“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 11 am?”
This is the question at the center of the Libor (London Interbank Offered Rate) firestorm. This single, seemingly innocuous, question could ultimately lead to billions in potential fines and settlements, possible jail time for some, higher borrowing costs globally, and will undoubtedly lead to increased regulatory scrutiny. It may also make liability insurers become more cautious about underwriting financial service firms.
How Libor Is Supposed to Work
It was, and is, the question asked of the largest global banks every day by the British Bankers Association. They ask the same question for different currencies and different tenors. (e.g. “At what rate could you borrow dollars for one month…”) The banks understood that their answers were then combined with the answers from other banks and the average used to calculate the index known as the London Interbank Offering Rate or Libor. The contributed rates are generally meant to reflect each bank’s assessment of the rates at which it could borrow unsecured interbank funds. Many financial institutions, including mortgage lenders and credit card agencies then set their own rates relative to Libor. At least that was the way it was supposed to work.
A number of regulators around the world have announced that they are investigating potential manipulation of the index. At least one institution has admitted to submitting biased submissions and agreed to pay hefty penalties.
The Big Questions
While the investigations continue, a few important questions remain unanswered:
- What was the real nature of the misconduct?
- Just who was harmed by the alleged misconduct (and is possible they were also benefited)?
- How will insurers be impacted?
- Is Libor salvageable?
There is no definitive answer, as of yet, as to what law was broken had a bank submitted an inaccurate quote to the association. No criminal matter or civil suit has yet been adjudicated. Most private claims filed to date have asserted that fraud was committed.
Under the Libor formula, banks were asked to determine the rate the bank could borrow a reasonable market size of funds just prior to 11 am. Traders were asked to determine the rate based on these guidelines. The particular nature of the submission makes establishing the misrepresentation of fact more difficult—not impossible, but more difficult.
This unusual methodology at the heart of the Libor calculation may well result in substantial costs as regulators, plaintiffs and defendants scurry to hire analysts and experts to establish the ‘truth’ in their daily rate submissions. In addition to analyzing historical market rates and borrowing data in search of quantitative evidence, investigators are examining internal emails and communications in an attempt to discover evidence of intentional schemes to influence the index.
A Difficult Fix
Complaints submitted to date have argued that Libor, as released, was lower than the actual borrowing costs of banks. If it is established that Libor was, in fact, lower than would have otherwise been the case, then millions of borrowers benefited on trillions of dollars of instruments, even as millions of investors lost money as a result of the lower index. There would be no way to accurately calculate and compensate all the parties that had gained and lost as a result of a shift in the index.
In certain class action litigation involving compensation to individual parties is simply too cumbersome, courts have developed creative solutions by establishing funds for the benefit of the injured parties or fashioned a remedy whereby the defendant accepts losses on future dealings as a way to compensate those affected. Civil remedies for losses resulting from Libor manipulation could be extraordinarily expensive and difficult to manage.
Some very large asset managers are evaluating whether to bring direct action on behalf of the investors they represent. Even a small move in the index would mean that many billions of dollars had been lost by investors and recouped by conversely benefited borrowers all around the world.
Authorities are currently reviewing whether to bring criminal charges. Prior to the passage of the Sarbanes-Oxley Act, it’s difficult to envision what criminal charges could have been leveled against bank employees submitting errant Libor submissions. The revisions made to the U.S Code under Sarbanes-Oxley, however, make any intentional attempt to defraud in connection with a security or commodity a crime.
Complaints filed by asset managers are alleging that the banks on the Libor panels cooperated in manipulating the rates. In order to prove that sort of collusion plaintiffs will need to show more than parallel actions. They will need to show that the banks actively worked together.
According to the Department of Justice, traders at one bank did request other banks to submit Libor submissions that would be favorable to their or their counterparts’ trading positions. It is unclear whether these communications alone can be used to establish more than “parallel action.”
Obviously proof of collusion to manipulate Libor has the potential to carry new charges and will strengthen the arguments of asset manager plaintiffs. Directors at impacted banks should be following this line of investigation closely.
What Impact Will Insurance Play in Addressing Libor Issues?
If the Libor manipulation is shown to be intentional fraud, insurers may not indemnify the losses of those involved. Penalties may be excluded by other provisions, and fraud or dishonesty, or personal advantage exclusions, may also serve to limit insurance coverage.
So are professional liability insurers off the hook? No. There is still the costly matter of defense along with settlements and court awards resulting from alleged negligence by the individuals and institutions involved.
The relevant liability insurance likely to be implicated would include professional liability (E&O or professional indemnity) as well as Directors & Officers (D&O) insurance. A basic but not always strict distinction between the two would be that professional liability claims allege failures in providing services and are brought by clients and customers, while D&O claims allege breaches of fiduciary duty to the organization as a whole and its stakeholders in particular. The “classic” D&O claim is brought by shareholders. Regulatory or enforcement claims can fall on either or both sides of this divide—further complicating the issue of which insurance policy is affected.
Once the policy or contract is determined, one looks to see if coverage has actually been triggered and what (if anything) is covered. A major battleground issue on this front has been investigations and whether or not regulatory investigations are sufficient to trigger coverage. Until recently, the Libor probes were likely to have been classified as simply investigations; now they have gone global.
When it comes to the question of just what is insured, at some point regulators may try to prohibit those who are subject to it from relying on insurance (something of an increasing trend) to pay some or all of eventual settlements or fines, even though we might view civil fines or penalties imposed for purely negligent conduct as insurable. While most global banks have sizable policies it is possible that the Libor-related suits and settlements may exceed the limits of even the largest insurance programs.
Preventing Future Problems
In September the heads of a number of central banks will be meeting and will discuss ways of improving, or possibly replacing Libor, according to Mark Carney, the governor of the Bank of Canada. However, the millions of securities and contracts that rely on the index make a simple reworking of the index problematic. Any change in methodology is likely to favor one counterpart or the other.
Other indexes may be introduced over time, but for the time being Libor continues.