FEDERAL COURT OF AUSTRALIA Mitsub Pty Limited v McGraw-Hill Financial Inc [2016] FCA 559 File number: NSD 1344 of 2015 Judge: RARES J Date of judgment: 20 May 2016 Catchwords: PRACTICE AND PROCEDURE – case management – identification of real issues in dispute – Pt VB of Federal Court of Australia Act 1976 (Cth) ss 37M, 37N, 37P – consideration of principles of case management – where eight current representative proceedings under Pt IVA of the Federal Court of Australia Act 1976 (Cth) in relation to ratings given to structured finance products – where same parties or their related entities respondents in all eight proceedings – where previous judgments considered aspects of finance modelling used to assign ratings to structured finance products –whether appropriate to seek explanation from respondents as to whether findings in earlier judgments about ratings modelling or methodology relevant to issues in eight current proceedings – whether chief executive officer of respondents should make affidavit as to any relevance of earlier findings to current proceedings Legislation: Federal Court of Australia Act 1976 (Cth) ss 37M(1), 37N, 37P Federal Court Rules 2011 (Cth) Practice Note CM1 Cases cited: ABN AMRO Bank NV v Bathurst Regional Council (2014) 224 FCR 1 Bathurst Regional Council v Local Government Financial Services Pty Ltd (No 5) [2012] FCA 1200 City of Swan v McGraw Hill Companies Inc (2014) 223 FCR 295 E I Du Pont de Nemours & Co v Commissioner of Patents (1987) 16 FCR 423 Expense Reduction Analysts Group Pty Ltd v Armstrong Strategic Management and Marketing Pty Ltd (2013) 250 CLR 303 Wingecarribee Shire Council v Lehman Brothers Australia Ltd (In Liq) (2012) 301 ALR 1 Date of hearing: 12 May 2016 Date of last submissions: 16 May 2016 Registry: New South Wales Division: General Division National Practice Area: Commercial and Corporations Sub-area: Corporations and Corporate Insolvency Category: Catchwords Number of paragraphs: 17 Counsel for the Applicant in NSD 1344 of 2015 and NSD 414 of 2016: Mr N Hutley SC with Mr C Withers Solicitor for the Applicant in NSD 1344 of 2015 and NSD 414 of 2016: Squire Patton Boggs Counsel for the Respondents: Mr S Finch SC with Mr J Hewitt Solicitor for the Respondents: Clifford Chance Counsel for the Applicant in NSD 417 of 2016: Mr M Hoffman QC with Ms F Ashworth Solicitor for the Applicant in NSD 417 of 2016: Johnson Winter and Slattery Table of Corrections 23 May 2016 On the orders page, the date "20 May 2016" has been replaced with "18 May 2016" ORDERS NSD 1344 of 2015 BETWEEN: MITSUB PTY LIMITED, AS TRUSTEE FOR THE CHRIS CARROLL SUPERANNUATION FUND ACN 130 784 333 Applicant AND: MCGRAW-HILL FINANCIAL INC (FORMERLY MCGRAW-HILL COMPANIES, INC First Respondent STANDARD & POOR'S INTERNATIONAL LLC Second Respondent JUDGE: RARES J DATE OF ORDER: 18 MAY 2016 THE COURT ORDERS THAT: 1. On or before 17 June 2016, the chief executive officer of the respondents file and serve an affidavit identifying, after personally reviewing the files in this and each proceeding set out in the Schedule of Proceedings to this order, whether the respondents contend that the findings of: (a) the Court and the Full Court ([2012] FCA 1200 and [2014] FCAFC 65) in each of the Bathurst Council and related proceedings (first instance files NSD936/2009, NSD1073/2009, NSD1268/2010 and appeal files NSD501/2013, NSD502/2013, NSD503/2013, NSD504/2013, NSD505/2013, NSD507/2013, NSD508/2013, NSD522/2013, NSD523/2013, NSD524/2013) concerning the inappropriateness of the use of the Gaussian copula; and (b) the Court ([2012] FCA 1028) in the Wingecarribee proceedings (NSD2492/2007) as to the reports in 2005 by the Bank for International Settlements ("The role of ratings in structured finance: issues and implications" (CGFS publication No 23)) and Banque de France, ("The CDO Market: Functioning and Implications in Terms of Financial Stability", Financial Stability Review, No 6 June 2005) concerning the inappropriateness of the ratings agencies' methodologies; in respect of rating structured products the subject of this and each proceeding set out in the Schedule of Proceedings address systemic events, do or do not apply to the respondents' ratings methodologies used for each product in issue in each current proceeding and, if he or she believes that those findings do not