By Simon Clarke, Herbert Smith Freehills

 

LONDON: 10 June 2014 - Simon Clarke and Harry Edwards of Herbert Smith Freehills examine the Federal Court's decision on the issue of credit ratings. The Full Federal Court in Australia has confirmed that, as a matter of Australian common law, a rating agency owes a duty of care to investors in a rated financial product. As such, the rating agency must exercise reasonable care and skill in the issue of the credit rating.

 

The essential basis on which the Full Federal Court reached that conclusion was that the rating agency knew that potential investors in a structured credit product would rely on its opinion as to the creditworthiness of the notes in making their decisions to invest. The judgment was given after an appeal from a first instance finding of such a duty, in Bathurst Regional Council v Local Government Financial Services Pty Ltd (No 5), on which senior associate Harry Edwards has previously commented.

 

This Australian litigation is significant more broadly because it remains the only common law example of a rating agency being found liable to investors as a result of ratings which were found to have under-estimated the default risk of products which performed poorly during the financial crisis. What is of particular interest is whether other common law courts would follow the reasoning of the Full Federal Court.

 

The claims were brought by a number of local councils against each of: the councils' financial adviser, Local Government Financial Services (LGFS), ABN Amro and Standard & Poor's (S&P). ABN Amro had been responsible for creating the structured credit product which was at the centre of the dispute, two series of constant proportion debt obligations (CPDOs), whilst S&P's role was in issuing the CPDOs with a AAA credit rating. LGFS, whose business was in marketing products to local councils and government bodies in Australia, had in 2006 procured the creation by ABN Amro of AUS$40m of Australian dollar-denominated issues of the CPDOs, which were known as the Rembrandt Notes.

 

The councils between them purchased AUS$16m of the Rembrandt Notes, leaving LGFS holding AUS$24m (and therefore LGFS was itself a claimant against ABN Amro and S&P). However, after their purchase, the Rembrandt Notes suffered a catastrophic fall in value caused by the dramatic change in credit conditions following the onset of the credit crisis. In particular, the Rembrandt Notes depended for their performance on the interaction between the mark to market value of a large number of CDS contracts underlying the notes and the premium income which the structure was generating on those contracts. The period of sustained widening in credit spreads caused losses within the structure when mark to market falls heavily exceeded the income. In simple terms, whilst their performance was expected to be strong if benign market conditions continued, the onset of the financial crisis caused the notes to fail.

In a mammoth 1,459 page judgment, Ms Justice Jagot found in favour of the councils in their claims against LGFS, ABN Amro and S&P, and also in favour of LGFS (in respect of the retained AUS$24m worth of the Rembrandt Notes) against both ABN Amro and S&P. The claims against ABN Amro and S&P were each put in terms of: (i) an Australian-specific statutory claim for misleading or deceptive conduct; and (more significantly for those outside Australia) (ii) breach of a duty of care to investors. In issuing the AAA rating it gave to the Rembrandt Notes (and in ABN Amro's case deploying that rating in its marketing materials), S&P had assumed a duty to exercise due skill and care to ensure that such an opinion was reasonably capable of being held. Having identified a number of flaws in the rating process and the assumptions which were adopted by S&P in issuing the AAA rating, S&P (together with ABN Amro) was found to have breached this duty and to be liable to each of the investors for their losses.

In the appeal court, S&P accepted that the rating itself was flawed, and focussed on the finding that it owed a duty of care to investors. In doing so, and perhaps indicative of the significance of such a finding, the parties between them advanced comprehensive grounds of appeal which the Full Federal Court said put in issue "just about every finding of fact and conclusion of law made by the primary judge" and pursued "each allegation of error with undiscriminating vigour". However, the central issues which are of wider significance to the potential for claims against credit rating agencies are those which go to the heart of the duty of care which was said to exist.

 

S&P contended that it did not owe a duty of care either to LGFS or to the local councils. In summary, it argued this on the basis of a lack of reasonable foreseeability in its conduct causing loss to those investors, and that the factors which the common law requires before it will impose a duty of care in the absence of a contract were not sufficiently present. Moreover, S&P contended that the effect of the first instance decision would be that rating agencies owed a legally enforceable duty to anyone who decided to take action based on a rating which they had issued and, effectively, to "turn predictions about the future into guarantees". As a matter of law and policy, it said, the decision should not stand.

 

The Full Federal Court was seemingly unimpressed by contentions that the important questions were ones of law and policy and instead concluded that S&P's liability to the investors turned simply on the application of established legal principles to the facts. Having described the applicable legal principles, which are largely similar to those which apply to the imposition of duties of care under English law, three key factors were considered in the context of whether such a duty should be imposed in these circumstances.

