The Dante notes that led to a financial inferno
Sydney Morning Herald
Wednesday February 23, 2011
Wingecarribee Shire Council made an expensive mistake in January 2008. The crisis in the United States subprime mortgage market was in full swing, triggering horror at a group of Australian councils, charities and churches which had invested in financial products marketed by Lehman Brothers Australia Ltd.Wingecarribee decided to bite the bullet on one of those products, called Federation notes. In a spooked market, the council sold for $450,000. It had paid $3 million for the notes less than two years earlier.Ten months later, Newcastle City Council had a different experience. It recovered in full the $2.5 million it had paid for some Federation notes. Manly Council recovered $500,000 in full too."The advice we got was good advice and it was advice to hold," says the general manager at Manly Council, Henry Wong.It was a bitter lesson for Wingecarribee, a shire in the Southern Highlands. Not only had it invested ratepayers' funds in a complex and risky financial product, it had sold at a very bad time.The governor of the Reserve Bank, Glenn Stevens, memorably warned in 2007 that local government authorities might not understand what they were buying."The real question is whether some bits of risk are being given to people who are unaware of what they're doing," he said.Manly, Newcastle and others were able to recover some of their investments in full because of a clause in the documentation for Federation notes triggered by the September 2008 bankruptcy of Lehman Brothers Inc.Now the same clause in other financial products marketed by Lehman Brothers Australia has thrown a wild card into a class action by councils, charities and churches.More than two years after the Australian company followed its New York parent company into insolvency administration, it's crunch time for local investors who claim they were misled and/or given conflicted advice in breach of fiduciary duty.Some investors, including Manly Council, are not members of the class action and are pursuing their claims through an alternative dispute resolution process set up by the liquidator of Lehman Brothers Australia, Stephen Parbery.For the 72 members of the class action, a two-day mediation ordered by Justice Steven Rares of the Federal Court begins today. If it fails, Justice Rares will begin hearing a six-week trial on Monday.Wingecarribee is a lead member of the class action and all those attending the mediation will be acutely aware of what happened when it sold its Federation notes at the wrong time.The fate of $286 million in similar investments called Dante notes, some of which are held by class action members including Wingecarribee, is in the hands of courts in Britain and the US.If the Dante noteholders wait, will they be able to replicate the success of the Federation noteholders?The exposure of Australian clients has been a moveable feast in other ways since Lehman collapsed.Manly purchased $500,000 in Federation notes and $4.5 million in other notes from Lehman. Wong says the council is still nursing a paper loss on the rest of its portfolio, but a much smaller one than it faced when Lehman collapsed in 2008."We have been approached, particularly over the past six months or so, by people who want to buy our securities," Wong says.The approaches are coming from institutional investors bidding about 60 to 70 in the dollar, as opposed to 5 to 10 during the global financial crisis."There's an emerging secondary market and I think the institutional players are becoming more confident in taking a risk on products that they think will recover," he says.Wingecarribee's director of corporate services, Barry Paull, says the value of its CDO portfolio, for which it originally paid $32 million, "bumps up and down".In addition to the $2.55 million loss on the Federation notes, Wingecarribee has, based on external advice, written down another $2.6 million on three other sets of notes.In contrast, two of its Lehman CDOs, which paid interest throughout the crisis, matured in September and December, and the principal amounts of $1 million and $500,000 were repaid to the council.The value of the portfolio 12 months ago was "probably significantly less than today," Paull says. "But who knows what the future holds?"That question will be on the minds of all who attend today's mediation, to be conducted by a former judge, Tony Fitzgerald, QC.Representing the councils, charities and churches will be their lawyers, Piper Alderman, and the listed company funding their class action, IMF (Australia). Across the table will be Parbery, a partner of the insolvency firm PPB Advisory.The chief allegations are that the company and its forerunner, Grange Securities, should never have advised these clients to invest in the exotic products known as synthetic collateralised debt obligations.The 72 investors say they were looking for high levels of capital security, little if any need for capital gains, and readily tradeable investments. They ended up with notes linked to credit default swaps.This left them exposed to defaults by companies named in the swap documents.Some members of the class action also allege that Lehman, not the client, made the investment