Case Note: Duty of Care, Rating Agencies and the 'Grotesquely Complicated' Rembrandt: Bathurst Regional Council V Local Government Financial Services Pty Ltd (No 5)

In Bathurst Regional Council v Local Government Financial Services Pty Ltd (No 5) {Bathurst) / 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 & Poor's (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.FactsCreation of CPDOsIn 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 byjagotj 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".'4Rating 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, non-stressed assumptions, calculations of likely default and account ratings migration.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.7Following 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'). …