Swinging into the rating liability trap

What is the legal assessment of the involvement of the Scope Group rating agency with the fund initiator Interlife Management and the sales company Deutsche Konsortial? portfolio international spoke to the Munich lawyer Johannes Fiala. The sales expert warns against a possible contributory negligence of the sales department in the case of erroneous judgements of rating agencies.

Mr. Fiala, is the kind of interlocking of personnel that existed between Fondscope/Scope Group, the initiator Inter Life Management and the sales company Deutsche Konsortial actually prohibited by law? No, these entanglements are not prohibited in principle. However, such a constellation can lead quite purposefully to the problem of rating liability, because the entanglements are quite obvious. There was a similar case last July. Huk Coburg had imposed an injunction on a rating company because of a health insurance rating. Persons acting at this rating company were also active in sales as brokers. This was not pointed out in the ratings. The news agency Reuters reported at the time that the judge at the Frankfurt Regional Court made it clear at the hearing that interlocking relationships which could lead to a possible conflict of interests must be pointed out in principle.

So the piquant thing about the Scope case is that the rating agency did not point out these personal entanglements? From my personal point of view, such an interconnectedness makes a rating flawed, vulnerable, and ultimately something like that purposefully leads to liability. “portfolio international” and also the “FAZ” on 11 February reported that the first investor is already on the mat and is making accusations along the lines of: “If I had known about the entanglement, then I would not have taken part in the product ultimately advertised by the rating agency”.
To what extent is the distinction important as to whether the persons acting at Scope were or are only indirectly involved shareholders or whether they were operationally active for the companies? This will certainly lead to the legal question of how much direct or indirect influence to disclose. In principle, the Federal Court of Justice has ruled, using the example of Stiftung Warentest, that published studies or ratings must be based on scientific methods. They must be comprehensible and at the core – and this is very important – impartial. This means that the implementation itself, and here the people involved are also meant, requires a neutral, objective and expert approach. With the expert execution we have also arrived at the error in the rating of the first fund of Interlife Management. As can be read in the “FAZ” and “portfolio international”, weaknesses in this fund were misjudged by the Scope rating agency.
In public reactions, the rating agency tries to play down the role of the persons involved. Martin Passenheim, for example, is referred to as an “accounting staff member” in a Scope circular to its licensees, even though he heads Scope’s finance and organization. How credible are such statements? The fact that the rating agency is now trying to play down the fact of its questionable neutrality in its press and public relations work strikes me as a typical rearguard action. One tries to keep the damage as small as possible by so-called crisis PR. We have two areas of error at Scope. The one area to be examined is the question of craftsmanship, i.e. whether the ratings from this house generally follow a scientific method, i.e. whether they are comprehensible by reason. Bafin has already requested and inspected documents from Scope in the case of Kanam’s open-ended real estate funds and initiated an investigation, as can be seen in various media. So there is a rating error as a suspicion here. On the other hand, we have an entanglement of interests – and this is what makes the matter so delicate – in which I assume that in a trial every judge will at least have to turn up his nose. These personnel links are objective facts, and this naturally touches on the question of the objectivity, neutrality and independence of a rating agency. Both areas of error are gateways to liability against data subjects who have relied on such information.
Regarding the rating of the first Interlife fund: It is documented that the initiator of the fund had no experience. Nevertheless, the fund was well rated, which also surprised the initiator’s competitors at the time. Does the rating agency actually have to prove that it acted neutrally, or does a plaintiff have to prove that it was not neutral? In such a case the question will not be “before the court and on the high seas”, but here in a liability case it would be “before the expert and on the high seas”. In other words, the case would be looked at very closely by someone the court calls in as an expert. There are ways and means in the Code of Civil Procedure, for example, to present the material now before Bafin to a plaintiff at trial as well. The plaintiff only has to sufficiently state which doubts he has about the quality of the rating.
The Scope rating agency has declared that it has adhered to an international standard for rating agencies, the Iosco Code of Conduct, since 2004. What is the significance of this declaration for conflicts of interest prior to this declared accession? Does this declaration have the effect of a kind of exemption from liability for the years 2003 and 2004? No, exactly the opposite is the case. If a rating agency submits to such quality or transparency standards, it is only a nice declaration of intent. Such a declaration of voluntary commitment has no legal significance in the sense that these requirements would not have had to be met for the past. However, a voluntary commitment from 2004 onwards may increase the level of responsibility since then.
The Scope Group has formulated neutrality statements which it claims have been certified by an auditor. So far, however, the rating agency has not substantiated this. How is this to be assessed? This is a very tricky question. First of all, you would have to look at those statutes. Then the question might arise: Did the auditor miss something? In that case, he’d have to answer for the statutes. But of course, the statement about neutrality statutes could be a mere marketing stunt.
What could be the gateway for investor lawsuits in the case of the rating of the first interlife fund? The gateway is a so-called contract with protective effect in favour of third parties. There are three parties involved in a rating: the rating agency, the company whose property is being rated and the public. The contract, which is usually between the rating agency and the initiator, has a spillover effect on the public, which typically comes into contact with the outcome of the rating. And so the activity of the rating agency develops a protective effect in favour of investors. That is, in this context, an investor may well take the view that he has relied on the rating. According to the German Civil Code, the rating agency is liable in principle even for the slightest negligence.
Does this also apply if the rating agency is not paid by the initiator but by investors and advisors who acquire licenses to use the rating results? That doesn’t matter a damn. If the contracts are between the rating agency and the intermediary, the intermediaries will of course have a direct claim against the rating agency for failure to perform the rating task entrusted to it. Such a contractual mode also has an additional protective effect in favour of the investors concerned.
How great is the danger now of a general suspicion against the Scope ratings? A blanket judgment against all ratings of this agency is prohibited, because that would go too far. However, the case of a defective rating activity in question affects the rating industry as a whole. Due to the very high requirements for ratings, the concerned reader of such a report will ask himself in the future: Is this a valuable source of information in terms of quality? If there is such doubt, then an intermediary may be in a shaky position vis-à-vis the client. If the rating appears to be a black box for the sales department, this may well result in contributory negligence on the part of the sales department in the event of erroneous judgements on the part of the agency. This is because, unlike in the case of private clients, where contributory negligence is generally excluded, the advisor is an expert. Conflicts of interest that could possibly lead to rating errors could result in the intermediary community in particular asking itself the question about ratings in general: How did this rating come about?
In ratings and analyses, the footer of the report often reads “errors excepted” or “liability excluded”. Is such a general release from liability possible? No, a limitation of liability or even an exclusion of liability is not possible at all in the core business of a service provider. In the core of the activity, no one can exclude his liability, even for slight negligence. All such liability avoidance clauses are simply invalid. On the contrary: according to the law, the rating agency is liable for main and secondary obligations even for the slightest negligence. In this respect, I am confident in predicting that rating agencies can run into major problems in cases such as these, and that their very existence can be threatened as a result.

The interview was conducted by Ali Masarwah
(portfolio-international 2.2006, 10)
Courtesy of www.portfolio-international.de

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About the author

Dr. Johannes Fiala
PhD, MBA, MM

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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