OPINION: “How was it that relatively unsophisticated Council officers came to invest many millions of ratepayers’ funds in these specialised financial instruments? That is the fundamental question at the heart of these proceedings,” mused Justice Steven Rares, before pronouncing judgement in a case that has far-reaching implications for the regulation of financial services both here and internationally (Wingecarribee Shire Council v Lehman Brothers Australia (in liq) [2012] FCA 1028 at 14).

Wingecarribee Shire Council v Lehman Brothers Australia cuts to the heart of both the form and purpose of financial regulation: do investment banks owe fiduciary duties and can these be voided either by contractual terms or legislative exceptions?

The Rares judgement provides the first definitive answer. It finds that Grange Securities, a wholly owned subsidiary of Lehman Brothers, breached its fiduciary duty and engaged in misleading and deceptive conduct in placing highly complex collateralised debt obligations in the portfolios of councils.

The judgement is the first time that the Australian Federal Court has entered these waters since finding in ASIC v Citigroup Global Markets Pty [2007] FCA 963 in 2007 that contractual terms can obviate obligation (at 278). Curiously, the previous judgement is not referred to in what is a damning indictment of financial engineering and the methods used by its leading practitioners to lure the unwary.

The United States investment bank Lehman Brothers had entered the Australian market through its acquisition of Grange Securities and Grange Asset Management in March 2007. In so doing, it took responsibility for the management of ongoing and prior relationships. These included the provision of transactional services and asset management for a number of local councils. The latter were governed through specific individual management protocols (IMPs). In December 2007, four months after the problems in the US securitisation market became apparent, the business was rebranded as Lehman Brothers Australia and Lehman Brothers Asset Management respectively.

The incoming chief executive was Jim Ballentine. He was acutely aware of the risks associated with complex derivatives. He was interviewed for a BusinessWeek article as early as 2005 on the risk associated with credit defaults and defective modelling in credit derivatives.

In 2005, Ballentine, as head of structured credit, was partly responsible for Lehman receiving the Euromoney Award for Excellence as “best derivatives house” — an award that the magazine claimed was based on the fact that “Lehman Brothers has been one of the more conservative credit derivatives houses … It has protected the bank from the reputational risk that the likes of Barclays Capital and Bank of America have run selling structured credit products”. It was a reputation that was not to last in either the United States or in Australia. Not only was Lehman to spectacularly blow up, the wave of litigation has now brought into question how government itself can protect itself from financial engineers.

The current case involves three local Australian councils representing a class action that includes non-profit and charity claimants. That in itself is interesting. Given the societal implications, it is curious that litigation of this nature was left to commercial funders, listed on the Australian Stock Exchange for profit, rather than the regulator funded by the taxpayer to uphold the public interest.

The Federal Court found that “the improvidence, and commercial naivety, of Grange’s council clients in entering into these transactions, that were highly advantageous to Grange,“ (at 266) could only have occurred because the investment bank was dealing with officials variously described as “financially quite unsophisticated and completely out of his depth” (at 483), “uninformed" (at 491), and “careless" (at 462).

Up to this point, “sophistication” had represented a get out of jail card for defendants, who could claim caveat emptor to sway judicial reasoning. The ability to contract out of investor protection mechanisms is central to the rationale behind the bifurcation between sophisticated ( wholesale or professional) and unsophisticated (retail) investors.

In most developed markets, much greater disclosure is required when products or financial advice are offered to retail clients. These restraints are designed to protect the naïve and the unwary from unscrupulous action by those with asymmetrical advantage. Sophisticated investors, by contrast, have traditionally been assumed to have the resources to make informed decisions. The judgement calls into question this critical bifurcation in the Corporations Act and indeed the timidity of its public enforcers to determining how to navigate competing imperatives.

The legislative bifurcation seeks to support financial innovation by offering complex products only to those in a position to evaluate them. Adjudication of sophistication is based on extremely limited criteria, such as wealth or size of specific transactions. There can be no doubting the level of judicial disgust at this crude calculation, a state of affairs worsened “given the subject matter involved, the prudent investment of public money" (at 790).

This also calls into question whether the range of options currently canvassed by the Department of Treasury, which are to (a) retain and update the current system; (b) remove the distinction between wholesale and retail clients; (c) introduce a new sophisticated investor test; or (d) no nothing are sufficient.

“The contrast between the actual, and patent, lack of financial acumen of the various Council officers at each of Swan, Parkes and Wingecarribee and the intelligent, shrewd and financially astute persons at Grange was striking,” said Justice Rares (at 752). “Generally, risk-averse people do not take bets with substantial assets held for public purposes” (at 895). That they did so, could, the court found, be rendered explainable only through an elaborate deception.

What also becomes clear in the reasoning is the extent of the risk that the financial industry has become parasitic on the public interest. Clients were mere patsies, with no “real appreciation of the true risks of SCDOS {synthetic collateralized debt obligations} or the financial wisdom [or otherwise] of its recommendation" (at 265).

Justice Rares is disarmingly forthright: “The nature and risks of a SCDO are concepts that are beyond the grasp of most people … Nonetheless, Grange portrayed itself as an expert in these investments. Most certainly, none of the seven council officers who gave evidence had any expertise in these financial products. Grange knew and preyed on that lack of expertise and the trust the councils placed in its expert advice" (at 410).

In a remarkably detailed judgement, the Federal Court holds that Grange could only do so by actively circumventing the stated objection of its clients. The point is highlighted in dealings with Wingecarribee Council. “Grange tested the water” and when the official “bit” he was “reeled in” by “words of comfort" (at 662). The councils believed that “they had the best of both worlds: principal protection and increased interest. For Grange, this manner of allaying risk averse, financially unsophisticated council officers’ fears of CDOs, was as easy as shooting fish in a barrel" (at 662).

By preying on an arm of government, the deception to society itself was rendered complete.

“Grange was a person who, unlike each of the council officers, had the necessary financial acumen and expertise to be categorised as a ‘sophisticated investor’ … That is the capacity in which each Council engaged Grange to act on its behalf,” rules Justice Rares (at 913).

In so doing, they were failed as much by changes to the law as by the individual executives handling the accounts.

“For many years, all one had to know was that the elegantly simple s 52(1) of the Trade Practices Act 1974 (Cth) prohibited a corporation from engaging in conduct, in trade or commerce, that was misleading or deceptive or likely to mislead or deceive … Now the community and the Courts must grapple with a labyrinth of statutes" (at 947).

The Federal Court makes clear its belief that the results have been debilitating for corporate morality, corporate purpose and public order.

“The last thing Grange wanted the Councils to think was that the investment in SCDOs had higher risk than the classes of investments with which the Councils were familiar and comfortable" (at 975). As a direct consequence it is only fair and reasonable that “Grange is liable to the Councils for their claims in contract, in negligence, for misleading and deceptive conduct, as well as for breach of fiduciary duty" (at 984).

As noted above, the Court decision is likely to complicate the Australian Treasury review into how complex financial products were systematically sold to mid-market participants — those that were deemed sophisticated or professional in legal terms but were, arguably, nothing of the sort.

The review heavily references the LBA litigation as the primary rationale for the consultation to redraw the boundary between private rights and public duties. We have yet to hear the outcome of that review. Given the Federal Court decision, we may well have to wait some more. It will be a wait worth having for society, if not for the financial services industry — or indeed the politicians reliant on its support.

Professor Justin O’Brien is director of the Centre for Law, Markets and Regulation in the UNSW Faculty of Law.

This opinion piece first appeared in The Conversation.