The known unknowns of USD LIBOR transition

13 May
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Many US treasurers lack clear timelines for LIBOR transition plans – and treasurers everywhere must scrutinise supply and other contracts. Tom Deas explains

The long effort to transition away from LIBOR that began following the 2008 financial crisis seems to be nearing its end. A timetable has now been set by the regulators in the UK and the US running to mid-year 2023.

With a nod to former US Secretary of Defense Donald Rumsfeld, in this effort, we have some things that we know, the knowns, and some that we have identified as not yet knowing, the known unknowns.

What are these, and how will corporate treasurers resolve them in the time allowed?

Readiness gap

When Andrew Bailey was chief executive of the Financial Conduct Authority (FCA), he famously sent up a red flare to the markets in July 2017.

That was when he warned that the FCA had obtained a voluntary undertaking from the LIBOR panel banks to continue submitting their quotations until year-end 2021 – but that those relying on LIBOR should plan on that as the end date.  

If we fast-forward to March 2021, the FCA announced that while certain USD LIBOR rates, such as the one-week and two-month quotations, would cease as of year-end 2021, other maturities very commonly used in financial instruments and contracts, including those for one, three and six months, would continue to be quoted until 30 June 2023.

That would allow some additional time for USD instruments and contracts to be amended to provide alternate references to the secured overnight financing rate (SOFR).  

Consider the known unknowns from just this decision:

  1. A primary responsibility of a corporate treasurer is to arrange, at all times, for adequate credit to run day-to-day operations, to provide for growth and critically to provide adequate liquidity during crisis events.
  2. Corporate treasurers fulfil this through making term financing arrangements and setting up standby credit most desirably from a syndicate of relationship banks that know the company and have committed their capital to its support.
  3. For US non-financial corporates (NFCs), a syndicated revolving credit is necessary if it is to be used for day-to-day funding – or, if the company has access to the commercial paper market for its day-to-day funding, a standby credit agreement with same-day funding is necessary to backstop its commercial paper issuances.
  4. US revolving credit agreements allow the borrower to take down multiple loans and to elect a different interest period for each and to change that election at the end of any upcoming interest period. Corporate treasurers manage the interest rate risk by adjusting these interest periods – but, as we have now learned, this will not be possible for the one-week and two-month periods after the coming year end. How will this be reflected in the credit agreement? Will it be a change to terms and conditions that the agent bank will send out detailing the new interest period and rollover mechanics that will apply after year end, or will this change require a formal amendment to the credit agreement, with typically all lenders giving their consent? If the later, what else would be timely to include in the amendment?

These known unknowns will have to be settled soon. But US treasurers complain that their banks are not yet engaging with them on the details of the transition away from LIBOR.

In the Non-financial Corporates Working Group of the Alternative Reference Rates Committee, fully two-thirds of those responding to a recent survey report that they have been unable to receive detailed proposals or timelines for implementation from their bankers.

These graphs illustrate the gap in communications and readiness:

Contractual tangles

For many corporate treasury departments, another set of known unknowns is made up of all those commercial contracts negotiated by other departments such as sales, procurement and engineering that may have references to LIBOR of which the corporate treasury is unaware.

In most companies, even this long into the LIBOR transition process, there have been no meaningful estimates of the commercial exposure NFCs manage as a result of business contracts they enter into as part of their day-to-day operations.

Consider these examples, which could apply to contracts in any IBOR currency and not just US dollars:  

Example 1: worldwide supply agreement

  • In today’s competitive marketplace, many Main Street companies enter into worldwide supply contracts in which they agree to buy all their needs for a particular commodity, or other input to their production process, if the supplier will give a volume discount for the quantity purchased.
  • In many of these agreements, the discount is negotiated to be paid up-front in anticipation of annual targeted purchases. If, however, the target is missed, the typical contract will call for a payment back to the supplier with the formula including LIBOR for the calculation.
  • If LIBOR ceases to be quoted, the parties to most supply agreements will have to negotiate a mutually acceptable resolution. During this negotiation, a supplier may suspend deliveries and a customer might withhold payments causing a major disruption in the economy.
  • The parties whose contracts are in dispute could very likely tie up state and federal courts with a logjam of cases.
  • Often in the case of long-term supply agreements, prices will have moved since inception and one of the parties will have an incentive to hold out for a price or quantity adjustment, making resorting to the courts more likely by the advantaged party seeking to preserve its contractual benefit.

Example 2: long-term construction agreement

  • Consider the purchase of a major piece of equipment where the construction process from order to delivery will take many months.
  • For example, state-of-the-art machines for paper production cost several hundred million dollars and can take over two years to construct. The paper company and the paper machine supplier enter into a multi-year purchase agreement that calls for periodic payments to be advanced by the customer upon the machine manufacturer’s completion of designated milestones.
  • If, however, the production of the paper machine falls behind schedule and a milestone is missed, the contract will call for a reduction in the purchase price based on a calculation using LIBOR.
  • Most of these types of agreements outstanding today were negotiated without any thought to what rates would apply if LIBOR was no longer quoted and are without fallback provisions.

With all these known unknowns, the way forward for the corporate treasurer is to identify all the many as yet unknowns in LIBOR transition and drive as quickly as possible to resolve them.

The best practice we see is for the treasurer to bring together a cross-functional team with representatives from those departments who manage these commercial relationships and to identify the contracts with LIBOR references, to work out a replacement strategy, to make the customers or suppliers know of the urgency, and finally to get their agreement on how to amend the contracts in time.

In parallel with this, we have to engage with the banks on the conventions of loans after LIBOR and to adapt systems to these new mechanics.

Further reading

Learn more about the known unknowns of USD LIBOR transition from this National Association of Corporate Treasurers (NACT) webinar, hosted by the Association of Corporate Treasurers

About the author

Tom Deas is chairman of the National Association of Corporate Treasurers, the US national treasurers' association. From 2001 to 2016, he served as vice president and treasurer of FMC Corporation. Prior to that he was vice president, treasurer and CFO of Applied Tech Products Corp, of Airgas Inc and of Maritrans Inc. He has served as a member of the Financial Stability Board’s Market Participants Group and is a current representative to the Federal Reserve’s Alternative Reference Rates Committee.
 

Further ACT resources on the LIBOR transition can be found here: treasurers.org/hub/technical/libor.

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