One of the key factors on which S&P had sought to rely was that the rating agency did not know the identity of the ultimate investors in the Rembrandt Notes or even how many investors there would be. More fundamentally, S&P argued that it publishes tens of thousands of opinions as to future likelihood of repayment by issuers and does so in a way which means that almost anyone, anywhere could access those opinions. Accordingly, if a duty of care arose as a result of its ratings, the class of potential claimants would be so vast and indeterminate that it offended one of the primary limitations which the common law was concerned to impose for establishing a duty of care.

 

However, the Full Federal Court found that liability in respect of the Rembrandt Notes was not indeterminate because, whilst it may not have known the precise identity or number of investors, S&P was aware that there were to be members of a class the essential characteristic of which was that they were to purchase Rembrandt Notes. Moreover, on the facts S&P, knew the size of the issue and the minimum level of subscription (and could thus establish that the maximum number of investors in the issue would be 80), and that S&P's potential liability would be limited in time for as long as S&P retained its rating (or the 10 year tenor of the Rembrandt Notes).

S&P contended that the relationship between rating agency and investor did not require the law of tort to intervene and protect the investors. It submitted that neither LGFS nor the councils were vulnerable and each was capable of protecting itself from the harm which it had suffered. S&P said that vulnerability was a prerequisite for a duty of care to avoid economic loss and, accordingly, no such duty arose in the circumstances.

 

However, the Full Federal Court emphasised that vulnerability is the consequence, not an additional requirement, of reasonable reliance by an ascertainable class of potential claimants. Moreover, the court placed great weight on the finding that neither LGFS nor the councils could replicate or "second-guess" the rating which S&P had given to the Rembrandt Notes. In having to rely on S&P's rating for the purpose of assessing the credit-worthiness of the Rembrandt Notes, neither LGFS nor the councils were able to protect themselves and were therefore vulnerable in the sense required.

S&P had no contractual relationship with either LGFS or the councils, a factor which is commonly found to be a pointer against a duty of care being present. S&P argued that the absence of direct dealing between itself and the investors ought to preclude the finding that it owed them a duty of care. However, that submission was robustly rejected. In circumstances where ABN Amro had engaged S&P for the purpose of communicating the AAA rating to an ascertainable class of investors, the Full Federal Court was clear that the authorities did not preclude such a duty on the basis that there was no contractual relationship.

The conclusions reached by the Full Federal Court confirm one of the most striking common law judgments in the aftermath of the financial crisis, given the role which rating agencies played in relation to so many of the financial products which fared poorly. The obvious question is whether it will stand alone or whether it will have a wider impact on claims by other investors in other products. Naturally, each case will depend on the precise factual findings and in particular the nature of the investors and products in question, as well as the documentation which was used by the parties.

 

However, it remains to be seen whether the Full Federal Court's reasoning would be followed by, for example, an English court. Fundamental to the liability of S&P both to LGFS and the councils is that each was treated as vulnerable to a flaw in the rating as a result of what was assumed to be reasonable reliance on the rating. A phrase which is repeated on a number of occasions in the judgment relates to the fact that the investors were not able to "second guess" the rating or undertake their own analysis of the risk of default, without considering in terms the question of whether investors placing such sole reliance on the rating for this element of the risk in a financial product is reasonable. Putting to one side the question of whether an entity such as LGFS was in fact unable to assess for itself the default risk attaching to products such as the Rembrandt Notes, such an approach surely risks providing investors with a route to recover losses in circumstances where they have made no attempt themselves to assess default risk. It is unclear that an English court would so readily adopt that approach. As Hamblen J put it in CRSM v Barclays, if there is one thing which a sophisticated investor should be deemed to have made up its own mind about when purchasing an investment product, it was default risk. Equally, if the investor truly did not, and could not, make its own assessment of the default risk of a particular product, it may be a better allocation of risk and reward for the investor either to engage an adviser who can (and to pay for that advice), or to instead choose to invest its funds elsewhere.

 

Finally, since the first instance decision, the European Regulation on Credit Rating Agencies (also known as CRA 3) has introduced a statutory cause of action which provides investors (and issuers) with a claim where a rating agency has, intentionally or with gross negligence, committed a breach of the regulatory requirements contained in CRA 3. This cause of action would be available in relation to ratings issued or retained after June 2013, but is not available retrospectively. However, it is noteworthy in the context of Bathurst that, to avail itself of the statutory cause of action, an investor must show that it has relied reasonably on the rating in question. This provision is intended to help to pursue the policy objective of reducing what is widely regarded as an over-reliance by investors on ratings. The unfortunate consequence of a decision such as Bathurst, at least were it to be followed more widely, may be to encourage greater reliance on ratings by (as S&P put it in its submissions) "turn[ing] predictions about the future into guarantees".

 

This case note originally appeared in the "Insights" series on the Herbert Smith Freehills website.