In January 2012, the Corporations and Markets Advisory Committee (CAMAC) released its “Derivatives Report” (Report) following its review of the existing Australian regulatory regime for derivatives (see the Report here). In particular, the Report examined the definition of “derivative” in the Corporations Act 2001 (Cth) (Corporations Act) and considered whether that definition should be amended to reduce the complexity of the law in this area.

The Report concluded that the definition of derivative is not unduly complex. It also confirmed that the definition in s761D of the Corporations Act is intended to have a broad meaning. That this was the intention of the Commonwealth Parliament was found to have been supported by the existence of specific exceptions to the definition of derivative provided for in s761D of the Corporations Act (and regulations made under that section) and by judicial interpretation of the definition of derivative (and the Report contains a useful summary of the relevant cases).1

The Report provides that the broad-based definition of derivative is intended to ensure that the definition will capable of applying to (and thereby regulating) new and innovative derivative products as they are developed and to ensure that the focus is on the substance of a product rather that its form.2 The potential for a broad definition to “over-reach” can effectively be dealt with by specific regulations exempting a particular arrangement from the definition of derivative.

With this background in mind, the Federal Court of Australia found, in Bathurst Regional Council v Local Government Financial Services Pty Ltd (No 5) [2012] FCA 1200 (Bathurst Regional Council), that a complex financial product known as a constant proportion debt obligation (CPDO) was a derivative, rather than a debenture, within the meaning of the Corporations Act. 

This find was made even though the CPDO product was structured with characteristics that might be viewed as more akin to a debt instrument and a commonly held perception by market participants that the product, and similar products, were debt instruments.

The Bathurst Regional Council decision

In 2009, 13 local councils in New South Wales commenced proceedings (in which Norton Rose acted for one of the respondents) in the Federal Court of Australia against Local Government Financial Services Pty Limited (LGFS) for losses allegedly incurred after the councils purchased a complex CPDO, known as “Rembrandt Notes” from LGFS.

LGFS had purchased Rembrandt Notes from ABN AMRO. Prior to this  purchase the product had been assigned a “AAA” long term rating by the credit rating agency Standard and Poor’s (S&P), which LGFS alleged was essential to its decision to purchase (and subsequent marketing) of the product. LGFS and the councils consequently brought claims against S&P and ABN AMRO.

The judgement of Jagot J in Bathurst Regional Council, which has attracted worldwide attention, held (among other things) that S&P was liable to both LGFS and the councils in respect of its rating of Rembrandt Notes, even in the absence of any direct relationship between S&P and LGFS or between S&P and the councils on the other.

The Court found that, by assigning a AAA rating to Rembrandt Notes, S&P conveyed, first, a representation that in S&P’s opinion the capacity of all financial obligations under the notes to be met was “extremely strong” and, secondly, a representation that S&P had reached this opinion based on reasonable grounds and as the result of an exercise of reasonable care.

As the Court found on the facts before it that neither representation was true, and found that S&P knew that neither was true at the time that the representations were made, the Court found that S&P had engaged in misleading and deceptive conduct under the Corporations Act and the Australian Securities and Investments Commission Act 2001 (Cth).

The Court finds the Rembrandt Notes to be a 'derivative'

In the course of her Honour’s judgement, which runs for over 1000 pages, Jagot J dealt with a number of important legal issues. One of those concerned whether the Rembrandt Notes constituted “derivatives” rather than “debentures” as defined in s761D of the Corporations Act.

If the Rembrandt Notes were found to constitute derivatives, LGFS would have been in breach of a condition of its Australian financial services license (AFSL) by recommending or advising the councils to invest in the Rembrandt Notes. This was because its AFSL only permitted LGFS to deal in and provide financial product advice relating to “securities”. Importantly, LGFS’ AFSL did not extend to providing these services in relation to “derivatives”.

