Recently, the Australian Federal Court handed down a landmark decision in a class action involving three representative local councils (Councils) in Wingecarribee Shire Council v Lehman Brothers Australia (in liq)  FCA 1028. This is the first decision anywhere in the world that examines the conduct of an investment adviser regarding the manufacture and marketing of synthesised collateralised debt obligations (SCDOs). It sets an important precedent on the treatment of unsophisticated investors and the duties around disclosure of risks in complicated financial products such as SCDOs. It is also the first time that the courts have classified local councils as "unsophisticated" investors. This may pave the way for similar types of investors to argue that they fall within the same classification.
The court's observations about the "legislative porridge" created by the current legislative framework contained in the Australian Securities and Investments Commission Act 2001 (Cth), the Corporations Act 2001 (Cth) and the Competition and Consumer Act 2010 (Cth) in relation to "misleading and deceptive conduct" may be addressed by Parliament. We welcome returning to a simple statutory prohibition against "misleading and deceptive conduct".
Prior to 2007, Lehman Brothers Australia (now in liquidation) (Lehman Australia) sold SCDOs to various local councils, charities, church groups and not-for-profits. At the time the SCDOs were sold, they had a high credit rating (at least equivalent to the credit rating of the four major Australian banks) and offered higher interest rates. These SCDOs went sour during the global financial crisis. As a consequence, these investors incurred substantial losses.
A single judge of the Australian Federal Court, Rares J, held that Lehman Australia is liable to compensate the investors for losses incurred as a result of investing in SCDOs. The fundamental question at the heart of the proceedings was this: "How was it that relatively unsophisticated Council officers came to invest many millions of ratepayers' funds in these specialised financial instruments?". The court found that the only way the Councils could have come to invest in SCDOs was because Lehman Australia had either recommended and advised them, or used its Investment Managed Portfolio (IMP) agreement mandate to purchase them. In doing so, the court said Lehman Australia "preyed on [the Council officers'] lack of expertise and the trust the Councils placed in its expert advice...".
The facts and findings set out below are a summary of the views of the judge and are not our views.
The relationship between Lehman Australia and the Councils
The Councils were typically conservative and riskaverse investors. They had usually invested in products such as bank bills, term deposits and bankissued Floating Rate Notes (FRNs). Council officers had little financial or investment experience outside those products. The Councils were unsophisticated investors. They were concerned to ensure that none of their investments had a substantive risk of loss of the capital invested but earned the best returns available consistent with their conservative investment policies.
Lehman Australia was engaged to act as the Councils' financial adviser. It was entirely conscious of their lack of financial sophistication. Lehman Australia represented to the Councils that it understood their investment requirements.
The Councils relied on Lehman Australia to make appropriate recommendations for investments that suited them. Council officers were not in a position to make independent investment decisions. Lehman Australia's persuasion informed or changed the Councils' perception of the material risks associated with the unfamiliar new SCDOs. Lehman Australia encouraged the Councils to infer that SCDOs with similar credit ratings had similar risks as other basic financial products.
DECISION: COMPREHENSIVE LOSS
Breach of fiduciary duties
First, Lehman Australia, as the Councils' investment adviser, owed them fiduciary duties, independent of any contractual obligation owed to the Councils. Lehman Australia had an obligation (a) not to obtain any unauthorised benefits from its relationships with the Councils and (b) not to put itself in a position where its interests or duties conflicted, or where there was a substantial possibility of a conflict arising.
Lehman Australia breached those fiduciary obligations. It made substantial profits in relation to the underwriting, structuring and selling of SCDOs. On average, Lehman Australia was making between $1 million to $2 million of profits per SCDO. It failed to (a) adequately disclose its own financial incentive to the Councils and (b) obtain informed consent on recommended investments. Whilst it disclosed to the Councils that it had an "interest" in the transactions, it did not disclose the extent of that interest. Consequently, the Councils could not have made a fully informed decision.
Lehman Australia also borrowed from its clients on the security of the SCDOs, on terms far less favourable than what could be achieved by borrowing from commercial financiers. Some of the clients lent money to Lehman Australia on the basis that the SCDOs offered as security had a value of 100% of their face value ie the SCDOs were as good as cash. The clients were not aware that the SCDOs could depreciate. Lehman Australia had not explained fully the risks of depreciation in the value of SCDOs. Lehman Australia capitalised on the Council's ignorance of this risk and breached its fiduciary duties.
