Asset managers wary about Libor oversight as loans still reliant on benchmark

NEW YORK: Asset managers are growing concerned about a US regulator's warning that it will scrutinize firms' plans and disclosures about the upcoming transition away from a key lending benchmark that trillions of US dollars of investments rely on.

The Office of Compliance Inspections and Examinations (OCIE) of the US Securities and Exchange Commission (SEC) will be conducting examinations of entities including investment advisors, investment companies and broker-dealers to assess their preparations for the discontinuation of the London Interbank Offered Rate (Libor) and their readiness to transition to an alternative benchmark.

Libor, which is used to set interest payments on investments, including leveraged loans and mortgages, is set to be phased out at the end of 2021. The Federal Reserve (Fed)-backed Alternative Reference Rates Committee (ARRC) is pushing markets to transition to the Secured Overnight Financing Rate (SOFR), in anticipation.

As borrowers in the US$1.2trn US leveraged loan market still peg their payments to Libor, some asset managers are grappling with how best to show they are preparing for the transition when the companies they lend to are still using the existing benchmark, according to sources.

"Governmental bodies are aware there is a big block in the loan market - all these non-bank lenders - who need a push, and a push they are going to get from the SEC," said David Wagner, a senior advisor at investment bank Houlihan Lokey working on the transition.

The US loan market has been slow to adopt SOFR, a broad measure of the cost of borrowing cash overnight collateralized by US Treasury securities. For some firms, recent efforts to prepare have been hamstrung by the coronavirus pandemic, which forced managers to direct resources to address the impact of the health crisis on portfolios. An announcement by ARRC recommending that no business loans maturing after 2021 should be originated using Libor after June 30, 2021, also weighed on firms that saw their window to adjust, shorten.

ORDERLY DISCONTINUATION

In late June, the OCIE said it would conduct examinations to assess investors' and advisors' plans "to help promote and facilitate an orderly discontinuation of Libor and transition to an alternative reference rate."

The OCIE conducts exams of SEC-registered investment advisers, investment companies, broker-dealers and more, to promote compliance with US securities laws, prevent fraud and monitor risk.

With its Libor review, the OCIE will assess registered entities' plans for exposure to Libor-linked contracts, including so-called fallback language, to help with the transition of existing contracts to a new rate. It will also check a firm's operational readiness, including modifications to systems, controls, processes and risk models associated with the change. Disclosure and representations made to investors about possible Libor cessation risks will also be reviewed as will efforts to replace LIBOR with an appropriate alternative.

"You see Libor as an examination priority because of the potential impact it could have - if asset managers have not properly evaluated risk, not properly explained that risk to investors or have unexpected consequences as a result of failing to adequately position for a move away from Libor," said John Mahon, a partner at law firm Schulte Roth & Zabel.

An SEC spokesperson declined to comment beyond the risk alert issued about the Libor transition preparedness examination initiative. The ARRC recommends that by September 30, all new loan agreements should include predetermined steps to move to a new rate from Libor, known as a hardwired approach. Most loan documents, however, favor amendment fallback language, which offers more flexibility but also more uncertainty because the final rate is unknown at origination.

In an analysis of 288 new and amended institutional loans, including repricings, arranged in the first half of 2020, credit research firm Covenant Review found that none included ARRC hardwired language.

While the loan market has been slow to adopt a new benchmark, the OCIE is not alone in its efforts to gauge the risk and preparedness of financial institutions for Libor cessation.

The Federal Financial Institutions Examination Council, which includes a member of the Fed, the Comptroller of the Currency and the Chairman of the Federal Deposit Insurance Corp, in July encouraged supervised institutions to continue to prepare for the transition and address associated risks, including inadequate fallback language.

Asset managers "are all becoming aware - because law firms and investment banks are talking - that this is an obligation of senior management to be addressing for regulators and shareholders and clients for whom you manage funds," Wagner said. "They need to have a consistent message and one that is going to be public. The SEC action is starting to have its intended purpose.