On 2 July 2012, the Chancellor of the Exchequer announced that Martin Wheatley – the prospective Chief Executive of the new Financial Conduct Authority – is to undertake a review of the framework for the setting of LIBOR. A relatively tight timetable for the review has been set with the intention that any necessary statutory amendments could be incorporated into the Financial Services Bill which is currently before Parliament.
On 30 July, the detailed terms of reference were published. Allegations as to past conduct clearly remain under investigation by various authorities and are thus outside the scope of the Wheatley Review. Rather, the review is designed to look to rate-setting for the future and the framework within which this will occur.
The purpose of this alert is to explain the current situation and to comment on some of the main topics which are to form a part of the review.
LIBOR – The Current Position
At present, LIBOR is quoted by the British Bankers' Association ("BBA") on a daily basis for ten currencies with a range of maturities from overnight to 12 month borrowings. It is formulated through submissions for those periods from the member banks on a panel for each currency. Quotations at the highest and lowest ends of the spectrum are then excluded, and LIBOR for the relevant currency is the average of the remaining quotations. In formulating its individual quotations, a panel bank is required to answer the following question:
"At what rate could you borrow funds, were you to do so by asking for and then accepting inter-bank offers in a reasonable market size just prior to 11am?"
The difficulty of course, is that a panel bank is unlikely to have borrowed funds in the relevant currency across the whole range of maturities on any given day. But it should be able to provide quotations by way of derivation from the information available to it. For example, if it has actually raised six-months funds during the course of the relevant morning, it should be reasonable to assume that shorter maturities would be a little cheaper, whilst longer maturities will be a few basis points higher. Equally, if a bank has not traded at all in the relevant currency during that morning, it will be reasonable to suppose that the previous day's rates remain valid, absent any changes in credit-standing or market conditions.
Nevertheless the question inevitably implies a degree of judgment and hence, subjectivity. This, among other factors, has created the environment in which the manipulation of LIBOR is said to have occurred. In addition, the challenges facing LIBOR and its computation were exacerbated by gridlock affecting the inter-bank market since the latter part of 2007. Unsecured inter-bank borrowing ceased to be readily available and fund-raising was instead conducted on a collateralised basis.
Against this background, it is possible to consider the Wheatley Review's main terms of reference.
LIBOR and UK Regulated Activities
The review is required to consider the current regulatory environment for the establishment of LIBOR, and to formulate policy recommendations for the future.
The process of submitting quotations for the purpose of establishing LIBOR is not, at present, a "regulated activity" under the UK's regime for the regulation of financial services. That legal regime is aimed at business activities including "investments". Whilst "deposits" do constitute "investments" in certain circumstances, this does not apply to deposits raised through the inter-bank market. For this and other reasons, the existing framework of "regulated activities" does not capture the mere submission to the BBA of actual or assumed borrowing rates for inter-bank deposits.
Although it is obviously not possible to pre-judge the outcome of the review, prevailing disquiet over the setting of LIBOR suggests that some form of regulation is inevitable. Whilst a range of policy options may be available, the most straightforward route would be to add the LIBOR quotation process to the list of regulated activities. This would introduce into the rate-setting process a number of high level principles, including obligations to conduct the business with integrity, to observe proper standards of market conduct and to avoid conflicts of interest. It would also import more detailed rules as to the conduct of business and introduce the possibility of disciplinary action in the event of misleading rate submissions.
Other parts of a panel bank's business will already be subject to regulation in any event, and there may thus already be procedures in place to restrict flows of information even though the rate submission process is not itself within the scope of regulation.
The Construction of LIBOR
The review is to consider "…how LIBOR is constructed, including the feasibility of using actual trade data to set the benchmark…".
This aspect of the review highlights the difficulty noted earlier, namely, that an individual bank's LIBOR submissions will not necessarily be based on actual transactions. A panel bank can scarcely be expected to enter into funding transactions purely for the purpose of supporting its rate submissions, and so it is difficult to see how the "actual trade data" requirement could be met on a daily basis. However, it might be possible to require banks to submit data in relation to such trades as they have contracted, so that extrapolated rates for other maturities could be justified. This is in some respects linked to the governance/audit issues noted below.
In the case of some currencies, the credibility of LIBOR could be reinforced by expanding the range of the rate-submitting banks. As is now known, this is one of the measures recommended to the Bank of England by the New York Federal Reserve Bank in May 2008 in the context of the US dollar panel.
