Case Note ABN Amro Bank NV v Bathurst Regional Council: Credit Rating Agencies and Liability to Investors Aarushi Sahore

Abstract Credit rating agencies perform the role of gatekeepers in the financial industry, particularly when investment products become increasingly complex. In a case the first of its kind, the Federal Court of Australia imposed liability on Standard & Poor’s for significant losses sustained because of its negligent and misleading credit rating of a highly complex structured financial product. The decision informs the content of the responsibility of credit rating agencies to investors who heavily rely on their expert opinions as to the creditworthiness of financial products. The decision is likely to have an impact on similar litigation around the world and on the direction of financial regulation in this context.

I

Introduction

Among the more notable legal fallouts of the so-called ‘Global Financial Crisis’ (‘GFC’) was the litigation commenced by local government councils that had lost millions of dollars after investing in AAA rated complex financial instruments. In a widely publicised decision,1 Jagot J of the Federal Court of Australia imposed civil liability on the credit rating agency (‘CRA’) Standard & Poor’s (‘S&P’) for losses caused by its negligent and misleading credit rating for a financial product.2 The investor councils simultaneously succeeded against the product arranger, investment bank ABN Amro, and the seller, Local Government Financial Services (‘LGFS’).

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BCom (Finance), LLB (Hons I) (Syd). This case note was prepared in my final year under the guidance of Professor Barbara McDonald. Any errors remain my own. See, eg, Leo Shanahan, ‘Councils Win Landmark Case against Standard and Poor’s, ABN Amro’, The Australian (online), 5 November 2012 ; Lucy Battersby, ‘Standard & Poor’s Hit With $20m Compensation for Wonky Ratings’, The Sydney Morning Herald (online), 6 November 2012 ; ‘Morning Business Round-Up: S&P “Misled Investors”’, BBC News (online), 6 November 2012 ; Nadine Schimroszik and agencies, ‘S&P Guilty of Misleading Investors’, The Guardian (online), 6 November 2012 . Bathurst Regional Council v Local Government Financial Services Pty Ltd (No 5) [2012] FCA 1200 (5 November 2012) (‘Bathurst Trial’). The claim was brought against McGraw-Hill International (UK) Limited, of which S&P is the ratings division. © 2015 Sydney Law Review and author.

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On appeal, in ABN Amro Bank NV v Bathurst Regional Council (‘Bathurst Appeal’),3 the Full Federal Court dismissed nearly all of the appeal grounds raised by ABN Amro, S&P and LGFS in respect of their liability to the councils and each other. The Bathurst Appeal is significant, primarily because it affirmed that a duty to exercise reasonable care and skill can be owed by a CRA to potential investors who rely on its rating. It also demonstrates how the law must grapple with the sheer complexity of modern financial investments, and the correlative need for investors to rely on credit ratings. Part II of this case note outlines the background to the proceedings, and relevant outcomes of the first instance decision. Part III analyses the appeal decision on negligent misstatement against S&P. In Part IV, the issues inherent in the credit rating industry and international perspectives on liability and regulation are considered.

II

Background to the Appeal

A

Facts and Chronology

In early 2006, investment bank ABN Amro invented a new financial product known as the ‘Constant Proportion Debt Obligation’ (‘CPDO’). This structured financial product, which the trial judge described as ‘grotesquely complicated’,4 involved leveraged investment in synthetic or notional credit default swaps by reference to global indices that tracked pools of such investments.5 The CPDO was issued in Australian dollars in the form of notes with 10-year maturities under the names of Rembrandt 2006-2 and Rembrandt 2006-3.6 The bank engaged S&P to rate the CPDO, a product which the market had not seen and which had never been rated before.7 ABN Amro made it clear that the highest rating of AAA was sought for the product.8 This was because it had intended to sell the product to LGFS, which in turn was to sell the product to local councils.9 Those local councils were the subject of strict investment guidelines requiring high ratings for investment to be permissible.10

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(2014) 224 FCR 1. See, eg, Bathurst Trial [2012] FCA 1200, [2182], [3527]. Bathurst Appeal (2014) 224 FCR 1, 31–2 [32]–[36]; Bathurst Trial [2012] FCA 1200, [55]–[61], [760]. Elsewhere the CPDO has been described as the ‘poster child for the excesses of financial engineering in the credit market’: Michael B Gordy and Søren Willemann, ‘Constant Proportion Debt Obligations: A Post-Mortem Analysis of Rating Models’ (Finance and Economics Discussion Series, Divisions of Research & Statistics and Monetary Affairs, Federal Reserve Board (Washington DC), 23 September 2009) 1 . Bathurst Appeal (2014) 224 FCR 1, 32 [38]. Ibid 33 [38]. Ibid 59 [86]. Bathurst Trial [2012] FCA 1200, [3199], [3272]. Bathurst Appeal (2014) 224 FCR 1, 25–9 [19]–[25].

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S&P was paid a substantial fee for issuing a credit rating.11 As the trial judge noted, the risks of the product could not be ‘gleaned by intuition’, so complex mathematical modelling was necessary to simulate its performance.12 S&P relied on a number of analysts, and took well over a month to model the product.13 The performance of the CPDO was sensitive to a variety of factors, and a number of inputs and assumptions were necessary in modelling the product.14 The trial judge observed that it was not possible for most investors to ‘second-guess’ or verify S&P’s credit rating.15 Ultimately, in late 2006, S&P assigned its highest credit rating of AAA to the two issues of the Rembrandt notes,16 a rating meaning that the instrument’s capacity to meet its financial commitment was ‘extremely strong’.17 The rating indicated that for a 10-year instrument, the probability of default was less than 0.728%.18 It should be noted that the rating signified the likelihood of repayments under the CPDO being made in accordance with its terms.19 The AAA rating was not an indication of the return on the investment or the magnitude of loss upon default, nor was it a signal that the investment was risk free.20 The rating was in fact unreasonable, unjustified and misleading.21 The evidence of multiple experts was considered at trial in order to determine how the product had been modelled and how the rating was calculated.22 Of particular concern was the assumed volatility of the underlying notional credit portfolio.23 While S&P originally proposed that volatility be 35%, after ABN Amro pressed for 25% or lower, 15% was used,24 at least until October 2006.25 This was unjustifiable and an ‘egregious error’.26 Indeed, what occurred in relation to the volatility input was described as ‘extraordinary’.27 As the evidence on volatility indicates, the coordinated strategy of ABN Amro and S&P was critical to the litigation, and relevant to a number of claims.28 For some time, S&P used ABN Amro’s model for an earlier product to test the

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Ibid 33 [41], 41 [56]. Bathurst Trial [2012] FCA 1200, [1776]. Bathurst Appeal (2014) 224 FCR 1, 34 [48]. See, eg, Bathurst Trial [2012] FCA 1200, [796]–[830], [2438]. Bathurst Appeal (2014) 224 FCR 1, 33 [39], 112 [580.19], 116–17 [599]–[560]. Ibid 39 [51], 40 [53]; Bathurst Trial [2012] FCA 1200, [268], [318]. Bathurst Appeal (2014) 224 FCR 1, 33 [42]. Bathurst Trial [2012] FCA 1200, [65]–[66]. Ibid [63]. Ibid [759]. Bathurst Appeal (2014) 309 ALR 445, 565 [563]. Paragraphs [374]–[563] are not included in the Federal Court Report of the Bathurst Appeal. The Australian Law Report is cited here and throughout where those paragraphs are cited. See Bathurst Trial [2012] FCA 1200, [691]–[959]. See Bathurst Appeal (2014) 224 FCR 1, 84–108 [145]–[163]. Bathurst Appeal (2014) 224 FCR 1, 87–91 [180]–[219]. Ibid 96 [265]. See, eg, Bathurst Trial [2012] FCA 1200, [2611], [2632], [2634], [2728]. Ibid [2611]–[2612]. Bathurst Appeal (2014) 309 ALR 445, 561 [527]. The issue forms a large portion (‘Part 3’) of the appeal decision: Bathurst Appeal (2014) 521–65 [145]–[563]. See also Bathurst Trial [2012] FCA 1200, [3088]–[3091].

