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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.

And so, during the debt-fuelled boom the agencies’ standards declined.

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.

Floodgates opened?

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.

47 comments

  • Now before all you investment bank apologists start chirping "caveat emptor" just take a step back and have a think about why firms such as ABN Amro and the like were pushing these products onto their clients. To enrich the clients? Absolutely not. To earn fees and get this type of rubbish off their own balance sheet? Absolutely. Councils are not what i would consider sophisticated investors and I do find it difficult their mandate would allow them to invest in these types of securities. However they were clearly reading the top line AAA rating and perhaps not the fine print. ABN and others were purely acting in their own self interest and should never have been shipping this type of rubbish to councils who should be sticking to term deposits and/or CMTs for any excess funds. If i knew that my rates money was being used to purchase these types of financially engineered malarchy i would have been front and centre at the coucil asking for a please explain!

    Commenter
    gb
    Location
    Sydney
    Date and time
    November 05, 2012, 12:07PM
    • As a ratepayer, you SHOULD be demanding the legal prosecution of the council people responsible for their negligent investment into very complicated derivative products. Yes, the investment bankers and rating agencies were culpable, but why were ratepayer monies chasing complex investments? It is ironic that Orange council was one of the Rembrandt investors - their namesake Orange County in the US lost 1.5 billion in 1993 from derivative investments, but our councils must have thought they were smarter than the yank councils...

      Commenter
      Tim
      Location
      Sydney
      Date and time
      November 05, 2012, 2:05PM
    • What on earth are you on about?

      It doesn't matter what you'd consider to be a sophisticated investor. What matters is what the Corporations Act considers to be a sophisticated investor.

      And there is no duty for product issuers to have as their motvation the enrichment of their clients. Their motivation should be to operate their business in the interests of their shareholders.

      When the councils invested in these products, thety did so based on the advice (since proven to have been incorrect) that they were a safe and stable investment. At the time, you would have not been in any better position to suspect that your rates were being poorly invested.

      So please, stop with your knee-jerk bank bashing and self-aggrandising pontificating.

      Commenter
      Verbal Kint
      Date and time
      November 05, 2012, 2:08PM
    • Sort of like the Canstar ratings for best of anything.....stores, insurance, coffee, banks etc etc. The companies pay for the rating & the poor sucker public believe it.
      Councils should be banned from investing in anything other than a bank.

      Commenter
      Bazza
      Date and time
      November 05, 2012, 2:10PM
  • The article does not indicate as to who will reimburse the damages to the councils?
    All rating agencies shall be liable for their opinion/ratings awarded for various finacial productes they rate? part of the compensation shall be provided by rating agencies and rest by the company whose product they rated so that the investor is protected from the losses to keep the trust in the system.
    currently financial institutions are manned by corrupt & incompetant people who manipulate the system to increase their bonuses. There shall be heavy penalties for people manipulating the system by Govt agencies.

    Commenter
    PG
    Date and time
    November 05, 2012, 12:23PM
    • At last, some action against the wide boys of Wall Street, and their fellow travellers in financial markets world-wide, who created the GFC (Greatest Financial Crime). And those governments which keep kow-towing to these so-called ratings agencies should examine closely Justice Jagot's finding that they are little more than lap dogs to slick merchant bankers. Funny how ordinary people around the world quickly arrived at that conclusion 4 years ago while our govts still struggle to catch on. Catch on, and reinstate laws that identify criminal fraud for what it is, not some allowable smart practice in a "free" market, and put these wide boys behind bars where they belong.

      Commenter
      Colt
      Location
      New Lambton
      Date and time
      November 05, 2012, 12:25PM
      • @Colt
        Well said that man. But of course the great and the good up on Macquarie Street will still rattle on (and on) about the need to retain our AAA credit rating, just like their predecessors did. The fact that these ratings are questionable at best appears to be wholly irrelevant to Bazza and co. The Emperor's Clothes, doubtless.

        Commenter
        daveinbalmain
        Location
        balmain
        Date and time
        November 05, 2012, 12:43PM
    • Finally... The system working as it should.

      I never quite understood how they rating agencies were going to defend the fact they gave these products AAA ratings when they could not model them.

      Wouldn't the complexity have set off alarm bells at many levels?

      Am I the only one thinking what good are these ratings if they are not to be trusted?

      Commenter
      Rainier Wolfcastle
      Location
      Springfiled
      Date and time
      November 05, 2012, 12:39PM
      • The ratings agencies defence was quite simple actually

        "These ratings are simply our OPINIONS and should be treated as such, and you should not base your investment decisions solely on these ratings"

        Tell that to all the municipal councils, Pension, Mutual and Super funds who plowed billions of dollars into them, only to get completely screwed in the end. The sad thing was, these types of entities which lost nearly everything are under regulatory mandate to purchase highly rated securities (only AAA) to minimise risk.

        Oh the irony!

        Commenter
        af612
        Date and time
        November 05, 2012, 1:36PM
    • So why is Barry O'Farrell so obsessed with maintaining NSW's AAA rating?

      Commenter
      Sarah
      Date and time
      November 05, 2012, 12:47PM

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