so apply, explaining why not and why the court will need to deal with the issue of reliability of the respondents' ratings that are impugned at a final hearing. SCHEDULE OF PROCEEDINGS FILE NUMBER PARTIES NSD1322/2012 MUSWELLBROOK SHIRE COUNCIL ABN 86 864 180 944 Applicant THE ROYAL BANK OF SCOTLAND NV ARBN 84 079 478 612 First Respondent MCGRAW-HILL INTERNATIONAL (UK) LIMITED (A COMPANY REGISTERED IN ENGLAND & WALES UNDER NO 64070) Second Respondent NSD1018/2014 LIVERPOOL CITY COUNCIL ABN 84 181 182 471 Plaintiff MCGRAW-HILL FINANCIAL, INC (FORMERLY MCGRAW-HILL COMPANIES INC)(A COMPANY INCORPORATED IN NEW YORK) First Defendant STANDARD AND POOR'S INTERNATIONAL, LLC (A COMPANY INCORPORATED IN DELAWARE) Second Defendant NSD1020/2014 COFFS HARBOUR CITY COUNCIL ABN 79 126 214 487 Plaintiff MCGRAW-HILL FINANCIAL, INC (FORMERLY MCGRAW-HILL COMPANIES INC)(A COMPANY INCORPORATED IN NEW YORK) First Defendant STANDARD AND POOR'S INTERNATIONAL, LLC (A COMPANY INCORPORATED IN DELAWARE) Second Defendant NSD957/2015 CLURNAME PTY LTD ABN 66 002 898 231 First Plaintiff GOULBURN MULWAREE COUNCIL Second Plaintiff MCGRAW-HILL FINANCIAL, INC (FORMERLY MCGRAW-HILL COMPANIES INC) (A COMPANY INCORPORATED IN NEW YORK) First Defendant STANDARD & POOR'S INTERNATIONAL, LLC (A COMPANY INCORPORATED IN DELAWARE) Second Defendant NSD1126/2015 CERAMIC FUEL CELLS LIMITED (IN LIQUIDATION) ACN 055 736 671 Plaintiff MCGRAW-HILL FINANCIAL INC. (FORMERLY MCGRAW-HILL COMPANIES, INC) (A COMPANY INCORPORATED IN NEW YORK) First Defendant STANDARD & POOR'S INTERNATIONAL, LLC (A COMPANY INCORPORATED IN DELAWARE) Second Defendant NSD414/2016 MDA NATIONAL INSURANCE PTY LIMITED ABN 56 058 271 417 Plaintiff MCGRAW-HILL FINANCIAL, INC. (FORMERLY MCGRAW-HILL COMPANIES, INC) (A COMPANY INCORPORATED IN NEW YORK) First Defendant STANDARD & POOR'S INTERNATIONAL, LLC (A COMPANY INCORPORATED IN DELAWARE) Second Defendant NSD417/2016 LIFEPLAN AUSTRALIA FRIENDLY SOCIETY LIMITED (ACN 087 649 492) First Plaintiff BIG SKY BUILDING SOCIETY LIMITED (ACN 087 652 079) Second Plaintiff MCGRAW-HILL FINANCIAL, INC (A COMPANY INCORPORATED IN NEW YORK) First Defendant STANDARD & POOR'S FINANCIAL SERVICES, LLC (A COMPANY INCORPORATED IN DELAWARE) Second Defendant STANDARD & POOR'S INTERNATIONAL, LLC (A COMPANY INCORPORATED IN DELAWARE) Third Defendant Note: Entry of orders is dealt with in Rule 39.32 of the Federal Court Rules 2011. REASONS FOR JUDGMENT RARES J: 1 At the directions hearing of these and two other proceedings, on 12 May 2016, I proposed an order that had the purpose of requiring the respondents (S&P), by their chief executive officer, to identify the real issues relating to the ratings methodology that they used in rating the various structured financial products the subject of eight representative proceedings currently before this Court. The proposed order was: On or before 17 June 2016, the chief executive officer of the respondents file and serve an affidavit identifying, after personally reviewing the files in each current proceeding, whether the respondents contend that the findings of: (a) the Court and the Full Court ([2012] FCA 1200 and [2014] FCAFC 65) in each of the Bathurst Council and related proceedings (NSD936/2009, NSD1073/2009, NSD1268/2010) concerning the inappropriateness of the use of the Gaussian copula; and (b) the Court ([2012] FCA 1028) in the Wingecarribee proceedings (NSD2492/2007) as to the reports in 2005 by the Bank for International Settlements ("The role of ratings in structured finance: issues and implications" (CGFS publication No 23)) and Banque de France, ("The CDO Market: Functioning and Implications in Terms of Financial Stability", Financial Stability Review, No 6 June 2005) concerning the inappropriateness of the ratings agencies' methodologies; in respect of rating structured products the subject of the 8 current proceedings in the Court to which the respondents are parties address systemic events, do or do not apply to the respondents' ratings methodologies used for each product in issue in each current proceeding and, if he or she believes that those findings do not so apply, explaining why not and why the court will need to deal with the issue of reliability of the respondents' ratings that are impugned at a final hearing. 