FEDERAL COURT OF AUSTRALIA

Liverpool City Council v McGraw-Hill Financial Inc (No 2) [2018] FCA 686

ORDERS

THE COURT RULES THAT:

1.    The report of Dr Min Shi dated 25 January 2018 be rejected.

Note:    Entry of orders is dealt with in Rule 39.32 of the Federal Court Rules 2011.

REASONS FOR JUDGMENT

(REVISED FROM THE TRANSCRIPT)

RARES J:

1    The respondents (S&P) seek to rely on the affidavits of Dr Min Shi of 25 January 2018 and 3 May 2018 in respect of the assessment of damages to which the applicants may be found entitled. Dr Shi is an economist who has 15 years’ experience in corporate finance and financial valuation, but she disclosed no experience whatsoever in dealing with structured finance products or how their credit ratings may bear on the value of the products or the prices at which they may be sold.

2    In her report attached to her affidavit of 25 January 2018, Dr Shi said without disclosing any experience that she ever had of a synthetic collateralised debt obligation (SCDO) [(3.3]):

In my experience, SCDOs with lower credit ratings are generally perceived to be a riskier investment, as the investors would have likely perceived the probability of not receiving the promised coupon payments and principal repayment in full to be higher. As a result, the investors expect greater returns to compensate for the perceived increase in risk. This means that the investors would not have been prepared to pay the same price for the Claim SCDOs in the counterfactual, in consideration of the perceived higher risk, compared to what they did pay in the actual scenario. A lower price for the same instrument would have enabled the investors to expect greater returns on an ex ante basis, in exchange for taking on the greater perceived risk that the promised future returns might not materialise. (emphasis added)

3    Table 2.1 in Dr Shi’s report set out the names, ratings at issuance, dates of issue, maturity dates (including any extended maturity dates) and spreads over the bank bill swap rate (BBSW) as initially fixed and after any extension. Dr Shi then asserted that she had identified a set of comparable instruments by reference to which she sought to arrive at a value for the SCDOs the subject of these five proceedings (the claim SCDOs), had S&P assigned them lower credit ratings at the time of their issue. She said ([4.12]):

An ideal set of Comparable Instruments would be similar to the Claim SCDOs in as many aspects as possible, other than credit ratings at the time of issuance. Below, I discuss how I identify the comparable instruments by reference to the main characteristics of the Claim SCDOs as set out in Table 2.1.

•    instrument type––ideally, a comparator instrument is an AUD-denominated SCDO not included in the Claim SCDOs. However, I was unable to locate such SCDOs based on information from the public domain. As an SCDO is a type of structured finance products, which are securitised collections of loans or receivables, I expand the instrument type to all types of structured finance products, which include ABS, CDO, CMBS and CMO (See CFA Institute (2016), ‘CFA Level II curriculum, Alternative investments and fixed income’, Chapter 7:Asset-backed securities, p. 423) (emphasis added)

4    That was the sum total of Dr Shi’s discussion of why she asserted that products such as a CDO (collateralised debt obligation) or ABS (asset backed security) was comparable to an SCDO. She did not explain what a product with the acronym CMBS or CMO was, let alone what features of those products or ABS or CDOs made them comparable to the claim SCDOs, beyond saying that each was a type of structured finance product. Dr Shi then said that she had identified 52 comparable instruments, all of which had been issued in 2006, that each had a rating and a floating coupon rate based on BBSW with maturities of one to nine years. From that, she asserted that they matched the claim SCDOs in terms of currency, issue dates, structure of the coupon rates, benchmark interest rates and maturity. She said the only aspect in which those “comparable” instruments did not match the claim SCDOs “is the type of instrument”.

5    However, Dr Shi gave no analysis of why the fact that each of her chosen “comparable instruments” was a different type of instrument to an SCDO either had no relevant effect or, to the extent that there was a relevant difference, how she had dealt with it in arriving at her assertions as to the comparability of the products. She said ([4.15]):

As the intended use of the Comparable Instruments is to estimate the increase in the initial YTM [yield to maturity] associated with lower credit ratings, it would be preferable to isolate the impact of other, non-credit-rating related, instrument-specific characteristics on the YTM. This is because instrument-specific characteristics, such as contractual terms and the nature of the underlying assets, sometimes can affect the YTM of the instrument, independent of the credit rating of the instrument.

6    She then said ([4.16]-[4.17]):

To eliminate the impact of instrument-specific characteristics on the YTM, I group the 52 Comparable Instruments into 17 sets where each set consists of instruments that are part of the same deal. Instruments within a deal are often different tranches of the same deal, with the same underlying assets and similar contractual arrangements, but with different credit ratings. This means that the differences in the initial YTMs of different instruments within the same deal can be considered good proxies for the impact of different credit ratings.

As an example, the CSCS 2006-1 deal contains four instruments:

CSCS 2006-1 A2, CSCS 2006-1 B, CSCS 2006-1 C and CSCS 2006-1 D. All of these instruments were issued on 21 December 2006 with a final maturity date of 20 June 2013. They all share the same underlying securities, which is a collection of real estate mortgages. Moreover, all the instruments in this deal have a floating-rate coupon linked to three-month BBSW, which is paid quarterly. The only difference among them is their credit rating, which is because they have different claims on the cash flows generated by the underlying securities. As a result, I consider the differences in their initial YTMs to be good proxies for the impact of different credit ratings. (emphasis added)

7    Below this Dr Shi set out a table analysing the 17 deals that she identified only by reference to an acronym. She did not identify the type of product in any of those deals. She drew the conclusion that, effectively, differences between gradations of S&P’s ratings led, as the ratings declined, to increases in the expected YTM. From this premise, Dr Shi drew the conclusion that a relatively fixed relationship existed to prescribe the additional number of basis points that should be added to the margin over BBSW if an instrument that had been rated AAA were downgraded by one or more notches to work out what she asserted would have been the issue prices of each of the claim SCDOs.

