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Rating Agency Guilty of Misleading Investors; Landmark Ruling

Thursday, November 8th, 2012
By for Profit Confidential

Landmark RulingIn what will most likely be a landmark ruling, Australia’s federal court has ruled that one of the world’s leading credit ratings agencies Standard & Poor’s (S&P) misled investors by issuing a AAA rating, its safest rating, to securities that were extremely complex and risky, and that ultimately lost most of their value.

One of the biggest problems following the crash is that investor sentiment has soured on the financial industry. Many people have the market view that the game has been rigged against the retail investor. During the bubble prior to the crash, rating agencies like S&P continually slapped AAA on risky investments. The entire system was built on generating revenue and commissions by packaging products that could be sold to people who should not have been buying them in the first place. By creating a false market view, investors who normally wouldn’t buy risky assets were tricked into believing that they were safe. This blatant misrepresentation has led to a lack of positive investor sentiment across many facets of the financial system.

Investor sentiment can be extremely fragile. Rulings such as this finally capture the anger that many have felt over the past few years. While investors have lost untold amounts of money, the rating agencies that people and institutions have relied upon have gotten off without any liability. The market view was that rating agencies could do whatever they wanted without repercussions. This appears to be changing.

Justice Jayne Jagot of Australia’s federal court stated that S&P was “misleading and deceptive” when it came to rating structured debt instruments during 2006. The debt instruments themselves were grotesquely complicated, according to her. (Source: “Standard & Poor’s misled investors—Australian court,” BBC, November 6, 2012.)

Not only did the courts find that S&P had published false and misleading information, but they also found that the firm had negligently misrepresented the risks associated to potential investors. In some cases, the court has found out that S&P didn’t even conduct its own calculations. It relied on the bank that was structuring the product for the calculations.

No wonder investor sentiment is so poor. If S&P can’t even do the basic due diligence, the market view for the products it rates should be taken into consideration with much more than a grain of salt. In fact, it raises the question of who even pays attention to S&P anymore, since it has lost most, if not all, of its credibility.

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This ruling will certainly pave the way for further actions in America and Europe against rating agencies. Investor sentiment needs to rebound, and the only way this will occur is if the integrity of the financial system is reinforced. Part of the problem is that credit agencies are paid by issuers. This system can certainly create plenty of conflicts of interest. If the market view is that firms are not being honest in their assessment, investor sentiment will continue to be poor.

S&P is a division of The McGraw-Hill Companies, Inc. (NYSE/MHP), whose shares have significantly sold off on this ruling. While S&P will be appealing the decision, it certainly is a major blow against rating agencies around the world.

Ultimately, we need to see more accountability throughout the financial system to regain confidence in investor sentiment. At the very least, this type of ruling will start to tilt public sentiment in believing that reforms can be made. Another side effect might be the rise of smaller, independent financial service firms that can provide unbiased information. While I applaud the Australian courts, much more work needs to be done to clean up the financial system and regain confidence and investor sentiment.

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Sasha Cekerevac - Investment Advisor, Fund AnalyzerSasha Cekerevac, BA Economics with Finance specialization, is a Senior Editor at Lombardi Financial. He worked for CIBC World Markets for several years before moving to a top hedge fund, with assets under management of over $1.0 billion. He has comprehensive knowledge of institutional money flow; how the big funds analyze and execute their trades in the market. With a thorough understanding of both fundamental and technical subjects, Sasha offers a roadmap into how the markets really function and what to look for as an investor. His newsletters provide an experienced perspective on what the big funds are planning and how you can profit from it. He is the editor of several of Lombardi’s popular financial newsletters, including Payload Stocks and Pump & Dump Alert. Add Sasha Cekerevac to your Google+ circles