United States: Tide Is Turning Against Credit Rating Agencies

Credit rating agencies ("CRAs") have been criticised for some time for their role in contributing to the global financial crisis, especially for assigning ratings to sub-prime structured finance instruments which did not reflect their true risk, and a number of claims have been made globally against CRAs. In November 2012, the Federal Court of Australia delivered a world-first judgment by ordering a CRA to pay damages for investor losses.

The first civil lawsuit by the US federal government against a CRA followed in February 2013. In light of these developments, it is expected that more claims against CRAs will follow, but it is almost six years since the start of the credit crisis and investors are running out of time under the applicable limitation periods to make claims. We report on the worldwide trends in relation to the claims against CRAs:

Australia: landmark decision Bathurst Regional Council v Local Government Financial Services Pty Ltd (2012)

In the first known decision of its type in the common law world, the Federal Court of Australia held that a CRA owes a duty of care to potential investors. Standard & Poor's ("S&P") AAA rating of certain investment products was held to be misleading and deceptive and involved negligent misrepresentations to investors. The Court held that a reasonably competent ratings agency could not have rated the products AAA in the circumstances. S&P and ABN Amro, together with another entity, were ordered to pay A$30 million in damages for losses caused to investors.

Background to the proceedings

S&P and ABN Amro were sued by investors for claims arising from the rating, sale and purchase of "Rembrandt notes", a type of structured financial product known as constant proportion debt obligations ("CPDO"). The products were "grotesquely complicated" financial instruments that were designed by ABN Amro Bank NV in April 2006.

ABN Amro engaged S&P to rate the CPDOs and sought an AAA rating. The Court found that in developing the product, ABN Amro had effectively "gamed" the model it knew S&P would apply to rate the CPDO. It also found that in engaging S&P, ABN Amro pressed S&P to adopt its model inputs as the basis for the rating. For example, S&P had not calculated the actual average volatility of the Globoxx (a global debt index), instead it followed ABN Amro's assertions. The actual average volatility should have been nearly double that asserted by ABN Amro.

S&P gave the CPDOs a rating of AAA and authorised ABN Amro to market the AAA rating to potential investors, which it did. The Local Government Financial Services ("LGFS") (an authorised deposit taking institution for local councils in New South Wales) purchased A$50 million of CPDO notes and sold approximately A$16 million of CPDO notes to 13 local councils in New South Wales.

The volatility emanating from the global financial crisis caused sustained spread widening, which was an inherent risk or quality of the CPDO products. This caused S&P to downgrade its rating of the CPDOs from AAA to BBB+ in February 2008. The councils ultimately received back less than 10% of the principal amount they invested and commenced proceedings, with the backing of IMF (Australia) Ltd ("IMF"), a litigation funder.

The Court's findings

In relation to the claims against S&P, the Court found, amongst other things, that:

  • Potential investors believed that a rating by an agency such as S&P represented the best available independent evidence of the risk of loss on the investment. Investors expected S&P to reach its opinion as the result of independent and objective processes
    • S&P's AAA rating conveyed representations to a class of potential investors that: in S&P's opinion the ability of the notes to meet all financial obligations was "'extremely strong"
    • S&P had reached its opinion based on reasonable grounds and as the result of the exercise of reasonable care
    • S&P knew that neither of the above representations was true at the time it was made. Even though S&P's rating was expressed to be an opinion, S&P's state of knowledge meant that it was still capable of being misleading and negligent
    • S&P's AAA rating was misleading and deceptive under the Corporations Act 2001
    • None of the disclaimers included in fine print by S&P erased the misleading nature of S&P's conduct. For example, they did not make it clear that S&P's rating was an opinion which did not have reasonable grounds and was not the result of reasonable care and skill - which would have been required
    • S&P owed the class of investors a duty of care. The very purpose of ABN Amro obtaining the rating was for dissemination to potential investors so they could rely on S&P's rating as S&P's expert opinion as to the creditworthiness of the notes
    • The investors were vulnerable and could not reasonably protect themselves from any lack of reasonable care by S&P in assigning the AAA rating
    • S&P breached its duty of care to potential investors in assigning the AAA rating because S&P did not have a reasonable basis on which to rate the products as AAA. Its analysis was fundamentally flawed, unreasonable and irrational in numerous respects
    • It did not matter that S&P could not have foreseen the global financial crisis because that was not the harm. The relevant class of harm was the cash-out of the notes caused by sustained spread widening. This class of harm was foreseeable; it was one of the two main anticipated risks inherent in the financial products

