Overlooked Issues for LIBOR Transition: Board Governance and Disclosure Requirements
LIBOR, or the London Interbank Offered Rate, is used extensively globally and in the United States. However, it is expected that LIBOR will be phased out of use after 2021, which could significantly impact financial markets and create multiple risks for market participants including companies and municipal entities. As US governmental officials have begun pressing banks to stop using LIBOR by the end of 2021, the Securities and Exchange Commission (SEC) is encouraging market participants to begin planning for the expected discontinuation of LIBOR (the “LIBOR Discontinuation”).
The SEC expects that the real estate, banking, and insurance industries will be the most impacted by the LIBOR Discontinuation. One way to prepare is to consider how the LIBOR Discontinuation will impact disclosure duties. The larger the entity, the more likely it has some LIBOR exposure, requiring the disclosure of the risks related to the LIBOR Discontinuation.
The SEC has issued several statements to aid market participants as they prepare for the LIBOR Discontinuation, emphasizing preemptive measures as a means to a successful transition. In a 2019 Staff Statement, the SEC provided broad guidance for how registrants can respond to the risks associated with the LIBOR Discontinuation (but see “Further Analyses of Overlooked Concerns” below):
- Companies should identify existing contracts that extend past 2021 and reference LIBOR, and determine how the LIBOR Discontinuation will impact the operation of such contracts.
- Future contracts should reference a rate other than LIBOR (such as SOFR) or include adequate fallback language if the contract does reference LIBOR.
- Market participants should consider other consequences the LIBOR Discontinuation could have on their business and create strategies to mitigate any risks involved.
Beyond the company’s LIBOR exposure, the LIBOR transition risks to customers and suppliers should be examined and disclosed if it impacts the company’s business.
The SEC is looking for companies to accurately and fully disclose the expected impact of the LIBOR Discontinuation on their businesses. To the extent that LIBOR has been pervasive in the past, identifying the impact of the LIBOR Discontinuation could be an extensive undertaking. However, adequate disclosure will require outlining how a market participant’s operations will be subject to change because of the LIBOR Discontinuation. This basically means evaluating how LIBOR currently impacts a market participant’s “strategy, products, processes, and information systems,” and then disclosing how the market participant plans to mitigate the risks created by the LIBOR Discontinuation. Adequate disclosure will allow an investor to evaluate those risks and make informed investment decisions.
In a 2019 Staff Statement, the SEC Division of Corporation Finance outlined rules and regulations that are relevant for the disclosure of risks related to the LIBOR Discontinuation. Those rules and regulations include:
- Item 105 of Regulation S-K and Item 3.D of Form 20-F: These regulations require companies to disclose significant factors that could possibly make investment in such companies speculative. The nature of these disclosures is meant to be specific to the facts and circumstances of the specific company. A company should therefore disclose how the LIBOR Discontinuation will impact that company individually, rather than using general language about the risks of the LIBOR Discontinuation.
- Item 303 of Regulation S-K and Item 5 of Form 20-F: These regulations require companies to locate known trends, demands, commitments, events, or uncertainties that will result in a material increase or decrease in liquidity. The LIBOR Discontinuation and transition to a different rate, such as SOFR or another replacement benchmark, could impact liquidity in many ways, so a company should identify and disclose the specific ways in which it will be impacted.
- Item 407(h) of Regulation S-K: This item requires companies to disclose the extent of its board’s role in the risk oversight of the company. A company should therefore outline how its board is managing its oversight function related to the risks of the LIBOR Discontinuation. This is particularly important for those companies with significant direct or indirect LIBOR exposure and may impact the company’s D&O insurance coverage.
The SEC also expects the LIBOR Discontinuation to have a significant impact on the municipal securities market.
SEC Rule 15c2-12 requires municipal securities holders to disclose material financial characteristics and material financial risks to investors through the Municipal Securities Rulemaking Board (MSRB) on an ongoing basis. Depending upon the municipal entity’s or conduit borrower’s LIBOR exposure, the LIBOR Discontinuation could be a material risk, especially for those municipal entities with a significant amount of variable rate financings and interest rate swaps. Therefore, any municipal entity that relies on LIBOR should disclose these material risks and their mitigation strategies.
The SEC guidance for companies referenced above, such as liquidity concerns and board involvement, should also be considered by municipal entities and conduit borrowers with significant LIBOR exposure.
