Case against S&P
Case against ABN Amro
Case against LGFS


In November 2012 the Federal Court of Australia handed down its landmark decision in Bathurst Regional Council v Local Government Financial Services. The ruling marks the first time that ratings agency Standard & Poor's (S&P) has been held accountable for the ratings opinions that it is paid to assign to financial products.

The implications of the decision are global and widespread within the financial services industry. The decision highlights the capacity for a duty of care to arise not only between investors and their financial advisers, but also between investors and the parties involved in structuring and rating the financial products that they purchase. It also exposes the inherent problems with an 'issuer pays' ratings process, under which ratings agencies are paid by the banks whose products they independently rate.

These problems have been widely discussed in the wake of the global financial crisis and the 2007/2008 collapse of billions of dollars in structured products that were issued with credit ratings of A and above by S&P and its ratings agency counterparts.


The proceedings were issued by 13 New South Wales local councils against their financial adviser, Local Government Financial Services (LGFS), in relation to its recommendation that the councils acquire holdings in a new financial product - a constant proportion debt obligation (CPDO) known as the Rembrandt 2006-3 CPDO.

The councils also brought claims in negligence and for misleading and deceptive conduct against:

  • McGraw-Hill International (UK) Limited, trading as S&P, for its assignment of a 'AAA' credit rating to Rembrandt; and
  • the arranger of Rembrandt, ABN Amro Bank NV, for its role in the assignment and dissemination of the AAA rating.

In April 2006 ABN Amro developed the first CPDO, a highly complex structured financial product which made use of leverage to provide returns to investors above the average 90-day bank bill swap rate. The CPDO was structured as follows:

  • The CPDO would earn or lose money through notional credit default swap contracts which referenced two credit default swap indices, the CDX and iTraxx Indices (which weighted equally together were known as the 'Globoxx Index').
  • The investor would receive a series of periodic (eg, monthly) premium payments under the credit default swap contract and in return would be obligated under the contract to make default payments to the swap counterparty if certain credit events occurred.
  • The CPDO was highly leveraged and employed a doubling strategy, whereby the amount of leverage would be increased in the face of losses in an attempt to mitigate the loss. ABN Amro and Justice Jagot likened this to the casino strategy of increasing bets after a losing streak in an effort to "bet yourself out of the hole". Significantly, if the net asset value fell below 10%, the Rembrandt notes were designed to 'cash out', paying back to investors less than 10% of their principal investment.

ABN Amro engaged S&P in May 2006 to assign a credit rating to the Rembrandt 2006-2 CPDO, the first CPDO to be issued in Australia. In September 2006 S&P assigned Rembrandt 2006-2 a AAA credit rating, S&P's highest rating, indicating that:

  • the product's capacity to meet its financial commitments was 'extremely strong'; and
  • the likelihood of default was less than 0.728%.

LGFS, a financial adviser in New South Wales that had operated for 25 years in the local government investment market, purchased A$10 million in Rembrandt 2006-2 notes for its client StateCover. LGFS then approached ABN Amro to create and structure the Rembrandt 2006-3 CPDO for the purpose of on-sale to LGFS's local government clientele. LGFS made ABN Amro aware that a high degree of security (ie, a low risk of default) was of central importance to local councils. Accordingly, in order for the Rembrandt 2006-3 deal to proceed, it was critical that the notes be assigned a AAA credit rating by S&P.

ABN Amro again engaged S&P, this time to rate the Rembrandt 2006-3 CPDO, and in October 2006 S&P assigned the notes a AAA rating. S&P authorised ABN Amro to disseminate the rating to potential investors, including to LGFS. LGFS purchased the entire A$40 million initial issue of the Rembrandt 2006-3 notes and proceeded to attempt to sell the notes to its local council clients. The applicants in the Bathurst v LGFS proceedings each acquired holdings of between A$500,000 and A$2 million in the Rembrandt 2006-3 notes on the advice of LGFS.

In 2007 sustained spread widening began to occur on the Globoxx Index, causing the value of Rembrandt to decline. It ultimately cashed out in October 2008 and the noteholders (including the councils) received back less than 10% of the principal that they had invested.

Case against S&P

The councils and LGFS successfully brought claims against S&P for negligence, alleging that S&P:

  • owed a duty of care to investors who had purchased the Rembrandt 2006-3 notes; and
  • had failed to exercise reasonable care and skill in assigning the AAA rating to the Rembrandt notes.

