In the wake of Wingecarribee Shire Council v Lehman Brothers Australia Ltd (in liq) [ 2012 ] FCA 1028 (see our other client update concerning this case), which found investment bank Lehman Bros liable for losses arising out of synthetic collateralised debt obligations, the Federal Court has handed down another decision on the sale of the synthetic collateralised debt instruments widely credited with playing a critical role in causing the global financial crisis. Justice Jagot found that financial advisor Local Government Financial Services (LGFS), investment bank ABN Amro, and ratings agency Standard and Poor’s (S&P), were liable for the losses sustained by 13 local councils arising from the sale and purchase of a structured financial product known as the Rembrandt 2006-3 constant proportion debt obligation (the CPDOs).


Described during the trial as a “grotesquely complicated” instrument, a constant proportion debt obligation is a synthetic collateralised debt instrument created by ABN Amro in April 2006. These CPDOs provided debt insurance on a group of 250 investment-grade companies by using the benchmark CDX and iTraxx index in North America and Europe (together, known as the Globoxx index). Under the CPDOs the investors were the sellers of protection against default by entities listed on Globoxx and the counterparty was the buyer of such protection.

ABN Amro retained S&P to rate the CPDOs and S&P issued a rating of AAA for the CPDOs. The two series of CPDOs marketed in Australia were known as Rembrandt 2006-2 and Rembrandt 2006-3.

LGFS, which had been looking for a way to compete with product providers who had been selling the collateralised debt obligations to various councils, sold approximately $16 million of CPDO notes to the 13 plaintiff councils from November 2006 to June 2007. Two of the councils had entered into a contract with LGFS to provide financial advice, while the other councils all had dealings with LGFS over many years. LGFS made a number of representations to the councils about the CPDOs suitability for councils while failing to disclose their high volatility and the true operation of the buy-back mechanism.

With the global financial crisis in mid-2007, the value of the CPDOs, held by both the councils and LGFS, plummeted to less than 10% of the principal investment. The councils claimed against LGFS, S&P and ABN Amro in respect of their losses, alleging:

  • Misleading and deceptive conduct.
  • Negligence.
  • Breach of fiduciary duty.
  • Breach of Australian Financial Services Licence (AFSL).
  • Breach of Contract.

LGFS also claimed against S&P and ABN Amro, alleging misleading and deceptive conduct, negligence and breach of contract.

Claims against S&P

Misrepresentation claims

Both LGFS and the councils brought claims against S&P for misleading and deceptive conduct and negligence. They contended that S&P, by its conduct in issuing and publishing in Australia the “AAA” ratings for the CPDOs, contravened ss 1041E and 1041H of the Corporations Act 2001 (Cth), and s 12DA of the Australian Securities and Investment Commission Act 2001 (Cth), prohibiting false or misleading conduct in relation to financial products.

S&P had defined its AAA rating as a statement of its opinion that the risk of principal and interest on each issue of the CPDO notes not being paid was equivalent to the risk of default on a AAA rated bond, namely that the issuer of the bond’s capacity to meet its financial commitments to pay interest and repay principal was extremely strong. In particular, S&P claimed that an AAA rating should be understood to mean that, in S&P’s opinion, a AAA rated product should survive a financial event in the nature of the Great Depression.

Both LGFS and the councils alleged that, as S&P is a ratings agency in the business of assigning ratings to financial instruments, the assignment of a AAA rating carried with it a representation that S&P had a genuine and reasonable basis for reaching the conclusions that it reached about the creditworthiness of the financial instrument about which the opinion is expressed.

The issue at trial was whether S&P had a reasonable basis for expressing that opinion, or exercised reasonable care in forming that opinion.

Ultimately, Jagot J was satisfied that:

  1. S&P’s rating of AAA of the CPDO notes conveyed a representation that in S&P’s opinion the capacity of the notes to meet all financial obligations was “extremely strong” and a representation that S&P had reached this opinion based on reasonable grounds and as the result of an exercise of reasonable care;
  2. Neither was true and S&P also knew this not to be true at the time made; and
  3. S&P’s rating of AAA of the CPDO notes was misleading and deceptive.  

