Summary
The Federal Court handed down its judgement in the case of Bathurst Regional Council v. Local Government Financial Services Pty Ltd (No.5) [2012] 1200. The case was a class action brought by 13 councils against Local Government Financial Services Pty Ltd (LGFS), ABN Amro Bank NV (ABN Amro) and McGraw Hill International (UK) Limited as publisher of the Standard & Poors ratings (S&P).
Background
The claims involved the issue of Constant Proportion Debt Obligation (CPDOs) arranged by ABN Amro and rated by S&P. The CPDOs were later bought by LGFS, who then on sold the CPDOs to the councils.
The CPDOs were given a AAA rating by S&P on the basis of information provided by ABN Amro. No additional steps were taken by S&P to verify this information.
The information given to S&P by ABN Amro was misleading in numerous respects, and was designed to "game" S&P's rating model to achieve a AAA rating.
This led to errors in the calculation of the ratings such as "unreasonable and unjustifiable" assumptions on volatility and spreads, non-stressed assumptions, errors or omissions in relation to calculations of default and a failure to take into account ratings migration. These errors led to the CPDOs being rated AAA by S&P.
Prior to the last issue of the CPDOs, S&P became aware of mistakes in the information provided by ABN Amro (which information would have resulted in the CPDOs being rated less than AAA) but gave the final issue of CPDOs a AAA rating on the basis of the previous ratings given to the earlier issues of the CPDOs.
LGFS was previously the authorised deposit taking institution (ADI) used by councils in New South Wales, and had previously been owned by the local government and shire association.
LGFS bought the CPDOs and on sold them to the councils. In doing so, LGFS was engaged as a financial adviser to two of the councils, but had a long-term relationship with the other councils through its history as the council's ADI.
Throughout 2008, the CPDOs declined in value. By the time the councils cashed out of the CPDOs, their return was less than 10% of the principal they had invested.
Findings
Summary
The court's findings surrounded five main legal issues being:
1) misleading and deceptive conduct;
2) negligence;
3) breach of fiduciary duties;
4) breach of contract; and
5) the classification of the CPDOs as derivatives.
Liability
Justice Jagot found that:
1) in respect of S&P:
a) S&P owed both LGFS and the councils a duty of care in the calculation and dissemination of the ratings. In rating the CPDOs as AAA (where no ratings agency acting reasonably could have given them a AAA rating) it breached that duty of care, which caused loss to the councils and LGFS.
b) S&P's conduct in calculating and disseminating the ratings breached sections 1041E (making false and misleading statements) and 1041H (engaging in conduct which is misleading or deceptive) of the Corporations Act 2001 (Cth) (Corporations Act) and section 12DA of the Australian Securities and Investments Commission Act 2001(Cth) (ASIC Act).
2) in respect of ABN Amro:
a) ABN Amro owed both LGFS and the councils a duty of care in calculating and disseminating the S&P ratings, and it breached that duty of care as it knew that the S&P ratings were based on inaccurate information. This breach of duty of care caused loss to LGFS and the councils.
Further, ABN Amro owed LGFS a duty of care in providing advice and services to LGFS, and breached that duty of care, which caused loss to LGFS.
b) ABN Amro engaged in conduct that was misleading and deceptive (in breach of sections 1041E and 1041H of the Corporations Act and section 12DA of the ASIC Act) and was knowingly concerned in S&P's misleading and deceptive conduct.
c) ABN Amro breached its contractual duties to LGFS in structuring the CPDOs. ABN Amro breached the statutorily implied duties in financial services contracts in section 12ED of the ASIC Act by failing to provide financial services to LGFS with due care and skill.
3) in respect of LGFS:
a) LGFS engaged in numerous instances of misleading and deceptive conduct in its interaction with the councils in breach of section 1041H of the Corporations Act and section 12DA of the ASIC Act.
b) LGFS owed a duty of care to the councils which it breached by negligently misrepresenting the nature and risk profile of the CPDOs (although not in its action of passing on the rating, because LGFS had no reason to believe the rating was inaccurate); which caused loss to the councils.
c) LGFS owed the councils a fiduciary duty:
i) in its capacity as financial adviser for the two councils it was engaged to act; and
ii) for the remaining councils because it induced the councils to believe that LGFS would act in the best interests of those councils (through its long-term relationships with those councils which had developed when LGFS was the ADI for councils across New South Wales) and those councils were at a vulnerability having a lack of knowledge of complex financial instruments;
which it breached by preferring its own interests (making money from the CPDOs) over the interests of the councils (making low risk investments).
d) LGFS breached the authorisations on its AFSL as it was not licensed to advise on or deal in derivatives (the CPDOs being derivatives).
e) LGFS breached its contractual obligations to the two councils, which it acted as financial adviser for.
Damages
In relation to the damages payable by ABN Amro, S&P and LGFS:
? the councils were awarded damages against ABN Amro, S&P and LGFS to be paid in equal proportions;
? the Court rejected the submission by ABN Amro, S&P and LGFS that damages should be awarded on the basis of contributory negligence;
? the councils were to be paid damages equal to the amount of the difference between the purchase price of the CPDOs and their return on the CPDOs (without deduction for coupons paid);
? LGFS was ordered to pay damages for breach of contract to the two councils it acted as adviser for;
? LGFS was ordered to pay the council damages for breach of LGFS' fiduciary duty; and
? ABN Amro and S&P were ordered to pay LGFS damages for the amounts it lost in holding the CPDOs and to cover amounts that LGFS had paid to settle another similar litigation.
Implications of the case
There are a number of implications for ratings agencies and product issuers from this case. These include:
? compliance costs can be expected to rise for product issuers and ratings agencies;
? AFSL holders will need to ensure that they are properly licensed to provide advice, or deal in products that they are advising on/dealing with;
? product issuers should consider the appropriateness and accuracy of information they provide to ratings agencies;
? rating agencies will need to ensure that they are sufficiently independent of product issuers;
? ratings agencies should not rely solely on information provided by product issuers and may have to take additional steps to verify information particularly where that information is publicly available;
? product issuers may have to consider additional compliance measures to ensure that products designed and rated for a specific, agreed upon/advertised purpose are actually fit for that purpose; and
? ratings agencies should employ greater scrutiny when dealing with complex products.
Action points
? Financial services entities will need to be careful in drafting and using disclaimers to ensure that disclaimers are consistent, relevant and prominently displayed.
? Financial advisers who provide advice to parties that are not their clients, should have appropriate notices and disclaimers in place notifying the other party that the adviser is not engaged as their financial adviser and does not take into account the interests of that other party.
? Financial product issuers seeking to have their product rated should ensure that the assumptions or other information they provide to ratings agencies have a reasonable basis.
? Financial product issuers should document the processes they use to determine that information and assumptions provided to ratings agencies are reasonable in the circumstances.
