Wingecarribee Shire Council v Lehman Brothers Australia Ltd (in Liq) [2012] FCA 1028 RARES J

SUMMARY

In accordance with the practice of the Federal Court in some cases of public interest, the following Summary has been prepared to accompany the reasons for judgment delivered today. The Summary is intended to assist understanding of the decision of the Court. It is not a complete statement of the conclusions reached by the Court or the reasons for those conclusions. The only

authoritative statement of the Courts reasons is that contained in the published reasons for judgment. The published reasons for judgment and this Summary will be available on the Internet at www.fedcourt.gov.au.

Wingecarribee Shire Council v Lehman Brothers Australia Ltd (In Liq) [2012] FCA 1028 RARES J
SUMMARY
This is a representative proceeding, or class action, under Pt IVA of the Federal Court of Australia Act 1976 (Cth). The three applicants, Wingecarribee Shire Council, Parkes Shire Council and the City of Swan (which I will call the Councils) sought damages against the respondent, Lehman Bros Australia Ltd (In Liq), which was called Grange Securities Ltd (Grange) before it was acquired by Lehman Bros Holdings Inc in early March 2007. The three Councils claimed that they suffered losses arising out of their acquisition of synthetic collateralised debt obligations and some other complex financial products (collectively SCDOs). Most of the dealings between the parties occurred before Grange was taken over and I will simply refer to the respondent as Grange.

In representative proceedings, the Court can resolve issues of fact and law involving the representative applicants and the respondent that are common to claims that other group members also have against the same respondent. Here, members of the group claim to have suffered losses as a result of acquiring SCDOs in their dealings with Grange between 2003 and 2008. There were numerous common issues of fact and law resolved in these proceedings that also appear to be relevant to claims of other group members.

In general, SCDOs are highly complex financial products. Because of their nature, they have many risks, some of which justify the higher interest rates the products offered over similarly rated securities. Grange used the high ratings of the SCDOs as a significant selling point to its risk averse Council clients. In a very broad sense, which is oversimplified from what I have described in detail in my reasons, an SCDO is a sophisticated bet. A bank or financial institution puts together, or arranges, a

product that offers investors a return at a marginal interest rate above the BBSW and which has a high credit rating. The SCDO will mature after a period, and if all goes well, the investors will receive their capital back. The product is issued by a specially incorporated company whose only business is to issue notes to investors and enter a credit default swap with the arranging bank. The swap works this way. The arranger identifies a portfolio of investment grade securities, usually being BBB or better rated, issued by corporations around the world. This is called a reference portfolio. Because it involves a number of companies loans or notes, the instrument is like a collateralised debt obligation. But, it is not necessary that the arranging bank have any loan or credit exposure to any of the corporations, or reference entities, in the reference portfolio. That is why these products are called synthetic they involve a collection of reference entities that may or may not default on their debts owed to persons who may have no connection to the arranging bank, or the terms of the SCDO may provide that a ratings downgrade or some other event affecting one of the reference entities will be a default. All such circumstances are called credit events.

Next, the arranger and issuer of the SCDO select a range of the possible number of credit events that investors are asked to bet will not occur. Thus, typically an SCDO will provide that a tranche of, say, between the first 6% and 7% of the total reference portfolio will not suffer credit events, but if it does, then some or all of the investors capital will be lost. So, for example, 10 credit events in a reference portfolio of 150 reference entities will have to occur before the next credit event affects the tranche between 6% and 7% of the reference portfolio. If that next credit event occurs, then the credit default swap requires that the issuer of the SCDO pay a percentage or the whole of the investors capital to the swap counterparty, often the arranging bank. Once that occurs, that part or all of the investors investment is lost, and the issuer ceases to pay interest on it. So, even if reference entities suffer ratings downgrades, or default but later pay their debts, the synthetic nature of the SCDO, means that no actual loss needs to be suffered by the swap counterparty for the investors to lose some or all their capital.

Each of the three Councils had a different relationship with Grange. These were, in turn, said to be representative of the range of relationships various group members had with Grange. Each of the Councils had substantial surplus funds to invest, 3

including rate revenue some of which would be needed to meet its expenses over the course of each financial or rating year. Before dealing with Grange, the Councils had invested conservatively, in bank products such as bank bills, term deposits and bank issued floating rate notes (FRNs). Those generally offered interest rates marginally better than the 90 day bank bill swap rate (BBSW). None of the Councils had officers with any significant experience in investment or financial products outside those limited classes of investments. Each Council was very concerned to ensure that none of its funds was invested in any products that had a substantive risk of loss of their ratepayers capital. Nonetheless, they wanted to ensure that their funds earnt the best returns available consistent with their conservative investment policies.

