The Libor scandal first began to unfold more than four years ago, but the with dramatic announcements in late June of the imposition of fines and penalties of over $450 million against Barclays PLC, the scandal has shifted into a higher gear and is now the leading story in financial papers around the world. At this point, it is apparent that the Libor scandal is going to be one of the hot topics for months to come. With that in mind, it seems appropriate to step back and take a detailed look at how this scandal developed, what seems likely to happen next, and what the implications may be.
Background about the Benchmarks
The London Interbank Offered Rate (Libor) is one of several benchmarks that banking institutions use to set the 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 Libor benchmarks are used as the reference rate for a wide variety of financial instruments, including forward rate agreements; short-term interest futures contracts; interest rate swaps and inflation swaps; floating rate notes; syndicated loans, and variable rate mortgages, among many others. According to the Accounting Degree website (here), the total value of all securities and loans relying on Libor totals $800 trillion. By way of comparison, the total amount of worldwide GDP is $69.65 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 fifteen different maturities in ten different currencies. (The currencies are 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 participate in the reporting panels for the different currencies and the lineup of panel participants has changed over time. There are currently 18 banks on the U.S. dollar panel (refer here for the current list) but at various time during the events that are at the heart of the current scandal there have been differing numbers; there were as few as 16 in December 2008 and as many as 20 in early 2011.
Three U.S. banks currently participate on Libor panels. Bank of America is a member of the U.S. dollar panel; Citigroup participates in several panels (including the U.S. dollar, the British pound and the Euro). JP Morgan Chase participates in nine of the ten Libor panels. The other participating banks are from several other countries, including the U.K. France, Germany, Japan, and Switzerland.
Libor is only one of several interbank lending benchmarks. Another prominent benchmark is the Euro Interbank Offered Rate (Euribor), a rate for interbank loans within the Eurozone. There are currently 43 banks from over 15 countries participating on the Euribor panels. Another interbank rate is Tibor, the Tokyo Interbank Offered Rate, and Sibor, the Singapore Interbank Offered Rate.
As discussed in detail in a July 19, 2012 New York Times article entitled "Libor-Scandal Shows Many Flaws in Rate-Setting" (here), the rate setting process used for Libor has a number of defects. Among other things, the process depends entirely on self-reporting, by participants who know their reports will be subject to public scrutiny. The other problem is that since early in the financial crisis, banks have stopped lending to each other. Accordingly, the reported rates often represent estimates, rather than actual borrowing costs. At best, the rates are the result of an artificial process that may have little relation to reality. And as time has shown, the rates are susceptible to manipulation and distortion.
Background regarding the Scandal
As early as August 2007, regulators and academics began to raise questions about Libor. These questions surfaced publicly in two Wall Street Journal articles published in spring 2008. The first of these, dated April 16, 2008 and entitled "Bankers Cast Doubt on Key Rate Amid Crisis" (here), reported concerns that Libor was "sending false signals" and could be "becoming unreliable." In particular, 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."
On May 29, 2008, the Wall Street Journal ran a second article, entitled "Study Casts Doubt on Key Rate" (here), in which the Journal reported, based on its analysis, that "banks have been reporting significantly lower borrowing costs for the London interbank offered rate, or Libor, than what another market measure suggests they should be." The Journal compared the panel banks reported borrowing rates to the costs of insuring the banks against default, two measures that historically moved in tandem. The Journal found that the two rates had recently 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." The participating banks were reporting similar borrowing rates even when the default insurance market was suggesting widely diverging market perceptions about the various banks' financial health.
It now appears that these concerns about LIbor were registering with regulators. It turns out that among other things, on June 1, 2008, then-New York Fed chair and current Treasury Secretary Timothy Geithner sent Mervyn King and Paul Tucker, the governor and executive director of markets at the Bank of England respectively, an email with a list of suggested "Recommendations for Enhancing the Credibility of Libor." Among other things, the list included the suggestion to "Eliminate Incentive to Misreport." According to a July 21, 2012 Wall Street Journal article (here), documents released by the Bank of England in connection with the ongoing Parliamentary investigation of the scandal revewal during 2008 that the Bank of England may have resisted taking a more active role in policing Libor, even as the problems surrounding the benchmark were coming to light.