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performance of the CPDO, rather than developing its own model.29 An S&P analyst observed in an email, for example, that ABN Amro’s work-in-progress model and rating had been ‘bulldozed through’, while other S&P employees had been ‘sandbagged a little’.30 However, even after doubts emerged in relation to the modelling, S&P did not change its approach.31 Both S&P and ABN Amro knew that the AAA rating was unreliable.32 S&P knew ABN Amro would use it to promote the product to investors:33 it was a public rating, and S&P had expressly authorised ABN Amro to disseminate it to potential investors.34 The bank used the rating, together with other documents provided by S&P,35 and its own information,36 to market the product to LGFS.37 As noted above, ABN Amro was aware that LGFS was interested in a product with a high degree of security, and placed emphasis on the credit rating in its marketing.38 In August 2006, $10 million of the Rembrandt 2006-2 notes were sold through LGFS to StateCover, a workplace insurer.39 Ultimately StateCover suffered significant losses, but its claim was settled by LGFS.40 The StateCover sale and settlement are material to this case note in that the modelling process for both issues of the Rembrandt notes was the same,41 and insofar as LGFS successfully claimed equitable contribution from S&P and ABN Amro for making the settlement payment.42 In October 2006, after the StateCover purchase, ABN Amro entered into a contract with LGFS agreeing to sell it $40 million, and then a further $5 million, worth of Rembrandt 2006-3 notes.43 The notes were then marketed by LGFS to the councils.44 At this time, LGFS had come to fulfil the role of financial or investment adviser to local councils, and had sought over some time to build a ‘strong relationship’ with them.45 The councils were permitted under the Local Government Act 1993 (NSW) and the relevant Ministerial Order to invest public money in particular financial products with secure credit ratings from well-known ratings agencies including S&P.46 LGFS, knowing the councils’ conservatism in investments and the rules to

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Bathurst Trial [2012] FCA 1200, [2551]. Ibid [306]; Bathurst Appeal (2014) 224 FCR 1, 101 [310]. Bathurst Appeal (2014) 224 FCR 1, 100–107 [305]–[370], see especially 107 [363]–[364]. Bathurst Appeal (2014) 309 ALR 445, 565 [563]. Bathurst Appeal (2014) 224 FCR 1, 111 [580.8]; Bathurst Trial [2012] FCA 1200, [2754]. Bathurst Appeal (2014) 224 FCR 1, 41 [54]. The Pre-Sale Report, Post-Sale Report and Ratings Letters are considered at Bathurst Appeal (2014) 224 FCR 1, 34–41 [49]–[55]. The Surf Presentation is considered at Bathurst Appeal (2014) 224 FCR 1, 42–51 [61]–[63]. Bathurst Appeal (2014) 224 FCR 1, 41–2 [59]–[60]. Ibid 42 [62], 59 [86]. Ibid 55 [76], 134 [719]. Ibid 55 [78]. Ibid 101 [312]. Ibid 195–9 [1009]–[1015]. Ibid 61 [93], [96]. The Mandate Letter between ABN Amro and LGFS is set out at 56–9 [83]–[84]. Ibid 73–8 [125]–[134]. Ibid 30 [29], 200 [1021]–[1024]. Ibid 25–9 [19]–[25].

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which they were subject, emphasised the AAA rating and the liquidity of the CPDO, but downplayed its more unsual features and volatility.47 LGFS ‘white badged’48 the Rembrandt 2006-3 notes, rebranding them as ‘Community Income CPDO Notes’49 and intending to give them a local government feel.50 The councils purchased some $16 million of the notes.51 LGFS retained notes it was not able to sell.52 In October 2008, following sustained credit spread widening in the wake of the GFC, the investments cashed out. LGFS had sold its retained notes to its parent company at the then market value of the notes, which was a fraction of the purchase price.53 Upon cash out, the councils also received a fraction of what they had invested.54 By this stage, S&P had downgraded its rating to BBB+ and the notes were priced at about 35% of their face value.55

B

The First Instance Decision

1

Negligence and Misleading Conduct

In a judgment spanning some 3700 paragraphs, Jagot J found S&P, ABN Amro and LGFS (together, ‘the defendants’) to be liable to the councils in negligence and statutory misleading conduct, and found S&P and ABN Amro liable to LGFS in negligence and statutory misleading conduct.56 Her Honour also found ABN Amro to be liable for knowing involvement in S&P’s conduct.57 The defendants’ attempts to rely on disclaimers in various documents were unsuccessful.58 In respect of negligence, each defendant’s duty to the investors differed in its content. S&P was found to have owed to LGFS and the councils a duty to take reasonable care in formulating the credit rating.59 ABN Amro owed two duties to LGFS and the councils: a duty to take reasonable care in respect of statements it made about the product; and a duty to take reasonable care to develop a product

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Ibid 75–6 [128]–[130], 77–8 [134], 200 [1024]. That is, LGFS sold the product as if it were its own creation rather than ABN Amro’s. See Bathurst Trial [2012] FCA 1200, [1071], [1031]. Ibid [48]–[49]; Bathurst Appeal (2014) 224 FCR 1, 59 [88]. Bathurst Appeal (2014) 224 FCR 1 54 [74]. Ibid 82–3 [140]. Ibid 83 [141]. Ibid 84 [144]; Bathurst Trial [2012] FCA 1200, [2400]. Bathurst Appeal (2014) 224 FCR 1, 83 [140]. Ibid 84 [142]; Bathurst Trial [2012] FCA 1200, [2875]. Bathurst Trial [2012] FCA 1200, [3722], [3486]; Bathurst Appeal (2014) 224 FCR 1, 23–5 [12], [14]. For S&P’s negligence, see Bathurst Trial [2012] FCA 1200, [2741]–[2883]; for ABN Amro’s negligence, see Bathurst Trial [2012] FCA 1200, [3267]–[3285]. For statutory claims against S&P, see Bathurst Trial [2012] FCA 1200, [2884]–[2924]; for statutory claims against ABN Amro, see Bathurst Trial [2012] FCA 1200, [3238]–[3253]. For the determination of claims by the councils against LGFS, see Bathurst Trial [2012] FCA 1200, [2119]–[2277], [2397]. Under ss 79 and 1041I of the Corporations Act 2001 (Cth) (‘Corporations Act’): see Bathurst Trial [2012] FCA 1200, [3254]–[3266]. Bathurst Trial [2012] FCA 1200, [2524]–[2543], [3101]–[3103]; affirmed on appeal: Bathurst Appeal (2014) 224 FCR 1, 117–20 [602]–[613], 146 [770]–[771], 150–1 [791]–[794], 164–5 [855]–[858], 173–174 [898]–[901]. See further Part III(A) of this case note. Bathurst Trial [2012] FCA 1200, [2819], [2956].

