By the end of June 2023, banks will no longer be required to publish rates used to calculate the U.S. Dollar London Interbank Offered Rate (USD LIBOR) for any tenor and the volume of outstanding USD LIBOR legacy products is far greater than for other currencies already transitioned. As the deadline nears, this article summarizes recent regulatory developments and areas of focus for transition planning. Are you ready?
Despite substantial efforts to encourage market participants to prepare for the cessation of USD LIBOR, there is still a large volume of USD LIBOR contracts that do not mature by June 30, 2023 and lack adequate fallback provisions. These are known as tough legacy contracts. Some states like New York have adopted legislation to establish consistent defaults in the absence of fallback language. However, further national legislation was needed to consistently address these legacy contracts.
On March 15, 2022, President Biden signed the 2022 Consolidated Appropriations Act, which also included provisions to address legacy USD LIBOR contracts, known as the Adjustable Interest Rate (LIBOR) Act—the LIBOR Act. This legislation lays out a set of default rules and creates safe harbors for the transition from USD LIBOR to the Secured Overnight Financing Rate (SOFR) for legacy contracts. The legislation applies to contracts governed by U.S. law and all contract types, e.g., a security, loan, mortgage, swap, etc. Application depends on the fallback provision in the contract:
- Contracts that lack any fallback provisions
- Contracts whose fallback provisions lead to a replacement rate that is itself based on LIBOR (including “Last LIBOR” fallbacks)
- Contracts that require polling for interbank rates
- Optional safe harbor for contracts that permit or require the selection of a replacement rate by a nominated party
The legislation does not affect contracts whose fallback provisions:
- Result in the use of a specified, non-LIBOR-based replacement rate (such as the prime rate, the federal funds rate, or base rate)
- Incorporate versions of the Alternative Reference Rates Committee (ARRC)-recommended fallback language that result in the use of a specified replacement rate
Any contract that would be within the legislation’s scope can be taken out of scope by mutual agreement of the parties to the contract.
The LIBOR Act generally provides that a bank may use any benchmark (including a benchmark that is not SOFR) in any non-LIBOR loan made before, on, or after the date of enactment of the LIBOR Act that the bank determines to be appropriate, and that no federal supervisory agency may take enforcement or supervisory action against the bank solely because that benchmark is not SOFR.
The LIBOR Act expressly preempts any provision of state or local law relating to the selection or use of a benchmark replacement or related conforming changes, or expressly limiting the manner of calculating interest (including the compounding of interest).
Federal Reserve Board (FRB)
On December 16, 2022, the FRB issued a final rule implementing the LIBOR Act, which is effective 30 days after Federal Register publication. The amendments automatically replace LIBOR references in certain contracts with an FRB-selected replacement rate after June 30, 2023. The contracts include those governed by domestic law that do not mature before LIBOR ends and that lack adequate fallback provisions. As required by the LIBOR Act, each replacement rate is based on SOFR. See Appendix for details.
While this legislative solution provides a backstop, proactive remediation should be the preferred transition approach. Consider a combination contract consisting of a loan and corresponding swap that would transition to SOFR-based fallbacks employing different conventions. Those situations—and others—could result in differences of calculated interest amounts or cash flow timing.
FASB Accounting Relief Extended
In 2020, FASB issued Accounting Standards Update (ASU) 2020-04, which provided temporary, optional expedients and exceptions for applying GAAP to held-to-maturity securities, contracts, hedging relationships, and other transactions affected by reference rate reform, most notably to:
- Simplify contract modification accounting
- Allow hedging relationships to continue without dedesignation upon a change in certain critical terms
- Allow a change in the designated benchmark interest rate to a different eligible benchmark interest rate in an existing fair value hedging relationship and allow flexibility in the accounting method for the effect of that change
- Simplify or temporarily suspend the assessment of hedge effectiveness for cash flow hedges
- Suspend the assessment of certain qualifying conditions for fair value hedges for which the shortcut method for assuming perfect hedge effectiveness is applied
Due to the unique nature of LIBOR sunset, ASU 2020-04 had an unusual effective date. The relief was set to expire for contracts entered into or evaluated after December 31, 2022, which was one year after the then-expected LIBOR cessation date. However, on March 5, 2021, LIBOR’s regulator announced that certain USD LIBOR tenors will continue to be published until June 30, 2023. FASB recently issued ASU 2022-06, which extends the available relief to December 15, 2024.
For additional details, see “FASB Finalizes LIBOR Transition Relief.”