decisions under mandates which obliged Lehman to pay particular regard to the interests of the client.When Lehman used that mandate to put its clients into products originated by its US parent, it breached its fiduciary duty, they claim.Fitzgerald will canvass issues such as whether Lehman Brothers Australia misled or deceived its clients or was negligent.If he gets far enough, he will also need to encourage Parbery and those running the class action to find common ground on the question of how to quantify the damages.Also on the minds of everyone at the mediation will be the bitter reality that Parbery is in charge of an insolvent estate.If the class action members establish that they have valid claims against Lehman Brothers Australia, they must then join the queue of all creditors and will get however many cents in the dollar Parbery distributes from the inadequate pool of assets.Also in the queue will be former clients using the alternative dispute resolution process and non-client creditors.The largest non-client creditor is Lehman Brothers Asia, which sent lawyers to a recent pre-trial hearing in the class action to foreshadowto Justice Rares that it wants toprotect its claim in the liquidation by arguing against the clientclass action.Parbery says the damages payable to clients could turn out to be "minimal". This is chiefly because of legal developments overseas which could result in noteholders receiving the collateral underlying the Dante notes."The biggest issue to be dealt with here in my view is the Dante collateral," Parbery says.He also points to improving secondary markets for CDOs.The executive director of IMF, John Walker, says because the legal status of the collateral remains unresolved, Dante notes are only changing hands at 30 to 50 in the dollar in the market.In any case, only one-third of the damages sought in the class action relate to Dante notes.Other notes held by the 72 members of the class action "are worth 20, 50, 80 cents in the dollar," Walker says."We say that the loss to our clients based on a purchase price less what their market price is now is about $250 million," he says.Some investors, like Wingecarribee, have two sets of lawyers trawling through the history of its relationship with Lehman.Piper Alderman is running the class action while Johnson Winter & Slattery is trying to retrieve $286 million for Australian holders of Dante notes through court action in London and New York.In December a different group of 1000 Australians, mostly individuals, settled a lawsuit in the US over $125 million of Lehman CDOs called Mahogany notes.Their litigation was run by the trustee, Perpetual Trustees.One of the settlement terms was that all details remain confidential until May, so it's hard to assess its impact on other Lehman Brothers Australia clients.But it's worth noting that it came after Perpetual won a court case and two appeals in London.A final appeal was outstanding when the settlement was struck.It also came weeks after a New York District Court judge ruled that Perpetual could appeal against a January 2010 victory by Lehman under US bankruptcy law.Judge Colleen McMahon said Lehman's efforts to shield itsvictory from appellate review were not surprising."Indeed, [Lehman] does not deny that, since the [January] decision was handed down it has used it as leverage in settlement negotiations concerning billions of dollars' worth of similar transactions," she said.Lehman's willingness to settle with Perpetual so soon after Judge McMahon set the clock ticking on the appeal suggests that the terms might have been generous to Perpetual and the Australian Mahogany noteholders.On the other hand, Perpetual faced much higher potential legal costs in the US than it did in Britain, where it pursued the case more vigorously and with repeated success.Since the December settlement, the Australian fight in the US and Britain has been continued by Johnson Winter & Slattery on behalf of the Dante noteholders.The Federation, Mahogany and Dante notes stand out because they are all CDOs not only marketed by Lehman Brothers Australia, but originated by the Lehman parent company.All Lehman-originated CDOs contained a clause, known as a "flip" clause, which the noteholders say gave them ownership of the underlying collateral when Lehman collapsed.The Federation noteholders acted quickly after the Lehman collapse and retrieved their funds.Then-competing Lehman creditors took steps to stop further calls on the collateral and the long legal process on two continents began.The collateral is commonly in the form of bonds issued by secure institutions such as the ANZ Bank and General Electric.It is held in London - hence the focus on British courts - by the trustee, Bank of New York Mellon.The final British appeal is set down for hearing next week. A Johnson Winter & Slattery partner, Jim Hunwick, says if the court processes deliver contrasting results in Britain and the US, "then we will be in uncharted waters legally"."We will be testing the willingness to apply the lip service that courts around the world pay to international comity," Hunwick says.By the time it's all over, Australian councils will have learnt more than they ever wanted to know about local and international insolvency law.