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Alarm bells for Financial Institutions and their insurers

5 December 2012

The fall out from sub prime mortgages focussed on those responsible for structuring and selling the products; the ratings agencies appeared to escape liability.

Whilst mis-selling of complex structured products migrated across the Atlantic, the principle of buyer beware was upheld in the UK (see Cassa Di Risparmio Della Repubblicca di San Marino SpA v Barclays Bank Ltd [2011] EWHC 484 (Comm) (09 March 2011)).

The same cannot be said of the approach of other common law jurisdictions. The first instance decision of Bathurst Regional Council v Local Government Financial Services Pty Ltd (No 5) [2012] FCA 1200, is an important case for rating agencies, financial institutions (FIs) and, potentially, insurers. Given the subject matter and the outcome of this case (although Standard & Poor’s (S&P) have indicated they wish to appeal), it is likely that the fruits of this litigation will find their way back to continental Europe.


ABN AMRO Bank NV (ABN AMRO) structured a highly complex derivative instrument named a constant proportion debt obligation (CPDO), and engaged S&P to rate the product. S&P adopted ABN AMRO’s model inputs without independent assessment, which the trial judge, Justice Jagot, considered should have been carried out by a reasonably competent ratings agency. Further, Jagot J found that at least two of the major inputs (volatility and long term average spread) used by S&P in its modelling were unreasonably optimistic and had no proper rational foundation, such that a AAA rating was not warranted and was “hopelessly deficient”.

S&P authorised ABN AMRO to disseminate its AAA rating of the CPDO notes to potential investors, and ABN Amro did so in the knowledge that the modelling was potentially deficient and the notes benefited from an unjustifiable rating. Despite queries from potential investors, in particular in relation to the cost of ratings migration, ABN AMRO professed confidence in the modelling and rating.

Following the successful sale of these notes, ABN AMRO devised a AUD denominated CPDO named Rembrandt 2006-2. The notes were rated AAA by S&P. One intermediary which showed an interest in the notes was Local Government Financial Service Pty Ltd (LGFS). It had been constituted by councils in New South Wales (NSW) to give them greater leverage when investing surplus funds. In time, it was sold by the councils to an unconnected entity, FuturePlus Financial Services Pty Ltd (FuturePlus). Amongst other clients, LGFS managed the investments of StateCover Mutual Limited (StateCover), a workers’ compensation insurer.

In mid 2006, ABN AMRO marketed the Rembrandt 2006-2 CPDO to FuturePlus and LGFS subsequently sold to StateCover AUS$10 million of the Rembrandt 2006-2 CPDO notes, contrary to StateCover’s investment policy (which prohibited investments in derivatives and which policy LGFS had devised).

Following the successful sale of the Rembrandt 2006-2 notes, LGFS engaged ABN AMRO to model and structure a further CPDO, Rembrandt 2006-3, with a rating of AAA from S&P. The intention was to on-sell these notes to LGFS’ council clients in NSW. One of the reasons for this sales push was an attempt by LGFS to combat the infiltration of CDOs sold by its competitors, which had caused LGFS’ profits to plummet (which was subsequently alleged (and found) to have been a conflict of interest).

Rembrandt 2006-3 notes were scheduled to be issued by ABN AMRO on 2 November 2006. Subsequently (and prior to their issuance), S&P realised that the decreased spreads and volatility assumptions meant that a AAA rating was no longer viable. However, on the basis of ABN AMRO’s description of the new security as being carbon copies of Rembrandt 2006-2 notes, a AAA rating was assigned to Rembrandt 2006-3 notes (despite continuing doubts as to whether the rating was warranted).

S&P again authorised ABN AMRO to disseminate its rating for Rembrandt 2006-3 notes to potential investors. LGFS purchased AUS$45 million of the notes, AUS$16 million of which were on-sold to 13 councils in NSW (who were the named applicants in the proceedings), with the remainder of the notes held by LGFS.

Two of the councils had entered into a contract with LGFS for the provision of financial advice, and all of the councils had dealings with LGFS over the years sufficient to establish a fiduciary relationship. The Court found that the marketing by LGFS of Rembrandt 2006-3 notes to the councils breached its fiduciary obligations by failing to disclose the conflict of interest. The Court also found that LGFS made numerous misrepresentations to the councils regarding the suitability of the notes for investment, and did not adequately explain the buy-back mechanism (which was dependent on the existence of a market to purchase the notes – which there was not).

