Devil in the detail for complex case

Elisabeth Sexton
June 17, 2011


Untangling the Lehman mess will take a while, writes Elisabeth Sexton.

The organisation most identified with the global financial crisis is Lehman Brothers. The product most associated with it is the collateralised debt obligation.

So, how hard can it be to run a compensation suit against the Australian arm of the collapsed investment bank for more than $250 million lost on CDOs?

On the final day of a class action by 72 local councils, charities and churches in the Federal Court last week, Justice Steven Rares described it as ''a very complicated case''.


Barrister for the councils Tony Meagher.

''It will take me a while to work out what the answer is to the questions you have posed here,'' the judge said.

One reason for the complexity is that the class action has not one but three local councils as lead members. Two of them had slightly different contractual agreements with Lehman and one bought from the firm periodically. Each dealt with diverse Lehman executives.

Another is that the class action made claims of negligence, misleading and deceptive conduct, breach of contract and breach of fiduciary duty. This blended principles of common law, the Corporations Act and the Fair Trading Act, each with its own wrinkles in terms of what evidence is required and what defences are available.

The liquidator of Lehman Brothers Australia, Stephen Parbery, mounted a detailed defence to all these allegations. In a report to creditors on June 7, Parbery, a partner of the accounting firm PPB Advisory, said that ''judicial determination of a series of difficult factual and legal issues'' in the class action would not only establish the validity of the claims of its 72 members, but help him adjudicate similar claims by 278 other Lehman clients.

Another complicating factor is the very nature of the financial products at the heart of the case, which raises the question of why local councils ever invested ratepayers' funds in them.

Five expert witnesses were called to debate technical issues including just what the councils ended up with when they bought interest-bearing notes bearing easily digestible names like Kakadu, Coolangatta, Endeavour, Blue Gum and Federation.

The class action involves 39 issues of synthetic CDOs, securitised instruments linked via credit default swaps to the creditworthiness of a ''reference'' portfolio of typically 100 companies.

They pay interest, commonly a market rate such as the bank bill swap rate plus a fixed extra component. If there are no defaults by the reference companies, the principal is repaid to the investor on maturity.

They bear some similarity to an insurance product, in that the investor is paid interest (akin to a premium) and the counterparty can access the principal sum (or claim on its insurance) if a certain portion of the companies in the portfolio default on their borrowings.

They are known as synthetic products because the counterparty does not have to suffer an actual loss from lending to the reference companies in order to claim.

Part of the answer as to why NSW councils bought such products is that investments in CDOs were allowed under an order published by the Minister for Local Government in 2000.

Its list of approved investments included ''any securities'' given a credit rating of A or above by Standard & Poor's or A2 or above by Moody's. Securities rated by Fitch Ratings were added to the list in 2005.

The ministerial order (revoked after the global financial crisis) created a market niche for firms such as Grange Securities, an unlisted public company set up in 1994 that became Lehman Brothers Australia 13 years later.

A retail broker of interest-bearing securities such as bonds, Grange held a financial services licence and was recognised as a participating organisation by the Australian Stock Exchange in 2000.

When synthetic CDOs hit the Australian market in 2002, Grange underwrote and sold issues put together by ABN AMRO, Deutsche Bank, Credit Suisse, BNP Paribas, Nomura, Barclays Capital, Calyon, Morgan Stanley, HSBC, Merrill Lynch, Toronto Dominion Bank and Lehman.

In March 2007 the US parent company of the Lehman group bought Grange and changed its name to Lehman Brothers Australia.

It marketed its last synthetic CDO in June 2007, when credit markets began to seize up. The global financial crisis brought down the global Lehman group 15 months later.

The class action heard evidence that Grange executives regularly attended conferences of local government finance officers and followed up with cold calls.

By 2006, its clients included 85 NSW councils, 40 Victorian councils, and 12 Western Australian councils.

In debate during closing submissions, Justice Rares repeatedly raised the ''trust'' that council officers placed in Grange.

''You were offering this service to councils, saying 'we know what your business is; we know what you want from us; these are the things we are suggesting to you','' the judge said.

