LIBOR Discontinuation: Preparedness Considerations for Funds and Investment Advisors

Background

The London Interbank Offered Rate (LIBOR) is used extensively in the United States and globally as a “benchmark” or “reference rate” for trillions of dollars in commercial and financial contracts, including many financing arrangements and investment products.

Publication of LIBOR will be terminated after 2021. Its phase-out and eventual discontinuation, and related effects on the financial markets, are expected to impact virtually all financial institutions and countless financial products and contracts. Private investment funds and their advisers are among the market participants expected to experience significant consequences from the cessation of LIBOR.

Regulators, including the Securities and Exchange Commission (SEC), are focused on the transition plans of impacted organizations. In January 2020, the SEC’s Office of Compliance Inspections and Examinations (OCIE) identified registrant preparedness for the LIBOR transition as an examination program priority. OCIE followed up with a Risk Alert on June 18, 2020, announcing an examination initiative focused on LIBOR transition preparedness.

This article will address:

• Why Interbank Offered Rates, including LIBOR, are being replaced
• What will replace LIBOR
• Key considerations for investment funds and their advisers
• More about OCIE’s examination initiative

Why are Interbank Offered Rates, including LIBOR, being replaced?

Interbank Offered Rates (IBORs) are benchmark interest rates used for computing valuations and interest obligations for a wide variety of financial contracts, instruments and products. LIBOR is one of the most widely utilized IBORs. LIBOR, which is published every London business day, is calculated using an average of panel bank submissions and serves as an indicator of the rate that banks pay to borrow unsecured money across five currencies (British Pound Sterling, Euro, Japanese Yen, Swiss Franc and U.S. Dollar) and seven tenors (overnight, 1 week, and 1, 2, 3, 6 and 12 months).

The aggregate amount of unsecured interbank borrowing transactions has significantly decreased since the 2008 financial crisis. Fewer banks have entered into such unsecured borrowings, and there has been a decline in the number of observable transactions. In 2017, in response to growing concern on the part of global regulators about the size and breadth of the market underlying IBORs, including LIBOR, and a related concern about the potential for manipulation of the rate-setting process, the UK’s Financial Conduct Authority (FCA) notified that, after 2021, it would no longer require banks to submit the rates to calculate LIBOR.

What will replace LIBOR?

The Alternative Reference Rates Committee (ARRC) is a group of private-market participants convened to help achieve a successful changeover from USD LIBOR to its recommended alternative reference rate, the Secured Overnight Financing Rate (“SOFR”).¹ Its membership includes banks, investment advisers, insurers, industry trade organizations and officials, including representatives of the SEC.

The Federal Reserve Board and the Federal Reserve Bank of New York (New York Fed) jointly convened the ARRC in 2014. In 2017, the ARRC identified SOFR as the rate that represents best practice for use in certain new USD derivatives and other financial contracts and its preferred alternative to USD LIBOR. It also published its “Paced Transition Plan,” which provides for specific actions and timelines intended to encourage adoption of SOFR. The ARRC’s work is in step with similar undertakings in each of the other LIBOR currency jurisdictions.

As further discussed on the ARRC website, SOFR is a broad measure of the cost of borrowing cash overnight, collateralized by U.S. Treasury securities in the repurchase agreement (repo) market. Compared to USD LIBOR, SOFR is based on a borrowing market exhibiting greater depth and liquidity and, as an overnight secured rate, SOFR is considered more reflective of the manner in which financial institutions fund themselves today. The transaction volumes underlying SOFR are notably larger than the transactions in any other U.S. money market. As such, SOFR is a transparent rate that is emblematic of the market across a wide range of market participants and, therefore, provides stronger protection from attempts at manipulation. The New York Fed publishes SOFR each business day.

Alternative reference rates may have certain structural differences compared to LIBOR. For example, USD LIBOR is typically a forward-looking rate that implicitly includes bank credit risk, while SOFR is a backward-looking overnight rate and is secured by collateral.

Although SOFR is the alternative reference rate recommended by the ARRC, there exists of a degree of uncertainty about which LIBOR successor reference rate will receive widespread market adoption. As of the publication of this article, an increase has been observed in the trading volume SOFR-linked cash and derivative products.

In its Risk Alert, OCIE disclosed its intended examination focus on registrants’ alternative reference rate selection process, including registrants’ strategies for identifying and addressing potential conflicts of interest associated with the substitution of an alternative reference rate for LIBOR.

