Thursday, November 15, 2012

Australian Court on Rating Complex Financial Instruments


The Federal Court of Australia has delivered an important ruling that pertains to the liability of credit rating agencies. In Bathurst Regional Council v. Local Government Financial Services Pty Ltd, the court found that Standard & Poors (S&P) was liable to several local councils in Australia for a AAA rating provided in connection with their investment in complex financial instruments known as constant proportion debt obligations (CPDOs). Along with S&P, ABN Amro which structured these instruments was also held liable.

The court found that S&P’s AAA rating was “misleading and deceptive and involved the publication of information or statements false in material particulars and otherwise involved negligent misrepresentations to the class of potential investors in Australia ...” Furthermore, it was found that S&P, in arriving at its conclusions, heavily relied upon inputs provided by ABN Amro without independently verifying them. In effect, this ruling no longer allows rating agencies to disown responsibility to investors who relied on their opinions to make investment decisions.

This judgment is interesting for several reasons. It involves a rare instance where rating agencies have been found to be liable. As the Economist notes, it is unlikely that other courts would adopt a similar stance. S&P is in any event said to be appealing this decision.

It is an unusual instance where the court has not shown any hesitation in delving into the technical aspects of complex financial instruments in minute detail. Jagot, J’s decision is 1,500 pages and 3,723 paragraphs long. The summary itself is 9 pages and 56 paragraphs long! Although the court was aided by expert evidence, the fact that these complex instruments have been stripped down to their essentials in determining the outcome of the liability of S&P and ABN Amro is remarkable.

This judgment would certainly call attention to the risk profile of rating agencies in terms of legal liability.

A further discussion of this judgment is contained in Reuters (which links to other coverage as well) and Prof. Jayanth R. Varma’s Financial Markets Blog (arguing from a financial modelling perspective that these instruments should not have been rated at all).

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