In one of the first cases in the world to hold an investment bank liable for its conduct in the lead up to the global financial crisis, the Federal Court of Australia found last Friday that the Australian branch of Lehman Brothers, formerly Grange Securities, breached its fiduciary duty and engaged in misleading and deceptive conduct in its financial and investment advice to local Councils. The Councils claimed that they suffered losses arising out of their acquisition of synthetic collateralised debt obligations and some other complex financial products (collectively, the SCDOs).

Background

The three plaintiff Councils, Wingecarribee, Swan and Parkes (collectively, the Councils), were representative applicants in a class action for other councils and not-for-profits. Prior to dealing with Grange, each of the three Councils had a conservative investment strategy, investing in relatively low-risk bank products such as bank bills, term deposits and bank issued floating rate notes (FRNs). None of the Councils had experience with investment in complex financial instruments. Each Council was conscious of its legislative and policy-based duties to avoid risk of loss to public money.

Grange began selling SCDOs to Parkes and Swan in 2003 and both Councils traded in a significant number of SCDO products between then and 2008. In early 2007, Wingecarribee and Swan also entered into a written Individual Managed Portfolio (IMP) agreement with Grange. As part of the IMP Agreements, Grange traded in SCDOs on behalf of Wingecarribee and Swan. 

When the Councils bought the SCDOs, the products had credit ratings that were better or equivalent to the credit rating of the four major Australian banks, and offered interest rates better than that of most products issued by Australian banks. Grange’s marketing strategy consistently represented to each of the three Councils that SCDOs either were FRNs or had an equivalent risk of loss, and suggested that there was no real likelihood of the products’ default or the council suffering any loss.

With the global financial crisis in mid-2007, the value of the investments plummeted, with several SCDOs being wiped out entirely.  The Councils claimed against Grange in respect of their losses, alleging:

  1. breach of contract; 
  2. negligence;
  3. breach of fiduciary duties; and
  4. misleading or deceptive conduct contrary to s 12DA(1) of the Australian Securities and Investments Commission Act 2001 (Cth).

Breach of contract

Each of the Councils alleged that Grange had breached the individual contracts they had made to purchase each SCDO because the product did not have the characteristics Grange had promised. Both Swan and Wingecarribee claimed that Grange had breached their IMP agreements by investing in the SCDOs when they were not appropriate investments for either Council.

Individual contracts in relation to SCDOs

Rares J found that each dealing between Grange and each of Swan and Parkes throughout their relationship was effected by a separate contract for the purchase or sale of a financial product. Grange was also engaged to act, and acted, for each of Swan and Parkes in each transaction as a financial adviser. From Grange’s representations to the relevant Councils, Rares J found that a number of key terms formed a part of the initial contract between Grange and the relevant councils, and later formed a part of the course of dealings between these parties. These key terms were as follows [ 721 ], [ 791 ]:

  1. the Product had a high level of security for protection of for the capital invested by the Council;
  2. the product was easily tradeable on an established secondary market;
  3. the product was readily able to be liquidated for cash at short notice;
  4. the product was a suitable and appropriate investment for a risk averse local government council;
  5. the product has a secure income stream; and
  6. Grange would exercise reasonable skill and care in making this investment recommendation and in giving this investment advice to the Council. 

Rares J found that Grange breached terms (i)-(iv) and (vi), specifically that:

  • Grange’s use of the high credit ratings in selling the Claim SCDOs gave the Councils a false sense of security of their capital, “particularly so in respect of the consequences of the occurrence of extreme market events” ([ 863 ]);
  • the SCDOs market did not include any informed buys or sellers, other than Grange, and predominately operated through suggested switch transactions facilitated by Grange between financially unsophisticated parties such as Councils, and hence were not easily tradeable on an established secondary market ([ 908 ]);
  • the lack of a market other than that which was controlled by Grange made it difficult to liquidate the Claim SCDOs for cash at short notice ([ 883 ]). 
  • For these reasons, the SCDOs possessed complexities and risks only understood by experts and were not appropriate for risk averse Councils;
  • Due to the fact that Grange breached terms (i) to (iv), Grange did not exercise reasonable skill and care in making each investment recommendation and giving investment advice to act on it to the relevant Councils.   

The Court found that Grange did not breach the term requiring that the product have a secure income stream because, in the absence of extreme market events, the income stream generated by the interest was relatively secure ([ 896 ]).