In any event, these developments and similar concerns led to a host of regulatory investigations in a variety of different countries. The roster of investigations and of countries involved continues to expand. A list of the banks that have disclosed that they are under investigation can be found here. In connection with these investigations, several of the banks involved have negotiated varying levels of immunity in exchange for cooperation. Investigations are pending in, among other countries, the U.S., the U.K. Canada, Switzerland, Japan, Singapore, Sweden and South Korea. In addition, several U.S. states are conducting their own investigations, including New York, Massachusetts, and Connecticut. Numerous press reports have stated that several governments are conducting criminal investigations. The publicly available information about the investigations is now sufficiently detailed that there are even press reports of the specific individuals that are under investigation.
The Barclays Settlements
The significance of these regulatory investigations took on an entirely new level of seriousness on June 27, 2012, with the announcements that Barclays had entered a series of settlements with regulators and enforcement authorities in the U.S. and the U.K. Barclays's June 27 press release about the settlements can be found here.
On June 27, the U.S. Commodities Futures Trading Commission announced (here) that Barclays had been ordered to pay a $200 million penalty for attempted manipulation of and false reporting concerning the Libor and Euribor benchmarks. The CFTC's June 27, 2012 Order Instituting Proceedings (here) details the allegations against Barclays. At the same time, the U.S. Department of Justice announced that Barclays had entered an agreement to pay a $160 million penalty to resolved violations arising from Barclays Libor and Euribor submissions. Barclay's June 26 non-prosecution agreement with the DoJ can be found here. The statement of facts accompanying the agreement can be found here.
In addition, the U.K. Financial Services Authority announced (here) that it had fined Barclays £59.5 relating to is Libor and Euribor submissions. The FSA's June 27, 2012 "Final Notice" to Barclays can be found here. The total U.S. dollar value of all of these fines and penalties is about $453 million.
As impressive as these figures are, they apparently reflect the benefits allowed Barclays for its cooperation. For example, in its announcement, the FSA noted that the fine, in addition to being the "largest fine ever imposed by the FSA," reflects a thirty percent discount in recognition of Barclays's cooperation with the investigation. Without the discount, Barclays fine would have been £85 million (about $133.5 million). The Department of Justice 's release also cited Barclays's "extraordinary cooperation," noting that Barclays had made timely, voluntary and complete disclosure of its misconduct," and adding that Barclays was "the first bank to cooperate in a meaningful way after disclosing its conduct relating to Libor and Euribor." The CFTC also noted Barclays's "significant cooperation."
The various regulatory and investigative filings allege that beginning at least in 2005 and through 2009, and at times on an almost daily basis, Barclays provided Libor and Euribor submissions that were false because they improperly took into account the trading positions of its derivatives traders or reputational concerns about negative media attention relating to its Libor submissions.
Specifically, it is alleged that between 2005 and 2007, and then occasionally through 2009, certain Barclays traders requested that Barclays Libor and Euribor submitters contribute rates that would benefit the financial positions held by those traders. The Order also alleges that during at least part of that period, the Barclays traders communicated with traders at other financial institutions to request Libor and Euribor submissions that would be favorable to their trading positions. Documents and emails cited in the FSA's and the CFTC's orders detail the traders' email requests to the persons who submitted the rates for Barclays.
In addition, the CFTC Order also alleges that between August 2007 and January 2009, in response to concerns about press suggestions that Barclays's high U.S. Dollar rate submissions reflected problems at the bank, members of Barclays's management directed that Barclays U.S. dollar rate submissions be lowered, without respect to the bank's actual borrowing costs. Among the many questions that have emerged is the debate whether or not the BoE's Paul Tucker authorized (or even directed) Barclays CEO Robert Diamond to have Barclays underreport its borrowing rates in October 2008, at the height of the credit crisis. (The emails between Tucker and Diamond can be found here.)
Barclays obviously sought through its cooperation to curry favor with regulators. As noted above, the bank's cooperation did at least result in a reduction of the FSA fine. But just the same, the bank's CEO, Robert Diamond, and its Chairman, Marcus Agius, were forced to resign in the days immediately after the settlements were announced, and the company has also been hit with various civil lawsuits as well. An interesting July 16, 2012 Wall Street Journal article (here) details how missteps and miscalculations may have thwarted Barclays best efforts to manage its fallout from the situation.
The irony is that there seems to be an informal consensus that Barclays may not have been the worst offender; a July 19, 2012 Fortune Magazine article suggests that Barclays was not "the worst Libor liar," but instead that title may belong to Citigroup, based on a recent academic study. The article does note that if Citi only underreported but did not also try to manipulate its reported rates for profit purposes, it may not fare as badly as Barclays.
In any event, there has been a recent suggestion that many of the banks under investigation are attempting a group settlement, as a way to try to "avoid a Barclays-style backlash by going it alone." According to a July 20, 2012 Reuters article, "none of the banks involved now want to be second in line for fear that they will get similarly hostile treatment from politicians and the public."