Second, Lehman Australia breached its agreements with the Councils by selling products that did not meet promised contractual specifications. The products sold (a) did not have a high level of security to protect the invested capital; (b) could not be easily traded on a secondary market; (c) were illiquid and (d) were inappropriate investments for risk-averse clients.
Misleading and deceptive conduct
Third, Lehman Australia engaged in misleading and deceptive conduct. Lehman Australia used the SCDOs' high ratings as a key selling point. False representations were made that SCDOs (a) had high credit ratings, which made them equivalent to the debts of major Australian banks; (b) were suitable for conservative investment strategies; (c) complied with the statutory and Council policy requirements; (d) had the risk profiles equivalent to traditional FRNs; (e) were prudent and capital-protected investments; (f) were readily redeemable for cash and (g) were tradeable on a secondary market.
Fourth, Lehman Australia was negligent in recommending and advising investments in SCDOs. Lehman Australia owed the Councils a duty of care as the Councils' financial adviser. This required it to provide a full and accurate explanation of the products it was marketing, recommending and purchasing. Alternatively, it had an obligation to act with reasonable skill and care in performing its functions under the IMP agreement. Lehman Australia breached its obligations by causing the Councils to invest in the SCDOs, which were illiquid and were not able to be sold on a secondary market. This conclusion was based on the Councils' complete reliance on Lehman Australia to provide appropriate investment recommendations.
The court rejected all Lehman Australia's arguments on absolving it from liability based on disclaimers, proportionate liability, concurrent wrongdoers and concurrent liability.
- None of the disclaimers in the presentations and documents provided to Councils and in the agreements were adequate.
- The court did not attribute any responsibility for the loss to ratings agencies as Lehman Australia's misuse of those ratings in its sales pitch caused the Councils to invest in SCDOs. The ratings agencies had no control over or responsibility for how Lehman Australia used ratings or what Lehman Australia told the Councils.
- The attempt to exclude liability by reference to acting in accordance with peer professional opinion was rejected. The court said this had no application to all the conduct complained of. Lehman Australia had also not proved the existence of any professional practice to make the recommendations it made to the Councils. Evidence of similar offers by other banks to the Councils was insufficient. The existence of such a practice did not displace the specific contractual requirements on how the Councils' money should be invested.
All the members of the class action must be compensated. The calculation of damages may have to be postponed if an appeal is lodged by Lehman Australia. Lehman Australia has yet to announce if it will appeal.
The key question - Is this decision a game changer for investors and advisers, or is it a case confined to its facts?
We think the court's decision will have an impact, both internationally and locally, given SCDOs have been sold all over the world. The court's findings will put many investment bankers and other professional advisers on the alert. The judgment sets a high bar for investment advisers.
Where a professional recommends a complex financial product, ordinarily clients are not equipped to properly analyse the basis on which the recommendation is given. It is not essential for a client to critique each recommendation in any detail once a professional has gained the client's confidence and the client continues to have that confidence in future dealings. Professional advisers should understand this when preparing their sales pitches, recommendations, presentations and documents.
Characterising the Councils as "unsophisticated investors" as they lacked sufficient knowledge about the SCDOs' operation on which to make an informed judgment of risks has wider implications for institutions selling financial services to councils, charities, church groups and not-for-profits. This makes this category of investors more like retail, or "mum and dad"-type investors. It hails potential changes to the level of disclosure and suitability of products for them. Clients need to be specifically informed if the products sold are not suitable for or are well beyond their stated risk appetite. They need to be told if there is a prospect that some part of their capital may not be recovered and that there may potentially be no redress for this loss.
Each circumstance will determine what exactly constitutes adequate disclosure by a fiduciary of its own financial interest. Professional advisers will have to tread with caution when faced with a situation where they have a potential conflict of interest. If they wish to contract out of a common law duty of care, they will have to state that in very clear words and ensure that their clients understand the effect of that disclaimer.
In addition, caution will have to be exercised in promotional material or in material that seeks to summarise complex financial products and associated documentation. The court disregarded the fact that the documents presented to the Councils referred them to underlying documents. It said that the recommendations made to the Councils were meant to and did induce the Councils into relying on them. It was "inappropriate and unhelpful" for Lehman Australia to refer the Councils to voluminous documentation. In fact, the Councils had no obligation to look any further than what was presented to them. In practical terms, this may mean that professional advisers cannot absolve themselves by providing a synopsis of documentation and then referring their clients to the actual documents for the details. They have the onus of explaining properly those documents and highlighting anything material.
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