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FEDERAL COURT OF AUSTRALIA
Wingecarribee Shire Council v Lehman Brothers Australia Ltd (in liq)
[2012] FCA 1028
Citation: Wingecarribee Shire Council v Lehman Brothers Australia
Ltd (in liq) Parties: WINGECARRIBEE SHIRE COUNCIL, CITY OF
SWAN and PARKES SHIRE COUNCIL v LEHMAN BROTHERS AUSTRALIA LIMITED (IN LIQUIDATION) (ACN 066 797 760)
File number: NSD 2492 of 2007 Judge: RARES J Date of judgment: 21 September 2012 Catchwords: CONTRACT – implication of terms – construction of
written and oral contracts for purchase or sale of complex financial products – construction of written contract authorising respondent to undertake transactions on applicants’ behalf NEGLIGENCE – implied contractual term and co-extensive tortious duty of financial adviser to exercise reasonable skill and care in making recommendations giving advice to, or acting on behalf of client in making investments – whether obligation or duty affected by written disclaimers – whether disclaimer sufficient to exclude liability for negligence in oral statements recommending or advising a course of action – where disclaimer purports to exclude liability and assumption of responsibility for financial advice and urges reader to seek advice from its own financial adviser – where author of disclaimer is client’s financial adviser – whether client affected or bound by disclaimer – whether applicants were contributorily negligent TRADE PRACTICES – misleading and deceptive conduct – whether respondent engaged in conduct that was misleading or deceptive contrary to s 12DA(1) of the Australian Investments and Securities Commission 2001 (Cth) – where pleaded representations made orally and in written material – where disclaimers appearing in small print on written materials qualified or contradicted oral assertions – where written disclaimers were not repeated
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orally or otherwise drawn to the applicants’ attention – whether person relying on representation failed to take reasonable care for purposes of s 12GF(1) of the Australian Securities and Investments Commission Act 2001 (Cth) EQUITY – fiduciary obligations – relationship between financial adviser and client – whether respondent owed fiduciary obligations to applicants in recommending or effecting transactions or giving financial advice – where respondent earned large profits from its sale of financial products to its clients including applicants – where such fees not disclosed – whether contractual term entitling client to request disclosure of any fees sufficient to relieve fiduciary of need to obtain fully informed consent – whether disclosure to client of possibility that respondent may earn fees sufficient to relieve fiduciary of need to obtain fully informed consent – whether respondent obliged (a) not to obtain an unauthorised benefit from the fiduciary relationship, and (b) not to be in position of conflict between the fiduciary’s interests and duties and interests of the applicants – whether respondent breached duty in failing to warn applicants about the risks associated with investments it recommended to or made on behalf of the applicants VALUATION –principles applicable to valuation of securities – whether, where no actual or sufficient market transactions, judicial valuer can rely on bids as evidence of value of illiquid securities DAMAGES – whether ‘left in hand’ test or difference between price and true value appropriate measure of damages in contract, tort or under s12GF(1) of the Australian Securities and Investments Commission Act 2001 (Cth) – where applicants induced to buy securities – where securities did not have properties warranted in contract – where recommendation or advice to buy securities given negligently – where recommendation or advice to buy securities misleading or deceptive PRACTICE AND PROCEDURE – group proceedings brought pursuant to Pt IVA of the Federal Court of Australia Act 1976 (Cth) – whether common questions of fact or law determined in representative proceeding
Legislation: Australian Securities and Investments Commission Act
2001 (Cth) s 12GF, 12GP, 12GR Civil Liability Act 2002 (NSW) ss 5B, 5C, 5D, 5E, 5O, 5R, 5S Civil Liability Act 2002 (WA) ss 5B, 5C, 5D, 5K
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Competition and Consumer Act 2010 (Cth) Sch 2, s 18 Corporations Act 2011 (Cth) Pt VB, ss 9, 554(1), 708(8), 761D, 764A,769B, 912A, 991E, 1041H(1) Corporations Regulations 2001 (Cth) reg 7.8.20(1A) Federal Court of Australia Act 1976 (Cth) Pt IVA Law Reform (Contributory Negligence and Tortfeasors’ Contribution) Act 1947 (WA) ss 3A, 4(1) Law Reform (Miscellaneous Provisions) Act 1965 (NSW) ss 8, 9 Local Government Act 1993 (NSW) s 625 Local Government Act 1995 (WA) s 6.14 Trade Practices Act 1974 (Cth) s 52(1) Trustee Act 1925 (NSW) ss 14A, 14C Trustees Act 1962 (WA) Pt III, ss 18(1)(a) Bankrupty Code (USA) Ch 11
Cases cited: Ackers v Austcorp International Ltd [2009] FCA 432
referred to ACQ Pty Ltd v Cook (2008) 72 NSWLR 318 doubted Adeels Palace Pty Ltd v Moubarak (2009) 239 CLR 420 applied Associated Alloys Pty Ltd v ACN 001 452 106 Pty Ltd (in liq) (2000) 202 CLR 588 applied Astley v Austrust Ltd (1999) 197 CLR 1 applied Austin v Austin (1906) 3 CLR 516 applied Australian Iron & Steel Ltd v Greenwood (1962) 107 CLR 308 referred to Australian Securities and Investments Commission v Hellicar (2012) 286 ALR 501 applied Australian Softwood Forests Pty Ltd v Attorney General (NSW) Ex Rel Corporate Affairs Commission (1981) 148 CLR 121 considered Banque Commerciale SA (in Liq) v Akhil Holdings Ltd (1990) 169 CLR 279 applied Beneficial Finance Corp Ltd v Karavas (1991) 23 NSWLR 256 applied Birtchnell v Equity Trustees, Executors & Agency Co Ltd (1929) 42 CLR 384 applied Blackmagic Design Pty Ltd v Overliese (2011) 191 FCR 1 referred to Blair v Curran (1939) 62 CLR 464 applied Bonnington Castings Ltd v Wardlaw [1956] AC 613 referred to BP Refinery (Westernport) Pty Ltd v Shire of Hastings (1977) 180 CLR 266 applied British Westinghouse Electric and Manufacturing Company of London Ltd v Underground Electric Railways Company of London Ltd [1912] AC 673 applied Burns v MAN Automotive (Aust) Pty Ltd (1986) 161 CLR 653 applied
- 4 -
Butcher v Lachlan Elder Realty Pty Ltd (2004) 218 CLR 592 applied Canson Enterprises Ltd v Boughton & Co [1991] 3 SCR 534 applied Cassi di Risparmio della Repubblica di San Marino SpA v Barclays Bank Ltd [2011] 1 CLC 701 referred to Chappell v Hart (1998) 195 CLR 23 referred to Commissioner of Taxation v Firth (2002) 120 FCR 450 applied Commissioner of Taxation v Radilo Enterprises Pty Ltd (1997) 72 FCR 300 applied Commonwealth Bank of Australia v Mehta (1991) 23 NSWLR 84 applied Commonwealth Bank of Australia v Smith (1991) 42 FCR 390 applied Construction, Forestry, Mining and Energy Union v Australian Building and Construction Commission [2012] FCAFC 44 applied Cordelia Holdings Pty Ltd v Newkey Investments Pty Ltd [2004] FCAFC 48 considered Cornish v Midland Bank Ltd [1985] 3 All ER 513 applied Daly v Sydney Stock Exchange Ltd (1986) 160 CLR 371 applied Daniels v Anderson (1995) 37 NSWLR 428 applied Dartberg Pty Ltd v Wealthcare Financial Planning Pty Ltd (2007) 164 FCR 450 referred to Dobler v Halverson (2007) 70 NSWLR 151 applied Doyle v Olby (Ironmongers) Ltd [1969] 2 QB 158 applied Farah Constructions Pty Ltd v Say-Dee Pty Ltd (2007) 230 CLR 89 applied Ferneyhough v Westpac Banking Corp [1991] FCA 709 applied Fouche v Superannuation Fund Board (1952) 88 CLR 609 applied Furs Ltd v Tomkies (1936) 54 CLR 583 applied Gates v City Mutual Life Assurance Society Ltd (1986) 160 CLR 1 applied Gluckstein v Barnes [1900] AC 240 referred to Goold v Commonwealth (1993) 42 FCR 51 applied Gould v Vaggelas (1985) 157 CLR 215 applied Government Employees Superannuation Board v Martin (1997) 19 WAR 224 applied Gray v New Augarita Porcupine Mines Ltd [1952] 3 DLR 1 applied Gull v Saunders & Stuart (1913) 17 CLR 82 applied Hadley v Baxendale (1854) 9 Exch 341 referred to Hawkins v Bank of China (1992) 26 NSWLR 562 applied Henderson v Amadio (1995) 62 FCR 1 applied Henville v Walker (2001) 206 CLR 459 referred to Hospital Products Ltd v United States Surgical Corp
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(1984) 156 CLR 41 applied HTW Valuers (Central Qld) Pty Ltd v Astonland Pty Ltd 217 CLR 640 applied IFE Fund SA v Goldman Sachs International [2007] 2 CLC 134 distinguished In re Coomber; Coomber v Coomber [1911] 1 Ch 723 applied In re Lehman Bros Holdings Inc 422 BR 407 (2010) referred to In re Whiteley (1886) 33 Ch D 347 referred to John Alexander’s Clubs Pty Ltd v White City Tennis Club Ltd (2010) 241 CLR 1 applied Jones v Dunkel (1959) 101 CLR 298 applied Kenny & Good Pty Ltd v MGICA (1992) Ltd (1999) 199 CLR 413 applied Kizbeau Pty Ltd v WG & B Pty Ltd (1995) 184 CLR 281 applied Kocsardi v Elegant Tiles Pty Ltd [1996] FCA 1014 referred to Maguire v Makaronis (1997) 188 CLR 449 applied Mathew v Blackmore (1857) 1 H&N 762 applied McCullagh v Lane Fox & Partners Ltd [1996] 10 PNLR 205 distinguished McDonald v Deputy Federal Commissioner of Land Tax (NSW) (1915) 20 CLR 231 applied McKenzie v McDonald [1927] VLR 134 applied Miller & Associates Insurance Broking Pty Ltd v BMW Australia Finance Ltd (2010) 241 CLR 357 applied Mills v Stanway Coaches Ltd [1940] 2 KB 334 referred to MMAL Rentals Pty Ltd v Bruning (2004) 63 NSWLR 167 applied Monaghan Surveyors Pty Ltd v Stratford Glen-Avon Pty Ltd [2012] NSWCA 94 referred to Nocton v Lord Ashburton [1914] AC 932 applied Nominal Defendant v Meakes (2012) 60 MVR 380 referred to Norman v National Australia Bank Ltd (2009) 180 FCR 243 applied North East Equity Pty Ltd v Proud Nominees Pty Ltd (2012) 285 ALR 217 applied Parker, In the matter of Purcom No 34 Pty Ltd (In Liq) (No 2) [2010] FCA 624 applied Perpetual Trustee Co Ltd v BNY Corporate Services Ltd [2012] 1 AC 383 considered Perpetual Trustee Co Ltd v BNY Corporate Trustee Services Ltd [2010] 2 BCLC 237 referred to Perpetual Trustee Co Ltd v Milanex Pty Ltd (In Liq) [2011] NSWCA 367 referred to Phillips v Brewin Dolphin Bell Lawrie Ltd [2001] 1 WLR 143 referred to
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Pilmer v Duke Group Ltd (In liq) (2001) 207 CLR 165 applied Podrebersek v Australian Iron & Steel Pty Ltd (1985) 59 ALR 529 applied Potts v Miller (1940) 64 CLR 282 considered Potts v Westpac Banking Corporation [1993] 1 Qd R 135 considered Re Opus Prime Stockbroking Ltd (2008) 171 FCR 473 applied Roads and Traffic Authority (NSW) v Refrigerated Roadways Pty Ltd (2009) 77 NSWLR 360 referred to Robinson v Harman (1848) 1 Exch 850 applied Rogers v Whitaker (1992) 175 CLR 479 referred to Shrimp v Landmark Operations Pty Ltd (2007) 163 FCR 510 referred to Smith New Court Securities Ltd v Scrimgeour Vickers (Asset Management) Ltd [1997] AC 254 applied Smith v Zhang (2012) 60 MVR 525 referred to St George Bank Ltd v Quinerts (2009) 25 VR 666 referred to Strong v Woolworths Ltd (t/a Big W) (2012) 285 ALR 420 applied Sydney South West Area Health Service v MD (2009) 260 ALR 702 applied Tate v Williamson (1866) LR 2 Ch App 55 applied Tepko Pty Ltd v Water Board (2001) 206 CLR 1 applied The King v New Queensland Copper Co Ltd (1917) 23 CLR 495 applied The “Putbus” [1969] P 136 referred to Thornton v Shoe Lane Parking Ltd [1970] 2 QB 163 referred to Trompp v Liddle (1941) 41 SR (NSW) 108 applied Trustees of the Property of Cummins (A Bankrupt) v Cummins (2006) 227 CLR 278 applied Twycross v Grant (1877) 2 CPD 469 applied Vale v Sutherland (2009) 237 CLR 638 applied Walker Corporation Pty Ltd v Sydney Harbour Foreshore Authority (2008) 233 CLR 259 applied Warman International Ltd v Dwyer (1995) 182 CLR 544 referred to Watson v Foxman (1995) 49 NSWLR 315 applied Wong v Silkfield Pty Ltd (1999) 199 CLR 255 applied Youyang Pty Ltd v Minter Ellison Morris Fletcher (2003) 212 CLR 484 applied Zhu v Treasurer of the State of New South Wales (2004) 218 CLR 530 applied References: JD Heydon and MJ Leeming: Jacobs’ Law of Trusts (7th ed), LexisNexis Butterworths Australia, 2006
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PA Keane: The 2009 WA Lee Lecture in Equity: The Conscience of Equity (2009) 84 ALJ 92
Dates of hearing: 2-3, 7-10, 14-18, 21, 24-25, 28-31 March 2011;
30-31 May 2011; 1-3, 6-7 June 2011; 1 December 2011; 3 February 2012; 20 August 2012
Date of last submissions: 10 September 2012 Place: Sydney Division: GENERAL DIVISION Category: Catchwords Number of paragraphs: 1247 Counsel for the Applicants: Mr AJ Meagher SC with Mr L Armstrong and Mr D Sulan
(2 March 2011-7 June 2011) Mr N Hutley SC with Mr D Sulan (1 December 2011 and 3 February 2012) Mr D Sulan (20 August 2012)
Solicitor for the Applicants: Piper Alderman Counsel for the Respondent: Mr J Sheahan SC with Mr S Nixon, Mr J Hutton and
Mr S Fitzpatrick Solicitor for the Respondent: Ashurst Australia
IN THE FEDERAL COURT OF AUSTRALIA
NEW SOUTH WALES DISTRICT REGISTRY
GENERAL DIVISION NSD 2492 of 2007
BETWEEN: WINGECARRIBEE SHIRE COUNCIL
First Applicant CITY OF SWAN Second Applicant PARKES SHIRE COUNCIL Third Applicant
AND: LEHMAN BROTHERS AUSTRALIA LIMITED (IN LIQUIDATION) (ACN 066 797 760) Respondent
JUDGE: RARES J
DATE OF ORDER: 21 SEPTEMBER 2012
WHERE MADE: SYDNEY
THE COURT ORDERS THAT:
1. The parties:
(a) prepare and exchange:
(1) on or before 8 October 2012 short minutes of orders to give effect to
the reasons for judgment delivered on 21 September 2012;
(2) on or before 12 October 2012 submissions as to matters on which they
cannot agree on the form of orders or to correct any omission or error
in those reasons;
(3) on or before 19 October 2012 submissions in reply;
(b) on or before 19 October 2012 provide a copy of such short minutes and
submissions to the associate to Rares J.
2. The proceedings stand over to 5 November 2012 for the purpose of making orders to
give effect to these reasons.
Note: Entry of orders is dealt with in Rule 30.32 of the Federal Court Rules 2011.
IN THE FEDERAL COURT OF AUSTRALIA
NEW SOUTH WALES DISTRICT REGISTRY
GENERAL DIVISION NSD 2492 of 2007 BETWEEN: WINGECARRIBEE SHIRE COUNCIL
First Applicant CITY OF SWAN Second Applicant PARKES SHIRE COUNCIL Third Applicant
AND: LEHMAN BROTHERS AUSTRALIA LIMITED (IN LIQUIDATION) (ACN 066 797 760) Respondent
JUDGE: RARES J
DATE: 21 SEPTEMBER 2012
PLACE: SYDNEY
REASONS FOR JUDGMENT
1 Introduction........................................................................................................ [1]
2 The Councils’ claims.......................................................................................... [10]
3 SCDOS - General ............................................................................................... [29]
3.1 Grange’s expert credentials...................................................................... [30]
3.2 A brief overview of SCDOs traded by Grange in 2002-2007.................. [34]
3.3 The nature of the Claim SCDOs .............................................................. [39]
3.4 The types of Claim SCDOs...................................................................... [52]
3.5 Relevant risks of the Claim SCDOs......................................................... [62]
3.5.1 Market implied risks..................................................................... [65]
3.5.2 The risk in respect of the amount of any loss............................... [80]
3.5.3 The risk of market price volatility ................................................ [85]
3.5.4 Liquidity risks............................................................................... [103]
3.6 The risks identified by the arrangers or issuers........................................ [114]
3.7 Risks identified in other contemporaneous documents............................ [126]
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4 Grange’s relationships with Swan, Parkes and Wingecarribee .................... [142]
4.1.1 Grange, its competitors and local government councils............... [146]
4.1.2 Grange’s personnel....................................................................... [148]
4.1.3 Grange’s business......................................................................... [154]
4.2 The initial relationship between Swan and Grange.................................. [155]
4.2.1 Swan’s personnel and its investment policy before 2003 ............ [155]
4.2.2 Swan’s contact with Grange before the 2003 Swan Policy.......... [167]
4.2.3 The 2003 Swan Policy.................................................................. [175]
4.2.4 Swan’s first investment with Grange – the Forum AAA SCDO.. [178]
4.2.5 Swan’s next investment: Argyle AAA SCDO ............................ [209]
4.2.6 Grange’s appreciation of Swan’s lack of financial sophistication................................................................................ [218]
4.2.7 Grange’s pattern of dealing with Swan from late 2003................ [229]
4.2.8 Swan’s dealings in 2005 with SCDOs ......................................... [244]
4.2.9 Grange’s “no haircut repos” ......................................................... [264]
4.2.10 Grange’s next dealings with Swan ............................................... [269]
4.2.11 Mr Senathirajah is succeeded by Mr Downing ............................ [274]
4.2.12 Mr Downing’s first transaction with Grange ............................... [285]
4.2.13 Grange’s 6 June 2006 IMP proposal for Swan............................. [292]
4.2.14 Why was Grange proposing switches?......................................... [293]
4.2.15 Swan’s transactions in 2006 after June ........................................ [308]
4.3 2007: Swan enters into an IMP agreement with Grange......................... [355]
4.3.1 The Swan IMP agreement ............................................................ [357]
4.3.2 Grange’s dealings under the Swan IMP agreement ..................... [363]
4.3.3 Mr Cameron succeeds Mr Downing in May 2007 ....................... [377]
4.3.4 Events after 2007 involving Swan................................................ [394]
4.3.5 Other factors going to causation of Swan’s investment decisions ....................................................................................... [396]
4.3.6 Causation ...................................................................................... [406]
4.4 The relationship between Parkes and Grange .......................................... [411]
4.4.1 Parkes’ personnel and investment policy before 2002................. [411]
4.4.2 Parkes’ initial dealings with Grange............................................. [430]
4.4.3 Parkes’ first SCDO investment with Grange – the Forum AAA SCDO.................................................................................. [439]
4.4.4 Parkes’ later dealings with Grange in 2003.................................. [463]
4.4.5 Parkes’ HY-FI transaction............................................................ [481]
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4.4.6 Parkes’ later dealings in 2003....................................................... [496]
4.4.7 Parkes’ dealings in 2004-2005 ..................................................... [501]
4.4.8 Parkes begins developing an investment policy........................... [553]
4.4.9 Parkes dealings with Grange in 2006-2007.................................. [565]
4.4.10 Parkes’ 2008 Esperance Combo Notes purchase ......................... [601]
4.5 The relationship between Wingecarribee and Grange ............................. [607]
4.5.1 Wingecarribee’s personnel and its investment policy in 2006..... [607]
4.5.2 Wingecarribee seeks to appoint an investment adviser................ [614]
4.5.3 Wingecarribee enters into the Wingecarribee IMP agreement with Grange .................................................................................. [637]
4.5.4 Wingecarribee’s and Grange’s early dealings under the IMP agreement ..................................................................................... [645]
4.5.5 The repos of 12 February 2007 and the meeting of 16 February 2007............................................................................... [653]
4.5.6 Wingecarribee’s finance committee meeting of 21 February 2007 .............................................................................................. [679]
4.5.7 Wingecarribee’s dealings with Grange to mid July 2007 ............ [689]
4.5.8 Wingecarribee’s decision to sell the Federation Claim SCDO .... [695]
5 The legal character of the relationships between the Councils and Grange................................................................................................................. [719]
5.1 The relationships between Swan and Grange .......................................... [721]
5.1.1 The pre-IMP agreement contractual relationship between Swan and Grange.......................................................................... [721]
5.1.2 Did Grange owe fiduciary obligations to Swan before 9 February 2007?............................................................................. [732]
5.1.3 What representations were made to Swan? .................................. [750]
5.1.4 Terms and representations not made out ...................................... [760]
5.1.5 The Swan IMP relationship .......................................................... [768]
5.1.6 What was Grange’s duty of care to Swan?................................... [784]
5.2 The legal consequences of the relationship between Parkes and Grange ...................................................................................................... [791]
5.2.1 The contractual relationship between Parkes and Grange............ [791]
5.2.2 Did Grange owe fiduciary obligations to Parkes?........................ [795]
5.2.3 What representations were made to Parkes? ................................ [796]
5.2.4 What was Grange’s duty of care to Parkes?................................. [807]
5.3 The legal consequences of the relationship between Wingecarribee and Grange ............................................................................................... [808]
5.3.1 The Wingecarribee IMP relationship ........................................... [809]
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5.3.2 What representations were made to Wingecarribee? ................... [814]
5.3.3 What was Grange’s duty of care to Wingecarribee? .................... [819]
6 Did Grange breach any obligation, duty or statute? ...................................... [820]
6.1 The Dante notes problem ......................................................................... [822]
6.1.1 The Dante notes in general ........................................................... [823]
6.1.2 The relevant terms of the Dante notes.......................................... [825]
6.1.3 The English and United States judgments.................................... [829]
6.1.4 Other developments relating to the Dante notes .......................... [833]
6.1.5 The position in respect of the collateral for the Dante Notes ....... [838]
6.2 Contractual breaches ................................................................................ [842]
6.2.1 The pre-Swan IMP agreement and Parkes contractual breaches by Grange ..................................................................................... [843]
6.2.2 Did the product have a high level of security for protection of the capital invested by the Council?............................................. [845]
6.2.3 Were the Claim SCDOs easily tradeable on an established secondary market? ........................................................................ [864]
6.2.4 Were the Claim SCDOs readily able to be liquidated for cash at short notice?.............................................................................. [883]
6.2.5 Were the products suitable and appropriate for a risk averse local government council?............................................................ [887]
6.2.6 Did the Claim SCDOs have secure income streams?................... [896]
6.2.7 Did Grange exercise reasonable skill and care in making each investment recommendation and giving that investment advice to Swan (before the IMP agreement) and Parkes? ....................... [899]
6.2.8 Did Grange breach the Swan IMP agreement? ............................ [904]
6.2.9 Did Grange breach the Wingecarribee IMP agreement?.............. [920]
6.2.10 Conclusions on contractual issues ................................................ [931]
6.3 Was there a breach of fiduciary obligation by Grange?........................... [932]
6.3.1 Did Grange commit a breach of its fiduciary obligations owed to Swan before 9 February 2007?................................................. [932]
6.3.2 Did Grange commit a breach of its fiduciary duty owed to Parkes?.......................................................................................... [942]
6.3.3 Did Grange commit a breach of its fiduciary duty owed to each of Swan and Wingecarribee in respect of their IMP agreements? .................................................................................. [943]
6.4 Were the representations made by Grange misleading or deceptive?...... [947]
6.4.1 The legislative context.................................................................. [947]
6.4.2 Were representations (1)(a) and (2) misleading or deceptive?..... [955]
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6.4.3 Were representations (1)(b) and (3)(g) misleading or deceptive? ..................................................................................... [961]
6.4.4 Were representations (3)(a), (b) and (c) misleading or deceptive? ..................................................................................... [969]
6.4.5 Were representations (3)(d), (e), (f) and (4) misleading or deceptive? ..................................................................................... [977]
6.5 Did Grange breach its duty of care?......................................................... [979]
6.6 Grange’s claim for indemnity under the IMP agreements ....................... [980]
7 Damages .............................................................................................................. [982]
7.1 The issues as to value of the Councils’ existing holdings of the Claim SCDOs...................................................................................................... [982]
7.1.1 The appropriate measure of damages - principles........................ [984]
7.1.2 How the damages should be assessed .......................................... [996]
7.2 Valuations of the Claim SCDOs .............................................................. [1007]
7.2.1 Swan’s and Parkes’ sales of the Kalgoorlie, Esperance and Blaxland Claim SCDOs................................................................ [1007]
7.2.2 The issues between the valuers .................................................... [1014]
7.2.3 The use of bids in valuation ......................................................... [1019]
7.2.4 The valuation of the remaining non Dante notes.......................... [1026]
7.2.5 The valuation of the Dante notes.................................................. [1053]
7.3 Other issues on valuation ......................................................................... [1074]
7.3.1 The restructure SCDOs non-issue ................................................ [1074]
7.3.2 The valuation issue in Grange’s liquidation................................. [1075]
8 Grange’s defences .............................................................................................. [1078]
8.1 The issues Grange raised as defences ...................................................... [1078]
8.1.1 Proportionate liability – principles ............................................... [1082]
8.2 Concurrent wrongdoers ............................................................................ [1085]
8.2.1 Grange’s claims that the ratings agencies were concurrent wrongdoers ................................................................................... [1085]
8.2.2 Were the ratings agencies concurrent wrongdoers? ..................... [1091]
8.2.3 Grange’s claim that Lehman Asia was a concurrent wrongdoer.. [1103]
8.2.4 Did Grange act in accordance with peer professional opinion? ... [1108]
8.3 Contributory negligence........................................................................... [1118]
8.3.1 The legislative schemes................................................................ [1118]
8.3.2 Principles applicable to contributory negligence ......................... [1123]
8.3.3 Was Swan contributorily negligent? ............................................ [1132]
8.3.4 Was Parkes contributorily negligent?........................................... [1143]
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8.3.5 Was Wingecarribee contributorily negligent?.............................. [1172]
9 Are the typical Claim SCDOs “derivatives” within the Corporations Act 2001...................................................................................................................... [1176]
9.1 The “derivatives” issue............................................................................. [1176]
9.1.1 The general nature of the issue..................................................... [1176]
9.1.2 The legislative scheme ................................................................. [1177]
9.1.3 The relevant features of the transaction documentation for the Blaxland Claim SCDO ................................................................. [1180]
9.2 The parties’ submissions .......................................................................... [1186]
9.2.1 The parties’ arguments – debentures............................................ [1186]
9.2.2 The parties’ arguments – managed investment scheme ............... [1189]
9.3 Consideration – Were the typical Claim SCDOs derivatives contracts?.................................................................................................. [1194]
9.3.1 Consideration – Were the typical Claim SCDOs debentures? ..... [1194]
9.3.2 Consideration – Were the typical Claim SCDOs a managed investment scheme?...................................................................... [1206]
9.3.3 Consideration – derivatives .......................................................... [1214]
10 Common questions............................................................................................. [1215]
10.1 The common questions identified? .......................................................... [1215]
10.1.1 The role of common questions ..................................................... [1215]
10.1.2 The common questions posed by the Councils ............................ [1219]
10.2 Common questions – consideration ......................................................... [1221]
10.2.1 Question (1): The features of the Claim SCDOs......................... [1221]
10.2.2 Question (2): Were the Claim SCDOs consistent with conservative investment strategies or investment requirements in legislation affecting local government bodies or trustees? ...... [1224]
10.2.3 Question (3): What was Grange’s obligation or duty to exercise reasonable skill and care and did it breach that obligation or duty?........................................................................ [1226]
10.2.4 Question (4): Did Grange engage in conduct that was misleading or deceptive? .............................................................. [1232]
10.2.5 Question (5): What contracts were made between Grange and its non IMP claimants, what, if any, fiduciary obligations did Grange owe and what, if any, breaches were there of either?...... [1235]
10.2.6 Question (6): What rights did the Western Australian IMP agreement claimants have?........................................................... [1241]
10.2.7 Question (7): What rights did the New South Wales IMP agreement claimants have?........................................................... [1242]
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10.2.8 Question (8): What are the correct principles for measuring damages? ...................................................................................... [1244]
11 Conclusion........................................................................................................... [1245]
1. INTRODUCTION
1 The three applicants, Wingecarribee Shire Council (Wingecarribee), Parkes Shire
Council (Parkes) and City of Swan (Swan) are local government bodies (the Councils).
