Structured credit products – key Australian decisions

In late 2012, the Federal Court of Australia handed down first instance judgments in two interesting cases involving claims brought by the purchasers of structured credit products prior to the widespread dislocation in the global market for such products. Each involved questions relating to the liability of those that structure and sell structured credit products and of the rating agencies that issue credit ratings to such products.

The striking findings include findings of liability against a credit rating agency and will be of interest and relevance to participants in the markets for structured products in the United Kingdom and beyond.

Wingecarribee Shire Council v Lehman Brothers Australia Ltd (in Liquidation)¹

Wingecarribee involved a class action brought by three Australian local councils (Wingecarribee, Swan and Parkes) against an Australian subsidiary of Lehman Brothers ("LBA") in relation to the purchase by the councils from LBA of a number of synthetic CDOs in the years between 2003 and 2008. For the first few years of the relationship, the CDO investments which the councils made were successful, in that they caused no material losses and generated satisfactory returns (and an improvement on the council's previous investments in term deposits and floating rate notes).

However, when the market dislocation took hold in 2007 (by which time two of the councils had entered into individual managed portfolios ("IMPs") with LBA), a number of the investments the councils had made had suffered significant losses. In particular, three of the synthetic CDOs which they had purchased had lost their entire value, and others had suffered material losses of capital. In addition, the councils' investments in the Dante series of notes were effectively in limbo pending the resolution of an impasse between the London and New York courts concerning the effectiveness of the notes' so called 'flip' provisions (which affect the priority of payments between the noteholders and the swap counterparty and therefore the value of the notes).

Between them, the councils claimed that LBA had breached its contract with them on the basis that the synthetic CDOs did not have the characteristics which had been promised in that LBA had said that they were suitable for a conservative investment strategy, that they were liquid, and that the high credit ratings they had been given placed them in the same investment 'universe' as Australian government and large bank debt. The two councils who had entered into IMPs with LBA further alleged that the synthetic CDOs breached the IMP agreements because they were not appropriate investments, and (in breach of the investment guidelines) they were investments: (i) for which there was no active secondary market; and (ii) which were derivatives.

In addition, the councils claimed that LBA had breached its fiduciary duties as an investment adviser in recommending products the sale of which LBA would benefit from without disclosing that fact to the councils. Finally, they each claimed for breach of an Australian-specific consumer protection provision of statute which creates strict corporate liability for misleading or deceptive conduct.

The Federal Court found that LBA was liable to the councils in respect of each of these claims and therefore for damages on the following bases:

• the councils' full loss incurred for those notes that had been wiped out;
• the difference between par and what the councils received for those notes that had matured (or that the councils had sold) at less than par;
• the difference between the current value and par of those notes the councils still held; and
• immediate payment of the net present value of the Dante notes (which, artificially, was calculated by averaging the differing outcomes dependent on whether the conclusions of the New York or UK courts prevailed).

Bathurst Regional Council v Local Government Financial Services Pty Ltd (No 5)²

The second case was also a class action, this time brought by a group of 13 Australian local councils and Statecover, a local government workers' compensation insurer. These claims were for negligent misrepresentation (and breach of the Australian statutory prohibition on misleading or deceptive conduct).  However, the claims were brought against each of the councils' financial advisor (LGFS), the arranging bank (ABN Amro) and the rating agency (S&P) in relation to the Rembrandt 2006-2 and 2006-3 series of notes, which were Australian dollar denominated issues of constant proportion debt obligations (CPDOs) created by ABN Amro.

The CPDOs were ten year notes which had, as their reference assets, a pool of Credit Default Swaps (CDSs) based on the constitution of the CDX and iTraxx indices (which together were known as the Globoxx index). The CDX and iTraxx indices were created in 2003 and sought to consist of CDS contracts with the 125 most liquid investment grade obligors consistent with a diversified industry make-up.

In simple terms, the performance of the notes depended on the interaction between the mark-to-market prices of the underlying CDS contracts on the one hand, and the income from CDS premiums which the structure generated on the other, as the bid-offer spreads on those CDS contracts rose or fell. It was explained by one of the experts at trial that the theory behind the structure was the tendency of credit spread curves to exhibit 'mean reversion', by which it is meant that, whether they go up or down in the short term, spreads tend to revert to a long term mean.

Unlike corporate obligors or country debt, for which the rating agency has a substantial amount of observable data on which to base its rating, S&P's methodology for rating structured products such as CPDOs placed heavy reliance on the use of quantitative modelling. This typically involved running a very large number of stochastic simulations, known as a Monte Carlo process, to predict what the default probability of the particular product would be (from which, subject to a further qualitative exercise, a credit rating would be derived). Inherent in this is that, in order to run the simulations, the rating agency will have to make a number of assumptions (or model inputs). Rating the CPDOs involved S&P applying a number of different inputs into the model:

• The starting, or initial, CDS spread;
• The long term average spread (LTAS) (i.e. the assumption made as to the mean to which spreads will tend to revert in the long run);
• The Mean Reversion Speed (i.e. the speed at which spreads will tend to revert to the LTAS); and
• The volatility of spreads (i.e. how far they will move up or down before reverting to the LTAS).

