"The Libor Scandal, its Implications, and Effect on the Corporate Trust Industry" by Romano I. Peluso
21 January 2013
The London Interbank Offered Rate (Libor) is one of several benchmarks that banking institutions use to set interest rates for lending between banks. In a process overseen by the British Bankers’ Association, each morning a panel of large banks reports to Thomson Reuters the interest rates they would pay to borrow from other banks. After removing the highest and lowest figures, the reported interest rates are averaged. The submissions of all of the participants are published, along with each day’s Libor rates. The rate is set for 1 day, up to a year.
The Libor benchmarks are used as the reference for a wide variety of financial instruments, ranging from complex interest rate derivatives to simple mortgages. They include forward rate agreements, short-term interest futures contracts, interest rate swaps and inflation swaps, floating rate notes, syndicated loans, and variable or adjustable rate mortgages, among many others.
The total value of all securities and loans relying on Libor totals $800 trillion. By way of comparison, the total amount of worldwide Gross Domestic Product is over $69 trillion.
Although Libor is often referred to as if it were a single figure, it actually consists of a series of benchmarks, representing interest rates for 15 different maturities in 10 different currencies – the Australian Dollar, the Canadian Dollar, the Swiss Franc, the Danish Kroner, the Euro, the British Pound, the Japanese Yen, the New Zealand Dollar, the Swedish Krona, and the U.S. Dollar.
Different banks from many countries participate on the panels which set Libor and they change over time. Current or recent U.S. banks that have served on panels are Bank of America on the U.S. dollar panel, Citigroup on several panels (U.S., British Pound and Euro panels) and JPMorgan Chase Bank which sits on numerous panels.
Libor is only one of several interbank lending benchmarks. Among several others, there is the Euro Interbank Offered Rate (Euribor), a rate for the interbank loans within the Euro Zone, the Tokyo Interbank Offered Rate (Tibor), and the Singapore Interbank Offered Rate (Sibor).
Several of these lending benchmark rates, besides Libor, have been alleged to having been rigged.
For the corporate trust industry in the United States, Libor not only sets interest rates for certain variable rate corporate debt securities, and for their possible redemption, but also may impact the municipal market, all as described in more detail below.
The Libor Scandal
As early as August, 2007 regulators and academics began to raise questions about Libor. These questions surfaced publicly in two The Wall Street Journal articles published in the spring, 2008.
The first article dated April 16, 2008 entitled “Bankers Cast Doubt on Key Rate Amid Crisis” reported concerns that Libor was “sending false signals” and could be “becoming unreliable.” The article reported “growing suspicions about Libor” that could be interpreted to suggest that “banks’ troubles could be worse than they’re willing to admit.” The article noted that “some banks don’t want to report high rates they’re paying for short-term loans because they don’t want to tip off the market that they’re desperate for cash.”
The second article dated May 29, 2008 entitled “Study Casts Doubt on Key Rate” reported that “banks have been reporting significantly lower borrowing costs for the London interbank offered rate than what another market measure suggests they should be.” The Journal compared the panel reported rates to the costs of insuring the banks against default, two measures that historically moved in tandem. The two rates instead diverged materially, in ways that could be interpreted to suggest that some banks were “low balling their borrowing rates to avoid looking desperate for cash.”
It now appears that these concerns about Libor were registered with regulators. On June 1, 2008, the Federal Reserve Bank of New York sent an email to the Bank of England with a list of suggested “Recommendations for Enhancing the Credibility of Libor.” 1
The scandal however only became visible this past summer. It came to light that bank traders set about manipulating the most important figure in finance. They joked, or offered small favors. “Coffee will be coming your way” promised one trader in exchange for a fiddled number. Another trader posted diary notes to himself so that he wouldn’t forget to fiddle the numbers the next week.2
Investigations and litigation
These developments and similar concerns have led to a host of regulatory investigations in a variety of different countries. In connection with these investigations, several of the banks involved have negotiated varying levels of immunity in exchange for cooperation. Others have reached monetary settlements.3
Litigation over the alleged manipulation of Libor has been filed in various forms. They include antitrust suits, shareholder derivative suits, regulatory investigations, securities fraud class actions, and possible criminal investigations.
A former trader at UBS AG and Citigroup, Inc. and two inter-dealer brokers, employees of the brokerage firm R.P. Martin Holdings Ltd., were arrested in London on December 11, 2012. The three were targeted by the UK Serious Fraud Office. These were the first arrests made over the Libor scandal.4
In the United States, for example, a homeowner whose home was repossessed filed the first known class action lawsuit in October claiming alleged Libor manipulation made mortgage repayment for thousands of Americans more expensive than they should have been. The class action, filed in New York, alleges that traders at 12 of the biggest banks in Europe and North America, were incentivized to manipulate Libor to a higher rate on certain dates on which adjustable mortgage interest rates were reset.5
A number of banks are currently under investigation by regulatory authorities in the United States, Switzerland, Japan, the United Kingdom, Canada, the European Union, and Singapore. In the U.S., the Department of Justice, the Securities and Exchange Commission, and the Commodity Futures Trading Commission have opened investigations. Barclays Bank plc reached a settlement agreeing to pay approximately $450 million in fines to U.S. and British regulators.6
On December 19, 2012, UBS AG became the first big global bank in more than two decades to have a subsidiary plead guilty to fraud. UBS agreed to pay $1.5 billion to U.S., UK and Swiss regulators to settle allegations of “pervasive” and “epic” Libor rate rigging charges as well as rigging similar benchmark rates between 2005 and 2010 by its Japanese subsidiary which pleaded guilty to criminal wire fraud.7
Implications for Corporate Trust in the United States
In the United States, Libor has a bearing on the following financings:
- Libor sets the interest rate for variable or adjustable rate residential mortgages used as collateral for derivative securities sold either privately or publically in the marketplace. Many of the subprime mortgage financings have defaulted.