The SEC’s Office of Municipal Securities noted that in the primary market, any new issues that are affected by the LIBOR Discontinuation should include disclosures about the material risks, mitigating actions, and any fallback language related to alternative interest rate provisions after LIBOR is discontinued. In the secondary market, the SEC is looking for “forward-looking information regarding the potential future impact of the LIBOR transition” so investors have a clear picture of the implications the LIBOR Discontinuation will have on municipal securities. Whether it is through required ongoing disclosures or voluntary disclosure, municipal securities holders should focus on how the LIBOR Discontinuation is impacting them specifically, rather than discussing the risks generally.
Further Analyses of Overlooked Concerns
Impact of ‘Industry-Standard’ Transition Documentation
Generally, the documentation being offered by banks to companies and municipal entities is not standard across the industry and not even standard within each financial institution as it depends upon when the documentation was presented to a borrower as the documentation has evolved over time.
However, the one aspect of the ‘industry-standard’ documentation that applies across the board – it disadvantages the very companies and municipal entities that are supposed to go through the transition with no serious repercussions as a result of the LIBOR Discontinuance.
This documentation generally provides for the (i) replacement of LIBOR with a benchmark determined in the sole and absolute discretion of the banks (rather than SOFR), (ii) a spread adjustment between LIBOR and the new benchmark replacement determined in the sole and absolute discretion of the banks and (iii) the timing of the benchmark replacement occurring at the sole and absolute discretion of the banks. This is in spite of governmental regulator warnings that the LIBOR Discontinuance is not to be used as an excuse to change the effective interest rates on existing financial instruments.
It is not often that companies, municipal entities, or conduit borrowers enter into financings without knowing the effective interest rates on their facilities, and with future effective interest rates determined without their input. In addition, ‘industry-standard’ documentation often prohibits companies and municipal entities from prepaying if the effective interest rate is not in line with such entities’ expectations.
Other Related Substantial Consequences
To the extent that effective interest rates change, there are a host of other issues beyond the scope of the disclosure and board oversight concerns raised above including:
- tax repercussions of entering into a materially different financial instrument
- related impacts on the entity’s financial statements
- operational issues, including financial covenant and related default concerns, in the event of debt service increases
- increased litigation risks
- potential waiver of existing legal rights in the ‘industry-standard’ documentation under:
- FINRA rules
- MSRB rules
The LIBOR Discontinuation will impact securities holders in many ways. To provide adequate, investor-focused disclosure, market participants should evaluate their current and future contracts that reference LIBOR, as well as LIBOR exposure of their customers and vendors, and ensure that adequate fallback language exists or that reference to an alternative rate is available. Furthermore, market participants should assess the material risks associated with the LIBOR Discontinuation and disclose those risks, as well as risk mitigation strategies.
Municipal security holders have further disclosure obligations, and dealers should ensure they are complying with Rule 15c2-12 by disclosing any material financial risks or material financial characteristics associated with the LIBOR Discontinuation.
The key is that the fallback language be fair to the borrower. Unfortunately, our experience has been just the opposite.
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 See Client Alert, LIBOR Transition: Potential Higher Interest Rates and Resultant Job Cuts
 Andrew Ackerman & Dave Michaels, U.S. Financial Regulators Push Banks to Transition Away from Libor, The Wall Street Journal.
 See 17 Code of Federal Regulations (CFR) § 240.15c2-12
 This is separate and apart from the borrower credit spread adjustment charged by the banks that most companies and municipal entities are familiar with and should remain unchanged with the LIBOR transition.
 In June 2021 (i) the SEC removed the Chairman of the Public Company Accounting Oversight Board (PCAOB) and announced that it intends to seek candidates to fill all five (5) board positions and (ii) the PCAOB’s Acting Chairman announced that he has directed staff to reassess PCAOB’s stakeholder engagement efforts, including the structure and membership of its advisory groups. ‘SEC Announces Removal of William D. Duhnke III from the Public Company Accounting Board; Duane M. DesParte to Serve as Acting Chair’ dated June 4, 2021 and ‘PCAOB Acting Chairperson Announces Reassessment of Stakeholder Engagement, Advisory Groups’ dated June 22, 2021.
PCAOB’s Chair cannot be a practicing certified public accountant (CPA) and no more than two (2) board members can be CPAs. This is to mitigate conflicts of interest under Sarbanes-Oxley. The PCAOB was created in 2003 to supervise accounting firms that audit publicly listed companies to prevent the recurrence of accounting scandals that toppled Enron, WorldCom, and Arthur Anderson, and cost investors $85 billion two decades ago. See ‘SEC Removes PCAOB Chairman Duhnke, Seeks to Fill All Board Member Positions’ in the Accounting & Compliance Alert dated June 7, 2021.
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