Section 761D(1) of the Corporations Act sets out the definition of a derivative as follows:

“a derivative is an arrangement in relation to which the following conditions are satisfied:

(a)  under the arrangement, a party to the arrangement must, or may be required to, provide at some future time consideration of a particular kind or kinds to someone; and (b)  that future time is not less than the number of days, prescribed by regulations made for the purposes of this paragraph,3 after the day on which the arrangement is entered into; and (c)  the amount of the consideration, or the value of the arrangement, is ultimately determined, derived from or varies by reference to (wholly or in part) the value or amount of something else (of any nature whatsoever and whether or not deliverable), including, for example, one or more of the following:

(i)  an asset; 

(ii)  a rate (including an interest rate or exchange rate); 

(iii)  an index; 

(iv)  a commodity.”

Section 761D(3) then excludes from the definition of “derivative” anything that is covered by s764A (other than paragraph (c) of that section). Therefore, a “security” (which includes a debenture4) is excluded from the definition of derivative5. As a result, if a product is a “debenture” (or some other type of “security”), then it is not a “derivative”.

Given that, if the Rembrandt Notes were found to be debentures, they would necessarily not be derivatives, much of the discussion in the judgement regarding the characterisation of the product focused on whether the Rembrandt Notes were debentures as defined in the Corporations Act. As a result, it is worth noting Jagot J’s comments in relation to the reasons why the Rembrandt Notes did not constitute debentures but, rather, constituted derivatives.

In finding that the Rembrandt Notes were not debentures and as such were derivatives, as defined in the Corporations Act, Jagot J accepted the reasoning submitted by the councils. In summary, the submissions of the councils were as follows:

  • the arrangement between the holders of the Rembrandt Notes and the Rembrandt Trust was such that the Rembrandt Trust would be required to provide consideration in the form of payments of principal and/or interest at future points in time;
  • the amount and extent of those payments depended upon the performance of a notional credit default swap (CDS) between the Rembrandt Trust and ABN AMRO;
  • in turn, the performance of the CDS depended on the performance of two indices (eg. movements in prices and the occurrence of certain events of default), which determined the amount of payments to be made to the holders of the Rembrandt Notes; and
  • accordingly, the amount payable to the holders of the Rembrandt Notes could not be determined at the time the Rembrandt Notes were issued and therefore they were not debentures and instead were “derivatives”.

The Court’s decision on this point is illustrative of the importance of considering whether a complex financial product may be structured to constitute a debenture but  may, in fact, be ultimately characterised as a derivative. In practice, the question of whether a particular arrangement could be characterised, from a legal perspective, as a derivative can arise in the following circumstances:

  • when considering whether the constitution of a company or the trust deed of a trust or constitution of a managed investment scheme gives the relevant entity the power to enter into the arrangement. For example, the entity may have a general power to borrow money (and issue debentures or other securities) but it may not have the power to enter into derivatives, or the power to enter into derivatives may be limited to real hedging transactions only;
  • statutory restrictions that restrict investments in derivatives may be applicable. For example, a trustee of a superannuation fund or a responsible entity of a managed investment scheme may only enter into derivatives for hedging purposes in very limited circumstances and government and semi-government authorities (and other similar bodies such as The Future Fund) may have specific investment and treasury guidelines that prescribe whether (and which types of) derivatives are permitted; and
  • similarly, investment management agreements will usually contain investment guidelines that prescribe whether particular investments, such as derivatives, may be entered into, the quantum of the exposure that is permitted and the circumstances in which they are permissible (eg. for hedging or other purposes).  In the absence of any specific definition of a “derivative” in those contracts, a court may well turn to the meaning of “derivative” under the Corporations Act and as interpreted by the courts, such as in the Bathurst Regional Council decision.

What next? Respondents to appeal the decision in Bathurst Regional Council

All of the respondents have now lodged an appeal to the Full Court of the Federal Court against the decision in Bathurst Regional Council.

ABN AMRO and S&P have appealed against the findings that they owed duties of care to the councils and LGFS, that they breached these duties and that they engaged in misleading and deceptive conduct in relation to the rating (and passing on of the rating) of the Rembrandt Notes.  LGFS has appealed against the findings that it owed a fiduciary duty to the councils and that it breached this duty.

At this stage, it is not possible to say whether the findings of Jagot J relating to the meaning of derivative under the Corporations Act will be considered by the Full Court of the Federal Court.

With plenty at stake, keen observers in Australia and other jurisdictions will be closely following the outcome and legal principles derived from the next round of these proceedings. Watch this space.