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1.3 Scope of ASC 848
Publication date: 31 Dec 2022
us Reference rate reform guide
In order to qualify for the guidance in ASC 848, ASC 848-10-15-3 states that a contract must reference LIBOR (any maturity, jurisdiction, or currency) or a reference rate that is expected to be discontinued as a result of reference rate reform. Some indicators that a reference rate is expected to be discontinued are outlined in ASC 848-10-15-4. ASU 2021-01, Reference Rate Reform (Topic 848): Scope, clarified the scope of ASC 848 to include derivatives that use an interest rate for margining, discounting, or contract price alignment that is modified as a result of reference rate reform. This includes derivatives for which the interest rate being changed or the underlying variable rate is not LIBOR or is not a reference rate that is expected to be discontinued (see REF 1.3.1.3 for further information).
The guidance in this Topic applies to all maturities of LIBOR in all jurisdictions and currencies. For other reference rates, an expectation of the discontinuance of the rate may result from any of the following:
- A public statement or publication of information by or on behalf of the administrator of the relevant reference rate or by the regulatory supervisor for the administrator
- Initiatives by a significant number of market participants or by market participants representing a significant number of transactions to move away from the reference rate
- The production method for the calculation of the published reference rate that is either:
- Fundamentally restructured
- Reliant on another rate that is expected to discontinue.
1.3.1 Qualifying modifications
With the exception of the optional expedients related to certain modifications of derivatives (see REF 1.3.1.3), the relief in ASC 848 applies to modifications of contracts that directly replace, or have the potential to replace, a reference rate that is expected to be discontinued. For example, if the contract is modified by replacing a reference to LIBOR with a reference to SOFR, this would be considered a direct replacement. Adding or modifying fallback language that would replace LIBOR with another reference rate upon a contingent event occurring is an example of a modification with the potential to replace a reference rate.
Only modifications to agreements that are made to affect the transition for reference rate reform will qualify for the guidance in ASC 848. If there are amendments to terms of the contract that change (or have the potential to change) the amount or timing of contractual cash flows that are unrelated to the replacement of the reference rate, the guidance in ASC 848 cannot be applied even if such amendments are made contemporaneous with amendments related to reference rate reform. If the modification does not qualify for the guidance in ASC 848, the modification (including any changes that are related to reference rate reform) should be assessed under other applicable guidance.
1.3.1.1 Modifications related to reference rate reform
Examples of modifications to terms generally considered to be related to the replacement of a reference rate, and therefore should qualify for the relief in ASC 848, are outlined in ASC 848-20-15-5.
Changes to terms that are related to the replacement of the reference rate are those that are made to effect the transition for reference rate reform and are not the result of a business decision that is separate from or in addition to changes to the terms of a contract to effect that transition. Examples of changes to terms that are related to the replacement of a reference rate in accordance with the guidance in paragraph 848-20-15-2(a) include the following:
- Changes to the referenced interest rate index (for example, a change from London Interbank Offered Rate [LIBOR] to another interest rate index)
- Addition of or changes to a spread adjustment (for example, adding or adjusting a spread to the interest rate index, amending the fixed rate for an interest rate swap, or paying or receiving a cash settlement for any difference intended to compensate for the difference in reference rates)
- Changes to the reset period, reset dates, day-count conventions, business-day conventions, payment dates, payment frequency, and repricing calculation (for example, a change from a forward-looking term rate to an overnight rate or a compounded overnight rate in arrears)
- Changes to the strike price of an existing interest rate option (including an embedded interest rate option)
- Addition of an interest rate floor or cap that is out of the money on the basis of the spot rate at the time of the amendment of the contract
- Addition of a prepayment option for which exercise is contingent upon the replacement reference interest rate index not being determinable in accordance with the terms of the agreement
- Addition of or changes to contractual fallback terms that are consistent with fallback terms developed by a regulator or by a private-sector working group convened by a regulator
- Changes to terms (including those in the examples in paragraph 848-20-15-6) that are necessary to comply with laws or regulations or to align with market conventions for the replacement rate.
1.3.1.2 Modifications unrelated to reference rate reform
Examples of modifications to terms that are generally considered to be unrelated to reference rate reform and therefore would not qualify for the relief in ASC 848 are outlined in ASC 848-20-15-6.
