Wednesday, January 13, 2021

LIBOR transition may present risks for muni market, OMS cautions

By Anne Sherry, J.D.

In a new statement, the SEC’s Office of Municipal Securities encouraged participants in the municipal securities market to mitigate risks in anticipation of the transition away from LIBOR. OMS urges obligors to identify existing contracts that extend past 2021 and to consider whether new contracts should reference SOFR or another alternative rate. Municipal obligors should also consider making appropriate disclosures regarding the material risks related to the discontinuation of LIBOR and the mitigation actions in response.

Late last year the ICE Benchmark Administration announced its plan to cease publication of one-week and two-month LIBOR at the end of 2021, with remaining rates to be sunset on June 30, 2023. U.S. banking regulators promptly encouraged banks to stop writing contracts referencing LIBOR. OMS staff believe that the expected discontinuation of LIBOR at the end of 2021 could present a material risk for municipal issuers and other obligated persons. Municipal obligors should consider actions to mitigate these risks, while municipal advisers should be aware of and take into account the issues arising from the LIBOR transition when advising clients.

Contracts. OMS urges obligors to identify existing contracts that extend past 2021 to determine their exposure to LIBOR and resolve any potential issues arising with the transition. In the staff’s view, changes in financial terms have a particular impact on instruments with an extended maturity or termination date, or where another arrangement exists as a hedge against an existing LIBOR-based instrument. Other factors that may be relevant for municipal obligors include:
  • State laws constraining obligor’s ability to replace LIBOR with an alternative reference rate;
  • Hedging strategies;
  • Tax consequences of a potential change in financial terms; and
  • The feasibility of, and repercussions from, amending outstanding debt instruments.
With regard to new contracts, municipal obligors should consider referencing SOFR or another alternative rate or incorporating effective fallback language. If using fallback language, obligors should also consider their effects, such as a potential change in interest rate levels or behavior under different market conditions. The staff statement notes the efforts of the Alternative Reference Rate Committee and ISDA to develop and implement fallback language.

Disclosure. Consistent with the SEC’s statement that investors in derivative and other municipal products need a clear understanding of terms and risk, OMS believes that municipal obligors should consider appropriate disclosures of the material risks related to the discontinuation of LIBOR and mitigating actions taken in response. In the primary market, the official statement for a new issue should include disclosures regarding the material risks, mitigating action, and fallback language relating to the discontinuation of LIBOR. In the secondary market, disclosures may be voluntary or required under continuing undertakings.

The statement references the SEC’s statement on the importance of disclosure in light of COVID-19. The discussion of considerations that weigh in favor of disclosure would generally apply to the LIBOR transition, OMS said. The staff also cautioned obligors to be aware of the Government Accounting Standards Board Statement No. 93 revising certain standards and accounting issues implicated by the LIBOR transition. If financial statements are included in disclosures, the municipal obligor should also seek to adhere to the applicable accounting standards.

Municipal advisers’ preparation. Finally, the statement cites a recent risk alert from the Division of Examinations, as well as applicable municipal advisor duties, to aid municipal advisers in preparing for the LIBOR transition. The risk alert identified aspects of the transition that may be relevant for municipal advisors, including the firm’s LIBOR exposure, its operational readiness, its disclosures, conflicts of interest, and clients’ efforts to replace LIBOR. Municipal advisers should also be aware of the duties imposed by MSRB Rule G-42 and Exchange Act Section 15B(c)(1).