Posted on September 28, 2012 by
Some lessons in councils’ landmark court win on failed investments
On Friday 21 September 2012, Rares J in the Federal Court of Australia gave judgement in favour of 72 local councils and charities who had invested with Grange Securities, an off shoot of Lehmann Brothers in the US, claiming losses exceeding $270 million: Wingecarribee Shire Council v Lehmann Bros Australia Pty Limited (in liquidation)  FCA 1028.
The plaintiffs argued that Grange (the name by which the company traded before being taken over by Lehmann Brothers in 2007) knew of the toxic nature of the investments it was offering and was conflicted in selling these to the councils and charities without detailing the risks involved.
In so doing, the plaintiffs argued that Grange had breached a variety of legal obligations it owed to the councils and charities and had preferred its own commercial interests in selling the investments to its clients’ interests in making properly informed investment decisions.
Synthetic collateralised debt obligations (SCDOs)
The Grange product was a series of loan portfolios from the US, known as ‘collateralised’ debt obligations because they were backed by mortgages. However, they were what we now term ‘subprime’, being loans to lower income earners who may not have been able, and who may never have been able, to repay the loans.
Unlike in Australia where entry into a loan agreement normally creates a personal obligation to repay the loan, US mortgagees can generally only pursue the borrower to the point of reclaiming the security, what we would term a ‘non-recourse’ loan. Ordinary home loan mortgages in the US are non-recourse: if the borrower fails to repay the loan, the lender is at risk of realising any asset value loss of the security.
With so many loans defaulting at the same time in 2007, the glut of properties on the market meant that homes became virtually worthless overnight, and the loan portfolios followed them into oblivion.
Rating, risk and government
The rating of the Grange product was crucial to the potential investors who were NSW councils because of the requirements of section 625 of the Local Government Act 1993. This section authorised councils to invest only in forms of investment notified by order of the Minister and published in the NSW Government Gazette.
The last such order before the Lehmann Brothers collapse and the Global Financial Crisis was published in the Gazette dated 29 July 2005. Apart from the usual State and Commonwealth securities and debentures, the order authorised investments that had a Moody’s, Standard & Poor’s, or Fitch’s rating in certain defined categories.
Rares J commented unfavourably on this practice as follows:
‘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.’
The councils’ claims
The representative actions on behalf of the councils were brought by Wingecarribee Shire Council and Parkes Shire Council in New South Wales, and the City of Swan in Western Australia.
The councils claimed that Grange was bound to them to provide sound financial advice and that it had failed to do so by providing advice that was misleading as to the risk profiles of the products it was selling, had exposed themto unnecessary and unacceptable investments risks, and had caused them damage when the investments failed.
The councils claimed that Grange had breached its contractual obligations to them, had engaged in misleading and deceptive conduct, was negligent and, moreover, had breached its fiduciary obligations to them by preferring its own commercial interests in selling the products over its obligation to provide independent and frank advice to them so as to enable them to make properly informed investment decisions.
Grange denied the council’s claims.
It maintained that it was a seller of financial products and, when it sold its products, it provided the usual caveats and written disclaimers, requiring its clients to make their own minds up about the qualities of its products.
Grange also argued that ratings agencies were ‘concurrent wrongdoers’ and should be considered culpable in relation to any alleged misrepresentation about the products because of the practice of giving an averaged rating to bubdkled investments could have the effect of masking the more risky investments in the bundle that had lower ratings if considered individually.
The Court’s decision
Rares J rejected Grange’s assertion that it was a mere seller.
His Honour found that Grange had actively paraded its credentials and expertise as investment advisers to local government and had promoted itself as offering advice on where a council should invest its money.
Rares J held that while Grange had disclosed to the councils the link between itself and the vendors of the SCDO’s, it had failed to highlight the financial benefit that it derived from selling such products to its clients.
His Honour dealt with the claim that the ratings agencies should share blame for the loss as follows:
‘Representations are not conveyed in a vacuum. They are communicated in a context. The mere publication of ratings by the rating agencies in association with, including in the name of, a Claim SCDO did not of itself make the representation about material risks or risk profile of one product, such as the SCDO, as compared to another class of product with the same rating, such as an ADI issued FRN. Grange encouraged the Council officers to use their existing understanding of what a credit rating signified in respect of products they were familiar with as the basis for them inferring that SCDO products with similar ratings, that Grange promoted to them, involved similar risks.’
Rares J held that Grange knew of the conservative risk profile the councils required and that by basing its advice on the ratings agency assessment and exploiting the councils lack of expertise in the complex and confusing world of international securities trading, it had represented that its products were both safe and of a higher than average potential yield.
His Honour found that, in reliance on such advice, the councils bought up $270 million worth of toxic products, which soon evaporated in the GFC.
His Honour held that Grange favoured its role as a seller to its fiduciary obligations to the councils, and the coiuncils paid the price. In so doing, Grange had breached its fiduciary responsibilities to them.
NSW Government responses to the Global Financial Crisis
Following the Lehmann Brothers collapse and the onset of the global financial crisis, the NSW Government initiated a review into local government investments.
The ‘Review of NSW Local Government Investments‘ by Michael Cole made a series of recommendations, the most significant of which was to change the investment order under section 625. This was done on 15 August 2008 (Gazette, p.7638).
The current order does not authorise investments that are tied to a ratings agency figure.
The Cole report also recommended that councils look not only to the order for direction, but also to the restrictions placed on investment by the Trustee Act 1925 (Recommendation 6).
Anticipating the Court’s ultimate findings, the Cole report also recommended that ‘Product manufacturers/distributors should be excluded from being appointed investment advisors to councils’ (Recommendation 3).
The Cole report generally approved of a document produced by the Western Australian Department of Local Government and Regional Development titled ‘Investment Policy – Local Government Operational Guidelines No 19 February 2008’. The NSW Division of Local Government’s ‘Investment Policy Guidelines’ published in May 2010 are similar to the WA document.
Although the State Government has largely accepted the recommendations of the Cole report, it is important to recognise that councils are still exposed to investment risk.
The Investment Policy Guidelines are merely a guide. They do not have the force of law, even though they do contain valuable advice for the setting up of investment portfolios for councils.
The Court’s decision gives added prominence to the guideline on investment advisors, which states:
‘The advisor must be an independent person who has no actual or potential conflict of interest in relation to investment products being recommended…. (and is) ..required to provide written confirmation that they do not have any actual or potential conflicts of interest’.
Further, Councils should not assume that just because an investment is allowed by the Investment Order it is therefore safe.
Finally, the Court made it clear that ratings are merely one tool in the context of a worldwide, complex market in investments and securities.