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June 8, 2018 Insights

3 Steps Your Organization Can Take Today to Prepare Contracts for a LIBOR Transition

By: Navin Mahavijiyan Patrick Won

While the specific future of LIBOR remains unclear, it is apparent that changes are happening now. In April 2018, the Federal Reserve started publishing three new reference rates for use in U.S. dollar-denominated derivatives and financial contracts. Other countries like the UK, have also started publishing alternatives to LIBOR.

The London Interbank Offered Rate (popularly known as LIBOR) is the average of interest rates major banks charge when borrowing from one another and was, until recently, a sacrosanct element of international finance and trade.

Reduced lending by the major banks and the unfortunate 2012 rate manipulation scandals have resulted in stricter requirements imposed by the Financial Conduct Authority (FCA) and moves toward using an alternative benchmark (such as the Secured Overnight Financing Rate “SOFR”, or the Sterling Overnight Index Average “SONIA”). Other regulatory bodies are following suit, as the U.S., Swiss, Japanese and Euro markets have all settled on a rate to use as a starting point for a LIBOR replacement.

Any transition away from LIBOR to an alternative benchmark involves substantial cost and risk to impacted organizations. Rates will change, payments will be revised, risk profiles will alter, hedging strategies will be shaken, valuations will splinter. Ultimately, many impacted organizations must walk the line between being proactive and reactive; between acting now and implementing sound solutions or waiting to see what happens and rushing toward a resolution with major time constraints.

Below are 3 critical steps that every impacted organization can take today to prepare for any transition away from the LIBOR status quo.

1. Identify, Assess & Prioritize All Impacted Documentation

Understanding the full scope and impact of a LIBOR transition is the most important and critical step for an organization to immediately take. The nature of its business and the size of the company will dictate the volume of contracts requiring review, and ultimately amendment.

If an organization has a substantial number of finance, derivative and debt-based contracts, using a contract review tool rooted in Artificial Intelligence can greatly speed the process of identifying active and inactive agreements, abstracting relevant contract provisions, pinpointing contract types for evaluation, and determining if fallback provisions exist.

At this stage, existing documentation that will expire during or prior to 2021 can be ruled out-of-scope while contracts that will continue beyond 2021 should be further reviewed. An organization can prioritize in-scope documentation based on risk, existence of acceptable fallback provisions, and also consider other “non-LIBOR” regulatory compliance adjustments that need to be made. New documentation negotiated over the course of business going forward would ideally incorporate alternative reference rates to ensure they do not inflate the volume of documents in the impending LIBOR transition exercise

Ultimately, many impacted organizations must walk the line between being proactive and reactive

2. Build A LIBOR Response Strategy

Once the scope of impacted documentation has been identified, organizations can assemble a comprehensive strategy covering end-to-end contract remediation and drafting for both existing contracts and new contracts on an ongoing basis.

This strategic “playbook” should include preferred alternative reference rates, model language, fallback positions and guidance on dealing with counterparty pushback on legal language and questions about the new/alternate reference rates. Incorporate all best practices, guidelines and document templates into the strategic playbook.

A well thought out strategy that standardizes the approach and gives consideration to potential issues while maintaining flexibility and crystal-clear language will help minimize risks, costs and delays associated with the next and final step.

3. Drafting & Preparing for Negotiation & Execution

Implementing the LIBOR strategy can be the most time and resource intensive portion of the endeavor. An organization can speed up the process through a mass outreach to counterparties, distributing amendments to in-scope contracts. These amendments, and sometimes fully repapered documents, would contain language changes deemed necessary by the organization (typically updated reference rates, fallback provisions and any additional language required for regulatory compliance).

Some delay is an inevitable part of a transition exercise as counterparties take time to review, responds and ask questions. Some counterparties will require multiple follow ups, so planning and building buffers ahead of deadlines will go a long way toward ensuring a smooth transition. A commonly predicted communication challenge is that counterparties may not be fully aware of the new reference rates being inserted and require clarification (e.g. LIBOR+100 basis points is comparable to SOFR+130 basis points), as reviewers for counterparties may assume that their rate is being increased. Negotiations are variable, with some wrapping up quickly and others requiring extensive back-and-forth or follow-up. Effective management of the exercise will alleviate many issues associated with delay.

With a wide variety of documents affected by these changes, organizations can benefit greatly from uploading new contracts into a contract lifecycle management platform or repository with the key terms entered in a structured data format. While having such a system in place can be highly beneficial, the lack of it will not completely derail a transition exercise.

Now is the Time to Begin

We predict that the majority of market participants will wait for additional information and recommendations from the FCA and other regulatory bodies, while keeping a close watch on potential impacts to their organizations. As authorities continue to grapple with the details surrounding a LIBOR transition, we recommend taking transition steps early. The steps outlined above will help an organization prepare early and plan for the necessary resources, both internal and external, to launch and implement an appropriate response.

Navin Mahavijiyan is Senior Manager of Contracts, Compliance and Commercial Services at Integreon.
Patrick Won is Manager of Contracts, Compliance and Commercial Services at Integreon.

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