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Australian Court Rules Against Ratings Agency

by Mary Swire,, Hong Kong

09 November 2012

The Federal Court of Australia has ruled that, when it rated a structured credit product for the Dutch bank, ABN Amro, to sell to Australian local councils, the credit ratings agency Standard and Poor's (S&P) did not act as "a reasonably competent ratings agency" and its rating was "misleading and deceptive".

The 'grotesquely complicated' securities, known as a constant proportion debt obligation (CPDO), were structured by ABN Amro in 2006, and sold to various councils in Australia on the basis of a top AAA-rating by S&P. The highly leveraged 10-year CPDOs subsequently lost most of their value, and the court proceedings therefore involved claims arising from their rating, sale and purchase.

As structured, the CPDO would make or lose money through notional credit default swap contracts (CDS), referencing two CDS indices using a fixed leverage formula. In effect, the CPDO in question started and remained at full leverage, meaning that the investor was taking 15 times the risk of their initial investment.

The judge said that, given its structure, such a security would need to be rated using various stress tests, but that, as ABN Amro had engaged S&P to rate other structured financial products, it had a good idea of how S&P would model the CPDO's performance to assess its creditworthiness and thus its rating.

ABN Amro had, the judge indicated, known what performance the CPDO had to demonstrate in order for it to be rated AAA and be attractive to the investors. She added that “at least one person within S&P considered that ABN Amro, whether intentionally or not, had effectively ‘gamed’ the model it knew S&P would apply to rate the CPDO.

The court’s conclusion, that S&P had failed to act “with reasonable care” and had given “negligent misrepresentations”, is the first to put a liability for investors' losses onto a credit rating agency.

S&P, together with ABN Amro, could have to pay some AUD30m (USD31.4m) in damages to the Australian councils out of this case, but, if the ruling was extended into Europe, it has been estimated that it could apply to over USD2bn of similar structured products.

However, in a statement, S&P is reported to have confirmed that it would appeal against the decision, which, it has emphasized, related to a specific rating. It has said that it rejected any suggestion that its ratings were inappropriate, and pointed out that the report it provided to investors stressed that they should not rely on the rating as investment advice.

TAGS: court | investment | law | capital markets | Australia | alternative investment

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