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commensurate with those statements.60 LGFS was found to have owed a duty of care in its position of financial adviser to the councils to analyse properly and provide advice on the suitability of the proposed investment.61 Two types of statutory claims were raised against each of the defendants. First, misleading or deceptive conduct was alleged under s 1041H of the Corporations Act and s 12DA of the Australian Securities and Investments Commission Act 2001 (Cth) (‘ASIC Act’). Both provisions mirror s 18 of the Australian Consumer Law,62 but apply in the context of financial products and financial services. The second type of statutory claim was brought under s 1041E of the Corporations Act, which prohibits the reckless or negligent making of a statement, or dissemination of information, that is false in material particulars or materially misleading in relation to the sale of financial products. Each defendant’s breach of duty and contravention of statute was found to have caused the losses sustained by the investors.63

2

Other Claims

In the unravelling of the complex set of facts, a number of other causes of action were considered in addition to negligence and misleading conduct. Those are not the focus of Parts III and IV of this case note, but are summarised here briefly to complete the picture. First, against ABN Amro, LGFS successfully argued that certain terms had been implied, under s 12ED of the ASIC Act, into the parties’ contract. These terms required, among other things, ABN Amro to render financial services with due care and skill, and for the CPDO notes to be reasonably fit for LGFS’s purposes. The trial judge found that those terms had been breached.64 Second, against LGFS, the councils brought actions for breach of contract, rescission of agreement, breach of licence and breach of fiduciary duties. Two of the councils, Cooma and Corowa, succeeded against LGFS for breach of contract, for substantially the same reasons as in the negligence claim.65 Each of the councils argued that they had rescinded their agreements to purchase the Rembrandt 2006-3 notes from LGFS under ss 925A and 925B of the Corporations Act, but that argument was rejected by the trial judge because there was insufficient evidence to satisfy the requirements of notice of facts entitling rescission, and a reasonable period of time.66

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Ibid [3179]–[3181], [3200], [3277]–[3279]. Ibid [2263]–[2265]. Competition and Consumer Act 2010 (Cth) sch 2 (‘Australian Consumer Law’). Bathurst Trial [2012] FCA 1200, [2275], [2849], [2881], [2922], [2959], [3177], [3216]–[3218], [3250], [3281]–[3284]. Ibid [3230]–[3236], affirmed on appeal: Bathurst Appeal (2014) 224 FCR 1, 182–3 [945]–[953]. The contract between LGFS and ABN Amro was the ‘Mandate Letter’: see above fn 43. Bathurst Trial [2012] FCA 1200, [2385]–[2396], affirmed on appeal: Bathurst Appeal (2014) 224 FCR 1, 245 [1224]. Cooma and Corowa were the only two councils to have entered into contracts with LGFS, namely the ‘Right Balance Agreements’: Bathurst Appeal (2014) 224 FCR 1, 70 [116]. Bathurst Trial [2012] FCA 1200, [3288]–[3307], affirmed on appeal: Bathurst Appeal (2014) 224 FCR 1, 248 [1247], 277–83 [1403]–[1445].

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LGFS was also found to be in breach of the terms of its Australian financial services licences (‘AFSLs’) under s 912A of the Corporations Act.67 LGFS’s licences allowed it to advise on and sell securities including ‘debentures’ but not ‘derivatives’,68 and CPDOs were ultimately held to be outside the definition of ‘debentures’.69 However, LGFS’s breach of licence did not assist S&P or ABN Amro in negating their duties of care to LGFS,70 nor did it prevent LGFS from making a claim against its insurer for losses incurred.71 Finally, the councils succeeded against LGFS for breach of fiduciary duties.72 Third, in respect of the councils, Jagot J found that they were each bound by s 625 of the Local Government Act 1993 (NSW), which provided that investments of public money could be made in accordance with Ministerial Orders. The relevant Order allowed the councils to invest in ‘securities’ rated AAA by S&P, among other things.73 Her Honour concluded that the councils were not in breach of the Order: here, ‘securities’ included the Rembrandt 2006-3 notes.74

3

Liability and Damages

The defendants were each held to be liable for one-third of the damages payable to the councils, being the millions of dollars lost on the investment in the notes upon cash out. Similarly, ABN Amro and S&P were each liable for one-half of the damages payable to LGFS, amounting to its loss of nearly $16 million upon resale of the notes.75 S&P and ABN Amro’s cross-claims against each other were rejected by the trial judge.76 Contributory negligence arguments, made against LGFS and the councils, were also rejected.77 As noted above, LGFS successfully claimed equitable contribution from S&P and ABN Amro for a claim it settled with

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Bathurst Trial [2012] FCA 1200, [2384], affirmed on appeal: Bathurst Appeal (2014) 224 FCR 1, 120–30 [617]–[700]. See Bathurst Appeal (2014) 224 FCR 1, 30–1 [30]–[31], 121 [618]–[620]. Bathurst Trial [2012] FCA 1200, [2367]–[2384], affirmed on appeal: Bathurst Appeal (2014) 224 FCR 1, 126–30 [661]–[700]. Cf Wingecarribee Shire Council v Lehman Brothers Aust Ltd (in liq) (2012) 301 ALR 1, 315–16 [1201]–[1203]. Bathurst Trial [2012] FCA 1200, [2955], affirmed on appeal: Bathurst Appeal (2014) 224 FCR 1, 130–4 [701]–[718], 165 [860]. Bathurst Trial [2012] FCA 1200, [3646]–[3660], affirmed on appeal: Bathurst Appeal (2014) 224 FCR 1, 335–8 [1758]–[1771]. Bathurst Trial [2012] FCA 1200, [2278]–[2324]. See Bathurst Appeal (2014) 224 FCR 1, 26–7 [19]–[20]. Bathurst Trial [2012] FCA 1200, [2224]–[2229], affirmed on appeal: Bathurst Appeal (2014) 224 FCR 1, 254–7 [1279]–[1296]. Bathurst Trial [2012] FCA 1200, [3361]–[3364], [3463], [3486], [3722], affirmed on appeal: Bathurst Appeal (2014) 224 FCR 1, 24–5 [14]–[15], 297–8 [1506]–[1513]. It should be noted that a significant portion of the Bathurst Trial and the Bathurst Appeal concerned the application of the so-called rule in Potts v Miller (1940) 64 CLR 282 to LGFS’s loss on resale of the notes: Bathurst Trial [2012] FCA 1200, [3364], [3384]–[3393], [3409]–[3415], [3430]–[3462]; Bathurst Appeal (2014) 224 FCR 1, 184–9 [958]–[971]. These interesting issues are beyond the scope of this case note. Bathurst Trial [2012] FCA 1200, [3471]–[3482], affirmed on appeal: Bathurst Appeal (2014) 224 FCR 1, 283–5 [1446]–[1456]. Bathurst Trial [2012] FCA 1200, [3344]–[3450], [3359], affirmed on appeal: Bathurst Appeal (2014) 224 FCR 1, 285–97 [1457]–[1505].

