Taken to the cleaners

In 2006, 15 Australian local authorities were advised to buy AU$16m of AAA rated constant proportion debt obligations (CPDO) notes, which were synthetic investments designed to increase in value providing that global CDS indices moved within a certain range.  When the global financial crisis came, CDS spreads shot through the roof and the councils lost 93% of their money.   It reminds us that wherever we are in the world, there are unscrupulous financial salesmen all too happy to fleece unsophisticated investors.  The big difference in Oz is that 13 of the councils sued their counterparty, the credit rating agency and their treasury adviser and won. The Federal Court of Australia ruled this week that Dutch bank ABN Amro, Standard & Poor’s and the Sydney-based Local Government Financial Services must each cover a third of the local authorities’ losses.

Most of the international press coverage has focused on the liability of S&P for the accuracy of its credit ratings. According to the 1,500 page judgement, the rating agency plugged wildly inaccurate data into their CPDO rating model to produce the required AAA answer. If any one of four input variables has just been optimistic, rather than vastly exaggerated, a lower rating would have popped out of the model, and the local authorities wouldn’t have bought the investments. And there lies the problem – no investors means no fees for the investment bank, the rating agency or the adviser.  The fact that S&P has not said “sorry, it was an isolated mistake, everything else we do is fine”, but is vigorously defending their rating methodology instead is a little worrying.  If they’ve rated lots of other products in this way, are their ratings any use at all? No wonder their share price is down.

But I think the other defendants are just as interesting. Firstly, the bank formerly known as ABN Amro is now part of the Royal Bank of Scotland Group, and hence the fines will ultimately be borne by RBS’s owners, the UK taxpayer.  ABN Amro apparently sold around €2 billion of these CPDO notes in the years running up to 2008, and if the Australian ruling encourages European investors to sue, it will be another nosebleed for RBS.

Then there’s the culpability of the treasury adviser, LGFS.  In a statement that could easily have been made in the UK, one Council CFO explained how they relied on them to provide high level investment advice. “LGFS held itself out to have the necessary expertise to advise councils about investments that complied with government guidance and which would not place the community’s funds at risk,” he said.  However, the court found that LGFS had breached the fiduciary duty it owed the councils as it had a conflict of interest: it had been losing business to rivals for years and saw this as an opportunity to earn a huge backhander.

The court found that LGFS had engaged in misleading and deceptive conduct, published false marketing information and otherwise made negligent misrepresentations to the councils about the CPDO notes.  The adviser also failed to notice that the investment was contrary to at least one council’s investment policy, despite having actually written the policy itself! To cap it all, LGFS breached its financial services license by selling products it was not authorised to trade in.

What lessons are there for us in the UK?  For investors, it’s an obvious reminder not to enter into transactions that you don’t fully understand, although that’s not an excuse not to learn about new products.  You should also be aware that the companies you deal with won’t always be on your side, especially if they have a conflict of interest.

David Green is Client Director at Arlingclose Limited.  This is the writer’s personal opinion and does not constitute investment advice.