Australian Court on Rating Complex Financial Instruments

The Federal Court of Australia has delivered an important ruling that pertains to the liability of credit rating agencies. In Bathurst Regional Council v. Local Government Financial Services Pty Ltd, the court found that Standard & Poors (S&P) was liable to several local councils in Australia for a AAA rating provided in connection with their investment in complex financial instruments known as constant proportion debt obligations (CPDOs). Along with S&P, ABN Amro which structured these instruments was also held liable.

The court found that S&P’s AAA rating was “misleading and deceptive and involved the publication of information or statements false in material particulars and otherwise involved negligent misrepresentations to the class of potential investors in Australia ...” Furthermore, it was found that S&P, in arriving at its conclusions, heavily relied upon inputs provided by ABN Amro without independently verifying them. In effect, this ruling no longer allows rating agencies to disown responsibility to investors who relied on their opinions to make investment decisions.

This judgment is interesting for several reasons. It involves a rare instance where rating agencies have been found to be liable. As the Economist notes, it is unlikely that other courts would adopt a similar stance. S&P is in any event said to be appealing this decision.

It is an unusual instance where the court has not shown any hesitation in delving into the technical aspects of complex financial instruments in minute detail. Jagot, J’s decision is 1,500 pages and 3,723 paragraphs long. The summary itself is 9 pages and 56 paragraphs long! Although the court was aided by expert evidence, the fact that these complex instruments have been stripped down to their essentials in determining the outcome of the liability of S&P and ABN Amro is remarkable.

This judgment would certainly call attention to the risk profile of rating agencies in terms of legal liability.

A further discussion of this judgment is contained in Reuters(which links to other coverage as well) and Prof. Jayanth R. Varma’s Financial Markets Blog (arguing from a financial modelling perspective that these instruments should not have been rated at all).

Rating Agencies Back in the Spotlight

S&P has indeed made a bold move by downgrading United States’ sovereign rating. While there may by political opposition, quibbles with the arithmetic, and the like, there is a strong view that those amount to “shooting the messenger”. The downgrading by S&P assumes greater importance because it comes in the wake of determined efforts by governments to tighten their control over credit rating agencies. These agencies had dented their credibility during the financial crisis on account of their stamp of star ratings to securities that were found to be toxic in nature.

By increasing the friction between credit rating agencies and governments, the US downgrade highlights power games that each can potentially play against the other by flexing their muscles. An op-ed in the New York Times by Professor Jeffrey Manns points to the fact that S&P’s downgrade of the US could be a deliberate strategy to achieve a push back against increasing regulation of rating agencies sought by the US Government. But he warns against any such pushback and advises that “the government should not give in to such extortion.” While that is certainly understandable, the principal issues that continue to affect the regulation of credit rating agencies are the oligopolistic nature of the industry with a handful of players wielding significant influence, and the conflict of interest generated by the financial model where issuers of securities remunerate the rating agencies for their services.

Episodes such as the US downgrade have also expanded the scope of alternative thinking. For example, the idea of doing away with credit rating altogether is also being bandied about. However, as this piece in the Economist notes, that is likely to be a tall order. The requirement of credit rating is now well-entrenched in the financial community as it is both prescribed as a requirement for regulatory purposes (e.g. for listing corporate bonds, for investment by regulated institutions) and also generally followed as a matter of practice in certain types of private contracting (such as in the case of derivative transactions or securities). In other words, credit rating agencies are here to stay because there is no suitable alternative.

As far as India is concerned, the rating agencies have not witnessed the kind of turmoil they experience in other countries. Even on the regulatory front, SEBI seems to have a significant amount of oversight on the Indian agencies compared to its counterparts elsewhere. Nevertheless, recent events have caused SEBI to step up its ante too, as it is keeping a close watch on the developments, and it is reportedly open to making changes to regulations affecting these agencies.

The regulatory debate surrounding credit rating agencies has resurfaced barely as it was dying down following the subprime crisis. On that occasion, the allegations against them were on account of their inability to spot weaknesses in the quality of the securities being issued to investors, but this time their role has come into the limelight for taking on the might of a sovereign.