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StateCover.78 Finally, LGFS’s insurer was found to be liable to indemnify LGFS for what it owed to the councils, and the losses LGFS itself suffered.79

III

Credit Rating Agency Liability — The Appeal Decision

In a number of appeals and cross-appeals, the Full Court of the Federal Court of Australia (Jacobson, Gilmour and Gordon JJ) upheld nearly every finding of fact and law made by the trial judge, despite each allegation of error being pursued with ‘undiscriminating vigour’.80 The Full Court overturned Jagot J’s decision in only minor respects, deciding that claims under s 1041E of the Corporations Act were not to be apportioned,81 and that the nature of LGFS’s breach of fiduciary duty should be differently described.82 The focus of Parts III and IV of this case note is the more controversial imposition of liability on a CRA for causing pure economic loss to unknown parties. Part III first considers the key claim of negligent misstatement against S&P, with an emphasis on how the Full Court rejected all of S&P’s appeal grounds in respect of liability. Second, a comparison between the misleading or deceptive conduct claim and negligent misstatement claim is drawn to illustrate the blurring of these causes of action in this context.

A

Negligence

S&P was found to owe a ‘duty to exercise reasonable care in forming, and to have reasonable grounds for, the opinion expressed by the rating’83 to both LGFS and the councils (together, ‘the claimants’).84 Importantly, the Full Court noted that this did not require S&P to issue the correct rating, but only to exercise reasonable care in forming it.85 The applicable law was the law concerning liability for negligent misstatement, as well as principles governing the recovery of pure economic loss in negligence generally. As a starting point, the Full Court noted that the case would be decided by applying established legal principles to facts not ultimately disputed.86 The Full Court said that there was nothing novel about the application of the law of negligent misstatement to expert opinions in the context of modern commercial life.87

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Bathurst Trial [2012] FCA 1200, [2991]–[2992], [3468], [3491], affirmed on appeal: Bathurst Appeal (2014) 224 FCR 1, 195–99 [1009]–[1015]. Bathurst Trial [2012] FCA 1200, [3533]–[3721], affirmed on appeal: Bathurst Appeal (2014) 224 FCR 1, 315–49 [1618]–[1858]. Bathurst Appeal (2014) 224 FCR 1, 21 [4]. Ibid 25 [15], 212–15 [1069]–[1084]. Ibid 24 [13], 248 [1245], 299–315 [1517]–[1611], see especially 300 [1521]. Ibid 108 [566], 111 [579], 195 [1003], 249 [1250]. Ibid 108 [566], 135 [722], 249 [1250], 252 [1266]. Ibid. Ibid 109 [572]. Ibid 114 [590].

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The Full Court affirmed the principles applicable to the law of negligent misstatement as set out by Barwick CJ in MLC v Evatt,88 followed by the High Court in Shaddock v Parramatta Council89 and most recently affirmed in Tepko Pty Ltd v Water Board.90 First, the speaker must realise that the recipient of the information intends to act on it in connection with a serious or business matter.91 Second, the circumstances (including the relative position of the parties) must make it reasonable for the recipient to seek, or accept, and rely on the information.92 The Full Court also acknowledged that the information does not need to be requested,93 but that the purpose of the information is critical.94 In short, there must be known, reasonable reliance.95 A number of factors supported a finding of known reasonable reliance. S&P’s business model involved publishing ratings, where their only purpose was to facilitate the marketability of financial products.96 S&P held itself out to be competent to analyse and rate structured financial products, and was paid to perform the service. It knew that the rating would be used by ABN Amro to promote its products to an ascertainable class of investors, and knew that the rating would be highly material to those investors’ decisions of whether or not to invest. It also knew that many investors would not have the capacity to second-guess the rating.97 It would appear, therefore, that any credit rating agency would find it difficult to deny a finding of known reasonable reliance on the part of an investor relying on its expert opinion in relation to a particular product. Reliance is engendered by the very nature of S&P’s business and the purpose of credit ratings, particularly in respect of complex financial instruments. S&P accepted on appeal that it had failed to exercise the requisite standard of care, if a duty was owed,98 but disputed the imposition of the duty on various grounds including indeterminate liability and the claimants’ lack of vulnerability. First, in respect of indeterminate liability, S&P submitted that to impose a duty of care on it would suggest that it owed ‘a legally enforceable duty to anyone who

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Mutual Life & Citizens’ Assurance Co Ltd v Evatt (1968) 122 CLR 556, 571 (‘MLC v Evatt’). L Shaddock & Associates Pty Ltd v Parramatta City Council (No 1) (1981) 150 CLR 225, 251 (Mason J), 256 (Murphy J), 256 (Aickin J), 233 (Gibbs CJ). (2001) 206 CLR 1, 16–17 [47] (Gleeson CJ, Gummow and Hayne JJ), 23 [75] (Gaudron J) (‘Tepko’). Bathurst Appeal (2014) 224 FCR 1, 109 [573]. Ibid 109–10 [573]–[574]. Ibid 110 [576], citing San Sebastian Pty Ltd v Minister Administering Environmental Planning Act 1979 (NSW) (1986) 162 CLR 340, 356–7. Bathurst Appeal (2014) 224 FCR 1, 110 [578], citing Esanda Finance Corp Ltd v Peat Marwick Hungerfords (1997) 188 CLR 241, 257–8 (‘Esanda Finance’). Bathurst Appeal (2014) 224 FCR 1, 116 [595], 250 [1260]. The purpose of the advice contained in credit ratings may be contrasted with the purpose of the advice contained in audits by reference to cases such as Esanda Finance. There, the High Court did not find a duty of care was owed by the auditors of a company to the financiers of the company partly because of the limited purpose of the audit report, which was not created to advise a potential financier about the position of the company: Esanda Finance (1997) 188 CLR 241, 257–8 (Dawson J), 261–2, 265 (Toohey and Gaudron JJ), 274–5 (McHugh J), 295 (Gummow J). See also Caparo Industries plc v Dickman [1990] 2 AC 605. Bathurst Appeal (2014) 224 FCR 1, 111–13 [580]–[582]. Ibid 135 [721].

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might stumble across its ratings on any security’.99 S&P submitted that it did not know the identity of the claimants, and that such knowledge was a prerequisite for the imposition of liability.100 On the facts, unlike ABN Amro, S&P did not know the councils or LGFS, nor their investment interests or goals. The Full Court rejected this submission, primarily on the basis that liability in negligent misstatement does not require the defendant to know the identity of the claimants; rather, the requirement of known reasonable reliance is a sufficient control on liability.101 The Full Court found that, in any event, determinacy does not require knowledge of the identity of potential claimants, but merely knowledge of an ascertainable class.102 Here, the characteristic of the relevant class of plaintiffs was that each was an ‘investor in the Rembrandt notes’ or ‘potential investor’.103 This conclusion effectively means that CRAs will be unable to rely on the indeterminate liability counterargument to the imposition of a duty of care in respect of any rated financial product, because those products are always designed to be sold to a class of investors or potential investors. Therefore, it would appear that known reasonable reliance is not a strong limitation on liability given that the very purpose of ratings is reliance by investors who cannot model the performance of the product for themselves. The exception may be where the product can be traded in secondary markets. In such a case, liability would be more easily characterised as indeterminate. Here, the Full Court acknowledged that the Rembrandt notes were issued for a circumscribed time and known face value, so there was a limited number of potential investors.104 Second, S&P argued that the claimants were not vulnerable, or that it did not know of their vulnerability.105 The Full Court rejected this argument, again on the basis that vulnerability is not an additional requirement in the law of negligent misstatement. Rather, vulnerability was held to be ‘the consequence of’ known reasonable reliance.106 This conclusion was based on the statement of Gleeson CJ in Perre v Apand, that knowledge of an ascertainable class of persons who are ‘reliant, and therefore vulnerable’ was necessary to establish a duty of care in negligent advice cases.107 While Perre v Apand was not a negligent misstatement case, it was the case that first emphasised the importance of a plaintiff’s ‘vulnerability’ in pure economic loss claims. Vulnerability was not an explicit requirement in the law of negligent misstatement as stated in the seminal cases of Hedley Byrne108 and MLC v Evatt,109 but has come to be a significant factor in negligently inflicted pure