The Swan and Wingecarribee IMP Agreement

The Court found that Grange breached both IMP agreements by causing or recommending an investment to be made in SCDOs. In particular, while the investment guidelines in the Wingecarribee IMP Agreement permitted Grange to invest Wingecarribee’s funds in both CDOs and structured products, they required that:

  • Grange could only invest Council funds in accordance with applicable Ministerial guidelines requiring the Council to “exercise the care, diligence and skill that a prudent person would exercise in investing council funds”; ([ 415 ]) and
  • all securities must have an active secondary market and that there should be no investments in derivatives.

Similarly, the Trial Judge found that there was an implied term in the Swan IMP Agreement that Grange would provide its services with the reasonable skill and care of a reasonable financial adviser. Rares J held that in circumstances where the SCDOs lacked a high level of security for the protection of the capital invested by the Councils, an established secondary market and liquidity the SCDOs were not a prudent form of investment and Grange did not exercise reasonable skill and care in making such investment recommendations.

Negligence

Because Grange was investing public money and that the Councils were not sophisticated investors, Rares J held that Grange had a duty of care to exercise reasonable skill and care in giving advice on each investment decision to each of the Councils. His Honour found that Grange breached this duty of care in advising public money be invested in products with the risk profile of the SCDOs.

The Court considered and rejected claims by Grange that its liability was diminished by the Councils’ contributory negligence. Rares J found:

  • the mere fact that Council officers were made aware of certain risks in relation to the investment would not of itself establish contributory negligence in circumstances where Grange was the Council’s financial adviser and gave recommendations and advice to the Council;
  • in circumstances where Grange was an investment adviser, recommending and advising on investments, it was proper for the Councils to rely on Grange to perform their contractual obligation and duty exercise reasonable skill and care, notwithstanding that the Council officer had not read all the material provided to it by Grange;
  • Grange failed to demonstrate what ‘reasonable care’ on the Councils’ part would have achieved other than discussing the investments with Grange personnel; 
  • Wingecarribee gave Grange express instructions that it did not want to invest in SCDOs and growth assets and acted reasonably in trusting Grange to follow its instructions.    

Findings in relation to fiduciary duties

Did Grange owe fiduciary duties to the Councils?

Justice Rares considered that Grange also owed each Council fiduciary duties as financial advisers concurrent to and independent of any obligation in contract and at common law, ([ 729 ]-[ 731 ]).

Prior to the IMP agreements

His Honour found that such fiduciary duties were owed since the inception of the financial dealings between Grange and the Swan and Parkes, prior to entry into the IMP Agreements ([ 745 ]). Those fiduciary obligations imposed by equity are that unless the fiduciary has the informed consent of the person to whom they are owed there is, firstly, a duty not to obtain any unauthorised benefit from the relationship and secondly, a duty not to be in a position where the interests or duty of the fiduciary conflict (or there is a real or substantial possibility that they may conflict) with the interest of the person to whom the duty is owed. In respect of their relationship with the Councils prior to the relevant IMP agreements, Grange pointed to disclaimers that it inserted in the product presentations that it made to the Councils as excluding any implication of fiduciary obligations ([ 725 ]). Those disclaimers typically warned potential clients not to act on any recommendations set out in those presentations without first consulting their investment adviser.

Justice Rares accepted that while the terms of a contract can modify or extinguish a fiduciary obligation ([ 729 ]), his Honour found that Grange had in fact had offered its services as, and acted as, a financial adviser to each of the Councils in respect of, among others, the particular transaction or dealing it was recommending to the Council and advising the Council to effect. By doing so, his Honour stated at [ 733 ]:

…Grange voluntarily assumed the well established obligations such a person owes to its clients to the extent that it did not exclude those obligations contractually.

Rares J emphasised that before the Councils invested in the SCDO products, they made clear to Grange that in arriving at a decision about investing the Council’s funds in such a sophisticated financial product, they were dependent on Grange’s advice. His Honour noted, in relation to Swan, that:

Swan reposed trust and confidence in Grange acting as its adviser on investing the Council’s money in financial products. Grange undertook, from when it negotiated the SCDO transaction, to act in the interests of Swan in the exercise of the Council’s investment powers and discretions that affected Swan’s interests in a legal or practical sense” ([ 743 ]). 

His Honour concluded that the fiduciary obligations owed by Grange to the Councils referred to above were operative. Rares J found that Grange had not obtained the Council’s fully informed consent, which will be a question of fact in all the circumstances of each case, to displace the otherwise operative fiduciary duties owed by Grange to the Councils as the Councils’ financial adviser. The disclaimers used by Grange did not amount to informed consent, nor did they relieve Grange of its contractual and tortious duty to exercise reasonable skill and care.

