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Case Note
Duty of Care, Rating Agencies
and the Grotesquely
Complicated Rembrandt:
Bathurst Regional Council v
Local Government Financial
Services Pty Ltd (No 5)
Rommel Harding-Farrenberg and Kieran Donovan*
In Bathurst Regional Council v Local Government Financial Services Pty Ltd (No 5)
(Bathurst),1 the Federal Court of Australia considered the liability of rating
agencies for the rating, sale and purchase of a structured financial product
called a constant proportion debt obligation (CPDO). A number of
Australian local councils lost money through their investments in the CPDOs.
Justice Jayne Jagot determined that the rating given to these grotesquely
complicated financial instruments was negligent, and that the rating agency
Standard & Poors (S&P) had engaged in misleading and deceptive conduct
in giving the CPDO a AAA rating. Further, the bank that had created the
CPDOs (ABN AMRO Bank NV (ABN AMRO)) and the agent through which
the investors purchased the CPDOs (Local Government Financial Services
(LGFS)) were also liable for the losses of the local councils.
S&P has indicated that it plans to appeal the ruling. Notwithstanding
any appeals and that Bathurst turns on its particular facts, Bathurst is a
landmark decision at the vanguard of legal actions against rating agencies
in connection with the global financial crisis, such as the US$5bn lawsuit
recently commenced by the US Government against S&P.
* Corrs Chambers Westgarth.
1 [2012] FCA 1200.

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Figure 1
Key points
1. A rating agency may have a duty of care to investors, notwithstanding that there is no contract
between them.
2. The duty is to ensure that there is a reasonable basis for issuing a rating.
3. Where a rating agency issues a rating without reasonable basis, or where there are significant flaws in
the methodology and model used, this will constitute a breach of that duty.
4. A rating agency may be liable for the total loss of an investors investment if it has breached that duty.
5. A rating agency may also be liable to investors if its rating is considered to be misleading or deceptive
or its rating constituted a misrepresentation.

Facts
Creation of CPDOs
In April 2006, ABN AMRO created the financial product that became known
as the CPDO. A complex, highly leveraged credit derivative, the CPDO was to
operate over a period of ten years and throughout that time it would make
a profit or loss as a result of notional credit default swap (CDS) contracts.
Investors were asked to invest in CPDO notes issued by a special purpose
vehicle, which was created specifically for the purpose of such issue. The issue
of the notes was on a non-tranched basis, so no investors were insulated from
the risk of default or loss. In order to offset any poor performance (if the value
of the CPDO fell), the CPDO was capable of leveraging up any losses on the
CDS contracts to 15 times the value of the principal amount. 2 The strategy,
which meant that the portfolio took on more risk as it suffered losses, was
based on an assumption that eventually the CDS contracts would provide a
return, and that to reach that the CPDO needed to fight to the death.3 The
result, as described by Jagot J and ABN AMRO, was a casino strategy, whereby
an investor doubled-down when the product performed poorly. In theory,
provided you double-down (to offset losses) enough and have enough
coverage to do so then you will eventually win. The theory was described
by ABN AMRO thus: if you hit a losing streak your net worth can become very
low, however most of the time you will be able to bet yourself out of the hole.4
Rating the CPDO AAA
S&P was tasked with rating the CPDO. When conducting an analysis of the
product, S&P did not seek out any more documentation than that which had
been provided by ABN AMRO. S&P, based on the figures and information
provided by ABN AMRO, assessed assumptions on volatility and spreads, nonstressed assumptions, calculations of likely default and account ratings migration.
2 [2012] FCA 1200 at [1221].
3 [2012] FCA 1200 at [53] referring to the Grove Report (16 November 2006) Key
Features CPDO (Grove Research and Advisory).
4 [2012] FCA 1200 at [84].

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The result of the analysis was a rating of AAA.


