Michael Cole. Image: Hugh O'Brien.

By Angela Dorizas

Councils that claimed to be in accordance with state legislation when investing in CDOs ignored their fiduciary responsibilities, the author of the Cole Report has said.

In a keynote address to the Government News Local Government Investment Conference, the author of the 2008 inquiry into council investments, Michael Cole, said although CDO investments were consistent with NSW legislation, councils should have exercised due diligence.

“Recent comments made by mayors of NSW councils describing their CDO investments as having been made in accordance with the Local Government Act 1933 and the Ministerial Order on Investment seems to imply there was a sufficient condition to make such an investment and results in a responsibility for the current problem,” Mr Cole said.

“My interpretation of this statement is that the investments were not ultra vires at the time of purchase.

“It ignores the fiduciary responsibility to protect the capital of the council’s investment and accept full responsibility for all investment outcomes.”

Mr Cole said there was a “broad filter” for determining permissible investments and consequently councils were offered a “smorgasbord of choice”.

“It wasn’t enough to say ‘They were consistent with the order, they have been ticked and I have no further responsibility’,” Mr Cole said.

Rating agencies and financial advisers also share the blame for local government’s CDO crisis.

“Various government inquiries into the role of rating agencies in the CDO risk assessment process have concluded their analysis at significant shortcomings,” Mr Cole said.

“The strong ratings, which have subsequently been discredited, facilitated CDOs being aggressively marketed to councils in New South Wales as an instrument compliant with an investment order.

“An increasing number of CDO investments have been classified as impaired by auditors and a range of councils have launched legal action for misleading and deceptive conduct.”

Mr Cole said there were 40 councils Australia wide with a prospective class action against Lehman Brothers; 12 NSW councils taking legal action against the Local Government Financial Services over the Rembrandt CDO; and prospective legal action by councils in various states against the Commonwealth Bank over the Oasis, Pure and Paladin CDOs.

“It is entirely appropriate for councils to pursue their legal rights in an attempt to retrieve their investment losses, but this will be an expensive and time consuming process,” Mr Cole said.

“It is also a poor substitute for investing in an instrument which returns principal on maturity in accordance with the conditions of the original investment contract.”

Mr Cole warned that the complexity of the underlying CDO security structures could result in further legal action and “problematic outcomes”.

“In the case of Mahogany CDO, Perpetual Trustee at its own expense won a case in the UK High Court to access the underlying securities, only to encounter the negative action from the US Attorney-General on the basis of the Lehman Brothers bankruptcy and now requires further legal action and appeal in the US jurisdiction,” he said.

Mr Cole said the outlook for investments continued to be uncertain, which is why one particular recommendation of his report remained relevant.

“That is, the need for those from the local government sector who are making decisions to be aware of their fiduciary responsibility, to understand their investment objectives and importantly, understand the risks inherit with any investment decision,” he said.

“The systemic threat of excessive liquidity has now been replaced by the probability of higher inflation and this change will challenge investors to protect their real returns.”

The inaugural Local Government Investment Conference also included presentations from the NSW Department of Premier and Cabinet – Local Government Division deputy-director general, Ross Woodward; Local Government Managers Australia chief executive officer, John Ravlic; TCorp general manager, Michael Allen; and University of NSW associate professor of actuarial studies, John Evans.

Full coverage in the April/May issue of Government News magazine.