«Abstract Credit rating agencies perform the role of gatekeepers in the financial industry, particularly when investment products become increasingly ...»
ABN Amro Bank NV v Bathurst Regional Council:
Credit Rating Agencies and Liability to Investors
Credit rating agencies perform the role of gatekeepers in the financial industry,
particularly when investment products become increasingly complex. In a case
the first of its kind, the Federal Court of Australia imposed liability on Standard
& Poor’s for significant losses sustained because of its negligent and
misleading credit rating of a highly complex structured financial product. The decision informs the content of the responsibility of credit rating agencies to investors who heavily rely on their expert opinions as to the creditworthiness of financial products. The decision is likely to have an impact on similar litigation around the world and on the direction of financial regulation in this context.
I Introduction Among the more notable legal fallouts of the so-called ‘Global Financial Crisis’ (‘GFC’) was the litigation commenced by local government councils that had lost millions of dollars after investing in AAA rated complex financial instruments. In a widely publicised decision,1 Jagot J of the Federal Court of Australia imposed civil liability on the credit rating agency (‘CRA’) Standard & Poor’s (‘S&P’) for losses caused by its negligent and misleading credit rating for a financial product.2 The investor councils simultaneously succeeded against the product arranger, investment bank ABN Amro, and the seller, Local Government Financial Services (‘LGFS’).
* BCom (Finance), LLB (Hons I) (Syd). This case note was prepared in my final year under the guidance of Professor Barbara McDonald. Any errors remain my own.
See, eg, Leo Shanahan, ‘Councils Win Landmark Case against Standard and Poor’s, ABN Amro’, The Australian (online), 5 November 2012 http://www.theaustralian.com.au/business/legalaffairs/councils-win-landmark-case-against-standard-and-poors-abn-amro/story-e6frg97xLucy Battersby, ‘Standard & Poor’s Hit With $20m Compensation for Wonky Ratings’, The Sydney Morning Herald (online), 6 November 2012 http://www.smh.com.au/ business/standard--poors-hit-with-20m-compensation-for-wonky-ratings-20121105-28u32.html;
‘Morning Business Round-Up: S&P “Misled Investors”’, BBC News (online), 6 November 2012 http://www.bbc.com/news/business-20218794; Nadine Schimroszik and agencies, ‘S&P Guilty of Misleading Investors’, The Guardian (online), 6 November 2012 http://www.theguardian.com/ business/2012/nov/05/standard-poors-guilty-misleading-investors.
Bathurst Regional Council v Local Government Financial Services Pty Ltd (No 5)  FCA
On appeal, in ABN Amro Bank NV v Bathurst Regional Council (‘Bathurst Appeal’),3 the Full Federal Court dismissed nearly all of the appeal grounds raised by ABN Amro, S&P and LGFS in respect of their liability to the councils and each other. The Bathurst Appeal is significant, primarily because it affirmed that a duty to exercise reasonable care and skill can be owed by a CRA to potential investors who rely on its rating. It also demonstrates how the law must grapple with the sheer complexity of modern financial investments, and the correlative need for investors to rely on credit ratings.
Part II of this case note outlines the background to the proceedings, and relevant outcomes of the first instance decision. Part III analyses the appeal decision on negligent misstatement against S&P. In Part IV, the issues inherent in the credit rating industry and international perspectives on liability and regulation are considered.
In early 2006, investment bank ABN Amro invented a new financial product known as the ‘Constant Proportion Debt Obligation’ (‘CPDO’). This structured financial product, which the trial judge described as ‘grotesquely complicated’,4 involved leveraged investment in synthetic or notional credit default swaps by reference to global indices that tracked pools of such investments.5 The CPDO was issued in Australian dollars in the form of notes with 10-year maturities under the names of Rembrandt 2006-2 and Rembrandt 2006-3.6 The bank engaged S&P to rate the CPDO, a product which the market had not seen and which had never been rated before.7 ABN Amro made it clear that the highest rating of AAA was sought for the product.8 This was because it had intended to sell the product to LGFS, which in turn was to sell the product to local councils.9 Those local councils were the subject of strict investment guidelines requiring high ratings for investment to be permissible.10 (2014) 224 FCR 1.
See, eg, Bathurst Trial  FCA 1200, , .
