Preparing Your Contracts for LIBOR
What You Need to Know & the Impact of COVID-19
After more than 40 years, the industry-wide standard for calculating interest rates — the London Interbank Offer Rate, or LIBOR is being put to bed. Today, LIBOR is tied to over $350 trillion in financial contracts, and yet the Financial Conduct Authority (FCA) has announced that it will phase out the use of LIBOR by the end of 2021.
Plenty of time for legal professionals to transition away from a decades-long standard, right?
Maybe not. The scope of the LIBOR transition may be enormous, but it’s not impossible to manage — especially not with the right strategy to guide your efforts and the right tools to help you carry them out.
So, what will really happen to contracts tied to LIBOR that mature past 2021?
Simply put, each of these contracts will expose your organization to greater and greater risk.
If enough banks stop submitting LIBOR estimates after end-2021, then the rate will simply cease to exist. However, there hasn’t been a ban on banks submitting LIBOR estimates, either; if a handful of banks continue to submit estimates, it could create a so-called “zombie LIBOR.” Contracts that continue to reference a zombie LIBOR rate won’t accurately represent the cost of funding and are likely to experience excessive volatility.
What about contracts with fallback language?
Fortunately, many contracts include fallback language specifying how to select an alternative reference rate (ARR) should the LIBOR be temporarily unavailable. Unfortunately, contractual fallback language doesn’t always offer a straightforward way to select a benchmark replacement. Even when it does, switching to an ARR can change the underlying economics of a contract, potentially causing one party to pay less or receive more, or vice versa.
Checking for weak fallback language isn’t a simple task, either. The language often differs between derivatives and cash product contracts and even varies amongst different cash products. As a result, reviewing contracts for weak fallback language can become a tedious, granular task.
Chief Executive of the FCA Andrew Bailey put it best in his 2018 speech at Bloomberg, London:
“Fall back language to support contract continuity or enable conversion of contracts if LIBOR ceases is an essential safety net – a ‘seat belt’ in case of a crash when LIBOR reaches the end of the road. But fall backs are not designed as, and should not be relied upon, as the primary mechanism for transition. The wise driver steers a course to avoid a crash rather than relying on a seatbelt.”
Why is the FCA dropping this problem in my lap?
There are a lot of good reasons why LIBOR is going away.
Revelations in 2012 revealed that financial institutions were manipulating LIBOR for their own gain, spurring investigators to take a closer look at the popular benchmark rate. When they did, they uncovered several failures inherent to LIBOR.
Banks are not borrowing from one another
The LIBOR is based on interbank lending, but modern banks aren’t borrowing from one another that much these days. Thus, the sample size used to calculate LIBOR is too small to be reliable.
Banks are guessing at theoretical interest rates
Since few actual transactions underpin LIBOR today, bank experts are submitting their LIBOR rates based on theoretical estimates.
The LIBOR is still vulnerable to manipulation
Because bank experts are submitting their estimated lending rates to fill in LIBOR’s small sample, it’s still relatively straightforward to manipulate the rate. Although such manipulation isn’t likely taking place today, it would only take a few unethical LIBOR panel banks to rig the rate.
All together, these weaknesses mean that organizations with LIBOR exposure need to prepare. Legal teams already have a lot on their plate, but end-2021 will be here in a flash; planning ahead is the best approach.
Will COVID-19 have an impact on the transition?
The COVID-19 pandemic has destablised the global economy, causing many to expect a recession. As a result, there has been some speculation that financial authorities will delay LIBOR transition activities to avoid further stress to the economy, including the date of the phase-out itself.
While this remains a possibility, the FCA stated that “the central assumption that firms cannot rely on LIBOR being published after the end of 2021 has not changed and should remain the target date for all firms to meet.”
However, the FCA did concede that the far-reaching impact of COVID-19 is likely to affect the ARR working group’s transition milestones, such as the creation of term rates, spread adjustment methodologies, and so on. Unfortunately, this will make it more challenging to implement a comprehensive LIBOR transition in time for end-2021.
Although COVID-19 has added to firms’ workloads, the uncertainty it has provoked makes it all the more essential that firms carry out their LIBOR transition smoothly and on schedule. Firms should regularly monitor statements made by their relevant ARR working group and other financial authorities, adjusting their transition plan accordingly.
How to prepare your contracts for the LIBOR transition
1. Assess your contracts
Collect your contracts into one place
Taking stock of your contracts and assessing your portfolio’s exposure to the LIBOR transition will be the first step to determining what you’ll need to start 2022 off smoothly. Unfortunately, for some organizations, this can be a Herculean task.
Not all organizations have solid contract management practices in place. Strong contract management is always going to be a valuable asset, even beyond the LIBOR transition. Use the transition as an opportunity to raise your contract management practices to a healthier level.
Assessing your organization’s position in the contract management maturity model (CMMM) is a great place to start.
While reaching level 5 in the CMMM should be the ultimate goal for any organization, being prepared for the LIBOR transition requires at least reaching level 3. Specifically, you will want to have a contract repository — a centralized, secure location to store all of your contracts and their pertinent details. Doing so will enable you to both review your exposure and begin preparing your contracts for the LIBOR transition in later steps. Consider using a contract management system (CMS) to build your repository, as this will facilitate any contract management tasks you’ll need to complete before transition.