The councils and LGFS also established that S&P's assignment of the AAA rating:

  • constituted misleading and deceptive conduct under:
    • Section 1041H of the Corporations Act 2001 (Cth); and
    • Section 12DA of the Australian Securities and Investments Commission Act 2001 (Cth); and
  • contained statements that were materially misleading and/or false in a material particular, in contravention of Section 1041E of the Corporations Act.

The court held that S&P did not have reasonable grounds on which to assign the Rembrandt notes a AAA rating. Furthermore, the rating was not the product of the exercise of reasonable care, because of fundamental errors made by S&P in modelling the performance of Rembrandt.

Jagot noted that the case focused not on the appropriateness of the AAA rating per se, but on the actions (or lack thereof) of S&P and whether its conduct was consistent with how a reasonable ratings agency would have conducted itself. The court found that S&P had acted in a way which no reasonable ratings agency would have done, noting that S&P's testing of the product disclosed "a pattern of irrational reasoning favourable to the performance of the CPDO". The councils had established that several inputs in S&P's modelling of Rembrandt (on which S&P based its ratings) could not reasonably be used by a ratings agency for the purpose for which S&P had used them. The court emphasised that: "S&P did not just fail to apply good ratings practice. It failed to act reasonably and rationally."

The court found the conduct of S&P fell below the standard of reasonable care expected of a reasonable ratings agency in the following ways:

  • S&P failed to develop its own model for rating CPDOs and instead adopted the model which had been developed by ABN Amro. This ratings model contained hidden biases (eg, a 7% roll-down benefit) that were favourable to the performance of the CPDO and of which ABN Amro had failed to notify S&P.
  • The method that S&P employed for modelling 'default risk' (ie, the risk that companies forming part of the CDX or iTraxx Indices would default) was flawed, meaning that a reasonably competent ratings agency should have viewed the modelling results with caution. S&P did the opposite.
  • S&P should have considered the effect of ratings migration in its modelling, but failed to do so. (The court found that ABN Amro had been aware of this issue, but had decided not to raise it with S&P.)
  • The court held that the figure that S&P had adopted for an input parameter known as the 'long-term average spread' of the Globoxx Index was an "arbitrary and irrational selection".
  • S&P adopted a 15% volatility figure (relating to the performance of the iTraxx and CDX Indices) that had been provided to it by ABN Amro. There was no evidence that S&P itself had checked the 15% volatility figure, although it could easily have done so. The correct figure was approximately 28%. Jagot concluded that a ratings agency acting reasonably would have calculated volatility for itself, and that no reasonably competent ratings agency would have adopted a volatility figure of 15%.
  • S&P did not model the Rembrandt 2006-3 transaction itself, but assigned the AAA rating to it on the basis that it was a repeat of the Rembrandt 2006-2 transaction. Furthermore, when modelling both transactions, S&P failed to use the actual starting spreads on the Globoxx Index at the time at which it issued the rating.
  • S&P failed to give consideration to model risk when assigning the AAA rating.

Had even one of these errors and omissions been rectified by S&P, the Rembrandt notes could not have achieved a AAA rating. Finally, Jagot concluded that a "minimum level of reasonable competence" would have required a ratings agency to test the performance of the CPDO, not only in reasonably expected market conditions, but also in 'exceptional but plausible' market conditions. S&P's modelling had failed to do this.

Duty of care
The most significant aspect of the decision is the imposition of a duty of care between S&P and the investors. In imposing a duty of care, Jagot emphasised that the class of persons who purchased the Rembrandt 2006-3 notes was ascertainable, as the class comprised potential purchasers of the minimum A$500,000 subscription in the A$40 million issue of the Rembrandt 2006-3 notes. The court rejected S&P's argument that the liability was indeterminate, as at the time Rembrandt was issued there was no secondary market for them and the factors confining the scope of potential liability were in the exclusive control of S&P, which:

  • chose which products to rate;
  • understood the issue size for each of the products;
  • understood the life of the notes for which its rating would be carried; and
  • maintained the ability to reduce or control its liability by downgrading or withdrawing its rating.