ABN AMRO then requested from S&P permission to publish the AAA
rating as part of the marketing package sent to potential investors. Some
potential investors questioned why ratings migration (an estimation of
obligor credit risk based on probability of default) was not considered in the
model that S&P used to work out the rating, and ABN AMRO opted not to
pass this concern on to S&P5 instead telling clients that the existing model
directly or indirectly captures [those] risks.6 When S&P later became aware
of these inquiries, they too decided not to apply this to the existing model
for fear that it would have had an unpredictable effect on the rating.7
Following the successful sale of the initial batch of CPDO notes, ABN
AMRO created a second tranche of CPDO notes titled Rembrandt 2006-2
(Rembrandt 2). These were in Australian dollars and also rated AAA by S&P.
LGFS buys in
The LGFS, a body that had originally been formed to invest and manage
surplus funds of councils in the state of New South Wales but was
subsequently sold off to a financial services business, was one funds manager
that showed an interest in the Rembrandt 2 notes. LGFS facilitated the sale
of AU$10m of notes to StateCover Mutual (one of the compensation funds
under LGFS management).
The sale of the Rembrandt 2 notes was considered successful and LGFS
engaged ABN AMRO to model and structure a third tranche of notes to be
known as Rembrandt 2006-3 (Rembrandt 3). LGFS planned to market these
to its clients who were local councils. Again, S&P gave these a AAA rating.
Prior to the issue of the Rembrandt 3 notes on 2 November 2006, S&P
became aware that decreased spreads and volatility assumptions meant that
a reassessment of the AAA rating should be undertaken. However, based
on ABN AMROs description of the Rembrandt 3 notes, namely that the
Rembrandt 3 notes were identical to the Rembrandt 2 notes, S&P went ahead
and issued a AAA rating.
LGFS purchased AU$45m of the Rembrandt 3 notes, on-selling AU$16m
worth to 13 New South Wales councils. As is now well known, the highly
leveraged notes ultimately suffered significant losses throughout 2007.
By February 2008, S&P was forced to downgrade the rating of both the
Rembrandt 2 and 3 notes to BBB+.
5 [2012] FCA 1200 at [30][31].
6 [2012] FCA 1200 at [2576].
7 [2012] FCA 1200 at [2570].

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Loss
When the councils who had purchased the products cashed out in October
2008, the value of the investment had dropped to less than one-tenth of
what it had been (once the investment dropped below ten per cent of the
original outlay, an automatic cash-out occurred).
Shortly thereafter, those councils brought proceedings against LGFS
(as the agent that facilitated the purchase), ABN AMRO (the creator of
the investment products) and S&P (as the agency that originally rated the
products AAA).
Cause of action
Bathurst involved two concurrent actions, one by LGFS against ABN AMRO
and S&P; the second by the local councils against LGFS, ABN AMRO and
S&P (the respondents). The councils alleged that each respondent engaged
in misleading and deceptive conduct in contravention of sections 1041E
and 1041H of the Corporations Act 2001 (Cth) and section 12DA of the
Australian Securities and Investments Commission Act 2001 (Cth). Further,
the councils alleged that the respondents had been negligent.
Before Bathurst
Until November 2012, courts in Australia and indeed most courts in other
jurisdictions around the developed world had been reluctant to find rating
agencies liable for the losses suffered by an investor who claimed that they
relied on the rating given to an investment product.
The rationale, which was discussed shortly before Bathurst in Wingecarribee
Shire Council v Lehman Brothers Australia Ltd (in liq),8 was that the typical
investor makes various investments based on recommendations and advice
given by financial advisers. Even though those financial advisers may be, in
turn, relying on or using the ratings given to certain products, the rating
agency does not have control over the way in which those ratings are used.9
Consistent with previous decisions, in Wingecarribee Justice Rares
determined that a rating given by S&P was not misleading or deceptive

8 [2012] FCA 1028.


9 For comparison and context, note that the Financial Ombudsman Service the body
empowered to mediate disputes between investors and financial advisers (among other
things) has since its inception categorically refused to consider disputes concerning the
investment performance of a financial product. Financial Ombudsman Service Limited
Terms of Reference (1 January 2012), cl 5.1(g).

