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Elimination of LIBOR Poses Significant Challenges

Companies with LIBOR-based agreements should be considering and planning for the impact of the changes now. Taking proactive steps and working with your financial and accounting advisors in advance of 2021 can greatly mitigate any negative effects to your company.

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Companies with LIBOR-based agreements should be considering and planning for the impact of the changes now. Taking proactive steps and working with your financial and accounting advisors in advance of 2021 can greatly mitigate any negative effects to your company.

Cessation of the London Interbank Offered Rate (LIBOR) is expected to occur in 2021. With significant borrowings being tied to the rate (an estimated $350 trillion in contracts internationally), dissolution of LIBOR poses a substantial challenge both globally in finding a suitable replacement as well as to individual entities to adapt from an operational and accounting standpoint.

Efforts to determine a suitable replacement for LIBOR and other interbank rates are currently in process worldwide. In the United States, a committee known as the Alternative Reference Rates Committee (ARRC) was formed by the Federal Reserve Board in 2014. This committee, comprised of both bank and non-bank members with collaboration between the both the private and official sector, was tasked with finding a replacement specifically for the USD LIBOR rate.

As a result of these efforts, in 2017 the ARRC proposed the use of the Secured Overnight Financing Rate (SOFR), an overnight cash borrowing rate collateralized by U.S. Securities in a repurchase agreement market. While it has many attributes that lend itself to being used in a manner similar to LIBOR, it is strictly an overnight rate, and due to the relative infancy of the SOFR, the required liquidity to be used for forward projections does not currently exist.

The ARRC transition plan includes setting up guidance that would allow for more instruments referencing the SOFR to be created and used as well as assisting with direction on the rates, their calculation and use, and the transition of LIBOR-based agreements to SOFR-based.

Despite being generally considered the current “frontrunner” to replace LIBOR (particularly within the United States), there is still a measure of uncertainty. Many speculate that in the absence of a dominant rate emerging, the previous LIBOR-based rates become fragmented between several alternatives. Despite those concerns, there are still steps that entities with LIBOR-affected agreements should take now in order to prepare.

Inventory Existing Agreements

Companies should compile an inventory of any agreements that are affected by or reference LIBOR that extend beyond 2021. This could include instruments such as loan, credit, swap or other hedge arrangements.

Evaluate Investments

Companies should consider any investments held that may be affected by LIBOR (e.g. certain asset-backed securities). A change from LIBOR could change investments liquidity, returns or classification.

Fallback Language

Do LIBOR-related agreements have fallback contract language that details procedures in the event LIBOR is no longer available for use? Those that don’t should be revisited now to minimize disruption in the event of such a transition.

Transition Approach

The ARRC recommends two transition approaches. The first is an “amendment approach,” which essentially lays the groundwork for the rate to be changed at a later date and agreed to in advance. The second is the “hardwired approach,” which says that the SOFR (plus a spread adjustment) will replace LIBOR at a specified date. For both transition approaches, the ARRC has developed template language that could be included in any affected agreements.

Tax Implications

Could a “significant modification” of the debt, resulting in tax consequences for the issuer and holder, result? These issues should be reviewed in detail with internal and external tax personnel as appropriate to ensure all appropriate tax planning has been done prior to 2021.

Hedge Implications

Would a change from a LIBOR-based agreement to an alternate rate cause the hedge to no longer be considered an effective hedge? This may require additional action to address unmitigated risks.

Financial Statements

Is exposure to the LIBOR or the change of the rate going to have a material effect on your company? If so, it may require specific disclosures be added to the financial statements.

To ease the potential accounting burden, revised guidance with several optional expedients and exceptions is currently in exposure draft by the Financial Accounting Standards Board. This proposal, if adopted, would allow certain contracts modified due to reference rate reform to be considered as a continuation of the contract. It further proposes updates to guidance over derivatives and hedging to allow for modification of the designated benchmark rate in existing hedging arrangements and to provide guidance addressing issues with hedge effectiveness and inconsistency of rates and portfolio approaches expected to arise from reference rate reform. Also included are temporary optional expedients designed to prevent reference rate reform from causing changes in whether a hedge is considered “effective” or not. In addition to the exposure draft, changes have been made to hedging standards to include the SOFR as a permissible benchmark rate. Companies will need to stay informed on these matters as they continue to develop.

Companies with LIBOR-based agreements should be considering and planning for the impact of the changes now. Taking proactive steps and working with your financial and accounting advisors in advance of 2021 can greatly mitigate any negative effects to your company.

 

Disclaimer: Any written tax content, comments, or advice contained in this article is limited to the matters specifically set forth herein. Such content, comments, or advice may be based on tax statutes, regulations, and administrative and judicial interpretations thereof and we have no obligation to update any content, comments or advice for retroactive or prospective changes to such authorities. This communication is not intended to address the potential application of penalties and interest, for which the taxpayer is responsible, that may be imposed for non-compliance with tax law. 

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