Fitch Lawsuit Update – Alleged Deceit and Dishonest Concealment

Since our last update there have been a number of developments.  For background, the basis for the potential legal action against Fitch Ratings (Fitch) over their rating of Kadadu, Henley and other SCDO’s (Kakadu) will likely involve similar claims to the claims made in separate proceedings which are currently being litigated being Midcoast Council vs Fitch Ratings (Midcoast).  These proceeding involve two unrelated SCDO’s named Palladin arranged by Merrill Lynch and distributed by CBA.

As part of Midcoast, it is claimed Fitch employed a “Hidden Table” which was contained in its VECTOR Model used to assign ratings to the SCDO’s.  The Hidden Table was used to map the output probabilities of default for the SCDO produced in the VECTOR model to the ratings actually assigned to the SCDO by Fitch and was not part of the model algorithm itself. 

It is alleged in documents filed with the federal court on 13 December 2018, the Hidden Table was different from the one published by Fitch in the Model User Manual and its publication Global Rating Criteria for Collateralised Debt Obligations dated 18 October 2006 (Published PD Table) and that “it was easier for an SCDO to attain a particular rating according to the Hidden Table than according to the Published PD Table”.

It is further claimed the probabilities in the Hidden Table “appear to have been set manually” and “[t]he making of the Published PD Table Representations together with the [non-disclosure of the Hidden Table] concealed from investors, arrangers, the users of Fitch’s ratings and any person concerned with the reliability of the Fitch’s ratings the fact that Fitch used probabilities of default for SCDO’s that were not based on rational or reasonable grounds”.

Squire Patton Boggs, the lawyers for Midcoast (SPB), plead investors in the Palladin SCDO’s would not have purchased these investments if they had known about Fitch’s “dishonest concealment” and had the SCDO’s been correctly rated, therefore SPB claim Fitch is guilty of the “tort of deceit”

In Amicus opinion it would logically follow that any findings as to the defects in the Fitch VECTOR Model and Fitch’s use of that model in the Midcoast case would very likely apply to Kakadu and other CDO’s which were also rated by Fitch using its VECTOR model.

The Midcoast case (which has now been running for five years) is set down for trial in September 2019.  In Amicus opinion, it would be the most sensible course of action for any potential litigant in Kakadu to await the outcome of the Midcoast case given there are common issues regarding the “tort of deceit” between the two cases. If the court rejects the tort of deceit arguments in Midcoast, then this sets a strong (and adverse) precedent for Kakadu. Conversely, if the court finds in favour of investors in Midcoast and upholds the tort of deceit arguments, it is extremely favourable for the chances of success in Kakadu.

As we discussed in our April article the fees taken by any litigation funder should be determined by the risk the funder is assuming in a competitive market.  Clearly if there is a strong precedent such as a favourable judgement in a very similar case (Midcoast) the funding percentage taken by the funder in the current case (Kakadu) should be minimal.  Further, by not filing the Kakadu case until Midcoast is decided, any funder minimises their downside risk.

In recent months there has been heightened criticism by the courts of the fees charged by litigation funders.  For example at the end of May, Harbour Litigation Funding’s fee of 40% (or four times the legal costs whichever is greater) was described by Justice Michael Lee (who was also the Judge on the 2018 case where S&P was sued regarding its rating of SCDO’s) as “fantastic in the true sense of the word” (which Amicus interprets as meaning “unreal” or “existing only in imagination” from the Old French fantastique).  Justice Lee said such fees “raise real issues about the ability of the court to regard any settlement, in these circumstance….as fair and reasonable in the interests of group members”. 

Also reported in May was the decision of Justice Julie Ward to choose Maurice Blackburn because of their “no-win, no fee” proposal from a field of five law firms vying to run a class action against AMP.  Maurice Blackburn’s proposal was selected as it involved no commission for a litigation funder “On most scenarios the net return for group members is likely to be the highest or around the highest” said Justice Ward.  Maurice Blackburn was also selected because of its “no-win, no fee” model to run a class action against BHP last month regarding BHP’s 2015 Samarco dam collapse when in competition with other law firms backed by funders.

Commenting on these decisions, Australian Industry Group Chief Executive Innes Willox said reforming the litigation funding industry to limit “excessive returns” was one of the issues he was going to press with the Coalition government’s Attorney General Christian Porter.

As an alternative to SPB and their funder in the Kakadu case, there are now several other entities that have expressed an interest in funding a group action at lower funding fees.  However, these alternates are awaiting the outcome of Midcoast to see whether the courts will accept the arguments raised setting a favourable precedent for Kakadu. Our understanding is that to date SPB has not filed any case in relation to Kakadu with the courts.

Amicus view is therefore there seems no urgency to sign up to any group action at this stage because no lawsuits have been filed. If there is an adverse opinion from the court on the tort of deceit in Midcoast, then Amicus believes the issue will simply fall away; however if it is a favourable judgement and the courts make a positive finding for investors, then Amicus anticipates there will be strong competition to run further cases against Fitch over their ratings of SCDO’s.

If the allegations made by SPB in Midcoast are proved in court, we would strongly encourage investors to consider joining a potential group to take Fitch to task on Kakadu.  We make this recommendation not simply on monetary grounds because claimants can recover losses, but on moral grounds because if Fitch is proven to have deliberately manipulated its ratings through the use of a manual table with no empirical, analytical or scientific basis beyond making its SCDO ratings “competitive” (i.e. easier to obtain a higher rating) with rival ratings agencies, then this would seem to be an outrage in Amicus’ opinion going far beyond negligence or incompetence and into areas of deceit and dishonest concealment.

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