Contract Modifications

Investment funds and their advisers will need to identify the population of contracts containing terms or provisions that are linked to LIBOR and which have durations beyond 2021. LIBOR may be referenced in a wide variety of contracts, including borrowing facilities or other financing arrangements; derivative contracts, including swap agreements; asset-backed securities, real estate mortgages, interest rate caps, private debt instruments, and floating rate notes. In addition to direct exposure to contractual terms that reference LIBOR, investment funds and their advisers may have indirect exposure via investments in portfolio companies that have LIBOR-indexed agreements. Contractual performance fees and carried interest provisions may also be impacted (for example, cases in which a hurdle rate or preferred return is linked to LIBOR).

In addition to inventorying the population of contracts that contain terms or provisions linked to LIBOR, entities should ascertain the nature and sufficiency of any existing “fallback language” contained in those contracts. Fallback language may provide for an alternative reference rate or protocol in the event of the unavailability of LIBOR. In evaluating the sufficiency of any existing fallback language, investment funds and their advisers should consider the timing (pre-cessation, post-cessation) or triggering event for the LIBOR replacement protocol and which alternative reference rate will be substituted for LIBOR. If acceptable fallback language is not present in the existing contract, renegotiation may be required.

For new contracts, investment funds and their advisers may be able to avail themselves of fallback language that is currently being proposed by various industry groups, if these achieve widespread acceptance. Such “generic” fallback language may provide for a hierarchy of LIBOR alternatives to be used in predefined circumstances. However, if this fallback language is deemed unacceptable to parties on either side of the agreement, additional negotiation may be required.

As it relates to certain derivatives and swaps, the International Swaps and Derivatives Association (ISDA) is aiming to launch a benchmark fallback protocol in the fall of 2020 that will amend the 2006 ISDA Definitions to include fallback language. The protocol will take effect on January 25, 2021 and will be applicable to new derivative contracts that incorporate the 2006 ISDA Definitions and reference one of the covered IBORs. Derivatives contracts existing as of January 25, 2021 will incorporate the new fallbacks if both counterparties have adhered to the protocol or otherwise bilaterally agreed to include the new fallbacks in their contracts.²

Amending contracts can be a lengthy process requiring coordination across different areas (e.g., portfolio management/deal team, legal team) and agreement with contract counterparties. Different types of contracts may require different alternative reference rates.

In its Risk Alert, OCIE disclosed its intended examination focus on registrants’ exposure to LIBOR-linked contracts that extend past the current expected discontinuation date, including any fallback language incorporated into these contracts.

Market Considerations

Investment funds and their advisers may face additional liquidity and valuation risk as a result of the LIBOR transition.

LIBOR-indexed contracts which do not contain sufficient fallback language could become less liquid as the date of LIBOR cessation draws nearer. As the LIBOR discontinuation date approaches, the trading volume of LIBOR-linked products is expected to decline. The erosion of liquidity may adversely impact an entity’s ability to exit or close-out positions.

Additionally, the substitution of an alternative reference rate for LIBOR may not be “value neutral.”

• Market value adjustments could result from structural differences between LIBOR and alternative reference rates and the complexity inherent in calculating the applicable spreads. The different regions impacted by the LIBOR transition are expected to adopt multiple (five, to be exact) alternative reference rates. Therefore, a firm dealing in multiple financial products, currencies and jurisdictions may end up with exposure to multiple alternative reference rates.
• Many hedges utilize LIBOR-based derivatives. Hedge effectiveness may be compromised if two contracts that had similar payment terms no longer match.

Financial Reporting and Disclosure Considerations

Investment funds and their advisers should consider potential impacts of the LIBOR transition on a fund’s financial statements, including:

• Whether the financial statements contain relevant disclosures about the impending discontinuation of LIBOR, the fund’s exposures and related risks.
• Transfers of certain investments within the fair value hierarchy (from Level 2 to Level 3, for example), necessitated by the reduced volume and observability of LIBOR transactions.

Other disclosures made to investors, including information contained in a fund’s offering documents or provided by investor relations, should also be reviewed for sufficiency.

With respect to potential accounting impacts, in 2018 the Financial Accounting Standards Board (FASB) launched a project to address potential accounting challenges expected to arise from the LIBOR transition. In March 2020, the FASB issued guidance providing optional expedients and exceptions for applying U.S. generally accepted accounting principles (GAAP) to contract modifications and certain qualifying hedges that reference LIBOR or another reference rate expected to be discontinued. The guidance, contained in Accounting Standards Update (ASU) 2020-04, Reference Rate Reform (Topic 848): Facilitation of the Effects of Reference Rate Reform on Financial Reporting, provides temporary relief and will be in effect through December 31, 2022. The accounting guidance simplifies the accounting analyses under GAAP for contract modifications, if qualifying criteria are met, and allows hedging relationships to continue without de-designation, upon changes to certain specified terms undertaken due to reference rate reform, among other provisions. Entities will need to assess whether and how the ASU will apply to their facts and circumstances.

