SEC Issues Statement on LIBOR Transition - Key Considerations
The SEC staff issued a statement “in light of the now-certain transition away from LIBOR” reminding investment professionals of their obligations when recommending LIBOR-linked securities and related investment products and strategies, including interest rate swaps, municipal securities and securitizations.
The statement highlights issues relating to the fact that many transaction documents that contemplate only a temporary cessation of LIBOR, or contain no fallback language, will likely experience material changes in their investment returns when the LIBOR is discontinued. Even newer issuances that contain fallback language may experience a change in potential returns on the investment because no replacement rate would provide a “perfect match” for LIBOR.
The statement also highlighted the potential impact on valuation measurements that use LIBOR as an input, including: (1) unlike LIBOR, SOFR does not reflect perceived bank credit risk; (2) potential changes in market liquidity and trading volumes during the transition both in the LIBOR market and with investments tied to alternative reference rates; and (3) that for some replacement rates (that are not term rates), the overall interest rate on an investment using the rate will not be known until near the end of the investment period.
Broker-Dealers: Recommendations to Retail Customers
The SEC staff urged broker-dealers need to be “especially mindful” when recommending LIBOR-linked securities, including securities with underlying investments in LIBOR-linked financial instruments, to retail customers. The staff explained that under Regulation Best Interest, a broker-dealer should understand the fallback language in any LIBOR-linked security which it recommends and have a reasonable basis to believe that the impact of that replacement is in the best interest of the particular retail customer.
The staff stated that it believes it “would be difficult for a broker-dealer to satisfy the Care Obligation [under Reg. BI] where it recommends a LIBOR-linked security with no fallback language absent the recommendation being premised on a specific, identified, short-term trading objective.” The statement further notes that a broker-dealer should consider the replacement rate for a LIBOR-linked security which, in certain circumstances, may involve considering whether New York state LIBOR legislation providing for a fallback will be applicable.
Municipal Securities Underwriting and Sales to Customers
Building on previous guidance from the Office of Municipal Securities and the MSRB, the staff provided the following guidance with regard to municipal securities activities and LIBOR:
under Exchange Act Rule 15c2-12 ("Municipal securities disclosure"), underwriters of primary offerings of municipal securities should consider the municipal obligor’s exposure to risks due to LIBOR transition;
broker-dealers should consider their obligations to retail customers under Regulation Best Interest discussed above and to non-retail customers under the suitability standards of MSRB G-19 ("Suitability of Recommendations and Transactions"); and
information known or available from established industry sources regarding the municipal obligor’s exposure to risks associated with the LIBOR transition may be material information under MSRB Rule G-47.
Registered Investment Advisers and Funds
The statement highlights LIBOR-related considerations as part of the fiduciary duty of investment advisers and disclosure obligations applicable to investment companies. Investment advisers should consider whether any advice regarding LIBOR-linked investments and applicable risks are consistent with their clients’ goals, which may include continuously monitoring whether a client should hold a LIBOR-linked investment. Investment advisors should also consider whether the contracts have robust fallback language and implications of any economic differences that may result from an alternative rate. The statement further urges advisers to consider whether disclosures are necessary in relation to benchmark-linked performance fees.
Disclosure Considerations for Public Companies and Asset-Backed Securities
Existing federal securities laws require disclosure about risks and events that a reasonable investor would consider important to their investment decision. Rules regarding risk factors, management’s discussion and analysis, board risk oversight, and financial statements may all require disclosure based on LIBOR’s discontinuation.
Issuers of registered asset-backed securities should consider the relevant disclosure requirements under Regulation AB, which necessitates an issuer must disclose how the interest rate of an asset-backed security is determined, how frequently it will be determined and provide asset level information not just at the time of the offering, but on an ongoing basis, which may dictate change based on the LIBOR transition.
The SEC encourages companies to provide qualitative and quantitative disclosures, such as how much debt with inadequate fallbacks are outstanding and what steps the company is going to take to address the situation. The SEC anticipates disclosures to evolve over time as companies transition away from LIBOR.
The statement is a must‐read for SEC registrants engaged in LIBOR‐related activities.