Never before has a rating agency been found to owe a
duty of care to investors. But that all changed when the Federal
Court found Standard & Poor's had engaged in misleading and
deceptive conduct and was liable for investors'
In Bathurst Regional Council v Local Government Financial
Services Pty Ltd (No 5)  FCA 1200, the Court ruled that
a rating agency may have a duty of care to investors where there is
no reasonable basis for issuing a rating or there are significant
flaws in the methodology used to produce a rating.
The decision is a good result for investors globally. Rating
agencies can no longer always rely on the conventional view that
they are free from a duty of care. It may drive wholesale changes
to the way agencies analyse and rate investments, with more
rigorous and independent due diligence a likely and desirable
In 2006 ABN AMRO created a complex, highly leveraged financial
product known as the "CPDO" (but marketed as
"Rembrandt" notes). The CPDO was to operate for 10 years
over which time it would make a profit or loss as a result of
notional credit default swap contracts.
S&P was tasked with rating the CPDO. It did so, but using
only the information provided by ABN AMRO. Without seeking any
further documentation or information, S&P gave the CPDO a
prestigious AAA rating.
Thirteen local councils in NSW invested A$16 million in
Rembrandt notes through financial adviser, Local Government
Financial Services Pty Ltd (LGFS), which had itself purchased A$45
million of the highly leveraged notes.
But in 2007 the value of Rembrandt notes went into freefall. By
the time the councils cashed out the notes in late 2008 their value
was one-tenth of what it had been. (Once the price dropped below
10% of the original outlay, it triggered an automatic
The councils brought proceedings against LGFS (as the agent that
facilitated the purchase), ABN AMRO (the creator of the financial
products) and S&P (as the agency that originally rated the
financial products AAA).
DUTY OF CARE AND MISLEADING AND DECEPTIVE CONDUCT
Until Bathurst courts globally had been reluctant to
find rating agencies liable for investor losses. The reasons were
explained in Wingecarribee Shire Council v Lehman Brothers
Australia Ltd (in liq)  FCA 1028 (which was handed down
shortly before Bathurst).
In Wingecarribee the Court ruled that the typical
investor makes a range of investments based on recommendations
given by financial advisors. Even though those financial advisors
may be relying on the rating given to financial products, the
rating agency cannot control the way the rating is used.
In Bathurst the court did not find the rating given was
worse than it should have been (or even that an alternative rating
should have been given), but instead found that there was a duty of
care owed to investors by the rating agency because there was no
reasonable basis for giving the rating that S&P assigned to the
The court further held that when S&P calculated and
disseminated its rating, its conduct involved the making of false
and misleading statements (as it did not have a reasonable basis
for making a AAA rating).
Bathurst is precedent that a ratings agency can owe a
duty of care to investors. This result is at odds with the current
position in the United States and the United Kingdom. However, with
litigation against rating agencies currently on foot or pending in
a number of jurisdictions around the world, including the US
Government's US$5bn action against S&P, there is a chance
that Bathurst may encourage other jurisdictions to impute
greater liability for the issuing of ratings.
The decision in Bathurst is one confined to the facts
of the case. The key message is that a court will not impute
responsibility for a rating simply because a financial product does
not provide a return (or in fact suffers loss). Bathurst
supports the finding of a duty of care only where the analysis
underpinning a rating is unreasonable.
In the wake of Bathurst, this duty will be a priority
concern for rating agencies, investment managers and the investment
banks that develop financial products. What's more, the due
diligence that is required to corroborate and verify the model used
to produce a rating is likely to be increased, regardless of the
ultimate outcome of any appeal.
Nevertheless, Bathurst should be a reminder to
investors in financial products that they must carry out their own
thorough due diligence.
The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.
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In the years following the global financial crisis of 2008 many Australian investors lost their life savings as financial products failed and the Australian Stock Exchange shed over 3,000 points.
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