Managed by infinma – Institut für Finanz-Markt-Analyse GmbH, Cologne
infinma: Mr. Fiala, you recently stated in an interview in “portfolio international” that a broker’s liability cannot be ruled out when ratings are used. The background to this was what happened in connection with the Scope rating agency and the valuation of real estate funds. First of all, can you briefly outline what exactly happened there?
Fiala: For example by press release of the agency Scope of 15.09.2004 real estate funds of the Kanam were recommended with “BUY”. It also states that Scope “…acts independently of sales and product interests.” Later on, “portfolio international” reported in issue 1 of February 2006 as well as the FAZ under 11.02.2006 that due to “family ties between Scope and a fund” (Kanam) a conflict of interest is in the room. While Scope (Managing Director: Florian Schoeller, son) then issued the recommendation “SELL” in January 2006, two funds of the initiator had to close. Researchers see the independence of the rating agency as being called into question by economic interests or family ties. After all, a family member acted on the side of the initiator (as consultant and from the beginning of 2004 as managing director: Manfred Schoeller, father). But it was not just a questionable conflict of interest that was at issue, it also appeared to be a “misrepresentation of the liquidity position” of a business partner in a key role. Scope had to correct itself on one important point, the FAZ reported.
infinma: The broker actually expects more security from the use of a rating and, ideally, a “release from liability”. How do you assess this in the specific case?
Fiala: It is an open secret that ratings and other “independent” analyses can sometimes come very close to so-called court reporting, and are therefore worthless: If you read something about “independent analyses” as a broker, you should question how the business model is financed. The FAZ reported on critical comments from BaFin, the Bundesbank and the Association of German Banks. The title “Spicy Rating Gang” in a professional journal probably reflects how little confidence there is in “independence and neutrality”. The prudent broker can only be advised to think carefully about which allegedly reputable ratings he expects to be “disengaged” from. Ignoring negative trade press by a broker could be held against him in a liability suit – as a gross violation of obligations to carry out the simplest plausibility checks.
infinma: Can the topic of Scope and real estate funds also be applied to the insurance industry and your companies and products?
Fiala: Transparency and neutrality must also be maintained in insurance rating – even the mere “bad appearance” of a lack of independence must be avoided. On 09.07.2005, UWG proceedings against PremiumRating GmbH came to an end before the Cologne Regional Court. In addition to the rating agency, the main shareholder and managing director, Mr Gorr, also operates as an insurance broker via his limited company. DPA reported on the main hearing, inter alia, “The court expressed in the oral hearing that a rating as such was by no means prohibited. This also applied if the rating was published by an insurance broker. In this context, however, the lack of transparency in the publication of the rating in Focus Money was objected to. In particular, it was not sufficiently pointed out that Gorr was also a shareholder and managing director of GVM Gorr und Partner GmbH and PremiumCircle. It was also criticised that the points awarded and the weighting were not disclosed in detail there.” As this case also shows, personal or personnel links can certainly justify doubts about the objectivity and independence of a rating agency. Transferred to the case of “Scope”, an investor – as it was formulated in the FAZ of 11.02.2006 as an accusation of an investor – could certainly refer to the fact that a rating was faulty and therefore claim damages. What needs to be noted here for the defectiveness of a rating is twofold: On the one hand, a lack of objectivity and neutrality must be disclosed. On the other hand, ratings must also be regularly consistent and transparent. As a rule of thumb for the broker, if I can’t understand the rating, then I should exercise the utmost caution.
infinma: Do you see a difference here between the use of product and company ratings?
Fiala: From the point of view of the user, i.e. the broker for example, it is of decisive importance that the rating is methodologically correct. If, for example, in a price ranking the prices are not determined in a representative manner, the ranking no longer appears to be impartial and the analysis or investigation no longer satisfies scientific method. Analyses must be based on neutral, objective and competent performance. Significant discretion may arise where valuation is concerned. Conclusions drawn must merely appear justifiable, i.e. debatable – this reflects the right of free expression of opinion, i.e. of evaluative criticism. The standards of the case law apply to both product and company ratings. As the actuarial expert Peter Schramm criticises, due to a lack of transparency of the insurance products and misconceptions about the actual interrelationships, company ratings that are actually correct are then often used improperly for the valuation of products. For example, a good financial strength rating may not indicate whether high surpluses are likely if it is based only on the company’s ability to pay what may be low guaranteed benefits. Anyone who then recommends a product with low guarantees because of a good financial strength rating should be able to justify this well, if necessary, as soon as the company demonstrates its financial strength capability in reality by reducing its non-guaranteed benefits.
infinma: If the broker uses a rating and it subsequently turns out that the product is not suitable for the client, can the client hold the broker liable for this?
