LIBOR rigging part 2

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This is part II of an article about LIBOR rigging. The first part is here.

Okay, so a picture is emerging. What follows is not authenticated history, but something more like a fable or a “just so” story: a simple device to paint a general picture. (Also, a cheeky way of avoiding having to dredge up and validate what actually happened.)

Interest rates as a “thing”

During the 1980s an “interest rate” transformed from being simply “the time cost of borrowing money”, thus intractably bound into indebtedness and a subordinate priority to getting your money back, to being a tradable instrument in its own right. One could be, and Tom Hayes was, a “rates trader”.

This is thanks to the emergence of interest rate swaps. By offsetting coterminous fixed and floating loans, you were left with a string of interest cashflows and no principal. (There was principal, as we argue elsewhere; it just didn’t manifest as part of the swap contract.)

This was a profound conceptual shift.

Suddenly, you could extract the “interest rate information” as a distinct financial concept from the substrate of indebtedness in which, hitherto, it had been buried.

Think of it like the transformation from analogue to digital: in the same way, and at broadly the same time — the coincidence of the information and derivative revolutions was, well, no coincidence — rapidly developing information technology was affording new techniques for abstracting the “information content” of written material from the physical substrate it was printed on. James Burke did a great Connections episode on it. It started with Jacquard looms.

But, with interest rates, there was a difference: whereas “information” is logically prior to the substrate in which it is articulated this is not true of interest. Interest is not logically prior to a loan, but its consequence.

An interest rate cashflow implies a loan.

The shadow with no occluder

Yet the derivatives wizards had invented a way of unshackling interest, the shadow, from principal, the occluder. This is deep, dangerous magic. Free of that mortal weight, financial analysts could create, hedge, and then sell to small and medium-sized enterprises, all kinds of funky new interest rate products: collars, caps, floors, more exotic things like extendable collars and, well, enhanced dual fixed rate protection strategies.

There is another story here — far more outrageous, in JC’s view — but it will have to wait. In the meantime, the point is “what LIBOR is used for” changed out of all recognition. Sleepy old deposits and mortgages were but a small part of a far bigger picture.

Banks across the street began engaging their derivatives trading teams in the LIBOR setting process. Tom Hayes, who traded Yen LIBOR swaps in Tokyo, was but one. Though in his mid-twenties at the time of the allegations, Hayes was greatly valued by a succession of banks for his “strong connections with Libor setters in London,” information they considered “invaluable for the derivatives books”.

As public interest focussed on LIBOR submission in the wake of the lowballing incident, sentiment — both inside and outside his employers — turned sharply against him.

“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 under the Fraud Act 2006, a new statute that followed a Law Commission survey of the ancient criminal law of fraud and which had recommended abolishing common law conspiracy to defraud, because of its “potential to catch behaviour that should not be criminal”.

Conspiracy to defraud was not abolished, still hasn’t been and that is what Tom Hayes was charged with. Being a common law offence, its ingredients are not well delineated (this in itself is a policy reason to prefer statutory crimes) but the ingredients seem to be along the following lines:

an agreement between persons intending to defraud someone by doing something dishonest with a likelihood of resulting loss, even if no loss eventually arises.

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

That, the court thought, came down to whether he “deliberately disregarded the “proper basis” for the submission of those rates”.

The court did not dwell on what the “LIBOR Definition” meant — there’s not much to dwell on — but rather asked whether Hayes’ intention when choosing the rate to submit reflected “the bank’s genuine perception of its borrowing rate”, instructing the jury as follows:

“1. Did Mr Hayes agree with any individual as named in the counts, to procure the making of a submission by a bank of a rate which was not that bank’s genuine perception of its borrowing rate for the tenor in question in accordance with the LIBOR definition but was a rate which was intended to advantage Mr Hayes’s trading?

If the answer is No, Mr Hayes is not guilty on that Count. If the answer is Yes, proceed to Question 2.

