First German decision holding credit rating agency liable to investors
22 september 2020
The German courts have taken the liability of credit rating agencies to the next level. In a series of recent decisions, the Berlin Regional Court has developed criteria under which credit rating agencies may be held liable for bond ratings under German domestic law. This development has included the first German decisions in which investors were awarded damages against a credit rating agency. The German decisions fit into a wider global pattern of attempts to hold credit rating agencies liable.
An emerging field of litigation
Courts in all jurisdictions dealing with investor claims against credit rating agencies face the same difficulty when ratings are addressed to the general public: How can you protect investors relying on ratings and at the same time keep the liability of credit rating agencies within reasonable and insurable limits? Furthermore, liability risks may create an incentive for credit rating agencies to give lower ratings. This can lead to higher interest rates.
Accordingly, decisions holding credit rating agencies liable are rare in all jurisdictions. Irrespective of the legal system, the threshold for liability is high. Plaintiffs regularly fail to meet, for example, the standard that a rating was ‘provably false’.
Legislators have tackled the issue with additional rules. The U.S. enacted the Credit Rating Agency Reform Act in 2006, followed by the Dodd-Frank Act in 2010. In the EU, the Credit Rating Agency/CRA regulation became effective December 2010 and, after an amendment in 2013, provides for civil liability of credit rating agencies. This liability regime applies in addition to the national rules of the Member States.
These rules have not yet generated many decisions; however, some courts begin to cover new ground:
- In 2009, the California Public Employees’ Retirement System (CalPERS) brought an action in California state court for negligent misrepresentation against several credit rating agencies. California’s Court of Appeal found that CalPERS demonstrated a likelihood of success on the merits for holding the credit rating agencies liable for negligent misrepresentation under California law for their ratings of privately placed securities. Subsequently, two credit rating agencies settled for USD255 million.
- In 2014, the Federal Court of Australia held a credit rating agency liable for unreasonable, unjustified and misleading ratings.
The decisions of the Regional Court in Berlin point in the same direction.
The decision of the Berlin Court
The Berlin Court, in May 2020, ruled in favour of investors who sued a German credit rating agency for the breach of a duty of care for a bond rating. The Court based the decisions on German domestic law rather than the EU CRA regulation, since the bond had been issued and rated before the EU CRA regulation became effective. Liability under domestic law is based on the idea of a 'contract-like' relation between the credit rating agency and the investors. This concept was developed by German courts, inter alia, with regard to the liability for expert opinions. Under specific circumstances experts can be held liable by parties who could reasonably be expected to rely on the expert opinion even if they do not have a contract with the expert. Similarly, the Regional Court in Berlin found a 'contract-like' relation between the buyers of the bond and the credit rating agency because of the following factors:
- the credit rating agency was publicly registered under the EU CRA regulation;
- the case concerned a bond rating and not an issuer rating, thus limiting the total liability of the credit rating agency to the buyers of the bond;
- the credit rating agency knew the principal amount of the bond issue and so knew its maximum liability; and
- the credit rating agency knew that the rating would be used to promote the distribution of the bond.
Under these circumstances buyers of the bond have the same rights as if they had a contract with the credit rating agency, the standard being negligent breach of a duty of care – not ‘gross’ negligence. The Court found a breach of the duty of care. The bond had been rated ‘A’ whereas the issuer had been rated only ‘CCC’. In the view of the Court there was no reasonable justification for this discrepancy. Further, the issuer’s only security was a ship, which at the same time served as the main source of income. The credit rating agency valued the ship with a higher value than it carried in the issuer’s balance sheet and failed to apply any form of margin.
Liability of rating agencies becoming more likely
While agreeing in principle with the concept of liability, another chamber of the Regional Court in Berlin, in 2019, had found no breach of a duty of care in a case concerning the same bond rating. Therefore, it is not surprising that the CRA appealed the decisions holding it liable. Irrespective of the outcome of the pending appeals, the decisions of the Regional Court in Berlin illustrate the increased liability risks for credit rating agencies in Germany. This may also extend to U.S. credit rating agencies as the German Federal Court of Justice confirmed that German courts may have jurisdiction if the credit rating agency has assets in Germany.
The next chapter will concern the liability regime under the EU CRA regulation. These rules pose a plethora of new questions: To what extent will breaches of the EU CRA regulation give rise to civil claims? And what is the exact scope of the liability regime? For instance, the Higher Regional Court of Düsseldorf (Germany) ruled in a decision, in 2018, that investor claims for issuer ratings were not covered by the European liability regime. The Court was criticised because it did not refer the case to the European Court of Justice to clarify the interpretation of the European liability rules.
What is certain is that we can expect more claims against credit rating agencies. It will be worth keeping a close eye on German and European decisions in this field.