Each had dealings with the respondent, Grange Securities Limited, as it was called, before
being acquired by the Lehman Bros group in early 2007 and being renamed Lehman Bros
Australia Ltd (I will usually refer to the respondent as “Grange” since most of the dealings
occurred when it was so named). These are representative proceedings or a “class action”
brought under Pt IVA of the Federal Court of Australia Act 1976 (Cth). The applicants claim
that the different manners in which each dealt with Grange reflect aspects of the relationships
that other group members (claimants) had with it on which the group claims are based. In
these reasons for ease of reading, I will describe the claims made by each Council without
referring separately to the fact that it is also a claim made generically for the claimants. I will
return to the group issues in section 10 below.
2 Each Council had surplus funds to invest. Each sought a secure investment with a
reasonable return. Before they commenced dealing with Grange, each Council had invested
surplus funds in floating rate notes (FRNs) with approved deposit taking institutions (ADIs),
such as Australian banks and building societies that were regulated by the Australian
Prudential Regulation Authority (APRA).
3 In about early 2003, Grange began recommending a new type of financial instrument
to persons with whom it sought to deal. This product was known as a synthetic collateralised
debt obligation or SCDO. SCDOs were extremely complex. They took hundreds of close
typed legally dense pages to document, and it was no easier to understand how they operated.
Each SCDO was a bespoke product, though they shared some common features. Grange was
the vendor of each SCDO it sold to the Councils.
4 Each Council claimed that Grange was an investment adviser to it. Grange, in
contrast, asserted that in most cases it was a financial product vendor, much like an
equipment supplier, or a salesperson. Both Swan and Parkes began dealing with Grange in
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around late 2002 and this relationship continued until late in 2007 or early 2008. These
dealings involved Grange proposing investments to each of those Councils in SCDOs.
Grange usually made presentations of the particular SCDO orally and in writing to the
Council’s responsible officer. Those presentations explained some features of the proposed
investment, but both Swan and Parkes assert that the explanations were deficient.
5 In January 2007, Wingecarribee entered into an individual managed portfolio (IMP)
agreement with Grange. This allowed Grange to invest the Council’s funds in financial
products with credit ratings of AA and above of a kind approved by the New South Wales
Minister for Local Government, including SCDOs as well as FRNs issued by ADIs. Later, in
February 2007, Swan also entered into an IMP with Grange.
6 Grange used its position under the IMP agreements to cause each of Wingecarribee
and Swan to purchase a number of SCDOs as part of their portfolios. By mid 2007 the seeds
of what has become known as the “global financial crisis” had begun to germinate. Until
then, Grange had made a secondary market for the SCDOs it had placed with the Councils,
that substantially allowed them to be bought and sold at or near face or par value. However,
the tightening of international credit markets significantly affected the liquidity of both
Grange and SCDOs generally. The SCDOs then held by the Councils (which I will refer to
as “the Claim SCDOs”) could no longer be sold at or near face value on the secondary
market made by Grange. In addition, a number of Claim SCDOs had suffered significant
events that had reduced or eliminated the sum for which they could be redeemed at maturity.
These consequences provided a practical illustration of significant differences between
SCDOs, on the one hand, and, on the other, FRNs of the kind the Councils had invested in
before they dealt with Grange.
7 The case involving each Council is based on its own individual facts and I will deal
with each case separately later in these reasons. In broad and over-simplified terms, the
Councils claimed that Grange acted in breach of contract, negligently and engaged in
misleading or deceptive conduct in recommending, advising on, or explaining, to them or
using its power in the IMP agreements to make, the investments in each of the SCDOs they
held. In addition, they claimed that Grange acted in breach of its fiduciary duty as investment
adviser or portfolio manager. The Councils argued in final address that, in essence, Grange
acted in the circumstances in breach of its duty of care (in both contract and tort) or its
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fiduciary duty in failing to warn them about, or investing in SCDOs under the IMP
agreements, by failing to inform the Councils of, or misrepresenting the nature of, three types
of risk. This was because the Councils contended that:
(1) the SCDOs were either illiquid, in that there was no active or assured
secondary market in them or they were materially less liquid than FRNs with
an equivalent rating;
(2) the SCDOs had the risk of market price volatility. The Councils argued that
this was because the price for which they could be realised depended on
Grange being able to make a secondary market in, or itself buy back, an
SCDO if a Council wanted to sell it before maturity;
(3) the SCDOs were not equivalent, as regards material risks, to other types of
financial products carrying the same ratings because the rating assigned to
each SCDO only addressed the probability of default and did not address:
(a) the market implied risk in the SCDO itself;
(b) the amount of loss in the event of default.
8 The pleadings cover an array of alleged risks, misrepresentations, breaches of duty
and defences. A number of these had fallen to the wayside by the time of the parties’ closing
written submissions and oral argument. It is not necessary to deal with those matters that
were not substantively in issue at the time of the oral argument. Even complex litigation such
as this cannot require the Court to phase and analyse in reasons for judgment a plethora of
issues, pleadings or contentions that neither party thought decisive enough to argue seriously
in final address.
9 The duty of all participants in litigation, including the Court, is encapsulated in the
overarching purpose of the civil practice and procedure provisions of Pt VB of the Federal
Court of Australia Act. It is to facilitate the just resolution of disputes according to law and
as quickly, inexpensively and efficiently as possible (s 37M(1)). Of course, that purpose is
facultative of the disposition of the substantive disputes as to the rights and obligations that
the parties have put in issue in their litigation. Nonetheless, pleaded points and issues that
have fallen by the litigious wayside should stay there. They should not burden the Court
further by requiring attention to be given in reasons for judgment to dealing with them, when
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the parties did not rely on them at the concluding phase of their dispute in final submissions.
In any event, if in these reasons I have overlooked a point of real substance that requires
resolution, the parties will be able to raise it since I will not be pronouncing final orders
dealing with the disposition of the Councils’ cases until after the parties have had the
opportunity to address the form of those orders in light of these reasons.
2. THE COUNCILS’ CLAIMS
10 As the hearing progressed the Councils’ cases changed from their initial emphases on
certain aspects of the SCDOs that they contended supported their cases to concentrate on a
narrower, and, according to Grange in some instances unpleaded, range of issues.
11 Modern pleading in commercial cases is often antithetic to identifying the real issues.
This is not necessarily the fault of a pleader. The plethora of available causes of action,
statutory, common law and equitable, entrances pleaders into categorising the material facts
into separately pleaded causes of action. In this case the final pleadings were over 200 pages
long. Yet, as is almost invariably the case in such litigation, neither the written nor oral
arguments actually analysed, subparagraph by subparagraph, each individual pleaded
contractual term or representation.
12 At various points in the trial and argument, each party invoked the pleadings to
support or attack a contention being advanced. All of the legal representatives were
competent. They concentrated on the significant issues, which allowed for the emergence
and disappearance of some issues as the case proceeded.
13 The claim SCDOs were highly complex financial instruments, underpinned by
equally complex, and at points arcane, legal documentation to give them effect. None of the
Council officers ever saw those legal documents. None of the actual transaction documents
that established any claim SCDO was tendered in evidence. The closest approximation was a
set of several hundred pages of the final documentation for the Blaxland SCDO, which the
parties agreed was typical of almost all the Claim SCDOs. Nonetheless, three experts spent a
day in concurrent evidence dealing with structural issues and differences in various claim
SCDOs.
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14 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. Each Council sought to explain that
outcome by reference to aspects of its relationship with Grange. Importantly, a significant
feature of the way in which Grange carried on its business was to target Councils, as potential
or actual clients with ready access to very large sums of money for investment over short,
medium and longer terms.
15 The Councils argued in submissions that Grange was a trusted financial adviser which
had recommended these investments. In contrast, Grange contended that it was a mere seller
of financial products and that had offered the Councils no financial advice, but merely made
an accurate sales pitch for those products. I will deal with the nature and operation of
Grange’s business in some detail later in these reasons. However, it is important to
understand that each transaction for the sale or purchase of an SCDO by a Council involved
Grange as a principal which either bought or sold the SCDO. The Councils were aware that
Grange was acting for itself as a principal in these dealings, but not aware of any particular
benefits it received from doing so. Grange, unlike the Councils, had the financial acumen,
skill and capacity to analyse the risks associated with, and to make assessments of the value
of, SCDOs as financial investments.
16 Each of the four principal bases on which the Councils claim against Grange requires
consideration in light of the actual relationship between the parties. Since the relationship
was governed by a contract, then that contract will provide a context for considering whether
any further duty of care or fiduciary duty applied as well as for assessing whether any
conduct by Grange was misleading or deceptive.
17 Contract: The contractual relationships fall into four categories. The first two are
the relationships between Grange and each of Swan (before it entered an IMP agreement with
Grange) and Parkes in respect of their dealings over the years 2003 to 2007 (the non-IMP
contracts). The second two are the relationships between Grange and each of Swan and
Wingecarribee under their respective, and differently worded, IMPs.
18 Non-IMP contractual issues: It is common ground that each of the purchases from,
and sales by, Grange of SCDOs that was effected between it and each of Swan, before it
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entered its IMP agreement with Grange, and Parkes occurred pursuant to a separate contract
for each individual transaction. One question is what, if any, additional terms formed part of
each such contract, apart from those dealing with the uncontroversial issues of price, subject
matter (i.e. what SCDO or other financial product was being purchased or sold) and
settlement of the transaction. Swan and Parkes claim, and Grange disputes, that each non
IMP contract also included terms that:
(1) the financial product would be suitable for an investor with a conservative investment
strategy; i.e. a strategy to invest in debt instruments that:
(a) were either short term (less than one year term to maturity) or, if longer term,
offered high levels of capital security rather than high rates of return;
(b) were easily tradeable on established markets;
(c) were readily able to be liquidated for cash at short notice;
(d) had a secure income stream and little need for capital growth;
(e) offered protection of capital to the extent this were possible;
(f) were not derivative or synthetic financial products;
(g) were transparent as to the underlying asset backing and risk exposures in terms
of any effect on return of an investor’s capital.
(2) the financial product would be suitable for the individual needs of the Council.
(3) Grange would provide the Council with all the relevant knowledge which it possessed
regarding that financial product concealing nothing that might reasonably be regarded
as relevant to the making of an investment decision.
(4) Grange would exercise reasonable skill and care in making any investment
recommendations to the Council.
19 The Councils alleged, and Grange denied, that Grange breached these contractual
terms. The bases on which the Councils claimed that Grange was in breach were because:
(1) each Claim SCDO purchased by each Council was not suitable for its individual
needs.
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(2) Grange did not adequately disclose to each Council any of a plethora of matters
including:
(a) Grange’s significant commercial interest in the transactions involving claim
SCDOs because of:
Grange’s role and liabilities as placement agent or underwriter of the
SCDOs or, after 7 March 2007, its relationship to its new parent,
Lehman Bros or related companies as arrangers or credit default
protection buyers of SCDOs Grange sold;
the nature and extent of fees and commissions Grange earned from
structuring and selling the SCDOs;
(b) Grange’s awareness of the terms of each of the Claim SCDOs and its having
all the documentation for them in its possession.
(c) the nature of the Claim SCDOs resulted in their not meeting the various
objectives of the Council’s conservative investment strategy because of the
following features that I broadly summarise here but later will, where they are
relevant, examine in detail and explain some of the terminology in section 3 of
these reasons, namely:
their synthetic nature and their complex structure;
the risk of loss of capital;
the impact on the return of capital to noteholders;
the impact of various pleaded risks if the claim SCDOs were not
transparent;
their being highly leveraged and, in most cases, consisting of thin
tranches, so that they were significantly sensitive to the performance of
their reference entities;
the lack of any active secondary market other than through Grange
acting either as a buyer, seller or placement agent for such transactions
with its other clients;
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they were “hold to maturity” investments with no right for a noteholder
to redeem early;
despite being rated for risk by ratings agencies, their risk profiles were
different from, and not equivalent to, those of other financial products
that had the same ratings as the Claim SCDOs;
they were materially different from “traditional” FRNs;
they were exposed to a number of unusual risks.
20 A number of the features and risks on which the Councils initially relied when they
opened their case at the hearing fell by the wayside by the time of final address. I have set
out in [7] above those that remained prominent at the latter time. Initially, the Councils had
pleaded that the Claim SCDOs were also affected by rating migration risk (being the effect
on the market value, rating and liquidity of the SCDO if there were ratings downgrades in the
reference entities); correlation risk (being the effect on the market value of the SCDO from
a number of contemporaneous or proximate credit events affecting several reference entities);
credit event risk (being the use of the collateral provided to support the issuer of the SCDO
to pay the credit default swap counterparty as a result of the occurrence of sufficient credit
events. Such payments would deplete or eliminate the collateral from which the investors
would be repaid the principal invested on maturity) and modelling risk (being the possibility
that a market change could occur that was not provided for in the assumptions or modelling
used in the SCDO that might affect its value).
21 Negligence: The Councils contended that Grange offered to, and did, provide them
with investment advisory services. Grange denied that it acted in that capacity at all, except
that it asserted that, after entering into IMP agreements with them, it provided each of Swan
and Wingecarribee with the services it had contracted to provide under its respective IMP
agreements.
22 The Councils alleged that Grange owed each of them a duty of care to ensure that
correspondingly it provided financial services advice to the standard of a person with
specialist skill and expertise in this field. The Councils asserted that Grange’s advice and its
services were deficient in the respects set out in [7] above. They also alleged that Grange
owed duties similar to a number of the contractual terms on which they relied including that:
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any investments that Grange made for, or recommended to, the Councils were
consistent with a conservative investment strategy and complied with statutory
and Council policy requirements;
financial products that Grange recommended had ratings that were equivalent,
as to risk, with investment grade ratings applied to other financial products;
Grange would monitor the investments the Councils made on its
recommendation and advise them whether or not to sell them;
when recommending a financial product, Grange would conceal nothing that
might reasonably be regarded as relevant to the making of a decision on
whether or not to invest in it.
23 The Councils alleged that they relied on Grange in making their investments in each
of the Claim SCDOs and suffered loss because of those investments and/or Grange’s non
disclosures of matters the Councils relied on as its breaches of contract.
24 Grange contended that its relationships in its dealings with Parkes and, before their
IMP agreement, Swan were those of arm’s length buyers and sellers of financial products. It
argued that it had not breached any duty of care.
25 Misleading and deceptive conduct: The Councils alleged that Grange made
representations to them that, in substance, repeated many of the asserted breaches of contract
and duty of care. Grange disputed most of these except where they reflected the terms of an
IMP agreement in respect of Swan and or Wingecarribee. Materially, these representations
were that:
(1) 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 (i.e. that in
[18(1)] above); and
(b) complied with statutory and Council policy requirements.
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(2) Grange observed prudent, conservative income defensive, capital protective and pro-
liquidity practices when investing on behalf of local government authorities or
investing with conservative investment strategies.
(3) the Claim SCDOs:
(a) were, or had, risk profiles (i.e, material risks) equivalent to, traditional FRNs;
(b) were equivalent as regards risk profile (i.e, material risks), to other types of
financial products with the same rating;
(c) were, or had risk profiles (i.e, material risks), equivalent to or better than the
four major Australian banks;
(d) offered excellent liquidity;
(e) were as liquid as traditional FRNs;
(f) were and would be readily redeemable in a secondary market;
(g) had maturity dates that were suitable to each Council’s needs and complied
with its investment policies;
(4) Grange was active in the secondary market for SCDOs and was bound to buy back the
Claim SCDOs, if requested to do so, to provide liquidity in illiquid products;
(5) the underlying risk exposures of any investment that Grange made would be fully
transparent in terms of their effect on the payment of the coupon rate of interest and
return of capital.
26 The Councils alleged that each of these representations was false and amounted to
conduct that was misleading and deceptive in contravention of s 1041H of the Corporations
Act 2001 (Cth) or s 12DA of the ASIC Act 2001 (Cth) as well as the Fair Trading Acts of
New South Wales and Western Australia. They also contended that each of the
representations in [25(2), (3)(d) to (g) and (4)] was a representation as to a future matter for
which Grange did not have reasonable grounds at the time it made the representation. I
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explain below in [755] why I have equated the pleaded expression “risk profiles” with
“material risks” in the pleaded representations..
27 Breaches of fiduciary duty: The Councils alleged that Grange owed each of them
fiduciary duties:
(a) not to act in a position of conflict between its interests or duties and the
interests of the Council;
(b) not to profit from its position of investment adviser or portfolio manager of the
Council other than as provided in either relevant contract for sale of the Claim
SCDO or the IMP agreement (as the case required).
28 The Councils alleged that Grange breached each of those duties by causing assets of
each Council to be invested without the Council’s fully informed consent in respect of
SCDOs in which Grange had a conflict of interest or duty in acting as a vendor to, or
purchaser from, the Council. The Councils contended that as a result of Grange so acting in
breach of its fiduciary duties it profited from its position as the relevant Council’s investment
adviser or portfolio manager and or the Council suffered loss and damage.
3. SCDOS - GENERAL
29 I will describe the general characteristics of SCDOs shortly. This is in order to
understand what may have been said or omitted when Grange’s officers explained, or
suggested investment in, SCDOs to the Councils and their officers. However, each SCDO
was a bespoke instrument, and so not every one may have each of these general
characteristics. In addition, the description “SCDO” may not be apposite for a small number
of the 39 instruments for which one or more of the Councils claim damages. However, all 39
were called “Claim SCDOs” by the parties. They were all structured products and had
relevant similarities. As the parties did, I will deal with the few products that were not
strictly SCDOs separately when it is necessary to distinguish them.
3.1 Grange’s expert credentials
30 The following description was common ground. Throughout the period from, at least,
late 2002 to 2007 Grange marketed itself to local government authorities, as having had
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expertise and experience in their sector since 1995. From 2002 Grange trained its staff on the
workings of collateralised debt obligations (CDOs) and SCDOs. It stated that this expertise
and experience extended to:
developing internal investment policies;
co-ordinating and reviewing investment strategies;
interpreting legislative requirements in respect of relevant investment criteria;
the development of risk and return profiles;
the active management of direct security portfolios;
preparing and reviewing regular investment reports;
co-ordinating revised investment strategies;
interpreting and managing economic conditions through appropriate
investment strategies.
31 In 2003, Grange had 30 specialist fixed interest staff providing what it described as a
broad market experience and expertise. It claimed that it supported all of its
recommendationsfor the products it sold to the Councils with rigorous research and due
diligence that looked beyond the explicit credit rating. Moray Vincent, Grange’s director,
debt capital markets made a presentation to councils at Orange, New South Wales in October
2004 in which he said that Grange:
was a market leader and the most experienced underwriter of investment grade CDOs
in Australia by number and volume;
was able to negotiate larger issue sizes with arrangers on behalf of investors;
partnered with arrangers to structure SCDOs to meet the time of maturity, rating,
yield and differentiation desired by investors;
thoroughly reviewed all aspects of each SCDO transaction and only approved those
that Grange deemed both offered good value and were appropriate for its investors;
had a dedicated team of experts with leading product knowledge.
32 By 2006, Grange was advising 85 councils in New South Wales, 40 in Victoria and
12 in Western Australia. It asserted that it had a detailed understanding of the local
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government market that was unmatched in the financial markets. Grange relied on its
expertise to claim that its product development for the local government market was “…
focused specifically to meet the financial needs of local government within the parameters of
relevant legislation”. Grange said that it had the largest fixed interest sales team of any
financial institution in Australia.
33 And Grange accepted in its written submissions that it had represented to both Parkes
and Swan that it had conducted “rigorous analysis” of each SCDO prior to marketing that
SCDO to its clients. Thus, in the slide presentation that Grange gave in mid 2003 to Swan
before it purchased the Forum AAA SCDO, it promoted itself as follows on a slide “Work
Grange Does Before it Recommends a Transaction”:
“Grange does a rigorous analysis of each deal (beyond the formal rating provided by S&P) before recommending it to clients. This includes:
Checking the credit quality of all the underlying entities using their CDS trading prices and KMV scores (a credit rating model based on equity prices);
Checking the tranche credit rating using its own proprietary binomial and
multiple binomial models (similar to Moody’s methodology);
Conducting a ratings transitions analysis assessing the current CDO market
and CDS markets.”
3.2 A brief overview of SCDOs traded by Grange in 2002-2007
34 Grange acted as the vendor, placement agent or underwriter in respect of at least 51
SCDOs between 2002 and 2007. Each SCDO was given a name under which it was
marketed. The products were also called “notes”. This was usually a locality. Grange began
marketing its first SCDO in early November 2002. It was called “Gibraltar AA” but none of
the Councils acquired it at that time. The first SCDO acquired by any of the Councils was
called “Forum AAA”. Grange placed or underwrote Forum and sold it to Parkes in March
2003 and Swan in September 2003. In June 2007, Grange sold or underwrote its final SCDO,
“Merimbula BBB”. The total face value of these products ranged in size from $7 million for
the Gibraltar product in 2002, to $135 million for the Newport AAA product in February
2006. In the period between 2002 and 2007 Grange dealt with a number of issuers and
arrangers most of which were, or were subsidiaries of, well known banks or investment banks
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such as ABN Amro, Deutsche Bank, Credit Suisse, BNP Paribas, Nomura, Barclays Capital,
Calyon, HSBC, Merrill Lynch, Morgan Stanley and Lehman Bros.
35 After Lehman Bros acquired Grange in March 2007, the new SCDOs sold by Grange
were arranged or issued by a Lehman Bros entity. I will need to deal with a particular
problem that these products had in section 6.1 below. Grange also engaged in arranging
“switches” of its clients’ holdings in SCDOs. In a switch transaction Grange would buy a
particular SCDO or product from its client and at the same time sell another SCDO or
product to the same client; hence the client “switched” its investment from one product to
another.
36 As I will explain in more detail below, each SCDO had a “maturity date”. That was
the time at which any money, including interest due by the issuer, had to be paid to the note
holders or owners of interests in the instrument. Some SCDOs had “call dates”, earlier than
the maturity date, on which the issuer or the arranger could elect to pay the money that would
otherwise only be due at the maturity date. Between 2002 and 2007, seven SCDOs that
Grange had placed or underwritten reached final maturity and investors received back the
sum they had invested together with all interest that had been payable. Seven of the other
SCDOs were fully bought back by their arranger before maturity, after Grange had acquired
them from its clients and any other holders, often through switches, in circumstances that I
will discuss later in these reasons.
37 In general, Grange engaged in switches, first, to facilitate a buy back by the arranger
of some or all of the issued notes or interests in an SCDO prior to the date of maturity of the
SCDO, or, secondly, to achieve a rearrangement of various clients’ holdings or its (Grange’s)
own risk, as I will also explain later in these reasons.
