Liability of Credit Rating Agencies for Issue Ratings

Courts

A new article discusses a dissenting verdict on the rating of a cruise ship bond.

The numerous decisions of the Berlin courts have brought the issue of the liability of rating agencies back into focus, writes lawyer Dr. Sunny Kapoor, Frankfurt a. M., in his article “Haftung von Ratingagenturen für Emissionsratings” (WM 2021 Heft 50-52, 2420). “They are of particular interest because they highlight the liability of rating agencies for allegedly incorrect issue ratings,” says Dr. Sunny Kapoor, “whereby the judgments available so far concern liability for issuer ratings. The judgments of the Regional Court of Berlin and the District Court of Berlin Mitte are in line with the previous overall evaluation and deny any liability on the part of rating agencies to investors.”

The question of the liability of rating agencies has been preoccupying the courts for several years. In the judgments issued so far, however, the claims of investors have always been dismissed and the question of third party liability of rating agencies has been answered in the negative. A common feature of the judgments known so far is that they focus on liability for allegedly incorrect issuer ratings. With the judgment of the 11th Civil Chamber of the Berlin Regional Court on May 5, 2020, a court decision has become known for the first time, which concerns the question of liability for issue (and not issuer) ratings.

This judgment is noteworthy for two reasons, according to Dr. Sunny Kapoor:

  • On the one hand, as far as can be seen, a German court has for the first time affirmed the liability of a rating agency to an investor for an allegedly incorrect rating.
  • On the other hand, the judgment emerged from a number of otherwise largely unsuccessful investor lawsuits that were brought against a European rating agency in connection with a bond it rated for the luxury cruise ship “MS Deutschland”.

Even though the judgments in this case are not yet final, it is nevertheless of interest to highlight the main reasons for rejection and, above all, to work out the first milestones for liability for issue ratings with a view to the differing judgment of the 11th Civil Chamber.

The only different decision of the 11th Civil Chamber should, however, have to be provided with some legal question marks, believes Dr. Sunny Kapoor. In any case, his evaluation of the judgments concludes that when it comes to the question of whether rating agencies are liable to investors for an allegedly incorrect rating, proof of the causality of the transaction should be decisive.

“Accordingly,” reasons Dr. Sunny Kapoor, “the investor must have taken note of the rating report and used it as the basis for his investment decision. Since the rating report usually also contains risk information or enables the investor to assess his own risk, it would be difficult to argue that the investor still assumed that the investment would be highly secure.”

In addition, an extension of liability on the basis of the contract with protective effect in favor of third parties should also have to be dealt with restrictively, in his opinion. Because in individual cases it should not only be doubtful whether the rating agency can actually identify and narrow down the group of investors to be included in the rating agreement.

“The question also arises as to whether the issuer commissioning the rating agency has a serious interest in including a large number of investors in the rating agreement. Ultimately, such a far-reaching extension of liability is likely to lead to a considerable increase in the cost of rating services.” Likewise, the extension of liability is likely to reduce the attractiveness of the issue rating for rating agencies.

However, if rating agencies shy away from creating issue ratings, an important point of reference for investment decisions would be lost, which, conversely, could not have a negligible effect on the entire capital market.

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people near grocer store inside building

Court Ruling Makes Rating Difficult to Assess

Courts

Tesco and other UK grocers are affected.

On June 3, 2021, the Court of Justice of the European Union (ECJ) ruled that the provisions in EU law relating to comparability between two different roles based in different establishments, but within one organisation, do apply directly to private businesses in the UK and can be advanced under European and UK law. Moody’s comments on a decision which was prompted by the “equal pay” claims of around 6,000 former and current Tesco Plc employees and allows claimants to compare the value of their work to that of their colleagues in Tesco’s distribution centres.

“Assuming that Tesco could be forced to pay compensation and increase the pay of each of its 250,000 store workers by £10,000-£20,000 a year,” says Moody’s, “the implied increase in annual wages could be £2.5-£5.0 billion.” Such an amount could more than halve or even exceed Moody’s forecast of Tesco’s £4.2 billion Moody’s-adjusted EBITDA over the next 12-18 months.

“The company’s Baa3 rating and the stable outlook do not factor in any significant cash outflow related to the equal pay claims”, warns Moody’s. “Tesco has made no provision in its accounts on the basis that any potential liability is not considered probable by the company’s directors. Tesco’s leverage, measured in terms of Moody’s-adjusted gross debt to EBITDA, was around 4.4x in fiscal 2021 (ended 27 February) and we expect it will improve to around 3.8x within the next 12-18 months, compared to leverage guidance of 3.75x-4.5x for the Baa3 rating.”

Tesco’s rating is also by the other leading agencies, S&P’s and Fitch Ratings, just a notch above the speculative grades. Whether the company’s liabilities slide into the speculative realm depends on the behavior of the courts. The observation of the rating must therefore start here:

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