2 After the parties had addressed the issue of whether I should make it, I formulated that proposed order and offered the parties the opportunity to comment on its form after the directions hearing, before I settled its terms and formally made it as an order. S&P subsequently, and without leave, filed a detailed written submission repeating and supplementing the objections to the making of any such order that it had advanced in oral argument on 12 May 2016. 3 On 18 May 2016, I made an order substantially in the form of the proposed order that I had adapted only so as specifically to identify the relevant proceedings. These are my reasons for suggesting the proposed order and making the order of 18 May 2016. Background 4 Jagot J discussed the use of the Gaussian copula in Bathurst Regional Council v Local Government Financial Services Pty Ltd (No 5) [2012] FCA 1200 (being the proceedings referred to in par (a) of the proposed order). Her Honour's decision was affirmed by Jacobson, Gilmour and Gordon JJ in ABN AMRO Bank NV v Bathurst Regional Council (2014) 224 FCR 1. Those proceedings involved a constant proportion debt obligation (CPDO), being a different and far more complex structured finance product than synthetic collateralised debt obligations (SCDOs). Her Honour said ([2012] FCA 1200 at [2556]): I do not understand it to be suggested that S&P's approach to default risk was of itself unreasonable. However, the expert evidence discloses that S&P would or ought to have known what was common knowledge in the industry, that modelling defaults using the Gaussian copula would seriously underestimate the potential for joint severe events because it "severely underestimates the correlation out in the tail of distribution". The expert evidence also discloses that S&P must have known that its model modelled default risk separately from spreads which is not how markets actually work. Both facts would have benefited the performance of the CPDO as modelled by S&P. If there was room for qualitative analysis in the rating of the CPDO these kinds of facts should have caused a reasonably competent ratings agency to err on the side of caution when considering the results of the modelling. It will become apparent that S&P took the opposite course. (emphasis added) 5 In Wingecarribee Shire Council v Lehman Brothers Australia Ltd (In Liq) (2012) 301 ALR 1 at 26-27 [67]-[68], 31 [83]-[84], 225 [847] and 226 [851] (being the proceedings referred to in par (b) of the proposed order), I discussed aspects of ratings methodologies for SCDOs that had been examined by the January 2005 report of a working group of the Committee on the Global Financial System of the Bank for International Settlements: The role of ratings in structured finance: issues and implications (CGFS publication No 23) and in an article published by the Banque de France in June 2005 The CDO Market: Functioning and Implications in Terms of Financial Stability (Banque de France: Financial Stability Review: No 6 June 2005). I noted that (301 ALR at 225 [847], 226 [851]): 847 The SCDOs offered a lower level of capital security than similarly rated ADI issued FRNs or corporate bonds, as the passage I have quoted from the Banque de France article in [83] explained. Critically, the SCDOs were susceptible to a qualitatively and substantively greater risk of unexpected loss because of their tranched structure and the products' use of reference entities that were significantly lower rated. As the 2005 working group report explained: Subordinated tranches, for example, can lose their entire value if losses in the asset pool are severe enough. This would not occur with an exposure to a straight bond portfolio, assuming that recovery rates are positive. Subordinated tranches will thus have higher unexpected loss than a bond portfolio with the same expected loss or probability of default. Given that the latter criteria (expected loss or probability of default) represent the one-dimensional risk indicators embodied in credit ratings, structured finance tranches can be riskier than investments in bond portfolios with equal ratings. … 851 A feature of the claim SCDOs as structured products was their particular susceptibility to extreme events events that could lead to significant loss. As the 2005 working group observed: The Working Group believes that risks associated with structured products may not