99

100 101 102 103 104 105 106 107

108 109

Ibid 109 [572]. Ibid 114 [587]–[588], 250 [1259]. Ibid 114 [590], 114 [589]. Ibid 115–16 [593]. Ibid 111 [580], 115–16 [593]. Ibid 116 [594]. Ibid 116 [596], 251 [1263]. Ibid 116 [598], 251 [1264]. Ibid 116 [598], quoting Perre v Apand (1999) 198 CLR 180, 194 [10] (emphasis added by the Federal Court in the Bathurst Appeal). Hedley Byrne & Co Ltd v Heller & Partners Ltd [1964] AC 465 (‘Hedley Byrne’). (1968) 122 CLR 556.

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economic cases generally. In such cases, vulnerability means the plaintiff’s inability to protect itself from the consequences of a defendant’s want of reasonable care. This view has been reiterated by the High Court in Woolcock and most recently affirmed in Brookfield,110 both of which concerned liability for latent construction defects to subsequent owners. In Woolcock, the High Court expressly decided that it was not necessary in that case to reconcile the place of vulnerability in negligent misstatement cases.111 Consistent with this, it appears that the Full Court responded to the defendants’ arguments about vulnerability by reiterating that the applicable principles were those of the law of negligent misstatement. However, the Full Court went further in its response — finding that in negligent misstatement cases, vulnerability is ‘the consequence of’ known reasonable reliance, rather than an additional criterion.112 It is not immediately clear why known reasonable reliance and vulnerability are linked in this way. It is also not clear whether vulnerability has the same meaning in negligent misstatement cases as it did in cases such as Woolcock and Brookfield. By way of illustration, the Full Court rejected S&P’s argument that LGFS was not vulnerable because it had an AFSL and its officers had years of experience in financial markets.113 The Full Court also rejected ABN Amro’s argument that LGFS was not vulnerable because it could have negotiated for contractual warranties to protect itself.114 However the Full Court’s finding of vulnerability emphasised the fact that LGFS could not second-guess or verify the rating.115 This suggests that in negligent misstatement cases vulnerability and reasonable reliance may both be present because of the plaintiff’s inability to verify the information provided by the defendant. This is consistent with the analysis of the High Court in Tepko, where the imposition of a duty of care depended in part on the ability of the plaintiffs to obtain information about the planned works elsewhere or from their own experts.116 In the Bathurst Appeal, it was clear that the credit rating was the only source of the information about the product’s creditworthiness.117 This may have made the claimants’ reliance reasonable, and rendered them vulnerable, that is, unable to protect themselves from the defendants’ want of reasonable care.

110

111

112 113 114 115 116

117

Woolcock Street Investments Pty Ltd v CDG Pty Ltd (2004) 216 CLR 515, 530 [23] (Gleeson CJ, Gummow, Hayne and Heydon JJ) (‘Woolcock’); Brookfield Multiplex Ltd v Owners Corporation Strata Plan 61288 (2014) 313 ALR 408, 416–17 [22], 418–19 [29] (French CJ), 424 [57] (Hayne and Kiefel JJ), 438 [130] (Crennan, Bell and Keane JJ). Woolcock (2004) 216 CLR 515, 531 [24]. In their joint judgment, Gleeson CJ, Gummow, Hayne and Heydon JJ acknowledged that Stapleton had argued that negligent misstatement cases could be explained by reference to notions of vulnerability, citing Jane Stapleton, ‘Comparative Economic Loss: Lessons From Case-Law Focused “Middle Theory”’ (2002) 50(2) UCLA Law Review 531, 558–9. In that article, Stapleton observed that the ‘normative concern with the protection of the vulnerable links what might otherwise seem to be diverse fact situations’: at 558. Bathurst Appeal (2014) 224 FCR 1, 116 [598], 158 [823], 251 [1264]. Ibid 117 [601]–[602]. Ibid 157–158 [820]–[823], 159 [829]–[830]. Ibid 117 [600]. (2001) 206 CLR 1. Gaudron J observed that the Water Board was not the ‘sole repository’ of the information the plaintiffs required and that the plaintiffs could have obtained their own experts: at 26 [87], see also at 17 [49] (Gleeson CJ, Gummow and Hayne JJ) regarding the retention of experts. On the facts, Kirby and Callinan JJ dissented and found that the Water Board was the sole repository of the information: at 28 [95]. Bathurst Appeal (2014) 224 FCR 1, 113 [581], 117 [601].

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Finally, S&P was unable to rely on disclaimers in its reports and ratings letters to the effect that the rating was an opinion and not a statement of fact or a recommendation to buy or sell the product.118 The Full Court agreed that the rating was not advice, but found that it was an expert opinion as to creditworthiness, and held that the disclaimer did not have any effect on the representation contained in the rating that S&P had reasonable grounds for its opinion.119 The Full Court indicated that if S&P wanted to disclaim responsibility for the rating it would have to do so in prominently displayed, clear terms.120 However, it would be difficult to draft an effective disclaimer in this context because it may require the CRA to deny responsibility for the very task it is engaged to perform, that is, to rate a product’s creditworthiness. The Full Court accepted that such a disclaimer would render the rating itself ‘devoid of content or meaning’ and ‘self-defeating’.121 This conclusion can be contrasted with the successful reliance by the defendant bank in Hedley Byrne on the verbal and written statement that the bank gave its advice ‘without responsibility’ on its part.122 There, the House of Lords did not consider that such a disclaimer rendered the subsequent advice devoid of content or meaning. As the discussion above concerning indeterminate liability, vulnerability and disclaimers indicates, it would appear that denying responsibility on the part of a CRA is difficult where its business model involves holding itself out to be an expert on creditworthiness and disseminating ratings for the very purpose of reliance by investors. The peculiar role of CRAs is discussed further in Part IV of this case note.

B

Misleading or Deceptive Conduct

On its face, an action for misleading or deceptive conduct is a very different cause of action to the tort of negligence. However, the line between the two causes of action is increasingly blurred. This is demonstrated by a number of aspects of the Bathurst Appeal. First, misleading or deceptive conduct does not impose a duty or obligation to a class of people, unlike negligence. Yet, in determining what is misleading or deceptive, the court must consider a class to which the statement or conduct is directed. Here, S&P’s conduct was found to be misleading or deceptive by reference to the ordinary or reasonable member of the class of ‘potential investors’123 (the same class to which the duty was owed).

