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Viewpoints: should ratings agencies be responsible for inaccurate ratings?

One of the world’s largest ratings agency, Standard & Poor’s, is back in court appealing the Federal Court’s landmark decision that it was responsible for the losses incurred by 13 New South Wales…

Investors around the world use ratings from agencies like S&P, Moody and Fitch to make investment decisions. But if all goes wrong, are the agencies to blame? EPA/Ian Langsdon

One of the world’s largest ratings agency, Standard & Poor’s, is back in court appealing the Federal Court’s landmark decision that it was responsible for the losses incurred by 13 New South Wales councils.

The local councils made losses on investments in complex instruments that had S&P’s coveted AAA rating. But the company told the ABC it was “not responsible for investment decisions and investors need to do their own analysis”.

In this Viewpoints, Binoy Kampmark argues investors should know ratings aren’t guarantees on risk; while Gail Pearson makes the case that investors expect the ratings to have a reasonable basis.

Binoy Kampmark: The question here is one of accountability, and what generates it. These are both ethical and legal questions. Credit rating agencies pride themselves on setting measurements about the financial health of assets, and more broadly, of a financial system.

These can have considerable economic impacts, none of which directly affect the ratings agency in question.

During the global financial crisis it became clear that these financial assessments were made without oversight. But is relying on these assessments without due diligence irresponsible in its own right?

It was clear that the credit mechanism being used in this case – the Constant Proportion Debt Obligation notes (CPDOs) – was unstable. Even economists at the US Federal Reserve admitted as much.

That these local councils were relying on just these assessments as statements of fact rather than assertions of opinion should itself be a cause for concern.

Gail Pearson: The issue of the reliance of the local councils is very important. But what were they relying on? They were relying on the expertise of their investment adviser – who was not the ratings agency – and they were also relying on the AAA rating given by the ratings agency.

I’m not sure about Binoy’s distinction between opinion and fact. The local councils knew there was risk in investing. They knew that there was a potential for loss. So they were relying on an assessment by the ratings agencies about the nature of that risk.

Part of the question is whether they were in a position to assess the risk of these very complex products for themselves. They weren’t.

It seems there was nothing in the documentation they received that indicated the extent of the risk. Assessment of investment risk is highly complex and technical. This is why investors rely on ratings agencies.

In any case, the distinction between fact and opinion is not very helpful to those who provide opinions that are not based on reasonable grounds.

We have, in Australia, a very well developed jurisprudence around the prohibition on conduct that is misleading or deceptive or likely to mislead or deceive. This prohibition exists in a number of pieces of legislation.

You fail to live up to this norm of conduct if you express an opinion without reasonable grounds for that opinion. If investors rely on the opinion of those who provide investment advice or those who grade an investment product, they are entitled to assume that the persons providing that opinion have a reasonable basis for what they are saying.

So the question comes back to whether ratings agencies, when they provide a particular rating, have a reasonable basis for saying that it has three gold stars or none.

It is not unlike ratings given in other contexts – think hats for restaurants or stars on travel websites. There must be a reasonable basis for the opinion. That was the issue here.

Binoy Kampmark: Gail makes the vital point on reliance. What were the local councils relying on? Advice from investment advisors, and the AAA rating from S&P.

It is true that opinion matters, and that opinion can then cause the person investing to rely upon it. In that sense, an opinion or a fact is one of those fabulously opaque areas of legal deliberation.

But we should be careful that, in so doing, we are not painting the councils involved as vulnerable and entirely at the mercy of an S&P rating.

While the entire business of ratings is shoddy, they are not, in the words of S&P’s disclaimer, “statements of fact or recommendations to buy, hold, or sell any securities or make any other investment decisions”.

There may be more to be said about the specific parties who marketed the CPDOs and gave undertakings about their reliable value. That would just be patently silly, but it does happen in the world of finance.

The assessment of investment risk is highly complex. But converting assessments into guarantees is as reliable as astrology.

We can choose to pay for those services, but we cannot hope that those predictions will come true. There are simply too many factors at stake.

The law on deceptive conduct is highly developed in Australian commercial law, but there are also instances where a person was irresponsible to be deceived in the first place.

Public bodies like local councils, using the money of ratepayers, must also be wary of the sorts of investments they seek.

The financial crisis, with its revelations of the risk in highly complex investment structures, showed how flawed government and private institutions could be in their decisions. S&P’s ratings work is but a symptom of that culture.