Critically, her Honour found that the modelling inputs adopted by S&P, which were the inputs that ABN Amro itself used for its modelling and pressed S&P to adopt, were not inputs that any reasonable ratings agency would have used. Jagot J found that S&P based its rating of AAA on assumptions that were substantially more favourable to the performance of the CPDOs than the actual economic conditions existing at the time, and unreasonably so ([ 2720 ]). These assumptions included:

  • making an unjustifiably and unreasonably low assumption that the average volatility of the Globoxx since inception was 15%. Although this was induced by ABN Amro’s misrepresentation S&P itself failed to calculate the volatility for itself, although it could easily have done ([ 2658 ]); and
  • using a long-term average spread (LTAS) of 40 bps for one year as its base case for modelling and rating the CPDOs. The modelling showed that if the assumed LTAS of 40bps was extended to two years then, the CPDOs did not meet the AAA rating quartile. S&P drew an “arbitrary, irrational and unreasonable” LTAS of 40 bps for one year and 40 bps for two years such that the CPDOs did meet the AAA rating requirement ([ 2720 ]).  

Her Honour found that at least one person within S&P considered that ABN Amro, whether intentionally or not, had effectively “gamed” the model it knew S&P would apply to rate the CPDOs ([ 14 ]). Her Honour also found that by the time S&P rated the second CPDOs, it already knew that the volatility input it had previously used was unjustifiable, but used the same input regardless ([ 2817 ]).

S&P argued in defence that the councils themselves failed to exercise the due care and skill by relying on the advice and recommendations of LGFS and the AAA rating and not having ensured that they understood for themselves the nature and risk of CPDOs (at [ 2471]). The councils also relied on various disclaimers in the S&P ratings reports and letters ([ 2519 ]). Jagot J rejected these arguments, emphasising that S&P knew that the councils were unsophisticated investors ([ 2484 ]), and that the very reason why S&P was paid by issuers of a financial product to assign a rating for that product was because the rating is well known to be highly material to the decision of potential investors to invest ([ 2480 ]). In those circumstances, her Honour considered it was reasonable for the councils to rely on LGFS’s advice and S&P’s rating, and it would have been “extraordinary” if they had not done so ([ 2498 ]).

Negligence claim

The councils also submitted that S&P were negligent in its assignment of a AAA rating to the CPDOs. Jagot J found that S&P owed a duty of care to potential investors in the CPDOs because it was not merely reasonably foreseeable that potential investors in Australia would suffer loss if S&P negligently assigned a rating of AAA to the CPDO notes issued in Australia. The purpose of ABN Amro obtaining the rating was for dissemination to such potential investors so that they could rely on the rating as S&P’s expert opinion in respect of the creditworthiness of the CPDO notes as issued. Her Honour also found that duty breached because it did not have a reasonable basis to conclude that the notes fulfilled its own criterion for a AAA rating.

S&P argued, among other things, that to impose a duty owed on it to every potential purchaser of the CPDOs raised a spectre of indeterminate and significant liability to a large class of applicants removed from S&P.  Jagot J did not accept S&P’s submission. Her Honour distinguished the case from Esanda Finance Corporation v Peat Marwick Hungerfords [ 1997 ] HCA 8 which had held that it would be too removed for an auditor of a company to be liable to every person who placed reliance on its audit of a company and suffered loss as a result. Her Honour noted that a rating was assigned to a financial instrument for the very purpose of communication to the class of potential investors for them to take into account and rely on in deciding whether or not to invest ([ 2758 ]).  

Claims against LGFS

Misleading and deceptive conduct

The councils claimed that LGFS engaged in misleading and deceptive conduct in selling them the CPDOs. They contended that LGFS made a number of representations concerning:

  • the expertise of LGFS in assessing whether the CPDOs were suitable for the councils;
  • the suitability of the CPDOs as investments for the conservative councils having regard to the liquidity and legislative requirements imposed on the council investments; and
  • the fact that LGFS made the representations knowing that it would be relied upon by the councils, with whom they had developed a trusting relationship.

Jagot J found that the councils invested in the CPDOs because of erroneous beliefs induced by LGFS’s representations as to the suitability of the CPDOs as an investment for them. Accordingly, LGFS's representations constituted a break of s1041H ([ 2232 ]). However, s1041E required the making of a false and misleading statement and that LGFS had actual or constructive knowledge of the false or misleading quality of the information. Hence, to the extent that the statements made by LGFS concerning the CPDOs were influenced by the S&P AAA rating and the information provided by ABN Amro, they did not contravene s1041E ([ 2237 ]).


Justice Jagot found that LGFS owed the councils a duty of care to:

  • properly analyse any investment, including the risks involved;
  • only recommend suitable investments; and
  • provided all information on the investment which might reasonably be considered as bearing upon the investment decision ([ 2263 ]). 

Justice Jagot found that by offering the councils an unsuitable product without identifying the risks involved and not properly providing the councils with the information material to its investment decisions, LGFS breached its duty to the councils ([ 2272 ]).