38 The first switch from one SCDO to another involving one of the Councils occurred in
February 2004 when Grange recommended to Parkes that it sell Griffin and purchase
Balmoral. The number of switches that Grange promoted to, or arranged for, its clients grew
significantly from 2005. Thus, in the period between 2005 and 2007, Grange recommended
16 switch recommendations to Parkes. As I will explain below, some of those switches
appeared to have no commercial purpose from Parkes’ perspective.
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3.3 The nature of the Claim SCDOs
39 Each of the Claim SCDOs was a structured finance instrument. In January 2005, a
working group of Committee on the Global Financial System of the Bank for International
Settlements published a report “The role of ratings in structured finance: issues and
implications” (CGFS publication No 23) (the 2005 Working Group report). This report
described these products as having 3 key characteristics: first, pooling of assets which can be
either cash based or synthetically created; secondly, tranching of liabilities that are backed
by the asset pool; and thirdly, de-linking of the credit risk of the underlying or “portfolio”
asset pool (such as loans, bonds or residential mortgages) from the credit risk of the
originator (or arranger) that is usually done through its stand alone, special purpose vehicle.
The second characteristic, tranching, differentiates structured finance from what the Working
Group described as traditional “pass-through” securitisations (being an instrument issued by a
borrower that gives the lender recourse to the company’s assets).
40 The conceptual structure and operation of an SCDO was explained by Paul Hattori, an
expert in credit derivatives and capital markets. He had been called by Grange. In an SCDO
transaction, a special purpose vehicle (SPV), usually resident in a tax neutral jurisdiction,
“issues debt”. That is, the SPV creates an obligation, typically in the form of notes or other
instruments promising to pay a return to a person who invests in or lends funds to the SPV.
The money invested or lent is placed in a highly rated asset, such as a bank deposit, a bond or
an insurance contract. That asset is called “collateral”. The SPV will receive periodic
payments of interest earned on the collateral. The SPV then enters into a derivative contract
with an investment bank in the form of a portfolio credit default swap (“PCDS or swap”).
The investment bank is called the “swap counterparty”. It pays a regular premium to the
SPV. The investment returns on the collateral and the regular premiums paid by the swap
counterparty enable the SPV to pay the interest due on the note to the note holders and the
balance to the issuer, as its profit.
41 If all goes well, the issuer can exercise its right to call in the notes on the call date or
at the maturity date. If, at that time, there has been no default under the PCDS requiring the
SPV to pay the swap counterparty some or all of the collateral (as explained below), then the
SPV terminates the PCDS, realises the collateral and uses the proceeds to repay the face
value of the notes. Thus, payment of the whole or some of the investor’s interest and
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principal will be dependent on the SPV not being required to pay the swap counterparty
money under the PCDS.
42 The swap works as follows. Usually, the terms of an SCDO will provide for the
issuer to repay or return the face value original price to an investor on the maturity date
together with any outstanding interest. In addition, most of the Claim SCDOs had a term
entitling the issuer to call the notes in and repay them early on its call date. This was usually
between 3 and 5 years after the initial issue date. The issuer’s incentive to exercise its right
to repay on the call date was that, if it did not, there was an increase in the interest rate
payable thereafter.
43 The PCDS identifies a notional portfolio of what are called “reference entities” and
defines various “credit events”. The reference entities in the Claim SCDOs are typically, but
not always, liabilities of companies listed on one or more stock exchanges that are rated by
credit rating agencies. The PCDS defines the particular loss that, for its purposes, is
attributed to the occurrence of the credit event. For example, if a reference entity defaults in
paying interest, the PCDS will define that as a credit event and attribute a loss to the holders
of debt issued by the reference entity. Then, the PCDS will deem the notional portfolio to
have suffered a loss. The credit events may also be defined in the PCDS as a default in one
of reference entities or a downgrading of its, or its issuer’s, credit rating. The corollary of
that loss to the portfolio’s value is that the PCDS will attribute a “recovery” value to it.
44 Mr Hattori explained that the aim of the PCDS is to transfer credit risk on the
portfolio from the swap counterparty (investment bank) to the SPV. That transfer of risk
occurs under the provisions of the PCDS dealing with the consequence of a credit event
experienced by a reference entity. In addition, the terms of the PCDS may include rules or
portfolio guidelines for changing one or more of the reference entities. The PCDS can
provide for the portfolio of the PCDS to be actively managed, so that the manager can replace
an entity in the reference portfolio that it anticipates is likely to suffer a credit event with one
that it considers to pose a lesser risk. Alternatively, the PCDS may not allow any
substitutions or changes in the reference entities.
45 The terms of the PCDS will define how the recovery value is determined. Typically,
the recovery value may be a predetermined fixed amount of the debt issued by the relevant
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reference entity or it may be determined by the then current market value of that entity’s debt
obligation (called a “floating” price). The following example illustrates the way in which the
PCDS will take account of the recovery value: if a bond with a face value of $100 trades at
$60 after a credit event, the portfolio will, first, suffer a loss of 40% of the bond’s notional
$100 value and have a “recovery” of 60%: i.e. the terms of the PCDS deem that the portfolio
will recover only 60% of its original valuation of the bond. The consequence of a credit
event is that the notional portfolio will be deemed by both the SCDO and PCDS to have
suffered a loss. In the case of the example, the deemed loss will be 40% of the original face
value of the debt of the reference entity. This loss may then result in the SPV being required
to make a payment to the swap counterparty, as if to compensate it.
46 The reference portfolio and the “loss” are both “notional” in the sense that, first, the
parties to these arrangements have not directly invested in any of the debt or issuing
corporations in the portfolio and, secondly, it is not necessary for anyone at all to suffer an
actual loss. For example, the reference entity that suffered a credit event, deemed by the
PCDS to cause a loss for its purposes, may only have suffered a downgrading of its credit
rating or missed an interest payment but may later pay the whole of its debt and interest to its
creditors. Nonetheless, the terms of the SCDO and PCDS will treat the credit event as a once
for all occurrence resulting in a final, deemed loss that is quantified in the way I have
described. This feature, of detachment of performance of the notional portfolio from any
underlying real world losses sustained by the parties to the transaction, is one reason why the
CDOs are called “synthetic”.
47 The SPV issues debt or notes of different levels or tranches of seniority. This
operates much like layers of cover operate in insurance and reinsurance markets. Thus, the
lowest or first tranche bears the first losses in the reference portfolio. Until the losses exceed
the value of that lowest tranche, the tranches above it remain intact, although they will be
more vulnerable to the impact of future credit events. This is because after an initial loss or
losses to the lowest or lower tranches, a lesser number of further credit events will now stand
between the layer or tranche covered by the SCDO and its corresponding PCDS.
48 Ordinarily, different persons will invest in the different issued layers or tranches of an
SCDO just as different insurers or reinsurers accept risk on different layers of cover. Mr
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Hattori provided the following diagrammatic representation of an example of the primary
cash flows in a fully funded SCDO structure:
Figure 1
49 One way Mr Hattori used to describe how the layers or tranches operate, was in terms
of the percentage loss each suffered on the underlying portfolio. There can be more or less
tranches than in the example illustrated in figure 1. He gave an example where the first loss
layer (the “equity” tranche in figure 1) covered the first 5% of losses. That layer has what is
called an “attachment point” or “threshold” or “subordination” of 0%. That is, the
tranche’s direct exposure to a loss occurs immediately, since there is no tranche below the
first. The tranche has what is called a 5% “thickness” or “exhaustion” or a variation of these
terms. This tranche will absorb up to the first 5% of losses. The second loss layer, or tranche
(the “junior” tranche in figure 1) might cover, say, the next 4% of losses. It will be said to
have a 5% lower attachment point, subordination or threshold, with 4% exhaustion, 5%-9%
or “5-9” attachment points, or similar.
50 The holders who own interests in a tranche above the lowest will only suffer loss on
their investment (as distinct from its market value) after the losses in all lower tranches have
passed each lower tranche’s exhaustion point or “wiped out” those tranches. Once that
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occurs, the attachment point of the holder’s tranche has been reached and any further losses
in the notional portfolio will have a direct effect in two ways: first, the principal sum on
which interest is calculated will be reduced to reflect the remaining proportionate thickness of
the holder’s tranche, secondly, the sum payable on the maturity date will be reduced to the
same proportion of the face value of the SCDO or the note issued to the holder in respect of
it.
51 The lowest tranche carries the greatest risk of loss. Thus, the risk taken on by the
SPV for a particular tranche in an SCDO is that it will have to pay the swap counterparty
from the collateral if notional losses occur on the notional portfolio within the attachment and
detachment points of the tranche. Once the collateral is reduced, the SPV usually will have a
smaller investment on which to earn interest to pay the coupon or interest due to holders of
the SCDO, and concomitantly a smaller sum with which to pay the amount due on maturity.
Depending on the terms of the SCDO and PCDS, if a credit event occurs the partial
realisation and payment of the collateral may be required immediately or be deferred until
maturity. In some cases, the SPV can issue debt obligations and enter into a PCDS that
covers only one tranche or different tranches and these can be in different currencies and in
different sizes.
3.4 The types of Claim SCDOs
52 Mr Hattori explained that the 39 Claim SCDOs fell into a number of classes. The
parties accepted his classifications. Only two of the Claim SCDOs were not based on credit
risk in the sense I have just explained: i.e. the risk of occurrence of a credit event that alone,
or after one or more earlier credit events, will cause a sale of the collateral that had secured
the ability of the SPV to pay holders both the sum due at maturity and interest in full.
53 Mr Hattori identified two structural subclasses for the 37 credit risk based Claim
SCDOs, first, tranche based SCDOs in the sense I have explained above, and secondly, Nth to
default (NTD) basket notes: i.e. a contract in which the SPV promises to pay the
counterparty a set amount after a specific number of defaults (N) have occurred in a defined
portfolio or “basket” of reference entities within a specified time period. The 4 NTD notes
were: 2 called Global Bank Note AAA and Global Bank Note 2 AAA, as well as those
named Mahogany and Nexus 4 Topaz. For example, the 2 Global Bank Notes were 2 NTD
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notes with 8 reference entities. Thus, if 2 of those reference entities defaulted nothing would
be payable at the time of maturity of the note.
54 One of the remaining 33 Claim SCDOs, Octagonal, was a balance sheet CDO, i.e. a
CDO that transferred risk to the SPV directly from the arranging bank’s lending book. In
other words, the arranging bank (in this case Deutsche Bank) transferred to the SPV the risk
of loan business it had written with its customers in the normal course of its banking
business. The 32 other claim SCDOs were “arbitrage” CDOs: i.e. the kind of product that I
described above in which the swap counterparty would not ordinarily own any of the
underlying credit risks in the normal course of its business. The reason that such CDOs are
called “synthetic” is that the issuer of the CDO (i.e. the SPV) takes a credit risk on a portfolio
of credit risks from the swap counterparty through a PCDS, as opposed to owning bonds or
loans directly. This is a feature that distinguishes SCDOs from “cash”.
55 The arbitrage SCDOs can be further categorised in light of their structural features
and the nature of their reference portfolios, relevantly investment grade risk (rated by both
Standard & Poors and Fitch at BBB- or above or by Moody’s at Baa 3 or above), high yield
risk (and hence, non-investment grade and thus viewed as speculative), asset backed
securities (“ABS”) (a bond that is secured on financial assets such as mortgages, or credit
card receivables, other CDOs (i.e. CDOs that use other CDOs as their reference entities:
these are called “CDO squared” or “CDO2”) and, finally 3 “rescue” CDOs that were created
as restructures of CDOs that had suffered significant credit events in about 2007 but were
restructured (these were called “combo notes” for products called Esperance, Coolangatta
and Kakadu).
56 One feature of an arbitrage SCDO is that the arranger or issuer can derive profits
between, on the one hand, the income paid through the SPV or issuer to the note holders and,
on the other hand, the cost of hedging that position. The income paid to the note holders
represents the cost to buy credit swap protection. The arranger (i.e. investment bank) can
make an arbitrage profit as follows:
The note holders pay the issue price for SCDO notes, say, $100 to the SPV.
The notes are for a 2 year term at a coupon (or interest rate) of BBSW plus
110 basis points (“bps”).
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The notes provide for the investor to be at risk for credit events in a tranche
between 5% and 6% in respect of 100 reference entities.
The SPV using the proceeds of the note issue, buys collateral, say, an FRN
from a relatively secure entity (that can be the arranger itself) which has a
coupon of BBSW plus a smaller amount (here, say, 10 bps).
The arranger agrees to a PCDS with the SPV in which the arranger pays the
SPV the difference between the coupon on the collateral and the coupon rate
that the SPV must pay the note holders – here 100 bps. In return, the SPV
becomes liable to pay the arranger from the collateral if credit events cause
losses in the tranche.
The arranger will seek to spend less in what it must pay the SPV for the PCDS
than what it can sell credit protection for, in respect of the reference entities in
the portfolio, in the market. This is how the arranger can earn profits from
arbitrage. There will be differences from time to time between the amount the
arranger agrees to pay the SPV before the SCDO notes are issued and the
underlying market values to buy credit protection for the individual reference
entities.
The arranger will use a computer model to optimise its position in respect of
the reference entities that it will include in the PCDS it will enter into with the
SPV.
57 This process selects reference entities with similar ratings given by a ratings agency.
However, the computer model recognises that all similarly rated reference entities are not
regarded by the market as having the same value or credit risk. In other words, for example
an FRN issued by one BBB rated corporation will not be regarded by the market as worth
exactly the same as an FRN issued by another BBB rated corporation. One or other of those
corporations may be regarded by the credit markets as more or less reliable than the other
despite the fact that the ratings are the same. This recognises that a rating, of say BBB,
covers a range of reference entities that are, self evidently, not identical, just as, say all “blue
chip” corporations whose shares are traded on a stock exchange are not identical. So, the
market will perceive subtle or other differences between the credit risk posed by identically
rated reference entities.
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58 An arranger will seek to create a portfolio with higher spreads, being one that
incorporates in the portfolio cheaper reference entities of the same rating (i.e. ones which had
a higher risk implied by their cheaper price in the market than identically rated entities). The
computer model could assemble a portfolio of reference entities with the highest spreads (and
hence ones with highest market implied risk that they would default) while maintaining the
required credit rating of the SCDO.
59 An arranger will engage in “adverse selection” if it chooses reference entities with
the highest spreads (i.e. greatest risk) from the “universe” of available reference entities that
could form the portfolio of an SCDO. The joint report of Mr Hattori, Dr Ronald Bewley (a
former professor of econometrics and former head of quantitative research and investment
strategy of the Commonwealth Bank of Australia Ltd, who was called by Grange) and James
Finkel (a specialist in structured finance, who was the Councils’ expert witness) agreed that
there were 32 arbitrage claim SCDOs in which adverse selection would have been possible.
But, they agreed that Mr Finkel had not identified any evidence that there had been actual
adverse selection in any of the Claim SCDOs.
60 The two Claim SCDOs that Mr Hattori said were outside the credit risk based class,
were issued in early 2007. The first was called Kalgoorlie. It was based on 11 commodity
trigger swaps, 4 involving agricultural products, 5 non-precious metals and the remaining 2,
silver and platinum. Mr Hattori explained that this product comprised a series of out of the
money put options (trigger swaps) sold by one party in the structure to provide option
premiums that fund payment of the coupon interest. Mr Hattori said, and I find, that the term
sheet used by Grange to describe the Kalgoorlie product wrongly used CDO terminology
such as “Portfolio Credit Linked Note Summary” and “Total Reference Points 100 (equally
weighted)” to describe this product. The second was the Lehman Bros Property Note. This
was based on the performance of two property funds and payment of the face value of the
note on maturity. This was the only SCDO that was unrated and it was guaranteed by a
Lehman Bros company. Despite Mr Hattori’s description, both of these Claim SCDOs were
instruments that had significant risks of the kinds described in section 3.5 below.
61 Cash CDOs had been issued in the international financial markets since about 1995.
Synthetic CDOs began to be marketed in about 1999. By then, according to an article
published in June 2005 by the Banque de France, (The CDO Market: Functioning and
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Implications in Terms of Financial Stability: Banque de France: Financial Stability Review:
No 6 June 2005) (the Bank de France article) the development of the market for CDOs had
gained pace on the back of the boom in credit derivatives. The Banque de France article
observed that by the end of 2002 this boom had led to a narrowing of yield spreads between
the underlying reference portfolios and the tranches issued in arbitrage SCDOs.
3.5 Relevant risks of the Claim SCDOs
62 The coupon or interest margin over the BBSW rate that was offered by the Claim
SCDOs generally was higher than that offered by corporate bonds or FRNs with the same or
a similar rating. The Councils argued that the reason for this differential was that the risks
inherent in the SCDOs were not reflected in the rating. Grange contended that the existence
of this higher return on the Claim SCDOs put the Councils on notice that these products did
have additional risks when compared to corporate bonds or FRNs of the same or similar
rating. It argued that those risks were not hidden from the Councils and that they understood
the correlation between risk and return when investing ratepayers’ funds in the higher
returning Claim SCDOs. Grange submitted that it followed that the Councils appreciated that
by investing in the Claim SCDOs in order to achieve higher returns, they were putting the
funds invested at greater risk.
63 I will examine the understanding of each of the Councils later in these reasons.
Before doing so, however, I will consider those risks of investment in SCDOs that were the
focus of the expert evidence and argument. This will assist in evaluating first, the whole of
the circumstances in which each Council came to invest in SCDOs through its relationship
with Grange and, secondly, whether or not the explanation that Grange gave sufficiently or
properly explained each relevant risk in issue in these proceedings.
64 The Councils relied, in their final submissions, on four principal risks that they
contended were not reflected in credit ratings for SCDOs. The four risks not reflected in the
credit ratings were, first, market implied risks, secondly, the amount of any loss, thirdly,
market price volatility and, fourthly, liquidity. Grange argued that some of these (market
price volatility, and market implied risk) were not pleaded by the Councils as material facts
and were thus not in issue. Once again, I will deal with the pleading issues later where they
arose.
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3.5.1 Market implied risks
65 Most of the Claim SCDOs were rated by Standard & Poor’s but some were rated by
Moody’s or Fitch. Each of the ratings agencies had its own distinct methodology for rating
products, including SCDOs. The agencies published their ratings for individual products they
had examined with some explanation, sometimes in a press release but usually in a fuller
report of what the rating signified. The detail of that explanation varied. In addition, the
rating agencies also published information as to their general approach to rating SCDOs.
66 Ratings of SCDOs by each of Standard & Poor’s and Fitch measured only the
probability of a default. Their ratings did not take into account the extent of loss that would
occur on a default beyond the first dollar of loss. In contrast, Moody’s ratings attempt to
assess both the probability of default and the expected loss. However, there is another
category of loss that is relevant for SCDOs namely, unexpected loss. One Claim SCDO, Blue
Gum, was rated by both Standard & Poors as (AA-) and Moody’s (as Aa3) and those ratings
were perceived by the market as equivalent. Blue Gum is the only Claim SCDO that by the
time of the hearing had completely defaulted.
67 The January 2005 Working Group report explained that conventional credit ratings
could not provide a complete summary of credit risk. This was because the ratings were
expressed on a one-dimensional scale based either on an assessment of expected loss or
probability of default being “actuarial notions of credit risk that depend only on the first
moment of the distribution of possible outcomes”. The effect tranching can have on an
investment is to disperse the distribution of loss among the tranches, while leaving unchanged
the expected loss or probability of default measures for the underlying entity. The Working
Group said:
“Holding EL [expected loss] constant, however, an investment will tend to be riskier if its loss distribution is more dispersed. For example, a bond is less risky (and in fact not risky at all) if it pays a certain amount of 99 at maturity, as opposed to paying 100 with 99% probability and paying an amount of zero with a probability of 1%. Risk profiles of financial instruments are, therefore, more fully described by a combination of EL and information regarding the ex ante uncertainty of losses as reflected, for example, in the variance and higher moments of the loss distribution. Ex ante credit loss uncertainty, in turn, has come to be commonly referred to as “unexpected loss” (UL). Considerations regarding UL are of particular importance in structured finance, as compared to bonds, because tranching can result in distributions of payoffs that differ significantly from the distributions of outcomes for the
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underlying asset portfolio. Accordingly, conventional credit ratings, because they are expressed on a one-dimensional scale and are based either on EL or on PD [probability of default], cannot be a complete summary of credit risk. Two types of risk comparison merit mention in this context: (1) risk comparisons among tranches and relative to the underlying asset pool; (2) tranche risk relative to portfolios of like-rated assets, such as corporate bonds.” (emphasis added)
68 In explaining the concept of risk comparison between tranches for structured finance
the 2005 Working Group report said that two factors were particularly important, the
seniority of the tranche (i.e. where the attachment point was) and its thickness (i.e. the
difference between the attachment and detachment points). The lower the seniority, the
lower the level of protection from loss. The narrower the tranche, “… the more the loss
distribution will tend to differ from the distribution for the entire portfolio” and the more
likely it will be riskier. The 2005 Working Group report also explained that the risk in
relation to a structured finance product (such as an SCDO) tranche can be different to the risk
for a similarly rated asset because of the possibility that lower or subordinated tranches could
have zero recoveries. It said:
“The narrower the tranche, the riskier and more leveraged it will be, as it takes fewer defaults for the tranche to be wiped out once its lower loss boundary has been breached. Subordinated tranches, therefore, have a wider distribution of outcomes than like-rated bond portfolios and will thus need to pay a higher spread to compensate for the added risk.” (emphasis added)
69 Here, a “spread” refers to a return or interest rate. Mr Finkel explained that the
ratings agencies did not take into account market implied risk when ascribing a rating for an
SCDO. He supported his reasoning with an example of two portfolios for identically
structured SCDOs with the same attachment and detachment point that could be assembled
with different reference entities having similar industry classifications and ratings. Mr Finkel
said that one portfolio might have an average credit spread of 100 bps over the risk free rate,
while the second, similarly constructed portfolio, could have an average credit spread of
150 bps. He pointed out that in such a situation, the second portfolio would have a greater
market implied risk than the first, but was identically rated.
70 Mr Finkel, Mr Hattori and Dr Bewley all agreed that in broad terms, to arrive at a
rating for an SCDO, a ratings agency would look at the composition of its portfolios as
comprised of so many similarly rated reference entities without taking any account of the
market spreads of the particular portfolio.
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71 The 2005 Working Group report explained that a rationale for the use of structured
finance was that originators and arrangers could profit from market imperfections. The report
observed that, in a world of perfect financial markets in which there were no information
asymmetries and all assets were readily tradable (without any liquidity premiums), “…
tranching would not add value relative to a [direct] share in the pool, since the structure of
liabilities would be irrelevant. Market imperfections are needed for structured finance to add
value”. The report gave two examples of imperfections – asymmetric information and
market segmentation.
72 The first imperfection, asymmetric information, could occur when an originator had
either, or both, private information about the quality of certain assets in the pool or a
comparative advantage over other market participants in valuing those assets. This would
enable the originator to adversely select some assets in the pool because investors would not
know their true quality. The 2005 Working Group report noted that structured finance could
diffuse, in some cases, the effects of adverse selection because of, first, the diversification
that pooling and tranching offered and, secondly, reputational concerns that might induce
originators and arrangers to trade off established track records.
73 The second imperfection, market segmentation, discussed in the report could create
arbitrage opportunities. One such arbitrage opportunity that the report identified was
consistent with Mr Finkel’s evidence concerning market implied risk. As the report stated:
“A second form of arbitrage opportunity may appear when market segmentation leads to pricing differentials across certain classes of assets that can be included in the underlying pools of structured finance instruments. One example is given by arbitrage CDOs, where the underlying asset pools are comprised of bonds or credit default swaps (CDSs). Originators of these instruments seek to take advantage of the fact that the market spreads of certain rating categories of bonds tend to be higher than what would be expected solely on the basis of the default risk, and that this difference has been greater for certain rating categories (eg BB) than for others. If the spread differentials across rating categories are large enough, it can be profitable for an arranger to assemble pools of bonds in the “cheaper” rating category, issue tranched securities against them, pay the holders of tranches in other rating categories a spread consistent with the market spread for bonds with similar credit risk, and compensate equity tranche holders with the “excess spread”.” (footnote omitted, emphasis added)
74 The report described a structured finance rating as an opinion regarding the likelihood
that cash flows from the underlying pool of assets in a reference portfolio for a finite life or
term will be sufficient to service the claims, such as interest and payment due on maturity
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associated with a particular tranche. It contrasted this feature with that of “traditional credit
ratings” which assess the likelihood that the obligor’s ongoing activities will generate the
cash flows required for debt service and repayment.
75 Standard & Poor’s strove to achieve comparability of its ratings across different
products. However, it made distinctions in its methodologies to produce ratings to address
different credit risks of different products. Thus, it did not rate a CDO in the same way it
rated an FRN. Standard & Poor’s published an annual “Global Corporate Default Study and
Rating Transitions” report in about late January each year. This data source was the best data
of its kind available to investors as at 2005.
76 Grange pointed to Mr Finkel’s statement that it would not have been unreasonable for
anyone looking at this data to think that the probability of a default for an SCDO was not
likely to be materially higher than the probability of default of a corporate FRN of the same
rating. Grange also referred to a statement in the joint reports of Mr Finkel, Mr Hattori and
Dr Bewley. They noted that by reference only to the ratings for CDO tranches, their
reference portfolios and swap counterparties, it was unlikely and reasonably unpredictable
that a CDO tranche with an investment grade rating would suffer any loss. However, the
experts then disagreed about the appropriateness of that approach. Grange argued that Mr
Hattori’s view should be preferred. He contended that spreads in the market did not
necessarily reflect credit risk in themselves. It its closing written submissions, it said that an
August 2007 publication by Standard & Poor’s, “The Fundamentals of Structured Finance
Ratings” supported Mr Hattori’s view. That publication contended that market pricing did
not reflect rational analyses of default risk alone.
77 I prefer Mr Finkel’s opinion that ratings agencies did not take into account market
implied risk and that consideration of such a risk is relevant to investment in SCDOs. First,
both Mr Hattori and the Standard & Poor’s 2007 article did not exclude market implied risk
as a relevant factor. Indeed, that article explained that the markets operated on the basis of a
variety of considerations, not just ratings, in arriving at prices for, among other products,
SCDOs. Secondly, the ratings were not intended to evaluate market implied risk. As the
2007 article said:
“One important point is that ratings represent ranges, not points, on the spectrum of default risk. Therefore, within a rating category there are differences in default risk.