How were the fiduciary duties affected by the IMP agreements?

Grange contended that there were several aspects of the IMP agreements which operated to extinguish any fiduciary obligation owed to each Council. It relied on:

  • Schedule 3 to the IMP, which disclosed that Grange may be entitled to fees paid by the issuer of a security in relation to its placement; and
  • clause 2.5 of the IMP which recorded the consent of each Council for Grange to enter into transactions as a principal with the Council or on the opposite side to the Council.   

Rares J concluded that Grange’s fiduciary obligation was attenuated by these terms, such that the Councils were not entitled to complain that Grange breached its fiduciary obligation merely by receiving payment, gain or profit from its sales to them of SCDO products ([ 776 ]) and Grange was contractually permitted to be the buyer from or seller to the council of financial products ([ 783 ]). However, neither clause operated to extinguish the fiduciary obligations Grange owed to each Council ([ 783 ]).

Did Grange breach its fiduciary duties to the Councils?

The Court found that Grange breached both its fiduciary obligations to the Councils (a) not to obtain any unauthorised benefit from their relationship and (b) not to be in a position where Grange’s interests or duties conflict with the interests of the Councils.

Rares J noted in relation to Grange’s duty not to obtain any unauthorised benefit that Grange’s revelation of its being the counterparty in, and on occasion, the possibility that it might earn unspecified fees or profits from trading with its clients, did not amount to a sufficient disclosure to the Councils. His Honour underscored that merely letting the Councils know that it was “interested” was not enough to put its clients into a position to make a fully informed choice whether to deal with Grange by acting on its advice about purchasing SCDOs ([ 937 ]-[ 939 ]).

His Honour also concluded that Grange was in breach of its proscriptive fiduciary obligation because it acted in effecting transactions with SCDOs with each of Swan and Parkes when its personal interest in the transactions conflicted with those of each Council. Grange failed to inform any of the Councils of how much it stood to make from any trade. Rares J emphasised that this information would have been significant in demonstrating, “why Grange was involved in advising and recommending SCDOs to its clients and…why it needed to provide, what it knew the products did not independently have – a secondary market and liquidity ([ 940 ]).

Findings in relation to misleading and deceptive conduct

Rares J found the following representations had been made to each of the Councils ([ 753 ], [ 755 ], [ 796 ], [ 814 ]):

  1. breach of contract;  the investments, including the Claim SCDOs, that Grange recommended to, or made on behalf of, each Council (a) were suitable for investors with a conservative investment strategy; and (b) complied with statutory and Council policy requirements.
  2. Grange observed prudent, conservative income defensive, capital protective and proliquidity practices when investing on behalf of local government authorities or investing with conservative investment strategies.
  3. the SCDOs had particular characteristics, including risk profiles equivalent to, other types of financial products with the same rating, specifically FRNs; 
  4. Grange was active in the secondary market for SCDOs and was bound to buy back the SCDOs, if requested to do so, to provide liquidity in illiquid products;

His Honour concluded that these representations were misleading and deceptive:

  • In the sense in which the parties used the concepts of a “conservative” investment or strategy, such investments had to have a high level of security for the protection of the Council’s capital.   The SCDOs did not provide such a high level of protection ([ 957 ]).
  • Investing in the SCDOs was contrary to the requirements of the prudent person test applicable to the exercise of the Councils’ investment powers ([ 962 ]).
  • the risk of market price volatility for SCDOs was unusual and created a different risk profile for the Claim SCDOs to similar rated products ([ 93 ], [ 976 ]). 
  • Grange did not have the capacity to provide liquidity or secondary market activity if economic conditions or its own thin capitalisation prevented it from doing so ([ 978 ]).  

Conclusion

Wingecarribee Shire Council v Lehman Brothers Australia has wide implications for financial advisers and their liability to clients for failed investments. Although the case emphasised that parties have the ability to contract out of investor protection mechanisms, it has made clear that much greater disclosure is required when products or financial advice are offered to retail investors, who do not have the resources to make informed decisions, than for sophisticated wholesale or professional clients. The Federal Court found that because Grange “was aware that the Councils trusted its advice and recommendations”, it was able to “exploit their significant access to large amounts of public money to finance Grange’s business of promoting and selling SCDOs for its own profit” ([ 474 ]).

The judgment will be keenly felt internationally and domestically, not only for investment banks around the world who traded in SCDOs on behalf of clients, but also for ratings agencies such as Standard & Poor’s, which rated products like SCDOs as triple A.