Culture Wars: Rate Manipulation, Institutional Corruption, and the Lost Normative Foundations of Market Conduct Regulation

• Publication year: 2013

SEATTLE UNIVERSITY LAW REVIEWVolume 37, No. 2, Winter 2014

Culture Wars: Rate Manipulation, Institutional Corruption, and the Lost Normative Foundations of Market Conduct Regulation

Justin O'Brien (fn*)

ABSTRACT

The global investigations into the manipulation of the London Interbank Offered Rate (Libor) have raised significant questions about how conflicts of interest are managed for regulated entities contributing to benchmarks. An alternative framework, which brings the management of the rate process under direct regulatory supervision, is under consideration, coordinated by the International Organization of Securities Commissions taskforce. The articulation of global principles builds on a review commissioned by the British government that suggests rates calculated by submission can be reformed. This paper argues that this approach is predestined to fail, precisely because it ignores the lessons of history. In revisiting the initial framing for market conduct regulation, this paper illuminates the lost normative underpinnings of the disclosure paradigm. By exploring the shadows of the past, it provides an essential guide for how to fix the legitimacy crisis engendered by the Libor scandal.

I. Introduction ....................................................................................... 376

II. James M. Landis and the Administrative Process ............................ 386

A. The Rationale for Intervention in Capital Markets ....................... 389

B. The Normative Foundations of the Disclosure Paradigm.............393

C. The Legitimacy of the Administrative Process.............................397

III. The Commodification and Corruption of Knowledge....................406

IV. Regulating Culture..........................................................................413

V. Conclusion.......................................................................................421

I. INTRODUCTION

The manipulation of the London Interbank Offered Rate (Libor) and associated benchmarks has far-reaching consequences for the financial institutions involved and for the integrity of the regulatory regimes charged with their oversight. The scandal derives from pervasive and widespread collusion between traders and those responsible-in major banks-for submitting hypothetical rates at which individual banks could raise financing. When aggregated by Thomson Reuters, those rates produce a daily benchmark interest rate. This rate is then used to benchmark trillions of dollars of derivative contracts in the over-the-counter (OTC) marketplace. The misconduct, designed to facilitate trading positions, as well as to create the erroneous impression of the health of individual banks, corrupted the market. To date, three major banks-Royal Bank of Scotland (RBS), Barclays in the United Kingdom, and the Swiss-domiciled UBS-have reached settlements with regulatory authorities in the United States, the United Kingdom, Japan, and Switzerland, with the cumulative fine standing at $2.6 billion dollars. These settlements mark the start rather than the conclusion of the process. An investigation in Singapore implicated major U.S. banks in attempts to manipulate the Singapore Interbank Offered Rate (Sibor). It is, therefore, only a matter of time before regulatory attention crosses the Atlantic to Manhattan.

The ongoing litigation risk cascades outwards from civil and criminal enforcement to individual and institutional class action claims. The structural and reputational risks are just as significant. Six years after the August 2007 onset of the global fiancial crisis, with the vaporization of the securitization market, regulatory authorities across the globe remain mired in crisis management. Within that timeframe, we have moved progressively from a rubric of "too big to fail" to a dawning recognition that systemically important financial firms are not only too big to manage and regulate but also too big to litigate effectively against. This recognition comes through most notably in the caustic and incisive questioning of Senator Elizabeth Warren.(fn1) We are now at a paradigmatic tipping point. Given Libor's pricing implications for the OTC marketplace as the key floating rate benchmark, has it become too big to change? This remains very much an open question.

British regulatory authorities maintain that Libor and submission-based benchmarks can be reformed. In sharp contrast, the United States is much more wary of reliance on the judgments of individual bankers. The chair of the Commodity Futures Trading Commission (CFTC), Gary Gensler, is cognizant of the need for an urgent replacement to Libor "to restore market integrity and promote financial stability."(fn2) As he put it in a recent interview with the Financial Times, "A benchmark that becomes untethered [from reality] becomes vulnerable to all sorts of misconduct. . . . It's best that we not fall prey to accepting that Libor or any other benchmark is too big to replace."(fn3) The Financial Stability Oversight Council in the United States has provided strong support for this proposition. This umbrella network of financial regulators has demanded a transition to an observable transaction framework, as a matter of urgency.(fn4) The interventionist agenda reflects the renewed power of the United States Department of Justice to frame financial regulation discourse, a position it last accrued in the immediate aftermath of the passage of the Sarbanes-Oxley Act in 2002.(fn5) Given its centrality in leading an international investigation that to date has seen the imposition of $2.6 billion in fines against three leading banks-RBC, Barclays, and UBS-the Department of Justice's emphasis on retribution, accountability, and punishment matters as much as the development of fair, effective, and efficient markets.(fn6) The renewed emphasis on criminal prosecutions, albeit against foreign subsidiaries, stands in marked contrast to the lack of criminal indictments in relation to unethical and dubious conduct exposed by the financial crisis. This can be traced, in part, to public outrage over the statute of limitations precluding holding those responsible to account for their actions and, in part, to the simplicity and blatant nature of the Libor deception. The Libor investigation, which remains at an early stage, has exposed systematic and pervasive corruption in the rate-setting process. Recent investigations uncovered systematic false reporting and manipulations of reference rate submissions dating back many years. This misconduct was designed to either increase the potential profit of the submitting firms or to convey a misleading picture of the relative health of the submitting banks. These actions were pervasive, occurred in multiple bank locations around the world, involved senior bank officials at several banks, and affected multiple benchmark rates and currencies, including LIBOR, EURIBOR, and the Tokyo Interbank Offered Rate (TIBOR). Each of the banks that faced charges engaged in a multi-year pattern of misconduct that involved collusion with other banks. These revelations have undermined the public's confidence in these benchmarks.(fn7)

The paucity of institutional memory in leading banks, the fact that manipulation continued even after bailouts, and a baleful reality of continued compartmentalized responsibility have made business ethics appear to be little more than an oxymoron.(fn8) As the investigation moves inexorably towards the major Wall Street banks involved in these accountability deficits, debates are likely to intensify, hence, in part, the movement in the United States towards a more radical approach.

In the United Kingdom, by contrast, a much more nuanced approach has been adopted, marked by an extensive consultation process (albeit one dominated by insiders).(fn9) Martin Wheatley, chair of the Financial Conduct Authority and an important figure in the regulatory redesign, is as critical as his counterparts in the United States of Libor's shortcomings. He has referred to it as "a broken system built on flawed incentives, incompetence [,] and the pursuit of narrow interests that are to the detriment of markets, investors[,] and ordinary people."(fn10) Critically, however, Wheatley concluded that Libor "can be fixed through a comprehensive and far-reaching program[] of reform. Although the current system is broken, it is not beyond repair, and it is up to us-regulators and market participants-to work together towards a lasting and sustainable solution."(fn11) This is a very dubious assumption.

There is no attempt in this policy calibration to change the normative foundations of the market. Instead, it is predicated on a continued belief that a re-ordering of technical rules and reliance on general principles will be sufficient. Without tackling the social norms of the market, however, the agenda is likely to privilege symbolism over substance. As this paper will show, such reasoning is a tactical and strategic mistake.

At its core the reform process, which envisages a gradual transfer towards observable transactions, is predicated on continued reliance on market participants to operate ethically within an ostensibly more rigorous system of oversight.(fn12) It does so because of an acknowledged fear that "a transition to a new benchmark or benchmarks would pose an un-acceptably high risk of significant financial instability, and risk...