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Although this is fairly self-evident, the effects are often forgotten, and are especially pertinent in the ‘AAA’ rating category. Here, although there is a default risk “ceiling,” beyond which securities would have to be rated ‘AA+’ or lower, there is no default risk “floor.” One structured finance security may be ‘AAA’ rated but just hover at the margin of ‘AA+’, whereas another may be so strong as to be virtually free of default risk. Both are in the same band of risk but they do not have the same risk. Within those bands of default risk it is natural for investors to make distinctions in terms of pricing. …” (emphasis added)
78 That passage recognises that the ratings do not capture or express every aspect of
default risk and that other factors may operate in ascertaining a price for an investor to pay.
The 2005 Working Group report explained an instance of the market imperfections that can
add value to an SCDO for its originator or arranger who is able to appreciate the way in
which market implied risks operate in assessing a proposed transaction. That report noted as
a key finding, with which Mr Hattori agreed:
“Despite this “value added” by the rating agencies, market participants, in using ratings, need to be aware of their limitations. This applies, in particular, to structured finance and the fact that the one-dimensional nature of credit ratings based on expected loss or probability of default is not an adequate metric to fully gauge the riskiness of these instruments. This needs to be understood by market participants.”
Immediately following that finding, the report continued:
“Interviews with large institutional investors in structured finance instruments suggest that they do not rely on ratings as the sole source of information for their investment decisions, which limits the potential for misunderstood risk exposures. Indeed, the relatively coarse filter a summary rating provides is seen, by some, as an opportunity to trade finer distinctions of risk within a given rating band.” …
And the report added prophetically:
“In particular, the Working Group believes that risks associated with investors that assume exposure to structured products without fully grasping the risk profile of these investments cannot be fully discounted. Unexpected losses on structured finance investments could thus become an issue going forward, particularly once the current environment of relatively low default rates and tight credit spreads comes to an end.” (emphasis added)
79 In other words, those spreads reflected fine distinctions in the informed market
participant’s evaluation of risk that were not measured in the one-dimensional rating. In
addition, as will appear below [777]-[778], [875]-[877], see too [303]-[305], [352]-[353],
[549], [858], Grange itself was actually aware of movements in market credit spreads, and
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among spreads in the reference portfolio and their impact on its potential profit when
negotiating the price at which it purchased SCDOs from the arrangers, originators or issuers
for on-sale to its clients, including the Councils.
3.5.2 The risk in respect of the amount of any loss
80 Both Standard & Poor’s and Fitch ratings only addressed the probability of default
and, unlike Moody’s ratings, did not seek to address the amount of loss in the event of
default. Most of the Claim SCDOs were rated by Standard & Poor’s.
81 The Councils argued that the structure of SCDOs and tranching led to risk profiles for
SCDOs that were substantially different to those of ordinary bond portfolios. They
contended that the amount of loss within a single tranche SCDO was affected by, first, the
credit support (i.e. the losses or defaults that would have to occur to exhaust the layers below
the attachment point of the tranche in which the holder had invested) and, secondly, the
thinness of the tranche (i.e. the gap between the attachment and detachment points). The
entire value of subordinated and lower tranches could be lost if losses or defaults in the
reference portfolio were severe enough. The Councils argued that the ratings did not reflect
these risks of substantive loss that were inherent in the Claim SCDOs.
82 Grange argued that, as Mr Finkel acknowledged, the application of differing
methodologies by each of Standard & Poor’s and Moody’s did not result in significantly
different ratings. This was illustrated by the equivalence of rating by both of those agencies
for the Blue Gum Claim SCDO rated AA- by Standard & Poor’s and Aa3 by Moody’s as at
October 2005. Grange reasoned that it followed that investors would not have received a
significantly different impression of the risks associated with the other Claim SCDOs, had
Moody’s ratings been used instead of those of Standard & Poor’s or Fitch. Grange contended
that the close outcomes of the differing ratings methodologies gave rise to the inference that
the probability of default for highly rated SCDOs was seen by both Standard & Poor’s and
Moody’s as so remote that the amount of loss, first, was not accorded much weight by
Moody’s and, secondly, would not materially affect the attractiveness of a product.
83 Grange’s argument is logical as far as it goes, namely that had Moody’s ratings or its
methodology been used for all of the Claim SCDOs, it is likely that the ratings outcome
would have been similar to that produced by Standard & Poor’s or Fitch, and would have
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conveyed the information in the above inference that Grange propounded. However, that
argument does not address the points made by both the 2005 Working Group and the Banque
de France article, that ratings do not provide a complete summary of the credit risks for
structured finance products. The Banque de France article explained the deficiency in ratings
in this respect in a passage that drew on the 2005 Working Group report and which Mr
Hattori accepted as correct in principle. The article posed the question “Are ratings a reliable
measure of the risk of CDOs?”. It noted that it was not uncommon for investors to assess the
risk of an instrument in which they wished to invest chiefly on the basis of its rating. The
article made the point that ratings reflected the credit worthiness of a security “in the form of
a simple alphanumeric symbol … making it easy to rapidly compare the securities of
different issuers across countries and sectors”. The article continued:
“As senior and mezzanine tranches of CDOs benefit, by construction, from investment grade ratings (typically AAA or A), they may appear to be an attractive and apparently low risk investment, especially since they offer much higher returns than those of corporate bonds with the same ratings. However, the structured nature of CDOs limits the significance of their rating, as it only reflects certain aspects of their credit risk. [A footnote here referred to the 2005 Working Group report.] While ratings reflect a security’s average level of risk, they do not factor in the dispersion of risk around its mean. Yet, the sequential allocation of losses to CDO tranches results in expected loss being concentrated in subordinated tranches, which consequently have a very different risk profile, for the same rating, from that of corporate bonds. For the latter, the probability of extreme events, such as the loss of an investor’s entire stake, is very low. Conversely, for the mezzanine tranche of a CDO, a fairly low proportion of losses on the underlying portfolio (around 6%-10%) would suffice for an investor to lose its stake. This also applies, to a lesser extent, to AAA-rated senior tranches of synthetic CDOs that, despite their name, are often subordinated to the super-senior tranche. Investors in CDOs that focus on excess returns, only using ratings to assess the risk, might thus be exposing themselves to greater-than-expected losses.” (emphasis added)
84 The 2005 Working Group report described this concept as the “unexpected loss
properties of structured finance products” in the passage quoted at [78]. Thus, although the
risk of loss of an investment is likely to be relatively small in a highly rated SCDO, it is a risk
that a relatively small number of defaults or losses in the reference portfolio can lead to a
substantial or complete loss of the investor’s stake in the product. That is a very different risk
to that in a similarly rated corporate bond or FRN where default by the issuer is likely to
leave the investor with substantively less risk of an unexpected loss.
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3.5.3 The risk of market price volatility
85 Grange argued that market price volatility was not a risk that the Councils had
pleaded specifically and that they should not be allowed to rely on this risk because it was
outside the confines of their pleaded case. It contended that they should not be allowed to
raise a new case in closing submissions. I reject that submission. Market price volatility
was pleaded as an unusual risk to which the Claim SCDOs were exposed in par 14.14(b) of
the third further amended statement of claim as follows:
“market price volatility – the risk that the market price would be more volatile, being dependent on the buy-back offer of [Grange] should the investor choose to liquidate before the maturity of the Claim SCDOs;”
86 That allegation succeeded the pleaded material fact in par 14.13 that the Claim
SCDOs “were risk rated and assigned a rating not equivalent, as regards risk profile, to other
types of financial products carrying the same ratings”. This allegation was particularised by
reference to the one dimensional nature of Standard & Poor’s and Fitch’s rating
methodologies to which I have referred. The Councils also pleaded that what they called
“traditional FRNs” were less susceptible than SCDOs to volatility in the international credit
markets (par 14.15(i)).
87 The pleading then alleged that by reason of, among others, the pleaded risks of the
Claim SCDOs, they were suitable only for sophisticated investors or investors with “an above
average tolerance for market price volatility” (par 15.1, 15.3(a)). Next, the Councils pleaded
that Grange had been negligent by not advising them that the SCDOs were not equivalent, as
regards risk, to other types of financial products carrying the same ratings (par 22.3). The
Councils pleaded that Grange had engaged in conduct, by giving them assurances that were
misleading or deceptive, that contravened s 12DA of the ASIC Act and its analogues. This
was alleged to be because, among others, the Claim SCDOs were not suitable for investors,
like the Councils, with conservative strategies and were not equivalent to, but rather had, a
significantly higher risk profile than other types of financial products carrying the same
ratings (pars 31.1(a), 31.4).
88 Grange argued that par 14.14(b) of the Council’s pleading addressed leverage and did
not make any link between leverage and market price volatility. Mr Hattori explained that
“leverage” is the increase in speculative risk and return for an investor in a particular
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investment through the use of borrowed money or derivatives as compared with an investor
who uses its own funds to make that investment. Grange accepted that the Claim SCDOs
were leveraged financial products, but argued that par 14.14(b) “… ascribes the alleged
volatility to a cause quite different from leverage”. It contended that par 14.14(b) could not
be read as creating “implications for the relationship between movements in the market value
of the reference portfolio and the market value of the Claim SCDOs”.
89 That argument was misconceived. The pleading did not confine the Councils’ case on
the risk of market price volatility to having a link to leverage. The first proposition of the
argument sought to read “leverage” into the pleading while its second proposition recognised
that par 14.14(b) itself said nothing about leverage. Mr Finkel explained market price
volatility in his first report. He said that a market change in the perceived risk of an
instrument is a major mechanism for bringing about changes to the value of an SCDO. He
said that such a change in risk perception by willing buyers and sellers reflected their
consensus on the probability of receiving a set of anticipated cash flows (i.e. interest and
principal) from the SCDO. This occurred, in general, without an established public
mechanism, like a stock exchange, on which trades were recorded. Mr Finkel said that
SCDOs had a heightened sensitivity to general market movements especially if there were
deterioration of the credit worthiness of reference entities in the SCDO’s reference portfolio.
90 In such a case a potential buyer would require a higher spread (i.e. so as to pay a
lower price in order to receive the promised payments of interest and principal) to take the
risk of the SCDO. Mr Finkel noted that investors who had to mark their investments to their
market value would have to record a loss if SCDOs were affected. He explained this risk
perception could cause significant price movements for SCDOs. He gave some examples of
variations in values before, at and after early 2008 as compared to January 2011, when he
wrote his report.
91 Grange obtained expert reports from Mr Hattori and Dr Bewley on, among others, the
issue of the risk of market price volatility and they, with Mr Finkel, prepared a joint report.
That addressed this issue before all of them gave concurrent oral evidence during which they
were cross-examined on it. For example, in his report in reply to Mr Finkel’s report,
Mr Hattori agreed to a limited extent with Mr Finkel that the SCDOs could have been
exposed to significant market price volatility by adding the qualification “as a consequence of
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leverage” in respect of SCDOs with thinner tranches. But, as he explained in oral evidence,
where big spread movements occurred, leverage was not the only factor that caused price
volatility. He accepted that the effect of leverage in such a case meant that the price of the
SCDOs would be affected to a much greater extent than the movement in the spread in the
underlying markets. Mr Hattori accepted that in the event of a general widening of spreads,
the prices of SCDOs would reduce to a significantly greater degree.
92 Both Mr Finkel and Mr Hattori agreed with the substance of the description of
“volatility” as a risk that was given in the offering memorandum for the Federation Claim
SCDO. That was in the following terms:
“Volatility. The credit markets may react strongly to certain events, which may have a leveraged impact on the value of the Notes. The occurrence of a credit event, downgrade or general spread widening with respect to a Reference Obligation is likely to adversely affect the value of the Notes, but the value of the Notes may also be affected by other events or conditions that affect the credit markets including general economic conditions and conditions that affect obligations similar to the Reference Obligations. Accordingly, any potential volatility in the credit markets, including volatility with respect to the Reference Obligations, may have a leveraged impact on the market value of the Notes. The Notes may be subject to price volatility and limited liquidity, particularly following the occurrence of a credit event.” (emphasis added)
93 I am satisfied that the Councils sufficiently pleaded the material facts that the risk of
market price volatility was unusual and created a different risk profile for the Claim SCDOs
to similar rated products. Grange prepared for and met that case at the trial. There is no
prejudice or unfairness to which Grange pointed to justify preventing this issue being decided
now. In any event, as Dawson J said in Banque Commerciale SA (in Liq) v Akhil Holdings
Ltd (1990) 169 CLR 279 at 296-297 in a passage approved by Gummow, Hayne, Heydon,
Crennan and Kiefel JJ in Vale v Sutherland (2009) 237 CLR 638 at 651 [41]:
“… modern pleadings have never imposed so rigid a framework that if evidence which raises fresh issues is admitted without objection at trial, the case is to be decided upon a basis which does not embrace the real controversy between the parties ... cases are determined on the evidence, not the pleadings.”
94 Grange argued there were three points to be noted on the substantive issues relating to
the market price volatility risks. First, it said that this risk was reflected in the financial
product’s price, not its rating. The consequence was that the SCDOs had a higher yield.
Grange argued that each Council appreciated that there was such a correlation between the
increased risk of market price volatility and a higher return in products with the same rating.
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95 Grange’s argument oversimplified the degree and nature of the increased risk of
market price volatility in the Claim SCDOs in comparison with those of similarly rated
products. Mr Hattori agreed with Mr Finkel that because the structure of SCDOs inherently
carried much more risk than the same or equivalently rated FRNs or corporate bonds, the
SCDOs had a greater risk of market price volatility. Of course, FRNs and corporate bonds
with high credit ratings also had a risk of market price volatility, as Grange noted. Indeed,
the same applies for every investment, including government bonds, which also carry such
risks. However, there is a qualitative difference between the appreciation that risk is inherent
in every investment and the nature and degree of the particular risk as it affects an individual
investment product. But as Mr Finkel and Mr Hattori agreed, the highly rated SCDOs were
inherently susceptible, because of their structure, to much more risk of market price volatility
than equivalently rated investment products.
96 Secondly, Grange contended that changes in a product’s trading price were not of
great concern to an investor who intended to hold it until it repaid its capital on maturity
while it continued to receive regular interest payments. Grange argued that the most
important consideration for such a investor was that it would be paid the full amount due on
maturity of the note, and, Grange noted, the rating addressed this issue. Grange argued that
“[e]arning a premium on the coupon rate for taking on a “risk” that was not relevant to a
hold-to-maturity investor’s strategy would be seen as an attraction of the [Claim] SCDOs”.
97 Once again, this argument oversimplified the qualitative impact of the risk of market
price volatility. An investor who saw the current value of its financial product significantly
fall, after its initial acquisition, as market events unfolded may or may not continue to wish to
hold such a product to maturity with the attendant risk that the then current market
assessment is right, as against the assessment made in earlier credit rating at the time of
acquisition. And, as Mr Finkel noted some investors must value investments in their
accounts at balance dates by marking them to market. The investor, or some of its
stakeholders, may not have the confidence, or be permitted by its investment criteria, to retain
its, by now, devalued investment.
98 Indeed, well before the onset of the global financial crisis, on 9 March 2006 Grange’s
senior management was urged by Mr Vincent, its director, debt capital markets and Paul
Hagan its director of risk management to “get a better handle on the risks we run” in relation
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to its own exposure to SCDOs that it held. Mr Hagan had written an analysis showing that on
8 March 2006 Grange held floating rate CDOs with a notional value of $99.2 million but, as
he stated, that holding:
“… exposes Grange to a potentially significant mark-to-market loss should a systemic or idiosyncratic event occur in the global credit markets. Further, should Grange be a forced seller of some or all of the position (possibly as a result of a significant reduction in short-term funding capacity) the loss will be crystallised.” (emphasis added)
99 Mr Hagan said that Grange lacked the ability to measure accurately its maximum
potential loss and that it needed to obtain the appropriate data to assess accurately the
“market risk exposure” of its own then current holdings. It is safe to infer from Grange’s
inattention to its own market price volatility risk, that it did not advise its clients, and in
particular the Councils about it.
100 Accordingly, it does not follow that the investor’s initial objective to hold the
investment in an SCDO to maturity will not be affected by an appreciation that its value,
from time to time, may be affected by the significantly different market price volatility of that
class of financial product as against that of similarly rated FRNs or corporate bonds. Further,
the Councils contended that they did not necessarily intend to hold the Claim SCDOs to
maturity. Indeed, whatever their intention, they did not hold all SCDOs until maturity
because of Grange’s frequent use of switches.
101 Thirdly, Grange noted that the description of volatility quoted at [92] above was in
fact contained in the written slide presentations of the Federation Claim SCDO it had made to
Swan and Parkes. Grange contended that each of them had not been affected in their
subsequent investment decision-making by that disclosure and that it had not caused either to
question their previous investments in SCDOs. However, Swan invested in the Federation
product because Grange made the decision to do so using its authority to do so under the
Swan IMP agreement. Swan was not involved in that decision (see [370]-[376] below and
see also at [591]-[594] in respect of Parkes).
102 Grange appeared to accept that description of volatility in [92] as accurate. That is
different, however, to whether it was adequate fully to explain to lay persons, in the position
of the Councils, the nature and extent of the risk of market price volatility as it may have
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been relevant to them investing in any of the Claim SCDOs. Additionally, neither Mr Finkel
nor Mr Hattori gave any evidence about the adequacy of that explanation to lay persons in the
position of the Councils in the context of what Grange had already informed them about these
products.
3.5.4 Liquidity risks
103 Both Mr Finkel and Mr Hattori agreed that the risk of (lack of) liquidity was not
addressed in the ratings of SCDOs. Grange argued that, as with market price volatility, a
particular investor’s circumstances may minimise any importance of liquidity of the product.
It contended that investors, such as, so it claimed, Wingecarribee and Swan, who were
interested in holding their investments to maturity, would not have attached much importance
to the liquidity of the Claim SCDOs. It referred to the likelihood that an investor wishing to
hold the SCDO to maturity would be more interested in assuring itself that the issuer of the
product would repay its capital value at maturity. Grange contended that it was reasonable
both for it and the Councils to see the Claim SCDOs as good investments given their high
ratings and coupon rates that were higher than comparably rated products.
104 Grange conceded, and I find, that the Claim SCDOs’ lack of liquidity was not
reflected in their credit ratings. And, it also accepted that Mr Hattori was correct to say, as I
find, that their liquidity was a factor that could affect their price.
105 However, Grange then contended that, as with the risk of market price volatility, a
particular investor’s circumstances could minimise the importance of these risks. As an
example, Grange pointed to evidence given by Stuart Downing, Swan’s chief financial
officer. He was responsible for its investments from April 2006. Grange contended that Mr
Downing had said that the Council’s investment strategy was to hold the Claim SCDOs to
maturity and he was not concerned about their liquidity, and that therefore liquidity risk was
not a matter of concern to Swan.
106 I will examine the circumstances of each Council’s investment decision-making in
respect of the Claim SCDOs and its relationship with Grange in section 4 of these reasons.
But, as Mr Downing was pressed about whether he paid much attention to Grange’s pre-
purchase written statement that there was a risk that the negative credit market movements
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may adversely affect the secondary market pricing of the Parkes AAA and AA- Claim
SCDOs, he replied:
“I can’t recall but it was not an issue. We were not buying them to trade them.”
107 However, he had been taken in cross-examination to a risk analysis table in a
document Grange had prepared on just the Parkes AAA Claim SCDO in which, on 8 August
2006, he decided Swan would invest $500,000 for settlement on 15 August 2006. The
portion of the risk analysis table reproduced below, to which Mr Downing referred in this
evidence, used the AAA rating to suggest that his approach was sound. The existence of a
secondary market was not an issue to him because he intended that Swan would hold the
investments to maturity (thus earning the promised interest and being repaid its invested
principal on maturity) The analysis suggested that the SCDOs became more valuable, but
were still liquid, the longer they were held:
Risk Analysis Grange has considered the following risks and identified the following mitigating factors.
Risk Mitigant
…. … Negative credit market movements adversely affect the secondary market pricing of the transaction (ie: cause an increase in the trading margin of Parkes) and limit investor’s ability to sell Parkes early in the transaction’s life, without recording a capital loss.
If the portfolio does not suffer unexpected levels of downgrades and defaults, then its credit quality will increase over time. An increase in credit quality is usually accompanied by a reduction in trading margin (increase in price).
Whilst it is not uncommon that investors in Grange Securities’s CDO transactions are able to realise a capital profit, ultimately CDO products rated ‘AAA’ are created with the intention of providing a very high level of capital security with a stable and secure income stream over the life of the transaction. Thus, at any given point in time if an investor wishes to liquidate their investment, the price of their investment will be subject to the prevailing market conditions. Offsetting this risk is the fact that the highly rated CDOs which Grange Securities distributes are created in a manner whereby in almost any circumstance, an investor who holds to maturity will
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earn a stable, secure & attractive return on their investment.
(emphasis added)
108 On 18 July 2006 Grange’s Perth based associate director, fixed interest, Ben Kay,
wrote an email to Mr Downing suggesting that Swan invest in the Parkes AAA or AA- Claim
SCDOs by switching out of its investment in the Blue Gum AA- Claim SCDO. Mr Kay
wrote that the Parkes notes had a call date after 3 years, following which the margin on the
AA- notes over BBSW increased from 2% to 3.25% so that Grange “… expect that it is very
likely to be called after 3 years”. Mr Kay then wrote about the SCDOs it had recommended
to Swan stating:
“… as you are aware, these notes are very liquid and Grange will always provide an active secondary market.” (emphasis added)
109 Mr Downing said that when he read these words about liquidity he did not understand
Mr Kay to be seeking to give comfort against the possibility that the Parkes AAA or AA-
SCDOs might not be called after the first 3 years. Mr Downing said that Mr Kay’s superior,
Rod O’Dea, Grange’s director fixed interest in Perth, had told him shortly before, when
discussing the Torquay SCDO that SCDOs had never in their history gone beyond their first
maturity, or call, date to their (final) maturity date. Mr O’Dea told Mr Downing that the call
date was deemed to be the maturity date on which Swan’s investment in an SCDO would
always be repaid. Having heard that explanation, Mr Downing said that he accepted it and
never thought about whether the issuer would not repay on the call date.
110 It is likely that because Mr O’Dea was aware of the 2003 Swan Policy requirement
that investments in products like SCDOs have no more than five years to maturity, he assured
Mr Downing that the Torquay SCDO (which had a call date in 2009 and a final maturity date
in 2013: i.e. seven years after the conversation) would be highly likely to mature within that
time. Nonetheless, I find that Mr Downing appreciated that the reference to a later maturity
date, in 2013, carried with it some risk that the Torquay product (as with similarly claused
SCDO term sheets that he saw) in some way could mature on that later date. But, Mr
Downing ignored this risk after Mr O’Dea effectively assured him that the first maturity, or
call, date was the date on which Swan would be repaid. It is also likely that Mr O’Dea told
Mr Downing that if the SCDO was not repaid on the earlier date, it could be sold into the
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secondary market with the higher coupon making the investment attractive ([309]-[310]
below).
111 None of Grange’s former employees gave evidence. I infer that their evidence would
not have assisted its case: Jones v Dunkel (1959) 101 CLR 298. I find that based on what
Mr O’Dea and Mr Kay had told Mr Downing, he understood that any SCDO would be highly
likely to be repaid on the call date, and as a consequence, Mr Downing did not think about
any disconformity between that advice and the documents he saw that also referred to a later
maturity date.
112 Thus, when Mr Downing made investment decisions that Claim SCDOs would be
held to maturity, he did so on the basis of Mr O’Dea’s advice that it was highly likely that the
term would last until the call date when it would be repaid. However, Mr Downing never
turned his mind to the possibility, of which he was aware, that if repayment did not occur on
the call date, Swan might have to sell the SCDO and if it did what, if any, liquidity or market
price volatility risks that might enliven. Importantly, as Dr Peter Arberg, the expert valuer
called by Grange, explained in his report, usually the swap counterparty had a call option
under the PCDS to terminate the swap on the call date. If this happened, then the issuer
would also exercise its option to repay the noteholders with their principal that had been
invested in the collateral at the time time. The swap counterparty had an economic incentive
to exercise its call option if the price it was paying for the PCDS at that time were greater
than the current market price for credit protection on the reference portfolio.
113 It is a curiosity that for other purposes in its defence, Grange relied on the disclaimers
in documents such as its slide presentations and emails to disavow responsibility for any
misrepresentations that they may have contained. However, Grange did not suggest, in cross-
examination of any of the Council officers who gave evidence, that it had made a disclaimer
for any oral statements its employees had made.
3.6 The risks identified by the arrangers or issuers
114 The documents that Grange presented to the Councils were different from, and far
simpler than, the transaction and disclosure documents for the claim SCDOs that were
entered into or issued by the arrangers or issuers. (I will refer interchangeably to these as
arrangers or issuers unless there is a distinction that needs to be made between an issuer,
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being the SPV, and an arranger being the bank arranging the transaction and utilising the
SPV.) Grange received those transaction and disclosure documents before or around the time
of issue of the SCDOs.
115 The transaction documents for an SCDO were voluminous and complex. For
example, some, but not all, of the transaction documents for the Blaxland Claim SCDO
extended over several hundred pages. This was typical. Generally, issuers published, among
other transaction documents, an information or offering memorandum or registration
document (I will refer to these as “information or offering memoranda”). This was itself
an extensive document. The parties agreed that part of the information memorandum for the
Blue Gum (AA- and Aa3) Claim SCDO contained a representative statement of risk factors
that an investor in the product would need to consider. This information memorandum
included over five pages headed “Risk Factors” that were put to a number of witnesses. In
contrast, Grange’s final term sheet for the Blue Gum Claim SCDO was five pages long,
including two pages just listing the 100 reference entities. That term sheet contained the
following information in the section captioned “Documentation”:
“This term sheet is a brief summary only; please refer to the specific issue documentation (including the Summary Indicative Terms & Conditions of the Notes and any “Risk Factors” which are part thereof, the Pricing Supplement and the Information Memorandum) for full Terms and Conditions. Official legal transaction documentation prevails in the event of any inconsistency.” (underlined emphasis in original; bold emphasis added)
116 Grange contended that this was an example of it consistently directing its clients to
the underlying documentation in order that they could make their own assessment of the
suitability of the product before investing. It also referred to the Best Practice Guide issued
by the New South Wales Local Government Managers Association – Finance Professionals
Special Interest Group (NSW Best Practice Guide). This had a non exhaustive checklist for
consideration when purchasing a CDO one item of which was:
“Investor Guide (or Prospectus/Information Memorandum if not listed on the ASX) … Legal document that should clearly outline terms and risks of the deal.”
