SEC staff stresses importance of fallback language in LIBOR transition

A staff statement from the SEC on Tuesday noted the duties broker-dealers and registered investment advisers and funds have to their clients under agency rules including Regulation Best Interest (Reg BI) and the Investment Advisers Act of 1940 (Advisers Act). SEC staff also touched on disclosure considerations for public companies and asset-backed securities issuers regarding progress toward LIBOR transition risk identification and mitigation.

LIBOR will cease to be available for new contracts as of Jan. 1, 2022. The rate, overseen by the U.K. Financial Conduct Authority, has historically been subject to manipulation, prompting its impending end and the regulatory push toward alternatives.

The process to move away from LIBOR dates back to 2017, though many financial institutions have been reticent to commit to alternatives. A report from the Wall Street Journal last week explored how some companies have still been pursuing LIBOR-leveraged loans as the end of the year nears, citing comfort with the expiring rate and familiarity with its behavior.

LIBOR will still exist for remaining U.S. dollar settings through June 30, 2023. Those contracts will receive scrutiny if they do not include language referencing alternative rates. The popular pick to replace LIBOR is the Fed-backed Secured Overnight Financing Rate (SOFR). The WSJ report noted recent deals reached by Columbus McKinnon and Fanatics that used LIBOR include plans to transition to SOFR.

Duty to clients

U.S. issuers are not obligated to include fallback language in transaction documents for new issuances to LIBOR-linked securities, SEC staff stated.

“Because no replacement rate is a perfect match for LIBOR, even when the transaction documents contain robust fallback language, the value of LIBOR-linked securities—and consequently their potential returns—may experience material changes upon LIBOR’s discontinuation,” the staff noted.

Though this is the case at a general level, certain entities might be required to include fallback provisions as part of their obligations under other rules. Reg BI, for example, includes a “Care Obligation,” which mandates broker-dealers to “exercise reasonable diligence, care, and skill to, among other things, understand the potential risks, rewards, and costs associated with [a] recommendation.”

Regarding LIBOR-linked securities or investment strategies, SEC staff said broker-dealers should understand whether fallback language is included in addition to the impact an alternative replacement rate would have on the LIBOR-linked deal.

“[G]iven the now-certain transition away from LIBOR as a reference rate, staff believes that it would be difficult for a broker-dealer to satisfy the Care Obligation where it recommends a LIBOR-linked security with no fallback language absent the recommendation being premised on a specific, identified, short-term trading objective,” SEC staff said. “The lack of fallback language as a practical matter guarantees that a material characteristic of the security at the time of the recommendation—the reference rate—will cease to exist during a period where a retail customer is likely to be holding the security.

“Accordingly, staff is of the view that the replacement rate for a LIBOR-linked security is a factor that generally should be considered as part of a recommendation.”

Similarly, investment advisers and funds complying with the Advisers Act and Investment Company Act of 1940 have a fiduciary duty to act in their client’s best interests. That includes consideration of robust fallback language in LIBOR-linked investments.

“Where fallback language references an alternative rate, advisers should consider whether any economic differences arising from the application of the alternative rate could cause the investment to depart from their clients’ strategy or risk tolerance,” SEC staff said.

The staff statement also noted obligations under certain Municipal Securities Rulemaking Board (MSRB) mandates might apply to brokers, dealers, or municipal securities dealers in their transition efforts away from LIBOR.

Disclosure considerations

“A number of existing rules or regulations may require disclosure related to the expected discontinuation of LIBOR, including … disclosure of risk factors, management’s discussion and analysis, board risk oversight, and financial statements,” SEC staff said. “Issuers of registered asset-backed securities also should consider relevant disclosure requirements under Regulation AB, as well as appropriate disclosures regarding the potential impacts of the LIBOR transition on investors in those securities.”

SEC staff suggested companies provide “detailed and specific disclosure” rather than general statements about transition progress. Such updates should include insight into what the company has done, what steps remain, and the timeline for further efforts.

SEC staff acknowledged it expects disclosures “to evolve over time as companies provide updates to reflect transition efforts and the broader market and regulatory landscape.”

Other regulator efforts

The SEC is far from the only government agency focused on LIBOR transition efforts. The Federal Reserve and other banking regulators have long stressed the need for urgency in the matter, in addition to hinting at the potential of enforcement against firms not making enough progress in transition efforts.

The Consumer Financial Protection Bureau (CFPB) on Tuesday issued a final rule establishing requirements for how creditors must select replacement indices for existing LIBOR-linked consumer loans after April 1, 2022. Meanwhile, the Commodity Futures Trading Commission (CFTC) last week continued its efforts to switch interdealer trading conventions from LIBOR to SOFR as part of its SOFR First initiative.