have been fully grasped by some investors. Similarly, with consensus on "best practice" regarding the modelling of portfolio credit risk still lacking, "model risk" in instruments such as collateralised debt obligations (CDOs) is an issue for even the most sophisticated market participants. Use of structured finance instruments, together with the occurrence of worst case scenarios relating to mispriced or mismanaged exposures, might thus lead to situations in which extreme market events could have unanticipated systemic consequences. Given these issues and the fact that structured finance markets are still largely untested, continued growth in structured finance activity warrants ongoing central bank awareness." (emphasis in original) 6 S&P was not a party in Wingecarribee 301 ALR 1 and I found that there was no issue as to the accuracy or reliability of the ratings in those proceedings (301 ALR at 284-287 [1091]-[1102]). I found that the respondent, Grange Securities Ltd (as Lehman Brothers Australia Limited had been called during most of the relevant events), was the sole wrongdoer, on the evidence in those proceedings and that it had misrepresented the nature of the ratings to the applicants in those proceedings (301 ALR at 286 [1097]). I found that Lehman had failed to prove that S&P and other ratings agencies were concurrent wrongdoers (301 ALR at 287 [1102]): see too my findings that different issues could arise in subsequent proceedings against S&P in respect of its by then impugned ratings of the same SCDOs in City of Swan v McGraw Hill Companies Inc (2014) 223 FCR 295. S&P's submissions 7 In essence, S&P argued that there was no power in the Court to make such an order and that, if there were, it should not be made because: the chief executive officer would need to rely on hearsay, the affidavit would thus be of no probative weight and would not narrow the issues; the order could cause S&P to disclose legally professionally privileged information; there were less intrusive and less onerous means available to elicit a similar response, such as directions for S&P to file submissions; the earlier findings about the Gaussian copula and ratings methodology referred to in the proposed order did not relate directly to any of the structured financial products or SCDOs the subject of any of the eight current proceedings and did not decide that use of the Gaussian copula in rating those products was inappropriate or resulted in the assigned ratings being erroneous; S&P only had to show that there were rational grounds for the assignment of the relevant ratings; there was no evidence, or finding, in the Wingecarribee proceedings 301 ALR 1, that any of S&P's ratings was incorrect; the applicants had not sought the proposed order; there was no limitation on how the contents of the affidavit might be used or what disclosure could be made of its contents; the proposed order was "more akin to a punitive sanction", where there was nothing in S&P's conduct that warranted censure. Moreover, in some of the eight proceedings, the pleadings had not yet closed; S&P had real and genuine grounds for defending its ratings methodology as evidenced in an affidavit made on 12 May 2015 by Cristina Polizu, a managing director and quantitative analyst of McGraw-Hill Financial Inc, the first respondent, in other proceedings brought by City of Swan that have recently settled; and the making of the proposed order would give rise to real and legitimate concerns as to whether I had prejudged the issues in the proceedings, including what will be a live issue as to the use of the Gaussian copula. The Court's powers 8 The Court has substantive case management powers, some of which are contained in Pt VB of the Federal Court of Australia Act 1976 (Cth). Relevantly, s 37M(1) identifies that the overarching purpose of the civil practice and procedure provisions, under that and any other Act, as well as the Federal Court Rules 2011 (Cth), is to facilitate the just resolution of disputes according to law and as quickly, inexpensively and efficiently as possible. The objectives of that purpose include the efficient use of the judicial and administrative resources available for the purposes of the Court, the efficient disposal of its overall caseload and the resolution of disputes at a cost that is proportionate