The court further held that:

  • S&P's conduct was not that of a reasonable ratings agency exercising reasonable care and skill and that it constituted a breach of the duty of care owed by S&P to investors, including the councils and LGFS;
  • the claim did not relate to whether S&P had failed to foresee the global financial crisis - the crisis was not an intervening cause of the councils' loss, as the experts agreed that it was not 'unprecedented', and even if the crisis had been unprecedented, the Rembrandt notes did not require an unprecedented event to cash out; and
  • the cause of the harm was the cash-out of the notes, which was found to have been caused by sustained spread widening on the iTraxx and CDX Indices. The court found that S&P knew that sustained spread widening was the main risk of cash out and accordingly, it was "not only reasonably foreseeable; it was one of the main anticipated risks the CPDO faced".

Misleading and deceptive conduct
The court found that S&P's assignment of the AAA rating constituted a 'financial service' and 'financial product advice' within the meaning of Section 12BAB(5) of the Australian Securities and Investments Commission Act. The AAA rating was found to convey that S&P had concluded that Rembrandt's capacity to pay interest and principal was 'extremely strong'. The rating carried with it a representation that S&P had reasonable grounds for that conclusion. However, for the reasons outlined above, the court concluded that S&P did not have reasonable grounds for assigning the AAA rating, in contravention of Section 1041E of the act. For the same reasons, S&P's conduct in authorising ABN Amro to disseminate the AAA rating to investors was found to be misleading and deceptive, in breach of Sections 1041H and 12DA of the act.

Reliance on disclaimers
In defending the claims by the councils and LGFS, S&P relied on disclaimers in various versions of the ratings report that it issued for Rembrandt. The report was published on the S&P website and was disseminated to ABN Amro before being passed to LGFS and the councils. The court held that the disclaimers were ineffective for avoiding liability, as the notion that "investors should not rely on the credit rating in making investment decisions" was inconsistent with the very purpose for which S&P was paid to issue its ratings. The court further found that the effect of the disclaimer would be to negate altogether the representations made in the S&P report and, in any case, a "far more prominent" disclaimer would have been required to achieve that effect. In addition, the disclaimers could not be understood to disclaim any exercise of care and skill in the assignment of the rating, and accordingly S&P could not rely on the disclaimers to avoid liability.

Implications for ratings agencies
Following the ruling, ratings agencies can now be held directly accountable to investors to ensure that their ratings are the product of reasonable care and are based on reasonable grounds. Ratings agencies can no longer rely on disclaimers that ratings are merely an "opinion in reliance on which no investment decisions should be made", as reliance by investors for making investment decisions is the very purpose for which the ratings agencies are paid to rate the product.

The decision creates a precedent for claims against S&P and other ratings agencies in respect of their ratings of other CPDOs and structured products. As the majority of these products were issued between 2005 and 2008 and defaulted in 2007 and 2008, this may mean an influx of litigation in the next two years.

Case against ABN Amro

The applicants were also successful in establishing claims against ABN Amro:

  • for knowingly being involved in S&P's contraventions of the Corporations Act - it was alleged that ABN Amro was aware of S&P's assignment of the AAA rating, having played an active role in the modelling and testing process in accordance with which the rating was assigned;
  • for breaches of Sections 1041H and 1041E of the Corporations Act and 12DA of the Australian Securities and Investments Commission Act - ABN Amro's dissemination of the AAA rating was misleading and deceptive and its representations as to the meaning of the rating were false (ABN Amro knew or should have known the rating was not based on reasonable grounds); and
  • in negligence, for breach of its duty to potential investors in the Rembrandt 2006-3 notes, by failing to disclose that the AAA rating was not based on reasonable grounds.

Knowing involvement
The court found that ABN Amro had actual knowledge of the falsity of the AAA rating and was 'involved', within the meaning of Sections 1041I and 79 of the Corporations Act, in S&P's contraventions of Sections 1041H and 1041E of the act. The court found ABN Amro knew that there were no reasonable grounds for S&P's rating, by reason of its involvement in the modelling of the CPDO and the assignment of the rating, and its knowledge of the fundamental errors in the assumptions adopted by S&P. Jagot summarised ABN Amro's involvement in the assignment of the AAA rating as follows:

"Although ABN Amro engaged S&P to assess the product and assign a rating to it, the only rating ABN Amro was interested in S&P assigning was a rating of AAA… To that end ABN Amro created and provided to S&P a model to assess the performance of the CPDO for ratings purposes. ABN Amro identified all of the inputs into that model that it wanted S&P to use. ABN Amro knew that S&P was using the model it had provided, albeit with some modifications that Mr Ding [of S&P] had made. ABN Amro knew what inputs S&P were using… It is also apparent that ABN Amro was involved in the drafting of the S&P reports."

