The Federal Court has delivered a landmark and lengthy appellate decision (over 400 pages) in the slowly expanding field of representative proceedings in Australia. Significantly, investors who suffer losses by investing in financial products in reliance upon negligent or misleading advice may now look to rating agencies for recourse as well as others involved in the sale of the products.
Thirteen local government councils in New South Wales (Councils) each purchased “grotesquely complicated” financial products known as constant proportion debt obligations (CPDOs) in reliance upon financial advice.
When the CPDOs subsequently underperformed, the Councils brought an action against the Royal Bank of Scotland owned ABN Amro Bank NV (ABN) (the creator of the CPDOs), Local Government Financial Services Pty Ltd (LGFS) (the AFSL holder, seller and advisor) and Standard and Poors (S&P) (the credit ratings agency).
The Councils were successful at first instance (Bathurst Regional Council v Local Government Financial Services Pty Ltd (No 5)  FCA 1200) and on appeal in ABN Amro Bank NV v Bathurst Regional Council  FCAFC 65.At first instance and on appeal, the conduct of:
- ABN in creating the CPDOs;
- LGFS in selling the CPDOs; and
- S&P in assigning the CPDOs a AAA credit rating,
was found to be misleading and deceptive and the Councils received substantial damages.1
In 2006, ABN created CPDOs as a form of structured financial product which utilised credit default swaps. Investors effectively purchased risk from a lender, and received a payout after a defined period of time (referred to as ‘maturity’).
S&P rated the CPDOs, at the request of ABN. S&P assigned the CPDOs a AAA rating, with the knowledge that ABN would disseminate the rating to interested parties and investors. The AAA rating was an important feature of marketing documents used by ABN and LGFS.
Put simply, CPDOs increase leverage when losses are taken and, in this sense, have been compared to a doubling down strategy, where bets are increased each time a loss occurs. Consequently, the value of a CPDO investment is highly volatile and if successive losses occur the net worth of the investment can decrease substantially (as happened in this case). In assigning the CPDOs a AAA credit rating, S&P significantly underestimated the likelihood of these ‘successive losses’ occurring.
LGFS purchased over $40 million of the CPDOs from ABN and sold $16 million of the CPDOs to the Councils. The Councils lost most of what they invested in the CPDOs.
The Councils brought proceedings in negligence and misleading and deceptive conduct against ABN, LGFS and S&P. At first instance, the Court found that the conduct of ABN, LGFS and S&P was misleading and deceptive and that both S&P and LGFS had breached their respective duties of care to investors. The Councils were awarded more than $25 million in damages, apportioned equally between ABN, S&P and LGFS.
ABN, LGFS and S&P appealed the overall decision, putting in issue almost every finding of fact and conclusion of law made by the primary judge. There were 306 grounds of appeal.2 The Councils cross-appealed the finding that damages which flowed from the contravention of s. 1041E of the Corporations Act 2001were apportionable.
The Full Court rejected almost all of the grounds of appeal raised by ABN, LGFS and S&P in relation to their liability as against the Councils (and each other) and upheld the primary judge’s ruling.
Importantly, the Full Court observed that:
- S&P’s assignment of a AAA rating to the CPDOs was unreasonable, unjustified and misleading, as S&P knew, or ought reasonably to have known, that the rating was flawed and proper care had not been exercised in assigning the rating; and
- ABN knowingly engaged in misleading conduct to potential investors as it knew that the rating lacked reasonable grounds and was misleading.
The Full Court upheld the first instance finding that it was reasonable for LGFS to rely on S&P’s AAA rating. However, the Full Court found that LGFS:
- made misleading representations to the Councils regarding the CPDOs;
- breached its fiduciary obligations to the Councils due to a conflict of interest between the fiduciary obligations owed to the Councils and the interest LGFS had in selling the $40 million in CPDOs that it had in inventory; and
- failed to disclose to the Councils that it purchased and held the CPDOs or that the longer it held the CPDOs the greater the risk of losses (as it knew).3
The Full Court overturned the primary judge’s ruling that all liability to the Councils be apportioned equally between ABN, LGFS and S&P.
In relation to s. 1041H of the Corporations Act (misleading and deceptive conduct), ABN, LGFS and S&P were found to be concurrent wrongdoers, each liable for one third of the Councils losses.4
However, the Full Court held that the claims under 1041E (false or misleading statements), were not apportionable. ABN and S&P were each found 100% liable for all of the losses suffered by the Councils. LGFS was found 100% liable for the losses of the 9 councils to which it had made certain misleading representations.5
Perhaps the most important consequence of this landmark decision is the clearly increased exposure for ratings agencies to representative proceedings. One can only speculate at this stage as to how wide the floodgates have opened, but there is no doubt that the ability for an investor to pursue claims against ratings agencies (specifically, in relation to the rating of various financial products) has broadened.
Fundamentally, the finding that a ratings agency may owe a duty of care to investors is something to which local governments and all other investors should now have regard. The decision also provides further clarity about the obligations of financial advisers.