The Follow-On Civil Litigation
As I have separately noted, a raft of private civil litigation has followed in the wake of the Libor investigation, in which various claimants have alleged that they have been harmed by the Libor and Euribor rate manipulation.
Beginning in 2011, a host of municipalities, pension funds and institutional investors initiated a series of private civil antitrust lawsuits. These cases have now been consolidated before Southern District of New York Judge Naomi Buchwald. On April 30, 2012, the various claimants filed their consolidated amended class action complaints. The City of Baltimore's amended complaint can be found here. The consolidated amended complaint filed on behalf of various commodities futures contract and options traders can be found in three parts here, here and here. (There were other complaints filed in the consolidated action on April 30, 2012, but for whatever reason the other complaints are not available on PACER.)
The amended consolidated complaints in these actions make for some interesting (albeit technical) reading. For example, the amended complaint filed on behalf of the futures traders details extensive expert analysis of the ways in which both the Libor benchmarks and the individual panel members' submitted rates deviated from other economic indicia. This analysis is extensively illustrated with numerous graphs and charts. The futures traders' complaint also contains extracts from documents filed in courts in Canada, Singapore and Japan in connection with investigations in those countries (see paragraphs 137 and following). Among other things, the information from the Court documents shows that regulators in those countries are probing possible manipulation of other interest benchmarks, such as Tibor and Yen-Libor.
In particular, excerpts from court filings in Canada and Singapore (at paragraphs 166 and following) provide extensive details about investigative actions in those countries concerning possible manipulation of the Yen-Libor rates, in order to produce trading gains on interest rate derivatives. The documents from the Singapore court proceedings (at paragraphs 177 and following) details alleged collusion between RBS traders and rate setters, calculated to maximize trading profits.
Another of the antitrust suits consolidated before Judge Buchwald in the Southern District of New York is a class action filed by the Community Bank & Trust of Sheboygan (Wisconsin) against the Libor setting banks, on behalf of similarly situated community banks. The suit alleges that the alleged manipulation of the benchmark rate hurt small banks that operate on thin profit margins and that rely more on interest income than large banks with diverse trading operations. In addition to antitrust claims, the community banks' suit alleges violations of RICO. Tom Hals's July 16, 2012 Reuters article about the small banks' suit can be found here.
A good short summary of the legal issues involved in the consolidated antitrust litigation can be found in a July 17, 2012 memorandum (here) from the Perkins Coie law firm.
In addition, as noted here, on July 6, 2012, plaintiffs initiated a separate antitrust action against a number of large banks, asserting antitrust claims as well as claims under the Commodities Exchange Act. The complaint in the action alleges that Barclays and several other banks conspired to artificially manipulate the reported Euribor rate, which, the complaint alleges is "the baseline interest rate used in the valuation of more than $200 trillion in derivative financial products." The complaint is filed on behalf of a class of persons or entities in the United States who purchased Euribor-related financial instruments between January 1, 2005 and December 31, 2009.
Beyond the antitrust litigation, there are reports that shareholders derivative actions have been filed against Citigroup and Bank of American directors and officers, although at this point I have not seen the complaints in these actions. (If any reader can provide me with copies of the complaints in these actions I will update this post with links to the documents.) UPDATE: Loyal reader Kari Timm of the Walker Wilcox Matousek firm has provided me with a copy of the Citigroup derivative suit, filed on June 6, 2012 in New York (New York County) Supreme Court against Citigroup, as nominal defendant, and the Citigroup board. The complaint, which can be found here, asserts a single count for breach of fiduciary duty.
Finally, as noted here, on July 10, 2012, litigants initiated a securities class action against Barclays and related entities as well as the bank's former CEO and Chairman. The complaint, which can be found here, is filed on behalf of class of persons who purchased Barclays ADRs between July 10, 2007 and June 27, 2012. The complaint alleges that the defendants participated in an illegal scheme to manipulate the Libor rates, and that the defendants "made material misstatements to the Company's shareholders about the Company's purported compliance with their principles and operational risk management processes and repeatedly told shareholders that Barclays was a model corporate citizen even though at all relevant times it was flouting the law."
Outrage over the manipulations and deceptions in the Libor scandal is at a fever pitch. Some commentators have called the revelations about Libor "the biggest scandal yet." Indeed, at least one observer, Rolling Stone's Matt Taibbi, is outraged that there isn't more outrage. The information that has surfaced to date does suggest that there almost certainly is a lot more to come on this issue. It seems likely that we are in for months if not years of periodic revelations and disclosures about misconduct at many of the participating banks.