117 Grange also argued that the Councils had not shown that provision of detailed written
risk disclosure material to them would have made any difference to their decisions to invest
in the Claim SCDOs. It pointed to the evidence of Parkes’ finance manager, Bob Bokeyar,
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who printed out documents Grange sent him and put them on the file without ever reading
them. Mr Bokeyar said:
“I never attempted to read one… it’s beyond me to understand what they are – the way they write them.”
118 I do not accept Grange’s characterisation of its mere references in its selling materials
to other documents that contained the full terms and conditions, including risk disclosures, as
an attempt to provide the Councils, as clients, any substantive assistance to understand the
underlying issues that may have affected the Councils’ investment decision-making. Those
documents were of a byzantine, or as Lord Mance said “purgatorial” Belmont Park
Investments Pty Ltd v BNY Corporate Trustee Services Ltd [2012] 1 AC 383 at 429 [383]
complexity. Indeed, it took experienced counsel on both sides about one day in final address
to go through aspects of one incomplete example set of transaction documents for the
Blaxland Claim SCDO consisting of hundreds of pages to explain their arguments about
whether or not these were “derivatives” within the meaning of the Corporations Act 2001
(Cth) (see section 9 below). Grange was aware of this complexity. That is why it prepared
its much pithier selling documents and spoke to the Council officers when seeking to
persuade them to purchase Claim SCDOs.
119 The transaction documents for the Claim, and other, SCDOs contained all the terms
and conditions governing the product including statements of the risk factors. But, Grange’s
statements to the Councils that they could look at the transaction documents to find out the
detail, when it gave them explanations itself, was calculated to induce, and did induce, the
Council officers to rely on and go no further than what Grange put directly before them in
oral and written explanation: cf Gluckstein v Barnes [1900] AC 240 at 251-252 per Lord
Macnaghten (set out at [243]). Indeed, Grange’s argument was spurious. It was an
experienced financial adviser. For Grange to tell a lay client to refer to and read the complex
transaction documents before acting on its recommendation or advice about a product, was as
unhelpful, and inappropriate, as a solicitor telling a client that if he or she wanted to
understand a transaction, the client should read the documents. That is not what professional
advisers such as Grange, or solicitors, do in discharge of their obligations in recommending
or advising on a course of action. I will deal with the individual interactions between Grange
and each Council later in these reasons.
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120 There are stark contrasts between the detail in the outline of “Risk Factors” in five
and half close typed pages in the information memorandum for the Blue Gum Claim SCDO
with both Grange’s term sheet’s elision of any discussion of risk and its slide presentation of
the Blue Gum deal. The slide presentation suggested that the Blue Gum SCDO notes would
be issued in early November 2005. A facsimile of the fourteenth page of that presentation is
as follows:
121 Notably, the last dot point suggested that the investor should carefully review the
final deal documentation “once it is made available”. No evidence suggested that Grange
informed any of the Councils when this became available.
122 In contrast, the risk factors in the information memorandum for the Blue Gum Claim
SCDO commenced with this emphasised warning:
“RISK FACTORS
The purchase of the Securities may involve substantial risks and is suitable only for sophisticated investors who have the knowledge and experience in financial and business matters necessary to enable them to evaluate the risks and the merits of an investment in the Securities.” (original emphasis and italics)
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Shortly after, the information memorandum said:
“Investor suitability Investment in the Securities may only be suitable for investors who: (i) have the requisite knowledge and experience in financial and business
matters to evaluate the merits and risks of an investment in the Securities and the rights attaching to the Securities;
(ii) are capable of bearing the economic risk of an investment in the
Securities for an indefinite period of time;
(iii) are acquiring the Securities for their own account for investment, and not with a view to resale, distribution or other disposition of the Securities (subject to any applicable law requiring that the disposition of the investor’s property be within its control); and
(iv) recognise that it may not be possible to make any transfer of the
Securities for a substantial period of time, if at all.” (emphasis added)
123 The risks just emphasised were not in any of Grange’s presentations of risk
disclosures to the Councils. They were never mentioned by Grange’s employees to any of
the Council officers. The evidence is replete with the lack of financial and investment
sophistication on the part of the Councils and Grange’s consciousness of this. Importantly,
points (ii) and (iv) went to the issues of the risks liquidity and the existence of a secondary
market. The latter risk was expanded on two pages later as follows:
“No secondary market No secondary market is expected to develop in respect of the Securities and, in the unlikely event that a secondary market in the Securities does develop, there can be no assurance that it will provide the Securityholders with liquidity of investment or that it will continue for the life of such Securities. Accordingly, the purchase of the Securities is suitable only for investors who can bear the risks associated with a lack of liquidity in the Securities and the financial and other risks associated with an investment in the Securities. Investors must be prepared to hold the Securities for an indefinite period of time or until final redemption or maturity of the Securities.” (emphasis added)
124 Similar risk factors were disclosed in other information or offering memoranda for
claim SCDOs in evidence, such as for the Scarborough, Flinders (which I will discuss in
more detail in relation to Swan at [251]-[252] below) and, Esperance Claim SCDOs.
Significantly, the risk factor quoted in [123] was substantively disclosed in each offering
memorandum contained in an agreed exhibit of representative sample transaction documents
for nearly 40 SCDOs, including Claim SCDOs, referred to in the evidence. That exhibit
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showed that most, but not all, of those offering memoranda also substantially included an
explanation of the risk factors set out in [122]. Far from disclosing the above risks as to
liquidity and secondary markets, Grange’s oral and written presentations on those topics were
to the effect of an earlier part of its Blue Gum product slide presentation. There, it told its
investors, three pages before the risk factors set out above:
125 The program memorandum for the Flinders Claim SCDO also explained its market
price volatility risk in the following terms:
“The value of the Notes may move up or down between the date you purchase them and the date of maturity. Therefore, in the event that you are able to sell your Notes in the secondary market during that time, you may sustain a significant loss. Several factors, many of which are beyond the control of [the issuer, Credit Suisse First Boston International] or any of its affiliates or the Issuer, will influence the value of the Notes. Factors that may influence the value of the Notes include:
the creditworthiness of each of the Reference Entities; the value of the Charged Assets and the creditworthiness of the obligors of
the Charged Assets (which will include the Custodian to the extent the Charged Assets comprise cash in the Cash Account and the issuers of any Eligible Collateral Assets (and of any bonds or other assets securing any Eligible Collateral Assets));
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economic, financial, political and regulatory or judicial events that affect financial markets generally;
interest, foreign exchange and yield rates in the market;
the time remaining to the maturity of the Notes;
the creditworthiness of Magnolia, the Counterparty as Counterparty under
the Charged Agreement and of the Custodian and Principal Paying Agent and Paying Agent.” (emphasis added)
The offering circular supplement for the Endeavour Claim SCDO pithily said:
“There is no active trading market for the Notes and it is highly unlikely that an active secondary market for the Notes will develop. Accordingly a lack of liquidity and price volatility may exist.” (emphasis added)
3.7 Risks identified in other contemporaneous documents
126 In March 2003, Grove Financial Services Pty Ltd published a critique of the Forum
SCDO that Grange was offering to its clients. Grove was a competitor of Grange’s in, among
others, the Australian local government sector market for financial services. Grove’s critique
identified two types of risks for SCDOs, namely credit risk and market risk. First, it
explained that credit risk involved the potential for loss after the losses in the reference
portfolio reached the attachment point. Secondly, Grove explained market risk as:
“… the risk that you will lose money if either you want to or need to sell your securities before maturity, i.e. in the next 5 years. CDO’s are generally extremely illiquid because the professional investors are not interested (This is why Forum is being offered to retail customers such as Councils.), and indeed there is no real secondary market in existing CDO’s in Australia.” (emphasis added)
127 The critique also described SCDOs as “long-term and illiquid”. It warned that they
might trade significantly below their issue price “from day one” and that if there were a
severe recession in the United States of America or Europe, or the price of oil “goes through
the roof”, investors should be prepared to lose all their capital. Significantly, the authors of
the Grove critique did not appreciate that the Forum AAA product was a synthetic CDO.
Instead, Grove asserted that the SPV for that product had bought the securities in the
reference portfolio from the promoter and continued:
“What is Forum? Forum is a variation on the standard CDO in that in addition to buying a portfolio of securities (in this case AAA mortgage backed securities) the investors are effectively providing $1 billion in credit insurance to the promoter (in this case Deutsche Bank).
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The credit spread paid by the promoter to the issuer is essentially the insurance premium. Thus, unlike standard CDO’s, in the case of Forum the investors credit exposure is $2 billion, i.e. $2 for every $1 invested. (emphasis added) … How risky are the securities in the credit swap portfolio? The $1 billion in AAA mortgage backed securities is undoubtedly highly secure. (Note that these securities are the collateral that the issuer is providing the promoter to ensure that the issuer can pay out if any of the riskier securities defaults!)”
128 It is difficult to know what Grove meant by asserting that investors in the product had
a “credit exposure” of “$2 for every $1 invested”. That raises the question that if Grove, a
competitor of Grange, did not understand accurately how an SCDO operated, having seen at
least some of Grange’s term sheet and presentation material for the Forum AAA product,
would Council financial officers, even with tertiary educational financial qualifications? As I
have sought to explain, having had the assistance of days of expert evidence, expert reports
and the detailed analyses in the parties’ oral and written submissions, in a synthetic CDO
neither the swap counterparty (the promoter in Grove’s explanation), nor the SPV, owns any
securities in the reference portfolio (see [53]-[54] above]) and the collateral is not comprised,
as Grove wrongly asserted, of those securities, but of assets bought with the net funds
received from the investors.
129 Part of Grove’s difficulty may have been caused because of the evolving nature of
SCDOs, as was recognised by Deutsche Bank, the PCDS counterparty for the Forum AAA
product in the research report it published on SCDOs on 29 April 2003. That stated that
“innovation continues to be the hallmark of this sector” and identified the emergence and
refinement of SCDOs as products in the derivatives market since 2000. That report was over
16 pages long and was also complex. I will return to other aspects of this critique in section
4.2.4 below.
130 At about the same time, March or April 2003, an internal Grange presentation
explained that “… the risk Investors are exposed to when they make their investment” was
the risk of sufficient defaults in the reference portfolio to arrive at the attachment point for the
tranche in the SCDO. This document also noted that Standard & Poor’s rated to “the first
dollar of loss”. Grange prepared a slide presentation for the Annual NSW Local Government
Financial Awareness conference held at the town of Parkes in early April 2003. That
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presentation was given to Mr Bokeyar of Parkes who attended the conference (see [468]-
[473] below). Under the caption “Conclusions” Grange made these points:
“If Councils do not possess the necessary investment skills they should seek external advice from a professional financial advisor but;
Councils should not allow professional financial advisors to avoid
responsibility for their investment decisions by hiding behind a credit rating or a fund manager.” (emphasis added)
131 In May 2004, Grove circulated a paper entitled “The 12 Common Misconceptions
Regarding Cash Investing” just prior to the annual conference of NSW Local Government
Finance Professionals. A copy of this paper was emailed to Michael Clout, divisional
director fixed income of Grange, who sent it to key members of its management with the
comment “They’re at it again! Grove that is”. The paper identified as misconception 5:
“CDO’s and FRN’s have similar risk profiles”. It stated that the two were “very different
financial instruments and possess very different risk profiles”. In addition, the paper
emphasised that CDOs were highly complex and required infrastructure and skills to analyse
their risks and conduct due diligence of the CDO’s manager and its reference portfolio,
adding:
“They currently lack a deep secondary market, meaning these types of investments suffer from high illiquidity. In other words, forced sellers will find it very difficult to find a buyer.”
132 On 4 April 2006, the Commonwealth Bank of Australia published a detailed research
document entitled “Understanding the Risks of Synthetic CDOs”. This commenced by
stating that SCDOs “have more risk than similarly rated corporate bonds. [SCDOs] should
therefore yield more return to investors”. In discussing risks of SCDOs, the document noted
that:
“… [m]arket or liquidity risk is probably the most significant of these risks in explaining the differences in yield between corporate bonds and CDOs. The liquidity of CDOs is often much lower than it is for corporate bonds. Therefore a liquidity premium often forms part of the yield to compensate investors for the difficulties faced in selling in the secondary market.”
133 A revealing insight into the arcane complexity of SCDOs and their inherent risks
appeared in an internal Grange email exchange on 22 September 2006. The exchange was
entitled “Re CDOs: The Free Lunch”. Richard Portlock, Grange’s Perth based director,
hybrid securities asked Mr Hagan, Mr Vincent and Josh Ackman, director, structural
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finance, for the explanation why an SCDO paid a higher coupon (i.e. interest rate) than a
similarly rated single credit (i.e. a corporate bond or FRN issued by a company with the same
credit rating). He proposed an example of an SCDO comprised of BBB rated reference
entities whose notes yielded an average 50 bps more than the BBSW where the investor
bought a tranche with a high enough attachment point to achieve a rating of AA so that it
offered a coupon of BBSW + 125 bps. Mr Portlock compared this example to an single name
FRN rated AA with a coupon of BBSW + 25 bps and asked: “Why the difference?”. He
pointed out that the ratings by Standard & Poor’s (assessing the probability of the first dollar
of loss) were “not terribly helpful for company investments with substantially different pay-
off profiles” (the underlying portfolio and the CDO tranches). And, he noted that similar
Moody’s ratings (assessing the expected loss) for two “investments [that] carry the same
expected (default) loss … cannot explain the difference in coupons”.
134 Mr Hagan responded that a large part of the explanation was that the rating agency
CDO models considered all entities with the same rating to have the same default risk while
the market did not. He commented:
“The default risk implied by market spreads can vary greatly within a ratings band and unsurprisingly there is generally a skew toward the ‘higher value’ credits within a typical CDO portfolio.”
He concluded:
“Perhaps it’s not so much a free banquet but rather a suspiciously good value dish – you think it’s Wagyu but in fact it’s Spot. Let’s face it, with enough HP sauce who can really tell the difference anyway …”
Mr Portlock retorted:
“… the old adverse selection problem…which clearly does not represent any sort of free lunch … I’d rather place my faith in market default probabilities than ratings agencies.” (emphasis added)
135 Mr Ackman replied that it was “not necessarily the case that all our CDOs are
adversely selected” (see [59]). He noted that Grange had done a good job thoroughly
screening and researching each proposed portfolio of reference entities to minimise both
overlaps between them and adverse selection, “… unless our view is different to the market”.
He gave two examples of how Grange had applied its judgment in assessing reference entities
differently to the market, concluding:
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“There is a very good reason why Grange has 40% market share for structured credit CDOs in Australia…our investors really aren’t stupid. You can fool some of the people some of the time, but not all of the people all of the time …”
136 Mr Portlock responded saying that he was still trying to understand the basis for the
higher returns from the SCDOs. He said that if it were the result of good selection of
reference entities, he would be satisfied, but still wanted to be clear about the reason, adding:
“… there is a lot of vague discussion surrounding CDOs which I find misleading when trying to work out what the investor is getting paid for …”
Mr Ackman replied:
“My take is there are many factors contributing to the reasons why CDOs yield better than comparably rated single names. The most important of these factors include, in no particular order:
- structural complexity (investors need to get paid for the “headache factor”);
- liquidity; - leverage; - risk of 0% recovery (which is really part of leverage[)]; - an element of adverse selection (although this is less so in Grange CDOs); - superior credit selection; - Supply and Demand: Supply is price dependent, but effectively almost
limitless given synthetic underlying; yet market / client incumbents whom are slow to adapt mandates and are not facing a need to learn about new products (as they do pretty well with their usual products already), mean that demand lags supply. As evidence of this, compare spreads on synthetic CDOs to the spreads of corporate bond CDOs … they have the same risk features with regard to leverage, etc. but spreads on synthetic CDOs are materially wider for a given rating …” (emphasis added)
137 Mr Vincent’s explanation was that even if there were no adverse selection, “CDOs
would still offer value over single name credits because you are diversifying the risk”. He
said that the effect of tranching in an SCDO was to create, from the portfolio of reference
entities, different instruments for each tranche that had “different risk return profiles” and that
the market determined the coupon return for the tranches after they had been rated.
138 The evidence does not establish if these exchanges made matters clear for
Mr Portlock, or even if he were better informed. The real point that emerges from these
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exchanges is that even the knowledgeable personnel within Grange could not provide a clear
explanation for why the coupon on SCDOs was greater than similar rated FRNs or other
notes issued by a single entity. And if it was not clear to Grange why the SCDOs had higher
coupons than similarly rated FRNs, there is no reason to conclude that its personnel who dealt
with the three Councils in these proceedings gave a better, let alone, full or appropriate,
explanation to the Council officers.
139 The Councils argued that since Grange controlled about 40% of the Australian market
it would have been aware of not just what Grove, but also of what other competitors, such as
the Commonwealth Bank, were saying about the risks inherent in SCDOs. They also relied
on “The Free Lunch” email exchange of 22 September 2006 for this purpose.
140 Grange inferred that the Councils’ argument was that it should have disclosed to the
Councils the risks referred to in the above contemporaneous documents. But, it contended
the Councils had not made a comparison of the content of the contemporaneous documents
with the disclosures it made to them.
141 I reject that contention. It failed to engage with the Councils’ argument that, to a
greater or lesser extent, the particular risks that they complain of were not explained or
identified to them adequately or at all by Grange. The contemporaneous documents
demonstrated that those risks were matters of significance that were, or ought to have been,
known to Grange throughout the period that it dealt with the Councils and that they were
relevant to an investor’s consideration of whether or not to invest in SCDOs.
4. GRANGE’S RELATIONSHIPS WITH SWAN, PARKES AND WINGECARRIBEE
142 I will examine the relationship between each of the Councils and Grange in turn in
this section of these reasons. Each of those relationships had individual characteristics, but,
as will become evident, there were common features and products. The parties suggested that
the relationships were illustrative, for the purposes of the class action, of the three roles
Grange played in dealing with its clients who were members of the class. First, Parkes dealt
with Grange as a client over five years buying and selling SCDOs and other financial
products on the basis of ad hoc, or individual, transactions. The Councils contended that this
was a relationship between client and investment adviser and in which Grange was subject to
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the fiduciary duties of such an adviser. Grange contended that the relationship was quite
different, being one between arm’s length buyers and sellers of financial products in which
Grange traded.
143 Secondly, the initial relationship between Swan and Grange was similar for about the
first four years, until they entered into an individually managed portfolio (IMP) agreement
(the Swan IMP agreement) on 9 February 2007. The Councils and Grange adopted similar
positions in respect of Parkes to those about the proper characterisation of the relationship
between Swan and Grange in the period before the Swan IMP agreement was made. Grange
had power under the terms of the Swan IMP agreement to select securities, including SCDOs,
and to purchase or sell them on Swan’s behalf. However, not all of Swan’s investment
portfolio was covered by this agreement. Grange did not have control over other substantial
holdings of investment products that Swan did not include in its portfolio with Grange.
Grange argued that the Swan IMP agreement limited its responsibility for investment advice
because it was not, and Swan was, responsible for the allocation and exposure of Swan’s
overall investment portfolio.
144 Thirdly, and in contrast, the relationship between Wingecarribee and Grange was
always conducted under an individually managed portfolio agreement (the Wingecarribee
IMP agreement) dated 15 January 2007. The Wingecarribee IMP agreement had additional
provisions that distinguished its terms from those of the Swan IMP agreement. Under this
IMP agreement Wingecarribee appointed Grange as its agent to make investment decisions
for the Council’s entire investment portfolio. Thus, although they have many relevant
provisions in common, it will be necessary to consider each of these IMP agreements
separately.
145 Since Grange conducted both types of dealings with Swan, I will consider their
relationship first, before coming to the positions of Parkes and then Wingecarribee. Each of
the seven former officers of the Councils who gave oral evidence did so many years after the
events. It was not suggested that any of them had a direct personal interest in the outcome of
the proceedings. In assessing the oral evidence of each of those former officers I have taken
into account the salutary warning of McLelland CJ in Eq in Watson v Foxman (1995) 49
NSWLR 315 at 318-319 in the following passage:
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“Where, in civil proceedings, a party alleges that the conduct of another was misleading or deceptive, or likely to mislead or deceive (which I will compendiously described as “misleading”) within the meaning of s 52 of the Trade Practices Act 1974 (Cth) (or s 42 of the Fair Trading Act), it is ordinarily necessary for that party to prove to the reasonable satisfaction of the court: (1) what the alleged conduct was; and (2) circumstances which rendered the conduct misleading. Where the conduct is the speaking of words in the course of a conversation, it is necessary that the words spoken be proved with a degree of precision sufficient to enable the court to be reasonably satisfied that they were in fact misleading in the proved circumstances. In many cases (but not all) the question whether spoken words were misleading may depend upon what, if examined at the time, may have been seen to be relatively subtle nuances flowing from the use of one word, phrase or grammatical construction rather than another, or the presence or absence of some qualifying word or phrase, or condition. Furthermore, human memory of what was said in a conversation is fallible for a variety of reasons, and ordinarily the degree of fallibility increases with the passage of time, particularly where disputes or litigation intervene, and the processes of memory are overlaid, often subconsciously, by perceptions or self-interest as well as conscious consideration of what should have been said or could have been said. All too often what is actually remembered is little more than an impression from which plausible details are then, again often subconsciously, constructed. All this is a matter of ordinary human experience. Each element of the cause of action must be proved to the reasonable satisfaction of the court, which means that the court “must feel an actual persuasion of its occurrence or existence”. Such satisfaction is “not … attained or established independently of the nature and consequence of the fact or facts to be proved” including the “seriousness of an allegation made, the inherent unlikelihood of an occurrence of a given description, or the gravity of the consequences flowing from a particular finding”: Helton v Allen (1940) 63 CLR 691 at 712. Considerations of the above kinds can pose serious difficulties of proof for a party relying upon spoken words as the foundation of a causes of action based on s 52 of the Trade Practices Act 1974 (Cth) (or s 42 of the Fair Trading Act), in the absence of some reliable contemporaneous record or other satisfactory corroboration.”
4.1.1 Grange, its competitors and local government councils
146 Grange was not the only entity that solicited business opportunities with local
government councils for investment of their surplus funds. Its two main competitors during
the period between 2002 and 2007 were Grove and Oakvale Capital Limited. Each of
Grange, Grove and Oakvale offered financial products to Councils that fell within the range
of investments they were authorised to make by legislation and their own investment policies.
Each of these companies had, and made use of, a right to access publicly available material
about the investment policies and investments of local government councils. They regularly
approached councils suggesting financial products which fell within the range of investments
that the three applicant Councils were authorised to make. Each presented information about
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their services and financial products at annual conferences of local government bodies in
order to attract custom.
147 Of course, the Councils could and did invest with other financial services providers,
such as banks, in order to earn interest on their surplus funds. Relevantly, the legislative
constraints operating in New South Wales and Western Australia, in respect of Councils
investing funds were similar, although it will be necessary to examine these separately as
they affected Parkes, Wingecarribee and Swan.
4.1.2 Grange’s personnel
148 I will briefly describe the roles of the Grange senior executives who featured in the
evidence.
149 Mr Clout was the divisional head, fixed income from around 2001 until September
2007. In that position he was responsible for Grange’s book of SCDO and CDO products.
From about mid February 2007, after Lehman Bros took over Grange, Mr Clout appears to
have reported to Leon Hindle a senior officer of Lehman Brothers Asia Limited (Lehman
Asia) who operated from Hong Kong. From this time, Mr Hindle and other officers of
Lehman Asia appeared to play significant roles in the structuring and trading of the new
SCDO products that Grange sold.
150 Mr Vincent was Grange’s director, capital markets from about 2002. Grange
described his role in October 2006, when expressing its interest in providing investment
advisory services to Wingecarribee, as running a “team of financial engineers who design
structured products and investment opportunities tailored to Grange’s clients’ needs. The
team has been particularly successful in the Collateralised Debt Obligation and related areas
where the team has completed over 20 transactions [since 2004]”.
151 Mr Portlock was Grange’s director, hybrid derivates from around 2003. Grange
described his role as providing excellent technical portfolio risk advice as part of its
investment committee.
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152 In Grange’s Perth office the two officers who principally dealt with Swan were Mr
O’Dea, director, fixed interest from about March 2003 and Mr Kay an associate director
from about September 2004.
153 The officer who dealt principally with Parkes was Jill May, who then was manager,
fixed interest. And, the officers who dealt principally with Wingecarribee were Stuart
Calderwood, director, fixed interest and David Rosenbaum, director, business development.
4.1.3 Grange’s business
154 Grange did not call any evidence from its former employees. Thus, the evidence of
the way in which it operated emerged from documents and the oral evidence of Council
officers.
4.2 The initial relationship between Swan and Grange
4.2.1 Swan’s personnel and its investment policy before 2003
155 Rajah Senathirajah was employed as Swan’s manager of finance from 1999. From
April 2003 until 4 May 2006, he was its group manager of finance. He had been admitted,
first, in December 1981 as a fellow of the United Kingdom Chartered Institute of
Management Accountants and, secondly, in September 1991 as a certified practising
accountant and a member of CPA Australia. He obtained a Masters of Business
Administration degree from Deakin University in 1994 (T365). Mr Senathirajah reported to
Swan’s executive manager for finance and information services who, until about mid 2005,
was Cliff Frewing and, then to his replacement, Gerry Poepjes. Mr Senathirajah was
responsible for a variety of day to day functions, including the issue of rate notices, collection
of rates, payment of all accounts, maintaining Swan’s asset register, administering its payroll,
preparing its annual budget, annual audited accounts and the monthly financial reports to the
Council.
