legal, regulatory, technology and other risks.
Navigating the LIBOR transition: Auditors
An interest rate benchmark can have a far-reaching impact on a company’s financial reporting, as can transitioning from one benchmark rate to another. The Office of the Chief Accountant (OCA) is actively monitoring the actions that auditors are taking to address financial reporting issues that might arise in connection with the transition from LIBOR to an alternative benchmark rate, including, for example, accounting and financial reporting for:
- Modifications of terms within debt instruments.
- Hedging activities.
- Inputs used in valuation models.
- Potential income tax consequences.
You’re encouraged to begin addressing these potential accounting considerations with management, if you haven’t done so already.
You’re also encouraged to participate in standard-setting processes, informing those discussions from a financial reporting perspective—discussions that the Big 4 accounting firms are already very much a part of through comment letters and other efforts. The FASB added a project to its agenda to address potential accounting and reporting implications of the expected discontinuation of LIBOR, and issued Accounting Standards Update No. 2018-16 in October 2018, allowing use of the Overnight Index Swap rate based on SOFR (SOFR OIS) as a benchmark interest rate for hedge accounting purposes. Similarly, the IASB published an exposure draft on interest rate benchmark reform in May 2019, inviting comments on various hedge accounting issues that might present themselves during the period leading up to the replacement of an existing interest rate benchmark (available on Thomson Reuters Checkpoint).
Practical implications moving forward
It’s imperative that market and financial reporting participants recognize that the end of 2021 is fast approaching and not underestimate the complexities involved in making the transition.
Public companies, be prepared for regular check-ins from regulators about your progress and your readiness for transition. It’s also important that you be prepared to provide meaningful information that’s tailored to your specific business risks as opposed to less helpful generic information. Otherwise, regulators may require more.
All companies should be working with auditors to tackle the potential accounting issues that may arise in connection with the LIBOR transition and to take part in standard-setting processes, especially since the OCA encourages discussion and analysis in this area, and both the FASB and the IASB welcome a financial reporting perspective.
All impacted parties working together will make for a successful transition away from LIBOR. To that end, it’s important for companies, auditors and other market and financial reporting participants to have clear-cut transition roadmaps that allow for the identification and management of relevant risks along the way.