The Australian Federal Court has this week delivered a landmark first instance judgment which holds a credit rating agency liable for the first time (among other things) for the negligent AAA rating of a structured financial product.
In Bathurst Regional Council v Local Government Financial Services & Ors (No 5)  FCA 1200, the court held that 13 local councils were entitled to be compensated for their estimated A$30 million losses arising out of their investment in Rembrandt notes, comprising constant proportion debt obligations (CPDOs) arranged by ABN Amro, rated AAA by Standard & Poors (S&P), and marketed and sold to them by the financial advisory business, Local Government Financial Services (LGFS). These defendants were held liable in equal measure on various grounds for misrepresenting, mis-rating and mis-selling the CPDOs.
The decision comes almost six years after the onset of the credit crisis, which coincides with the expiry of the limitation period which typically applies to claims in negligence. As a consequence, it is likely the decision will in the near future result in a spate of copy-cat claims in Australia, and very possibly elsewhere. S&P warned the court in its ultimately unsuccessful trial submissions that holding S&P liable for what it characterised as its opinion rather than advice would result in "a flood of claims by disappointed investors". Unsurprisingly, S&P has said it will appeal.
BACKGROUND & DECISION
Insofar as it is relevant for the purpose of this note (which focuses on the rating agency aspects of the decision), S&P were retained by ABN Amro to rate the CPDOs, which S&P proceeded to do using a financial model provided to S&P by ABN Amro.
S&P was found to have used unjustified and unreasonably optimistic assumptions for some of its inputs for the modelling of the CPDOs' performance, which produced a AAA rating. Had they been eliminated or properly stress-tested, the modelled performance of the CPDOs would have changed from AAA to sub-investment grade (ie below BBB). In those circumstances, the Councils would have been prevented by law from investing. There was ample evidence that S&P knew ABN Amro had engaged it to provide a credit rating for the very purpose of communicating it to potential investors and that S&P's expert opinion of the creditworthiness of the CPDOs was intended to be relied upon by those investors, particularly those who were restricted to investing in products rated at or above a certain level, such as the claimant Councils.
Further, the Councils were found, following the earlier decision of the Federal Court in Wingecarribee Shire Council v Lehman Brothers Australia Ltd (in liq)  FCA 1028, to have been unsophisticated investors who were unable to "protect themselves from the consequences of [S&P's] reasonable care" because they did not have the "resources or expertise to assess creditworthiness or to second-guess the rating of a structured financial product" (read our report on Wingecarribee here). It is noteworthy that Jagot J thought the CPDOs were "grotesquely complex."
As a consequence, Jagot J held (among other things) that S&P:
- owed a duty of care to potential investors who were vulnerable in the sense that they were unable to assess the creditworthiness of the CPDOs or to second-guess S&P's AAA rating of the same, which included the Councils;
- breached that duty because S&P's analysis was "fundamentally flawed, unreasonable and irrational in numerous respects" and comprised "failures of such a character that no reasonable ratings agency exercising reasonable care and skill could have committed in the rating of the CPDOs"; and
- was liable (together with ABN Amro and LGFS, for other reasons) to compensate the Councils for the loss they had suffered by investing in the CPDOs, which had performed badly and well below the standard expected of a AAA investment, rejecting out of hand that the global financial crisis was the "real, essential or effective cause of the loss".
Jagot J's judgment, which fills several hundred pages, is significant because of Her Honour's findings about the obligations of a rating agency to investors with whom they have no contract (they are usually hired and paid by the arranger), and to whom their advice or opinions are not addressed (they typically provide their ratings advice or opinions to the relevant issuer of the financial product concerned). The device used to overcome these difficulties was to impose a duty of care for the reasons referred to above and to characterise the rating as the making of a representation. While this creates a precedent under Australian law, which will no doubt be called in aid by similarly situated claimants in future cases there, it swims against the tide of decisions and legal principle in other common law jurisdictions.
In the various European cases which have been brought, and under English law, the disclaimers of liability which usually accompany credit ratings are typically applied and upheld, in the absence of contrary legislation, so as to deprive an investor of the ability to pursue a negligence claim. The underlying logic for this is that an investor cannot claim to have relied upon a credit rating (and thus to be owed a duty of care) where a valid exclusion of liability provision states that they may not do so and recommends they take independent financial advice before investing.
Jagot J considered the disclaimers relied upon by S&P were not effective because she was not satisfied adequate steps had been taken to bring them to the attention of investors. It remains to be seen whether European or English courts would be prepared to adopt a similar position, particularly given the clear and unambiguous terms of most disclaimers and any applicable regulatory requirements for those marketing or selling financial products to bring all material information to the attention of would-be investors, particularly unsophisticated investors such as the claimant Councils.
There is also a threshold question which has yet to be answered under English law, but which has been addressed in the United States, as to whether a credit rating constitutes advice or an opinion. Whereas the former is actionable where the advice is negligent, the argument goes that the latter is not. In a number of US cases, credit rating agencies have successfully established that their ratings are in the nature of an opinion as to the creditworthiness of a transaction, in respect of which they enjoy the right of free speech and First Amendment protection under the US Constitution.
Jagot J rejected this characterisation (ie the dichotomy between advice and opinion) and held that the assignment of a AAA credit rating carried with it a "representation that S&P has a genuine and reasonable basis, formed following the application of its expertise, for reaching the conclusions that it reached..." The US position aside, where constitutional arguments apply, it is questionable whether English law would impose liability for an opinion which can be construed as the making of a representation, without also considering the effectiveness of accompanying disclaimers of liability.
This decision is being pored over by the credit rating agencies, their lawyers, myriad regulators and countless aggrieved investors all of whom are pondering the question whether the decision of the Australian Court will survive an appeal and if so, and perhaps in any event, followed in future claims against rating agencies. Media reports suggest that many such cases are planned in Europe, the UK and the US.
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