LIBOR Governance Structure
The review is to consider "…the appropriate governance structure for LIBOR…"
Governance of the LIBOR system is currently in the hands of the Foreign Exchange and Money Markets Committee ("FXMM Committee"), which is independent of the BBA. Fixings and Oversight Sub-committees are respectively responsible for the supervision of rates and for questions concerning particular panel banks.
Membership of the FXMM Committee includes – but is not confined to – representatives of the panel banks responsible for rate submissions to the BBA. If the FXMM Committee remains responsible for LIBOR governance, then it may be that the balance of its composition may have to be revised in order to avoid perceived conflicts of interest. In that event, it may perhaps be expected that reporting and coordination lines between the FXMM Committee and the regulators may have to be enhanced and formalised.
In this area, in May 2008, the New York Federal Reserve Bank recommended to the Bank of England:
(a) the publication of "best practices" for the calculation and submission of rates, including procedures to prevent any form of misreporting; and
(b) a requirement for internal/external audit sign off on the bank's adherence to those procedures.
In this context, the US Federal Reserve Bank has also floated its interest in regulating the rate-setting process, but has not yet published any specific proposals.
Alternative rate-setting processes
The review will examine "…the potential for alternative rate setting processes…".
The introduction of a rate-setting process as a substitute for LIBOR would be an untidy process, largely because of the large number of contracts that rely on LIBOR as a medium of calculation. If LIBOR were replaced then it may be an implied term that the contract should refer to the new benchmark as the most comparable rate. That may well be convenient but it is not a straightforward analysis or conclusion. In particular, many contracts will include "fallback" or other mechanisms in the event that LIBOR ceases to be available, with the result that transition to the substitute benchmark may be difficult to manage and could potentially lead to litigation.
It is difficult to see much value in seeking to formulate an entirely new inter-bank lending benchmark, since this would again have to rely on market data and would thus be subject to difficulties similar to those that have confronted LIBOR itself. Given the transitional difficulties which a substitute basis would create, it would seem more straightforward to incorporate any proposed reforms into the existing LIBOR calculation process. At least, this would appear to be the position in the United Kingdom. In other countries, the difficulties surrounding the use of a London-based rate may lead to political pressure for a different solution.
The review will consider "…the financial stability consequences of a move to a new regime and how a transition could be appropriately managed…"
As noted above, the creation of an entirely new benchmark rate will give rise to a number of practical difficulties. In particular, the obligations of parties under a vast number of contracts may be obscured by the problems of transition. It is often stated that financial markets depend on legal certainty; a new benchmark would undermine that certainty and, hence, have adverse consequences for the stability of the financial system as a whole.
If, however, it is felt that the credibility of the system requires an entirely new rate under a new title, then steps would have to be taken to modify market – standard documents for the purpose of future transactions. Once again, however, the main difficulties would arise in the context of ongoing contracts and the possible operation of "fallback" rate provisions. Given that many transactions involving LIBOR will be governed by English or New York law, the problem could be partially solved by new legislation in those jurisdictions substituting the new benchmark for existing contractual references to LIBOR. But this would by no means solve the entire problem and, in practice, it would probably be necessary to coordinate simultaneous legislation with a large number of jurisdictions.
The difficulties inherent in the management of a transition tend to reinforce the impression that the solution must lie in the modification of LIBOR itself, rather than in the establishment of a new benchmark.
Adequacy and Scope of Sanctions
The review will consider "… the adequacy and scope of sanctions to appropriately tackle LIBOR abuse…"
On the basis that quotations for LIBOR purposes have been deliberately misstated, it is necessary to consider the sanctions that might be available against the banks and the individuals concerned.
Odd though this may appear, it is not easy to identify provisions within the existing financial market legislation and regulatory regime that may penalise such conduct. For example:
(a) penalties are provided for "market abuse" which includes the dissemination of information which gives or is likely to give, a misleading impression as to a qualifying investment. The difficulty is that inter-bank deposits are not "qualifying investments" for these purposes, with the result that the submission of LIBOR quotations is outside the scope of the market abuse framework;
(b) an individual who "…makes a statement, promise or forecast which he knows to be misleading , false or deceptive in a material particular…" commits an offence "…if he makes the statement, promise or forecast… for the purpose of inducing, or is reckless as to whether it may induce, another person (whether or not the person to whom the statement, promise or forecast is made)…to enter or offer to enter into, or to refrain from entering or offering to enter into, a relevant agreement or…to exercise, or refrain from exercising , any rights conferred by a relevant investment…". It may be argued that the submission of a misleading rate for LIBOR calculation purposes may ultimately have the result that parties might enter into contracts for the sale/purchase of investments under circumstances where they might not otherwise do so. But this would be a difficult case to pursue because a degree of speculation appears to be involved;
(c) furthermore, any person "…who does any act or engages in any course of conduct which creates a false or misleading impression as to the market in or the price or value of any relevant investments is guilty of an offence if he does so for the purpose of inducing another person to acquire… those investments…". Again, for reasons given earlier, an inter-bank deposit is not a "relevant investment" for these purposes and it is therefore difficult to see how a case of this kind could succeed.
