Standard & Poor’s misled investors by giving its highest credit grade to securities whose value plunged during the global financial crisis, an Australian judge ruled. The ratings company said it will appeal.
S&P was “misleading and deceptive” in its rating of two structured debt issues in 2006, Federal Court Justice Jayne Jagot said in her ruling released today in Sydney. The Australian municipalities that brought the case are entitled to damages from S&P and two other defendants, ABN Amro Bank NV and Local Government Financial Services Pty., she ruled.
Twelve Australian councils claimed they lost more than 90 percent of the A$16 million ($16.6 million) they invested in so-called Rembrandt notes rated AAA by S&P and linked to credit-default swaps on investment grade companies. The repackaging of debt into securities with top rankings from S&P and other rating companies contributed to more than $2 trillion in losses and writedowns as Lehman Brothers Holdings Inc. collapsed in 2008 and the world fell into recession.
“This is the first time that a ratings agency has been held liable for their opinion in this way,” said Harald Scheule, as associate professor of finance at the University of Technology Sydney. It may spur efforts to move the industry toward a model in which consumers instead of issuers pay for credit opinions, he said.
The 1,459-page ruling is a “major blow to the ratings agencies, which for years have had the benefit of profiting from the assignment of these ratings,” Amanda Banton, a partner at law firm Piper Alderman, which represents the councils, said in an e-mailed statement. It will promote transparency in the ratings process, she said.
“We reject any suggestion our opinions were inappropriate and we will appeal the Australian ruling, which relates to a specific rating,” S&P said in a statement. The New York-based unit of McGraw-Hill Cos. had argued that a report provided to the Australian towns said investors can’t rely on the ratings themselves as investment advice.
S&P reported $502 million in revenue in the third quarter, the highest in 19 quarters as companies around the world tapped debt markets at the fastest pace ever. McGraw-Hill is splitting its ratings business from its education unit.
The ruling may have implications in other jurisdictions, said John Walker, executive director of IMF (Australia) Ltd., a company that invests in litigation and funded the action. IMF is funding a claim in the Netherlands over 2 billion euro ($2.6 billion) in similar securities sold in Europe by ABN Amro and rated by S&P, he said in an e-mailed statement.
The notes, known as a constant proportion debt obligation, or CPDO, were arranged by ABN Amro, an affiliate of Royal Bank of Scotland Group Plc, rated by S&P, and sold to the Australian councils by municipal adviser Local Government Financial Services.
The securities were unwound less than two years after the towns bought them because credit spreads kept increasing and their cash value was exhausted, according to a court filing.
Town officials said during the trial they hadn’t read all of the accompanying documents and relied on the AAA rating to make the decision to invest in the notes. Among the councils that bought the notes was Corowa Shire, a three-hour drive from Melbourne and home to the country’s biggest hog farm.
Cooma-Monaro Shire, a region in the Snowy Mountains south of Canberra which lost A$1.9 million on the notes, had to cancel planned upgrades to its footpaths and public toilets after the event wiped out about half of its discretionary budget, mayor Dean Lynch said by phone.
“That was a massive blow to our budget,” he said by phone. “That money was essentially put aside for a rainy day.”
Local Government Financial Services purchased A$45 million of the Rembrandt notes from ABN Amro and resold A$18.5 million in 2006 and 2007, including A$17 million to the Australian towns that sued, according to court documents. A 13th township sued separately after losing more than 90 percent of its A$1 million investment in the securities.
LGFS also sued S&P, accusing the company of breach of duty and negligence in giving the notes the highest investment rating. LGFS and the Australian councils also sued ABN Amro, claiming it was negligent in passing on S&P’s AAA ratings.
The municipal adviser is entitled to damages from S&P and ABN Amro, Jagot ruled. The councils are entitled to damages equivalent to their A$15.8 million in losses. A separate hearing will be held to make final orders, she said.
“We are studying this long and complex judgment,” RBS spokesman Allan Watt said in a statement.
ABN Amro was “knowingly concerned in S&P’s contraventions” and engaged in misleading and deceptive conduct, according to today’s ruling.
The case is: Bathurst Regional Council v. Local Government Financial Services Pty. NSD1268/2010. Federal Court of Australia (Sydney).