In 2007, the global financial crisis resulted in sustained spread widening, causing the CPDOs to be vulnerable to cash-out. S&P downgraded its rating of Rembrandt 2006-2 and 2006-3 notes to BBB+ in February 2008. Due to the terms of its investment policy, LGFS was no longer permitted to hold the notes and arranged for a sale to its parent company, sustaining a loss of principal of nearly AUS$16 million. The councils retained the notes until cashing out in October 2008, receiving less than 10% of the principal invested.

The Court found:

  1. S&P’s rating of AAA for Rembrandt 2006-2 and 2006-3 notes was misleading and deceptive, and involved the publication of information or making of statements which were false in material particulars and otherwise involved negligent misrepresentations to investors.
  2. No reasonably competent rating agency would have produced such a rating. S&P owed a duty of care to potential investors and had negligently rated the notes such that a loss was reasonably foreseeable. Further, both ABN AMRO and S&P were aware that the existence of a AAA rating was a condition of the investors’ decision to buy the notes in question.,/li>
  3. Whilst S&P’s rating was expressed as an “opinion”, the rating conveyed an “extremely strong” representation that S&P actually believed that the notes were capable of meeting all financial obligations, such belief having been reached through the exercise of reasonable care. In fact, to S&P’s knowledge, this was not the case.
  4. ABN AMRO was knowingly concerned in S&P’s misleading and deceptive conduct, and had also engaged in such conduct.
  5. In marketing the notes to LGFS and, in turn, to the councils, ABN AMRO also committed negligent misrepresentations (a) by its own adoption of S&P’s AAA rating, and (b) by its representations as to the meaning and reliability of the AAA rating.
  6. ABN AMRO breached its contract with LGFS under which it was to model and structure the transaction whereby LGFS would purchase Rembrandt 2006-3 notes having a rating assigned by S&P of AAA.
  7. LGFS engaged in misleading and deceptive conduct by its publication of information and false statements as to the suitability of Rembrandt 2006-3 notes as an investment for the councils. LGFS had held itself out as an investment advisor, i.e. an expert on whose advice the councils could rely, as distinct from a mere salesman. Further, it had breached its Australian Financial Services Licence in advising the councils in connection with the notes, which were derivatives that LGFS was not licensed to deal in (and the councils were not authorised to hold), and breached its fiduciary duties to the councils.
  8. The council investors were found not to have been sophisticated investors: certainly not sufficiently sophisticated to understand the CPDO investments which Jagot J. described as “grotesquely complicated”. There was no contributory negligence on the part of the councils, nor was there contributory negligence on the part of LGFS in respect of the sale of Rembrandt 2006-3 notes to which it was entitled to damages from S&P and ABN AMRO in equal proportions for its own loss on the sale to its parent company. S&P, LGFS and ABN AMRO were liable in equal proportions in respect of the settlement of proceedings against LGFS by StateCover and the councils.


The Bathurst case is an important development for all of the affected interests. Whilst some heads of liability are specific to Australia, others have potentially wider application, particularly as similar products were rated by S&P and marketed in Europe:

  • Rating agencies: The case has established the precedent that a ratings agency owes a duty of care to investors in rated instruments with whom there is no contract.
  • Financial Institutions: The case reinforces the imperative of maintaining an arm’s length relationship with the rating agency. In Australia, at least, FIs need to understand how the ratings were assigned to products, and the ramifications of selling those products, particularly if defective modelling techniques were employed. FIs cannot hide behind a rating which they have cause to believe is defective, and may potentially be liable as accessories to the conduct of the rating agencies.

What does this mean for FIs underwriters?

Inevitably, the answer will depend on the Professional Indemnity/Civil Liability wordings that are employed. Coverage for mis-selling has been available on some FI programmes for some time, although questions of aggregation remain (given the sums involved in cases of this magnitude, aggregation is unlikely to be a significant issue).

Other programmes have totally excluded mis-selling of products (and any carve in has been on the basis of employees failing to follow internal sales procedures and issues of aggregation still remain). In addition, issues in connection with market fluctuation are likely to arise.

On a more general note, given the findings of fact of the Court, it might be argued that a FI which closely aligns or dictates the ratings or methodology of a rating agency may fall foul of the concept of lack of fortuity, such as to deny cover.

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