In a landmark decision, a bench of three judges of the Full
Federal Court—which essentially acts as the Federal court of
appeal in Australia—has, in ABN AMRO Bank NV v Bathurst Regional
Council [2014] FCAFC 65, unanimously upheld a first
instance decision which ruled that global ratings agency Standard
& Poor's ("S&P") had breached a duty of care
it owed to investors and had misled or deceived investors by
assigning S&P's highest rating of AAA to a volatile
structured finance product, known as constant proportion debt
obligations ("CPDOs"), arranged by investment bank ABN
Amro Bank NV ("Amro").
The particular CPDOs at issue in the case were sold by Amro as the
"Rembrandt Notes". Twelve Local Councils in the State of
New South Wales ("Councils") had invested in the
Rembrandt Notes in late 2006 in reliance upon the AAA rating that
S&P had assigned to the Rembrandt Notes. The Councils would not
have invested in the Rembrandt Notes had they not had a AAA
rating.
Less than two years after purchasing the Rembrandt Notes, the Local
Councils lost more than 90 percent of their original A$17 million
invested in them due to the
Rembrandt Notes' very high level of volatility.
S&P accepted on appeal that the AAA rating it had assigned to
the Rembrandt Notes was flawed.1 In respect of the
process undertaken by S&P to assign a AAA rating to the
Rembrandt Notes, the Court concluded that "S&P's
rating of the Rembrandt notes was unreasonable, unjustified and
misleading (and ABN Amro knew that to be so)",2 as
the rating, the Court held, adopted a flawed base case volatility
parameter—that is, S&P assumed the Rembrandt Notes were
much less volatile than they should have assumed—and adopted
other overly favourable assumptions.
Claim for Negligent Misstatement
The Councils claimed, and the Court agreed, that S&P owed
them, as investors in the Rembrandt Notes, a duty to exercise
reasonable care in forming, and to have reasonable grounds for, the
opinion expressed by the rating.3
In upholding the Council's claim, the Court ruled that
S&P's function was to rate the notes and, in particular, a
certain aspect of the Rembrandt Notes—their creditworthiness.
S&P knew that its function was specialised and that the members
of that ascertainable class were likely to rely on S&P carrying
out its function.4 Indeed, the only available
information as to the creditworthiness of the notes was
S&P's rating. None of the Councils could replicate or
"second-guess" S&P's rating or undertake its own
analysis of the credit risk of the Rembrandt
Notes.5
S&P's duty was to exercise reasonable care in forming and
expressing the relevant opinion about the credit risk of the
Rembrandt notes. It was in that respect, and that respect alone,
that S&P owed a duty of care to the Councils.6
S&P did not know the precise identity of the Councils.
Nevertheless, the Court held, the class to which the Councils
belonged was not indeterminate. It was both known and identified.
The class to which the duty was owed was investors in the Rembrandt
Notes.7
The Court also held S&P knew the foreseeable type of
loss.8 It is the nature of the loss, not the precise
amount, which is relevant. Here, the Court held, the nature of the
foreseeable loss was not in doubt. S&P knew that if
S&P's opinion as to the creditworthiness of the Rembrandt
Notes was careless, investors were likely to lose the money they
had invested in the notes. And, in that context, S&P knew that
based on the size of the notes issued and the level of minimum
subscription, investors would rely on S&P's ratings and the
10-year period to the maturity of the notes.
The Court rejected arguments that the Councils were contributorily
negligent.
As there were two other defendants who were also found to have
breached their duties of care to the Councils, the Court
apportioned S&P's liability arising from this cause of
action as a third of the Councils' losses and a third each to
Amro and another defendant.
Claim for Misleading or Deceiving Investors
The Court also held that S&P's rating of AAA, in
contravention of a multitude of statutory provisions, was
misleading and deceptive and involved the publication of
information or statements false in material particulars to the
class of potential investors in Australia, which included the
Councils.
The statements were held to have been false because by the AAA
rating there was conveyed a representation that in S&P's
opinion, the capacity of the notes to meet all financial
obligations was "extremely strong". The rating was also a
representation that S&P had reached this opinion based on
reasonable grounds and as the result of an exercise of reasonable
care and skill. Neither of these representations was true, and
S&P also knew them not to be true at the time they were
made.
Amro
Although this update focuses on the position of S&P, as alluded to above, the Court was also critical of Amro. Amro was found to have inappropriately influenced S&P and misrepresented information that S&P then relied upon in formulating its incorrect AAA rating of the Rembrandt Notes. Moreover, the Court also ruled that Amro itself engaged in misleading and deceptive conduct and had breached various other fiduciary and contractual duties owed by them.
What's Next?
This judgment has serious implications for rating agencies.
S&P and Amro may now seek special leave to appeal to the High
Court of Australia, the highest court in this country. If judgment
stands, it can be expected to encourage other investors in other
jurisdictions to pursue ratings agencies. Elsewhere, for example,
S&P already faces billions of dollars in litigation arising
from ratings assigned in the lead-up to the credit crunch.
The decision could also lead to significant reforms by financial
services regulators in order to "crack down" on the
inherent conflicts that presently exist between investment banks
and ratings agencies in the arrangement and rating of financial
services products.
Footnotes
1 At [1].
2 At [563].
3 At [1260].
4 At [1265].
5 At [1265].
6 At [1266].
7 At [1260].
8 At [1260].
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