Traditionally: no liability for rating agencies
One cause of the global financial crisis was the failure of complicated derivative products based on “unsafe” home loans principally in the USA but also elsewhere. These products were often marketed with the benefit of an AAA rating by one of the major rating agencies. In many cases, upon a post facto review, these ratings were issued negligently. Can rating agencies, which issued these ratings, be liable to investors?
Courts have traditionally refused to hold a credit agency liable to investors for a negligent rating. This has been based on various grounds, including for many years in the United States, on the grounds that a rating is a statement of opinion not advice and, as such, is a form of free speech protected by the First Amendment.
It has also been held that a rating agency does not owe a duty to unnamed investors and furthermore, disclaimers, which invariably accompany a rating, negate any liability that may exist.
S&P found liable in Australia
In a landmark decision in late 2012 , Justice Jagot of the Federal Court of Australia held, that Standard & Poor’s (“S&P”) was liable to investors for engaging in misleading and deceptive conduct in breach of specific provisions of Australian statutes, and also in tort for negligent misstatements by assigning the rating of AAA to a structured credit product. This was the first time a court had determined a rating agency to be liable to investors with whom it had no contractual relationship.
Full Court confirms liability
On 6 June 2014 the Full Court of the Federal Court upheld Justice Jagot’s judgment and dismissed all appeals.
The Full Court decided that S&P’s assignment of a AAA rating to the product was misleading and deceptive and involved negligent misrepresentation to the class of potential investors in Australia (including the plaintiffs).
The AAA rating conveyed a representation that in S&P’s opinion the capacity of the product to meet all financial obligations was “extremely strong” and a representation that S&P had reached this opinion based on reasonable grounds when this was not the case.
The decision on common law liability did not turn on the fact that the rating proved to be wrong, rather because the rating was a misrepresentation.
On appeal, S&P accepted the rating was incorrect but claimed that it did not owe any duty to the investors. S&P argued that it was not reasonably foreseeable that its conduct could cause loss to investors and, in any event, the disclaimers accompanying the rating negated any liability.
Applicable legal principles
The Full Court rejected all of S&P’s arguments, finding that liability was established by the application to the facts of established legal principles. For there to be a duty to exercise reasonable care in making a statement or giving advice the speaker must realise (or should realise) that the recipient of the information or advice intends to act on it in connection with some business or serious matter. Further, the circumstances must be such that it is reasonable for the recipient to rely on the utterance of the speaker. It is not necessary that the speaker knows the identity of the person who may rely on the advice.
If these matters are established, the speaker is liable to the recipient for losses, which are reasonably foreseeable from any breach of the duty of care it owes to the recipient.
Investors were vulnerable
The Court held that the investors (regional councils) and the financial intermediary, were “vulnerable” and therefore entitled to the protection of a tortious obligation because they were not in a position to “second guess” the rating and they were not therefore in a position to protect themselves in the relevant sense. The finding of “vulnerability” in the case of the sophisticated financial intermediary, and the regional councils is particularly interesting. The court held that the investors were not in a position to test the rating in any real sense because they did not have access to the various inputs and the analysis needed to come to a conclusion as to the risk of the product.
Disclaimers
The Court examined the disclaimers contained in the relevant documents. The Court did not accept that on the facts there was an effective disclaimer in relation to the rating given by S&P.
Furthermore for a disclaimer to be effective it needs to be in unambiguous language and prominently displayed and the Court held that this was not the case.
Will this open the floodgates?
A key question is to what extent this decision may be followed in other jurisdictions where there are currently many cases in progress against rating agencies or whether it will be confined only to very similar facts, even in cases in Australia.
The key findings in the case are that the general principles of tortious liability for negligent misstatement can apply in appropriate circumstances to a credit rating.
This seems to be a correct statement of the law in Australia. Very similar principles apply in many other common law countries.
The finding that investors who would be considered to be sophisticated were “vulnerable” may surprise courts in some jurisdictions. However, if the evidence establishes that the product is so complicated it is not possible for even a sophisticated investor to test the risk of default, it would seem quite reasonable to conclude that they cannot “second guess” the rating and they are in the relevant sense “vulnerable” and, as such, it is reasonable for them to rely on the rating.
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