It is well known that LIBOR is going away in 2021. Much has been said and written about this fact, and the reasons for its demise, since the issue was raised in 2014. However, with the deadline looming a couple of years away, exactly what progress has been made?
The SOFR (Secured Overnight Financing Rate) is the replacement rate that has been pushed to the forefront by the Alternative Reference Rates Committee (“ARRC”) appointed by the New York Federal Reserve. This rate was first published on April 3, 2018, by the New York Federal Reserve Bank and is now published each business day at approximately 8:00 a.m. The new rate is based on an average of short term repo loans that are backed by Treasury securities.
The transition to the SOFR in the traditional lending space will require market acceptance and adaptation. In what has been hailed the first big step in the direction of such acceptance in late July, Fannie Mae sold $6,000,000,000 of adjustable rate securities with interest at the SOFR plus a small spread. While meriting a story in the Wall Street Journal, it should be noted that this particular transaction does not provide any guidance to lenders who recognize the need to “do something” with respect to existing loans already on the books that mature after the critical date in 2021.
In anticipation of LIBOR being eliminated in 2021, a transition timeline has been published; however, the primary focus now is on products other than term lending. Many lenders may take comfort in the fact that their loan documents provide that in the event the LIBOR Rate is unavailable, the lender may substitute an alternative index, which is usually some variation of Prime Rate. A couple of problems come to mind in connection with relying on this provision.
One concern is that the current alternate rate provisions in existing loan documents were intended to address a potential short disruption (whether mechanical or otherwise) in the ability of a financial institution to obtain a LIBOR quote in the market; these provisions were never intended to be a long-term fix for any and all issues that arose. Another issue is that the SOFR is an overnight rate that does not deal with either credit risk concerns and/or stress in the credit markets. Consider that if this fall back rate was implemented today, prime rate plus any spread is going to be significantly higher than the current LIBOR, which could even be more of any issue as prime rates continue to rise. The long and the short of it is that the SOFR it is not going to be readily adopted in its current form as it does not reflect long term risk.
On a positive note, the Alternate Reference Rates Committee has implemented working groups to address business loans, variable rate notes and mortgages, and is in the process of developing a rate that can be used in the syndicated loan market. It is anticipated that the SOFR will be modified to include a one or three month rate option (as opposed to an overnight rate) and that some quantum of risk will be incorporated.
On a not so positive note, it has also been suggested that LIBOR will not completely go away in 2021, opening the door for a “Zombie rate”. The Zombie rate could take a couple of forms. One possibility that has been suggested is that a lender and a borrower could agree that on the day the last the LIBOR is published in 2021, that published rate would govern the loan going forward to its maturity date. The other way that zombies could walk the earth is that a handful of banks will continue to quote a LIBOR rate of some sort. Neither one of these scary things should come to pass, but accelerating the LIBOR replacement process will cause bankers to sleep better.
On May 11, 2016, FinCen (the Financial Crimes Enforcement network of the U. S. Treasury Department) issued a final rule regarding enhanced customer due diligence (“CDD”) requirements that amends regulations under the Bank Secrecy Act. While the rule has been in effect for almost 2 years, compliance is mandatory by May 11, 2018. While Customer Identification Program (“CIP”) procedures have been around for quite some time, this new CDD rule requires additional layers of inquiry, diligence and collection of data with respect to “legal entity customers” who open new accounts or receive extensions of credit.
The CDD rule adds a “fifth pillar” to the “four pillars” of an effective anti-money laundering program. The first four pillars consist of the following, at a minimum, to be performed by a bank:
- A system of internal controls to assure ongoing compliance;
- Independent testing for compliance, to be performed by the bank or third parties;
- Designation of individual(s) responsible for monitoring and coordinating day-to-day compliance; and
- Training for appropriate personnel.
The fifth pillar adds a new layer of complexity, as follows:
- Appropriate risk-based procedures for conducting ongoing customer due diligence, to include (but not be limited to):
- Understanding the nature and purpose of customer relationships for the purposes of developing a customer risk profile, and
- Ongoing monitoring to identify and report suspicious transactions and on a risk basis, and to maintain and update customer information, with customer information to include information about the “beneficial ownership” of “legal entity customers”.
What is a “legal entity customer“?
Legal entity customers include corporations, LLCs, partnerships, business trusts and any other entity created by a filing with a state office. This term does not include natural persons, sole proprietorships, unincorporated associations, trusts (other than those created by a state filing) and various regulated entities such as banks, insurance companies, registered investment adviser, etc.
Banks are now required to identify the “beneficial owners” of each legal entity customer and collect and collect the following information with respect to each beneficial owner: name, address, date of birth, Social Security number (or similar numbers for non US persons).
What is beneficial ownership?
Beneficial ownership for purposes of the CDD rule consists of 2 prongs:
- Ownership Prong: Any individual who, directly or indirectly, owns 25% or more of the legal entity customer. Entities such as non-profit or public benefit corporations are not subject to the ownership prong.
- Responsibility Prong: Any individual who has “significant responsibility to control, manage, or direct the entity”. The following are given as examples: CEO, CFO, COO, managing member, general partner, president, vice president, treasurer or any other person who regularly performs similar functions.
As an example, if the legal entity has 4 owners who each own 25%, there are 4 beneficial owners and the required information must be collected from each of the four. If no one person owns 25% or more, no information has to be collected from such owners but one person must always be identified under the responsibility prong.
Practical Notes:
Forms: The collection of the required information be done by following and filling out the form suggested by FinCen (found at 82 Federal Register 45184 (published 9-28-17) or obtaining the required information from the individual who will certify the accuracy of the information provided.
Originals v. copies. Since the beneficial owner(s) may not be in your office when the account is opened, a bank may use photocopies of identification.
Reliance on customer: You may rely on the certification of the information furnished by the customer, so long as the bank has “no knowledge of facts that would reasonably call into question the reliability of the information.”
Not retroactive: The CDD rule is not retroactive, but new accounts opened by existing customers after May 11, 2018 are subject to the new CDD rule and the obligation to update customer information is “event based”, which means that if the bank learns something about a customer that is relevant to reevaluating or reassessing the risk posed by that customer, then the beneficial ownership information should be updated.
Record Retention: As a general rule, the records must be kept for 5 years.
Rely on other banks? You may rely on information from other banks, but similar to the CIP, an bank may rely on such information if (i) the reliance is reasonable under the circumstances, (ii) the bank supplying the information must be subject to AML requirements and be regulated by federal functional regulator and (iii) must enter into a contract requiring it to annually certify that it has an AML program and that it will perform the specified beneficial ownership diligence.
Relief on the Horizon? Congress is considering a bill, the Counter Terrorism and Illicit Finance Act, which would, among other things, require legal entities to submit beneficial ownership information to FinCen to create a national directory of beneficial owners. Having such a directory would eliminate some of the back office detective work and potentially create a safe harbor for relying on the published information.