S&P has said that it intends to appeal the decision.

Potential implications of the decision

It was a combination of the specific circumstances in this case which led to the Court's significant findings. These included:

  • ABN Amro had been able to exercise real and substantial influence over S&P's rating process. S&P representatives had been "sandbagged" by the ABN Amro representative and had simply "bulldozed" the CPDO rating through
  • S&P adopted ABN Amro's assertions in the rating process, without making important calculations independently. Several of these assertions were severely inaccurate or inadequate

While the Court found S&P liable under Australia's misleading and deceptive conduct legislation, S&P was also held to have breached duties of care owed to the investors under common law principles of negligence which will be relevant to many other jurisdictions around the world.

Europe: claims in Germany and Italy but none yet in England

IMF has stated that it intends to approach investors in Europe (including in the UK, Netherlands, Germany and France) to discuss potential similar lawsuits over CPDOs. Approximately €2 billion worth of CPDOs are said to have been sold by ABN Amro (now a subsidiary of the Royal Bank of Scotland) and rated by S&P in Europe. They were known as Castle Finance or Chess notes.

Press reports indicate that, before the Australian judgment, about 60 cases had been filed globally against CRAs. Most were filed in the US but about a dozen cases against CRAs were reported to have been filed in Germany and Italy focussing on bonds and other products related to Lehman Bros. On 13 December 2012, Germany's Federal Court of Justice ruled that investors could sue S&P for failing to adequately reflect the deteriorating financial health of Lehman Bros in its rating assessment shortly before the bank became insolvent. Reuters report that this is the first time that a German court has admitted a case brought by retail investors against CRAs, potentially opening the door to further claims. Reuters also report that Italian prosecutors in southern Italy are seeking trial for seven current and former employees at S&P and Fitch over their downgrades of Italy, which could lead to the first European court case over sovereign rating cuts. The allegations are that the reports on Italy and its banking system by the agencies were inaccurate and leaked during market hours.

In England, there have not yet been any reports of claims being made against CRAs in relation to their role in the financial crisis. Investors face a number of difficulties in pursuing claims:

  • The key hurdle will be for investors to prove that agencies owe them a duty of care when a rating is normally addressed to and paid for by the issuer of the bonds and where agencies do not have any relationship with potential investors, or even know their identity
  • Circulars sent with any ratings have clearly worded disclaimers which the agencies will argue prevent a duty of care from arising or negate that duty. It is not known whether an English court would follow the approach of the Australian Court, which considered that S&P's disclaimers were ineffective as inadequate steps had been taken to bring them to the attention of investors
  • Investors are running out of time to bring claims arising out of the credit crisis as, in the absence of fraud, investors' tort claims will be barred if brought more than six years after their loss is suffered

Following the financial crisis, EU regulation on CRAs was introduced to resolve the perceived issues surrounding the role of CRAs. Agencies have to be registered, ensure that ratings are not affected by any actual or potential conflict of interest and use methodologies which are rigorous and systematic. The European Securities and Markets Authority has the power to impose fines on agencies who commit infringements. Under the proposed CRA III Regulation which is expected to be adopted by the Council of the EU in first half of 2013, investors will be able to sue a CRA which, intentionally or with gross negligence, infringes the obligations set out the CRA Regulation (Regulation 1060/2009), thereby causing damage to investors.