118

119 120 121 122 123

Ibid 41 [55], 117–120 [602]–[613]. See further George Harris, David Clifford and James Darcy, ‘Disclaimers — Ally or Neutral Bystander?’ (2013) 24(2) Journal of Banking and Finance Law and Practice 141; Mark Doepel and Sarah Love, ‘Ratings Agency Pierces the Disclaimer Veil: Bathurst Regional Council v Local Government Financial Services Pty Ltd (No 5)’ (2013) 9(8) Australian Civil Liability Newsletter 112. Bathurst Appeal (2014) 224 FCR 1, 119 [609]. Ibid 119 [608]. Ibid 119–20 [613]. Hedley Byrne [1964] AC 465 at 467–8, 492, 504. Bathurst Appeal (2014) 224 FCR 1, 146–7 [772].

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Second, liability for misleading or deceptive conduct is strict,124 whereas liability in negligence requires conduct falling short of an expected standard of care. However, on the facts in the Bathurst Appeal, S&P’s representations that were found to be misleading or deceptive included that reasonable care had been taken in formulating the rating.125 Arguably, there is no material difference between a duty to take reasonable care and an obligation not to mislead about having taken reasonable care. S&P itself accepted in the Bathurst Appeal that its conduct as relevant to the statutory and tort claims was ‘relevantly indistinguishable’.126 Third, the common law has demonstrated reluctance to impose liability for negligently inflicted pure economic loss,127 whereas such loss is the primary concern of the statutory liability. Considerations of indeterminate liability and vulnerability have been regarded as important controls on liability in negligence. In some circumstances, public policy factors in terms of balancing the interests of the plaintiff and defendant can play a role in whether or not a duty should be imposed.128 The court will consider whether liability would unfairly burden the legitimate pursuit of the defendant’s business interests. Concerns about the coherence of the law will preclude the court recognising a duty in tort to the plaintiff that would conflict with a statutory duty imposed on the defendant.129 In comparison, a statutory cause of action for misleading or deceptive conduct invokes no such considerations. On that basis, a defendant might be more likely to be found liable for statutory misleading conduct than negligence if it could rely on public policy arguments negativing a duty. In the Bathurst Appeal, however, the Full Court’s application of the legal or policy controls on negligence did not assist the defendants at any point. To the extent that S&P repeatedly argued that it did not know the identity of the investors, or that it had no direct relation with them, its view appears to echo requirements of ‘proximity’, long abandoned as a freestanding touchstone of negligence liability in Australian law.130 Fourth, the requirement in negligence of reasonable reliance appears to be a distinguishing factor between the causes of action, but reliance also goes to causation in the misleading or deceptive conduct claim. Whether that reliance was

124

125 126 127

128

129 130

Colin Lockhart, The Law of Misleading or Deceptive Conduct (LexisNexis Butterworths, 4th ed, 2014) [3.9], [313]; R P Balkin and J L R Davis, Law of Torts (LexisNexis Butterworths, 5th ed, 2013) [22.4]. Bathurst Appeal (2014) 224 FCR 1, 135 [723]. Ibid 145 [766]. Ultramares Corporation v Touche, 255 NY Rep 170, 179–180 (Cardozo CJ) (NY, 1931); Hedley Byrne [1964] AC 465, 536–7 (Lord Pearce); Balkin and Davis, above n 124, [13.9]–[13.10]; Candlewood Navigation Corporation Ltd v Mitsui OSK Lines Ltd [1986] AC 1, 25. Chief Justice Murray Gleeson, ‘Australia’s Contribution to the Common Law’ (2008) 82 Australian Law Journal 247, 253; Prue Vines, ‘The Needle in the Haystack: Principle in the Duty of Care in Negligence’ (2000) 23(2) University of New South Wales Law Journal 35, 35–36. However, this is more pronounced under the Caparo test in England: Caparo Industries plc v Dickman [1990] 2 AC 605, 617–18. Sullivan v Moody (2001) 207 CLR 562, 580. Ibid 578–9 [48].

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reasonable can be relevant to the statutory cause of action as well.131 This is because the statute requires consideration of all the circumstances and the position of an objective or reasonable member of the class.132 Furthermore, as noted above, reasonable reliance is readily established in the case of a CRA paid to provide credit ratings for products that investors cannot rate themselves, so it is not the case that negligence is a more circumscribed cause of action. Fifth, it should be noted that S&P attempted to rely, in its defence of the statutory claim, on disclaimers contained in its pre- and post-sale reports, which were provided to ABN Amro and passed on to LGFS and the councils. This submission was rejected, in the same way it had been in respect of the tort claim.133 Finally, causation under both causes of action was considered simultaneously.134 In its consideration of ‘scope of liability’ in the negligence claim,135 the Full Court rejected arguments to the effect that it was not appropriate for S&P to be liable to the claimants. This conclusion, according to the Court, was ‘not harsh’, and ‘accord[ed] with the facts’.136 Therefore, through consideration of scope of liability under both causes of action, the Full Court found S&P’s liability to be warranted, even from a normative point of view. The above factors demonstrate that a CRA faces significant challenges in disputing liability under either cause of action. It appears that much the same evidence and argumentation will apply to both and that, perhaps contrary to intuition, negligence is not more circumscribed than the statutory actions.137

IV

Liability of Credit Rating Agencies — An International Concern

Part IV first considers some of the implications of the Bathurst Appeal on future claims against CRAs. Second, the unique position of CRAs as players in the investment industry is described with reference to aspects of the Bathurst Appeal. Finally, this Part outlines regulatory developments directed to managing the interests of investors given their increasing reliance on CRAs.

A

Implications for Future Cases

The court-imposed liability of a CRA to investors whose identities it did not know is novel. Already, other councils’ claims are on foot against S&P following the

131

132 133 134 135 136 137

Balkin and Davis, above n 124, [22.27]; Lockhart, above n 124, [10.16]; Barbara McDonald, ‘The Legal Framework of Claims against Ratings Agencies in Australia’ (2013) 28(6) Butterworths Journal of International Banking and Financial Law 383, 384. Bathurst Appeal (2014) 224 FCR 1, 146 [772]. Ibid 146 [769]. Ibid 147 [774]. Civil Liability Act 2002 (NSW) s 5D(1)(b). Bathurst Appeal (2014) 224 FCR 1, 149 [784]. Cf Mylton Burns, ‘Has s 52 of the TPA Rendered Negligent Misstatement Irrelevant to Australian Professional Indemnity Insurance for “Advice” Professionals’ (2001) 12 Insurance Law Journal 1.

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Bathurst Appeal.138 The decision will also have an impact on similar claims in other jurisdictions, including the Netherlands — where the litigation funder which funded the councils’ claims in Australia is funding similar claims for losses on CPDOs in Europe.139 Admittedly, the circumstances of the Bathurst Appeal are unusual. Critical factors include: the known conservatism of and statutory restrictions on the councils; the councils’ relative lack of sophistication; the extreme complexity of the product; the coordinated strategies of the product arranger and rating agency; the lack of a secondary market for the product; and the delay by each of the defendants in correcting the representations made when doubts emerged about the product. However, determinations by the Full Court in the Bathurst Appeal ring alarm bells for CRAs generally. The Bathurst Appeal demonstrates that disclaimers included in the publishing and dissemination of credit ratings must be much more precise, more explicit and carefully targeted in order to be effective in disclaiming liability. In the United States (US), the First Amendment140 has been a viable defence for CRAs that are the subject of claims relating to mortgage-backed securities on the basis that they are publishers of opinions.141 However, it would appear that, in this jurisdiction at least, it is insufficient for a CRA to convey that the rating is merely an expression of opinion rather than a statement of fact. The Full Court accepted that the rating was an expert opinion, but also found that it conveyed a representation that S&P had reasonable grounds for and exercised reasonable care in formulating that opinion.142 Furthermore, in respect of negligence, there are two ways in which the decision has general implications for claims against CRAs. First, in this case a CRA failed to convince the Full Court that its liability would be indeterminate, or that its responsibility for the loss should be limited by reference to the appropriate scope of liability under s 5D of the Civil Liability Act 2002 (NSW). As discussed in Part III above, the Full Court found that the ascertainable class was ‘potential investors’ in the product and that finding S&P liable was ‘not harsh’. This is cold comfort to CRAs, given that it would be difficult to cavil with the proposition that a CRA must know that there is a class of potential investors in respect of each product that it is engaged to rate. Second, in respect of causation the Full Court rejected an argument that the loss sustained by the claimants was caused by the supervening event of the GFC. The trial judge observed that the GFC was simply an instance of sustained credit