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because S&P had no responsibility for the use of its rating by financial
advisers (at [1099]).
However, in Bathurst, Jagot J questioned whether this position ought to be
reconsidered and whether the case of misleading and deceptive conduct, or
negligence, had been made out in the circumstances at hand.
Findings in Bathurst
The court considered the liability for each of the respondents in relation to
its involvement in the process of issuing the CPDOs.
LGFS
The court held that the marketing of Rembrandt 3 notes to the local
councils, in circumstances where LGFS had taken a significant role in the
development of this tranche of products, was in breach of its fiduciary
obligations to the councils.10 It was, in effect, a conflict of interest that
should have been disclosed.11
LGFS was also found to have made misleading statements and
misrepresentations to the councils regarding the quality of the Rembrandt
3 notes. The marketing of the notes was held to be hopelessly deficient.12
ABN AMRO
Justice Jagot, looking concurrently at the conduct of S&P and ABN AMRO,
found that ABN AMRO was complicit and involved in the misleading and
deceptive conduct of S&P.13 Further, her Honour held that the marketing of
the notes to LGFS and the councils involved negligent misrepresentations
because of the statements made about the reliability and integrity of the
AAA rating.14
S&P
Finally, the court turned its attention to S&P and whether it had any
responsibility in relation to the councils reliance on the AAA rating. The
court found against S&P on three main grounds.
10
11
12
13
14

[2012] FCA 1200 at [2324].


[2012] FCA 1200 at [1373].
[2012] FCA 1200 at [2232] and [2494].
[2012] FCA 1200 at [2460].
[2012] FCA 1200 at [2461].

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First, the AAA rating S&P had assigned to the Rembrandt 2 and
Rembrandt 3 notes was misleading and deceptive.15 The rating was based
on statements that were false in material particulars and involved negligent
misrepresentations to the investors.
Secondly, S&P owed a duty of care to potential investors and was negligent
in rating the Rembrandt notes when loss was reasonably foreseeable (and S&P
was aware that the AAA rating was required to induce the investors to invest).16
Thirdly, and notwithstanding that the AAA rating was described as an
opinion subject to conditions, it prima facie conveyed an extremely strong
representation that S&P believed that the notes were very capable of
providing a financial return on investment.17
Duty of care owed by rating agencies
Never before had a court found that a rating agency owed a duty of care to
investors. Owing to the complexity and subjectivity of the analysis involved in the
provision of a rating, the courts had previously been reluctant to impute liability
for what was published. The absence of a contractual relationship between
investors and the relevant rating agency was also a factor in the courts reluctance.
Duty of care: not the rating itself
In Bathurst, there was no question that the ratings information provided
was the result of a very complex assessment. Her Honour pointed out that:
[the rating] was a record of an opinion of Standard & Poors, which held
itself out as having specialist expertise in assessing the creditworthiness of
financial products and was intended to be understood as such.18
Accordingly, the rating itself was not considered to be advice as to whether
or not to invest nor a guarantee of the CPDOs performance.
In order to ascertain whether S&P had acted negligently or had misled
investors the question for the court was not whether an alternative rating
should have been given, but simply whether there was a reasonable basis for
the rating that was given.19
The court came to the conclusion that a rating agency owes a duty of
care to potential investors who are vulnerable, in circumstances where the
investors are unable to assess the creditworthiness of the relevant financial
products or to challenge the rating agencys rating of the products.20
15
16
17
18
19
20

[2012] FCA 1200 at [2416].


[2012] FCA 1200 at [2455].
[2012] FCA 1200 at [2423].
[2012] FCA 1200 at [1277].
[2012] FCA 1200 at [2423].
[2012] FCA 1200 at [2459].