to the importance and complexity of the matters in dispute (s 37M(2)). The parties and their lawyers have statutory duties to conduct the proceedings, including negotiations for their settlement, in a way consistent with the overarching purpose (s 37N(1) and (2)). The Court can give directions about the practice and procedure to be followed in relation to the whole or any part of a proceeding, including requiring things to be done (s 37P(2), (3)(a), (7)). The Court's Practice Note CM1, Case Management and the Individual Docket System, also explains that parties and their lawyers can expect the Court to have regard to the desirability of, first, identifying and narrowing the issues in dispute as early as possible and, secondly, ascertaining the degree of difficulty or complexity of the issues really in dispute (see [3.2](a), (b)). 9 Provisions such as Pt VB have the purpose of ensuring that the conduct of civil proceedings, as French CJ, Kiefel, Bell, Gageler and Keane JJ said in Expense Reduction Analysts Group Pty Ltd v Armstrong Strategic Management and Marketing Pty Ltd (2013) 250 CLR 303 at 323 [56], "is firmly in the hands of the Court". Their Honours continued (at 323 [56]-[57]) saying of an analogue of Pt VB (being the Civil Procedure Act 2005 (NSW) referred to as "CPA" in the passage below): 56 … It is the duty of the parties and their lawyers to assist the court in furthering the overriding purpose. 57 That purpose may require a more robust and proactive approach on the part of the courts. Unduly technical and costly disputes about non-essential issues are clearly to be avoided. However, the powers of the court are not at large and are not to be exercised according to a judge's individualistic idea of what is fair in a given circumstance. Rather, the dictates of justice referred to in s 58 require that in determining what directions or orders to make in the conduct of the proceedings, regard is to be had in the first place to how the overriding purpose of the CPA can be furthered, together with other relevant matters, including those referred to in s 58(2). The focus is upon facilitating a just, quick and cheap resolution of the real issues in the proceedings, although not at all costs. The terms of the CPA assume that its purpose, to a large extent, will coincide with the dictates of justice. (emphasis added) 10 Having had, in some cases with Wigney J, responsibility for case management of these eight representative proceedings, I formed the preliminary understanding that a substantive issue common to all of them involves the assertion by the various applicants that S&P's use of the Gaussian copula in its ratings modelling for each SCDO or other structured finance product in issue was flawed for the reason articulated by Jagot J in the passage I have quoted from her reasons (Bathurst [2012] FCA 1200 at [2556]). I also formed the preliminary understanding that her Honour's reference to the Gaussian copula's possible underestimation of "the potential for joint severe events" appeared to refer to a similar concept to that identified in the 2005 working group report as "situations in which extreme market events could have unanticipated systemic consequences" and "model risk" (Wingecarribee 301 ALR at 226 [851]) and the similar concept discussed in the Banque de France article (see 301 ALR at 31 [83], [84]). 11 Of course, I have not come to any clear view or understanding of these matters, and there is no evidence about them, in any of the current proceedings before me. Rather, I am seeking to understand how best to give appropriate directions in the future to enable the Court to deal with the real issues, many of which have superficially, at least, some common features. As Sheppard J (with whom Burchett J agreed on this point at 434) said in E I Du Pont de Nemours & Co v Commissioner of Patents (1987) 16 FCR 423 at 424, judges have power "to make, and continue to make, such directions as seem to them best suited properly and adequately to manage and direct the cases in their lists". He said that the Court had a duty to make appropriate directions, even if necessary, against the will of the parties, that were adequate for and suited to the needs of the case. That inherent or implied power of the Court is reinforced by Pt VB and authorities such as Expense Reduction 250 CLR 303. I considered that it would be informative and important to understand, having regard to Jagot J's finding about what S&P knew or ought to have known concerning what she found was the common knowledge of the issues concerning the use of the Gaussian copula in ratings modelling, what, if any, bearing her Honour's finding and the two Central Bank reports, might have on the preparation of the eight current proceedings for trial. 