LIBOR rigging

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“The courts have for many years been developing and using a broad concept which at times has threatened to bring chaos rather than light to the solution of the legal problems it has affected. This concept enunciates the division between questions of law and questions of fact.

—What is a “Question of Law”?, Arthur W. Phelps, 1949, bringing yet more chaos to the table.

“If the law supposes that,” said Mr. Bumble,… “the law is a ass—a idiot. If that’s the eye of the law, the law is a bachelor; and the worst I wish the law is that his eye may be opened by experience—by experience.”

— Charles Dickens, Oliver Twist

Tom Hayes’ appeal from his conviction for “LIBOR rigging” follows Matt Connolly’s and Gavin Black’s acquittals in 2022 on equivalent US charges relating to the same actions. It centres on a two-limbed question:

What do the LIBOR and EURIBOR fixing rules mean?

Whose job was it to decide what they meant, and by reference to what?

LIBOR and the business of banking

The basic model of a bank is to borrow short-term, at a low rate, and lend long-term to businesses and homeowners at a high rate. Thus, overnight deposits pay interest at a floating rate. Most term loans pay interest at a fixed rate. Not all; but most.

As a general proposition, therefore, banks borrow in floating and lend in fixed. They have “structural interest rate risk”. They want floating rates on their deposits to be low. In that case, all other things being equal, they make money. All other things are not always equal, though, as we know (but, apparently, Silicon Valley Bank did not).

How to determine what that floating rate should be day to day?

Enter the British Bankers’ Association. This was just the sleepy, city-grandees-in-a-smoke-filled-gentlemen’s-club-in-Threadneedle-Street of your imagination. Inasmuch as it ever did anything useful, the BBA compiled LIBOR, sleepily, by inviting about 18 banks, literally, to phone in the rate at which they could borrow in various currencies and maturities in the market each day, They would “trim” the top and bottom four entries and average the remainder to produce the LIBOR rate for each currency and maturity for that day, then toddle off for a liquid lunch before their regular three o’clock tee time.

The banks could then set their rates — for deposits and loans — based on the day’s relevant LIBOR rate.

Notwithstanding that this process played an important part in the world’s financial plumbing, LIBOR submitting was yet a dull, unexotic backwater. All the cool kids were out shorting structured credit.

As per the basic model, to manage their structural interest rate risk, Banks generally would want LIBOR low — but overnight deposits are not the only show in town. Investment banks had exposure to the interest rate market in other ways: principally through swaps.

Here, the bank “swaps” interest rates with its customers: one customer might agree to pay over a fixed rate in return for a floating rate; another might swap floating for fixed. Some LIBOR banks are also swap dealers.

If a bank swaps a fixed rate for a floating rate, and then LIBOR goes up, by definition the replacement value of its incoming floating rate will increase — a stream of 3.25% cashflows is numerically worth more than a stream of 3.00% cashflows, all else being equal — while the replacement cost of the outgoing fixed rate stays the same. The bank’s net position in that swap —its “mark-to-market exposure” — has moved in-the-money.

While dealers try to balance their customer swaps to offset each other as far as possible, they may also wish to manage that structural interest rate risk that arises from their normal banking activities.

What with all the frenetic customer activity and market conditions constantly changing it is quite conceivable that, though simplistically a bank should always want the LIBOR rate to be low to improve its spread on deposits against loans, the positioning of its interest rate derivatives book might offset or even reverse that such that it might suit the bank for LIBOR to be high.

The question arises: when submitting a rate, what account can you take of your bank’s derivatives trading book?

The LIBOR Definition

The BBA’s guidance came in the form of “Instructions to BBA LIBOR Contributor Banks”. The critical part of these — what the court called the “LIBOR Definition” — ran as follows:

“An individual BBA LIBOR Contributor Panel Bank will contribute the rate at which it could borrow funds, were it to do so by asking for and then accepting inter-bank offers in reasonable market size just prior to 1100.”

On any day there would be a range of rates available to a bank at which it could borrow. These might be firm offers from other lenders, good faith estimates or model outputs. Say the range on a given day was between 2.50% and 2.53%. Which of these was, for the purpose of the LIBOR Definition, “the rate at which it could borrow funds”? Plainly, a submitter could not submit all of them.

It seems to JC the logical options (leaving aside their legality for a moment) were:

Pick one of the available rates: Choose one rate from those that were genuinely available per the bank’s good faith enquiry as above.