Next, you’ll need to identify which contracts should be examined more thoroughly. A good place to start is to look for contracts that do not include fallback language, as these are the most likely to pose a risk to your organization after the LIBOR transition.
These types of contracts are a priority, but equally disruptive are contracts with inadequate fallback language. Determine which contracts include language that is at best intended for a temporary switch to an ARR.
Fallback language should explicitly address three items:
● The fallback trigger event
● The benchmark replacement rate
● The benchmark adjustment — since LIBOR captured bank credit risk while ARRs do not, it will be necessary to include a spread adjustment.
Any contract that lacks one of these items or contains ambiguous language should be flagged for further review. Later in the transition process, you’ll develop more thorough model fallback language to apply to your contracts.
Next, regardless of which ARR is designated for after the LIBOR transition, identify those contracts whose economics are at significant risk of changing in favor of one party or the other. Since the methods for calculating LIBOR and ARRs are different, one party may pay or receive more than the other.
It’s especially important to pay attention to contracts with parties that have less bargaining power, such as small firms. These groups will be the most vulnerable to and affected by the transition, and may file claims against the other party if they believe they have been unfairly treated.
Additionally, identify which contracts are being used as hedging instruments. Under International Financial Reporting Standards (IFRS), certain changes in the terms of hedging instruments (such as the use of an ARR) will de-designate the hedging relationship. From an accounting perspective, this may result in greater volatility in your organization’s financial statements.
Build a transition team
To reduce your exposure to the LIBOR transition, it will be important to assign an individual or group the responsibility of overseeing transition activities. The size and structure of this group will vary depending on the nature of your organization, but here are a few examples of the sorts of key stakeholders who should be involved.
● A member of senior management, such as a Chief Financial Officer.
Given the scope of the LIBOR transition and how widely its impact will affect financial organizations, senior management will need to be apprised of their firms’ transition strategy. Additionally, there will need to be a stakeholder with the authority to make decisions that may significantly affect the future of your organization.
● Legal team members
General counsels will spearhead transition activities. Reviewing fallback language, assessing clarity, identifying contracts that require renegotiation — the bulk of transition activities will fall under the purview of your organization’s general counsels. Because this group plays such an important role, you may wish to bring in outside consultants to support their efforts.
● IT team members
If your contractual data is integrated with your organizations’ systems, then it’s critical that IT members are looped in to ensure that any new instruments and rates function within the system as expected.
● Accounting team members
The LIBOR transition will affect how payments are made and received by your organization, making the accounting department an important voice in transition activities. Additionally, transitioning away from the LIBOR in a hedging instrument may result in the de-recognition of a hedging relationship, which will affect how your accounting team develops and reviews financial statements.
● Other stakeholders as needed
No two organizations are alike, and the LIBOR transition is a far-ranging event; take stock of your business processes and consider which departments may be impacted.
2. Define a clear transition strategy
Having gathered your contracts, identified high-risk contracts and built your transition team, it’s time to start planning your transition strategy.
Develop a strategy document that comprehensively describes your planned transition activities, including tactics to minimize your organization’s risks, costs and delays. This should take into account a few key concerns.
What ARRs must be used?
There are a variety of alternative risk-free rates that have emerged as potential replacements for the LIBOR. Nearly all have the advantage of being based on actual transactions, making them more accurate, reliable and less manipulatable than LIBOR.
Which ARR you use will depend on your primary currency denomination. The following table lists five major ARRs and their key characteristics.
|ARR||Working Group||Administrator||Key Features|
|Secured Overnight Financing Rate (SOFR)||Alternative Reference Rates Committee (ARRC; US)||Federal Reserve Bank of New York||● Secured
● Based on overnight repo market
|Reformed Sterling Overnight Index Average (SONIA)||Working Group on Sterling Risk-Free Reference Rates (UK)||Bank of England||● Unsecured
● Based on overnight wholesale deposits
|Euro Short-Term Rate (ESTR)||Working Group on Risk-Free Reference Rates for the Euro Area
|European Central Bank||● Unsecured
● Based on overnight wholesale deposits
|Swiss Average Rate Overnight (SARON)||The National Working Group on CHF Rates (Switzerland)||SIX Swiss Exchange||● Secured
● Partially transaction-based (built from transactions and quotes on the SIX platform)
● Based on interbank overnight repo market
|Tokyo Overnight Average Rate (TONAR)||Study Group on Risk-Free Reference Rates (Japan)||Bank of Japan||● Unsecured
● Based on overnight call rate market
As the markets grow more volatile due to COVID-19 and a possible recession, general counsels should monitor the corresponding volatility of their relevant ARR as well as the LIBOR. This will give you a sense for how suitable your rate is for replacing LIBOR and how your contracts will perform during times of economic stress.
A note about yield curves and term rates
The various working groups are in the process of developing term ARRs. However, since many of these ARRs are relatively new, their underlying markets are not sufficiently liquid to build a robust term rate. The majority of working groups have promised to release an official term rate for their ARRs before the end of 2021.
