Alternative Benchmarks for Use in Litigation
in Light of LIBOR’s End
Appraisal and litigation support professionals consider various rates to use as part of a financial model, including LIBOR. Near the end of July 2017, British banking regulators made waves in the business world by announcing the end of the London Interbank Offered Rate, or LIBOR, by the end of 2021. LIBOR’s end will mean the loss of a financial benchmark that is not only ubiquitous in commerce, but a valuable tool in creating discount rates in financial litigation. Fortunately, the Alternative Reference Rates Committee (ARRC), organized by the Federal Reserve, has already identified alternative benchmarks, which should prove helpful as substitutes in creating damages models after LIBOR becomes unavailable.
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Near the end of last month, British banking regulators made waves in the business world by announcing the end of the London Interbank Offered Rate, or LIBOR, by the end of 2021. LIBOR’s end will mean the loss of a financial benchmark that is not only ubiquitous in commerce, but a valuable tool in creating discount rates in financial litigation. Fortunately, the Alternative Reference Rates Committee (ARRC), organized by the Federal Reserve, has already identified alternative benchmarks, which should prove helpful as substitutes in creating damages models after LIBOR becomes unavailable.[/su_pullquote]
In the wake of the 2008 financial meltdown, widespread manipulation of LIBOR was discovered, and numerous high-level banks became embroiled in the scandal. Additionally, LIBOR itself became suspect as a benchmark once it became clear banks were falsifying their interest rate submissions, which were in turn used to calculate LIBOR. For example, a bank might submit a lower interest rate than it had actually obtained in order to give the impression it was more creditworthy, or a higher interest rate to profit off of its own loans that used LIBOR as a benchmark. Until these problems surfaced, LIBOR had been widely relied on for commercial transactions, especially in crafting variable interest rates, and also served an important role in damages models for litigation purposes. For example, it can be used to derive a discount rate to apply towards future economic damages, and it can be used to calculate prejudgment interest for damages that had occurred prior to a judgment being entered.
While efforts were made to reform LIBOR, the damage was done. Banks grew reluctant to make the types of loans that served as underlying data for LIBOR, further undermining LIBOR’s reliability as a benchmark. It became clear LIBOR would no longer be a suitable benchmark for interest rates, despite its previous widespread use. Accordingly, on July 27, 2017, British regulators announced that LIBOR would be eliminated at the end of 2021. Jones, Huw, Britain to Scrap LIBOR Rate Benchmark from End of 2021, July 27, 2017, https://www.reuters.com/article/us-britain-regulator-libor-idUSKBN1AC18L.
The question facing anyone who has relied on LIBOR becomes, what can be used as a substitute benchmark? For financial litigation, this means after 2021, a new figure will be needed for use in calculating discount rates. In its efforts to find an alternative to LIBOR, the ARRC has provided at least two possibilities to consider: one based on repurchase agreements (repos), typically involving Treasury-based collateral, that offers a wide range of underlying trade activity, and another, based on overnight lending between banks, that can serve as a proxy for a risk-free rate.
After the problems related to LIBOR and its reliability as a benchmark became apparent, the Federal Reserve convened the ARRC, made up of representatives from key participants in the banking industry, on November 17, 2014. It assigned them the task of recommending a new benchmark. One specific guideline the ARRC was given was to search for “appropriate risk-free rates as alternatives to LIBOR.”  ARRC, 12/12/14 Meeting Minutes, https://www.newyorkfed.org/medialibrary/microsites/arrc/files/2015/Dec-12-2014-ARRC-Minutes.pdf.
The ARRC quickly focused on two possible benchmarks. ARRC, 4/2/2015 Meeting Minutes, https://www.newyorkfed.org/medialibrary/microsites/arrc/files/2015/April-2-2015-ARRC-Minutes.pdf. The first candidate, a benchmark based on overnight repos, would have the advantage of capturing a broad range of instruments, giving it flexibility to adapt to future market changes. Ibid. The second was an overnight bank funding rate. Because only creditworthy banks could make these types of loans, it could better represent a risk-free rate of interest. Ibid. The ARRC later identified a specific rate that could serve as this second benchmark: the Overnight Bank Funding Rate (OBFR), which the New York branch of the Federal Reserve has begun publishing. ARRC, 1/28/2016 Meeting Minutes, https://www.newyorkfed.org/medialibrary/microsites/arrc/files/2016/Jan-28-2016-ARRC-Minutes.pdf. In comparing the repo-based benchmark and the OBFR, the ARRC recognized a trade-off between a robust, flexible benchmark as offered by a repo-based rate, and a benchmark best reflecting a risk-free rate, as offered by the OBFR. ARRC, 4/2/2015 Meeting Minutes.Â
On May 20, 2016, the ARRC issued an Interim Report confirming its focus on two main candidates for an alternative benchmark: the OBFR and the repo-based benchmark, which they more narrowly defined as an overnight Treasury “general collateral” repo rate (the GC Repo Rate). In its report, the ARRC noted the clear benefit of using a risk-free rate as a benchmark instead of LIBOR: it would “reduce the incentive to manipulate rates that include bank credit risk.” ARRC, Interim Report and Consultation (Interim Report), May 20 2016, pg. 6, https://www.newyorkfed.org/medialibrary/microsites/arrc/files/2016/arrc-interim-report-and-consultation.pdf?la=en, citing Financial Stability Board, Reforming Major Interest Rate Benchmarks, July 2014, Section III.C, Page 11.