Grange put itself forward to Councils as a financial adviser that understood the investment requirements of local government, including relevant legislative and policy constraints. In late 2000, the New South Wales Minister for Local

Government had made an order under the Local Government Act 1993 (NSW) that allowed councils to invest in any securities at all, however exotic, that had been rated A1 or above by the ratings agencies. How that could have been considered

appropriate for local government Councils when such ratings could be given to highly complex derivatives that had no relevance to local councils or their operations was not explained in any evidence.

At the times of Granges sales to the Councils, its SCDO products had credit ratings that were between AAA (the highest possible) and AA- (equivalent to the credit rating of the four major Australian banks). In general, Granges SCDOs offered interest rates in between about 0.75% and 1.50% above the BBSW. The extra interest, while usually better than that of products issued by Australian banks, was still relatively modest and was paid by a product with very high credit ratings.

Grange told the Councils when it dealt with them that its SCDO products were a form of floating rate notes. Grange told them that if the SCDOs were held to maturity the Councils would get their money back and that the products high credit ratings put them in the same universe of investments as debts of the AAA rated Australian Government and AA- rated four major Australian banks.

Grange also represented to the Councils that the investments, including SCDOs that it recommended or made on their behalves, were suitable for a conservative investment strategy. It represented that those products were prudent, capital protective

investments and that they complied with statutory and Council policy requirements. Grange also represented to the Councils that those products were as liquid as the bank FRN products that the Councils were familiar with, could readily be redeemed for cash and were easily tradeable on an established secondary market. In addition, Grange represented to the Councils that the maturity dates for the SCDOs were suitable to the Councils needs.

Both Parkes and Swan began buying SCDOs from Grange in 2003. Over the next four years both Parkes and Swan bought from and sold back to Grange a considerable number of SCDOs. Those transactions always resulted in the Councils earning

interest rates that were satisfactory and not suffering any losses of capital on any sales (leaving aside immaterial differences that were netted out with substantial profits from contemporaneous trades).

In late 2006, Wingecarribee called for expressions of interest for the provision of investment advisory services. That Council sought to improve the returns it was getting from its conservative investments predominantly in bank bills and short term deposits. In December 2006, Grange made a presentation to Wingecarribee during which the Council stated that it did not want to invest in CDOs. In early January 2007, Wingecarribee entered into a written individual managed portfolio (IMP) agreement with Grange. In February 2007, Swan also entered into an IMP agreement with Grange in respect of a large part of its investment portfolio. However, Swan also continued to hold substantial investments with other institutions.

The IMP agreements were drafted by Grange.

Under an IMP agreement, Grange

could decide to invest in any products, subject to, first, the agreed investment guidelines and, secondly, to the Councils right to require Grange to remove any investment it chose at market price. In this way the IMP agreement gave Grange control of the Councils relevant investment portfolio. In Wingecarribees case this was worth over $50 million. The Wingecarribee IMP agreement contained

investment guidelines that expressly permitted Grange to invest Wingecarribees 5

funds in both CDOs and structured products.

However, it also required any

investment to be in a product for which there was an active secondary market and prohibited investment in derivates. In contrast, the Swan IMP agreement required that the Council have ready access to its funds for its day to day requirements without penalty.

After the global financial crisis began to develop in around mid 2007, many of the Councils SCDOs suffered credit events. Three have been wiped out (i.e. all money invested in them has been lost). In addition, 11 of the products issued by Lehman Bros Special Financing Inc and guaranteed by Lehman Bros Holdings Inc have been directly caught up in a conflict between judicial decisions in the United Kingdom and the United States that arose from the Chapter 11 bankruptcy of the US Lehman Bros companies. These notes were called the Dante notes. That problem has meant that the money now due to be repaid to investors in the affected products is frozen and unlikely to be returned for some years while the Courts work out whether some of the money that is available should be paid to the Lehman Bros companies, even though they have suffered no relevant loss, or returned to the investors as the Supreme Court of the United Kingdom decided last year.