There are good reasons for the outrage. Because of the role Libor has played in the global financial markets, the impact of the rate manipulations involved is enormous. Anytime you have a factor that affects transactions valued in the hundreds of trillions of dollars, even small deviations can have effects measured in the billions. Because of these kinds of figures, much of the press coverage and commentary about the Libor scandal has a sensational, sometimes almost apocalyptic tone.
There is no doubt that the dollars involved in the Barclays settlements helps to drive the sensational tone of much of the press coverage. After all, if Barclays, which took the initiative to cooperate with investors, wound up paying those kinds of amounts, what does that imply for the other banks involved in the investigations? It does seem probable that by the time this scandal plays itself out, there will be many more regulatory settlements, some of which might make the Barclays settlements look like pocket change.
A related issue that often follows is whether the banks' civil litigation exposures are also going to be similarly enormous. It is clearly far too early at this point to know for sure. But there are a number of factors that should be kept in mind before anyone jumps to conclusions that the Libor scandal represents a huge litigation event of the kind, for example, that followed the subprime meltdown and the credit crisis.
There are a variety of different countries around the world where litigation relating to the Libor scandal might be filed. However, the litigation forum of choice for any prospective litigant is the United States. The availability of contingent fees (and the absences of a loser pays regime), as well as the availability of discovery and jury trials, means that prospective litigants will want to file their claims in the U.S, if they can. But there are a host of impediments that might restrict the availability of a U.S. forum for many of the potential claims.
First of all, there are only three U.S. banks involved (Bank of America, Citigroup and JP Morgan Chase). All of the other Libor and Euribor participating banks are domiciled outside the U.S. Among other things, this means that a U.S. court is unlikely to be an available forum for many kinds of cases. For example, because of the "internal affairs doctrine," which provides that the courts of the country in which a corporation is domiciled should address issues concerning the governance of those companies, U.S. courts are unlikely to be attractive forum for shareholders' derivative suits against the Non-U.S. banks.
And while many of the Libor and Euribor participating banks are publicly traded, only some of them have shares or ADRs that trade on U.S. exchanges; the banks that do not have U.S. listed securities cannot be subject to a suit under the U.S. securities laws. Only a few of the banks caught up in the scandal could even potentially subjected to a securities suit in the U.S. relating to the Libor scandal.
There are some even more basic issues affecting the banks' potential liabilities. The most important of these is the complicated ways that financial market participants were affected by the rate manipulation. Among other things that should be kept in mind is the fact that the banks involved were not the only ones that benefited from the rate manipulation. For example, in the May 2008 Wall Street Journal article that first tried to quantify the extent of the rate manipulation, the paper noted that if Libor were understated as much as it appeared to be, the reduction "would represent a roughly $45 billion break on interest rate payments for homeowners, companies and investors over the first four months of this year." Of course, investors whose interest income was reduced by the rate reductions experienced losses of a comparable magnitude.
Many marketplace participants likely experienced both of these effects from the manipulation of Libor. As noted in a July 17, 2012 Reuters article entitled "Funds May Have Won and Lost in Libor Scandal" (here), most of the institutional investors that potentially might assert Libor-related claims both paid interest and collected interest at rates determined by Libor. And to further complicate things, many of these same investors also participated in comprehensive interest rate hedging strategies. As one commentator quoted in the article says, "If they hedged themselves, there might not be any provable loss." Of course, there may be other participants where the calculation of loss is more straightforward (for example, the community banks). For many prospective claimants who claim harm directly as a result of the interest rate manipulation, the damages calculation could be very complicated.
Another practical constraint that may affect a prospective claimant is that even if the Libor manipulation damaged them, the claimant may have no direct commercial relationship with the banks that did the manipulating. For example, if I bought an interest rate paying investment from, say, Vanguard, and I believe that I lost interest income because Libor was suppressed, I am going to have a very hard time asserting a claim against the banks that manipulated Libor, since I have no direct commercial relationship them. To put this constraint in the context of the pending antitrust litigation, there is a legal principle that is part of the U.S. antitrust law called the Illinois Brick doctrine. This doctrine basically says that indirect purchasers of goods and services cannot assert antitrust claims. In other words, potential claimants who cannot show that they purchased goods or services directly from the Libor participating banks may find it difficult to assert antitrust claims against them.
