Will Lehman eat porridge for SCDOs?
The liquidators of Lehman Brothers Australia are appealing a landmark Federal Court decision that found it liable for losses suffered by a number of local councils and charity groups.
Late last year the Federal Court became one of the first courts in the world to hold an investment bank to account for its role in selling synthetic collateralised debt obligations (SCDOs) – the high-risk financial products that formed the black hole at the centre of the GFC that were closely linked to the subprime mortgage crisis – to vulnerable consumers in the lead up to the recession. In a class action brought by 72 plaintiffs, including 3 local councils (Wingecarribee and Parkes Shire Councils and the City of Swan) as the representative applicants, it was alleged that Lehman (previously known as Grange Securities) sold or advised each Council to buy SCDOs between 2003 and 2009 and lost a significant amount of money after following Lehman’s advice. The decision of Justice Rares not only throws the spotlight on the underhand investment practices of Lehman but also on the state of Australia’s misleading or deceptive conduct laws, which His Honour describes as “legislative porridge”.
At the heart of the case is the very question that opens the judgment: “How was it that relatively unsophisticated Council officer’s came to invest many millions of ratepayers’ funds in these specialised financial instruments?”
According to Justice Rares, the answer was as a result misleading and deceptive conduct, breach of contract, breaches of fiduciary duties and negligence with His Honour finding in favour of the class in respect of each such claim. In a meticulous 450 page decision, Justice Rares found that:
• Lehman had made a number of misrepresentations, such as that SCDOs were conservative investments that complied with statutory and Council policy requirements and were similar in nature and risk to financial products the Councils had previously dealt in, as well as that Lehman observed prudent, income-defensive practices when investing on behalf of local government;
• as many of the misrepresentations were enshrined in written agreements with some of the Councils, Lehman was liable for breach of contract;
• the fact that Lehman had earned unspecified profits from its relationship with Councils and failed to avoid a conflict between its duty to give sound financial advice and its own interest in earning significant profits in its sales of the SCDOs and in repurchasing them from the Councils, it breached fiduciary duties it owed them; and
• perhaps, most controversially, because the Councils were handling ratepayers’ funds, that Lehman owed the Councils a duty to exercise reasonable care and skill in giving investment advice but breached this duty in using the public money in such high risk endeavours; and
• the defence of contributory negligence was not available to Lehman.
Although Justice Rares held Lehman liable to compensate the plaintiffs for all their losses, it is still unclear how much they will be able to recoup. It also remains to be seen whether there may be further waves of class actions by aggrieved investors (at least against those financial advisers and investment banks still standing). The plaintiffs however may be waiting for some time for an ultimate outcome – if the appeal proceeds it may take years and any disbursements even longer – although Lehman’s liquidator has indicated its hope that creditors may accept a renewed offer of settlement in the coming months.