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June 7, 2019 Insights

Three Steps to Prepare Your Contracts

for a LIBOR Transition

By: Navin Mahavijiyan Patrick Won

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The future of LIBOR is now clear. LIBOR is going dark at the end of 2021 and the march to Alternative Reference Rates is happening now. 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. 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.

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 a move 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, and valuations will splinter. Many impacted organizations have chosen to avoid action. Forbes has noted that only 3% of impacted organizations have successfully transitioned. This is a mistake and will only serve to make the impending transition more difficult and opens up organizations to unnecessary risk.

Below are three essential steps that every impacted organization can take today to prepare for transitioning away from the LIBOR status quo.

Identify, assess and prioritize all impacted documents

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 (AI) 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 given further review. An organization can prioritize in-scope documentation based on risk, existence of acceptable fallback provisions, and consider other “non-LIBOR” regulatory compliance adjustments that need to be made. New documents 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, impacted organizations must realize that the time to be proactive has long since passed.”

Build a LIBOR response strategy

Once the scope of impacted documents 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 considers potential issues while maintaining flexibility and crystal-clear language will help minimize risks, costs, and delays associated with the next and final step.

Draft and prepare for negotiation and execution

The implementation phase of your LIBOR strategy can be the most time and resource intensive portion of the endeavor. Organizations can expedite the process by conducting 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 as counterparties take time to review, respond, 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 common communication challenge is due to counterparties often not being 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 can vary with some wrapping up quickly and others requiring extensive back-and-forth or follow-up. Effective management of this 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 (CLM) 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!

As predicted, many market participants chose to wait for additional information and recommendations from the FCA and other regulatory bodies. Integreon’s recommendation is to take transition steps immediately. The steps outlined above will help you prepare 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 & Commercial Services and Trade Derivatives & Financial Documentation at Integreon.

Patrick Won is Senior Manager of Contracts, Compliance & Commercial Services at Integreon and A.I. Augmented Review.

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