Significant progress has been made over the past year in transitioning away from LIBOR for new contracts and securities. Adoption of SOFR, the ARRC’s recommended replacement for USD LIBOR, has been significant. In December 2022, the Financial Stability Board (FSB) published a Progress Report on LIBOR and Other Benchmarks Transition Issues, which highlighted the following progress:
- In cash markets, SOFR is now the predominant reference rate, with almost all USD floating rate notes and all USD adjustable-rate agency mortgages being tied to SOFR. Almost all new USD loans currently reference term SOFR; for syndicated loans, nearly 100% of USD syndicated lending references SOFR, compared to 30% in December 2021.
- In over-the-counter derivatives, SOFR average daily interest rate risk traded, as measured by duration-adjusted trading volumes, grew to more than 90% of interdealer swaps traded in the outright linear swaps market in October 2022, from less than 20% in July 2021.
- In exchange-traded derivatives, SOFR futures average daily trading volumes are now roughly three times more than those of Eurodollar futures after being less than a quarter of Eurodollar futures volumes at the start of the year.
- In May 2022, CME announced an initiative to accelerate the growth of SOFR options trading. Since the launch of the CME initiative, SOFR average daily options activity grew to surpass that of Eurodollar options.
However, the FSB report also notes there is still roughly $85 trillion of USD LIBOR that will mature after June 2023. An FSB survey indicated that the lack of ability to change or agree on fallback provisions and lack of engagement from nonfinancial institutions were the main roadblocks to migrating these contracts. Syndicated loan agreements with multiple financial institutions also were cited as being particularly challenging.
Source: Progress Report on LIBOR and Other Benchmarks Transition Issues, FSB, December 16, 2022
What to Do Now
The use of LIBOR within organizations is deeply rooted. Here are several steps to begin now to help ensure a smooth transition:
- Identify and assess the effect of LIBOR exposures. In addition to derivative exposure, be sure to review other common uses of LIBOR:
- Committed credit agreements, including commercial paper backup lines
- Inter-affiliate/intra-group loans
- Term loans, floating rate notes, and asset securitizations
- Accounting – Fair value calculations and lease valuations
- Asset purchase and sale agreements – Adjustments for changing closing date
- Supply agreements – Adjustments for volume variances and late payments
- Employee benefit payments – Adjustments for payment delays
- Review legacy contracts to understand mutual rights, obligations, and roles of different parties (borrower, lender, administrative, and calculation agent) and fallback language (trigger, fallback rates, and spread) in the event of LIBOR cessation
- Assess the effect of LIBOR transition on valuation, accounting, tax, financial disclosures, and hedging strategy and the need for actions to mitigate the effect
- Engage with service providers to discuss transition strategy for legacy LIBOR transactions
- Mobilize internal or external legal counsel to address amendments or transition of legacy contracts
- Understand the key differences between LIBOR and the new reference rate and how the new benchmark will perform through an economic cycle
- Engage with external data and systems providers to help ensure operational readiness to transition away from LIBOR to a new reference rate
The transition away from LIBOR will be complicated and likely will require significant hours to implement correctly for companies with a large volume of contracts. If you would like assistance with reference rate reform, please reach out to a professional at FORVIS or submit the Contact Us form below.
Appendix – FRB Replacement Rates
The FRB final rule identifies the following selected benchmark replacements:
- For a LIBOR contract that is a derivative transaction, the “Fallback Rate (SOFR)” as defined in the 2020 IBOR Fallbacks Protocol published by the International Swaps and Derivatives Association (ISDA protocol), which incorporates the statutorily prescribed tenor spread adjustment
- For a LIBOR contract that is a Federal Housing Finance Agency (FHFA)-regulated-entity contract:
- For Federal Home Loan Bank advances, the “Fallback Rate (SOFR)” as defined in the ISDA protocol
- For all other FHFA-regulated-entity contracts, SOFR (in place of overnight LIBOR) or 30-day compounded average SOFR published by the Federal Reserve Bank of New York (FRBNY) (“30-day Average SOFR,” in place of one-, three-, six-, or 12-month LIBOR), plus the applicable statutorily prescribed tenor spread adjustment
- For a LIBOR contract that is a Federal Family Education Loan Program asset-backed security, either (i) 30-day average SOFR (for one-, six-, and 12-month LIBOR) or (ii) 90-day compounded average SOFR published by FRBNY (for three-month LIBOR), plus the applicable statutorily prescribed tenor spread adjustment
- For all other LIBOR contracts, including consumer loans, SOFR (in place of overnight LIBOR) or term SOFR published by CME Group Benchmark Administration, Ltd. (in place of one-, three-, six-, or 12-month LIBOR), plus the statutorily prescribed tenor spread adjustment