Australia: High standard of care when dealing with unsophisticated investors and public funds

Last Updated: 19 January 2013
Article by Nicole Wearne and Steven Donley

Wingecarribee Shire Council v Lehman Brothers Australia Ltd (in liq) [2012] FCA 1028

The unreported decision of Rares J contains a well reasoned and detailed judgment from His Honour canvassing many current legal topics ranging from representative proceeding process to the duty of financial advisers in negligence, under statute and the imposition of fiduciary duties. This article confines itself to a summary of the facts, the key findings and implications for financial advisers and their insurers arising from the judgment.

Facts

Three local councils, Wingecarribee Shire Council (Wingecarribee), Parkes Shire Council (Parkes) and the City of Swan (Swan) sued Lehman Brothers Australia Ltd (in liq), formerly Grange Securities Limited, (Lehman Bros) in the Federal Court of Australia seeking to recover losses sustained by the Councils due to their acquisition, through Lehman Bros, of collateralised debt obligations including synthetic collateralised debt obligations (SCDOs). The councils were representative applicants for 72 Australian investors who lost approximately $250 million on their investments during the GFC.

From 2003, the councils sought advice from Lehman Bros as to the investment of surplus funds. Lehman promoted itself to councils as a financial adviser that understood the investment requirements of local government, including relevant legislative and policy constraints. In late 2000, the New South Wales Minister for Local Government had made an order under the Local Government Act 1993 (NSW) that allowed councils to invest in any securities at all, however exotic, that had been rated "A1" or above by the ratings agencies. Lehman Bros were aware that the councils wished to invest in a conservative and risk averse manner and that the councils' officers were unsophisticated investors. Lehman Bros recommended and sold SCDOs to the councils. Between 2003 and 2007, the councils purchased SCDOs on an ad hoc basis through a series of individual contracts. In 2007, Wingecarribee and Swan entered into Individual Managed Portfolio (IMP) agreements with Lehman Bros, which authorised Lehman Bros to invest council funds in financial products with credit ratings of AA and above and in classes approved by a Ministerial order (which permitted investments in SCDOs).

At the time the SCDOs were issued they had high credit ratings, however returns or losses on the investments were based upon the accuracy of the holder's predictions concerning the occurrence of credit events, being ratings downgrades or defaults on the loans upon which the SCDOs were based. At the time of issue, the SCDOs provided a relatively stable fixed-income return of around 2 percent above the bank interest rates. However, it was known by Lehman Bros that the capital invested could be particularly vulnerable to loss upon the occurrence of major market events. Further, Lehman Bros was the only informed investor transacting in SCDOs on the secondary market, meaning the councils' investment was likely to be illiquid in unfavourable conditions.

As a result of the GFC, many of the SCDOs suffered adverse credit events in 2007. Three of the SCDO investments were completely wiped out, and 11 were frozen by court orders made in international proceedings arising out of the liquidation of the US parent of Lehman Bros.

The councils claimed against Lehman Bros for breach of the ad hoc purchase contracts, breach of the IMP contracts, negligence, breach of fiduciary duty, and misleading and deceptive conduct contrary to section 12DA(1) of the Australian Securities and Investments Commissions Act 2001 (Cth) (ASIC Act). All claims succeeded.

Breach of Contract

The Court found that the ad hoc purchase contracts required Lehman Bros to supply investment products with the following characteristics:

  1. a high level of security for protection of the invested capital;
  2. easily tradeable on an established secondary market;
  3. could be readily liquidated to cash;
  4. appropriate for a public authority with risk-averse investment goals; and
  5. a secure income stream.

The contracts also required Lehman Bros to exercise due care and skill in the provision of investment advice.

The later IMP contracts authorised Lehman Bros to invest its monies subject to the following relevant conditions:

  1. investments were to comply with the councils' investment guidelines requiring risk aversion and capital preservation;
  2. the councils were to have ready access to the funds without penalty;
  3. there must be an active secondary market; and
  4. investment in derivatives was prohibited

The court ruled that Lehman Bros breached the ad hoc contracts and the IMPs by selling SCDOs with the following characteristics:

  1. the high credit ratings falsely represented that the invested capital was secure, when it was vulnerable to the consequences of extreme market conditions;
  2. there was no established secondary market;
  3. the SCDOs were difficult to liquidate; and
  4. the complexities of SCDOs made them unsuitable for unsophisticated and risk-averse investors.