Bathurst Appeal (2014) 224 FCR 1, 31–2 –; Bathurst Trial  FCA 1200, –, . Elsewhere the CPDO has been described as the ‘poster child for the excesses of financial engineering in the credit market’: Michael B Gordy and Søren Willemann, ‘Constant Proportion Debt Obligations: A Post-Mortem Analysis of Rating Models’ (Finance and Economics Discussion Series, Divisions of Research & Statistics and Monetary Aﬀairs, Federal Reserve Board (Washington DC), 23 September 2009) 1 http://www.federalreserve.gov/pubs/feds/2010/201005/ 201005pap.pdf.
Bathurst Appeal (2014) 224 FCR 1, 32 .
Ibid 33 .
Ibid 59 .
Bathurst Trial  FCA 1200, , .
Bathurst Appeal (2014) 224 FCR 1, 25–9 –.
2014] CASE NOTE: ABN AMRO v BATHURST REGIONAL COUNCIL 439 S&P was paid a substantial fee for issuing a credit rating.11 As the trial judge noted, the risks of the product could not be ‘gleaned by intuition’, so complex mathematical modelling was necessary to simulate its performance.12 S&P relied on a number of analysts, and took well over a month to model the product.13 The performance of the CPDO was sensitive to a variety of factors, and a number of inputs and assumptions were necessary in modelling the product.14 The trial judge observed that it was not possible for most investors to ‘second-guess’ or verify S&P’s credit rating.15 Ultimately, in late 2006, S&P assigned its highest credit rating of AAA to the two issues of the Rembrandt notes,16 a rating meaning that the instrument’s capacity to meet its financial commitment was ‘extremely strong’.17 The rating indicated that for a 10-year instrument, the probability of default was less than 0.728%.18 It should be noted that the rating signified the likelihood of repayments under the CPDO being made in accordance with its terms.19 The AAA rating was not an indication of the return on the investment or the magnitude of loss upon default, nor was it a signal that the investment was risk free.20 The rating was in fact unreasonable, unjustified and misleading.21 The evidence of multiple experts was considered at trial in order to determine how the product had been modelled and how the rating was calculated.22 Of particular concern was the assumed volatility of the underlying notional credit portfolio.23 While S&P originally proposed that volatility be 35%, after ABN Amro pressed for 25% or lower, 15% was used,24 at least until October 2006.25 This was unjustifiable and an ‘egregious error’.26 Indeed, what occurred in relation to the volatility input was described as ‘extraordinary’.27 As the evidence on volatility indicates, the coordinated strategy of ABN Amro and S&P was critical to the litigation, and relevant to a number of claims.28 For some time, S&P used ABN Amro’s model for an earlier product to test the Ibid 33 , 41 .
Bathurst Trial  FCA 1200, .
Bathurst Appeal (2014) 224 FCR 1, 34 .
See, eg, Bathurst Trial  FCA 1200, –, .
Bathurst Appeal (2014) 224 FCR 1, 33 , 112 [580.19], 116–17 –.
Ibid 39 , 40 ; Bathurst Trial  FCA 1200, , .
Bathurst Appeal (2014) 224 FCR 1, 33 .
Bathurst Trial  FCA 1200, –.
Bathurst Appeal (2014) 309 ALR 445, 565 . Paragraphs – are not included in the Federal Court Report of the Bathurst Appeal. The Australian Law Report is cited here and throughout where those paragraphs are cited.
See Bathurst Trial  FCA 1200, –.
See Bathurst Appeal (2014) 224 FCR 1, 84–108 –.
Bathurst Appeal (2014) 224 FCR 1, 87–91 –.
Ibid 96 .
See, eg, Bathurst Trial  FCA 1200, , , , .
Bathurst Appeal (2014) 309 ALR 445, 561 . The issue forms a large portion (‘Part 3’) of the appeal decision: Bathurst Appeal (2014) 521–65 –. See also Bathurst Trial  FCA 1200, –.