156 Pertinently, Mr Senathirajah had the task of investing the Council’s funds that were
not immediately required by it. These consisted principally of immediately surplus rate
income and reserve funds. Rate income constituted Swan’s main source of revenue.
Following the despatch of annual rate notices in July, Swan received about 60% of its annual
rate income in August and September each year. Some ratepayers opted to pay by
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instalments, and so the Council would receive the balance of its rate income from these at
regular periods in each financial year. Mr Senathirajah had to invest most of the rate income
Swan received on a short-term basis so that it was available to be drawn upon when required
from time to time during the financial year. The reserve funds, also called “restricted” funds,
were moneys set aside by Swan for a particular purpose, such as a capital works or
expenditure program. After the initial rate income had been received, Swan had in the order
of $15 million to invest on a short-term basis to be available for draw down over the balance
of the financial year, and in the order of $6 to $8 million in reserve funds.
157 In late 1998, the Council adopted what was called an “investment practice” though
this was more a policy (the 1998 Swan Policy). The 1998 Swan Policy applied to the
investment of surplus funds. It required investments to be made prudently after assessing
credit risk and diversification limits with a view to maximising earnings while ensuring
security of the Council’s funds (cl 2.1). Clause 2.2 required all its investments to be made in
accordance with s 6.14 of the Local Government Act 1995 (WA) and Pt III of the Trustees
Act 1962 (WA). That clause reflected s 6.14(1) of the Local Government Act, that authorised
a council to invest its surplus funds in accordance with Pt III of the Trustees Act. Although
that power was subject to any matters prescribed in regulations, no regulations are relevant
for the purposes of these proceedings. Relevantly, s 18(1)(a) of the Trustees Act, which was
in Pt III, provided that subject to any instrument creating a trust, in exercising a power of
investment a trustee whose profession, business or employment included acting as trustee or
investing money on behalf of other persons, had to exercise the care, diligence and skill that a
prudent person engaged in that profession, business or employment would exercise in
managing the affairs of other persons.
158 The 1998 Swan Policy authorised, but did not limit Swan to, investment in bank
accepted or endorsed bills, bank negotiable certificates of deposit, bank interest bearing
deposits, State or Commonwealth government bonds, and funds managed by fund managers
who had Standard & Poor’s credit ratings of not less than AA- (cl 2.4), in investments rated
no less than A1+ for short-term or AA- for long term (cl 2.5(b)). The policy expressly
delegated authority to invest funds to Swan’s administrative staff (cl 2.3).
159 The 1998 Swan Policy required investments to have a term to maturity within the
range of “at call” up to 365 days (cl 2.5(a)(ii)). It also placed limits on the value of
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investments in any one financial institution or managed fund based on Standard & Poor’s
ratings (cl 2.5(c)).
160 Mr Downing succeeded to the responsibilities of Mr Senathirajah and became chief
financial officer of Swan in May 2006. Mr Downing held a Bachelor of Business degree
with a major in accounting and in 2000 obtained a Masters in Business Administration from
the University of Western Australia. He also had obtained in 2002 a postgraduate Diploma in
Company Secretarial Practice from the Institute of Company Secretaries. Prior to working
for Swan as a projects officer in October 2005, Mr Downing had worked in various positions
in local government and the private sector. Mr Senathirajah briefed Mr Downing on the
investments and Swan’s then investment policies, as he was handing over his role.
Mr Downing left Swan on 5 April 2007.
161 Colin Cameron completed a Bachelor of Business degree in 1996 and qualified as a
certified practising accountant in 2000. He completed a Masters of Business Administration
degree from Curtin University in 2005. He had worked in a number of government
departments before taking up a local government position in October 2002. In May 2007 he
commenced working at Swan as its executive manager of corporate services.
162 In practice, Mr Senathirajah, after considering an investment, made recommendations
to his superior who then made a decision. Mr Downing had delegated authority to make such
decisions himself. The Swan IMP agreement was in place when Mr Cameron became
responsible for Swan’s investments. Grange relied on Swan’s failures to call Mr Frewing, Mr
Poepjes and the administrative officers who reported to Mr Senathirajah, Mr Downing or Mr
Cameron as significant omissions in its case. However, for reasons that I will explain later
([408]-[409]) I am comfortably satisfied that recommendations by Mr Senathirajah and Mr
Downing were the common sense causes of the decisions of Swan to invest in the claim
SCDOs. Had they not made the relevant recommendations, their superiors would not have
considered those investments at all. And, once Mr Frewing had made the initial decisions, he
accepted Mr Senathirajah’s recommendations to buy or sell a Grange product on most
occasions, except when Mr Frewing considered that Swan required the funds for other
purposes. I infer that a similar situation developed between Mr Poepjes and Mr Senathirajah.
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163 I am not persuaded that the administrative officers who worked under Messrs
Senathirajah, Downing and Cameron had any substantive role in Swan’s decision making
processes in relation to its investments in Claim SCDOs. Grange identified these officers and
I will briefly deal with each in turn. First, Ms Metelda Perera sent an email simply attaching
the 1998 Swan Policy to Grange in 2003 at Mr Senathirajah’s request. No doubt there were
many employees of Swan who worked in its administration and would perform routine tasks
such as that for senior officers like Mr Senathirajah. Grange did not suggest that Ms Perera
did anything relevant. Secondly, Ms Gwen Le Lievre was responsible for keeping Swan’s
records of its investments and reported to Messrs Senathirajah, Downing and Cameron. She
sometimes received copies of emails from Grange that it also sent to her superiors.
164 Grange referred to two instances of such emails involving Ms Le Lievre, one of
28 August 2006 and the other of 1 September 2006. Mr Downing gave evidence that he had
had discussions with Grange’s Mr Kay or Mr O’Dea. Those email chains included Ms Le
Lievre as an addressee, referred to discussions with Mr Downing and her and concluded in
her relaying orders for Claim SCDOs. However, the emails on their face do not suggest that
Ms Le Lievre had a decision-making role. Rather, I infer that she was assisting Mr Downing
on those occasions and acted on his instructions in placing the orders on 28 August 2006 and
1 September 2006. I find Ms Le Lievre’s role was only to carry out instructions and to assist
her superiors Messrs Senathirajah and Downing. Mr Downing was not cross-examined to
suggest that Ms Le Lievre had any responsibility for those decisions. To the contrary, he was
cross-examined only on the 28 August 2006 emails on the basis that he had made the decision
to invest.
165 Grange also argued that Mr Cameron had left it to Ms Le Lievre to manage Swan’s
day to day investments for about two months after he arrived at the Council on 23 May 2007.
However, there was no evidence to suggest that Ms Le Lievre’s role had become that of a
decision-maker in that period. Rather, Grange was managing those of Swan’s investments
that were in its control under the Swan IMP agreement. Grange continued to report in its
usual format to Swan each month. The only activity involving Ms Le Lievre and Grange in
evidence during this period, apart from her receiving the monthly reports, was an email she
sent to Grange on 25 May 2007 saying that the Council required $3,000,000 to pay creditors
by 31 May 2007 and asking what she needed to do “to recall the money”. By 24 July 2007
Grange was emailing Mr Cameron directly (without copying in Ms Le Lievre) with an update
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briefing note dealing with SCDOs. As Mr Cameron said, when he took up his position he
was very busy because he had to prepare the Council’s budget and, there were vacancies in
the positions of three key managers who should have reported to him, including the position
of finance manager.
166 In all these circumstances, Ms Le Lievre is unlikely to have played any decision-
making role in relation to the Claim SCDOs. I am not satisfied that she or her replacement,
Catherine Burns, could have added any relevant evidence. The same conclusion follows in
respect of Stan Kocian, a management accountant, who also reported to Mr Senathirajah.
There is no evidence to suggest that Mr Kocian played any decision-making role.
4.2.2 Swan’s contact with Grange before the 2003 Swan Policy
167 Prior to September 2003, Swan’s investments had been in term deposits and managed
funds. Mr Cameron gave unchallenged evidence that I accept that in the period between
January 2000 and early September 2003 Swan invested in bank bills, negotiable certificates
of deposit and term deposits. All these investments appeared to be with recognised banks. I
accept Swan’s description of these investments as “conservative”. The Council also invested
in this period in managed funds through Grove. Swan had contained its relationship with
Grove that had begun before Mr Senathirajah joined its staff.
168 A letter from Grove to Mr Senathirajah dated 4 June 2002 indicated that Swan had
investments in three managed funds conducted by fund managers associated with banks and
insurers. There was no substantive evidence of the nature or extent of Swan’s dealings in this
class of investments. In that letter, Grove suggested changes to the 1998 Swan Policy and
enclosed an updated draft policy that permitted investments with funds or fund managers
rated no less than A+ to A- rather than the then current minimum rating of AA.
169 Prior to May 2003 Swan had conducted an internal review of how its managed fund
investments were performing. Mr Senathirajah said that this had revealed that the managed
funds mostly invested in floating rate notes. In this way he and, so, Swan became interested
in investing directly in FRNs. Mr Senathirajah understood that the 1998 Swan Policy did not
permit it to invest directly in FRNs. He understood that a term deposit was made for a fixed
period at a specified interest rate and that if the Council sought to redeem it early there would
be an interest penalty. Mr Senathirajah understood that an FRN was issued by a bank,
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financial or other large commercial institution, had an interest rate based on a margin above
the BBSW at the date of investment and that this rate would vary with any subsequent
quarterly variations in the BBSW. Before May 2003, Mr Senathirajah had not heard of the
term “CDO”.
170 In May 2003 Mr Senathirajah asked an administration officer in Swan’s financial
services department to send Mr O’Dea of Grange a copy of the 1998 Swan Policy. Mr
Frewing was copied into this email. Because that policy was a publicly available document
Swan provided it to whomever may have requested it. It is likely that Mr Senathirajah had
met Mr O’Dea before this occasion at one of the twice yearly Western Australian conferences
for local government managers.
171 On 4 June 2003, Mr O’Dea sent an email to a large number of West Australian
Councils, including to Mr Frewing at Swan, offering an investment in the Argyle CDO and
attaching a term sheet for this. Significantly, Mr O’Dea described this instrument in the
email as a floating rate note. He then wrote that it “… is based upon a Collateralised Debt
Obligation (CDO) and structured as a floating rate note which ultimately matures 15/10/07”.
Mr O’Dea then stated that investors were “… able to use these instruments for much shorter
periods as they are tradable on the secondary market”. I infer that Mr Frewing was included
in this email as part of a marketing exercise by Grange rather than as a result of some direct
dealing that he, rather than Mr Senathirajah, had had with Mr O’Dea.
172 On 19 June 2003, Mr O’Dea visited Swan and had a meeting with Mr Frewing, Mr
Senathirajah, Mr Kocian and Ms Le Lievre. They discussed financial products, including
FRNs, that Grange could offer and what Swan’s investments were. Mr O’Dea told them that
Grange could help Swan get a better yield for its ratepayers. Mr O’Dea emailed them on 20
June 2003 thanking them for their time and confirmed to Mr Senathirajah that Grange had an
FRN product available being an A+ rated 30 day deposit with a 5% interest rate. Mr
Senathirajah exchanged a number of emails with Mr O’Dea. Mr Senathirajah also consulted
with Mr Frewing informing him that the 1998 Swan Policy did not allow the Council to
invest in an FRN. After this, Mr Senathirajah wrote to Mr O’Dea on 23 June saying that
Swan’s current investment policy did not allow it to take up the offer. However, he attached
to this email a copy of a draft proposed revised investment policy that would give Swan a
wider range of investment possibilities and asked for Mr O’Dea’s comments. The proposed
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policy had been drafted in May or early June 2003 and included, as acceptable investments,
FRNs rated “A” or better by Standard & Poor’s and mortgage backed securities with a
minimum credit rating of AA. It also continued to require that the term to maturity of any
direct investment be no more than 365 days (cl 2.6(ii)).
173 Mr O’Dea sent a detailed response to the draft policy on 25 June 2003. He referred to
other Councils’ investment policies that he had seen. He suggested that rather than the policy
referring to floating rate notes, it could be widened to include fixed and floating rate interest
bearing deposits or securities. Mr O’Dea’s rationale for this was that there might be
problems because of prohibitive costs for the issuers of small issues of FRNs to get them
rated. Mr O’Dea also noted that securities with a floating rate typically had 3-5 year
maturities when he commented on the current draft policy limit of a one year term to
maturity. Mr Senathirajah accepted this as a rational explanation even though in his own
mind he thought Swan would only hold products like FRNs for a year, even if they had a
longer term to maturity. This was because generally the Council would need the funds within
a year. Swan also sought and received feedback on the draft policy from Oakvale and Grove.
Among others, Oakvale suggested a 10 year maximum term to maturity while Grove
suggested a five year maximum.
174 I infer that Mr O’Dea wanted to ensure that the final version of the 2003 Swan Policy
allowed Swan to invest in SCDOs marketed by Grange, like the Forum AAA product and to
reassure Swan through Mr Senathirajah, as well as Mr Frewing, that the products he offered
conformed to investments that its new policy permitted. It would not have been in Grange’s
interests to sell products to a council that it was not authorised to buy. And Mr O’Dea was
aware from Mr Senathirajah’s email to him of 23 June 2003 that the 1998 Swan Policy did
not enable Swan to invest in FRNs, SCDOs or other instruments with a term greater than one
year. Moreover, he was aware of how complex SCDOs were and of the lack of any previous
knowledge or experience of these products of Mr Frewing, Mr Senathirajah and Swan.
4.2.3 The 2003 Swan Policy
175 On 27 August 2003, Swan adopted a new investment policy (the 2003 Swan Policy).
This delegated the Council’s investment authority to its chief executive officer who, in turn,
had power to sub-delegate to designated council officers (cl 2.3). Each of Mr Senathirajah,
and as chief financial officer, Mr Downing had this power delegated to him. The new policy
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had objectives of enhancing the yield to Swan through prudent investment of funds,
achieving a return on investment funds consistent with the BBSW or similar average 90 day
rates and a high level of security for the overall portfolio by using recognised ratings criteria,
maintaining an adequate level of diversification and having ready access to funds for the
Council’s day to day requirements without penalty (cl 2.1). The 2003 Swan Policy contained
the same provisions as its predecessor for all investments to be made in accordance with
s 6.14 of the Local Government Act and Pt III of the Trustees Act (cl 2.2). This policy
provided in cl 2.4:
“2.4 Investments Authorised Investments would include but not necessarily be limited to: • Fixed and floating rate interest bearing deposits/securities issued by
Approved Deposit Taking Institutions (ADIs) authorised by the Australian Prudential and Regulatory Authority (APRA), including Fixed Term deposits and Floating Rate Notes;
• State/Commonwealth Government Bonds;
• Mortgage and Asset Backed Securities with a credit rating of
‘AA-’ or better;
• Managed funds with a credit rating of ‘A-’ or better.”
In addition, cl 2.6(a)(ii) provided:
“(ii) Term to Maturity
• Fixed rate investments up to 1 year • Investment grade ADI floating rate investments of more than 1 year
to legal maturity, subject to the investments having the capacity to be able to be sold at any time before maturity
• Investment grade mortgage/asset backed securities up to 5 years
(weighted average life)
• Non-rated ADI securities up to 6 months.” (emphasis added)
176 This policy also had a diversification and credit risk section that set maximum
investment limits for direct investments and managed funds in both the long and short terms
based on minimum Standard & Poor’s ratings in each category. The policy stated that
consideration should be given to the relationship between credit rating and interest rate when
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placing investments. This reflected Mr Senathirajah’s view that credit ratings should be a
primary selection criterion. He held that view throughout his dealings with Grange.
177 Mr Senathirajah had prepared a report for the Council to explain the purpose of the
proposed new policy before it was adopted. The report noted that key reasons for the new
policy had been Grove’s invitation to Swan to invest its new Grove Portfolio On-Line
program and the existence of other investment products on the market that might give a better
return for comparable levels of risk. It also stated that the Council had a statutory duty to
apply the prudent person principle in making investments, and this duty not only prevented
Swan investing in speculative or hazardous products but also required it not to be overly or
“lazily” conservative when investing. The report advised the Council that the new policy
would permit investment in FRNs and mortgage backed securities serviced by cash flows
from residential or commercial mortgages. It emphasised that the policy created a primary
selection criterion for an investment of the credit rating of the product or the issuer.
4.2.4 Swan’s first investment with Grange – the Forum AAA SCDO
178 Shortly before the 2003 Swan Policy was adopted by the Council, Mr O’Dea emailed
Mr Senathirajah on 18 August 2003 attaching a background note on Grange and an
explanation of FRNs. Mr O’Dea provided these in order to assist councillors with their
consideration of the adoption of the 2003 Swan Policy. The background note stated that
Grange was an independent fixed interest and investment specialist. The note continued by
saying that Grange:
“… places a high value on its reputation and prides itself on the quality of advice provided by it [sic] professional staff. A key objective of the firm is to add significant value to the financial affairs of its clients. With offices in Melbourne, Sydney, Brisbane and Perth, Grange services private and professional investors, and government and corporate borrowers Australia Wide. Our dealers service over 10,000 private clients, 500 financial planners and accountants. Grange is an accepted counterparty with all major financial institutions and fund managers in Australia. Grange continues to have significant involvement with the local Government sector … Grange offers a range of services including investment recommendation, asset and liability portfolio analysis, investment policy construction, debt consolidation and competitive loan tendering.” (emphasis added)
179 The explanation of FRNs extended over four pages. It commenced:
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“This note provides a brief explanation of floating rate note investments, their suitability for local government and corporate investors. It also addresses some of the important issues in relation to direct investment, and in particular, direct investment through Grange Securities Limited (Grange) in floating rate or fixed interest rate securities.” (original emphasis in non-italic bold; emphasis added in italicised bold)
The explanation also stated:
“… Grange Securities does not recommend lower rated corporate non bank FRN’s as appropriate investments for risk averse local government and corporate investors. Grange Securities does not recommend ASX listed perpetual income securities as an appropriate or sensible investment for local government investors. Many of these securities are issued by non-bank corporates; they have no set maturity date, hence they are described as ‘perpetuals’. These securities are susceptible to the vagaries of the stock market. … Grange Securities does recommend investments in floating rate notes issued by licensed Australian banks, building societies and credit unions. We conduct comprehensive research and analysis on all issuing financial institutions that we recommend – this is our expertise.” (original emphasis in non-italic bold; emphasis added in italised bold)
180 In addition, the explanation highlighted that specific advantages of investing in
licensed ADI floating rate notes included:
“• Always tradeable (i.e. liquid) … • Flexibility to hold to maturity or to sell at any time prior to maturity • Principal is repaid in full upon maturity”
It also emphasised that FRNs were tradeable investments and that many of the best
investment opportunities arose in the secondary market. The explanation concluded:
“Dealing in Fixed Interest Securities through Grange Securities Ltd. Grange is required by its client base to support issues on a secondary market basis to guarantee liquidity in any issues offered to clients. Demand for quality and suitable floating rate notes by Grange customers far exceeds supply, and as such we would be pleased to provide a market for sellers in the current environment. Grange is highly specialised in Australian fixed interests markets with highly qualified analysts and executives. Grange is dedicated to providing secure investments that generate quality returns for our customers through a diversified approach to investing.” (emphasis added)
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181 Mr Senathirajah gave evidence, and I accept, that Mr O’Dea told him and the other
Swan representatives, originally when they met on 19 June 2003 and repeated in subsequent
presentations of Grange products, that there would be a secondary market for those products
and, if there were not, Grange would buy the product back. Mr O’Dea emphasised this to Mr
Senathirajah as a reason for Swan to buy the financial products it offered, saying that Grange
was committed to providing a secondary market for its customers.
182 Mr Senathirajah said that at some point which he could not identify more precisely,
between June 2003 and mid September 2003, Mr O’Dea came to Swan’s offices and made a
presentation to Messrs Frewing and Senathirajah, and possibly others, using slides entitled
“Understanding Investment Grade CDO’s (Using the example of Forum ‘AAA’)”. For the
reasons I will give below, I find that this presentation occurred before the 2003 Swan Policy
was made in late August 2003. Mr Senathirajah said, and I find that, Mr O’Dea introduced
the Forum AAA SCDO to them as an FRN. At the foot of each slide was a disclaimer in very
small print stating:
“… Grange has taken all care and used its best endeavours in the preparation of this document, however, Grange does not accept liability for any errors, omissions or inaccuracies or any losses or damages suffered or incurred by any party relating in any way to this document.”
However, the disclaimer sentence followed two sentences dealing with the only subject
matter indicated for the small print, namely the bolded, block lettered word in larger type:
“CONFIDENTIALITY”. In all likelihood no-one in the position of an investor approached
by Grange would have read on past the first line which said that “the contents of this
document are meant for the recipient only and must be treated in confidence”. Moreover,
there was no evidence that Grange ever made an oral disclaimer to any of the Councils for its
spoken statements, including any repetition of the contents of its slides.
183 The presentation was over 20 slides long. Mr Senathirajah retained a hard copy of the
slides at the end of the presentation. It opened by explaining that the AAA rated Forum notes
were “investment grade” meaning that “the entities behind the transaction are investment
grade (ie: high credit quality assets)”. Next, the first slide stated that “collateralised” meant
that there were “physical assets backing the transaction and that Investors have security over
these assets”, and that those assets were AAA Australian mortgage backed securities. Mr
Senathirajah understood that meant that the investors’ capital was secured by a mortgage to
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protect the CDO from failing. The next slide said that the key terms of the Forum AAA note
included:
“• Standard Australian Dollar Floating Rate Note format …
• Note is also linked to the performance of a portfolio of 142 international
investment grade companies • This performance risk is also rated ‘AAA’.”
184 Two slides explained the mechanics of how an investment would work. The first of
these slides explained that most investment grade CDOs, such as the Forum AAA product,
operated “through ‘Insurance Contracts’ commonly know[n] as Credit Default Swaps”. It
said that a special purpose company, set up by Deutsche Bank to do the transaction, had
entered into a contract with that bank “to ‘insure’ a portfolio of 142 Investment Grade
Companies against loss”. The slide explained that investors bought debt issued by the SPV,
being the Forum AAA notes. The second of these slides stated that if losses occurred above
6.50% of the portfolio, then the investment bank (in the position of the swap counterparty)
could offset any of its losses from the mortgage collateral, but if no losses occurred, the
mortgage collateral would be sold at the end of five years (when the notes matured) to return
principal to investors. This slide concluded, Delphically:
“Anything that could weaken the credit strength of the transaction below a ‘AAA’ credit rating is covered in the legal documentation.”
185 During this presentation or at about this time, Mr Frewing and Mr Senathirajah told
Mr O’Dea that they were the financial officers responsible for running the Council’s affairs
and that because these were sophisticated financial products, they were dependent on advice,
from people who knew best about those products, to help the Council make a decision as to
whether or not to invest in them. Mr O’Dea assured them that even if he did not have full
knowledge about those products, Grange’s Sydney office had specialists who were well
versed in them and who would provide support for the Council if needed. Mr O’Dea also
said that Grange would monitor the performance of the products, make recommendations and
give advice to Swan about whether or not it should sell, leaving the final decision, however,
to Swan.
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186 Mr Senathirajah told Mr O’Dea that the Council did not have the time or competence
to monitor those products and that if it invested, it would expect Grange to monitor them and
give advice on whether or not to sell. Mr O’Dea said that this was part of Grange’s service
that it provided to local government and would provide to Swan. Mr O’Dea said that, in
relation to such products, he was well aware of the competencies in Swan, as well as in local
government bodies generally.
187 Mr Senathirajah understood from the slides, and from what Mr O’Dea said in
explaining them, that there was some possibility that if the Council invested in the Forum
AAA SCDO some of its money could be lost. He appreciated that the gradations in ratings
descending from AAA, reflected an assessment that the issuer of a lower rated product had a
lesser capacity to repay than a higher rated one. He understood that, in recommending
SCDOs to Swan, Grange was aware of the requirement in the 2003 Swan Policy that
consideration be given to “the need to maintain the real value of capital”. Mr Senathirajah
himself understood, and considered that Grange understood, that this meant that, if Grange
recommended a product to Swan, there was a minimal probability of loss, although he
accepted that there was a theoretical possibility that the Council could suffer such a loss. He
explained:
“There is theoretical loss in everything. You can put money in the bank on a term deposit; there is a possibility that the bank will not pay back the money. There is no guarantee.”
188 That understanding was reinforced by the slides and what was said orally. The slides
stated that the percentage chance of loss on the Forum AAA notes “is so small it is rated at
the highest possible rating of ‘AAA’” and that their structure had “the capacity to pay high
premiums in return for taking minimal risk”. One slide, headed “Risk Comparisons”, equated
a rating of “AAA” with the credit risk of the Australian Government, saying this was a risk of
loss over five years of 0.003%. That was stated to be in contrast to the “AA-” ratings of three
of the four major Australian banks which reflected a risk of loss over the same period of
0.142%. Mr Senathirajah recalled from Mr O’Dea’s use of that slide, that an investment in
the Forum AAA product “was more secure than the big banks”.
189 That impression was reinforced by another slide headed “Low Market Risk” that
stated:
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“• Prudent Investment - No Currency Risk
- No Interest Rate Risk; beyond floating rate note - No Credit Risk; beyond AAA level
• “Bullet” Structure – no prepayment risk • Coupons 3 Month BBSW + 1.30%” (emphasis added)
Mr Senathirajah understood this to mean that, what it said, namely that there was no credit
risk.
190 The next slide was headed “Liquidity”. It stated that Grange had placed two earlier
instruments, Gibraltar AA and Nexus AA+ with numerous investors including governmental
and corporate ones across most of Australia and that the Forum product’s AAA rating would
probably allow a wider class of investors. The slide concluded:
“Grange will always provide a best endeavours bid for the bonds as part of normal Grange service.”