Breach of fiduciary Duty

In holding itself out as an expert entity on which the councils could rely to provide suitable investment opportunities to the councils, LGFS moved beyond the role of a salesman and acted as an investment adviser, subsequently attracting a fiduciary duty to avoid conflicts of interest. LGFS breached this duty when it did not disclose that it was selling the CPDOs in order to improve its weak balance sheet.

Breach of contract

Two of the plaintiff councils, Cooma and Corowa, each entered into contracts with LGFS, which included the following key terms:

  • LGFS was to develop an investment strategy for the councils diligently, accurately and efficiently;
  • LGFS was to ensure that all information provided to the councils about investments was accurate and complete; and
  • LGFS provided a warranty that it would, at all times, exercise all due diligence and vigilance in carrying out the agreement ([ 2385 ]).

Justice Jagot found that, for the reasons that her Honour relied on to find that LGFS had breached its duty of care to the councils, LGFS had also breached its obligations under the contract to provide its services with reasonable care ([ 2395 ]).

Breach of AFSL

The Court found that LGFS contravened its AFSL in breach of s912A(1)(b) of the Corporations Act. This is because the AFSL did not authorise LGFS to deal with derivatives and the Court found that the CPDOs were in fact derivatives, rather than securities ([ 2385 ]).

Claims against ABN AMRO


Justice Jagot held that ABN Amro owed a duty to LGFS, and the councils, to exercise reasonable care and skill in the provision of information and advice to LGFS about the CPDOs ([ 3179 ]). Her Honour found that the duty extended to the councils because ABN Amro was aware that the CPDOs were intended to be sold to the councils as high security investments ([ 3277 ]).

The Court found that ABN Amro did not exercise reasonable care when it deployed the AAA rating in its dealings with LGFS with respect to the CPDOs. ABN Amro’s argument that it had fulfilled its duty of care by engaging a rating agency in S&P to provide an independent rating was rejected because ABN Amro knew the rating to be misleading because it had itself effectively “gamed” the model it knew S&P would apply to rate the CPDOs ([ 14 ] and [ 3204 ]).


LGFS claimed that ABN Amro breached the terms of a contract contained in a mandate letter sent between the parties. These terms include:

  • ABN Amro would render its services with due care and skill.
  • The CPDOs would be reasonably fit for the purpose for which they were supplied to LGFS.
  • ABN Amro would structure and arrange the notes so that they would be reasonably fit for the purpose of being held by LGFS and the councils to whom they might be sold as investments. 
  • ABN Amro would structure and arrange the notes so that they would be reasonably be expected to have a high degree of security ([ 3220 ]).

Justice Jagot found that ABN Amro did not render its services with due care and skill, as demonstrated by their failure to structure and arrange the CPDOs so that they would be reasonably fit for the purpose of being held as an investment with a high level of security. Furthermore, it was found that ABN knew or ought to have known that the CPDOs could not reasonably be rated as AAA. Consequently, ABN Amro was found to have breached its contract with LGFS ([ 3229 ]).

Misleading and deceptive conduct

LGFS claimed that ABN Amro engaged in misleading and deceptive conduct as per the relevant provisions of the Corporations and ASIC Act. Such claim was derived from ABN Amro's representation that that the risk of default of the CPDOs was commensurate with the risk of default of a AAA rated bond; in particular, that the capacity of the issuer to repay interest and principal was ‘extremely strong’ ([ 3163 ]).

The Court found that ABN Amro must have known that S&P’s model was unreasonably and unjustifiably weighted in favour of a positive rating. This meant that ABN Amro made materially false and misleading representations when it deployed the AAA rating to LGFS ([ 3013 ]).

ABN Amro’s conduct was also found to be misleading in respect of the councils as ABN Amro knew that CPDOs were intended for the councils, and still chose to deploy the AAA rating, which it knew to be false.


The ruling against ABN Amro and S&P exposes the flaws in a system in which ratings upon which investors rely for an independent evaluation of default risk are made by agencies which are themselves paid by the issuers to rate their products. Even more than Wingecarribee Shire Council v Lehman Brothers, the consequences of this decision are likely to reverberate around the globe. ABN Amro sold about €2 billion worth of similar products, rated by S&P, in Europe. Other credit rating agencies, such as Moody’s and Fitch, which also rated CPDOs and CDOs, could also be affected. 

Bathurst Regional Council v Local Government Financial Services reinforces the lesson from Lehman Brothers that it will now be far more difficult for financial service providers, investment banks and rating agencies to rely on disclaimers to absolve themselves from liability.