Credit ratings from the “big three” agencies (Moody’s, Standard & Poor’s, and Fitch) come with a notorious caveat emptor: they are produced on the “issuer-pays” model, meaning that sellers of financial instruments pay the agencies to rate them, much as if a car dealership paid a magazine to write reviews of its vehicles. Historically, the law has insulated agencies from the complaints of irate investors. But now, in what is being hailed as the first decision of its kind, an Australian court has found a ratings agency responsible for investors’ losses on structured debt products sold in the years leading up to the financial crisis.
Australia’s Federal Court has ruled that Standard & Poor’s was liable for losses that Australian town councils incurred on financial instruments they bought from Dutch bank ABN Amro in 2006, and for which S&P provided the ratings. The councils sued both ABN and S&P. (An S&P spokesman declined to comment, and an ABN spokesperson could not be reached by press time.)
The Federal Court is the country’s second highest court, which means S&P could still appeal and take the case to the High Court. So far it has not announced a decision to do so. Here are the salient points of the judgment, which ratings agencies, their lawyers, and probably every class-action attorney in North America will be poring over today.
ABN Amro sold the town councils fiendishly complex credit derivatives. In 2006, ABN Amro sold 13 Australian councils instruments called “Constant Proportion Debt Obligations” (CPDOs). These contain credit default swaps (CDS): wagers where one side (party A) bets that that the likelihood of default of one company or an index of companies is low, while the other side (party B) bets defaults will rise. The bank, in this case ABN Amro, arranges the bet. When a certain level of defaults occur, party A pays party B. In this case, the Australian councils were party A. (Party B was not identified in the judgment.) The councils’ bet was based on the future performance of companies that made up a global debt index called the Globoxx. The councils got the bet wrong and lost around A$16 million (US$16.6 million now, somewhat less at the time) between them.
“The CPDO was described in part of the evidence as a ‘grotesquely complicated’ instrument,” judge Jayne Jagot wrote in her ruling, and added, “This is accurate.” But the real problem was that the councils assumed they were making a safe investment because S&P erroneously rated the products AAA, its top rating of safety. In fact, judge Jagot ruled, the product was only rated safe because S&P allowed ABN to supply inaccurate data for its pricing model. Save for this error, “the CPDO could not have been rated AAA by S&P on any rational or reasonable basis.”
S&P, by not doing enough research, allowed itself to be “gamed” by the bank. ABN Amro had “employed two former employees of S&P” to learn the agency’s methods, the judge said. It knew, for example, that for S&P to give the derivatives the top rating, its models had to show a likely default rate of less than 0.728%. The bank supplied erroneous data (whether intentionally or not, the judgement doesn’t say). Crucially, ABN inaccurately told S&P that the historical average volatility of the Globoxx index was 15%, when in fact it was 28%. This, the judge said, was something S&P could, and should, have checked: “S&P did not calculate the volatility for itself although it could easily have done so and, in my view, was required to do so as a reasonably competent ratings agency.”
Nor did S&P act when it started to suspect it had been misled. Later in 2006, ABN hired S&P to rate a third set of the CPDO notes. By this time, the ratings agency “had realised” the 15% volatility assumption was too low, the judge said. And people working in the small cottage industry of structured derivatives were raising suspicions, to the point that S&P was “receiving daily calls on quantitative issues relating to CPDO criteria.”
A senior analyst in S&P’s New York office told his managers that employees who came up with the AAA rating had been “sandbagged a little by ABN,” the judge said. This analyst, the ruling continued, then recommended S&P do nothing. The judge further found:
This analyst recommended that as the AAA rating of CPDO had gained such huge attention in the markets S&P should either stick with all its assumptions “and emphasize that we stress other factors” or stick with its assumptions for existing deals only and then change its assumptions for future deals.
Could all this make ratings agencies vulnerable to being sued? As financial consultants’ Brattle pointed out in this research paper (pdf, p.1) ratings agencies rely on First Amendment freedom-of-speech disclaimers to shield their analysis from litigation. That defense is weakening. Earlier this year, a US district court ruled against it. Amanda Banton, a partner at Piper Alderman, the law firm representing the Australian councils in the case against ABN and S&P, said in an interview with Quartz: “This ruling shows ratings agencies cannot hide behind their [freedom of speech] disclaimers anymore.”
Of course, that is the sort of thing plaintiff lawyers say to scare defendants into paying out quick settlements instead of appealing. Piper Alderman’s clients are relying on loans from a litigation funding outfit in Australia to pay their legal fees. But if the High Court upholds the ruling against S&P, the whole ratings model might be in need of re-examining.