Fiala: For the broker, this situation is doubly precarious, because the broker would have to prove in court that he was not at fault for having selected an unsuitable product. And this naturally leads to the consideration that it must be possible for a broker to use more than just one rating for product selection. From the customer’s perspective, a rating can be quite a blessing. If the broker is uninsured or underinsured, the CRA can also be sued. Numerous rating agencies make this very easy for the customer, because they use legally invalid general terms and conditions (GTC). A typical example is the following note: “The agency assumes no responsibility for the topicality, correctness, completeness or quality”: Such disclaimers are regularly ineffective. The following questions may arise for the broker: a) Do I want to use a rating for which the agency apparently does not want to take responsibility? What value then does such a rating have as a basis for an investment decision or other selection of products or product providers? b) Do I want to trust an agency that already practices banal basic errors in simple liability questions with reference to its own agency assets? Would it be illogical to deduce from such errors that the ratings are also likely to be flawed?
infinma: Can liability for the broker vis-à-vis the client be ruled out with certainty if the broker uses a defective rating for a product which is in itself suitable for the client?
Fiala: If the product is suitable for the customer, the customer will rarely be interested in the rating. With regard to liability, a residual risk always remains for the broker. Therefore, a broker should take the usual measures to minimize his personal liability – this starts with subjecting the prospectuses and ratings to a plausibility check. Reading and archiving (genuine) trade press can also serve as a safeguard. Not to forget the documentation of the consulting process at the client, the use of a suitable company form, as well as the VSH insurance of the remaining risk. Even those who buy in ratings and analyses can derive their own recourse claims against analysts or rating agencies: This is where some corporate legal protection comes in. It is therefore possible to position oneself as a broker in a strategically professional manner. This area also includes the product provider’s liability for damages due to incorrectly calculating sales software, incomplete instructions or incorrect information during product training.
infinma: What requirements are to be placed on ratings or rating agencies at all? Where do you see possible conflicts of interest?
Fiala: The preparation of a merely false rating will not suffice for liability without further ado. It would be necessary for the rating agency to be able to be reproached, for example for negligent research and investigation into the basis of its rating – or for example for gross recklessness through statements made “in the dark”. However, reckless conduct may be sufficient for liability for “immoral damage under § 826 BGB” if the rating agency’s actions are judged to be unconscionable. Here, it may be sufficient for the court to have a variety of circumstantial evidence. Incidentally, courts have also repeatedly sentenced “sales managers” with an internal knowledge advantage to pay damages due to induced misinformation. Planned misinformation regularly leads to liability in sales – misinformation by training managers would be just as likely to be considered here as such by rating agencies and supposedly independent analysts. Thus the actuary Peter Schramm quotes on its side www.pkv-gutachter.de judgements, which condemned insurers to the payment of damages or to the payment of the originally in prospect placed annuity, because they had still sold the old too low calculated annuity insurances partly even forced in the knowledge that the life expectancy had extended. Then, in retrospect, they wanted to cut pensions because of extended life expectancy.
infinma: Could a rating supervision help here?
Fiala: Whereas rating agencies used to be described as the “largest uncontrolled power in the financial sector”, at the beginning of 2005 the opinion prevailed that politically one would like to focus on “self-regulation”. In my personal opinion, it is enough to treat the ratings and their authors with a friendly distrust. If you want to make sure that a rating is on solid ground, you can follow up and check its plausibility. Such a work is also scientific when it is comprehensible to the intellect. In any case, lack of transparency should be a “knock-out criterion” for every broker in order to distinguish “cheap” advertising from serious rating work.
infinma: In your opinion, what can the broker do at all to protect himself against possible liability risks?
Fiala: In addition to the above-mentioned in-house tasks (documentation of advice, correct company form, VSH insurance), further training plays a decisive role. I’m not thinking of sales training courses with the motto “you keep them stupid – I’ll keep them poor”. It also seems important to me to exchange ideas with colleagues, preferably across disciplines: some dialogue with an actuary, lawyer, insurance advisor, etc. can broaden horizons on both sides. Transparency can only be expected from insurers to a limited extent, as internal calculation bases are regularly regarded as business secrets to be protected – which can only be compensated for to a limited extent by ratings.
infinma: Mr. Fiala, thank you for the interview.
(competence-site (April 2006))
Courtesy ofwww.competence-site.de andwww.infinma.de.
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About the author
Dr. Johannes Fiala has been working for more than 25 years as a lawyer and attorney with his own law firm in Munich. He is intensively involved in real estate, financial law, tax and insurance law. The numerous stages of his professional career enable him to provide his clients with comprehensive advice and to act as a lawyer in the event of disputes.
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