191 Mr Senathirajah said that Mr O’Dea explained that statement by saying that, when the
Council wanted to sell, Grange would try to obtain the best price in terms of a margin above
the face value of the product. Mr Senathirajah accepted that he did not recall the exact words
used by Mr O’Dea when he was giving evidence nearly eight years later but maintained that
Mr O’Dea had conveyed that impression. I accept his evidence that Mr O’Dea conveyed
such an impression. It is readily understandable that Mr O’Dea’s presentation would convey
such an impression and, even if not in those exact words, by implication. That impression is
consistent with the context of the bullish assertions in the slides, including that the Forum
AAA notes had no credit risk and were as safe a risk as the Australian Government, and that
Grange would always make a best endeavours “bid”, for this apparently minimal risk
investment. The impression is also consistent with the history of Grange’s subsequent
dealings with Swan and its other clients. Until mid 2007, when Grange bought SCDOs from
its clients, it almost always paid no less than face value. On the very few occasions on which
Grange paid less, the difference was minimal. The first occasion was in June 2006 when
Grange bought back a product for $99.503 per $100 face value. Even then, Grange told
Swan that it had made a net gain as a result of the higher interest yielded by the product:
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[288]-[291]. Nothing in the presentation of the Forum product suggested that an investment
with the same credit risk as the Australian Government had a market risk that, if it needed to
be sold before maturity, would be worth less than its face value.
192 Moreover, Grange was conscious it was dealing with Council officers who were risk
averse and had a responsibility to act as a prudent person investing public money. These
SCDO products were being put to Swan by Grange as alternatives to, and at least, equally
safe as, ADI issued FRNs. Such FRNs were highly unlikely to be sold at a capital loss. This
was a new and unfamiliar product for Mr Senathirajah. Mr O’Dea was trying to sell it to him.
It is unlikely, and there is no evidence, that Mr O’Dea orally identified risks associated with
an investment in this product that were not specifically stated in the slides or other
contemporaneous written material and emails that Grange provided or sent to
Mr Senathirajah or Swan.
193 The next slide showed that typical returns on alternative investments, such as major
bank debt rated AA- (which I infer was a reference to major Australian banks) for a three
year term was BBSW plus 10 to 20 bps, corporate debt rated A- to AAA for five years was
BBSW plus 50 to 70 bps while an investment in the Forum notes, rated AAA, for a five year
term was BBSW plus 130 bps. The slides also informed the reader that there was an
opportunity for capital appreciation in an investment in the Forum notes and of the work
Grange did before “… it Recommends a Transaction”. There was no dispute that Grange did
substantial research into each product before marketing it to investors. Importantly, the slide
described Grange as “recommending” the investment. This suggests that Grange’s
“recommendations” were of the character of financial advice to clients.
194 At the time of this presentation Grange’s personnel were aware that its competitor,
Grove, had circulated to some councils in March 2003 a two page critique of the Forum AAA
product to which I referred at [126]-[129]. That critique identified only two risks for the
product, namely, credit risk (explained as the risk of loss if credit events affected the AAA
tranche) and market risk (explained as the risk of losing money if the investor wanted or
needed to sell the product in the five years before its maturity). Grove’s critique stated that
CDOs were generally extremely illiquid because professional investors were not interested in
them and that was why the Forum AAA product was being offered to retail customers, like
councils. It asserted that there was no real secondary market.
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195 Grove’s critique also highlighted comments made by Standard & Poor’s that CDOs
were not always transparent and “… investors need to look at the underlying credit and
structure of the transactions, in terms of credit quality, asset diversity, maturity, and
liquidity”. Grove concluded by reiterating that CDOs were long-term, illiquid and in the
class of non current assets. It noted that investors should be prepared to lose all of their
capital if there were a depression or severe recession in either the United States or Europe or
if the price of oil “goes through the roof”. This was in contrast, the critique noted, to the
position of a direct investment in each of the reference entities, where if 10% went bankrupt,
an investor would only lose 10% rather than everything, as it would if defaults in the AAA
tranche were sufficiently severe.
196 The risks that Grove’s critique highlighted were downplayed in Grange’s slide
presentation. In particular, the illiquid nature of the SCDOs and the critique of Grange’s
offer of a secondary market were glossed over by Grange’s assurance that its “normal …
service” included its always providing “a best endeavours bid”.
197 Then, on 15 September 2003, Mr Senathirajah sent Mr O’Dea a copy of the 2003
Swan Policy. This was so that Grange could make recommendations to Swan that were in
accordance with this policy. Within three hours, Mr O’Dea emailed Mr Senathirajah and Mr
Frewing with details concerning the Forum AAA CDO and a term sheet that Mr O’Dea wrote
contained “finer security details”. The email referred to a phone conversation they had had
earlier that day about this product. The email explained that the current coupon was BBSW
plus 1.1% (i.e. less than the original 1.3%) and continued:
“There is a very healthy secondary market already so City of Swan will own a very liquid security should they wish [to sell] ...” (emphasis added)
198 The term sheet still had the original margin of 1.3% over BBSW. It noted that it was
a summary only and invited readers to refer to “programme documentation for full Terms and
Conditions”. It said that that documentation prevailed in the event of any inconsistency.
Grange placed a similar, but not identical, disclaimer in very small print at the foot of the
second page of the term sheet.
199 The email’s assurance about the secondary market was important to Mr Senathirajah
and Swan. About 40 minutes after receiving the terms sheet, Mr Senathirajah emailed
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Mr O’Dea saying that Mr Frewing had authorised Swan to invest the minimum sum allowed
in the term sheet.
200 As was its practice, Grange emailed to its client a computer generated contract note
early the next day. This confirmed to Mr Senathirajah, as he appreciated, that Grange had
sold Swan for $510,295 an FRN known as Forum AAA at a “Capital Price (per $100 Face
Value)” of $100.781 (the difference representing accrued interest that would be payable on
the next quarter day). The contract note said that maturity was on 28 March 2008. Unlike
the position from about early 2005 that I describe in section 4.2.8 below ([254]-[255])
Grange’s contract note did not contain any statements concerning margins, money or benefits
it might receive in the transaction that it recorded. Soon after, on 19 September 2003, Grange
wrote a detailed letter to Swan dealing with its services, including the giving of advice, and
its status as a licensed securities dealer.
201 Mr Senathirajah was unable to recall in giving his evidence exactly when Mr O’Dea
presented the slides on the Forum AAA product. I have found that that had occurred before
27 August 2003 when the 2003 Swan Policy was made. This was because of the speed with
which Mr Frewing and Mr Senathirajah decided that Swan would invest in this product on
15 September 2003, Grange’s descriptions of it as an FRN and Mr O’Dea’s email of
18 August 2003 attaching the background note that gave Grange’s explanation of FRN’s.
Over the months preceding 15 September 2003, Mr O’Dea had provided explanations and
information to Swan, and particularly Mr Senathirajah, on Grange’s services and products.
These were by no means the sole source of the wider range of investments that Swan
permitted in its new policy. However, the input from Grange, through Mr O’Dea, resulted in
Mr Senathirajah and Mr Frewing drafting the policy to permit Swan to invest in products
such as SCDOs that Grange was interested in selling to it. The Forum AAA slide
presentation was calculated to create a high level of confidence in the secure, attractive and
top rated product, and type of product, it described. Grange’s explanation of FRNs had
emphasised that it understood that local government bodies, such as Swan, were risk averse
and had particular investment constraints. But the explanation assured the reader that those
concerns would be met by Grange’s “advice” on direct investment, through it, in suitable
FRN products that it had thoroughly appraised before it would recommend any such products
to its clients.
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202 Thus, I am satisfied that the slide presentation had been used before 27 August 2003,
treating the Forum AAA product as an example, to provide a context in which the 2003 Swan
Policy would be drafted so as to allow investment in Grange’s SCDO products.
203 In its final submissions Grange sought to portray itself as simply a seller of financial
products, rather than as the Councils asserted, an investment adviser. I reject Grange’s
argument. I find that from August 2003 Grange, as an expert, offered to, and did, provide
investment advice and recommendations to Swan as to investments that were suitable for the
purposes in the 2003 Swan Policy. In essence, Grange’s relationship with Swan reflected
what it had said about itself in the background note Mr O’Dea emailed to Mr Senathirajah on
18 August 2003: [178]. It portrayed itself as aware of investments that were appropriate for
Swan as a “risk averse local government” investor.
204 Grange contended that there was no evidence that it had assured Swan that the Forum
AAA product satisfied the 2003 Swan Policy. I reject that contention, even though
Mr Senathirajah did not say so in terms, and Mr Frewing was not called. Mr O’Dea was
aware that Swan was developing a new investment policy around the time he made the
presentation of the Forum AAA product to Messrs Frewing and Senathirajah. Next,
Mr Senathirajah emailed the 2003 Swan Policy to Mr O’Dea at his request on 15 September
2003. It is safe to infer that this occurred after they had had a discussion, no doubt as a result
of Mr O’Dea following up Swan’s interest in products that he had presented in the previous
few months as securities that Grange categorised as FRNs. In the context of what occurred
on 15 September 2003, it is difficult to think of any reason why Mr O’Dea discussed with
Mr Senathirajah, and obtained a copy of, the 2003 Swan Policy unless it was to ensure that
Swan could invest in the Forum AAA product as Mr O’Dea was proposing. Mr Senathirajah
said that he sent the new policy to Mr O’Dea because Swan had promised to do so when it
was made and so that he could “recommend to us products which were in line with Council
policy”. Grange had portrayed itself as doing work “Before it Recommends a Transaction”
in the slide presentation using the Forum AAA product as an example. I infer that when they
discussed the Forum AAA product on 15 September 2003, Mr O’Dea recommended it to
Mr Senathirajah as a product that Swan should invest in, since the 2003 Swan Policy now
permitted the Council to do so (see too [209]).
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205 These proceedings were constituted as a class action in 2010 about six years, and at
the time of the hearing over seven years, after the events. It is unsurprising that
Mr Senathirajah could not remember a conversation or exact details of other conversations
given the passage of so much time. Neither Mr Frewing nor Mr O’Dea gave evidence and I
infer generally that nothing either could have said would have assisted respectively, Swan’s
or Grange’s case: Jones v Dunkel (1959) 101 CLR 298. Mr Senathirajah had the day to day
responsibility for Swan’s investment decisions and its relationship with Grange at this time. I
find that, had he not been satisfied that Swan could and should invest in the Forum AAA, he
would have recommended against doing so to Mr Frewing. It is likely that Mr Frewing
would have accepted that recommendation from his subordinate who had the day to day
control of Swan’s investment decisions and the drafting of the 2003 Swan Policy. As
Mr Senathirajah said “I did the leg work and recommended it to Mr Cliff Frewing, and if he
agreed, we went ahead and did the investment”, although he accepted that his superior made
the final decision.
206 It is also likely, and I find, that had Mr Senathirajah not recommended investing in
Forum AAA, Swan would never have invested in any SCDOs through Grange. Mr O’Dea’s
previous presentation on the Forum AAA product and his assistance in making suggestions
for the drafting of the new 2003 Swan Policy are likely to have made each of Mr
Senathirajah’s recommendation, and Mr Frewing’s decision, subsequently to invest in the
Forum AAA SCDO on 15 September 2003, a formality. The new policy now appeared to
allow this form of investment. Mr O’Dea had explained what the very product was when
presenting the slides before the final version of the 2003 Swan Policy was adopted by the
Council with the input of both Mr Frewing and Mr Senathirajah. Mr O’Dea had endeavoured
to bring about the very result of Swan investing in SCDOs by his work over the immediately
preceding period. Despite the absence of direct evidence from Mr Frewing, many years after
the events, about his state of mind, the evidence of Mr Senathirajah and the contemporaneous
documents provide a reasonable basis from which findings can be made.
207 I accept Mr Senathirajah’s evidence that in making his investment recommendations,
he was mindful of the obligation that the Local Government and Trustees Acts required the
Council, through him, to exercise a “prudent person” approach so as to be careful with its
funds and ensure that there be no loss of its capital. He considered that this obliged him to
get advice from more qualified people in the relevant field if he did not have sufficient
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knowledge of the proposed investment himself. He regarded Grange and Mr O’Dea as
qualified and expert to give that advice. I also accept his evidence that he would have been
concerned if Mr O’Dea had told him prior to Swan’s decision to invest in Forum AAA that,
although the CDOs that Grange was recommending were rated AA or AAA, they had, or
involved, more risk than an equivalently rated corporate or government bond.
Mr Senathirajah explained that he had used his understanding of the credit ratings for other
similarly rated products as being the same, in a general sense, as that for CDOs. Had he been
told that these ratings were not equivalent and that CDOs or SCDOs had more risk he would
have discussed his concerns with Mr Frewing. I find, that if such a discussion had occurred,
Swan would not have invested in any SCDOs through Grange.
208 Moreover, the emails, and their timing on 15 September 2003, provide a
contemporaneous setting in which commonsense inferences of what is likely to have
happened can be drawn. Grange was aware that local government authorities, such as Swan,
were constrained in their investment powers and the investments they could make by
legislation such as the Local Government Act (WA) and each council’s internal policies. Not
only did Grange’s participation, with its competitors, in giving input in the formulation of the
2003 Swan Policy show that those entities were conscious of the legislative and policy
contexts, but so did their annual participation at local government conferences. Indeed, just
over six weeks later on 30 October 2003, Mr O’Dea made a slide presentation to a finance
managers’ breakfast for the local government managers association. These slides noted
Grange’s experience in institutional and private client “advisory services”. One slide was
headed “Grange is a Unique Advisor to Councils”. It stated that “Grange advocates prudent
investments which meet regulations & investment policies”, that Grange had over 30
specialist staff for fixed interest investments providing “broad market experience and
expertise” and offered a comprehensive service providing research, education, advice,
liquidity, and local support (original emphasis). That slide presentation, which was not
drawn to his attention during his oral evidence, is consistent with Mr Senathirajah’s evidence
as to the assuring advice he, and, I infer, Mr Frewing, received from Mr O’Dea. And
Grange’s choice of wording in the heading, describing its role as a unique adviser to councils,
is in telling contrast to its submissions as to its role made in the trial.
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4.2.5 Swan’s next investment: Argyle AAA SCDO
209 Soon after Swan invested in the Forum product, on 6 October 2003, Mr O’Dea
emailed Mr Senathirajah with his suggested investments in four securities that “meet the
investment policy but have ensured that you can see a spread of investments from AAA
through to unrated but issued by an ADI (ie: Bendigo Bank is actually rated BBB but the
investment listed [is] not rated)”. The four investments included the Argyle SCDO, rated
AAA, with a coupon of BBSW +1.1% and subordinated debt notes issued by St George
Bank, rated A- with a coupon of BBSW +0.90%, Bank of Queensland rated BBB- with a
coupon of BBSW +1.30% and an unrated subordinated debt note issued by Bendigo Bank
with a coupon of BBSW +1.15%. Mr O’Dea pointed out that Bendigo Bank was also rated
BBB.
210 Unsurprisingly, Mr Senathirajah then asked Mr O’Dea for more information on the
AAA rated product. He obliged, sending a Grange research sheet and a term sheet the next
day. The research note had been prepared by Mr Vincent on 15 June 2003. Mr Senathirajah
read the note, although he did not concern himself with some of its technical jargon,
concentrating instead on its more readily comprehensible assertions that Grange had
highlighted by underlining such as:
“Grange is satisfied that all credits in the portfolio are currently robust”. “Grange believes that it is highly unlikely the portfolio will suffer sufficient defaults for the investors to lose capital”
211 The Argyle AAA product had a maturity in October 2007. The research note also
said, with original emphasis:
“For investors, particularly concerned about geopolitical or event risks, CDO’s are a particularly suitable investment as single company event risks are largely eliminated through diversification of the pool and the subordination that will, in the first instance, absorb any unforseen losses that may occur.”
212 Additionally, the research note referred to trading in other “Grange led” issues of
SCDOs having “traded inside their initial offering level since launch”, meaning at an
increased price. It attributed this to increased familiarity and confidence of investors in
SCDOs and “as secondary market demand and liquidity through Grange is seen to occur”.
And, in the section headed “conclusion”, the research note gave this assessment:
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“The high level of subordination in the Argyle “AAA” tranche gives Grange a high degree of confidence that it is a remote possibility that investors will suffer any loss of principal or interest over the life of the notes. On the reward side, 110 bps over BBSW for a four year and three month maturity is an excellent return for “AAA” risk compared to alternative investment assets available to Australian investors.” (emphasis added)
213 This is an example of what Mr O’Dea had told Mr Senathirajah about Grange doing
its own research and only recommending products that were suitable for local government,
such as Swan. Mr O’Dea had also told Mr Senathirajah that if Swan wanted to sell a CDO
product, say after becoming aware of a first default or credit event affecting a reference
entity, it could sell the product before any further defaults. Mr Senathirajah regarded
Grange’s promise, given during the Forum AAA presentation, to buy the CDO products back
at any time as very valuable to Swan. Mr Senathirajah said that he understood that Grange
was offering to buy back any CDO product at face value. He did so on the basis that Grange
would be monitoring the performance of the reference portfolio of the CDO products it sold
to Swan and would warn Swan when it needed to take action to protect its position.
214 Swan invested $1,000,000 in the Argyle AAA product on 15 October 2003 and
Grange issued it a contract note that day. On 16 October 2003 Mr O’Dea emailed
Mr Senathirajah suggesting that two FRNs that Grange had purchased from Australian banks
would make “good additions to the portfolio” and that Grange could recommend Swan
investing about $1 million in each. Mr O’Dea followed this up on 20 October with a term
sheet for only the FRN rated A- issued by BankWest, which he said was “quite standard” for
Australian Banks. Mr O’Dea noted that BankWest itself was rated A.
215 Then, on 21 October, Mr O’Dea emailed Mr Senathirajah saying he had only just
been made aware of the Nexus AA+ floating rate note which would become available the
next day and matured in December 2007. He attached a term sheet and said the new product
was very similar to the Argyle and Forum products and was “actively traded each day”.
Mr O’Dea wrote that he would call later that day to see “if it all makes sense”. The term
sheet was more expansive in discussing risks than most others in evidence. It stated that
Grange could envisage three risks that alone or in combination could lead to “poor
performance” of the Nexus AA+ tranche. Those were, first, adverse movements in the
underlying credit default swap markets (which Grange said could affect the trading spread –
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i.e. the price – of the product in the short term), secondly, credit downgrades in the
underlying portfolio (which Grange said could cause a credit downgrade of the notes, but it
considered this risk “remote”, and that investors could not suffer any loss unless underlying
entities actually defaulted), and thirdly, defaults in the underlying portfolio (which Grange
said was “the most serious but also the most remote risk”). Grange said again in the term
sheet that “in the remote possibility that losses do occur they may be substantive” but
concluded, with its own emphasis:
“Grange believes it is extremely unlikely that the portfolio will suffer sufficient defaults for investors to lose any interest or capital”
And, if that were not enough, it reiterated this, with its own emphatic statement that Grange
had “a high degree of confidence that it is a remote possibility that holders will suffer any
loss of principal or interest over the life of the deal”.
216 As Mr Senathirajah said, he looked at the parts of this and like documents that Grange
had itself highlighted because he assumed that was what Grange wanted the reader to pay
attention to as being important. That was a natural reaction and one the documents were
calculated to induce. Nonetheless, Mr Senathirajah appreciated throughout his dealings with
Grange that there was what he described as a “hypothetical” risk, in the sense of a remote
possibility, of substantial capital loss from Swan investing in the SCDO products.
217 Later, on 21 October, Mr Senathirajah caused Swan to invest $500,000 in the Nexus
AA+ SCDO, which Grange’s contract note continued to refer to as an FRN. I am satisfied
that this occurred in the context of Mr Senathirajah’s understanding that there was a
minimum of risk that a tranche in an SCDO in which Swan might invest could suffer loss as a
result of a significant number of prior credit events. However, he also understood that
Grange’s monitoring work would mean that Swan was told well before sufficient credit
events occurred to reach that stage and it could sell the SCDO before its credit rating was
affected.
4.2.6 Grange’s appreciation of Swan’s lack of financial sophistication
218 At an early stage in these dealings, Mr Senathirajah discussed the level of Swan’s and
his own financial sophistication with Mr O’Dea. This occurred in response to an emailed
term sheet for the Griffin AA SCDO that Mr O’Dea had sent Mr Senathirajah on 28 October
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2003. The term sheet again described the “instrument” as a floating rate note while stating
that the “instrument type” was “collateralised Australian Dollar notes linked to the
performance of 150 investment grade corporate entities” and that investors would “bear any
losses on the portfolio above the credit support (or subordination) amount”. The terms sheet
had two categories of minimum investment either $500,000 or, “if the relevant investor
satisfies one of the other sophisticated investor tests (to be verified by Grange)” $50,000.
Mr Senathirajah asked Mr O’Dea what those tests meant. Mr O’Dea told him that
sophisticated investors were people who really understood the products and took decisions to
invest on their own. Mr Senathirajah told Mr O’Dea that Swan did not qualify as a
sophisticated investor on that basis and Mr O’Dea said that he accepted this. I infer that both
of them understood that Mr O’Dea had been referring to an investor, unlike Swan, who did
not need financial advice or guidance in taking investment decisions on complex or other
financial products.
219 This exchange reflected Grange’s consciousness of both the arcane complexity of the
SCDOs, that it was marketing to the Councils as a species of the familiar product they knew
as an FRN, and of the trust that Councils, through officers such as Mr Senathirajah, placed in
Grange’s advice and recommendations. In August 2003, Mr O’Dea had sent Swan Grange’s
explanation of FRNs from which I have set out extracts above. That portrayed Grange’s
avowed understanding of “appropriate investments for risk averse local government” as not
including “lower rated corporate non bank FRN’s”. It suggested the advantages of investing
in FRNs issued by licensed ADIs. Grange had at the same time set the scene for Swan by
presenting the AAA rated Forum product as an FRN with some additional features. But the
overall picture of an SCDO conveyed by Grange to the Council officers, was of a security
that was rated as safe as the Australian Government, and much better rated, and hence, safer
than the FRNs issued by the major Australian banks which had AA- ratings. Grange knew
that the Councils trusted it once they had begun to choose its products as investments.
220 In an internal Grange strategy session held on 19 September 2004 by its senior
executives, including Mr Clout and Mr Vincent, Mr Clout’s team was given responsibility for
the following matters described in the action list from the meeting as:
1
Grow Mandate Accounts Prime target for conversion → Existing clients who currently operate on a high trust basis with GSL
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Benefit – 1) ↓ our underwriting risk, 2) ↑ our underwriting capacity, 3) ↑ funds under management for GAML
…
3
Relationship Marketing to Councils Formulate specific marketing plan for this sector Thus far successful with CDO’s and Sub-debt → Need to broaden their product base (underlining is original emphasis)
221 The first action item recognised that Grange’s existing clients who operated on a high
trust basis with it (i.e. they trusted Grange) were prime targets for conversion into clients who
had, what was called by 2006, an IMP agreement. The third item recognised just how
successful Grange had been in getting local government bodies to buy SCDOs, in
circumstances where it knew that Councils such as Swan had no real financial sophistication
to enable them independently to understand the nature and extent of the risks involved in
these products. This reflected Grange’s appreciation that it was treated by clients, such as
councils, as a trusted financial adviser, in the same way as Mr O’Dea’s breakfast slide
presentation had acknowledged in late October 2003.
222 Grange argued that by sending emails attaching research briefs or terms sheets it was
seeking, through Mr O’Dea, to educate Mr Senathirajah about SCDO investments. It pointed
to an email sent by Mr O’Dea on 27 January 2004 annexing Grange CDO research notes on
the performance of the Forum AAA and Griffin AA SCDOs. The email acknowledged that
Swan had not invested in the Griffin product. Mr O’Dea wrote that these research notes
would help build up the Council’s information base on CDOs. He said that the review of the
Forum AAA CDO showed it to be a little stronger then than when it had begun. He
explained that as CDOs moved toward maturity two forces operated; first, the margin above
BBSW reduced as did the risk and, secondly, the credit quality of the reference portfolio was
influenced by the actual number of any downgrades or defaults (i.e if credit events or
downgrades experienced were less than in the budget or model, the credit quality would be
improved, but it would remain constant if the CDO had performed as predicted in the budget
or model). Mr Senathirajah responded about 15 minutes later thanking Mr O’Dea for the
information and saying “We are learning … slowly!”. Mr O’Dea emailed back later that day
saying “I think you are doing just fine, and earning some extra interest for your trouble”. He
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offered to call into the Council to explain the information if Mr Senathirajah or others
wished.
223 Mr Senathirajah understood that the point Mr O’Dea was making was that both the
CDOs were doing well and Swan should continue to hold its investment in the Forum AAA
product. He also looked at the two attachments to Mr O’Dea’s email later to try to learn.
Nonetheless, the attachment dealing with the Forum AAA product noted that its analysis was
based on Grange’s calculations and used the Standard and Poor’s CDO Evaluator software
version 2.2 for calculations. Those critical modelling assumptions and data were never given,
or explained, to any of the three applicant Councils in these proceedings. The upshot was, as
Mr Senathirajah said in evidence, that Swan and he expected Grange to condense, or identify,
the key matters that should be considered, because some of the material Grange provided was
too advanced for their understanding.
224 Moreover, it is common experience that people do not read, or have time to read,
every email or attachment that is sent to them. Grange was trying to interest Mr Senathirajah
to invest any available funds that Swan had from time to time by keeping him informed of
what Grange had to offer. But I accept Mr Senathirajah’s evidence that he understood that
Grange would only offer CDOs that were suitable for Swan’s purposes and complied with its
investment duties and policies and, so, Grange acted as filter for Swan of what was available.
Thus, for example, when Mr O’Dea sent an email on 20 November 2003 attaching Grange
research on the Tungsten AA- CDO, Mr Senathirajah understood that this was a
recommendation by Grange that the product was suitable for Swan. In addition,
Mr Senathirajah’s practice was only to look at the material if Swan was then interested in
buying a new investment.