Make a blended rate: Contrive some artificial rate from within that range, reflecting a weighted average, or some such thing.

Make one up: Submit a rate that did not fall within the estimated range, whether lower or higher.

“Making something up” plainly falls outside the scope of the LIBOR Definition. “Making a blended rate” does not quite match the literal text, but perhaps captures its spirit. But in any case, Hayes did neither of these things.

Picking one of the available rates is what Hayes actually did. The complication is that Hayes actively sought out opinions as to which available rate would best suit the bank’s overall derivative trading position. That is, he was guided by the bank’s overall commercial interest, and not, well, its basic banking commercial interest.

This is the crux of the case. This, so the Crown alleges, is a punishable conspiracy to defraud. Hayes’ motivation was dishonest in light of the proper basis for the submission of those rates.

“A conspiracy to defraud”

Hayes was indicted on the ancient common law offence of “conspiracy to defraud”. Criminal law minutiae, perhaps, but he was not charged with a statutory criminal offence under the Fraud Act 2006. That was enacted following a Law Commission report which recommended abolishing common law conspiracy to defraud, because it was “unfairly uncertain, and wide enough to have the potential to catch behaviour that should not be criminal”.

“The government decided to retain it for the meantime, but accepted the case for considering repeal in the longer term.”

Shout out to my buddies in Kiwiland, by the way, where all criminal offences were codified and all residual common law crimes abolished in 1961. Good job, Kiwis!

In any case, common law conspiracy to defraud was not abolished, still hasn’t been, that is what Hayes was charged with.

The elements of the offence are, more or less, that there was an agreement between persons who intended to defraud someone by doing something dishonest and a likelihood of resulting loss, even if no loss arose..

The crux: was Hayes dishonest when he submitted his LIBOR rates?

That, in turn, came down to whether Hayes “deliberately disregarded the “proper basis” for the submission of those rates”.

And that came down to whether Hayes’ submissions complied with the LIBOR Definition.

If they did then, Q.E.D., he was not conspiring to defraud anyone if his submissions happened to be in his interest — though no particular emphasis fell on whether this was because it was not a fraud in the first place, or because Hayes was not, therefore, being dishonest. The court focused on the dishonesty.

So, what did the LIBOR Definition mean?

Meanwhile, in Gotham City

Now, an ocean away, an American appeals court had considered that very question in the matter of United States v Connolly and Black, two Deutsche Bank submitters convicted for manipulating LIBOR. Followers of current events may even know that the US courts overturned their convictions, considering the question before them to be one of fact: the text of the “LIBOR Definition” as filtered through the prisms of grammar, usage, subject matter expert opinion and industry practice. This question of law — whether it was dishonest — depended a great deal on matters of fact — what did those submitting rates believe was permitted within the LIBOR Definition, and if that seemed far-fetched, what a reasonable person reading the definition would think it required.

The precise hypothetical question to which the LIBOR submitters were responding was at what interest rate “could” DB borrow a typical amount of cash if it were to seek interbank offers and were to accept. If the rate submitted is one that the bank could request, be offered, and accept, the submission, irrespective of its motivation, would not be false.

This led the US courts to conclude that Hayes’ method — picking from a range of available rates — could not be false.

Crimes and contracts

Bear in mind that the “legal question” to be answered here is one of criminal law, not contract. The contract is merely the factual background upon which a crime was allegedly committed.

Under the intellectual theory of criminal law, ignorance or misunderstanding of the law is no excuse. This is axiomatic for an effective criminal justice system, just as “all interests in cash pass by delivery” is to finance. The system would not work defendants were allowed to plead ignorance, even presumptively. Ignorantia legis non excusat, if you are blameless in your inadvertence, is a moral iniquity but still a logical imperative of government.

The same imperative does not hold for a contract. Quite the opposite: the whole theory of contract is that the parties are materially cognisant of the whole thing. That is what offer and acceptance requires. So the rules of contractual interpretation have forged a different path:

Interpretation is the ascertainment of the meaning which the document would convey to a reasonable person having all the background knowledge which would reasonably have been available to the parties in the situation in which they were at the time of the contract. [...] The background was famously referred to by Lord Wilberforce as the “matrix of fact,” but this phrase is, if anything, an understated description of what the background may include. Subject to the requirement that it should have been reasonably available to the parties and to the exception to be mentioned next, it includes absolutely anything which would have affected the way in which the language of the document would have been understood by a reasonable man.

