- The US sub-prime crisis and the consequent liquidity freeze have to date resulted in relatively little litigation in Australia (in contrast to the US), but further proceedings are likely.
- Sub-prime related litigation has the potential to contribute to the development of investor class actions, and provide guidance as to what conduct is likely to mislead or deceive a non-retail investor.
It is a measure of how interconnected the global economy is that a collapse in a segment of the US home loan market can wreak havoc throughout the world's financial system. In the space of six months, the fallout from the US sub-prime mortgage crisis wiped billions of dollars from the balance sheets of major financial institutions and led to a liquidity freeze. This arose because financial institutions became extremely reluctant to lend to each other due to uncertainty as to who would wear the estimated global sub-prime related losses of US $1 trillion. The crisis can also be viewed as having contributed to the recent decline in equity markets.
In Australia alone, exposure to sub-prime backed securities led to the collapse of Basis Capital, and Absolute Capital is in voluntary administration. The resulting liquidity freeze has also had serious consequences for highly geared groups like MFS/Octaviar, Allco and Centro, and non-bank lenders who rely on global credit markets to obtain funding (notably RAMS Home Loans).
An overview of the US experience
The sub-prime crisis has, perhaps unsurprisingly, triggered a wave of litigation in the USA. Litigation continues to be commenced against many financial market participants associated with sub-prime mortgages and securities. The causes of action have been diverse, and include:
- sub-prime mortgage lenders being sued by shareholders for failing to disclose that they were experiencing higher than average default rates on sub-prime loans;
- the Securities Exchange Commission prosecuting sub-prime lenders for accounting fraud for seeking to hide their losses;
- issuers of sub-prime backed securities being sued by investors for breaches of contract and their fiduciary duties; and
- a shareholder class action against a credit ratings agency alleging the agency engaged in securities fraud by assigning excessively high ratings to sub-prime backed bonds. It is alleged that the revelation of the inflated ratings caused the agency's share price to fall.
In contrast to the USA, in Australia relatively few proceedings have been commenced or threatened that relate to the sub-prime crisis (even indirectly). Those that have can be grouped in to two categories:
- claims against listed companies or entities significantly affected by the liquidity freeze which have suffered significant declines in their share or security prices; and
- claims against participants in the financial market who have some involvement with structured finance products.
Litigation consequences: entities caught out by the liquidity freeze
In Australia, much of the publicity around sub-prime litigation has been generated by revelations to the market that investor class actions will be brought against MFS, Allco and Centro.
Two groups of class actions have been commenced against, in effect, the Centro group's two listed property investment vehicles.
In the earlier proceedings, funded by litigation funder IMF (Australia) Limited (IMF), the participating investors allege that the relevant Centro entities engaged in misleading or deceptive conduct and breached their continuous disclosure obligations1 The claims relate to the adequacy of disclosure the two entities made about the level of short term debt they carried and their difficulties in refinancing that debt. IMF initially announced that the claims would be for a maximum of $100 million each, but has since advised the market that the value of the claims has increased materially.
Slater & Gordon has filed a separate action on behalf of a wider class of investors2 This action alleges that the Centro entities engaged in misleading conduct by falsely characterising current debt as non-current debt in their unaudited 2007 full year reports.
IMF has also announced that it will fund investor class actions against MFS and Allco. Details of these claims have not been released, but media reports suggest they will follow a similar tack to the existing actions.
These investor class actions may have to overcome problematic evidentiary issues to succeed. One can imagine the difficulties associated with establishing that all claiming investors relied on the same information in making their investment decisions.
However, the claimants in these cases may argue that they do not need to prove that each investor individually relied on the impugned conduct in making their investment. That is, they may argue that it is sufficient to demonstrate that the market relied on the impugned conduct and so attributed an inflated price to the shares or securities. This proposition was advanced by the plaintiffs in the recently settled Aristocrat class action3 Had the plaintiffs' argument been accepted in that case the landscape of investor class actions in Australia would have shifted significantly in favour of claimant investors.