138

139

140 141

142

See the interlocutory decisions in City of Swan v McGraw-Hill Companies Inc (2014) 223 FCR 295; McGraw-Hill Financial Inc v City of Swan [2014] FCA 665 (24 June 2014); City of Swan v McGraw-Hill Financial Inc (2014) 223 FCR 328; City of Swan v McGraw-Hill Companies Inc (2014) 226 FCR 462. Bentham IMF Limited, ‘Bentham IMF Backs $250m Dutch Claim against RBS and S&P Filed by European Investors over GFC Losses’ (Media Release, 5 December 2013). United States Constitution amend I. Theresa Nagy, ‘Credit Rating Agencies and the First Amendment: Applying Constitutional Journalistic Protections to Subprime Mortgage Litigation’ (2009) 94(1) Minnesota Law Review 140. Bathurst Appeal (2014) 224 FCR 1, 113 [581].

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spread widening in which the CPDO was going to cash out.143 The Full Court held that ‘S&P was the cause of the loss’ in failing to exercise reasonable care in assigning the AAA rating. The rating was directed to a particular risk and it was that risk which materialised.144 This indicates that a CRA cannot deny its responsibility to investors by arguing that losses suffered by investors were caused by the unpredictable trends in financial markets.

B

The Peculiar Role of CRAs

The Bathurst Appeal also exposes systemic issues in the structure of the industry in which CRAs operate. As a starting point, CRAs perform a particularly important role in rating creditworthiness where complex financial products are concerned. First, the failure of CRAs in rating various types of securities has been recognised as the cause of stock-market crashes and economic recessions.145 As noted above, in the US, CRAs have evaded liability in respect of mortgage-backed securities by relying on the First Amendment.146 And while one objection to the outcome in the Bathurst Trial might be that the Court failed to consider the notion of caveat emptor,147 structured financial products are, by nature, complex and difficult to understand, especially but not only for non-institutional investors. In fact, the CPDO in the Bathurst Trial was regarded by the Full Court as being so complicated that a lack of questions from potential investors did not mean they understood the product. Rather, the councils were held to be unable to know what questions to ask at all.148 This is unsurprising. Payne has described credit derivatives (of which the CPDO is an example) as ‘opaque’,149 and stock-market expert Warren Buffett has said that derivatives are ‘financial weapons of mass destruction’.150 Perhaps the local government councils in the Bathurst Trial were sympathetic claimants, given their role as collectors of rates and their statutory obligation to invest public money responsibly, but the general point about complex financial instruments probably applies to all noninstitutional investors.

143 144 145

146 147

148

149

150

Bathurst Trial [2012] FCA 1200, [2824], [3417]. Bathurst Appeal (2014) 224 FCR 1, 148 [782]. Don Mayer, Anita Cava and Catharyn Baird, ‘Crime and Punishment (or the Lack Thereof) for Financial Fraud in the Subprime Mortgage Meltdown: Reasons and Remedies for Legal and Ethical Lapses’ (2014) 51(3) American Business Law Journal 515, 555; Frank Partnoy, ‘Rethinking Regulation of Credit Rating Agencies: An Institutional Investor Perspective’ (White Paper, Council of Institutional Investors, 2009) 3. United States Constitution amend I. Harry Edwards, ‘Liability for the Rating and Sale of Structured Credit Products: Australian Cases and Their (Much) Wider Implications’ (2013) 7(2) Law and Financial Markets Review 88, 90. Bathurst Appeal (2014) 224 FCR 1, 235 [1177], 240 [1201], 242 [1211], 252 [1268], 265 [1340], 195 [1497]. Jennifer Payne, ‘The Role of Gatekeepers’ (Oxford Legal Studies Research Paper No 22/2014, Oxford University, 2014) 7. Quoted in Bryan Pape, ‘Arbitrating Financial “Star Wars”’ (2013) 24(3) Journal of Banking and Finance Law and Practice 174, 174.

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Second, and more generally, CRAs correct inherent information asymmetry in the market.151 They perform a gatekeeper role for the industry by distilling complex information into easy-to-use symbols.152 The significance of S&P’s role is evidenced in the Bathurst Appeal, where the cause of loss was not the inherent design of the product, but rather the misrepresentations about its creditworthiness as contained in the rating. But for S&P’s rating, LGFS or the councils would not have invested in the notes.153 CRAs therefore adopt a risk in rating products even though they do not develop them or sell them directly. This, LGFS noted in its submission, was reflected in the fact that S&P was entitled to a bigger fee for its service if the note was issued for a larger amount.154 The significance of S&P’s role can also be considered through comparison with ABN Amro’s as product inventor and arranger, and LGFS’s as the seller and financial adviser to the councils. On the one hand, it would appear that ABN Amro and LGFS’s liabilities are less controversial than S&P’s, in that they had more direct relationships with the councils, and greater awareness of their investment purposes.155 S&P, like most CRAs, had no knowledge of the identity of the potential investors. On the other hand, S&P’s role in providing the rating was critical to the councils’ decision to invest, and perhaps more so than representations by other parties. This possibility is exposed by ABN Amro’s argument that imposing a duty on it would be ‘inefficient, inutile and inappropriate’, because it was the responsibility of S&P — an independent expert CRA — to rate the product. It was only S&P’s opinion, ABN Amro argued, that investors would rely upon.156 ABN Amro’s argument mirrors the notion that CRAs perform a public role, and effectively issue regulatory ‘licences’ to issuers. The regulatory licence model regards a CRA’s favourable ratings as regulatory licences issued to product arrangers, because such ratings allow them to escape regulatory burdens, or confer a defence on those who advise on or sell the instruments.157 It follows from the regulatory licence model that once S&P issued the rating it would be liable rather than — or at least be more culpable than — those who passed on the rating. So a CRA can potentially be liable to an unknown investor if an adviser merely passes on its rating. On the facts, however, ABN Amro’s submission did not succeed, as it did not merely pass on the rating ‘for what it was worth’, or as a mere conduit, but adopted and reinforced it.158 Moreover, ABN Amro, aware of LGFS’s requirement for a AAA rating, pressed S&P for the AAA rating. In this case, ABN Amro and S&P bore interrelated responsibilities.159

151

152

153 154 155

156 157 158 159

Gianluca Mattarocci, The Independence of Credit Rating Agencies: How Business Models and Regulators Interact (Academic Press, 2014) 1–3. John C Coffee Jr, Gatekeepers: The Professions and Corporate Governance (Oxford University Press, 2006), 283. Bathurst Appeal (2014) 224 FCR 1, 148 [779]–[780], 259 [1309]. Bathurst Trial [2012] FCA 1200, [2413]. The relation between financial adviser and investor councils was considered in Wingecarribee Shire Council v Lehman Brothers Aust Ltd (in liq) (2012) 301 ALR 1. Bathurst Appeal (2014) 224 FCR 1, 167 [870], 265–6 [1343]. Coffee Jr, above n 152, 288. Bathurst Appeal (2014) 224 FCR 1, 169–74 [884]–[903]. Ibid 289 [1477].

