Federal Court of Australia Finds S&P Liable for AAA Rating Assigned to Highly-Leveraged Credit Derivative

In a landmark opinion, the Federal Court of Australia ruled that a credit rating agency’s AAA rating for a complex, highly leveraged credit derivative was misleading and deceptive and involved the publication of materially false information and otherwise involved negligent misrepresentations to the class of potential investors, which included local government councils. The Court said that the AAA rating conveyed a representation that in the rating agency’s opinion the capacity of the financial instrument to meet all financial obligations was extremely strong and a representation that the rating agency had reached this opinion based on reasonable grounds and as the result of an exercise of reasonable care when neither was true and the rating agency also knew not to be true at the time made. Describing the credit derivative as a “grotesquely complicated” instrument, the Court found that S&P’s modelling and assignment of the AAA rating was not such as a reasonably competent ratings agency could have carried out and assigned in all of the circumstances. (Bathhurst Regional Council v. Local Government Financial Services Pty, Ltd, Federal Court of Australia, Nov. 5, 2012).

The Court also noted that the financial institution that developed the derivative product was knowingly concerned in the rating agency’s contraventions of the various statutory provisions proscribing such misleading and deceptive conduct, and also itself engaged in conduct that was misleading and deceptive and published information or statements false in material particulars and otherwise involved negligent misrepresentations to investors.

According to the Court, the credit derivative was rated AAA by S&P on the basis of an unjustifiably and unreasonably low assumption as to volatility of 15 percent induced by the financial institution’s misrepresentation and the rating agency’s failure to calculate the actual average volatility. The rating was also based on non-stressed assumptions as to mean reversion speed on spreads that tend to revert and roll-down benefits.

The Court also found that S&P assigned the AAA rating to the first incarnation of the credit derivative without assessing the instrument’s performance with regard to ranges of inputs or market conditions which included both reasonably anticipated or expected inputs or market conditions and exceptional but plausible inputs or market conditions. To the contrary, at least two of the major inputs were unjustifiably and unreasonably optimistic and had no proper rational foundation. Apart from this, the detrimental impact on the credit derivative’s performance of ratings migration and the beneficial effect of modelling defaults were overlooked.

The Court noted that credit ratings are a guide or standard for an investor, which indicate the ability of a debt issuer or debt issue to meet the obligations of repayment of interest and principal. Credit rating agencies such as Moody’s and Standard and Poor’s make these independent assessments based on a certain set of market and non-market information. Ratings in no way guarantee the investment or protect an investor against loss.