Prior to the rating of the Rembrandt 2006-3 series of notes, S&P had rated earlier iterations of ABN's CPDO product on assumptions which were criticised by the judge as not having been what a reasonable and competent rating agency would have adopted to rate the notes. In summary, some of the inputs used by S&P were found to have been overly optimistic assumptions, whilst others were found to have been "arbitrary, irrational and unreasonable". Overall, the rating process failed to ensure that the performance of the CPDOs was modelled on the basis of market conditions which were reasonably anticipated (non-stressed) as well as exceptional but plausible (stressed).

The net result of these failings was that the earlier CPDOs had received an AAA rating from S&P which, on standards of reasonable competence, no rating agency would have given them. On behalf of one of its clients, Statecover, LGFS purchased AUS$10m of one such note (the AAA-rated Rembrandt 2006-2 CPDO notes) from ABN Amro.

Towards the end of 2006, LGFS was looking for financial products it could market to its clients to compete with its competitors' successful marketing of CDO products to local councils, which had caused LGFS's profits to plummet in recent years. In that context, the Rembrandt 2006-3 note was created by ABN Amro specifically for LGFS for the purposes of on-selling to its clients. As such, it needed to be issued with an AAA rating from S&P.

The judge found that, notwithstanding material changes to the market conditions, S&P nevertheless assigned the notes an AAA rating (and had allowed the rating to be disseminated to potential investors) on the basis that ABN Amro had described the notes as a carbon-copy of the series 2 notes. Significantly, S&P did not carry out any modelling of the series 3 notes for the purpose of the rating. The judgment cites contemporaneous evidence of a concern about the ratings process within S&P, referring to an internal S&P email in which one senior ratings analyst described the rating as "analytical bs at its worst. I know how these ratings came about and they had nothing to do with the model!"

The 13 councils between them purchased AUS$16m of the Rembrandt 2006-3 notes, with LGFS retaining a further AUS$24m on its balance sheet. However, the sustained widening of spreads (i.e. in the absence of mean reversion) from mid-2007 caused the notes to fail, initially being downgraded to a BBB+ rating and then finally collapsing, returning less than 10% of the initial capital investment, in October 2008.

The Court found that S&P was liable to the councils and LGFS both for breach of the statutory prohibition on misleading or deceptive conduct and, more interestingly from the perspective of market participants outside Australia, negligent misrepresentation. This was on the basis that the AAA rating was a representation that, in S&P's opinion, the issuer had an "extremely strong capacity" to meet its obligations and that this opinion was held on reasonable grounds after taking reasonable care.

ABN Amro was also liable to the councils and LGFS on the basis that it had deployed the AAA rating and, in doing so, had made its own representations as to the meaning and reliability of that rating, which amounted both to misleading or deceptive conduct and negligent misrepresentation.

LGFS was also liable to the claimants for, inter alia, negligently advising them that the notes were a suitable investment and for breach of its fiduciary duties to the councils.

Accordingly, LGFS, S&P and ABN Amro were proportionately liable to the claimants for the loss suffered from their investment in the Rembrandt 2006-2 and 2006-3 notes, and S&P and ABN Amro were liable to LGFS for its loss on the retained balance of the 2006-3 notes.

Points of interest

• The willingness of the Federal Court of Australia to find that a duty of care was owed to investors (and that this duty was breached) by the rating agency, S&P, is especially striking given the absence of any contractual nexus between the parties. This is particularly so given that the development of Australian case law on liability for pure economic loss has tended to follow similar lines (and take into account similar factors) to that in England.
• S&P's disclaimers were found to be ineffective on the basis of both their manner of communication to the councils (which was insufficiently prominent given their purported effect) and because the Court found that S&P was attempting to exclude liability to investors who had relied on the rating for their investment decisions in circumstances where S&P had been paid precisely for the provision of an opinion about that investment. It was found that to give effect to the disclaimer would have been to render the rating "meaningless".
• The finding of negligent misrepresentation against the selling and structuring banks regarding their deployment of the AAA or AA credit ratings which the relevant products received presents an interesting contrast to the analogous case of CRSM v Barclays³ in the English Courts, in which implied representations about the meaning attributable to a AAA rating were found to be limited to the fact that the products (notes linked to a series of CDO²s) had received such a rating. (Click here for our briefing on the CRSM case).
• The treatment of LGFS as both an investment adviser to some of the councils, and having owed them fiduciary duties, was on the basis of a prolonged course of conduct, including suggestions that they would act as a 'trusted adviser' and was in spite of the absence, for most of the councils, of any formal retainers.

¹ [2012] FCA 1028.

² [2012] FCA 1200.

^{3 Cassa di Risparmio della Repubblica di San Marino S.p.A. v Barclays Bank Ltd [2011] EWHC 484 (Comm)}