The Councils (and other group members) claim to have suffered significant losses as a result of the 3 SCDOs that were wiped out, a number of others being redeemed after deduction of some losses and their need to hold other SCDOs, including the Dante notes, for long periods, which may or may not be repaid in full at some time in the future.

Each of the Councils alleged that Grange had breached the contracts they had made. Parkes and Swan both claimed that Grange had breached the individual contracts to purchase each SCDO because the product did not have the characteristics Grange had promised. Both Swan and Wingecarribee claimed that Grange had breached their IMP agreements by investing in the SCDOs when they were not appropriate investments for either Council. In addition, Wingecarribee claimed Grange breached its IMP agreement because the SCDOs had no active secondary market and were also derivatives.

The Councils also alleged that Grange had engaged in misleading and deceptive conduct contrary to what is now a plethora of pointlessly technical and befuddling statutory provisions scattered over many Acts in defined situations. The repealed, simple and comprehensive s 52 of the Trade Practices Act 1974 (Cth) that prohibited corporations engaging in misleading or deceptive conduct in trade or commerce has been done away with by a morass of dense, difficult to understand legislation. Those Acts, that now deal with misleading and deceptive conduct, apply differently depending on distinctions such as whether the alleged misleading conduct is in relation to a financial product or a financial service (s 1041H(1) of the Corporations Act 2001 (Cth)) or financial services (s 12DA(1) of the Australian Securities and Investments Commission Act 2001 (Cth)). Those apparently simple terms are nothing of the sort. A financial product is defined in mind-boggling detail in 7 pages of small type in Div 3 of Pt 7.1 of the Corporations Act while a financial service takes another 6 pages to be defined in Div 4 of Pt 7.1. The ASIC Act only takes about 4 pages to define financial service in s 12BAB. Obviously, there are differences in what each of these Acts and definitions cover but why? The cost to the community, business, the parties and their lawyers, and the time for courts to work out which law applies have no rational or legal justification. The Parliament should consider returning to a simple clear two line long universal norm of conduct, as was contained in s 52, if it considers that misleading and deceptive conduct in trade or commerce ought be prohibited.

The Councils also claimed that, in each situation in which it acted for them, Grange was an investment adviser that owed them fiduciary duties.

Granges explanations to the Councils of the way in which the SCDOs worked emphasised that their high credit ratings reflected a very remote risk that the Councils capital could be lost, similar to the risk of loss from a loan to the Australian Government or the large local banks. However, that explanation was wrong. If general or systemic extreme market events occurred, such as a large market correction, a recession or as happened, the global financial crisis, the synthetic or structured nature of the SCDOs created a significantly greater risk of loss for investors than for similarly rated products, such as Australian government, a corporate or bank debt. That was because if a corporation or bank went into liquidation, a 7

creditor, ordinarily, would not lose all its investment.

Rather, the liquidator,

ultimately, would pay a proportion of the amount owing. The SCDOs, on the other hand, were not investments in a corporation, but in a bundle of rights that were subject to all or nothing credit events. The credit events did not need to cause any

real world loss to anyone, yet could cause loss of some or all of the investors investment.

Prior to mid 2007, Grange had provided a secondary market that enabled its clients to buy and sell the SCDOs as a feature of its promotion of its sales of the SCDOs. Grange ensured that this market operated in such a way that, while economic conditions were stable, SCDOs could be sold quickly for at or above face value. But this market depended entirely on Grange being able either to on-sell a product to another client or to fund its repurchase itself. Grange made very large profits from selling new issues of SCDOs to its client base and from its trading with them in this secondary market. But the market was fragile. Grange was undercapitalised and, when economic conditions began to deteriorate, it could not operate the market any longer. The risk of this happening was set out by issuers of SCDOs in their offering documents. However, Grange did not tell its clients that there was no assurance that any secondary market would exist or continue to exist or that there would be any liquidity for the SCDOs. Nor did Grange tell its clients of the risk that the SCDOs would be effectively unsaleable if it did not continue to provide this market. If the worst happened, that would have the consequence that the Councils and group members would have to hold the SCDOs until they matured, sometimes several years later. Only once in about April 2007 did Grange provide information to its clients, and then in fine print, about the possibility of those risks in a slide presentation for the Lehman Bros SCDO known as Federation.

