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’ losses.
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 outcome.
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 cash-out).
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 CPDOs.
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.
A detailed paper on the findings in Bathurst and the consequences for rating agencies, investment managers and investment banks has been published in Business Law International May 2013 edition, click here to view.