2. Was what Mr Hayes did dishonest by the ordinary standards of reasonable and honest people?

If the answer is No, Mr Hayes is not guilty on that Count. If the answer is Yes, proceed to Question 3.

3. Did Mr Hayes appreciate that what he was doing was dishonest by those standards?

If the answer is No, Mr Hayes is not guilty on that Count. If the answer is Yes, Mr Hayes is guilty on that Count.”

The jury answered, “yes” to all three questions. Tom Hayes was sent to prison for 14 years. He was not the only one. In total, thirty-seven traders were prosecuted in London and New York for interest rate benchmark manipulation. Of these, nineteen were convicted and nine imprisoned.

At the time, there was plenty of righteous dudgeon about LIBOR rigging. None of it favoured the prosecuted rate submitters, who fitted a popular narrative. Even their employers — one of whom had paid Hayes a $3m signing bonus as late as 2009 — affected a tone of wounded indignance that their reputations can have been so rudely traduced.

But if little old ladies make bad law, then what about young male investment bankers?

Meanwhile, in Gotham City

The travails of other LIBOR submitters are interesting because of the sheer scale of the ostensible “criminal enterprise” — we’ll come to that — but also because two of them, Matthew Connolly and Gavin Black, successfully appealed their convictions in the United States in 2022.

In United States v Connolly and Black the United States Court of Appeals for the Second Circuit found construing the LIBOR Definition to be a question of fact: filtered through the prisms of grammar, usage, and context, and upon which evidence of industry practice from subject matter experts would have a bearing.

The question of law — were the submitters dishonest? — depended a great deal on what the LIBOR Definition actually meant:

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 court to conclude that picking from a range of available rates, however motivated, could not be fraudulent.

“Here, the government failed to show that trader-induced LIBOR submissions did not reflect rates at which DB could have borrowed. If the submissions did reflect rates at which DB could have borrowed, they complied with the BBA LIBOR Instruction, and the LIBOR submissions were not false.”

It was within the rules. Connolly and Black were acquitted.

Buoyed by the outcome in New York, Tom Hayes persuaded the UK Criminal Cases Review Commission to refer his case back to the Court of Appeal — which, significantly, had already heard and rejected his appeal once — for reconsideration.

The Court of Appeal handed down its decision in March 2024.

The Hayes appeal

The Court of Appeal considered first that question of legal methodology — whose job was it to determine what the LIBOR Definition meant — and came to a different conclusion. Under English law, contractual interpretation is a matter of law, to be resolved by the judge. Evidence of market practice, or the subjective belief of submitters, does not enter into it.

The Court of Appeal interpreted the LIBOR Definition to require a bank to always submit the lowest of the available 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.

Crimes and contracts

Bear in mind that the “legal question” to be answered here is one of criminal law, not contract: whether the nebulous ingredients of common law “conspiracy to defraud” were satisfied.

The LIBOR Definition was not a statute at all, let alone a criminal one. It was, the Court of Appeal ruled, part of a contract between the submitting banks and the BBA. That it was not a criminal offence per se to fail to comply with the LIBOR Definition did not move the court:

That is not, however, determinative. It was not a criminal offence per se to fail to comply with the Take-over Code, but that did not stop it being treated in Spens as something which demanded construction as a question of law in the same way as primary or delegated legislation. Although compliance with LIBOR or EURIBOR was not directly a regulated activity, it was indirectly so: failure to comply with their provisions could give rise to regulatory consequences.

R v Spens concerned a breach of the Takeover Code, and expressed the view that “[the Takeover Code] sufficiently resembles legislation as to be likewise regarded as demanding construction of its provisions by a judge.”

But inasmuch as the Takeover Code regulates behaviour in connection with mergers and acquisitions it is a quasi-regulatory arrangement. The calculation of an interest rate benchmark is not. That failure to comply with its terms indirectly “could give rise to regulatory consequences” is beside the point, and is true of any contract.