If these sub-prime crisis related class actions proceed to trial, one thing to watch will be the extent to which they utilise the plaintiffs' arguments in Aristocrat.
Litigation consequences: participants in the financial market
To date, the litigation in Australia has been focused on those entities severely affected by the liquidity freeze rather than participants in the segment of the financial market that deals in sub-prime backed securities and other structured finance products.
Nevertheless, proceedings have been commenced in NSW by an investor against at least one participant in this market. Central to that claim are allegations of misleading or deceptive conduct in relation to the marketing of a product known as a "collateralised debt obligation", despite the fact that investors in structured products in the wholesale financial market are necessarily sophisticated. This aspect of the claim is brought under the financial services equivalents of section 52 of the Trade Practices Act.
It is unusual for non-retail investors to claim they were induced to purchase a financial product on the basis of misleading conduct. Indeed, we are not aware of any case which considers what conduct will mislead such an investor.
A key consideration in a court's determination of whether conduct is misleading is the level of sophistication of the relevant audience. In making this determination in the present context, a court will likely have regard to the assumption underlying Australian corporations law: that sophisticated investors have the capacity and resources to independently obtain information necessary to assess the merits of a proposed investment4 It will be interesting to learn the extent to which this policy will reduce the possibility of misleading or deceptive conduct providing a viable cause of action for such investors.
The other obvious area of law that may be invoked in such claims is negligence. Financial service professionals owe their clients a duty of care in administering their affairs. The applicable standard of care is that of a person in the industry possessing the particular skill who is reasonably competent and careful. This is determined with regard to the market and commercial and financial background of the parties at the time of the transaction5 However, as financial markets are inherently volatile, exceedingly strong evidence must be led to establish negligence6
Australian regulators have not announced any major reform plans in response to the sub-prime crisis, although the Minister for Corporate Law recently announced that Treasury and ASIC will review the regulation of credit rating agencies and financial product research houses7
The review is intended to ensure that the existing regulatory framework is up to date. More generally, recent comments from the Prime Minister indicate that any moves to enhance regulation will be made in cooperation with other economies and international financial institutions8 At this stage, it appears that the reform priorities internationally are improving transparency in financial markets and enhancing risk management practices to avoid a repeat of the liquidity freeze.
In terms of litigation, the range of claims that may be made as a result of the sub-prime meltdown and resulting global liquidity crisis is yet to fully emerge in Australia. However, it is clear, given the relatively limited direct exposure Australian investors have to sub-prime backed assets, that this range will not approach the US experience.
Nevertheless, as is apparent from the themes highlighted above, we are gaining an insight into how the fallout from this latest financial crisis might be litigated in Australia. In the near term, we can expect to see debate and consideration within the legal community regarding the continued development of investor class actions and the law of misleading or deceptive conduct in the financial sector.
1 Federal Court of Australia proceedings VID326/2008
2 VID327/2008, filed on 9 May 2008. Federal Court of Australia proceeding VID366/2008, filed on 23 May 2008.
3 Dorajay Pty Ltd v Aristocrat Leisure Ltd, Federal Court of Australia proceeding NSD 362/2004
4 See discussion in B Salter, "Civil liability for errors and omissions in information memoranda in the wholesale debt capital markets" (2003) 14 JBFLP 61 at 78..
5 Lloyd v Citicorp (1986) NSWLR 286.
6 Stafford v Conti Commodity Services  All ER 691, also cited in Lloyd v Citicorp (1986) NSWLR 286.
7 Minister for Superannuation and Corporate Law, Senator the Hon. Nick Sherry, media release, "Australian Review of Credit Ratings Agencies", 22 May 2008
8 Prime Minister of Australia, "Towards a Productivity Revolution: a new agenda for micro-economic reform for Australia" address to the Australian/Melbourne Institute 27 March 2008.
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