Ratings have limitations
Financial advisers need to be aware of the limitations of the ratings provided by ratings houses, according to specialist financial services lawyer Peter Townsend.
Townsend, the principal of Townsends Business and Corporate Lawyers, said that if ratings were discussed it was vital the adviser made the client fully aware of what the ratings actually meant and how they could be used in assessing a product.
Advisers who want to use ratings to sell product must explain to the client the limitations of those ratings, Townsend warned.
"To do otherwise is to run a material risk of failing to fully meet the adviser's duty to the client," he said.
He referenced court findings with respect to action by Wingecarribee Shire Council against Lehman Brothers Australia and the use of product ratings.
Wingecarribee Shire Council lost a substantial amount of money by investing in so-called Synthetic Collateralised Debt Obligations (SCDOs), and it and many other councils took a class action against their adviser, Grange Securities, which had been taken over by Lehman Brothers Australia.
Lehman argued that the major ratings agencies (Standard & Poors, Fitch, and Moody's) had given the SCDOs high ratings and should have be proportionately liable for the councils' losses.
The argument ran that the ratings were effectively a representation that the SCDOs were equivalent, as regards risk profile, to other types of financial products carrying the same rating from the same ratings agency.
"The court would have none of it," Townsend said. "It held that the ratings did not convey that message. Rather it was how the adviser used the ratings that was the real concern.
"In this case Grange used the ratings to suggest that the products with similar ratings had similar risk profiles," Townsend said.
"Grange did not put the ratings, and the use to which they could be put, into context or explain to the client the limitations of the ratings in respect of identifying material risks of the product or its risk profile."
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