12 Each of the SCDOs or structured products in issue appears to have experienced either some defaults or a wipe out because of extreme market events occurring from 2007, the effects of which are commonly known as the Global Financial Crisis. If (and I stress that at this point the question is based on a preliminary understanding of findings on other, but apparently related, issues after the two lengthy earlier trials) the Gaussian copula seriously underestimated the potential for joint severe, or extreme market, events, then it will be important to understand, at a broad, high level how S&P will defend its alleged use of the Gaussian copula to arrive at the ratings challenged by the various applicants. 13 Given that the trial of the Bathurst proceedings took about three months and the appeal a further two weeks, and the trial of the Wingecarribee proceedings took about one month, the eight current proceedings have the potential to absorb a very large amount of Court time, both in their case management and subsequent trials. I was concerned to ensure that the person within S&P with ultimate management responsibility, namely, the chief executive officer, explain at a high level, and of course without revealing any information that is protected by S&P's right to maintain legal professional privilege, his or her understanding from actually considering the eight proceedings, as to whether the earlier findings referred to in the proposed order applied and, if not, what issues the Court would have to consider in relation to the reliability of S&P's challenged ratings. 14 I was also concerned that Mr Hutley SC, senior counsel for most of the applicants, indicated that they were not aware why, in substance, the finding of Jagot J as to the use of the Gaussian copula in ratings would not apply to S&P's ratings of the SCDOs and any other structured products in issue. He said that his clients would be assisted by such an affidavit as I had suggested. 15 The litigation of those issues, if fully contested in respect of each rated product, is likely to be very expensive and time consuming both for the parties and the Court. I wished to be assured that the chief executive officer, as the person ultimately responsible for the decision to litigate them, had actually turned his or her mind to those issues and explained, at a high level, why the Court, having already spent considerable time and resources on different, but somewhat apparently (on my current understanding) related issues, should revisit those generated in the eight current proceedings involving the use of the Gaussian copula. 16 And, having considered these eight complex cases, the chief executive officer may well have his or her own insights as to how the real issues should be litigated. If there is some matter in the affidavit, when it has been made, that would make it appropriate for an order limiting its, or a part of its, use or publication, of course, S&P will be able to apply for orders to achieve such a purpose. Conclusion 17 It follows that I reject S&P's submissions. The purpose for which I sought the affidavit is to assist in the case management of the eight proceedings. It is not punitive or any kind of sanction. And, it is in no way based on any prejudgment about any of the complex and, as yet, protean matters potentially in issue. But, for the purpose of case management the Court can require a party, by its proper officer, to explain the reason why it needs to litigate particular issues in the proceedings and thus to require the Court and the other parties to devote resources to deal with those issues. That is why I made the order on 18 May 2016, that substantially reflected the form of the proposed order. I certify that the preceding seventeen (17) numbered paragraphs are a true copy of the Reasons for Judgment herein of the Honourable Justice Rares. Associate: Dated: 20 May 2016