Lehman Bros was also found to have breached its contractual obligations to exercise due care and skill.

Negligence

His Honour found that Lehman Bros owed a common law duty to the councils to exercise reasonable care in the provision of investment advice. When determining the scope of the duty, the court had regard to the councils' lack of investment sophistication and the fact that public funds were involved. Lehman Bros was found to have breached its duty of care by representing that SCDOs were suitable, given the complexity of the investment, the risks to the invested capital and the lack of liquidity.

Breach of Fiduciary Duty

The court ruled that Lehman Bros owed fiduciary duties to the councils when carrying out ad hoc purchases of SCDOs. Lehman Bros had, when negotiating the SCDO transactions, undertaken to act in the councils' interests when exercising investment powers and discretions. Thus, Lehman Bros was placed under fiduciary duties to refrain from obtaining any unauthorised benefit and to avoid any conflict of interest. The terms of the IMPs attenuated the earlier position somewhat, permitting Lehman Bros to receive fees from the SCDO issuers and to act for both buyer and seller at the same time.

Swan was not using Grange as its exclusive source of financial advice or its sole means of investing its funds.Lehman Bros argued that, consequently, Swan could not have used it as a financial adviser on discrete investment products. His Honour rejected that argument.

"Relationships, and their incidents, depend on what happens, not on preconceived notions such as (Lehman Bros) seemed to assert, that a financial adviser had to be a confidant of its client in respect of every aspect of the client's finances. There is no reason why( Lehman Bros) could not have been an adviser, owing duties, including fiduciary duties, to a council such as Swan, on a single transaction or a number of individual transactions over a period. After all, a family solicitor is ordinarily in a fiduciary relationship with and must advise his or her clients on individual issues, such as the purchase or sale of property, the drawing of a will or their taxation affairs, even though the solicitor may not know about all aspects of the clients' affairs. The facts, not preconceptions, determine what the relationship is and what duties are owed by the professional."1

Lehman Bros was found to have breached its fiduciary duties in three key respects:

  1. by receiving substantial undisclosed fees in connection with the SCDO transactions;
  2. acting in its own interests by earning large profits from every sale and by controlling the secondary market; and
  3. entering into re-purchase agreements with the councils whereby the councils effectively leant funds to Lehman Bros at below market rates.

Misleading and Deceptive Conduct

Lehman Bros' representations regarding the capital risk and suitability of the SCDOs were found to constitute misleading and deceptive conduct contrary to section 12DA(1) of the ASIC Act.

Implications

The decision has implications for financial advisers and their insurers. The decision highlights that courts will impose a high standard of care on financial advisers, especially where the management of public funds is concerned or where investors are relatively unsophisticated.

When advising unsophisticated clients, even business or institutional clients, financial advisers must fully disclose risks and assist clients to make good decisions consistent with their own guidelines and policies. The judgment also calls into question the extent to which advisers can rely on the credit ratings assigned to products by ratings agencies.

Finally, financial advisers who are given a discretion to invest on behalf of their clients must be mindful that fiduciary duties will be imposed upon them. The imposition of such a duty requires the adviser to ensure that they provide sufficient disclosure of their interests and obtain fully informed consent from their client to the benefit they might obtain. A general statement that the adviser will receive a benefit is not sufficient. The extent of the fee must be disclosed. The new statutory regime introduced under the Future of Financial Advice (FOFA) package of legislation which took effect from 1 July 2012 is intended to ban conflicted remuneration structures including commissions. However financial advisers and licensees ought to review their adviser agreements to ensure compliance with the new provisions and to make clear their interest where an authority to exercise a discretion to invest is held.

Footnotes

1[2012] FCA 1028 at para 226

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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