Standard & Poor’s lost a landmark case in Australia yesterday over top-flight ratings given to financial products that collapsed in the build-up to the 2008 economic crisis.
The Federal Court of Australia ruled that S&P’s “AAA” rating of constant proportion debt obligation (PDO) notes created by banking giant ABN AMRO and sold to the councils of 13 Australian towns had been “misleading and deceptive.”
It is the first time a ratings agency has faced trial over synthetic derivatives and the case could set an important precedent for future litigation.
“[It is a] decision that is likely to have global implications and be felt hardest in Europe and the US, where similar products were sold to banks and pension funds,” said Piper Alderman, the law firm representing the councils. “No longer will rating agencies be able to hide behind disclaimers to absolve themselves from liability.”
IMF Australia, a publicly listed company that provides funding for large legal claims and bankrolled the case, said it was already mulling similar actions in New Zealand, Britain and the Netherlands.
“We expect that investors, banks and regulatory authorities around the world will be examining this judgment carefully to determine the broader implications,” IMF director John Walker said.
S&P has already been warned by the US Securities and Exchange Commission that it could face a lawsuit over its rating of a similar product, Delphinus CDO 2007-1, a package of collateralized debt obligations.
The derivatives market, involving the trade of complex instruments based on the risk of loans going bad — from mortgages to the debts of developing countries — was a key driver of the global financial meltdown in late 2008.
S&P said it was “disappointed” and would challenge the ruling.
“We reject any suggestion our opinions were inappropriate and we will appeal the Australian ruling, which relates to a specific CPDO rating,” a spokesman said.
Within months of the councils buying the CPDOs from Australian firm Local Government Financial Services (LGFS) in late 2006, assured they had a less than 1 percent chance of failing, the notes defaulted.
The councils, from small, mostly mining and farming towns, lost A$16 million (US$16.5 million) on the so-called “Rembrandt notes,” more than 90 percent of the original capital invested.
Judge Jayne Jagot said S&P’s assessment of the products as “extremely strong” had been central to the loss.
“The CPDO could achieve a rating of ‘AAA’ only on the basis of an unreasonable combination of unreasonably optimistic inputs but not otherwise,” she said. “S&P did not assess the CPDO notes by reference to exceptional, but plausible events in any way. To rate the CPDO notes ‘AAA’ without having done so was to act without reasonable care as a ratings agency.”
The judge ruled that ABN AMRO had also been “knowingly concerned in S&P’s contraventions of the various statutory provisions proscribing such misleading and deceptive conduct,” and had engaged in such conduct itself.
She made a similar ruling on LGFS and rejected the three financial agencies’ arguments that the councils should bear a part of the blame due to to their “contributory negligence.”
Jagot ordered S&P, ABN AMRO and LGFS to each pay one-third of the councils’ losses plus interest, meaning the total compensation would be about A$30 million.