For those reasons, I have found that the SCDOs did not have the characteristics that Grange promised Parkes and Swan they would have in their individual contracts: that is, the SCDOs did not have a high level of security for the invested capital, were not easily tradeable on an established secondary market or able to be readily liquidated for cash and were not suitable investments for risk averse Councils. I have also found that Grange was negligent in recommending to and advising Parkes and Swan to make those investments. Similarly, I have found that by using its powers under the 8

Wingecarribee and Swan IMP agreements to invest in SCDOs, Grange breached its obligations under those agreements. That was because it was negligent to use public money in investments with the risks that I have found the SCDOs had. In addition, Grange breached the Swan IMP agreement because the SCDOs did not provide that Council with ready access to funds, because of their lack of liquidity. It also breached the Wingecarribee IMP agreement because the SCDOs had no active secondary market and were derivatives.

For the same reasons, I have found that Grange engaged in misleading and deceptive conduct in breach of s 12DA of the ASIC Act when it promoted the SCDOs to the Councils as suitable investments.

I have also found that Grange acted in breach of its fiduciary duties as a financial adviser to each of Parkes and Swan, and in making investments as the agent of Swan and Wingecarribee under the IMP agreements. This was because Grange had a conflict between its duty to give sound financial advice to, or make investment decisions on behalf of, the Councils and its own interest in earning very large fees or profits in its sales of SCDOs that it did not disclose to any of the Councils. Grange would buy a new issue of an SCDO at between about 1.75% and 3% below face value before on-selling the issue to its clients at face value, thus making between about $1 and 2 million in profits or fees from each new issue for itself. In addition, because Grange controlled the secondary market, it set the purchase and sale prices and its profit margins in dealing with its clients at whatever level it chose. Grange also borrowed from its clients by what it called no haircut repos or repurchase agreements. These were short term loans on the security of SCDOs at BBSW + 0.1% (less than the interest rate on a bank issued FRN). It also used its powers under the IMP agreements to borrow from its clients using these repos. The

inappropriateness of such a transaction was explained in an internal email written in late 2006 by Moray Vincent, Granges director debt capital markets. Mr Vincent wrote about the problems that Grange was then suffering from having to fund the promises it had made to its clients that it would provide a secondary market and liquidity, saying:

The situation is analogous to our no haircut repos with Councils. In reality

although these guys have no haircut, they have the defence that if we dont buy the stock back from them that we knowingly took advantage of them and they would have a case against our deep-pocketed Directors. If we did repos with haircuts, this case of being uninformed would be severely weakened as the haircut is defacto an acknowledgement of the risk of price movement and counterparty being caught short with Grange going bust and the stock post haircut being worth less than their investment. However obviously the informed institution makes the haricut [sic] so large that is [sic] covers their mpl [scil: maximum potential loss] scenario that makes funding stock with informed investors prohibitive for us. (emphasis added)

This showed that not only were the SCDOs risky, illiquid, and, if sold, might realise far less than their face value, but also that Grange was conscious that the trust its uninformed Council clients had placed in it was being used to Granges advantage.

For those reasons, Grange is liable to compensate the Councils for their losses incurred as a result of their investments. I have concluded that damages should be assessed on the basis that the Councils are entitled to:

(1)

the amount lost in investments in SCDOs that have either been wiped out or paid less than 100 cents in the dollar on maturity or which the Councils sold at a loss in an effort to avert further loss (being $3 million for Swan, over $4.1 million for Parkes and $8.80 million for Wingecarribee);

(2)

the difference between the par values and the values that I have assessed of unmatured SCDOs;

(3)

in respect of the Dante notes, net present values essentially based on averaging the two possible outcomes of the current conflicting UK and US court decisions and the substantial delay that is likely before any sum is repaid to the investors.

The parties will need to calculate the amount of each Councils loss in the second and third categories of damages on the basis of the values I have found for each relevant product.

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There are many issues that the parties will need to consider in order to assist the Court to make final orders that are appropriate. Because Grange is in liquidation it cannot be ordered to make any payments at this time. Rather, as all the parties requested at the hearing, they will need to work through the reasons (over 440 pages long) to identify what orders should be made and any matters that I have overlooked or that require attention so that all outstanding issues can be resolved. These will include those findings that are relevant to resolve issues in the class action generally.

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