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Article:

Headaches about your LIBOR-based contracts? Try this

12 November 2019

I recently saw a headline in the Financial Times that said some big banks think that shifting out of
LIBOR may cost more than Brexit. I am sure that headline caused a collective gasp in some corners
of the United Kingdom.

It is hard to say which one of these monumental changes will have a bigger price tag, but a few
things are clear: leaving the London Interbank Offered Rate for a new benchmark rate is highly
complex, will cost a small fortune and, in contrast to Brexit, it will not be debated widely by the
general public because it will be handled mostly by specialists.

That may keep the noise level down, but the impact is far-reaching and potentially destabilising
nonetheless. Perhaps the absence of a big public debate is one reason why many banks and other
companies have not taken critical steps to manage the contracts they have that will have to be
linked to a different benchmark rate. The deadline though is looming as, under the current
timeline, when the clock strikes midnight on 31 December 2021, LIBOR will lose the standing that it
currently has.

The current conversation in the market is, in my opinion, still too focused on what regulatory
moves may still be coming, if regulators are serious about the current timeline, and how and if
leeway will be granted for particularly complex cases.
I think that conversation needs to turn quickly and sharply to concrete strategies organisations can
take to manage the risk of the transition inherent in their contracts.

Fortunately, it seems that the discussion about leaving LIBOR is no longer focused on whether this
is necessary. The market has accepted that, as I like to say, it is not good practice to mark your
own homework. This is essentially what happens now with LIBOR, which is based on estimates from
a few banks. Under the new system that gets established, whichever one that is, the benchmark
that determines so many other things – including rates on mortgages, corporate loans, government
bonds, credit cards and derivative products – will be calculated on the basis of actual trades and
not a few trader’s estimates.

But the transition to the new rate and the new system may leave some companies exposed with
possible losses because of differences in interest rates with a new peg. The possible loss will come
from the difference between the floating rate that is set based on actual trade data under a new
framework, compared to what is now being set based on rate submissions.

I am advising my clients to do three things now to manage transition risks in their contracts: First,
they should capture their universe of risk – e.g. find out where they have contracts linked to LIBOR.
Second, once the contracts exposed are identified, dig into the details about what it means and
possible remedies, based on those contract’s terms and conditions. Third, create a plan for
managing the transition and determine processes – e.g. what needs to be done by the legal team,
by finance, by IT and so on.

But this is not just about contracts. There are also implications for amounts that will be reported in
companies’ financial statements. Global standard setters are working on the issue in phases, such
as those effects that arise prior to the changes to benchmark rates and those effects that will arise
when the changes to rates are actually made.

Get the overview and understand the impact

My first and second recommendations sound very basic – take an inventory of and determine your
exposure to LIBOR – but many companies still have not tallied everything up because of the
complexity and enormity of the task.

If a company is large and decentralised with a central treasury function, then people in the remote
legal entities may not be aware of where they are exposed to LIBOR. Plus contracts tend to be
long, dense and voluminous, and some companies may think the banks that lent them money should
be the ones taking action.

In some cases, particularly in contracts that were drawn up in the last two or three years, language
may already exist about how a transition from LIBOR will be handled. But older contracts simply
will not contemplate this. Before LIBOR manipulation was uncovered in 2008, contract lawyers
were probably not thinking ahead to a day when LIBOR would be phased out.

And all this is not to mention that what should be written into contracts in terms of rates has not
yet been precisely determined – we have indications about what will replace LIBOR, but nothing is
firm yet. In the UK, we have SONIA, the Sterling Over Night Index Average, but transactions that
currently refer to this rate remain low.

I mentioned the complexity of the task of assessing the extent of exposure to LIBOR. Let me give
you an example due to wide differences in contracts. Consider that one loan agreement between
Company 1 and Bank A can look very different to a loan agreement between Company 1 and Bank B
and so on: They may be for similar transactions but the terms and conditions may be worded
slightly differently, and therefore the implications for LIBOR transition are different.

As companies get into the nitty gritty of this exercise, they will likely need to group the types of
contracts they have into those that exhibit certain criteria (even though those groups will not be
100% homogeneous in terms of specifics), such as contracts with variation clauses for what happens
when LIBOR is no more, and contracts that do not have such clauses.

I know I am spending a lot of time talking about what makes this job so difficult, when I could be
using this space to focus on convincing organisations to commence the exercise. My hope is that if
your company has not yet taken action, you will see your reasons as to why reflected here, and you
will acknowledge that the regulator will not have any sympathy for what those reasons are.
In other words, I urge you to remember that waiting just makes the problem worse.

Create your plan

My third recommendation is to make and launch your game plan for managing the risk of the LIBOR
transition in your company’s contracts that mature after 2021. Here it is important to consider all
that needs to be done and how the steps can best be divided up between divisions, types of experts
(such as internal, external, finance, legal, IT) and machines. Artificial intelligence and Robotic
Process Automation (RPA) are tools that could possibly help, once the scope and complexity of the
task is known.

It is also useful to have absolutely up to date information on the current regulatory thinking and
conduct some test rounds to identify the different types of remedies that may be used, their
impact, and the process steps for each type of case. For instance, if a preferred method is to
scratch out LIBOR and substitute a different rate, how much will that cost whom? If the answer to
that question is not acceptable, what is the next step in that case?
The recording of these changes for financial reporting purposes is not set in stone yet either
although, as I have noted above, global accounting standard setters are already dealing with some
of the issues. In the coming months, they will be debating issues such as whether the changes
should result in an impact in profit or loss and whether changes to contracts mean that there is
effectively a new one and a new transaction. Clarity about the accounting approach is needed to
avoid diversity across companies and to minimise the potential for results to be affected by ‘cherry
picking’.

I expect that in some cases, companies will conclude that they need to renegotiate their contracts.
And, with the best will in the world, this will not be done quite right and there will be disputes.
As you can see, transitioning out of LIBOR will neither be quick nor low-cost.
Remember what I said at the opening of this article? That some companies think the transition will
cost more than Brexit? Well, now that we have discussed only a few of the intricacies, maybe that
statement does not sound so far-fetched after all. And it is not just GBP LIBOR - it is also USD
LIBOR, EURIBOR, TIBOR, CHIBOR and the rest of the IBORs.