- Libor establishes, plus or minus certain basis points, the interest rate for the next interest period for floating rate bond financings sold by foreign issuers, either within or outside the United States.
- The indenture or trust agreement under which certain early international financings were issued, many of which are still outstanding, provide that if the adjusted interest rate pegged to Libor reaches higher than a specified level, all outstanding bonds are required to be redeemed.
- For municipal financings sold to cover the cost of building a project, the bond proceeds held by the trustee frequently are invested at the direction of the issuer in Guaranteed Investment Contracts (GICs), an investment offered by financial service institutions that pay a rate of return, usually close to the current yield on high grade bonds for a stated term. The rate of return for certain GICs is tied to Libor.
The exculpatory standard for trustees indicates that a trustee is liable for its own negligent action, its own negligent failure to act, or its own willful misconduct. However, the trustee must be protected from liability for any error of judgment made in good faith by a responsible officer, when the trustee was not negligent in ascertaining the pertinent facts.8
Recommendations for Improving Libor
On September 25, 2012, the British Bankers’ Association said that it would transfer oversight of Libor to a new administrator, whose role will be made a regulated activity under the UK’s financial services framework, as proposed by Martin Wheatley, the Managing Director of the Financial Services Authority and the CEO of the new Financial Conduct Authority.9
On September 28, Wheatley’s independent review was published recommending that:
- an independent organization with government and regulator representation, manage the process of setting Libor under a new external oversight process providing for transparency and accountability.
- submissions to Libor would be required to be based on actual inter-bank deposit market transactions and records be kept supporting those submissions.
- libor submissions be published, but only after three months, to reduce the risk that they be used as a measure of the submitting banks’ creditworthiness.
The Wheatley report noted that the adoption of an entirely new interest rate benchmark would have led to uncertainty in a vast range of financial contracts, both in the UK and internationally, and that despite recent damage to its credibility, Libor continues to be used as a benchmark in new financial arrangements.10
The British government agreed to accept all the recommendations and will draft legislation to implement them.
Wheatley and Gary Gensler, Chairman of the Commodity Futures Trading Commission, have both been working together on rate- guidelines that will be issued in March 2013 by the International Organization of Securities Commissions.
Gensler has stressed that Libor lacks transparency and needs an overhaul.11
With the consensus to the Wheatley recommendations, it is hoped that those recommendations to improve the setting of Libor will be implemented through legislation in the UK in the near future. The outcome is still unknown to the myriad of lawsuits that have been filed globally.
In the meanwhile, the British government on November 26, 2012 selected Mark J. Carney, governor of the Bank of Canada, to succeed as the next governor of the Bank of England. Carney will be the first foreigner to lead the Bank and will also take responsibility for the health of the British financial system. 12
1. www.dandodiary.com, Directors and Officers Liability and Insurance, Securities Litigation, LaCroix, Kevin M. “A Closer Look at the Libor Scandal,” July 23, 2012.
2. The Economist, The LIBOR scandal, “The rotten heart of finance,” “A scandal over key interest rates is about to go global,” July 7, 2012.
3. Endnote 1.
4. Enrich, David, “Libor Dragnet Snares Three Men in U.K.,” The Wall Street Journal, December 12, 2012 and Binham, Caroline, Daniel Schafer and Brooke Masters, “Trader and two brokers held in first arrests over Libor scandal,” Financial Times, December 12, 2012.
5. Binham, Caroline, “US woman takes fight to banks in first homeowner Libor class action,” Financial Times, October 15, 2012.
6. www.newsandinsight.thomsonreuters.com , Berry, Bass “Libor-related litigation: Update and forecast,” September 10, 2012.
7. Scannell, Kara, Brooke Masters, Caroline Binham, Tom Burgis and James Shotter, “$1.5bn Libor penalty rocks UBS,” Financial Times, December 20, 2012 and Enrich, David and Jean Eaglesham, “UBS Admits Rigging Rates in ‘Epic’ Plot,” The Wall Street Journal, December 20, 2012.
8. Landau, Robert I. and Romano I. Peluso, Corporate Trust Administration and Management, Sixth Edition, Chapter Three, June, 2008.
9. Enrich, David, “U.K. Regulator Outlines Overhaul; ‘Integrity’ Is Goal,” The Wall Street Journal, September 28, 2012.
10. Masters, Brooke, Patrick Jenkins, and Ben McLannahan, “UK Libor plan to be world template,” Financial Times, September 29-30, 2012.
11. Protess, Ben, “Libor Case Energizes a Wall Street Watchdog,” The New York Times, August 13, 2012 and Froymovich, Riva and Jamila Trindle, “CFTC Chief: Libor Needs Overhaul,” The Wall Street Journal, September 25, 2012.
12. Giles, Chris and Patrick Jenkins, “Canadian takes helm at BoE,” Financial Times, November 27, 2012 and Thomas, Landon and Julia Werdigier, “Britain Selects a Canadian to Lead the Bank of England,” The New York Times, November 27, 2012.
Romano I. Peluso, CCTS
Romano I. Peluso served on the Subcommittee to review the Annotated Trust Indenture Act Report prepared by American Bar Association. The Report cites the case law for each provision of the Trust Indenture Act of 1939, as amended. The Report was published in The Business Lawyer, Section of Business Law, American Bar Association, August 2012, Volume 67, Issue 4, pages 977 - 1192.
Do note that the opinions voiced in these articles and the topics discussed are in no way linked to, nor do they represent, Law Debenture or any of its groups or subsidiaries