Lehman Brothers, Grange liable for council sub-prime losses

By Julian Bajkowski

Local governments, charities and and not for profit groups have finally won a phyrric victory over collapsed US investment bank Lehman Brothers, after the Federal Court ruled that the institution is ultimately liable for almost $250 million in losses suffered by investors.

Handed down by Justice Steven Rares on Friday, the decision is a legal landmark for local government investors around the world because it sets out important precedents over the treatment of investors and the duty of care surrounding disclosure ofassociated  risks in complicated financial products.

The class action against Lehman was backed by litigation funder IMF and front-run by two NSW councils, Wingecarribee and Parkes as well as the City of Swan in Western Australia. Another 69 parties, who cannot be named for legal reasons, also joined in the action.

Despite the legal win, Australian ratepayers and their councils dudded by Lehman will be lucky to get back 30 cents in the dollar according to litigation funder IMF.

At the core of the matter is whether councils were effectively duped into buying derivative financial products well beyond their stated risk appetite, largely  because they represented soft targets for unscrupulous salespeople over more sophisticated investors.

Dubbed  synthetic collaterised debt obligations, or SCDOs, the toxic financial products were ultimately linked to sub-prime mortgages that heralded the start of the global financial crisis.

The derivatives were sold to local governments and not for profits in Australia through Lehman’s subsidiary Grange Securities.

Justice Rares said the question of how “relatively unsophisticated Council officers came to invest many millions of ratepayers’ funds in these specialised financial instruments” was the fundamental question in the case.

In a stinging assessment, he went on find Grange had essentially tricked the local governments into taking up the derivatives against their instructions and intentions.

“The cardinal fact at the heart of the assessment process is that Grange caused the Councils to buy the Claim SCDOs (either by recommending and advising them, or using its IMP agreement mandate, to do so) in circumstances where they would not have done so at all, had Grange fulfilled its contractual obligations, duty to exercise reasonable care and not engaged in conduct that was misleading and deceptive or in breach of fiduciary duty,” Justice Rares said.

He said that: “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.”

The finding that Lehman’s and Grange misled the local governments has big implications for local government investors across Australia.

A key aspect is that the legal decision makes clear that the councils who successfully sued could not be regarded as so-called ‘sophisticated investors’ because they did not have sufficient knowledge on the operation of complex financial products on which to make an informed judgement of risks.

The characterisation of local government investors as more akin to retail, or typical mum and dad investors, has serious implications for institutions selling financial services to councils because it has the potential to change the level of disclosure and suitability of products.

The success of the class action and the precedents it has set also opens the door for local governments to sue banks over supposedly safe investment schemes that go on to blow-up.

Leading academics such as Professor Justin O’Brien from the University of New South Wales’ Centre for Law, Markets and Regulation have questioned why it was ultimately commercial litigation funders rather than authorities who took Lehman to task on behalf of ratepayers.

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