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Finally, the overlap in responsibility illustrates the inherent conflict of interest in the CRA industry. Issuers of investment products pay CRAs to rate their products. The issuer-pays model gives rise to clear conflicts of interest, because the rating agency can become beholden to the payer seeking a favourable rating.160 These conflicts are apparent in the Bathurst Trial: S&P was reluctant to admit its errors, and worked together with ABN Amro to decide on the ranges of certain inputs into the model. Furthermore, it has been noted that unlike other gatekeepers such as auditors, conflicts of interest faced by CRAs are exacerbated by the oligopoly structure of the CRA market.161 The lack of competition in the market can mean that CRAs continue to become more profitable while their ratings become more unreliable.162 The oligopolistic nature of the CRA market is something that the most recent regulatory development in the European Union (EU) attempts to address.163

C

International Developments

Litigation risk is only one way of imposing standards on CRAs to deter repeat offences.164 In light of recognition of the failures of CRAs in the GFC and other stockmarket crashes, the question of how best to regulate CRAs is increasingly debated.165 International developments in this area appear to focus on the approach of discouraging over-reliance on ratings by investors when making investment decisions. For instance, US legislation encourages federal agencies to remove references to ratings in their regulations and turn to other assessments of creditworthiness.166 EU regulations recite that investors should not rely on ratings blindly or mechanistically, and must do their own due diligence.167 Consistent

160

161

162 163

164

165

166

167

Coffee Jr, above n 152, 286–7; Payne, above n 149; Ann Wardrop, ‘Civil Liability of Credit Rating Agencies to Investors’ in Shelley Griffiths, Sheelagh McCracken and Ann Wardrop (eds), Exploring Tensions in Finance Law: Trans-Tasman Insights (Thomson Reuters, 2014) 45, 47. Frank Partnoy, ‘How and Why Credit Rating Agencies are Not Like Other Gatekeepers’ (Legal Studies Research Paper No 07-46, University of San Diego School of Law, 2006) 60. Ibid. Regulation (EU) No 462/2013 of the European Parliament and of the Council of 21 May 2013 [2013] OJ L 146. See Harry Edwards, ‘CRA 3 and the Liability of Rating Agencies: Inconsistent Messages From the Regulation on Credit Rating Agencies in Europe’ (2013) 7(4) Law and Financial Markets Review 186, 190. Matthias Lehmann, ‘Civil Liability of Rating Agencies: An Insipid Sprout from Brussels’ (LSE Law Society Economy Working Paper 15/2014, London School of Economics and Political Science Law Department, 2014), 4, 6–8; Coffee Jr, above n 152, 302. See generally Tin A Bunjevac, ‘Credit Rating Agencies: A Regulatory Challenge for Australia (2009) 33(1) Melbourne University Law Review 39; Paul U Ali, ‘Is There a Change in the Regulation Landscape of Credit Rating Agencies?’ (2010) 28 Company and Securities Law Journal 222, 224–8; Paul U Ali, ‘Credit Rating Agencies: Time to Act’ (2009) 27 Company and Securities Law Journal 125; Brigitte Haar, ‘Civil Liability of Credit Rating Agencies — Regulatory All-orNothing Approaches between Immunity and Over-Deterrence (SAFE White Paper No 1, Sustainable Architecture for Finance in Europe, 2013); Alessandro Scarso, ‘The Liability of Credit Rating Agencies in a Comparative Perspective’ (2013) 4(2) Journal of European Tort Law 162. Dodd-Frank Wall Street Reform and Consumer Protection Act, 15 USC § 939A (2010). See also Jeffrey Manns, ‘Downgrading Rating Agency Reform’ (2013) 81(3) George Washington Law Review 749. Regulation (EC) No 1060/2009 of the European Parliament and of the Council of 16 September 2009 on Credit Rating Agencies [2009] OJ L 302, recital (10). The Regulation has been amended

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with these approaches, the international Financial Stability Board (established after the G20 meeting in 2009) has developed ‘Principles for Reducing Reliance on CRA Ratings’.168 However, these attempts to discourage reliance may have limited effectiveness. First, CRAs are ‘hard-wired’ in the financial system.169 This is reflected in the use of ratings in the Ministerial Order to which the councils in the Bathurst Appeal were subject. It is difficult to conceive of alternative measures of creditworthiness. The attempt to encourage self-reliance is debatable, especially given the sheer complexity of financial instruments and the information asymmetry noted above. Discouraging reliance would appear to contradict the more realistic assessment of the Full Court that reliance by the councils and LGFS on the rating in the Bathurst Appeal was reasonable in part because ‘the only available information as to the creditworthiness of the notes was S&P’s rating’.170 Finally, in the United Kingdom, a novel cause of action has been created by the Credit Rating Agencies (Civil Liability) Regulations 2013 (UK). It imposes liability on CRAs if senior management engage in ‘gross negligence’ in failing to comply with art 35a of the EU-wide regulations referred to above.171 ‘Gross negligence’ is defined as recklessness as to whether there was infringement of the EU regulation.172 On its face, this is a more stringent test of liability. However, the Regulation requires reasonable reliance by the investor on the rating, and defines reasonable reliance in accordance with the general law of negligent misstatement.173 It is likely that the considerations of the Full Court regarding reasonable reliance will therefore play a part in the implementation of this statutory cause of action. The imposition of liability by an Australian court is an important step in defining the content of the responsibilities that CRAs have in respect of one of the many roles that they perform in the financial market. The Bathurst Trial and the Bathurst Appeal provide important and useful analyses of the indispensability of CRAs in investment decisions. Although other jurisdictions may not have a statutory framework prohibiting misleading or deceptive conduct, the imposition of a duty of care and liability for common law negligent misstatement on a CRA for causing pure economic loss is noteworthy. Imposing a duty of care empowers investors to bring suits against CRAs, without having to rely on or hope for the investigations and decision-making of government regulators. The Bathurst Appeal is likely to be a point of reference for future litigation and continuing regulation.

168

169 170 171

172 173

by Regulation (EU) No 513/2011 of the European Parliament and of the Council of 11 May 2011 [2011] OJ L 145 and Regulation (EU) No 462/2013 of the European Parliament and of the Council of 21 May 2013 [2013] OJ L 146. Financial Stability Board, ‘Principles for Reducing Reliance on CRA Ratings’ (2010) . Payne, above n 149, 19. Bathurst Appeal (2014) 224 FCR 1, 113 [581]. Regulation (EC) No 1060/2009 of the European Parliament and of the Council of 16 September 2009 on Credit Rating Agencies [2009] OJ L 302, as amended: see fn 167 and accompanying text. Credit Rating Agencies (Civil Liability) Regulations 2013 (UK) reg 4. Ibid reg 6.