Rembrandt ruling puts heat on S&P
“ABN simply bulldozed it (the rating) through.” The rating of the Rembrandt notes as AAA had been “sandbagged a little”.*
The Federal Court’s Justice Jayne Jagot has accepted the evidence from 13 NSW councils - who claimed they had been duped into buying a toxic financial product - that the ratings agency Standard & Poor’s was little more than a lap dog for slick merchant bankers.
Investors are entitled to and indeed do rely on credit ratings and can expect them to be based on reasonable grounds.
The ruling means the councils will recover about $30 million in losses following failed investments in complex synthetic derivatives known as constant proportion debt obligations, or CPDOs, that were arranged by ABN Amro, rated AAA by S&P and sold by LGFS in 2006.
This judgement was a long time in the coming. The financial crisis, from which the world economy has yet to recover, was caused in part by the widespread sale of toxic and highly leveraged credit derivatives. Investment banks created this deceptive rubbish and the rating agencies lent their imprimatur.
In the direct aftermath of the crisis in 2009 a Congressional inquiry in Washington heard testimony, which came to light in an email between S&P employees, “We’d rate a cow”, if paid for.
Duty of care for investors
It has taken three years but finally a court has ruled what most people had suspected, that the rating agencies have a duty of care to investors, that their AAA ratings should have mattered, and yes, not only that they would rate a cow for money but they did rate a cow.
That cow was a “Rembrandt” CPDO (Constant Proportion Debt Obligation). S&P had assigned its top rating, AAA. Yet it was highly leveraged and highly risky financial product and it blew up 90 per cent of its value six months after the councils had purchased it.
The Federal Court’s finding that S&P was negligent has tremendous implications. It will reverberate around the globe, perhaps exposing the ratings agencies to a slather of lawsuits here and abroad.
The essential problem in the system has been exposed, and now judged by a court. That is, that the ratings agencies are private companies whose shareholders benefit if the stock price rises. They are paid by the banks to rate their products. The more ratings they apply, the more profit they make.
These CPDOs were even more leveraged and risky than your average CDO (collateralised debt obligation) and there were approximately 5 billion euros worth of CPDOs issued globally, the vast majority of which defaulted during the height of the financial crisis.
It will now be far more difficult for rating agencies to hide behind disclaimers to absolve themselves from liability. The Court’s finding this morning acknowledges that investors are entitled to and indeed do rely on credit ratings and can expect them to be based on reasonable grounds.
S&P cannot express its opinion, knowing that investors rely upon it, get paid for that opinion and then disclaim liability.
It remains to be seen whether the Court’s finding that S&P engaged in misleading and deceptive conduct in assigning its coveted-AAA rating to the CPDO will open the flood gates for actions against credit rating agencies in relation to other structured products such as CDOs. Logically, CDOs are also in the gun. Most enjoyed the top rating, most blew up.
The CDO market was much larger than the CPDO market - by the end of 2006, the size of the CDO global market was close to $2 trillion, much of which was lost to the global financial crisis.
Now that a legal determination of liability has been made against S&P, disgruntled investors may start undertaking investigations into the reasonableness of the ratings issued for the CDO products.
Much of the investigative work has already been undertaken. Both the SEC and the United States Senate Permanent Subcommittee of Investigations have issued reports on the conduct of rating agencies and both have concluded that ratings were inaccurate and that the failures of credit rating agencies were essential cogs in the wheel of financial destruction.
The judgement against ABN Amro should also serve a warning to all investment banks who issued structured financial products throughout the market. Although a rating is not a representation of the bank, the bank can still be found liable for passing on those ratings in circumstances where they know the rating was not based on reasonable grounds.
In this case, ABN Amro supplied S&P with incorrect data to be used in the ratings process. It knew that the product should not have been rated AAA and yet knowingly allowed investors to be deceived.
Implications for financial advisors
Then there are the implications for financial advisors. This is the second Federal Court decision in the space of six weeks to confirm that an investment advisory relationship can exist in the absence of a written agreement.
Today’s decision, together with the recent findings by Justice Steven Rares in the Lehman Brothers proceedings, confirms that the existence of an advisory relationship is determined on a case by case basis. It swings on the relationship between the investor and the adviser.
No written agreement is necessary. Such advisory relationships, if established, bring a fiduciary duty. The adviser will have to fully and accurately disclose all matters that could reasonably be considered relevant to an investor’s decision to invest and institutions who consider themselves mere sellers of financial products may now find themselves embroiled in litigation for failing to fulfil their obligations as financial advisers.
LGFS (the investment adviser) was found to owe duties to the councils to disclose all factors which were material to the decision to invest in the Rembrandt Notes. LGFS was negligent and guilty of misleading and deceptive conduct in failing to fully and accurately disclose all the material risks the councils, who LGFS knew reposed trust and confidence in them and relied on them to adequately explain the structure and risks.
LGFS were also found to be in breach of their fiduciary duties to the councils by failing to disclose that they had a significant financial interest in selling the products to the councils. LGFS had bought the $40 million issue of the product and would be forced to hold it on its own books if it would not on-sell them.
The proceedings were filed by the applicants in the Federal Court of Australia in September 2009. The 13-week trial commenced before Justice Jagot in October 2011 and concluded in March this year.
S&P says it plans to appeal the ruling.
"We are disappointed with the court's decision, we reject any suggestion our opinions were inappropriate," the ratings agency said in an emailed statement.
*These are quotes from internal emails that emerged during the hearings of the case and were mentioned by Justice Jagot in her ruling.