From Richard Farley, Leveraged Finance partner at lawyers Paul Hastings
Last Friday, Britain’s top financial regulator, Martin Wheatley of the Financial Services Authority, issued his final report with recommendations for the comprehensive reform of the scandal-ridden LIBOR setting process. Rather than recommending the replacement of LIBOR with other benchmark alternatives, Wheatley has wisely determined that LIBOR should be preserved and recommended a number of necessary changes to the external regulatory structure for LIBOR, the governance and oversight of the LIBOR determination process and to the rates themselves. The initial reaction to Wheatley’s thoughtful and comprehensive report has been positive. However, one of Mr. Wheatley’s recommendations – passing legislation to provide the FSA with the power to compel banks to make LIBOR submissions – should not be adopted absent legislation protecting the banks from the enormous liabilities they are subject to from the acts of rogue traders who try to manipulate LIBOR for personal financial gain.
Mr. Wheatley has rightly pointed out that the more submitting banks there are for a LIBOR rate, the less chance of manipulation and the more robust the rate setting process will be. Accordingly, one of his recommendations is to encourage banks to participate as widely as possible in the LIBOR compilation process. A problem Mr. Wheatley rightly anticipates is that many banks, facing billions in claims in the ongoing rate-fixing scandal, are having a difficult time justifying to their boards of directors and shareholders continuing participation in a rate setting process that generates negligible revenue to the bank.
LIBOR rates are estimated to be reference rates for approximately $300 trillion in financial transactions. Analysts have estimated bank exposures to class action lawsuits in the current scandal to be as high as $35 billion. This is over and above the regulatory fines that have been imposed and will continue to be forthcoming. Last month, Barclays paid £290 million to settle claims with U.K. and U.S. regulators. Many insurance companies that cover the liability exposures to banks and their employees have indicated that they may exclude LIBOR-setting exposures from new policies going forward.
Mr. Wheatley’s recommendation to simply legally compel participation is the wrong approach. Like it or not, banks that participate in the LIBOR setting process do so effectively as a public service to the financial markets. They certainly benefit from this public service but so do many more market participants – including tens of millions of borrowers. The preservation of LIBOR and robust participation by banks in its compilation are important goals, but the risk of bad actors manipulating it cannot fall exclusively on the shareholders and boards of directors of the banks.
As a companion proposal to Wheatley’s compulsory participation recommendation, the British parliament – and the U.S. Congress – should limit the liability the banks are exposed to for setting LIBOR, either by raising the legal standard of culpability – to say, acts of willful misconduct by senior bank supervisory officials – and/or instituting monetary damages caps. Similar approaches have been taken in the past with respect to vaccine makers, who when facing massive damages awarded in the 1980s from a relatively small number of injuries threatened to stop producing vaccines unless some limitation on damages was implemented. This approach would not reduce any of the criminal or civil liability consequences to the wrongdoers themselves who should face severe consequences. But as long as the banks are in substantial compliance with the code of conduct and other procedures that will be forthcoming in the new LIBOR regulations, they should be entitled to reasonable protection in exchange for participating in the LIBOR compilation process.
If financial history teaches us anything, it is that rogue traders have always and will always be a menacing fact of life for financial institutions. No matter how rigorous controls and best practices may be, bad actors will find a way to circumvent them. While banks should bear some responsibility for the acts of employees, even when performing a public service function, that responsibility should not be disproportionate. With LIBOR, compelling banks to take on the risk of astronomical damage claims is unacceptable and unfair.
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Richard Farley is a partner in the Corporate practice of Paul Hastings and is based in the firm’s New York office. Mr. Farley has extensive experience in complex syndicated loan and high-yield debt financings.