In its Risk Alert, OCIE disclosed its intended examination focus on registrants’ disclosures, representations, and/or reporting to investors regarding its efforts to address LIBOR cessation and the adoption of alternative reference rates.

Operational and Other Considerations

Investment funds and their advisers may face operational challenges stemming from the LIBOR transition. To start, entities should identify any models, calculations, processes, and systems with LIBOR dependencies. These may include:

• Valuation and pricing models
• Risk models
• Performance benchmarking
• Interest calculations
• Margin calculations
• Collateral management systems
• Trade reconciliation processes
• Performance fees (for example, cases in which a hurdle rate is linked to LIBOR)

Investment funds and their advisers should assess their data needs and develop a strategy for sourcing replacement data, including alternative reference rates. Entities should also review back office systems, including information technology systems, in preparation for the LIBOR transition.

Investment funds and their advisers may have greater dependencies on third party organizations, compared to other entities. Efforts to identify and assess LIBOR dependencies, replacement data sources and information technology systems may need to be coordinated with administrators, custodians, brokers, pricing vendors, sub-advisers and other vendors or counterparties.

In its Risk Alert, OCIE disclosed its intended examination focus on registrants’ operational readiness, including any enhancements or modifications to systems, controls, processes, and risk or valuation models associated with the LIBOR transition.

More About OCIE’s Examination Initiative

In its June 18, 2020 Risk Alert³, OCIE announced its intention to assess the LIBOR transition preparedness of registrants through its examination program. An objective of the Risk Alert was to provide registrants with information about the scope and content of these examinations.

The Risk Alert emphasized the following:

• Timeliness of preparation is key. A certain amount of lead time will be required to complete contract modifications or update information technology systems, for example. Registrants should be developing and executing strategic plans now.
• LIBOR transition plans should be formally documented. This includes drafting strategic plans, completing written assessments, holding regular meetings and keeping minutes of the same.

In a rare move, OCIE included in the Risk Alert a sample request list for an examination of a registrant’s LIBOR transition preparedness. The request list provides examples of the types of information that OCIE may use in conducting its examinations. While the request list should not be considered all-inclusive, it provides some insights into potential focus areas of the examinations. The sample request list includes:

• Information regarding the entity’s risk and impact assessment, including inventories of impacted:
  • Contracts and obligations
  • Performance composites and performance advertising
  • Investor fee structures
  • Risk and valuation models
  • Third-party vendors
  • Information technology systems
• Information regarding the individuals responsible for overseeing the preparation for and implementation of the entity’s LIBOR transition plans, including any third parties that will be utilized.
• Actions taken with respect to entity governance, including communications with, and materials provided to, the board of directors (or equivalent oversight body).
• Disclosures provided in the registrant’s filings with the SEC and/or to investors during the period of January 2019 to the present.

In the Risk Alert, OCIE encouraged registrants and investment professionals to visit the ARRC website (https://www.newyorkfed.org/arrc) to subscribe for updates and source best practices with respect to the LIBOR transition. In addition, OCIE stated that it welcomes a discussion of the transition and encourages the public to share information about the potential impact of the expected discontinuation of LIBOR via email to: [email protected].

Conclusion

The discontinuation of LIBOR is quickly approaching. Investment funds and their advisers are likely to experience impacts on numerous fronts, including contractual, market, financial reporting, and operational impacts. The SEC is focused on entity readiness, and OCIE will prioritize this area in its upcoming examinations. Entities should be addressing the LIBOR transition now. By thinking about the impacts now and taking steps to manage those impacts, entities can minimize risks and achieve a successful LIBOR transition.

Sources

1. Information cited in this article with respect to the Alternative Reference Rates Committee (ARRC) and the Secured Overnight Financing Rate (SOFR) is sourced from the ARRC website.
2. Information cited in this article with respect to the International Swaps and Derivatives Association (ISDA) launch a benchmark fallback protocol is sourced from the ISDA website.
3. Information cited in this article with respect to the examination initiative of the Securities and Exchange Commission’s (SEC) Office of Compliance, Inspections and Examinations (OCIE), focusing on LIBOR transition preparedness, is sourced from the Risk Alert published by OCIE on June 18, 2020.