Lehman's barrister, John Sheahan, SC, responded that council staff had obligations when investing ''large amounts of public money,'' which included carefully reading documents sent to them by Grange.

''These are very complicated concepts, these products,'' the judge said. ''You don't expect people to read everything to the nth degree.''

Sheahan also said the documents made it easier for officers to seek the views of colleagues or people outside the council.

''If they are getting advice from you, why would they?'' Justice Rares asked. ''Your business was to go out and sell these things to councils. Why would I expect in the ordinary course of things that once they have a trusting relationship that you thought they would be going off questioning it? You were getting them a good return, no question about that, until the GFC hit.''

Sheahan said the risks of investing in CDOs were all spelt out in ''simple, accurate'' terms in documents sent to the councils.

The finance manager of Parkes Shire Council in the central west of NSW, Bob Bokeyar, was handed some of those Grange documents in the witness box.

He had earlier given evidence that he made investment decisions based on conversations with a Grange executive, Jill May.

He read a one-page summary of a synthetic CDO called Forum, in which Parkes Shire Council invested $1 million in 2003, which referred to risks of price volatility and temporary drops in liquidity.

"If I had read that summary, I wouldn't have invested in that product; I can tell you that absolutely," Bokeyar told the court.

Sheahan described Bokeyar as having ''an almost relentless disregard of information''.

In his closing submission, Sheahan said it was hard to work out just what Parkes Council was alleging against Grange.

''We gave in simple terms an explicit written disclosure to the person they put forward as their investment officer,'' Sheahan said.

''He says to your Honour that if he had read it at the time, he would not have invested because it disclosed the very risks that have become the whole focus of the case, liquidity and price volatility.

''We disclosed it in this document in terms that would have put him off investing - if he had bothered to read it.''

The barrister for the councils, Tony Meagher, SC, said in his closing submission that the documents sent to his clients were ''snippets of hints'' about risks, without ''putting them squarely''.

''If Grange has undertaken to give advice and only to propose products which are suitable for local government, it's not for the client to say 'by the way, we don't understand how these products work','' Meagher said.

''Grange knew that these people had obligations to invest prudently in the same way that trustees had such obligations; it knew that they were not in a position where they could expose the investments to any real risk of capital loss,'' he said.

''It must have been appreciated that these investment officers were proceeding on the basis that that risk didn't exist.''

Grange was ''holding itself out'' as an expert, he said, and if there was any question about the suitability of a particular product it had to ''bring it to the attention of the client in a way which the client is likely to understand''.

Lehman, which decided to call no witnesses, argued that the judge should put more store in the documents than in ''distant, interested recollections'' of conversations recounted by council witnesses.

Officers from Wingecarribee Shire Council in the NSW southern highlands put ''their own gloss'' on what Grange executives David Rosenbaum and Stewart Calderwood had told them, Sheahan said.

Wingecarribee's general manager, Mike Hyde, gave evidence that the pair had promised the council would be able to redeem its investments from Grange within a month at face value.

He resisted when Sheahan suggested to him that Grange's undertaking was to buy back the CDOs at the prevailing market price.

''You can't say to his Honour on your oath can you, Mr Hyde, that either of the Grange representatives said to you: these products are capital guaranteed?'' Sheahan asked.

''I can't say they used those actual words one after the other,'' Hyde replied.

In his closing submission, Meagher said it was to the credit of council witnesses that they could not recall particular expressions being used and instead told the court ''that's what they implied, that's what I understood''.

''The response to that might be that's because they were very clever about the way they went about it in that they managed to create the impression without using the words,'' he said.

Meagher said Grange failed to make clear that the only party likely to buy any CDOs back from councils was Grange itself, a ''small, highly leveraged'' company with $10 million in capital.

''They never said that if the value of these gets below face value, the reality is that Grange can't afford to make a market and will not make a market,'' Meagher said.

Quoting from an internal Grange document, he said ''they recognised that if there was an adverse global credit event, the clients would want to sell, the price would fall and the reality was in those circumstances that Grange could not afford to make a market - as indeed happened''.

Read more: http://www.smh.com.au/business/devil-in-the-detail-for-complex-case-20110616-1g64m.html#ixzz1RTAMyGiS