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Last updated: November 5, 2012 6:57 pm
Standard & Poor’s misled investors by awarding its highest rating to a complex derivative product that collapsed in value less than two years after it was created by ABN Amro’s wholesale banking division, an Australian judge has ruled, in a landmark case that could pave the way for legal action in Europe.
In a damning verdict, the Federal Court of Australia ruled S&P and ABN Amro had “deceived” and “misled” 12 local councils that bought triple-A rated constant proportion debt obligations (CPDOs) from an intermediary in 2006.
The court said a “reasonably competent” rating agency could not have given a triple A rating to the securities, which were described as “grotesquely complicated”. S&P and ABN’s wholesale banking arm, which is now owned by RBS, also published information and statements that were either “false” or involved “negligent misrepresentations”, Justice Jayne Jagot found.
The 1,500-page ruling marks the first time a rating agency has stood a full trial over a structured finance product.
The Australian ruling led some investors to reassess their previously sanguine view of the legal landscape for the rating agencies. In New York trading, S&P’s parent McGraw-Hill closed 4 per cent weaker, versus a broadly flat equity market. Moody’s fell 3 per cent.
“This is a major blow to the rating agencies, which for years have had the benefit of profiting from the assignment of these ratings without ever being accountable to investors for those opinions,” said Amanda Banton, the lawyer representing the councils.
“No longer will rating agencies be able to hide behind disclaimers to absolve themselves from liability.”
John Walker, executive director of IMF Australia, the listed litigation company that funded the action by the local authorities, said the Australian ruling was likely to pave the way for “significant recoveries” in Europe.
Nevertheless following Monday’s ruling, lawyers outside of Australia were sceptical about how easy it would be to pursue similar claims in the US or Europe.
In the US and other jurisdictions, rating agencies have been largely successful in batting away dozens of legal cases claiming that they should be held liable for inaccurate ratings on derivatives and other securities that fell in value during the financial crisis. The agencies have successfully argued that their ratings are just opinions, protected by the US Constitution’s free speech guarantee and by disclaimers in their published reports.
In one important outstanding case, however, Abu Dhabi Commercial Bank and a group of other investors have been granted a trial to decide claims that Moody’s and S&P were party to a fraud because they did not believe their ratings on a structured investment vehicle marketed by Morgan Stanley.
The councils in New South Wales were assured the CPDOs purchased in late 2006 from Local Government Financial Services, a municipal adviser, had only a small chance of defaulting. But less than two years later the securities, which were linked to credit default swaps on investment grade companies, were liquidated as spreads rose and the cash backing the notes fell to dangerously low levels.
The councils lost more than 90 per cent of the A$17m they invested in the securities, also known as the “Rembrandt” notes. A 13th council, which sued separately, lost almost A$1m.
Following Monday’s ruling, the councils stand to receive A$16m in damages but the total cost of the case including legal fees and interest could reach A$30m, according to Mr Walker.
LGFS, which counter sued ABN Amro and S&P, has been told that it is also entitled to compensation for the A$16m loss it incurred on the sale of the notes to its parent company. LGFS purchased A$45m of the securities from ABN Amro, reselling A$18.5m to the councils and keeping the rest.
S&P, a division of publishing company McGraw-Hill, said it planned to appeal. “We are disappointed with the court’s decision, we reject any suggestion our opinions were inappropriate and we will appeal the Australian ruling, which relates to a specific CPDO rating,” S&P said in a statement. RBS said in a statement it was “studying this long and complex judgment”.
During the trial S&P argued that the councils had not done any work to try and understand the investments, relying on advice from LGFS. S&P claimed its role was limited to the issuing of an opinion about the creditworthiness of the notes and had not been subject to any undue influence from ABN Amro.
This article is subject to a correction and has been amended.
Additional reporting by Stephen Foley in New York and Mary Watkins in London
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