—Lord Hoffman in Investors Compensation Scheme Ltd v West Bromwich Building Society [1998] 1 WLR 896

A couple of observations:

One: plainly, what a contract means is, in some way, fact-dependent. It is not, purely, a matter of law. A contract is evidence of the parties’ agreement. It is not sovereign to it.

Another: how everyone behaved when interacting with the LIBOR Definition helps work out what a reasonable person would have understood it to mean. There is no better indication of reasonableness than direct evidence of the actual belief of fellow passengers on the Clapham Omnibus.

There is here the odd spectre of the law of contract forming the backdrop, and comprising some of the elements of a criminal allegation. This is rare. Usually, the criminal authorities stay well out of commercial disputes, even where allegations of fraud are flying around — there is a civil tort of fraud — seeing it as a matter of civil loss between merchants perfectly able to look after themselves, and not one requiring the machinery of the state.

LIBOR, on whom the mortgage repayments of unwitting retail punters depend, made things a bit different. This is no private matter to be sorted out between gentlemen with revolvers. Nevertheless, still one must apply contractual principles, not criminal ones, to matters of contractual practice.

Everyone was at it

A fun game, if you have twenty minutes, is to google the names of the LIBOR panel banks to see which were not somehow implicated in so-called “LIBOR rigging”. If you haven’t got twenty minutes, the WSJ’s brilliant interactive spider network will give you the answer in an instant.

Everyone was at it.

We must draw one of two conclusions: either there was a colossal conspiracy by which everyone was trying to rip off the general public or this is how everyone understood LIBOR to work.

Bear in mind: borrowing at the lowest rate

It might not be edifying, but employees have fiduciary obligations to their shareholders, and if everyone acts according to those fiduciary obligations — or even their own personal self-interests — the selfishness cancels itself out. This is exactly the logic of Adam Smith’s invisible hand.

Now, seeing as the different desks and functions of a universal bank borrow in different markets, from different counterparties and in different circumstances, clearly, there will be no single unitary rate that the market will offer. The submitter will be confronted with a range of rates. Plainly it would be odd to submit a rate that was completely outside that range, but each of those rates counts as “a rate at which it could borrow funds”.

The judgment interpreted that as the lowest of the submitted rates in the range.

In the LIBOR Definition what is required is an assessment of the rate at which the panel bank “could borrow”. That must mean the cheapest rate at which it could borrow. A borrower “can” always borrow at a higher rate than the lowest on offer. But the higher rate would not reflect what the LIBOR benchmark is seeking to achieve, namely identification of the bank’s cost of borrowing in the wholesale cash market at the relevant moment of time. If in a stable and liquid market a submitting bank seeks and receives offers for a reasonable market size at the very time it is to make its submission, and receives offers ranging from 2.50% to 2.53%, it would accept the offer at 2.50%. It would be absurd to suggest that the LIBOR question could then properly be answered by a submission of 2.53%. The bank “could” borrow at that rate in the sense that it was a rate which was available, but that is obviously not what “could” means.

There is some economic logic to this argument, though it seems a brutal grounds for sending someone to prison for 14 years given how easy it would have been for those drafting the LIBOR rules to have put the matter beyond any doubt: namely, by inserting the word “lowest”:

“An individual BBA LIBOR Contributor Panel Bank will contribute the lowest rate at which it could borrow funds ...

And the argument here is not about economic reality, but legal meaning, and legal meaning follows natural, ordinary meanings, and in the world of contractual interpretation, they tend to be construed from the perspective of the person endeavouring to perform the contract and against the draftsperson’s interest, giving the benefit of the doubt to the reader.

As a matter of plain English, the court openly concedes that “could” does not logically rule out a higher rate, but implies it: “a borrower can always borrow at a higher rate than the lowest one on offer”.

But — per the wording in the LIBOR definition — there is not an unlimited upper bound to that: it is delimited by the range of “inter-bank offers in reasonable market size just prior to 1100”.

A submitted could not submit a rate higher than that actually offered range any more than it could submit a rate lower than the actually offered range.

To conclude this “could” does not mean that, therefore, involves implying a term into the contract. Inserting an adjective that the drafters of the rules could easily have included but chose not to.

Evidence was not led as to how the rules were drafted, and what flexibility the British Bankers’ Association had in mind. and after all, history has borne out that, sometimes, there are times where Banks and their regulators are rightly motivated by considerations other than the actual (lowest) rate at which one could borrow.

See also

• Contract
• LIBOR