Gail Pearson: But were the local councils irresponsible? It is easy to say in retrospect when they lost a lot of money that they did not do the right thing.

The local councils did understand that they were investing in a product with risk. They believed they were receiving sound advice from a trusted advisor and that this advice was reliable as it was linked to a rating from one of the world’s leading bodies that rates risk in investment products.

To say they were irresponsible might be to say that we can never trust or rely on any expert of whatever kind – very hard in most contexts.

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20 Comments sorted by

  1. Mick Shadwick


    The business model for the ratings agencies is severely flawed and can disadvantage (as happened in the GFC) the investor. The agencies are paid by the sellers of a financial product to rate that product, so they have a strong incentive to rate that product as high as possible, otherwise they'll lose the business of the sellers. Good governance and oversight is totally lacking, and the agencies are now trying to avoid accountability for their poor performance.

  2. Eli Rabett

    logged in via Facebook

    In the US, towns and government organizations such as pension boards are often required only to invest in AAA securities. If this was the case in Australia, then clearly S&P cannot claim that the councils were free to ignore their ratings.

  3. Joy RIngrose

    Retired Maths/Science teacher

    A ratings agency is in the business of properly rating the strength of weakness of a financial situation. To do so they need to understand the nature of what they are dealing with, to investigate its mechanics and understand them in order to predict risk. They should not issue a rating if they do not understand the product/situation.
    By issuing a rating they are giving a confident prediction of how that product or situation is performing. If they are not prepared to stand by that assessment then they should not be in the ratings business, because they are either incompetent or fraudulent. Hence the councils are within their rights to blame the agency for losing their money due to an incorrect or misleading assessment.

  4. Sean Harrison

    Paraplanner, Advisor

    I would like to know how other AAA rated products compared in performance and security of capital to these particular products, or even if AA rated products (not comprised of these junk investments) preformed better (or similar) and displayed more security of capital. Whilst due diligence is expected of the investor, an expectation of reliance on a rating when comparing one product to another by a rating agency is also expected. Its obvious that these investments were junk from those on the inside…

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  5. Michael Mihajlovic


    A ratings agency's product is predictions NOT GURANTEES.
    Its reputation and value of its product stand or falls on the accuracy of its predictions.
    As their disclaimers say, reliance on the predictions is entirely at the user's own risk.
    Whilst the Councils are solely responsible for their actions, neither the ratings agency nor the Councils are necessarily to blame.

  6. Andy Saunders


    Not a lawyer, but I would have thought ratings agencies and investment advisers had a duty not to be negligent (i.e. do their homework and be diligent), as well as a duty not to be grossly negligent (e.g. deliberately offer biased advice/ratings).

    The basic problem with ratings agencies is that they are paid by the issuers, not the buyers, of securities, and so have an incentive to bias their ratings. Very difficult to prove they actually did or do such things.

    1. Jeremy Culberg

      Electrical Asset Manager at Power Generation

      In reply to Andy Saunders

      I think to balance the equation, it needs to be made explicit that a ratings agency can be sued if they can be shown to be negligent / incompetent / etc with regards to ratings, given they have a strong financial incentive to be positively biased. This capacity to be sued may put a slight damper on the irrational exuberance.

    2. Michael Mihajlovic


      In reply to Andy Saunders

      Hi Andy,
      As I said above, if a ratings agency makes predictions with a low accuracy outcomes its reputation will fall and it will be ignored.
      To my knowledge investment advisers, whilst competent professionals, only explain options to the client and in order for him to make informed choices. I believe that if they express an opinion they do not take responsibility fo it.
      You are perfectly correct that it would be extremely difficult to prove a case of deliberate deception or incompetence.

    3. Andy Saunders


      In reply to Jeremy Culberg


      I think that's a little tricky - I don't believe that to be the case currently, and it is not completely obvious that it is a good idea for the future.

      Imagine a ratings agency honestly (yeah, I know...) issuing a rating based on a judgement call (these things are all probability-weighted) and it going bad. Someone is sure to have a go at them saying they were incompetent simply because the security fell over (which there was always a chance of).

    4. Andy Saunders


      In reply to Michael Mihajlovic

      Michael, the problem is that ratings agencies logically care more about their reputation with issuers (their clients who are paying them...) than the buyers of securities.

      Issuers are also notorious for trying to discover the rating system's algorithms and then game the ratings.