Overnight unsecured lending rates like the OBFR have the benefit of consistent activity; in fact, the OBFR includes data from over 150 banks in the U.S., and captures a volume of about $300 billion in daily transactions. Interim Report, pg. 15. In addition, unlike other rates published by the Federal Reserve, the OBFR is not a target rate, and is therefore insulated from its monetary policy decisions. The GC Repo Rate, on the other hand, was based on an underlying market of repo agreements secured by Treasury assets, as well as others that are “accepted as collateral by the majority of intermediaries in the repo market.” Ibid, pg. 17–18. At the time of the Interim Report, the ARRC had not yet identified whether bilateral repo transactions would be included in deriving the GC Repo Rate, or only tri-party transactions involving a clearing bank. Ibid, pg. 18. However, it did note that this market was robust, had a high trading volume, and enjoyed wide use among market participants, all of which would help it serve as a data source for the GC Repo Rate. Ibid, pg. 17.
In its Interim Report, the ARRC rejected other possible benchmarks, including policy rates like the effective federal funds rate (because of its ties to monetary policy), Treasury rates (because while there is a robust Treasury market, it could be distorted in times of economic distress when investors flocked to Treasuries), and term unsecured lending rates (because they share many of LIBOR’s problems, including an unstable market and a limited transaction volume). The ARRC used several accepted principles for benchmark selection in narrowing its candidate list to the OBFR and the GC Repo Rate, including liquidity, transaction volume, and resilience to change based on illiquidity, regulatory action, or a change in monetary policy. Interim Report, pg. 13–14.
Soon after the Interim Report was issued, the New York branch of the Federal Reserve announced its plans to publish three different rates related to overnight repo transactions collateralized by Treasury securities, any of which could be used by the ARRC as its GC Repo Rate. ARRC, 12/1/2016 Meeting Minutes, https://www.newyorkfed.org/medialibrary/microsites/arrc/files/2016/ARRC-Dec-1-2016-meeting-minutes.pdf. Each rate built upon the next by adding a wider range of transactions: the first two focused on tri-party trades, while the last included “the Federal Reserve’s overnight open market operations in the repo market.”  Federal Reserve Bank of New York, Operating Policy—Statement Regarding the Publication of Overnight Treasury GC Repo Rates, November 4, 2016, https://www.newyorkfed.org/markets/opolicy/operating_policy_161104. The New York branch of the Federal Reserve expressed hope that this market-driven approach of seeking “arms-length” transactions to derive a rate would create greater transparency in the repo market. Altman, Alexander, et al., Investigating the Proposed Overnight Treasury GC Repo Benchmark Rates, Dec. 19, 2016, http://libertystreeteconomics.newyorkfed.org/2016/12/investigating-the-proposed-overnight-treasury-gc-repo-benchmark-rates.html.
Finally, on June 22, 2017, the ARRC recommended the GC Repo Rate instead of the OBFR as an alternative benchmark to LIBOR, based upon the broadest rate that the New York branch of the Federal Reserve is planning to publish. ARRC, The ARRC Selects a Broad Repo Rate as its Preferred Alternative Reference Rate, June 22, 2017, https://www.newyorkfed.org/medialibrary/microsites/arrc/files/2017/ARRC-press-release-Jun-22-2017.pdf. The ARRC based this selection on “the depth of the underlying market and its likely robustness over time, the rate’s usefulness to market participants,” and whether the rate’s characteristics met with accepted principles for financial benchmarks, as outlined in its Interim Report. Ibid.
