Australian Federal Court Paves the Way for Actions against Financial Product Ratings Agency

In the first known decision of its type in the common law world, the Federal Court of Australia has held that a ratings agency owes a duty of care to potential investors. On November 5, 2012, the Federal Court of Australia handed down its landmark decision in the matter of Bathurst Regional Council v Local Government Financial Services Pty Ltd (No 5) [2012] FCA 1200[1] ("Bathurst"). The court ruled that global ratings agency Standard & Poor's ("S&P") had misled or deceived investors and was negligent by assigning S&P's highest rating of AAA to a volatile structured finance product arranged by investment bank ABN Amro Bank NV ("Amro"), known as Constant Proportion Debt Obligations ("CPDO"). As a result of the decision, investors who relied upon that rating could recover losses from S&P.

Bathurst involved a claim made by 12 Local Councils in the State of New South Wales (the "Investors") against S&P, Amro, and municipal financial advisor Local Government Financial Services ("LGFS") for losses suffered by the Investors as a result of their investment in the CPDO. It was submitted by the Investors, and accepted by the Federal Court, that they had been induced to invest in the CPDO in reliance upon, among other things, the AAA rating that S&P had assigned to the CPDO. Given the high volatility of the CPDO, the court held that any reasonably competent ratings agency in the position of S&P could not have rated the CPDO with such a high rating on any "rational or reasonable basis," [2] and that as a result of S&P's negligence, the investors suffered loss and damage by relying upon S&P's AAA rating in forming their decision to invest.

In attributing blame to S&P, the court went on to note that the investors were particularly vulnerable in that they could not reasonably protect themselves from any lack of reasonable care by S&P in the assigning of the rating.[3] Indeed, less than two years after purchasing the securities in late 2006, during the global financial crisis, the Local Councils lost more than 90 percent of their original A$17 million invested in the CPDO[4] due to its inherent volatility in the market. The court was also critical of Amro, which it found to have inappropriately influenced S&P and misrepresented information that S&P then relied upon in formulating its incorrect AAA rating of the CPDO. Moreover, the court also ruled that Amro and LGFS had themselves engaged in misleading and deceptive conduct and had breached various other fiduciary and contractual duties owed by them.

Bathurst is a first instance judgment from a single judge in the Federal Court of Australia. Given the serious implications of the judgment for rating agencies, it is likely that the decision will be scrutinized by appellate courts. If the decision stands, it can be expected to encourage other investors in other jurisdictions to pursue ratings agencies. The decision could also lead to significant reforms by financial services regulators in order to "crack down" on the inherent conflicts that presently exist between investment banks and ratings agencies in the arrangement and rating of financial services products.

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[1] Bathurst Regional Council v Local Government Financial Services Pty Ltd (No 5) [2012] FCA 1200 per Justice Jagot.

[2] Federal Court of Australia Summary of Bathurst Regional Council v Local Government Financial Services Pty Ltd (No 5) [2012] FCA 1200 at [22].

[3] Bathurst, n 1 at [2816].