    5. Jeremy Culberg

      Electrical Asset Manager at Power Generation

      In reply to Andy Saunders

      It becomes a risk thing for ratings agency - they get more right than they get wrong, they make money. They will put more caveats on their ratings. They will take out insurance - which in and of itself will drive behaviours to keep the insurance premiums down. In any case, the capacity to sue would be still be based on the normal categories - negligence, incompetence - which means that the person suing still has to convince those who sit in judgement that a reasonable person could have reasonable been likely to acted in a better way.
      What appears to have happened with these ratings agencies is that material that was definitely NOT rock solid, will always pay, were given the best possible rating - AAA. That to me is a case for either negligence or incompetence or both.

    6. Jeremy Culberg

      Electrical Asset Manager at Power Generation

      In reply to Andy Saunders

      I'll add to my other comment that ratings agencies would keep fairly extensive records of what research was done to achieve a particular rating, so that in the event of a court case they could simply demonstrate that they took reasonable measures. If they didn't keep records (from now on), then it becomes fairly clear to any observing is that the rating was issued based on the size of the cheque to ratings agency.

    7. Andy Cameron

      Care giver

      In reply to Andy Saunders

      Andy, as a taxpayer, I demand my elected officials not to spend my money on things that do not concern them, which includes US-based complex derivative instruments!

    8. Sean Harrison

      Paraplanner, Advisor

      In reply to Andy Cameron

      They were not "spending" the money, they were making an attempt to invest the funds in what by all appearances was a safe investment vehicle according to its rating. Maybe they should have kept the cash in a shoebox under the bed?

  7. Jason Thompson

    Research Fellow, PhD Candidate at Monash University

    This whole thing seems circular to me.

    The ratings agency sets up a series of 'standards' that perhaps no-one trusts at first but over time, they become reliable and people make investment judgements based on them because they reflect good fundamentals.

    The ratings become so reliable that the fundamentals fade into the opaque distance and the rating, itself becomes the fundamental element, regardless of its basis.

    Whilst the failure of an AAA rated product may be an oversight on behalf of the ratings agency, I don't think they can be held responsible for the poor quality of their rating, as long as they did not deliberately mislead the client. It simply means that the ratings can not be trusted in their current form.

    The client has a responsibility to assess the quality of the 'rating' on the product, not just believe what it says on the packet.

    If it was too confusing for the various Councils, they should have hired someone who understood it or put it in a bank.

  8. Jane Somebody


    "As I said above, if a ratings agency makes predictions with a low accuracy outcomes its reputation will fall and it will be ignored." But this is what's so infuriating: the GFC was caused by the junk debt (sub-prime mortgages), and that junk debt was was rated as prime AAA debt by the credit reporting agencies, who have suffered no financial penalties for the losses arising from people relying on those ratings. Either those ratings mean something or they don't. If they are of value, then the companies should bear some responsibility when their ratings turn out to be so wrong; if the ratings are worthless, then the companies should go out of business. But they have managed to have their cake and eat it too, merrily continuing in their business of rating other companies while so many other institutions have been bankrupted by the GFC and millions made unemployed globally.

    The real question is: why do people STILL use them?

  9. John Kelmar

    Small Business Consultant

    Surely any organisation that purports to be an expert in its field has a degree of responsibility to ensure that its comments are accurate and based on evidence that can be substantiated.

    Any deviation from this norm would open the doors to legal action.

    1. Michael Mihajlovic


      In reply to John Kelmar

      Hi John,
      You are perfectly correct and I am certain that their assessments are supported by evidence collected and analysed, but, that research, like like any research and analysis, is subject to human error. Besides, after all, it is a prediction subject to many variables and not a certainty and no person intheir right mind is prepared to guarantee a prediction in those circumstances. As for the GFC the Banks were responsible for that and I am certain that if any ratings agency had discovered the cause in advance, the advantage of being the World's first and only ratings agency to identify and predict the GFC would have overriden any vested interest in "issuers (their clients who are paying them...)".

  10. Lulu Respall-Turner

    logged in via Twitter

    I am with Gail Pearson on this one. ‘Duty of care’ appears to be important factor in this situation, both by the councils and the ratings agency. But the burden of ‘cuty of care’ falls more heavily on the ratings agencies, because it’s on their professed expertise and judgement that councils’ decision rely on.

    1. Michael Mihajlovic


      In reply to Lulu Respall-Turner

      Hi Lulu,
      The Councils have no idea of the ratings agencies' method or expertise. The Councils would have opted for the agency with the best reputation based on success rate of predictions in the past.
      As I said no one predicted the GFC. Refer to my post above yours.