Most executives either haven't started thinking about moving away from LIBOR or are just now doing so even though the transition is approaching and unlikely to get pushed back because of the pandemic, according to a webcast by global advisory firm Duff & Phelps.
U.S. and European Union regulators are replacing the London Inter-bank Offered Rate (LIBOR) at the end of 2021, a move that creates administrative and potential liability headaches for businesses across the board.
Since the mid-1980s, LIBOR has been the go-to rate for most commercial and consumer loans, structured products, contractual agreements, derivatives, corporate securities, floating rate instruments, and benchmarked instruments.
Regulators called for a transition away from the index after the 2008 financial meltdown because of increasing problems with the credibility of the rates it was based on. In the U.S., regulators are expected to support what's known as SOFR, or the Secured Overnight Financing Rate, as its replacement. In the E.U., the preferred replacement is expected to be SONIA, the Sterling Over Night Index Average.
The transition puts businesses under the gun to look at their investments, loans, hedges, contracts and other potential exposure points. They must assess which changes, if any, are needed to account for the end of LIBOR, something that was never contemplated when many of these instruments were created.
For most businesses, the transition burden falls on CFOs, an informal poll conducted during the webcast shows. Almost half of the attendees named the CFO as the point person; no other executive came close.
Even for mid-sized companies, potential exposure to the transition can be large. One Duff & Phelps client, a real estate operating company — though not considered an especially large enterprise — has tens of thousands of financial instruments, contracts, and governing documents that must be sorted through to see if they have relevant LIBOR clauses and, if they do, if they need amending.
In some cases, the terms of the LIBOR reference end before the transition, so no action is needed. In other cases, the terms already include language governing what to do if an alternative to LIBOR is needed. In these cases, the language needs to be checked to ensure it remains appropriate for a final cessation of LIBOR. In other cases, there's no applicable language; it must be added in.
Getting ready for the change involves three steps:
- Check your instruments and documents for LIBOR references
- Replace terms where needed
- Get buy-in from counterparties
For companies with hundreds of instruments and documents, just finding and identifying those with potential exposure is a big task best done using an internal steering committee with representatives from all relevant divisions, including finance, procurement, legal, IT, and others, depending on your business.
"Large enterprise or small, a lot of the time they're not even aware of where all the contracts are and who's in control of them," Rich Vestuto, managing director of information governance at Duff & Phelps, said.
For a company he worked with that had tens of thousands of documents to assess, Vestuto's team used artificial intelligence-assisted natural language processing (NLP) software to speed up the search process. By using contract attorneys to review how well the software identified relevant documents, the team was able to define the search parameters over time until the results were close to what they wanted.
"We'd tweak the NLP application, look at the output, and do it again until we were really satisfied we were capturing everything," Vestuto said.
The team worked with counsel to draft new contract language as well as two or three fallback clauses to replace the LIBOR references.
In most cases, the team was able to get the counterparties — those on the other side of the transaction or contract — to okay the proposed revised language or one of the fallback clauses, typically by email, without much difficulty.
"If we can get three quarters of them done that way, they saved a ton of money and effort," Vestuto said.
The cases in which counterparties tend to push back are those where the transition to an alternative index results in materially higher costs or lower returns for them.
"As the contracts change, there are going to be winners and losers," said Charles Parekh, Duff & Phelps managing director of the firm's disputes consulting practice. "If the losses are large enough on one side, it often ends up in a lawsuit in which they're trying to blame someone or recoup some of those losses."
The pandemic is compounding the problem because of the financial turmoil it's causing some companies.
"What is due to bad act and what is due just to bad luck?" Parekh said. "All of this requires having financial experts, damages experts, and securities and LIBOR experts on hand."
In addition to the contractual changes, companies must model financial impacts based on revised rates under the new indices.
"Valuation and risk models potentially will need changing to take into account new conventions involved in the rates," said Marcus Morton, Duff & Phelps managing director of valuation services.
"You have to make sure the financial modeling with that fallback language still makes sense," Vestuto said.
Modeling valuations is particularly challenging for hedging instruments.
"It's hard to model hedging requirements until you have a picture of your whole portfolio," Mark Turner, managing director for regulatory consulting at Duff & Phelps, said.
Even though the transition is looming, companies are often still using LIBOR to model a forward-pointing curve because of limited data from other indices.
"SOFR is backwards-looking right now," Jennifer Press, Duff & Phelps' managing director of alternative asset advisory, said. "The forward-curve SOFR is still being developed."
Governance, communication key
The steering committee will want to keep executives and the board updated on the transition's progress. Especially for larger companies with thousands of exposure points, it's important the process not be allowed to backslide.
"It really calls for good project governance," Vestuto said. "Normally, you have a meeting and you decide on something, come up with a plan. Then everybody goes back to their day jobs and you meet two weeks later and nothing has moved forward."
Vestuto said it can help to bring in an outside firm to manage the process. "They're going to carry the ball forward between meetings," he said.
Good communication has to carry to the counterparties as well. Depending on the side of the transaction you're on — as a lender or a borrower, for example — you don't want to wait until you're contacted about an instrument. It's better to take the initiative and get the agreement that's needed to change the terms.
"Firms shouldn't sit back and wait, and if they're not getting communications, assume they're clear from counterparties and lenders," Turner said. Instead, you should let counterparties know you want to take action, telling them you need more from them and expect their support.