For, unlike crimes and torts, contracts do not admit of mental states or “culpability”. There is no need for mens rea. You either comply with a contract or you don’t. Your intention, recklessness or negligence in performance does not come into it.

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

But, again, this does not hold for contract. Quite the opposite: under the intellectual theory of contract the parties are required to be materially cognisant of the whole thing. That is what offer and acceptance requires: if they do not, there is no contract.

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

Interpreting the consensus ad idem manifested under a contract demands a wholly different approach than does construction of criminal legislation where the defendant’s understanding of the legislation is irrelevant.

Surely, evidence of how everyone behaved when interacting with the LIBOR Definition will help with what a reasonable person would have understood it to mean. There can be no better indication of reasonableness than direct evidence of the behaviour of fellow passengers on the Clapham Omnibus.

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

LIBOR, on which the bank deposits and mortgage repayments of unwitting retail punters depend, made things different. To be sure, 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 interpretation.

And the argument here is not about economic reality but legal meaning, and legal meaning follows natural, ordinary meaning, and in the world of contractual interpretation, that is viewed from the perspective of the person performing the contract, “contra proferentem” — against the draftsperson’s interest — giving the benefit of the doubt to the person on whom the terms are imposed.

Defendants get the benefit of the same doubt in case of ambiguously-framed crimes.

Why didn’t it just say “lower”?

Besides, if the LIBOR Definition meant to mandate this “obvious” outcome, why did it not just say so? As a matter of plain English, “that rate at which it could borrow” does not rule out a higher rate but, rather, implies it: the Court of Appeal concedes as much, at para 89:

“The bank “could” borrow at that [higher] rate in the sense that it was a rate which was available, but that is obviously not what “could” means.”

The “obviousness” to which the Court appeals here is not a legal one — there is no authority for that proposition — but the Court’s economic intuition based upon an abstract conceptualisation of “borrowing”. It is a simple appeal to common sense: why would anyone borrow at rate higher than one on offer?

But, that is not what the LIBOR Definition says. Per its plain words, there is an upper bound, delimited by the range of “inter-bank offers in reasonable market size just prior to 1100”. A submitter could not submit a rate higher than one actually offered, any more than it could submit a rate lower than one actually offered.

So, to construe “the rate at which it could borrow funds” to mean “the lowest rate at which it could borrow funds”, one must imply a term into the contract that easily could have been, but was not, put there. Courts do not do this lightly:

“That which in any contract is left to be implied and need not be expressed is something so obvious that it goes without saying; so that, if, while the parties were making their bargain, an officious bystander were to suggest some express provision for it in their agreement, they would testily suppress him with a common ‘Oh, of course!’”

There are good reasons to imagine at least thirty-seven LIBOR submitters might not have reacted that way if anyone had asked them. And it would have been easy enough for the old grandees of Threadneedle Street to put the matter beyond doubt. All it would take would be a single modifying adjective:

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

They did not add that adjective.

There were other techniques they might have used to prevent banks from talking their own book: for example, inviting them to submit the minimum rates they were prepared to lend to each other, rather than borrow.

They did not do that, either.

As Tom Hayes’ original pleading made clear, a bank submitting the rate at which it could borrow has an inherent conflict of interest. There were any number of ways it could craft the data it received in ways no one could check: by carefully selecting the banks from whom it did, and did not, seek offers. From its timing. From the phrasing of the request. From the person to whom it was addressed.

If LIBOR had a problem it was not, principally, with the submitters: it was with the process.

If you allow merchants scope to align their behaviour with their commercial interests, it is an odd merchant who will not do it.

The LIBOR interactive spiderweb

And after all, 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 ones were not somehow implicated in “LIBOR rigging”. If you haven’t got twenty minutes, the WSJ’s brilliant interactive spider network will give you the answer in an instant. There were thirty-seven prosecutions for LIBOR manipulation.

Everyone was at it.