The issue

8    The applicants objected to the admissibility of Dr Shi’s evidence on the basis that she had not demonstrated any expertise by reference to which she was able to express opinions of the kind that she did in her report. S&P argued that what she had done was to identify the comparability of other structured finance instruments by reference to the 17 sets of comparable instruments, comprising 52 total tranches, and the differences in the YTM of each internal tranche in each instrument. From this, S&P argued she had worked out how a rating change affected the YTM of any particular tranche.

Consideration

9    Absent from Dr Shi’s analysis was any reference to her ever having conducted a valuation of a structured finance instrument or of having analysed any of the instruments that she identified as being comparable or explained how they were comparable to an SCDO. A valuer of real estate may be qualified to express expert opinions based on his or her experience of residential home sales in respect of other residential home sales by identifying comparable sales and the features of such sales based on his or her training, study or experience, that supports that analysis. But a real estate valuer who only had experience in valuing individual homes in a rural town in Western Australia, but had had never valued a large commercial office block in the central business district of Sydney, would need to demonstrate some basis for being in a position to give expert evidence about the latter subject matter when he or she had no apparent knowledge of the market or the types of property there, about which he or she was seeking to express a valuation opinion. The mere fact that a person has a qualification as a valuer of some category of asset (such as residential property) does not, without more, qualify him or her to give expert evidence as to the valuation of another category of asset (such as a corporate group or business).

10    Here, there are different markets for the distinct categories of products to which Dr Shi referred as comparables. For example, the market for residual mortgage backed securities (RMBS) concerned an investment involving exposure to actual reference entities’ performance for the purposes of deriving a yield. That market involved a different market to that for SCDOs. The latter involves reference to hypothetical exposure to reference entities and the hypothetical impact on the reference portfolio of defaults in the real world of those entities in accordance with the contractual provisions of the SCDO transaction.

11    Dr Shi gave no evidence to explain that, based on her study, training or experience, she was able to identify, as comparable to an SCDO, the particular categories of transactions that she chose. She never mentioned that she had had any training, study or experience in understanding the characteristics or nature of any structured finance products, in their valuation, or in assessing their pricing.

12    In the joint expert report on damages, in which Dr Shi participated, she and the other three experts, Mr James Wood, Dr Jon Gregory and Professor Christopher James agreed that a debt-like instrument, such as an SCDO, could be valued at a particular point in time by estimating the present value of the promised coupon payments and the promised principal payment. Significantly, they said that placing a precise value on an SCDO “requires a complex modeling exercise.”

13    However, the other three experts agreed, without Dr Shi expressing any opinion, that in the period around 2006, being that which Dr Shi considered, there was a standardised methodology of valuing SCDOs for investors and arrangers in the marketplace, albeit that there were several minor variants within that methodology. That methodology was the base correlation/Gaussian copula model. None of those three experts suggested that any methodology such as that which Dr Shi employed was used or recognised in the marketplace to value or price SCDOs. Moreover, Dr Shi gave no evidence of any study, training or experience that she had in the marketplace for SCDOs or other structured products.

14    An expert valuation is, ordinarily, an opinion about the market value of an asset based on the test in Spencer v The Commonwealth (1907) 5 CLR 418, as applied in Walker Corporation Pty Limited v Sydney Harbour Foreshore Authority (2008) 233 CLR 259 at 276-277 [51] per Gleeson CJ, Gummow, Hayne, Heydon and Crennan JJ, namely, what price a willing, but not anxious, vendor and a willing, but not anxious, purchaser would agree in a fully informed market for the asset sought to be acquired, including by reference to all of the characteristics of the particular asset. In contrast, Dr Shi simply asserted that she considered that other structured finance products, regardless of their characteristics as compared to those of SCDOs in the markets in which they were bought or sold, were good proxies for ascertaining the market value of, the claim SCDOs, were they to be rated lower than they were rated at the time of their issue. In effect, her reasoning was no more than, if one considered the 17 products which she identified as comparable, one could work out from the sale prices of each different tranche differences in the margin of the coupon above BBSW for an SCDO tranche of the same rating and that this, therefore, provided a good proxy for her analysis. That reasoning did not portray any conclusion based on her study, training and experience in valuing, first, SCDOs or, secondly, any other structured finance product, about which, as I have said, her evidence was entirely silent.

15    In my opinion, Dr Shi’s evidence was analogous to that of the witnesses whose evidence was found not admissible as expert evidence in Clark v Ryan (1960) 103 CLR 486 and HG v The Queen (1999) 197 CLR 414 at 429 [44]. In the latter decision Gleeson CJ said:

Experts who venture “opinions” (sometimes merely their own inference of fact), outside their field of specialised knowledge may invest those opinions with a spurious appearance of authority, and legitimate processes of fact-finding may be subverted.

16    Dr Shi’s evidence fell into that category. There is no doubt she is a knowledgeable economist and academic, but she has no expertise in the characteristics, pricing or valuation of any structured finance products. The opinions that she has expressed are not admissible for the purposes of s 79 of the Evidence Act 1995 (Cth).

Conclusion

17    I am not satisfied that she has specialised knowledge, based on her training, study or experience, to express opinions as to the price which an SCDO might have received or its value had it been rated differently, as compared to the price that the applicants paid for those SCDOs when they acquired them, or when the products were issued. For these reasons, I reject Dr Shi’s evidence.

Associate:

Dated:    15 May 2018

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