In the recent case of ABN AMRO Bank NV v Bathurst Regional Council [2014] FCAFC 65, the Federal Court of Australia confirmed the first instance finding in Bathurst Regional Council v Local Government Financial Services Pty Ltd (No 5) [2012] FCA 1200 that, as a matter of Australian common law, a rating agency owes a duty of care to investors in a rated financial product. The principal basis on which the Federal Court reached this conclusion was that the rating agency knew that potential investors would rely on the agency’s opinion when making investment decisions.

By Thomas Werlen/Yasseen Gailani (Reference: CapLaw-2014-25)

1) The Facts

In 2006, ABN AMRO created two series of bespoke constant proportion debt obligations (CPDOs) which were known as the Rembrandt Notes. The Notes were denominated in Australian dollars and were marketed to Australian local authorities. As part of the structuring process, ABN engaged the ratings agency, S&P, to evaluate the Notes’ creditworthiness. S&P gave the Notes a AAA rating, but shortly after issuance the Notes suffered heavy losses as a result of mismatches between the mark to market value of CDS contracts that underpinned the structure and the premium income those contracts were generating.

2) The First Instance Judgment

At first instance Jagot J found that S&P owed the claimants a duty to exercise reasonable care and skill in issuing its rating. The Judge went on to find that S&P had breached that duty and that S&P’s breach had caused the claimants’ loss. This was because S&P’s rating was flawed, had been based on a number of unreasonable assumptions in relation to the Notes’ default risk, and had been relied upon reasonably by the claimants when making their investment decisions.

3) The Appeal

On appeal S&P accepted that its rating had been fl awed. Accordingly, the focus of the appeal was on Jagot J’s finding that S&P had owed the claimants a duty of care. In pursuing its appeal, S&P’s main argument was that it was not reasonably foreseeable that its conduct could cause loss to the claimants. This was because the composition of the class of investors in the Notes had not been determined when S&P issued its rating. Accordingly, if a duty of care had been owed, the scope of that duty would have been potentially indeterminate. S&P also argued that the claimants should

have evaluated the Notes’ risk of default independently and that the absence of a contractual relationship between S&P and the claimants meant that a duty should not be recognised.

4) The Federal Court’s Findings

The Federal Court gave short shrift to S&P’s arguments. In particular:

• As to the issue of indeterminate liability, the Federal Court found that although S&P may not have known the precise identity or number of investors, the class of investors to whom a duty was owed was limited because the investors would all by definition have been purchasers of the Notes. On the facts S&P knew the size of the issue and the minimum level of subscription. It would therefore have been able to establish that there would be no more than 80 investors. S&P also knew that its potential liability would be limited temporally by reference to the duration of its rating and ultimately by the term of the Notes.
• As to the issue of independent valuation, because of the complexity of the structure, the Federal Court found that the claimants were in practice unable to replicate or “secondguess” S&P’s rating. The reliance on S&P’s rating was therefore reasonable in the circumstances.
• As to the absence of a contractual relationship, S&P’s submission was robustly rejected. In circumstances where ABN AMRO had engaged S&P to issue an AAA rating to an ascertainable class of investors, a contractual nexus was not required for liability to ensue.

5) Wider Impact of the Decision

The Bathurst case is noteworthy because it is the only common law case in which a ratings agency has been found liable to compensate investors for losses suffered as a result of investments in rated products that performed poorly in the financial crisis. However in key respects the case appears to have turned on its own facts, and overall it may be questioned if the decision will be of wider signifi cance in other common or civil law jurisdictions. By way of example, one point that was central to the findings at first instance and on appeal was the evidence that, owing to the complexity of the products, the claimants were unable to analyse the Notes’ ratings independently. It was therefore reasonable for the claimants to have relied on the ratings, but in other cases this type of evidence may well be unavailable. As a number of years have now passed since investors first began to suffer losses on rated products in the financial crisis, it is also likely to be increasingly difficult for new claims to be commenced on statute of limitation grounds.

In any future case where an EU investor suffers loss as a result of investing in rated products, Regulation 462/2013/EU on Credit Rating Agencies will provide a statutory cause of action in circumstances where a rating agency has, intentionally or with gross negligence, committed a breach of the standards prescribed by the Regulation and the investor has acted reasonably in relying on the rating. Viewed purely as a case study, however, the decision in Bathurst is a telling reminder that defective ratings played a key part in causing the financial crisis and that the financial and regulatory community must make every effort to ensure that the agencies’ failings do not occur again.

Thomas Werlen (thomaswerlen@quinnemanuel.com)
Yasseen Gailani (yasseen.gailani@weil.com)