Unlike the rates initially proposed by the New York branch of the Federal Reserve, which only included tri-party transactions, the GC Repo Rate will also be derived from cleared bilateral repo transactions. Federal Reserve Bank of New York, Operating Policy—Statement Regarding the Publication of Overnight Treasury Repo Rates, May 24, 2017, https://www.newyorkfed.org/markets/opolicy/operating_policy_170524a. To prevent the benchmark from being distorted by bilateral “specials transactions” made to acquire specific securities rather than the most competitive return, a “trimming mechanism” will be used to limit their influence by removing outlier trades from the underlying data. Bowman, David, et al., The Cleared Bilateral Repo Market and Proposed Repo Benchmark Rates, February 27, 2017, https://www.federalreserve.gov/econresdata/notes/feds-notes/2017/cleared-bilateral-repo-market-and-proposed-repo-benchmark-rates-20170227.html. Despite the need for this measure, bilateral transactions will be included in the GC Repo Rate because they make it more robust by including a greater range of market activity and increasing the volume of underlying transactions supporting it. Bayeux, Kathryn, Introducing the Revised Broad Treasuries Financing Rate, June 19, 2017, http://libertystreeteconomics.newyorkfed.org/2017/06/introducing-the-revised-broad-treasuries-financing-rate.html.
Both the GC Repo Rate recommended by the ARRC and the alternative it considered, the OBFR, appear to be suitable benchmarks, which are critical in financial litigation because a rate used for either prejudgment interest or discounting future economic injury, such as lost profits, must be found appropriate by the court. JTH Tax v. H&R Block E. Tax Servs., 245 F.Supp.2d 749, 753-54 (E.D. Va. 2002). In JTH Tax, the court noted there was “no clear formula” for finding the right discount rate, but indicated a general approach that compares a proposed discount rate to a return earned by the “best and safest investments.”  Ibid, pg. 753, quoting Chesapeake & Ohio R. Co. v. Kelly, 241 U.S. 485, 491 (1916). The court further discussed the underlying financial instruments that could be used to calculate a discount rate, but continually returned to the concept of a “safe investment.”  Ibid, pg. 753–54; see also Abernathy v. Superior Hardwoods, Inc., 704 F.2d 963, 973-74 (7th Cir. 1983) (saying that the proper discount rate for damages in a wrongful death claim is “the inflation-free, discount rate for riskless investments”). This suggests a court would prefer a benchmark reflecting a “risk-free” rate, such as the OBFR, over the GC Repo Rate recommended by the ARRC. However, the fact that a discount rate should reflect the “best and safest investments” means the GC Repo Rate, based on a robust repo trade, can also serve as a reliable tool in creating a discount rate.
In the past, LIBOR could conveniently be used as a benchmark, including in damages models, due to its ubiquitous use in commercial transactions. Although after 2021 it will no longer be available, the work done by the ARRC should prove helpful to financial litigation consultants, who can either use the GC Repo Rate, or the OBFR that was also thoroughly considered by the ARRC. Of course, they would not be strictly limited to either benchmark. As CBRE Group recently noted, there are numerous other liquid, transparent markets involving short-term securities that could also be used to derive an alternative benchmark to LIBOR. CBRE, U.S. Marketflash—Goodbye LIBOR, July 28, 2017, https://www.cbre.com/research-reports/US-MarketFlash-Goodbye-LIBOR. Ultimately, any alternative benchmark would be “almost identical to LIBOR in mathematically determining” a floating rate of interest. Ibid. Put another way, the work involved in deriving a discount rate is similar regardless of the benchmark used, whether it is LIBOR or an alternative. The key is that the benchmark should have a quality underlying market, including high liquidity, sufficient transaction volume, and a resilience to change. ARRC, Interim Report, pg. 14.
The planned elimination of LIBOR presents problems for financial litigation in that a new benchmark will be needed for use in damages models. The ARRC, in recommending the GC Repo Rate, should alleviate this problem. Its strength lies in the wide range of underlying transactions it includes, and it appears to be a robust benchmark, given the frequency and volume of the trades it will be derived from. Alternatively, the OBFR, now being published by the Federal Reserve, provides a public, inexpensive source of a risk-free rate. Accordingly, either benchmark could potentially serve as an effective LIBOR substitute. The ARRC’s actions should continue to be observed to see what is ultimately implemented as a new benchmark, but its work so far can be utilized to prepare oneself well in advance of LIBOR’s demise.
Steven A Migala is a partner with Lavelle Law, LTD, a Chicago and Schaumburg, IL-based law firm. Mr. Migala focuses on banking, estate planning, corporate law, and real estate. He earned a JD from the University of Illinois College of Law, magna cum laude; and a BS from Bradley University, summa cum laude, Finance. Possessing over 20 years of experience representing banks, businesses, and their principals, he strives to offer quality recommendations and practical advice at reasonable rates. Mr. Migala brings a passion to his work and a commitment to excellence regardless of the size of the client or scope of the matter.
Mr. Migala can be reached at (847) 705-7555 or by e-mail to Smigala@Lavellelaw.com.