We must draw one of two conclusions: either there was a colossal conspiracy among middle-ranking bank employees, to which management was totally inadvertent, by which everyone was trying to rip off the general public, but yet failing (the judgments are full of awkward remarks like, “it was impossible to assess the scale of the loss to the counterparties”) or this is just how everyone understood LIBOR to work.

It might not be edifying, but if everyone acts according to personal self-interest, the selfishness cancels itself out. This is exactly the logic of Adam Smith’s invisible hand.

The prosecution theory

It is not clear what the theory underlying the LIBOR prosecutions was. We can speculate, but none survive close inspection:

Is a merchant who prefers its own commercial interests somehow reprehensible? This will be news to economists, and indeed the commercial courts who have frequently expected merchants to do nothing else.

Should LIBOR submitters should avoid conflicts of interest? How can they? The LIBOR rate is structurally fundamental to the economics of banking. All banks are exposed to interest rates. All have skin in the game. All are necessarily conflicted if asked to opine on what they think the interest rate should be. Any submission must, at some level, support or undermine the bank’s intrinsic interest rate exposure. A submission weighted to the lowest available rate structurally favours a bank that is not hedging its interest rate risk: why is that okay?

Is the LIBOR rate designed to protect investors, and if so who? Depositors? Borrowers? Why? As noted, classic bank customers, who borrow fixed and deposit floating, would benefit from a higher rate, not a lower one. This is, of course, all very complicated because banks are very complicated. It is not obvious what is or is not in a bank’s interest.

Stare decisis

There is a final lawyer nerd-out, but in forming its decision on this review, the Court of Appeal was confronted with some of its own prior rulings and judgments. The common law doctrine of precedent means an appeal court is generally bound by its own previous decisions in analogous cases. Usually, previous decisions are from unrelated cases. This gives the court scope to distinguish inconvenient earlier decisions “on their facts”.

But not here. Here, the prior authorities were decided in previous appeals of Hayes’ actual case when it was first appealed to the Court of Appeal. This is unusual, due to the convoluted route by which the case came to the Court of Appeal, having been referred to it by the Criminal Cases Review Commission. Hayes’ original conviction had already been appealed once to the Court of Appeal.

On one hand, it should not make a difference that it is the same case. It removes any possibility of “distinguishing on the facts”. On the other, asking the same court to reconsider decisions it is constitutionally bound to follow is a bit futile. What is the point of reviewing a case you are bound to follow?

This should, at least, be good ground for allowing Hayes a further appeal to the Supreme Court, which is not so bound by earlier precedent.

Upshot

None of this is to say that the financial services industry is without sin, nor that the LIBOR submitters were some monastic order of chaste knights acting only in the selfless pursuit of a noble, holy quest.

But insofar as they were not, their behaviour took place within a context. We cannot conveniently ignore that in the interests of making an example out of them.

Until 2008 the LIBOR submission process was normalised, tolerated and even exalted throughout the industry. Banks vied for Tom Hayes’ services. He was offered, and paid, seven-figure salaries. In his twenties. Nor did he make any secret of what he did: he posted his LIBOR desires each day on Facebook, for heaven’s sake. This was hardly the actions of some secret society. It is absurd to regard this as some kind of conspiracy amongst a cabal of bad apples conducted away from the eyes of witless employers.

That a global system was so badly conceived, configured and operated as to be defenceless against such “travesties”; that for decades it could neither see nor stop what we are now asked to accept was systemic, widespread, criminal activity — surely this is the elephant in the room, not cavalier twenty-five-year-olds behaving badly. That is a regrettable — inevitable — upshot of a far bigger failing further up the chain. We do ourselves, and not just Tom Hayes and his fellow defendants, a disservice if that is the view we take.

Whether Tom Hayes’ appeal will be heard by the Supreme Court remains to be seen, but, given the Court of Appeal’s declared inability to gainsay its own previous judgments in Hayes’ case, it is hard to see how a rational judicial system could tolerate anything else. We will have to see.

See also

• LIBOR rigging part 1
• LIBOR lowballing
• Interest rate swap mis-selling scandal