US: lawsuits from investors and recent federal action

CRAs have hotly contested claims arising from the sub prime crisis which have been made by investors in the US. CRAs have argued that their role is equivalent to a restaurant or film critic and relied on the First Amendment which guarantees the right to free speech. Although some of the cases have survived initial motions to dismiss them, none have yet reached the trial stage. The federal courts have characterised the ratings as opinions as to the creditworthiness of a transaction, and have generally agreed that opinions are not actionable statements of fraud unless those opinions are not believed by the speaker at the time they are made.1 CRAs appeared to be in a strong position as the Securities and Exchange Commission did not take any enforcement action after its investigations.

However, some recent district court decisions appear to assist investors in making claims. In Abu Dhabi Commercial Bank v Morgan Stanley & Co, the plaintiffs invested in a structured investment vehicle arranged and placed by Morgan Stanley and rated by Moody's and S&P. In August 2012, District Judge Shira Scheindlin dismissed the agencies' motion to dispose of fraud claims on a summary basis. Reconciling federal and New York state law, the court stated that ratings are neither objective statements of fact nor "mere puffery"; rather they are statements of opinion and assessment of the objective value of a financial instrument. According to District Judge Shira Scheindlin, "if a rating agency knowingly issues a rating that is either unsupported by reasoned analysis or without a factual foundation, it is stating a fact-based opinion that it does not believe to be true." The court found that the plaintiffs had presented sufficient evidence for a jury to infer that the agencies did not believe the ratings at the time they issued them and therefore made opinions that would be actionable statements of fraud. This case has not yet reached trial.

CRAs are also now under pressure as a result of the lawsuits commenced last month by federal government and a number of states. On 4 February 2013, the Department of Justice ("DoJ") filed a civil suit in a federal court in California alleging that, from 2004 to 2007, S&P engaged in a scheme to defraud investors in structured financial products known as Residential Mortgage-Backed Securities ("RMBS") and Collateralized Debt Obligations ("CDOs"). This civil lawsuit is the first significant action by the US federal government against a CRA. It appears that pre-action settlement talks with S&P broke down. The complaint alleges that S&P falsely represented that its ratings were objective, independent, and uninfluenced by S&P's relationships with investment banks when, in actuality, S&P's desire for increased revenue and market share led it to favour the interests of these banks over investors. S&P provided millions of pages of emails to the US government and the DoJ refers in its complaint to a number of emails in which S&P analysts expressed concern about how securities were being rated and joked about the effect of the collapse of the housing market. One analyst in March 2007 even recorded a parody of the Talking Heads song "Burning Down the House." The DoJ alleges that S&P was so concerned with the possibility of losing market share and profits that it limited, "adjusted and delayed" updates to the ratings criteria and analytical models it used to assess the credit risks posed by RMBS and CDOs and knowingly disregarded the true extent of credit risks. In issuing the ratings, the complaint alleges that S&P deceived financial institutions into believing that S&P's ratings reflected its true current opinion regarding credit risks of CDOs, when in fact they did not. S&P denies the allegations.

The complaint seeks civil penalties under the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (FIRREA) which allows the DoJ to file a civil lawsuit alleging criminal fraud against federally insured financial institutions and to seek civil penalties up to the amount of the losses suffered as a result of the alleged violations. To date, the government has identified more than $5 billion in losses suffered by federally insured financial institutions in connection with the failure of CDOs rated by S&P from March to October 2007.

Since the DoJ action, 16 states and the District of Colombia have also filed suits against S&P. The lawsuit brought by the Attorney General of the State of California refers to losses of US$1 billion suffered by the California Public Employees Retirement System (the largest public pension fund in the US) and the California State Teachers Retirement System.

These lawsuits clearly have the potential of encouraging investors to make further claims against the rating agencies, but many claims in relation to ratings provided pre-credit crisis are likely to be time-barred.

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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