You may recall that at the end of last year, SEC Chair Jay Clayton and Corp Fin Chief Accountant Kyle Moffatt were warning at various conferences about some of the risks the SEC was monitoring, among them the LIBOR phase-out, which is expected to occur in 2021. As reported by the WSJ, Moffatt indicated that “to the extent that the phaseout of Libor is material to a company,…we would definitely expect a company to disclose that fact and describe the implications of the phaseout, including any associated risks, to investors.’” (See this PubCo post.) But, in making that assessment and any related disclosure, what should companies consider?
LIBOR, the London Interbank Offered Rate, is calculated based on estimates submitted by banks of their own borrowing costs. In 2012, the revelation of LIBOR rigging scandals made clear that the benchmark was susceptible to manipulation, and British regulators decided to phase it out. In his speech, Clayton reported that, according to the Fed, “in the cash and derivatives markets, there are approximately $200 trillion in notional transactions referencing U.S. Dollar LIBOR and… more than $35 trillion will not mature by the end of 2021.” Clayton indicated that an alternative reference rate, the Secured Overnight Financing Rate, or “SOFR,” has been proposed; nevertheless, there remain significant uncertainties surrounding the transition. For public companies that have floating rate obligations tied to LIBOR, as discussed in this PubCo post, Clayton warned, a significant risk is
“how to manage the transition from LIBOR to a new rate such as SOFR, particularly with respect to those existing contracts that will still be outstanding at the end of 2021. Accordingly, although this is a risk that we are monitoring with our colleagues at the Federal Reserve, Treasury Department and other financial regulators, it is important that market participants plan and act appropriately. For example, if a market participant manages a portfolio of floating rate notes based on LIBOR, what happens to the interest rates of these instruments if LIBOR stops being published? What does the documentation provide; does fallback language exist and, if it exists, does it work correctly in such a situation? If not, will consents be needed to amend the documentation? Consents can be difficult and costly to obtain, with cost and difficulty generally correlated with uncertainty. In the area of uncertainties, we continue to monitor risks related to the differences in the structure of SOFR and LIBOR. SOFR is an overnight rate, and more work needs to be done to develop a SOFR term structure that will facilitate the transition from term-based LIBOR rates.”
This article from Compliance Week discusses the “compliance headaches” that many companies will face in connection with the transition away from LIBOR. According to the article, SOFR, the new reference rate, is widely expected to replace LIBOR in the U.S., but the change to the new benchmark is expected to have a significant impact, “both from an operational standpoint as well as from an accounting and financial reporting standpoint.” As Clayton suggested above, companies will need to review arrangements tied to LIBOR, such as loan arrangements, securities, interest-rate swaps and other derivatives, to determine whether they expressly provide for a transition to a new benchmark rate and, if so, what, if anything, needs to be done. For example, loan agreements with floating-rate debt may well be tied to LIBOR. If the agreements do not provide for a transition, they may require renegotiation. According to a BDO partner quoted in the article, the “transition is not as simple as swapping out a new rate for an old one….While LIBOR is a rate banks use to lend among themselves, SOFR is a secured overnight rate. Credit risk is embedded in LIBOR, but not in SOFR, he says. ‘There’s going to have to be some negotiation for the credit spread that was implicit in LIBOR….That will take some time.’” A global regulatory leader at PwC advises in the article that companies begin to identify instruments that reference LIBOR, putting together a team of finance support personnel, controllers and risk managers to help analyze the impact and identify next steps. Depending on the circumstances, including personnel from the business side could also be useful. As the SEC has admonished, companies will also need to prepare (and update) disclosure where appropriate and may even need to consider whether communication outside the company, such as with investors, would be useful.
There could also be a significant impact on the accounting treatment. Corporations often manage risk exposures with swaps and other derivatives, and, according to a principal of KPMG, the transition may create a number of issues surrounding the accounting for these derivatives: not only could the “transition to a new benchmark… affect the valuation for balance sheet purposes, but it also affects hedge accounting compliance, which is a complex area of Generally Accepted Accounting Principles.” Elaborating on that point, a partner at D&T observed in the article that, under GAAP, companies “could face questions, for example, about whether their hedges are effective and, therefore, eligible for hedge accounting.” (In that regard, see the SEC staff remarks below.) Another issue that may arise is whether “a change in the underlying benchmark represents a modification,…which has serious implications that could disqualify a particular transaction from hedge accounting. The consequences of losing hedge accounting include onerous fair-value exercises and potential income statement volatility.” In the less likely event that changes in the debt arrangements are “significant enough, companies may need to regard the transition as ending one debt arrangement and beginning a new one. Under accounting rules, that means taking the old loan off the balance sheet at its carrying amount and adding the new loan at fair value, with changes reported through earnings.” Another area that may require examination relates to discount rates used in fair-value measurements, which are sometimes based on LIBOR. According to the BDO partner, the transition away from LIBOR “will change the way you construct curves for valuations. The rates, the models, the processes all would have to be adjusted, and systems changes might need to be made.’”
FASB has implemented one change that allows SOFR to be designated as a benchmark interest rate and has a current project to consider and implement other changes to GAAP that might be required to facilitate the transition. And the SEC has so far been relatively accommodating. In remarks before the 2018 AICPA Conference on Current SEC and PCAOB Developments, Professional Accounting Fellow Rahim M. Ismail provided an update on a stakeholder consultation regarding the impact of the LIBOR transition on the stakeholder’s existing cash flow hedge accounting related to variable rate debt instruments. Under these instruments, the hedged item was LIBOR-based interest payments. The stakeholder had two questions that—caution—were deep in the accounting weeds:
Probable of occurring. For hedge accounting to be applicable, “the forecasted transaction being hedged, in this case the LIBOR based interest payments, has to be probable of occurring.” The stakeholder asked whether companies could continue to assert that cash flow hedges were “probable of occurring” where the hedged item was LIBOR-based interest payments for variable rate debt with terms that extended beyond the LIBOR transition date. The staff did not object to the stakeholder’s view that “hedge documentation involving LIBOR based cash flows implicitly considers the rate that would replace LIBOR, thereby allowing an entity to continue to assert that the hedged item is probable of occurring.”
Highly effective. For hedge accounting to be applicable, “a hedge must be assessed as highly effective both on a prospective and retrospective basis.” The stakeholder asked whether and how the expected LIBOR transition would affect the assessment of the effectiveness of a cash flow hedge of LIBOR-based variable rate debt. The staff did not object to the stakeholder’s view that, “as part of its assessment of hedge effectiveness, an entity could consider an expectation that anticipated changes to LIBOR will impact both the hedged item (e.g., forecasted interest payments on debt) as well as the hedging instrument (e.g., interest rate swap). The stakeholder further asserted that in light of this expectation, the anticipated transition away from LIBOR in and of itself would not impact the effectiveness of the hedge.”