Since the submission of rates for LIBOR purposes appears to fall outside the scope of the framework of the financial market legislation, the authorities would need to examine the possibility of proceedings under more general statutory provisions.
As a result, the Serious Fraud Office is currently examining cases based on statutes of wider application and, on 30 July, it issued a press statement to the effect that existing criminal offences are capable of dealing with the alleged misstatement of LIBOR submissions. Although no details of the relevant statutory provisions were made available, possible options might include (i) the offence of "false accounting" under the Theft Act 1968 and (ii) the "false representation" offence under the Fraud Act 2006. It should be carefully emphasised that any such cases would be highly fact-specific, but it may be possible to offer a few general observations:
(a) the offence of "false accounting" involves the falsification of "…any account or any record or document made or required for any accounting purpose…". An individual charged with this offence would no doubt argue that the submission of a rate to the BBA for the purpose of establishing LIBOR is not made "…for any accounting purpose…" within the sense just described; or
(b) a person may commit an offence under the Fraud Act 2006 if:
(i) he dishonestly makes a false statement as to a factual matter (including his own state of mind); and
(ii) he intends thereby either to make a gain for himself or any other person, or to inflict a loss on another person or to expose them to a risk of loss.
Individual cases may therefore turn on the exact purpose or intention behind a particular rate submission and the extent to which actual dishonesty can be proved.
As a separate matter –and although this particular issue seems to lie beyond the scope of the Wheatley review—it may be helpful briefly to note that counterparties to swap and other contracts have begun to pursue civil actions both in the United Kingdom and the United States, with a view to recouping their losses. Litigation of this kind will obviously present a range of challenges. First of all, there will be the practical difficulties of (i) demonstrating that LIBOR was inaccurate on the particular dates on which it fell to be ascertained for the purposes of the relevant contract and (ii) calculating the resultant loss. Secondly, any misconduct in the rate submission process would probably have to be attributed to the bank as a whole in order to found a claim. In other words, it may be necessary to demonstrate that any irregularities were sanctioned at a senior level within the bank. Thirdly, market standard documentation often includes provisions denying the existence of any form of advisory relationship and excluding responsibility for any representations made outside of the documents themselves. Clauses of this kind have recently been upheld by the English courts in cases brought by sophisticated counterparties, and a potential claimant will therefore have to accept the challenge of circumnavigating these provisions. In spite of the evidence that has now become available as a result of regulatory investigations, it is clear that the pursuit of this type of litigation will require a certain level of determination and tenacity on the claimant's part.
Finally, it may be added that a counterparty who has entered into a swap contract with a bank which is not a member of the relevant LIBOR panel or which was not involved in the submission of inaccurate rates is unlikely to have any claim against that bank and will remain bound by the contracted transaction. In such cases, LIBOR will effectively have been used as an independent benchmark and the bank will have no responsibility for its accuracy. It remains to be seen whether such a counterparty will seek to maintain an action in tort against any panel bank that is shown to have been party to any misconduct in this area.
The current controversy surrounding LIBOR has served to highlight an apparent gap in the UK regulatory regime.
In the present climate, it seems reasonable to assume that the Wheatley Review will result in:
(a) the regulation of rate submissions for LIBOR purposes, whether as a "regulated activity" or through some other statutory medium; and
(b) enhanced governance and audit processes.
On the other hand:
(a) it is difficult to see how the benchmark could be constructed exclusively on "actual trade data"; and
(b) the substitution of a new benchmark in place of LIBOR may appear to be politically attractive, both in the United Kingdom itself and, more especially, in other countries. In practical terms, however, this is likely to be problematic and may further undermine the stability of the financial markets.
We will publish further updates on this subject as occasion demands.