Examples of changes to terms that are generally unrelated to the replacement of a reference rate in accordance with paragraph 848-20-15-3 include the following:
- Changes to the notional amount
- Changes to the maturity date
- Changes from a referenced interest rate index to a stated fixed rate
- Changes to the loan structure (for example, changing a term loan to a revolver loan)
- The addition of an underlying or variable unrelated to the referenced rate index (for example, addition of payments that are indexed to the price of gold)
- The addition of an interest rate floor or cap that is in the money on the basis of the spot rate at the time of the amendment of the contract
- A concession granted to a debtor experiencing financial difficulty
- The addition or removal of a prepayment or conversion option, except for the addition of a prepayment option for which exercise is contingent upon the replacement reference interest rate index not being determinable in accordance with the terms of the agreement
- The addition or removal of a feature that is intended to provide leverage
- Changes to the counterparty except in accordance with paragraphs 815-20-55-56A, 815-25-40-1A, and 815-30-40-1A
- Changes to the priority or seniority of an obligation in the event of a default or a liquidation event
- The addition or termination of a right to use one or more underlying assets in a lease contract
- Changes to renewal, termination, or purchase option provisions in a lease contract.
ASC 848 presumes that contractual fallback terms added or amended such that they are consistent with or substantially similar to recommendations from a regulator or a private-sector working group convened by a regulator (such as the ARRC) are related to reference rate reform. This includes a predefined method to replace the current reference rate upon the discontinuance (or an expected discontinuance) of the reference rate.
Although ASC 848-20-15-6(c) lists changing to a fixed rate as a modification unrelated to reference rate reform, ASC 848-20-15-9 clarifies that adding a provision that the rate in a contract becomes fixed at the last published rate of an interest rate index would not preclude application of ASC 848.
In addition, ASC 848-20-15-8 provides that if a modification to a contract includes a fallback provision which includes a term that would generally be considered unrelated to reference rate reform (such as the addition of a prepayment option or a possibility that the rate could become fixed), such provisions would be disregarded if a reporting entity concludes at the time the fallback terms are added or amended that activation of that term is not probable of occurring if the fallback terms are triggered. This was included in the guidance as in some instances, fallback language may specify that the terms would change based on a “waterfall preference” established in the contract. For example, upon discontinuance of LIBOR, the reference rate would change to a term SOFR rate, however if a term SOFR rate was not available it would change to overnight SOFR, and if overnight SOFR was not available it would change based upon a sequenced list and in the event that it is unable to change to another reference rate, change to a fixed rate or permit prepayment as a “last resort.” If this final change to a fixed rate is not probable of occurring at the time of amendment, the provision would not prevent application of ASC 848.
Question REF 1-3
If a contract has been modified to replace the reference rate within the contract from USD LIBOR to overnight SOFR, and the contract is subsequently modified through a separate modification to replace overnight SOFR with term SOFR, would the second contract modification qualify for the ASC 848 relief?
If a contract has been modified to replace the reference rate within the contract from USD LIBOR to overnight SOFR, and the contract is subsequently modified through a separate modification to replace overnight SOFR with term SOFR, would the second contract modification qualify for the ASC 848 relief?
PwC response
No. ASC 848-20-15-2 states that the guidance within ASC 848 is applicable to contract modifications that replace or have the potential to replace a reference rate within the scope of ASC 848-10-15-3. In order to be within the scope of ASC 848-10-15-3, the rate being modified must be a reference rate expected to be discontinued as a result of reference rate reform (such as LIBOR). Therefore, once the contract has been modified to replace USD LIBOR with overnight SOFR, that contract no longer references a rate within the scope of ASC 848-10-15-3. Any subsequent modifications made to this contract would not qualify for the contract modification relief. The modification should be assessed under other applicable guidance.
Alternatively, at the time the initial contract modification was made when the contract still referenced USD LIBOR, a fallback protocol may be inserted into the contract that would allow the contract to “fallback” to overnight SOFR to the extent that a term SOFR market was not yet available and then pursuant to contractual terms that were included in this initial modification, change to term SOFR once available. In this case, the initial contract modification would qualify for the ASC 848 relief since the initial modification has the ability to replace a reference rate expected to be discontinued (USD LIBOR) by inserting fallback language. If the reference rate subsequently changes from overnight SOFR to term SOFR in line with the contractual provisions of the modified agreement, it is not considered a modification as it was triggered by existing contractual provisions.
1.3.1.3 Modifications related to the discounting transition
In order to support the transition away from interbank offered rates to alternative rates, the central clearing parties and (potentially) other market participants are undergoing various transitions to market conventions for interest rate derivatives. This includes changing the interest rates used for margining, discounting and contract price alignment (“the discounting transition”). The scope of the discounting transition is not limited to derivatives that have an underlying variable rate or an interest rate used for margining, discounting or contract price alignment that references LIBOR or another reference rate that is anticipated to be discontinued. ASU 2021-01, Reference Rate Reform (Topic 848): Scope, added ASC 848-10-15-3A to clarify the scope of ASC 848 to include all derivatives that are modified due to the discounting transition.
Certain provisions of the guidance in this Topic, if elected by an entity, shall apply to derivative instruments that do not meet the scope of paragraph 848-10-15-3 that use an interest rate for margining, discounting, or contract price alignment that is modified as a result of reference rate reform (see paragraph 848-10-55-1).
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