Develop model fallback language
Evaluate your organization’s contracts and begin building model fallback language to incorporate into contracts referencing LIBOR that mature past 2021. These will be your primary targets, but it’s equally important to incorporate robust fallback language in new contracts that already reference an ARR. After all, there’s no guarantee that there won’t be future disruptions to your replacement rate, or even another transition.
Both the ARRC and the International Swaps and Derivatives Association (ISDA) have developed guidelines for robust fallback language. For derivatives, the ISDA should be consulted, while cash products should be based off of the relevant working group’s guidelines. In order to be robust, however, your model fallback language should take into account three elements at minimum:
● Successor rates, spread adjustments and trigger events
● Consistency of terms and conditions across asset classes
● The feasibility of implementation and fairness towards counterparties
Identify contracts with problematic language
Based on the model language you’ve developed, look through your contracts to see which contain weak fallback language (or none at all!) that don’t meet the standards you’ve set.
Develop a playbook for counterparty communication
Counterparties will have questions about how the LIBOR transition affects them; it’s important to develop a unified communication strategy to get your organization on the same page. Your communication strategy should address questions about the new rates as well as concerns over whether the transition will have a negative impact. Be proactive and transparent when communicating with counterparties, especially those you identified as being at risk of paying more or receiving less due to the transition.
Identify tools and experts to support your transition
With end-2021 right around the corner, you’ll want to take every advantage you can get. Many of the steps outlined in this guide and the further work of processing your contracts can be made easier with the right tools and experts. Exigent has worked with hundreds of clients on unprecedented legal challenges, and we know our way around the tools and techniques that it takes to navigate these uncharted waters. Here’s what you should look for.
Rather than creating a contract repository in a drive or a spreadsheet, using a CMS will set you up for success when processing your contracts for the LIBOR transition.
Not only will creating a contract repository in a CMS enable you to securely store your contracts and track their histories, the right CMS will also enable you to search by expiration dates, counterparties, clauses and provisions — a feature that will help immensely when searching for high-risk contracts.
Artificial intelligence/machine learning
While manual search is an option for organizations with fewer contracts, it’s not feasible for organizations with a high volume of contract data to review. Doing so may take a prohibitive amount of time and increases the chances that LIBOR-referencing contracts are missed. Each one of these missed or erroneous contracts act like ticking time bombs, liable to interfere with revenue and expose you to litigation.
When trained on the right set of data, artificial intelligence and machine learning (AI/ML) can identify different values within contracts and contextualize them as well. As an example, you could train an AI/ML solution to identify contracts with weak fallback language, or contracts whose underlying economics will change substantially when switching to an ARR.
Data capture capabilities
In order for AI/ML to work well, it needs high quality data. But that data can be difficult to capture, especially if you’re working with contracts that have been stored in a wide variety of formats. Capabilities like optical character recognition (OCR) and natural language processing (NLP) will be necessary in order to gather data from these sources to be processed by your AI/ML capabilities.
Robust NLP capabilities are a particularly critical aspect of any contract management solution. One of the foundational qualities that makes for a great legal mind is attention to language and linguistic precision — an NLP tool used in the legal space has to approach this attention to detail and understanding of context.
Reporting and analytics
If it’s worth doing, it’s worth measuring. Transitioning away from LIBOR is likely one of the biggest legal challenges your organization will face, and tackling it will take time. You’ll want to report on and measure your progress to stay on track.
Whichever tool you use for reporting and analytics, it should be able to provide you with critical insights, such as:
● Accurate assessment, visualization and communicate of your exposure risk
● The scope of contracts requiring remediation
● The degree to which transitioning will change contract economics
● Your overall progress towards transition
Having access to these insights will make managing your transition project significantly easier. You’ll be able to call in additional resources before they’re needed, and you’ll avoid an overworked (and more error-prone) team.
Much of your LIBOR transition activities will lean on the skills of your organization’s general counsels and financial experts. However, making the most of these tools and conducting your transition expediently and thoroughly will require additional support.
When building an AI model to assess your contracts, for instance, you’ll need to bring on data scientists to provide model training and maintenance. Integrating these tools into your existing systems will require the support of IT experts as well. These experts, however, aren’t typically found in most organizations’ legal departments; you’ll need to identify technical experts with the necessary legal background to carry out your transition project successfully.
Don’t shy away from asking for help
The LIBOR transition may seem like a beast, especially if your legal team already has their fill of daily duties and hasn’t had experience with the necessary tools. Luckily, it doesn’t have to be. Exigent can help.
Exigent’s approach incorporates legal professionals, technology and business expertise, all of which are necessary to start 2022 with a healthy contract portfolio. Our team of over 400 attorneys, business analysts, developers and consultants is available to support general counsels across the globe, including the US, Canada, UK, Australia, and South Africa.
The LIBOR transition is an unprecedented event that will challenge legal teams in new ways — consulting with Exigent gives you access to the novel legal mindset necessary to tackle this challenge. Don’t hesitate to speak with one of our experts about how we can help.