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Breach of duty: the underlying support for the rating


The court focused on three key criteria that had been used by S&P to
determine the rating, which were considered to have contributed to a rating
that did not properly qualify the product. In this regard, S&P:
1. utilised a number of significant inputs that were incorrect (and S&P
ought to have known that such inputs were incorrect);21
2. failed to make an assessment based on alternative, reasonably anticipated
and exceptional but plausible inputs;22 and
3. failed to ascertain the sensitivity of the performance of the CPDOs to
even slight changes to the inputs used in the model.23
Recalling that S&P had taken at face value the information provided to it
by ABN AMRO for the purpose of making the ratings calculation, the court
found that the assumptions underlying this information were unreasonably
optimistic and unjustified yet these were used for the modelling of the
CPDOs performance.24 Evidence was adduced at trial which suggested that
S&P knew that the rating was to be provided for the specific purpose of
inducing potential investors to acquire the notes.25 This was very much the
case with investors like the LFGS, which was prevented by law from investing
in any product rated less than A.26
Conduct of S&P
The court went on to identify the particulars of the conduct behind the
S&P rating:27
1. ABN AMRO encouraged S&P to adopt, as the basis for rating, ABN
AMROs model inputs and assumptions;
2. S&P accepted these inputs and assumptions;
3. ABN AMRO, which had provided the subjective data for the modelling,
was thus aware of the inadequacies in the rating (but they would still
benefit from it);
4. S&P authorised ABN AMRO to disseminate the AAA rating to market
the CPDO to potential investors; and
5. the issues that arose once the CPDO was put to the market were kept
secret by ABN AMRO.
21
22
23
24
25
26
27

[2012] FCA 1200 at [2547].


[2012] FCA 1200 at [2582][2589].
[2012] FCA 1200 at [2669].
[2012] FCA 1200 at [2547][2548].
[2012] FCA 1200 at [2499].
[2012] FCA 1200 at [1256].
[2012] FCA 1200 at [2544][2554].

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The court eventually concluded, in relation to the actual analysis


undertaken by S&P to produce the ratings information, that: no reasonable
ratings agency exercising reasonable care and skill could have committed
[to the rating].28
Scope of the duty
In Bathurst the court did not find that the rating given was worse than it
should have been or that an alternative rating should have been given,
but instead found that there was a duty of care owed because there was no
reasonable basis for giving the rating that S&P assigned to the CPDOs.
Misleading and deceptive conduct
In relation to misleading and deceptive conduct, the courts findings in
Bathurst are also significant.
The court held that when S&P calculated and disseminated its ratings, it
breached sections 1041E and 1041H of the Corporations Act 2001 (Cth).29
The conduct involved the making of false and misleading statements, and
the conduct more broadly was misleading or deceptive.
In addition, the court held that the AAA rating by S&P was a representation
that the Rembrandt notes capacity to meet its financial obligations over the
term was extremely strong.30 Further, the rating conveyed a representation
by S&P that its opinion (ie the rating) was based on reasonable grounds and
determined as a result of an exercise of reasonable care.31
Use of disclaimers and the opinion defence
S&P argued, as it has successfully in other jurisdictions around the world,
that even if it did have a duty to the investors, the disclaimers populating
its rating would obviate any liability.32 Nevertheless, Jagot J determined that
the disclaimers were not effective in this instance because those disclaimers
were not brought to the attention of investors. This is an important point.
Where appropriate disclaimers are brought to the attention of investors, the
position may be different.

28
29
30
31
32

[2012] FCA 1200 at [2617].


[2012] FCA 1200 at [2132].
[2012] FCA 1200 at [1442] and [2154].
[2012] FCA 1200 at [2439].
[2012] FCA 1200 at [2539][2543].

