Rembrandt suit shines light inside S&P

Set against the vast impact of the global financial crisis, a loss of $933,225.83 by the ratepayers of Corowa Shire in October 2008 might appear inconsequential.

But writing off 93 per cent of a $1 million investment hurt enough to prompt the council from the northern side of the Murray River to lead 11 other regional and suburban councils into the Federal Court to seek compensation.

Four days into a scheduled 10-week hearing, the case has already begun to expose the inner workings of a European investment bank and a large international credit rating agency.

"I know how those ratings came about and they had nothing to do with the model!" wrote a Standard & Poor's executive Perry Inglis in an email on October 27, 2006.

Who knew what, and when they knew it, will be central issues in the suit, which started in a courtroom in Sydney on Tuesday.

So will claims of unjustifiable ignorance on the part of the aggrieved investors.

The case is about interest-bearing instruments with a value that depended on movements in the iTraxx credit default swap index in Europe and its United States counterpart, the Dow Jones CDX.

Exotic structured finance instruments such as these have, in hindsight, become closely associated with the global financial crisis and the case could explain a lot to Australians about how it came about.

Many of the documents referred to in opening submissions were written overseas, as a team from the Dutch investment bank ABN AMRO (bought by Royal Bank of Scotland in 2007) created what their promotional material called a "breakthrough" financial product and S&P gave it its highest rating, AAA.

A submission filed by Noel Hutley, SC, for the councils, helpfully included extracts from the Merriam-Webster dictionary to clarify the meaning of terms in foreign emails.

"Sandbagging", for example, is defined as "to conceal or misrepresent one's true position, potential or intent especially in order to take advantage of"or "to hide the truth about oneself so as to gain an advantage over another".

The term was used in an email to Inglis, S&P's European head of CDOs and credit derivatives, from a senior S&P analyst, Elwyn Wong, who noted that an ABN executive, Mike Drexler, was "a smart and charming man".

"Cian and Sriram were, I think, sandbagged a little," Wong wrote about two S&P employees in London who worked on the rating assigned to financial products bought on behalf of ratepayers in the shires of Cooma Monaro, Corowa, Deniliquin, Eurobodalla, Moree Plains, Murray, Narrandera, Narromine, Oberon, Parkes and the cities of Orange and Ryde.

Bathurst Regional Council has also taken action, using a separate legal team.

The notes were officially called Constant Proportion Debt Obligations, or CPDOs, and marketed by ABN's Australian arm under the more investor-friendly name of Rembrandt Notes.

The bank found a receptive audience in an advisory organisation owned by the NSW local government superannuation scheme, Local Government Financial Services Pty Ltd, which holds a financial services licence.

Between October 2006 and July 2007, LGFS invested $49 million in the notes. It on-sold $18.5 million worth to its clients after rebranding them Community Income Notes, and retained $26.5 million worth.

One client, StateCover Mutual, invested $4 million via LGFS and $6 million direct with ABN, bringing the total Australian purchases to $55 million.

In October 2008, the notes were "cashed out" - or failed - and the investors still holding them recovered 6.7 per cent of their $55 million.

LGFS lost about $16 million, StateCover more than $9 million and the councils from $466,000 to $2.8 million each, prompting a web of claims and cross-claims being heard together by Justice Jayne Jagot.

On August 30, LGFS settled a claim by StateCover for $3.2 million. It is trying to retrieve that sum from ABN and S&P.

LGFS also has its own claims against the bank and the ratings agency. The councils are suing LGFS, ABN and S&P for negligence and for misleading and deceptive conduct. A group of insurers has been drawn in and most parties have cross-claims against most other parties.

ABN's barrister, Ian Jackman, SC, was not offering idle compliments when his opening submission said S&P was "a world-renowned, market-leading credit ratings agency".

His point was that his client simply passed on to LGFS a report from a reputable source.

"There's nothing actionable at all in us being a conduit for that information, whatever the merits of the opinion held by S&P may be," Jackman said on Thursday.

Hutley's suggestion ABN "actually controlled S&P in its rating process" was "utterly fanciful", he said.

This was a response to Hutley's submission that the bank "substantially drafted" S&P's presale report for the notes.

"At one point, an ABN AMRO employee expressed surprise that ABN AMRO was to prepare the presale report, asking, quite saliently, 'Isn't this S&P's job?'," Hutley said. He quoted from a 2007 email, in which one S&P analyst accused another of being "the wuss for bending over in front of bankers and taking it".

As for LGFS, Jackman said the evidence would show it in a "disgraceful light" because of its "full knowledge of all the risk factors which this product presented".

ABN's written presentation to LGFS had disclosed those risks, including potential loss of almost all capital invested, "but there's very little if any disclosure of risks by LGFS to the councils", he said.

Jackman accused the councils of breaking a cardinal rule of investing.

"If you don't understand something, don't invest in it," he said.

Outlines of evidence to be given by council witnesses indicated "they really didn't have a clue what they were doing", he said.

This might help them pursue their claim of fault on the part of LGFS but they would "shoot themselves in the foot on contributory negligence in the process", he said.

Hutley predicted the bank and the rating agency would blame the losses on an unforeseeable crisis in 2007 and 2008. "We say that's complete obfuscation," he said on Wednesday.

The email correspondence within ABN in 2006 showed "there was an initial realisation of an inherent attribute of this product and its acceptance essentially as a gambling exercise", he said.

For example, in the development phase, when CPDOs were called "Anti DPNs", an ABN banker, David Poet, sent an email to a London colleague Jamie Cole which said: "Btw, when Anti DPNs knock out, they really knock out, you get nothing back."

"Mr Poet was not imagining the GFC," Hutley said.

"People were contemplating what might be called an inevitable feature of the marketplace periods where the market goes badly from the point of view of persons seeking to invest in it," he said.

"We say the GFC had nothing to do with the real risks which were known within ABN AMRO and, we will also establish, within S&P."

S&P's barrister, Steven Finch, SC, began his opening address yesterday by saying if the councils had done "even a tiny bit of homework, the characteristics of the notes about which they now complain would have been obvious to them".

He read from the transfer note they all signed. The buyer "acknowledges that (1) the holding of the notes is subject to investment risk including possible delays in payment and loss of income and principal invested", it said.

This was not fine print or a disclaimer but "perfectly understandable language", Finch said.

Guidelines from the NSW Local Government Department in language "frankly as clear as a kick in the shins" told council officers that credit ratings did not guarantee an investment or protect an investor against loss, he said.

Nor had the councils made any effort to find out what S&P meant by its AAA rating.

"They didn't look it up, they didn't ask us, they didn't go on the internet," Finch said.

A rating was the product of "judgment, of opinion, about which reasonable minds could, did then, and still do differ", he said.

Hutley, for the councils, told Justice Jagot her decision could have wide ramifications.

S&P was "hotly contesting" whether it owed a duty of care to his clients "for obvious reasons extending beyond its potential liability in this case", he said.

He did not say one way of avoiding those ramifications would be an out-of-court settlement with no admissions of liability. Faced with a long, large and therefore expensive case, the councils are doubtless keen to explore such an option. They are meeting stiff resistance.