The Federal Court of Australia has found that Standard & Poor's actions in giving a triple-A rating to two structured credit products were misleading and deceptive. The ruling relates to the agency's rating of Rembrandt 2006-2 and 2006-3, two Constant Proportion Debt Obligations designed and sold by ABN Amro in 2006.
CPDOs were just about the peak of the structured credit lunacy that went on during the boom years before the crisis. This highly innovative product was soon shown to be more than a little too funky. When credit markets turned in an unexpected direction, this leveraged product based on credit default swaps went sour.
S&P and the bank were being sued by 12 local authorities in New South Wales that had bought the triple-A paper and lost money.
The Australian court case marks the first time since the financial crisis that a court has ruled a rating agency liable for its view on a structured finance security.
Dozens of other cases in the US and some in Europe have seen investors file suits, only for judges to find almost unanimously that credit rating agencies only offer an opinion. They are entitled to express those views — and for them to be incorrect.
The courts’ defence of rating agencies’ right to get it wrong is fair when an honest mistake is made. Too easily are rating agencies made scapegoats for issuers’ cunning and investors’ laziness in the boom years.
But according to the Australian court, in this case S&P’s behaviour spread beyond mere incompetence. The judgement said the awarding of a triple-A rating to the senior tranches of two CPDOs was “misleading and deceptive” and involved “negligent misrepresentations” to the investor claimants.
Most damningly of all, the court ruled that S&P knew at the time that it had not reached its opinion “based on reasonable grounds and as the result of an exercise of reasonable care”.
The landmark victory for the Australian council claimants could inspire other investors to bring similar cases to court in other jurisdictions. Already there is talk of a class action.
This momentum is worrying. If rating agencies or banks are found to have been misleading or deceitful, they should indeed be liable.
But on those occasions when incompetence is to blame, investors should not be compensated for losses. A whirlwind of litigation blowing through the entire industry will serve very few interests other than those of the legal profession. It would undermine the rating agencies’ already weakened credibility, could make them more cautious and possibly encourage investors to blame the agencies for their own poor credit decisions.
ABN Amro’s role in the debacle should not be overlooked — it should be a focal point, if lessons are to be learnt. In its evidence for the case, S&P said that ABN Amro had “simply bulldozed the rating through” and described S&P analysts on the CPDO as “sandbagged a little” at a time when the agency's rating model for the new CPDO product “was a work in progress”.
The judgement found that the bank on five different occasions wrongly asserted to S&P that the average volatility since inception of the Globoxx index (an important input for modelling the transaction) was 15%. According to the court judgement, the actual volatility since inception was nearly double that.
The judgement found that S&P should have calculated the volatility for itself, but that the agency had instead believed ABN. The conclusion of the judgement was that the Triple A rating awarded to the CPDOs would not have been awarded if the volatility assumption had been correct.
What the case should surely prompt is a fresh examination of whether rating agencies should be allowed to carry on being paid by issuers.
The independence of rating agencies is inevitably curtailed when they rate transactions for the hand that feeds them. Since the financial crisis, rating agencies have sought to establish tougher criteria and more distance from issuers to restore their credibility. But ultimately they know they cannot survive without issuers bringing them transactions in the future.
An investor-funded model makes sense. Rating agencies would then unquestionably be the “investor service” they already purport to be. They would be accountable to the buyside. And most importantly of all, harsh treatment of issuers’ deals would have no impact on their future business, as ratings shopping would be irrelevant.
The financial world may not be ready for such radical change, but only when the issuer-pays model is undone will rating agencies feel completely unshackled in offering their credit opinions.