Credit ratings arbitrage
On March 9 2011 judgment was handed down in Cassa di Risparmio della Repubblica di San Marino SpA v Barclays Bank Ltd.(1) The case concerned a misselling claim brought by San Marino against Barclays in relation to the portfolio composition of a complex financial product.
Barclays constructed and sold to San Marino four sets of structured notes, which had embedded within them credit derivatives known as collateralised debt obligations (CDOs). These CDOs gave exposure to the credit risk of a portfolio of reference assets through a portfolio credit default swap. The reference assets in turn included further CDOs, each of which was in turn referenced to another portfolio of some 50 credit default swaps - an arrangement termed a 'CDO squared'.
San Marino claimed that it was induced to buy the notes and agree to a subsequent restructuring by misrepresentations which were either fraudulent or negligent. This update considers San Marino's claim in fraudulent misrepresentation relating to Barclays' alleged credit ratings arbitrage.
A claim in fraudulent misrepresentation is normally labelled as 'fraud', although in formal terms it is the tort of deceit. As stated in Clerk & Lindsell on Torts:
"The tort [of deceit] involves a perfectly general principle. Where a defendant makes a false representation, knowing it to be untrue, or being reckless as to whether it is true, and intends that the claimant should act in reliance on it, then in so far as the latter does so and suffers loss the defendant is liable for that loss."(2)
Silence by itself cannot found a claim in misrepresentation. However, an express statement which is literally true may implicitly represent something because of matters which the representor omits to mention. For example, in Oakes v Turquand,(3) an old case about statements made in a company prospectus, Lord Chelmsford noted as follows:
"[I]t is said that everything stated in the prospectus is literally true, and so it is; but the objection to it is, not that it does not state the truth as far as it goes, but that it conceals most material facts with which the public ought to have been made acquainted, the very concealment of which gives the truth which is told the character of falsehood."
The onus is on the claimant who alleges fraud to prove a lack of honest belief on the part of the representor. It is plainly therefore not a straightforward claim and one which requires detailed analysis and a full understanding of the context in which representations have been made.
Credit ratings arbitrage, of which Barclays was accused, involves taking advantage of two features of the methods by which rating agencies at that time assessed the risk of default in a CDO squared.
First, rating agencies looked at historical default rates to estimate the probability of default of the CDO reference entities. Meanwhile, credit derivative traders used credit spreads to estimate the probability that companies would go bust in future. The historical default rates took no account of current circumstances and expectations. There was also an invariable delay between the deterioration of a particular credit and a subsequent ratings downgrade.
Second, rating agencies did not estimate the probability of default on each reference entity individually. Instead, they simply looked at their own credit rating for the entity and then assumed that its probability of default was the same as the overall default rate for all entities in that rating category. However, as the credit spreads demonstrated, there was a spectrum of risk within the same rating.
The arbitrage occurs when traders bundle debt and subdivide it in the form of CDOs. Conservative investors bought these products on the basis of AAA credit ratings, accepting a low return in exchange for safety. However, bankers designing CDOs could profit from the difference between the ratings of the assets and their market price.
According to analysis presented by San Marino, the AAA credit rating of the notes implied a probability of default of less than 1%. However, it was alleged the credit spread approach used internally by Barclays suggested a default probability of more than 25%.
Accordingly, San Marino claimed that at the same time that it was sold the CDO squareds on the basis of the AAA rating, Barclays was deliberately structuring the CDO squareds in such a way that they had, on Barclays' own calculations, a very substantial risk of default. San Marino maintained that this was demonstrated by Barclays' own internal emails.
San Marino alleged that Barclays had deliberately selected, for inclusion in the reference portfolios, entities within each category at the top end of the range of risk by including entities with high spreads for their ratings. The effect was to skew the risk profile upwards. San Marino contended that it had bought products which paid a return of 1% over Euribor, believing them to be a secure investment, when on Barclays' calculations it was alleged that the return which would have been necessary to compensate for the actual risk of default was around 5% over Euribor, equivalent to the rate payable on a 'junk' bond.
San Marino's claim was unsuccessful. The judgment is long, but the main points can be summarised as follows.
The judge accepted that Barclays, in choosing entities for inclusion in the reference portfolios of the CDO squareds, had deliberately selected entities with high spreads for their ratings. He stated: "It is not conceivable that the concentration found by the experts of names with high spreads for their ratings could have occurred other than by design."
The judge also acknowledged that Barclays must have regarded the data from its pricing model, derived from credit spreads, as sufficiently certain to meet the accounting standards of revenue recognition to justify net profits being reflected in its accounts.
Although the judge recognised that the pricing model used by Barclays could be used reliably to estimate its profits, he found - perhaps surprisingly - that the pricing model could not be used to estimate long-term default risk. Given that the judge acknowledged that Barclays' pricing model estimated its net profits by reference to the probability that the investor would not be paid back at the end of the relevant period (ie, the default risk), this reasoning is difficult to follow. The transaction worked on the basis that Barclays' profit was directly equal to the amount of San Marino's estimated loss.
Furthermore, the judge considered that the rating agencies' use of historical defaults was a more accurate guide to the possibility of default than the market's present assessment on the basis of credit spreads. On the face of it, this was also a surprising finding.
On the basis that figures derived from credit spreads are unreliable, the judge held that it was reasonable and justifiable for Barclays to take advantage of the difference between such figures and a price which reflected the default risk implied by rating agencies. Furthermore, he held that it was reasonable and justifiable to take full advantage of the arbitrage opportunity provided by accentuating the difference through the selection of reference entities with high spreads for their ratings. The judge held that in pushing up its profits in this way, Barclays had an honest and reasonable view that there was not an equivalent or high 'real world' probability of default.
The judge considered that to find against Barclays would potentially undermine the practices of the banking market. He stated that:
"[t]he evidence showed that it was the very basis of the CDO business to make an arbitrage, buying protection at spreads which meant that Barclays would make a [mark-to-market] profit on the CDO. Further, the evidence was that it was common for banks to make profits thereby of the order of more than 10%."
Finally, the judge held that contracts between banks for the sale and purchase of complicated structured products work well on the basis of the 'buyer beware' principle. He considered that the buyer is meant to make its own assessment of the risks of the transaction and to make an independent decision as to whether to enter into it.
Most investors in this area will be surprised by the judge's conclusion on the basis of the CDO business. Many are increasingly concerned by banks' manipulation of portfolios to maximise their profit, whereby they increase the corresponding risk to investors while maintaining the credit rating that their clients sought. Such investors might argue that they were sold investments on the basis that the skill of the structuring banks would be used to their advantage. They may question whether this case should have been distinguished from Oakes v Turquand. Barclays understood that San Marino wanted the notes to have a AAA rating and that it therefore wanted an asset with a low default risk. In such circumstances San Marino no doubt considered it material that Barclays, on its pricing model, was pushing the estimated risk of default as high as possible within the boundaries of a AAA rating in order to maximise its profits. It is unlikely that San Marino would have purchased the notes if it had known what Barclays was doing.
This is the latest in a series of recent English cases relating to the misselling of financial products which have favoured investment banks. Investors which have suffered serious losses on products that were sold as low risk will be concerned to see whether the Commercial Court, in particular, will pay sufficient regard to the substantial asymmetry of information and sophistication that exists between the arranging banks and the institutions with which they deal.
For further information on this topic please contact Andy McGregor at Reynolds Porter Chamberlain LLP by telephone (+44 20 3060 6000), fax (+44 20 3060 7000) or email ([email protected]).
(2) 20th edition, Paragraph 18-01.