440 SYDNEY LAW REVIEW [VOL 37:437 performance of the CPDO, rather than developing its own model.29 An S&P analyst observed in an email, for example, that ABN Amro’s work-in-progress model and rating had been ‘bulldozed through’, while other S&P employees had been ‘sandbagged a little’.30 However, even after doubts emerged in relation to the modelling, S&P did not change its approach.31 Both S&P and ABN Amro knew that the AAA rating was unreliable.32 S&P knew ABN Amro would use it to promote the product to investors:33 it was a public rating, and S&P had expressly authorised ABN Amro to disseminate it to potential investors.34 The bank used the rating, together with other documents provided by S&P,35 and its own information,36 to market the product to LGFS.37 As noted above, ABN Amro was aware that LGFS was interested in a product with a high degree of security, and placed emphasis on the credit rating in its marketing.38 In August 2006, $10 million of the Rembrandt 2006-2 notes were sold through LGFS to StateCover, a workplace insurer.39 Ultimately StateCover suffered significant losses, but its claim was settled by LGFS.40 The StateCover sale and settlement are material to this case note in that the modelling process for both issues of the Rembrandt notes was the same,41 and insofar as LGFS successfully claimed equitable contribution from S&P and ABN Amro for making the settlement payment.42 In October 2006, after the StateCover purchase, ABN Amro entered into a contract with LGFS agreeing to sell it $40 million, and then a further $5 million, worth of Rembrandt 2006-3 notes.43 The notes were then marketed by LGFS to the councils.44 At this time, LGFS had come to fulfil the role of financial or investment adviser to local councils, and had sought over some time to build a ‘strong relationship’ with them.45 The councils were permitted under the Local Government Act 1993 (NSW) and the relevant Ministerial Order to invest public money in particular financial products with secure credit ratings from well-known ratings agencies including S&P.46 LGFS, knowing the councils’ conservatism in investments and the rules to Bathurst Trial  FCA 1200, .
Ibid ; Bathurst Appeal (2014) 224 FCR 1, 101 .
Bathurst Appeal (2014) 224 FCR 1, 100–107 –, see especially 107 –.
Bathurst Appeal (2014) 309 ALR 445, 565 .
Bathurst Appeal (2014) 224 FCR 1, 111 [580.8]; Bathurst Trial  FCA 1200, .
Bathurst Appeal (2014) 224 FCR 1, 41 .
The Pre-Sale Report, Post-Sale Report and Ratings Letters are considered at Bathurst Appeal (2014) 224 FCR 1, 34–41 –.
The Surf Presentation is considered at Bathurst Appeal (2014) 224 FCR 1, 42–51 –.
Bathurst Appeal (2014) 224 FCR 1, 41–2 –.
Ibid 42 , 59 .
Ibid 55 , 134 .
Ibid 55 .
Ibid 101 .
Ibid 195–9 –.
Ibid 61 , . The Mandate Letter between ABN Amro and LGFS is set out at 56–9 –.
Ibid 73–8 –.
Ibid 30 , 200 –.
Ibid 25–9 –.
2014] CASE NOTE: ABN AMRO v BATHURST REGIONAL COUNCIL 441 which they were subject, emphasised the AAA rating and the liquidity of the CPDO, but downplayed its more unsual features and volatility.47 LGFS ‘white badged’48 the Rembrandt 2006-3 notes, rebranding them as ‘Community Income CPDO Notes’49 and intending to give them a local government feel.50 The councils purchased some $16 million of the notes.51 LGFS retained notes it was not able to sell.52 In October 2008, following sustained credit spread widening in the wake of the GFC, the investments cashed out. LGFS had sold its retained notes to its parent company at the then market value of the notes, which was a fraction of the purchase price.53 Upon cash out, the councils also received a fraction of what they had invested.54 By this stage, S&P had downgraded its rating to BBB+ and the notes were priced at about 35% of their face value.55
1 Negligence and Misleading Conduct In a judgment spanning some 3700 paragraphs, Jagot J found S&P, ABN Amro and LGFS (together, ‘the defendants’) to be liable to the councils in negligence and statutory misleading conduct, and found S&P and ABN Amro liable to LGFS in negligence and statutory misleading conduct.56 Her Honour also found ABN Amro to be liable for knowing involvement in S&P’s conduct.57 The defendants’ attempts to rely on disclaimers in various documents were unsuccessful.58 In respect of negligence, each defendant’s duty to the investors differed in its content. S&P was found to have owed to LGFS and the councils a duty to take reasonable care in formulating the credit rating.59 ABN Amro owed two duties to LGFS and the councils: a duty to take reasonable care in respect of statements it made about the product; and a duty to take reasonable care to develop a product Ibid 75–6 –, 77–8 , 200 .
That is, LGFS sold the product as if it were its own creation rather than ABN Amro’s. See Bathurst Trial  FCA 1200, , .
Ibid –; Bathurst Appeal (2014) 224 FCR 1, 59 .
Bathurst Appeal (2014) 224 FCR 1 54 .
Ibid 82–3 .
Ibid 83 .
Ibid 84 ; Bathurst Trial  FCA 1200, .
Bathurst Appeal (2014) 224 FCR 1, 83 .
Ibid 84 ; Bathurst Trial  FCA 1200, .