Misleading and deceptive conduct
The court was satisfied that in marketing Rembrandt to LGFS and the councils, ABN Amro had made misleading representations that:

  • the capacity of Rembrandt to pay principal and interest was extremely strong;
  • the risk of default was not more than 0.728%; and
  • S&P's rating of AAA could be safely relied on, in breach of Sections 1041H and 1041E.

Jagot concluded that ABN Amro must have known that the capacity of Rembrandt to repay interest and principal was not 'extremely strong' and that S&P's rating of AAA could not be safely relied upon. She noted that "[g]iven what ABN Amro knew, it is difficult to see how ABN Amro could have deployed the AAA rating at all without engaging in misleading conduct" (at [3174]).

ABN Amro was also held to owe a duty of care to the councils and to LGFS to exercise reasonable care and skill in the provision of information and advice to LGFS about Rembrandt. This was because it knew that LGFS required a rating of AAA for the purpose of selling the notes to local councils. It was not significant that ABN Amro did not know the identity of the particular councils to whom LGFS intended to market the Rembrandt notes, as ABN Amro was aware that the class of potential investors was a limited class entirely comprising public bodies dealing with public funds.

ABN Amro was found to have breached that duty by disseminating the AAA rating to LGFS and causing it to be disseminated to the councils. A significant consideration was that ABN Amro had the capacity to replicate S&P's modelling (and did so), but had no reasonable basis for the assumption that LGFS or local council investors could also replicate it in order to identify deficiencies in the rating.

Implications for arranging banks
The court's finding against ABN Amro should serve as a warning to all investment banks that have issued and continue to issue structured financial products. Although a rating is not a representation of the bank, the bank can still be found liable for passing on such credit ratings to investors in circumstances where the bank has knowledge that the rating is not based on reasonable grounds.

Case against LGFS

The councils also successfully established claims against LGFS for breach of fiduciary duty, negligence, misleading and deceptive conduct, breach of contract, and breach of the terms of LGFS's Australian Financial Services Licence, in respect of LGFS's recommendation to the councils to purchase Rembrandt.

LGFS was largely successful in cross-claiming against S&P in respect of its liability to the councils, by reason of LGFS's own reliance on the AAA rating.

The court held that the Rembrandt notes were a derivative, and that accordingly LGFS was prohibited from dealing in such notes or providing financial product advice, under the terms of its licence (which did not permit LGFS to deal in, or provide advice about, derivatives). However, Jagot rejected S&P's contention that LGFS had breached its licence simply by acquiring the Rembrandt notes, noting that LGFS was free to purchase the Rembrandt 2006-3 notes for itself.

The court further held that, in breach of Section 912A(1)(e) of the Corporations Act, LGFS had failed to maintain the competence required to provide the financial services covered by its licence, as it failed to appreciate that there was an issue as to whether the Rembrandt notes were a derivative and therefore might not fall within the terms of its licence. LGFS was also found to have breached Sections 912A(1)(a) and (aa) of the act, as it failed to maintain safeguards to ensure that the products it dealt with were covered by its licence and did not implement adequate arrangements for the management of conflicts of interest.

Implications for financial services providers
The finding that the Rembrandt notes were a derivative, not a debenture, may mean that other licensees dealing in similar structured products are operating, or have already operated, outside the boundaries of their licence. The decision should serve as a reminder to licensees to maintain procedures for ensuring that new financial products, particularly structured financial products, fall within the terms of their licence.


This decision confirms that an investment advisory relationship - giving rise to a duty of care and a fiduciary relationship - can exist between a financial services provider and its investor clients, notwithstanding the absence of a written agreement between the parties.

The wider effect of Bathurst v LGFS may ultimately be to create greater independence between ratings agencies and arranging banks, resulting in more reliable and truly independent ratings for investors. There is also potential for further claims to be brought in Europe, where €2 billion in CPDOs has been issued and rated.

S&P has announced its intention to appeal the decision.

For further information on this topic please contact Amanda Banton or Denee Theodorou at Piper Alderman by telephone (+61 2 9253 9999), fax (+61 2 9253 9900) or email ( or

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