LIBOR rigging

The Jolly Contrarian Law Reports Our own, snippy, in-house court reporting service. →Go uptown Editorial Board of the JCLR: Managing Editor: Lord Justice Cocklecarrot M.R. · General Editor: Sir Jerrold Baxter-Morley, K.C. · Principle witness: Mrs. Pinterman Common law | Litigation | Contract | Tort | Click ᐅ to expand: Case notes Tell me more Sign up for our newsletter — or just get in touch: for ½ a weekly 🍺 you get to consult JC. Ask about it here.

“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

Banks have structural interest rate risk

The basic model of a bank is to borrow, short-term, at a low rate, and lend, long-term, at a high rate. Generally banks calculate interest on deposits, by which they borrow, at a floating rate and on term loans, by which they lend, at fixed rates.

Since banks borrow in floating and lend in fixed, they have “structural interest rate risk”. It flows naturally as a function of how banks work. They want floating rates to be low, and to move lower. If they don’t manage this risk, things can get funky, fast. Just ask Silicon Valley Bank.

So knowing what that floating rate is, and managing it, is an important function. So, a foundational question: How to determine the floating rate, day to day?

Enter, lifetimes ago, 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 the “London Interbank Offered Rate” — “LIBOR” — sleepily, by inviting 18 major banks to, literally, phone in the rate at which they believed they could borrow in various currencies and maturities in the market each day.

The BBA would compile the submissions, “trim” off the top and bottom four, average the rest and publish the result as a set of daily LIBOR rates for each currency and maturity, before toddling off for a liquid lunch at the Garrick and a regular three o’clock tee time.

You get the picture.

With LIBOR published, the banks could then set the rates for their deposits and calculate a suitable fixed rate for new term loans. Happy, dull stuff, carried out by happy, dull people: look: we don’t want to run the interest rate-setting world down, but before 2007, this was the after-school chess club: all the cool kids were out shagging, smoking weed and shorting structured credit. No-one cared much about LIBOR.

Interest rate derivatives

As per the basic model, to manage their structural interest rate risk, banks generally would want LIBOR low — but deposits are not the only show in town. Banks have other exposures to the interest rate market. One notable category: interest rate swaps.

Here, the bank “swaps” interest rates with individual (large) customers: it might, for an agreed period, pay one customer a fixed rate and receive from it a floating rate; with another it might pay floating and receive fixed.

There is no structural bias to swap trading. If a bank swaps a five-year fixed rate for a five-year floating rate, and LIBOR goes up, by definition the bank profits: the “present value” of its incoming floating rate will increase while the present value of its outgoing fixed rate stays the same. The dealer is therefore “in-the-money”. If it swapped floating for fixed in the same case, it would book a loss.

While banks try to balance their books so their customer swaps offset each other as far as possible, how they “position” the book might help manage the bank’s structural interest rate risk.

We can see in any case that, notwithstanding the bank’s structural interest rate risk, a swap trader who is, net, “long” floating rate wishes floating rates to go higher. If her position is large enough, so might the whole bank.

This prospect, we venture, was not wildly present in the minds of the Sir Bufton Tuftons who formulated the LIBOR rules defining how submitting banks should choose the rates they submit each day.

It is one of JC’s axioms of financial scandal that calumny happens where you least expect it. This is because success in financial services is in large part about “edge”, and you find the most edge where no-one else is looking. In the lead up to the global financial crisis, no-one was looking very hard at LIBOR.

Tom Hayes was a cool kid (metaphorically: he doesn’t seem to have been very literally cool at all). But he hung out in the chess club. He, and a bunch of other groovers, found some edge there, where no one was looking for it. No one bothered them and they didn’t do any harm — at least, not that anyone has been since able to point to. But they sent each other lots of embarrassing emails. In any case, they made an effort to submit LIBOR rates that suited their derivatives trading books and not, necessarily, the bank’s structural interest rate position.

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 at which a bank could borrow. These might be firm offers from other lenders, good faith estimates or model outputs. There is an excellent subjunctive in there, by the way: “were it to do so” implies that it need not actually do so.

Say the range of available rates on a given day was, as the court hypothesised, between 2.50% and 2.53%. Which of these was “the rate at which it could borrow funds”? Plainly, a submitter could not submit all of them.

The logical options (setting aside for now their legality) were:

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

Manufacture a blended rate from the range: 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 one up” plainly falls outside the scope of the LIBOR Definition.

“Making a blended rate” does not quite conform to the 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 selected the available rate that best suited his derivative trading position. That is, he was guided by his desk’s commercial interest, and not, the bank’s “structural” commercial interest.

This is the crux of the case. Having this ulterior motive — dishonest in light of the proper basis for the submission of those rates so the Crown alleged — was an imprisonable conspiracy to defraud.

“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