By Lynn Sumlin, Director in the Financial Services division at Seal Software
As we begin to phase out Interbank Offered Rates (IBOR Benchmark Rates), including the London Interbank Offered Rate (LIBOR), the financial services industry faces a significant contractual shift. While there are numerous IBOR Benchmark Rates, LIBOR has been most commonly used interest rate benchmark in a wide variety of transactions, including credit agreements, bonds, and qualified financial contracts. As the reference rate for more than $100 trillion of financial products, LIBOR’s prevalence makes it a nearly universal contractual component. IBOR Benchmark Rates, including LIBOR, are being phased out by 2021 in favor of Alternative Reference Rates.
Unfortunately, the shift to the new rates is not a matter of simple substitution. The proposed Alternative Reference Rates vary from their IBOR predecessors in a variety of characteristics, including the existence of a robust market, tenor options, whether secured or unsecured and resulting accounting implications.
The IBOR phaseout is estimated to impact over $350 trillion worth of contracts. In order to effectively manage the transition, companies and financial institutions alike must review every aspect of their business that depends on any of the IBOR Benchmark Rates. Risk management and remediation are often time-consuming and costly, posing key challenges during the review process, however those processes will be crucial in the transition away from IBOR Benchmark Rates.
Contractual documents in the IBOR equation
Identification of transactions that are subject to the IBOR Benchmark Rates is the critical initial step. Companies and financial institutions must identify all legal documents with an IBOR Benchmark Rate implication in order to manage their transition. Importantly, some contracts may not include a specific IBOR Benchmark Rate reference but are related to an underlying IBOR Benchmark rate related contract. These contracts are important in the review because they often contain critical rate adjustment provisions. Financial institutions need to understand their contract landscape, in order to begin segregating contracts based upon factors such as expiration or tenor, identification of the form of IBOR Benchmark Rate, as well as potential rate adjustment or fallback options. The goal will be to segregate or triage existing contracts for risk prioritization review. Triaging the contracts into like groups will serve to streamline the remediation workflow.
A well-defined and cross-functional transition program is vital to remediation at this scale. Organizations must establish a governance structure across impacted business lines, allocate a budget, and identify clear workstreams for effective transition. Consequently, the success of an IBOR remediation workflow plan depends on an ability to clearly identify and understand the nature and scope of the impacted contract landscape, and the ability to efficiently take the steps needed to transition away from IBOR Benchmark rates. Organizations will be able to minimize risks and challenges through an established and clearly defined remediation program that allows for early engagement of contracting parties, regulators and industry associations.
As an example of the benefits of early review and triage, the identification and segregation of template contracts allows for an expedited and defined workflow to be put into practice. Template contracts, with and without modification, can be assessed now and pushed into defined remediation workflow process that can be implemented immediately. Expeditious segregation of those template-based contracts affords more time for dedicated review of contracts that require a unique remediation approach.
Each institution appears to have a unique approach to its remediation workflow. Some triage bucketing examples may include contracts expiring prior to 2021, meaning they will naturally go through remediation process prior to IBOR retirement. Additionally, contracts that identify a specific non-IBOR replacement benchmark, such as SOFR, SONIA or other Alternative Reference Rate, as well as those with a substitute rate determined by the administrative agent and borrower, must be evaluated. In some cases, contracts will specify conversion to a fixed rate, or they will be silent on determination of a replacement rate, and these also must be segregated.
Further, patterns may arise that will allow for a defined remediation workflow to develop. In order to have a successful remediation solution, institutions need a thoughtful remediation structure but will also need to be flexible to adjust as new patterns emerge and more clarity surfaces regarding use of Alternative Reference Rates.
Contract analytics in a well-managed transition
Contract analytics solutions, particularly those that employ advanced Artificial Intelligence (AI), accelerate contract review and remediation efforts of critical financial transactions. By identifying legal documents based on the presence of IBOR-related terms, these platforms can deliver insight and automation to streamline the IBOR review process. Best-of-breed solutions can identify and extract key IBOR-related topics from a wide range of financial transactions, including commercial credit agreements, derivatives and trading instruments, mortgages and bonds. They make it possible to recognize variance in standard contracting language, a capability that not only expedites the triage process, but also feeds directly into automated decision-making regarding replacement documents.
Moreover, AI can deliver additional critical insight with respect to the contents of financial contracts. For example, AI-driven contract analysis is adept at identifying contractual clauses and terms relating to the waterfall of rate adjustment provisions. AI can also be trained, in support of remediation decision-making processes in critical financial transactions, to find and extract organization-specific risk management terms.
By way of example, discerning whether an agreement contemplates an IBOR successor rate will allow management to quickly determine whether existing rate adjustment provisions provide sufficient guidance on replacement rates, or whether the contract must undergo an amendment or full repapering process. Another example of organization-specific terms relates to when that institution (or any of its related entities) serves as the Administrative Agent or Calculation Agent. This insight can provide further risk prioritization bucketing assistance as the institution is on notice that it has higher duties and obligations in those transactions.
The most effective AI tool for IBOR remediation will not only have a deep understanding of the key issues of concern and contract analytics in place for the IBOR remediation analysis, the most effective AI tool for IBOR remediation also will be flexible to incorporate new guidance, such as the ARRC or ISDA fallback language provisions as those provisions begin to be incorporated into relevant agreements. Additionally, the ability to create institution-specific contract analytics will significantly enhance the ability to efficiently review and triage contracts. An important goal of such a massive remediation effort is to tackle the steps to remediation in an efficient and clear manner.
Risk and opportunity on the horizon
While the phaseout of IBOR Benchmark Rates is clearly on the horizon, there is still much uncertainty about the use and effectiveness of the proposed Alternative Reference Rates. Even though the future of the rates and the related cost implications may remain unknown for some time, institutions are well advised to heed regulatory warnings to begin the contract landscape review now.
Beyond the contract landscape review, there are other widespread implications that each institution must assess, including customer outreach, information systems and strategies. Those assessments also will require heavy resources and time, thus another reason to make contract landscape exposure review as efficient and expeditious as possible through the use of AI contract analytics.
It is arguably mission-critical to build actionable insight from the data made available in the IBOR phaseout to minimize risk and maximize revenue. A smooth process, and one that avoids litigation or costly administrative burdens, will provide insight into contracts and lend certainty to the shift that lies ahead. Further, the work done today will better position the institution for the next regulatory shift. After years working in regulated industries, we can be certain that there is always another shift on the horizon.
Lynn Sumlin is a Director in the Financial Services division at Seal Software. With knowledge gained from more than 25+ years in the practice of law and the use of legal technologies, Sumlin has served in leadership roles as both an attorney and an expert in the use of advanced analytics for contract management and remediation. She is a graduate of the Fredric G. Levin College of Law at the University of Florida and Vanderbilt University.