Another consideration should be taken into account before anybody jumps to the conclusion that the Libor scandal is going to be a cataclysmic litigation event. That is, the universe of potential defendant companies is finite and relatively small. There are a defined number of identifiable banks that were involved in setting the benchmarks. It is always possible that entrepreneurial plaintiffs' lawyers will find a way to expand the list of target defendants beyond the roster of benchmark participating banks, but absent some creative development along those lines, the list of potential litigants is limited to a specific pool of large banks. To be sure, these banks could be sued over and over again, but what is not going to happen is that there are not going to be hundreds and hundreds of different companies dragged into litigation, the way so many companies were in connection with the credit crisis litigation wave and even the options backdating scandal.
All of that said, there is going to be a lot more private civil litigation to come. Which in turn raises the question of what all of this might mean from an insurance perspective. First of all, and in light of all of the foregoing considerations, it seem unlikely that the Libor scandal is going to become a massive, market changing event for the D&O insurance industry. It undoubtedly will have a significant impact, particularly among those carriers that were most involved in providing insurance to these large banking institutions. But taken in the aggregate, the Libor scandal litigation may not produce as big of an impact as other recent scandals.
Among other things, many of the undoubtedly huge costs that are looming likely will not represent insured amounts. The regulatory fines and penalties will not be insured. The company investigative costs also are likely not covered. In addition, most of the antitrust litigation filed to date has named only corporate defendants. Under the typical D&O insurance policy, the companies themselves are only insured for securities claims. So the antitrust litigation, for example, would likely not be covered under the typical D&O insurance policy.
Any shareholders derivative litigation potentially would be covered under most D&O insurance policies, but there is a limited universe of potential defendant companies that can be sued in U.S. in derivative suits in the U.S. There is always the possibility of private civil litigation outside the U.S. but based on historical patterns that possibility is somewhat less likely and represents a diminished threat as well.
Perhaps the most interesting question is whether or not there will be further securities litigation, which if filed would likely fall within scope of coverage of most D&O insurance policies. The extent of securities litigation may determine how big of an event this is for the D&O insurance industry. As noted above only some of the banks potentially involved in the Libor scandal have shares or ADRs that trade in the U.S., and so it is possible that the securities litigation arising from the scandal may not be that extensive.
A further consideration that may diminish the potential impact of this scandal on the D&O insurance industry is the fact that many of these large banks do not carry traditional D&O insurance or may only have restricted insurance. Because of extensive prior losses in the industry, the availability of D&O insurance for these kinds of banks is restricted, and for some of the banks may not even be available at commercially acceptable prices. In some instances, the banks' insurance may include a substantial coinsurance percentage or a massive self-insured retention. Other banks may only carry so-called Side A only insurance, which covers individual directors and officers only and is only available when the corporate entity is unable to indemnify the individuals due to insolvency or legal prohibition. Given that none of the potentially involved banks have failed, it seems unlikely that this Side A only coverage would be triggered.
All of these considerations make me think that in the end, the Libor scandal may not prove to be a significant event for the D&O insurance industry. Of course, events could prove me wrong. The plaintiffs lawyers may come up with creative ways to expand the universe of defendants, or claimants may meet with unexpected success in asserting claims outside the U.S. If these kinds of things were to happen, then the Libor scandal could prove to be a more serious event for the D&O insurance industry. But as things stand, I do not believe this scandal is the kind of thing that is, by itself, going to change the market.
The question of what the impact on the D&O insurance industry will be is a different question that what the overall magnitude of this event will turn out to be, outside of the insurance context. Time will tell of course, but on this question of the scandal's broader impact, I think we will see some very substantial regulatory fines and penalties and we will also see some very sizeable litigation settlements.
The one thing I know for sure is that this scandal will continue to unfold in the months and even years to come. And on that score, as a blogger, I would like to express my heartfelt thanks to the financial services industry. I have been blogging now for close to seven years, and it seems like every time I feel I am running out of things to write about, the financial services industry will serve up yet another outrageous set of circumstances that sets off a media scrum and yet another wave of litigation. This latest scandal seems likely to provide me with worthy blog fodder for quite a while. So a very special tip of the blogging hat to the financial services industry. I don't know what I would do without you guys.
On Summer and Time: For those of you who have not yet seen my recent post about Pentwater, Michigan, I would like to urge you to take a minutes and read my article - or at least look at the pictures and read the many comments from readers. If you have already seen the post, please send along a link to the article to a friend. The post, which you might have missed because it came out right around the July 4th holiday, can be found here. Thanks to everyone who posted a comment and to the many readers who have sent me notes about the post.
Read other items of interest from the world of directors & officers liability, with occasional commentary, at the D&O Diary, a blog by Kevin LaCroix.
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