In what has been reported to be a landmark ruling, the Australian Federal Court has ordered Standard & Poor’s (S&P) and the issuing bank (the bank that arranged the derivative product in question) to pay 30m Australian dollars (£19m) in damages to several Australian local governments.  The claim concerned the AAA rating (their safest credit rating) given by S&P to two structured debt issues in 2006, which later lost almost all of their value.  It signals the first ruling on a rating agency’s liability for investor losses. 

The Facts

The claim concerned the rating, sale and purchase of a complicated structured financial product known as a constant proportion debt obligation (CPDO).  The CPDO was a complex, highly leveraged credit derivative, operating over a term of 10 years, within which the CPDO would make or lose money through notional credit default swap contracts (CDSs) referencing two CDS indices known as the CDX and iTraxx indices.

The issuing bank (through their previous dealings with S&P) had a good idea of how S&P would model the performance of the CPDO to assess the creditworthiness and the rating.  Thus the issuing bank proceeded to model the CPDO in a way to ensure that they achieved a rating of AAA.  When engaging S&P, the issuing bank pressed S&P to adopt its model inputs as the basis for the rating.  Due to a series of errors, omissions and unjustifiable assumptions, S&P rated the CPDO as AAA and authorised the issuing bank to disseminate that rating to potential investors which the issuing bank did.  The issuing bank created further versions of the CPDO’s all of which received a AAA rating from S&P.  These investments were purchased by various Australian local governments through an intermediary in 2006 and later went on to lose almost all of their value.

Decision

The court ruled that S&P’s rating of AAA was misleading and deceptive and that S&P along with the issuing bank had been involved in the publication of information and statements that were false in material particulars and involved negligent misrepresentations being made to potential investors.  The court stated that the rating implied that the likelihood of the financial obligations being met was extremely strong.  The issuing bank was also criticised as it was “knowingly concerned” in S&P’s misleading and deceptive conduct and engaged in misleading and deceptive conduct itself.  The court stated that a reasonably competent rating agency could not have reached the conclusion that the derivative should be given a AAA rating.  The court has ordered S&P and the issuing bank to pay 30m Australian dollars (£19m) in damages to several Australian local governments.

Comment

While the role of the rating agencies (who tend to receive their fees from the entities which they are rating) came under much scrutiny during the sub-prime crisis, the ruling is the first of its kind on a rating agency’s liability for investor losses and is the first time that a rating agency (many of whom have previously argued that their ratings are simply opinions) has been taken to a full trial over a structured financial product.  S&P has said that it plans to lodge an appeal against the decision. 

The decision means that rating agencies who have previously been unaccountable to investors may no longer be able to hide behind their disclaimers to protect them from liability.  It has been reported that this decision could signal the way for investors to recover significant losses from S&P and the issuing bank in Europe.  However, it remains to be seen whether such a claim would succeed in other jurisdictions (such as the English courts which have proved relatively unsympathetic to some investor claims, at least those by sophisticated investors) and raises interesting questions about the extent to which ratings agencies can be said to owe a duty to individual investors.

Further reading: Bathurst Regional Council v Local Government Financial Services Pty Ltd (No 5) [2012] FCA 1200 (5 November 2012)