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S&P also put it to the court that there was a dichotomy between advice
and an opinion the latter of which ought not to attract any sort of liability.
Justice Jagot rejected this false separation and focused on the representation
that was put forward by the rating agency in giving the rating.33
Bathurst distinguished: no likely floodgate
Bathurst has opened the door to further claims against rating agencies for
their rating of financial investment products. There is now precedent that
a rating agency owes a duty of care to investors.
However, the circumstances in which such a duty will be imputed were
expressly limited by the court. In Bathurst, the duty of care was owed because
S&P had been engaged by ABN AMRO to rate the CPDOs and it was obvious
to any reasonable person (including S&P) that S&Ps rating was to be used
to market the investment product to a particular class of investors.
This fact helped the court to distinguish Bathurst from existing case law.
Justice Jagot was careful to distinguish the case from circumstances where
a company such as S&P offers ratings information concerning public
companies (and where the information gleaned to produce that rating is
obtained from publicly available information).
Is Bathurst the case to encourage liability for ratings opinions in the
United States?
The result in Bathurst is at odds with the current landscape in the United
States. To date, it appears to have been very difficult for a plaintiff to argue
successfully that a rating agency ought to be liable for or has a duty of care
to investors for the ratings it issues. This has ordinarily been the result
of the strength of the First Amendment protection of free speech and the
right to expression of opinions. Whereas English courts have not delineated
between whether the rating is advice or an opinion, the American courts have
comfortably formed the view that a rating is an opinion, and thus subject to
protection under the First Amendment.
In considering what (if any) fiduciary duty might be owed by either a
rating agency or the agency responsible for an investment product to the
actual investor, a New York Court of Appeals in June of 2012 dismissed a suit
against S&P, declaring that no such duty existed.34
33 [2012] FCA 1200 at [2402].
34 Oddo Asset Management v Barclays Bank, New York State Supreme Court, New York County
(No 08-109547).

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As recently as December 2012 the Second Circuit Court of Appeals


dismissed a class action against McGraw-Hill concerning ratings of mortgagebacked securities by S&P shortly before the global financial crisis. The case
saw a number of pension funds argue unsuccessfully that their investment
in these products was the result of false and misleading statements made by
S&P in relation to the integrity of the ratings given.35
The recent decision in Bathurst may, however, be a trigger for a deeper
consideration of the duties and liabilities of rating agencies elsewhere around
the world, including the United States.
With litigation currently pending before the New York federal court
(which in August 2012 denied motions for the summary dismissal of a case
against Moodys and S&P) and in Illinois (where the state Attorney General
has brought an action for misleading conduct against S&P) and the US
Governments US$5bn action against S&P in federal court in Los Angeles,
there is a chance that Bathurst may encourage other jurisdictions to impute
greater liability for the issuing of ratings.
Conclusion and the future for ratings
It is relevant to note that the decision in Bathurst is at first instance. It is likely
that this matter will be considered at length on appeal. Developments in this
regard will be watched with much interest.
Contrary to some reports in popular media, the decision in Bathurst is
one confined to a very particular set of circumstances. A court will not
impute responsibility for ratings simply because a financial product does
not prove fruitful based on Bathurst a court will only consider doing so in
circumstances where the analysis underpinning a rating is unreasonable. A
rating agency may, however, owe a duty of care to potential investors who
are considered vulnerable those unable to assess the creditworthiness of
the products or challenge the rating given.
As a result, the decision in Bathurst is likely to be an ongoing concern
for in-house lawyers at the rating agencies, investment managers and the
investment banks that develop financial products that are to be rated. The
due diligence undertaken to corroborate and verify the model used to
produce a rating (including in relation to assumptions and stress testing)
is likely to be increased in the wake of Bathurst, regardless of the ultimate
outcome of any appeal.
The quantum of damages in Bathurst, which were awarded against ABN AMRO,
S&P and LGFS in equal shares, is significant. The total amount of damages
35 Boca Raton Firefighters & Police Pension Fund v Bahash, et al (12-cv-1776) (US Court of
Appeals for the Second Circuit).

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was equal to the difference between the purchase price paid by the councils for
the CPDOs and the return to the councils on the CPDOs (as a result of their
cash-out). The amount of damages ie covering all loss might encourage
other investors to seek compensation for losses in similar circumstances.
While it may not open the floodgates to similar litigation, Bathurst stands
as a poignant reminder that the information that underpins a rating of a
financial product must be comprehensive and vetted critically before the
rating is finalised and product marketing is distributed to potential investors.
It also stands as an example of why investors must carry out their own
due diligence the circumstances in which investors will be able to claim
successfully damages from a rating agency appear relatively narrow.