225 Grange argued that Mr Senathirajah chose to purchase SCDOs over bank issued FRNs
offered by it. However, I accept his evidence that over time, Swan did invest in some FRNs
offered to it by Grange. Grange prepared a report for Swan in respect of funds invested
through Grange at 31 May 2005. That showed that of about $5.5 million invested through
Grange, Swan had invested about $1.5 million in Australian bank issued FRNs, the balance
being in SCDOs.
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226 Swan was not using Grange as its exclusive source of financial advice or its sole
means of investing its funds. Grange argued that, consequently, Swan could not have used
Grange as a financial adviser on investment products. I reject that argument. Relationships,
and their incidents, depend on what happens, not on preconceived notions such as Grange
seemed to assert, that a financial adviser had to be a confidant of its client in respect of every
aspect of the client’s finances. There is no reason why Grange could not have been an
adviser, owing duties, including fiduciary duties, to a council such as Swan, on a single
transaction or a number of individual transactions over a period. After all, a family solicitor
is ordinarily in a fiduciary relationship with and must advise his or her clients on individual
issues, such as the purchase or sale of property, the drawing of a will or their taxation affairs,
even though the solicitor may not know about all aspects of the clients’ affairs. The facts, not
preconceptions, determine what the relationship is and what duties are owed by the
professional: In re Coomber; Coomber v Coomber [1911] 1 Ch 723 at 728-729 per Fletcher
Moulton LJ; Warman International Ltd v Dwyer (1995) 182 CLR 544 at 559-560 per
Mason CJ, Brennan, Deane, Dawson and Gaudron JJ.
227 After mid 2003 and until they entered into the IMP Agreement, the relationship
between Swan and Grange involved Grange advising Swan about buying and selling
particular financial products on particular occasions as ones that were suitable for Swan as a
council governed by Western Australia law and that complied with its investment policy.
The nature of the relationship between Swan and Grange before 2007 was encapsulated by
Grange’s letter to Mr Senathirajah of 23 March 2006. The letter sought to encourage Swan to
enter an IMP agreement and explained the difference between the current and proposed
relationships as:
“Grange Securities Ltd (Grange) provides clients with investment advisory services that range from an ad hoc, or broking, service through to a comprehensive IMP service which includes all tactical and strategic aspects of portfolio management and administration. The IMP service includes assistance with specific issues, such as interest rate forecasts, and general issues such as investment policy reviews. The IMP service is discussed in detail below. The broking service which Swan has been utilizing to date does not generally include the detailed monthly reports which have been provided, these have been provided to assist Swan in assessing the IMP service. Grange does however, provide broking clients with regular valuations on request.” (emphasis added)
228 The letter recognised that Grange had provided Swan with an ad hoc broking
investment advisory service. On his last day with Swan, 31 March 2006, Mr Senathirajah
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wrote a memorandum concerning this letter to Mr Poepjes. He said that Swan’s officers kept
track of investment opportunities within the 2003 Swan Policy “through research and liaison
with institutions that provide these products”. He noted that Swan had been dealing with
Grange “on an ad hoc basis” since September 2003. Mr Senathirajah referred to Grange’s
offer as being to manage the Council’s portfolio “more actively” than currently done by
Swan’s officers, to improve the investment yield. He explained his understanding that this
would essentially be done by more frequent switches between products that still fell with the
2003 Swan Policy. Moreover, as Grange’s submissions emphasised it was also, in the
majority of the parties’ trading activity, the buyer or seller of the financial products. Thus,
Grange had placed itself in the position of giving financial advice to its client, Swan, to buy
from, or sell to, it. Mr Senathirajah concluded the memorandum by recommending that Swan
enter an IMP agreement with Grange.
4.2.7 Grange’s pattern of dealing with Swan from late 2003
229 From late 2003 Grange settled into a pattern of dealing with Swan, principally
through contacts between Mr O’Dea and Mr Senathirajah. Grange would raise a new
proposal to invest in a SCDO either in a conversation or email between Mr O’Dea and
Mr Senathirajah. This would be initiated or followed by Grange providing a term sheet or
product note and often a slide presentation for the products. Sometimes Mr O’Dea or
Mr Kay sent emails solely to Mr Senathirajah or Swan, and on other occasions the emails
would be addressed to a large number of people. So, in August 2004, when Swan began to
receive its rate income for the new financial year, Mr O’Dea visited the Council and gave a
slide presentation on the Endeavour AAA SCDO, leaving a copy with Mr Senathirajah. This
was what is known as a CDO2, or squared, because the reference portfolio consisted of other
CDOs, rather than individual corporation’s debt instruments. There were six AA rated CDOs
in the reference portfolio. Mr O’Dea said that this form of CDO would give Swan more
confidence because it spread the risk across more entities. He said it had two levels of
subordination – namely that of each underlying CDO as well as Endeavour’s own
subordination. He explained that there had to be sufficient defaults to affect the reference
CDOs enough before that would cause the Endeavour product to exceed the level of its
subordination (i.e its attachment point).
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230 The slides emphasised that the Endeavour product was “an attractive transaction to
Grange investors”, rated “AAA” with a portfolio structure that “is extremely robust to
adverse market conditions should they occur”. One slide headed “Endeavour risk is Low as
per Historical Default Rates” stated that default rates needed “… to be over twice the worst
case experience in the previous 20 years to impact ‘AA’ CDOs”. Another drew attention to
Standard & Poor’s “Excellent Track Record” in never having a default for a CDO it had rated
“AA” or “AAA”. During his presentation, Mr O’Dea said that Swan could rely on the rating
agency in deciding whether to invest in the Endeavour AAA product. Mr O’Dea then drew
attention to the slide below.
231 The dark oval at the top left of the slide has the caption “Structured Credit”. The
caption “RMBS” stands for “residential mortgage backed securities”. The visual message
conveyed by the slide was that structured credit, including SCDOs, were among the safest
form of Australian dollar investment, like government debt, but paid a significantly higher
coupon than other products with the same credit ratings. That visual message also conveyed
the telling point that SCDOs were safer and paid better coupons than banks. Similar graphs
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were used by Grange in slide presentations for other Claim SCDOs. Mr Senathirajah recalled
that Mr O’Dea said during the presentation for the Endeavour product that this graph
highlighted the attractiveness of investing in structured credit assets compared to banks and
other products. He pointed out that the Government debt rated “AAA” was giving very low
spreads (i.e. coupon rated above BBSW) whereas products like the Endeavour AAA product
with the same rating were giving higher spreads.
232 The next slide headed “Grange CDO’s are Traded on the Secondary Market”, stated
that of 12 Grange CDOs all but one, Ascot rated “AA”, had appreciated in price on the
secondary market since their issue. However, the accompanying graph only showed about 15
bps upward movement in the margin for Ascot, and did not make any reference to prices for
any of the SCDOs.
233 Mr Senathirajah appreciated from the slide that the Ascot CDO had fallen in value
because of the affect on it of the major corporate failure of Parmalat, one of its reference
entities. I do not accept Mr Senathirajah’s evidence that he was not aware of any impact
from Parmalat’s failure. The Endeavour slides twice made specific reference to the potential
of such an impact. However, the graph on the slide did not quantify or illustrate what had
happened to the prices of any of the SCDOs including Ascot. Thus, there was nothing in the
presentation, or in evidence, that explained that the consequence of Parmalat’s failure was
anything greater than a downgrading of the SCDO’s rating. That was Mr Senathirajah’s
understanding of the result of defaults, no doubt reinforced by Grange’s failure to flesh out
what might have happened had there been further defaults after Parmalat’s in the Ascot
product’s reference portfolio.
234 Mr Senathirajah understood that Grange was the buyer or seller for transactions on the
secondary market and that when Swan bought or sold investments through Grange on the
secondary market, Grange was its contractual counter-party. This was reinforced by the next
slide headed “Grange Actively Supports its Transactions”. The slide showed turnover
statistics of its purchases and sales of CDOs stating:
“Grange provides ongoing monitoring of the transactions and provides follow-up research reports to investors at timely intervals Grange is extremely active in the secondary markets providing liquidity to investors” (emphasis added)
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235 This was re-emphasised by Mr O’Dea saying that Grange would buy back products it
had sold to Swan, that a secondary market was developing and that Grange provided liquidity
to its clients. As a result of Mr O’Dea’s continued assurances on this and other occasions, Mr
Senathirajah did not consider that products Swan purchased from Grange had any liquidity
risk. In addition, Mr O’Dea told the Swan personnel at this presentation, as he had on earlier
occasions, that Grange did ongoing monitoring and research reports on its products so as to
be in a position to let Swan know if it needed to take any corrective action by switching to
what appeared to be a better security or better yielding product with the same level of
security. Mr O’Dea said that Grange’s monitoring checked if there were any defaults and on
whether the price was being affected by supply and demand. Mr Senathirajah said that he
understood this reference to price to be variations in the margin above the product’s face
value, not to prices below face value in the secondary market. In cross-examination he
accepted that a credit downgrade of a CDO would be likely to cause a reduction in its value.
He claimed that Mr O’Dea had promised that Grange would buy back for at least an SCDO’s
face value at any time. Mr Senathirajah thought this promise was potentially very valuable to
Swan but he appreciated that the promise was never stated in any of Grange’s written
material. He drew the implication that Grange would always buy back an SCDO at no less
than face value from its and Mr O’Dea’s statements that Grange would provide liquidity and
buy back on a best endeavour’s basis, together with Swan’s experience in its dealings with
Grange that all products bought back were purchased at no less than face value.
236 Swan accepted in final address that Grange and Mr O’Dea had not stated expressly to
Mr Senathirajah that Grange would buy back any SCDO at no less than face value. But,
Swan contended, that from what Grange and Mr O’Dea said and left unsaid, a necessary
implication in Grange’s offers of liquidity and the provision of a secondary market, in the
context of its relationship with a risk averse client like Swan and its representations that it
would monitor performance, was that it would buy the product back without a loss being
incurred by Swan. I accept Mr Senathirajah’s evidence that Grange and Mr O’Dea conveyed
in the circumstances a representation to the effect that Grange would buy back products from
Swan without capital loss if Swan needed liquidity or if all reasonable steps to monitor the
performance of SCDOs held by Swan indicated that one or more of its SCDOs could have its
or their capital value adversely affected if not sold.
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237 In cross-examination Mr Senathirajah explained that if Grange monitored the SCDOs
and warned Swan when to take corrective action, then the Council could sell before it would
suffer loss. He also understood that the corollary of early corrective action would be that
Grange would not be exposed to any loss in that situation if it had to buy an SCDO back at no
less than face value since it would have acted before an significant adverse effect were felt in
the value of the SCDO. Mr Senathirajah referred to an instance where Grange had advised
Swan to effect a switch because one of its SCDOs had suffered a credit event or default.
However, I do not accept that Swan or Mr Senathirajah understood that Grange would be in a
position to, or promised that it could always, buy back products after some unforeseeable,
general economic catastrophe. The implication I have found necessarily extended to Grange
representing that it would buy back at no less than face value SCDOs that had begun to suffer
credit events that might lead them to be downgraded or to come close to reaching their
attachment point for the tranche of Swan’s risk in the SCDO.
238 The terms sheet for the Endeavour AAA product repeated the two classes of
investment of $500,000 or, for a “sophisticated investor”, $50,000. On 27 August 2004
Grange issued a contract note to Swan recording its purchase of $1 million worth of the
Endeavour AAA product which had a maturity date seven years later.
239 Similarly to what I noted in [124]-[125] above, in contrast to the Endeavour AAA
slide presentations coupled with Mr O’Dea’s statements about liquidity and the existence of a
secondary market, the offering circular supplement for this product of 4 August 2004 stated:
“There is no active trading market for the Notes (i.e. the Endeavour AAA product being sold by Grange] and it is highly unlikely that an active secondary market for the Notes will develop. Accordingly a lack of liquidity and price volatility may exist.” (emphasis added)
240 Mr Senathirajah said, and I find, that Mr O’Dea did not say anything to the effect of
the last sentence, nor did he provide to Swan the arranger’s and other disclosures. Mr
Senathirajah said that he would not have agreed to buy the Endeavour AAA Notes if he had
been informed of that information. He said that this was because the offering circular
conflicted with his understanding of the 2003 Swan Policy that there should be no capital loss
and there be liquidity of its investments at all times.
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241 I have some difficulty with that reasoning. First, the 2003 Swan Policy required
consideration to be given to the need to maintain the real value of capital (cl 2.5), but
secondly, it contained an investment guideline permitting acquisition of investment grade
mortgage/asset backed securities with terms of up to five years. The Endeavour AAA notes
matured seven years later in 2011, as was apparent in the slides, term sheet and contract note.
Although Mr Senathirajah was pressed in cross-examination that cl 2.5 of the 2003 Swan
Policy did not go so far as to prohibit investment where there was a risk of capital loss, I
accept that Swan’s officers, including Mr Senathirajah, were not prepared to invest the
Council’s funds in a product where they considered that there was any real likelihood or risk
that it could suffer a capital loss. However, the investment in the Endeavour AAA notes, that
had a seven year term, was not authorised by the 2003 Swan Policy. Thus, Mr O’Dea’s
recommendation, and Mr Senathirajah’s purchase, of this product show that neither paid
much attention to, at least, this 2003 Swan Policy requirement.
242 Nonetheless, I am satisfied that had he been made aware of the stark warnings
conveyed by Endeavour AAA’s offering circular supplement of the lack of liquidity and price
volatility, Mr Senathirajah would not have invested in this product. And, those warnings
were never hinted at in Grange’s and Mr O’Dea’s communications with Swan which were to
the opposite effect.
243 Grange argued that Swan should have asked for the program documentation, as its
term sheets suggested. I reject that argument. First, the term sheets said nothing about
liquidity, secondary markets or price volatility. Secondly, Grange was providing Swan with
financial advice that this product was suitable for it. The issuer’s warning only had to be
glanced at to recognise its incompatibility with what Grange knew of Swan’s requirements.
Hence, Grange’s use of slide, written and oral presentations that emphasised the liquidity,
existence of a secondary market and (by implication) the lack of price volatility. Thirdly,
Grange had the full documentation and chose to present its own very different picture of the
product. The effect of the term sheet’s suggestion was just as brazen and misleading as that
identified by Lord Macnaghten in the following passage from his speech in Gluckstein [1900]
AC at 251-252:
“Surely ordinary persons reading the prospectus, and attracted by the hopes of profit held out by it, would say to themselves, “Here is a scheme which promises well. The gentlemen who are putting the property on the market know something about it, for they were the sole directors and managers of ‘Venice in London,’ which was a very
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profitable speculation. They have had the whole property valued by well-known auctioneers, who say that it is worth more than is asked for it. True, they secure a profit of 40,000l. for themselves, but then they disclose it frankly, and it is not all clear profit. There is interest to be paid, and all the expense of forming the company. And they have actually agreed to pay 140,000l. down. That sum, they tell us, is ‘payable in cash.’” You will observe those last words, “payable in cash.” Their introduction is almost a stroke of genius. That slight touch seems to give an air of reality and bona fides to the story. Would anybody after that suppose that the directors were only going to pay 120,000l. for the property, and pocket the difference without saying anything to the shareholders? “But then,” says Mr. Gluckstein, “there is something in the prospectus about ‘interim investments,’ and if you had only distrusted us properly and read the prospectus with the caution with which all prospectuses ought to be read, and sifted the matter to the bottom, you might have found a clue to our meaning. You might have discovered that what we call ‘interim investments’ was really the abatement in price effected by purchasing charges on the property at a discount.” My Lords, I decline altogether to take any notice of such an argument. I think the statement in the prospectus as to the price of the property was deliberately intended to mislead the shareholders and to conceal the truth from them.” (emphasis added)
Of course, there is no suggestion here (and I do not make any findings) that Grange
deliberately intended to mislead its clients, including the Councils. It appears to have
genuinely believed that by providing its secondary market and doing its research it would
overcome the offering memoranda’s warnings concerning the lack of such a market liquidity
and price volatility.
4.2.8 Swan’s dealings in 2005 with SCDOs
244 On 21 January 2005, Mr O’Dea visited Swan’s offices with Anthony Smit, a Grange
employee from interstate. They made an oral presentation to Mr Frewing, Mr Senathirajah
and Ms Le Lievre on how CDOs were performing in the then current economic conditions.
They also discussed switching some of Swan’s investments to higher yielding products.
Their proposals included selling the Forum AAA CDO and a Deutsche Bank FRN to buy a
new SCDO squared, Flinders AA. I have discussed some aspects of this product in [124]-
[125] above. Mr O’Dea and Mr Smit explained that Swan should sell Forum and buy
Flinders because the latter gave a better return. Mr Senathirajah understood that, in general
terms, every time Grange effected a transaction for Swan it made a profit or broking fee,
including on a “switch” transaction: i.e. where one product was switched by its sale to
finance the purchase of another. Mr O’Dea said that the price Grange would offer for the
Forum notes was negotiable but depended on whether it could on-sell those notes to a third
party for a profit. Mr Senathirajah also understood that Grange could make a margin from
the on-sale of a product it had repurchased from Swan and a commission in buying and
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selling, but otherwise he was not aware of any other source of remuneration or profit arising
for Grange from its dealings with Swan.
245 Although Mr Senathirajah did not recall being shown a presentation for the Flinders
AA product and was not taken to any he assumed that Mr O’Dea and Mr Smit had taken the
Swan personnel through a set of slides. The Flinders AA presentation slides described the
product as providing “a superior risk/return profile” with a seven year term and as being a
“Standard AUD floating rate note” securitised in an FRN format. The presentation showed
the collateral and tranche structure. Another slide was headed “No ‘AA-’ CDO has ever
defaulted” and went on to state that the underlying portfolio CDOs were all rated AA- by
Standard & Poor’s, while another slide’s heading extolled “S&P has an Excellent Track
Record on CDOs”. Another slide explained how Grange provided a liquid secondary market
as follows:
246 This was followed by another slide with a different heading, and a different
illustration of structured credit’s place in the “universe of … floating rate debt instruments”
than that for the Endeavour AAA presentation (see [230] above). This graph referred to
seven year instruments and moved the “structured credit” balloon to a less secure place than
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for a “AAA” rated product. Nonetheless, structured credit still had the appearance of being
safer and to offer better coupons than a bank issued FRN:
247 The final slide had a disclaimer that noted that any securities recommendation or
opinion in the presentation was “general advice only and does not take into account your
personal objectives, financial situation or needs”. It said that the reader should consult his or
her investment adviser as to those matters. It also noted:
“[Grange], its officers, employees, agents and associates (“Associates”) may hold an interest in Flinders through participation in the primary or secondary markets and may benefit from any increase in the price or value of them. Grange is Sole Underwriter to the Flinders Issue and will receive fees for acting in that capacity.”
248 Mr Senathirajah understood in a general way that, when Grange was seeking to sell a
new product, it was an underwriter of the issue and could earn fees in that capacity.
However, there was no evidence that Grange ever disclosed to any of the Councils any fee or
profit it could earn for underwriting or selling any issue. And, there was no evidence that
Grange was the underwriter of the Flinders AA product. Rather, it purchased, at a discount
of 2.38%, the whole of the notes issued for that product from Credit Suisse and then onsold
them at face value. Thus, the disclosure was neither accurate nor, if Grange were a fiduciary,
sufficient. It fell far short of being full or frank: Gray v New Augarita Porcupine Mines Ltd
[1952] 3 DLR 1 at 14-15 per Lord Radcliffe. Similar “disclosures” were made in its
promotional material prior to the entry into the contracts in which Swan bought the following
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SCDOs: Argyle AAA, Nexus AA+, Endeavour AAA and Quartz AA. The slide
presentations for the latter product had substantively the same disclosure as the one in [247]
above.
249 On 24 January 2005, Mr O’Dea sent the Swan personnel an email outlining his
recommendations as to how Swan could buy some Flinders AA notes. He offered two
alternatives, a switch of an existing SCDO or the use of funds from other investments. He
proposed that a switch could be made by Swan selling its Forum AAA notes at a price that
would make the actual yield to the buyer (Grange) BBSW plus 0.90%. Mr O’Dea
commented that if Swan did this, it would make a capital gain on the sale and “a pickup on
running yield” (i.e. because the coupon on the Flinders AA notes was BBSW + 1.5%, as
compared with the coupon on Swan’s Forum AAA notes of BBSW + 1.1%). Mr O’Dea also
noted that if Swan sold back the Deutsche Bank FRN it would not make any profit on that
sale, but since its coupon would be BBSW + 0.45% Swan would obtain “a substantial pickup
on running yield”. Mr O’Dea recognised he had no comparative information about Swan’s
other investments, that had not been made through Grange, and so could not “rationalise”
what Swan should do if it chose to sell one or more of those. He wrote that if Swan chose his
second alternative:
“… Grange is very comfortable with all City of Swan’s existing investments sourced from Grange and Flinders AA would complement as all other CDOs are based upon Investment Grade issuers (Endeavour has approx 4% below IG) which Flinders is based upon a very diverse portfolio of high yield names.” (emphasis added)
The email concluded, as did all emails Grange sent to the Councils, with footers including, as
the last:
“Grange Securities Limited (Grange) believes that the information or advice (including any recommendation) contained in this document is accurate when issued. Grange does not warrant that such information or advice is accurate, reliable, complete or up to date, and, to the fullest extent permitted by law, disclaims all liability of Grange and its Associates for any loss or damage suffered by any person by reason of the use by that person of, or their reliance on, any information contained in this document or any error or defect in this document, whether arising from the negligence of Grange or its Associates or otherwise.”
250 The next day Mr Senathirajah instructed Mr O’Dea that Mr Frewing had agreed for
Swan to invest $1,000,000 in the Flinders AA product and sell to Grange the $500,000 worth
of the Forum AAA product at BBSW + 0.90%. He said that Swan would provide the balance
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of $500,000 by redeeming managed funds. Mr Senathirajah had recommended this course to
Mr Frewing by suggesting a redemption of a managed fund with a coupon of 6.22% before
fees, so as to achieve an effective coupon on the Flinders AA product of 6.91% (at the current
BBSW).
251 Once again, Grange did not provide Swan with any of the underlying documentation
that it had for the Flinders AA product, such as the offering or program memoranda. That
documentation had at least two separate sections headed “investor suitability”. Each of those
sections had a warning (similar to that for the Blue Gum product set out in [122]-[123]
above) that investment in the Flinders AA product, (which the documentation called “credit
linked notes”) was only suitable for investors who:
were capable of bearing the economic risk of that investment for an indefinite
period of time;
were acquiring the notes for investment and not with a view to resale or
disposition;
recognised that it may not be possible to transfer the notes for a substantial
period, if at all.
252 Another section of the Flinders AA documentation stated a second warning:
“You should be willing and able, in the light of your circumstances and financial resources, to hold your Notes until maturity. Neither CSFBi [the issuer, Credit Suisse First Boston International] nor any of its affiliates (including CSFB Sydney) will make a market in the Notes or offer to buy or be required (or likely) to buy them back. Other dealers may make a secondary market for the Notes but, if such a secondary market develops, there can be no assurance that it will continue or that it will be sufficiently liquid to allow you to resell your Notes. Therefore, if you need to sell your Notes prior to maturity, you may have to do so at a substantial discount from the initial price at which you purchased the Notes, and as a result you may suffer substantial losses.” (emphasis added)
253 I accept Mr Senathirajah’s evidence that had Mr O’Dea or Mr Smit told him anything
to the effect of either those two warnings about the Flinders AA product, Swan would not
have invested in it. This was because, Swan did not want, and was not authorised in the 2003
Swan Policy, to hold that, or any, investment for an indefinite period. Mr Senathirajah said,
and I find, that Swan’s purpose was to invest in a product that could be sold in a short time
frame in a liquid market. Mr Senathirajah had told Grange that Swan would need access to
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the funds it invested in securities on an “as and when required” basis and that when it did
require funds it wanted to be able to liquidate an investment to realise the funds. Had he
appreciated that the second warning in [252] applied in respect of all SCDOs (as I find in
substance it did), Swan would have sought to get out of its existing investments in SCDOs. I
also accept Mr Senathirajah’s denial that Mr O’Dea ever suggested that the biggest liquidity
risk to Swan was that Grange might become insolvent and if it did the Council might have to
hold the notes.
254 On 31 January 2005, Grange issued contract notes to Swan, buying the Forum AAA
notes with a face value of $500,000 and selling $1 million at face value of the Flinders AA
notes for settlement on 10 February 2005. These contract notes contained the following
clauses:
“TERMS AND CONDITIONS OF DEALING WITH GRANGE SECURITIES The client has agreed to be bound by the terms and conditions below. … Fees and Charges Grange Securities acts as principal when we buy and sell fixed interest securities in the secondary markets. The yield that we quote to you incorporates any margin that we will receive. The margin is the difference between the price at which we, as principal, buy the security and the price at which we sell the security to you. Grange Securities may also receive placement fees from Issuers for distributing securities on their behalf.” (emphasis added)
255 The heading “Fees and Charges” and the clauses under it were new or had been
included sometime after 2003 ([200], see section 4.2.4 above). There is no evidence that
Grange ever drew these changes to the attention of either Swan or Parkes. Once again, this
was not a full or frank disclosure sufficient to obtain a fully informed consent if Grange were
a fiduciary. Mr Senathirajah denied that during the slide presentations, Mr O’Dea explained
how many defaults the SCDO could withstand before the investors would suffer losses of
their capital. He asserted that Mr O’Dea had explained that the defaults would affect only the
rating of the tranche and therefore the price of the SCDO (T461, 506). I do not think it likely
that Mr O’Dea contradicted the slides. However, given Grange’s bullish endorsement of the
SCDOs in the slides and presentations, and its limited discussion of the risks of those
instruments, it is not likely that Mr O’Dea emphasised or explained in any depth the risk of
loss of capital. The thrust of the presentations was that the products Grange was selling were
safer, in terms of ratings, than the major Australian banks and, in some cases as safe as the
Australian Government, while offering better coupons than investments with those sources.
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256 Grange emphasised the high credit ratings, the history of minimal defaults in the
reference portfolios of similarly rated products, Grange’s continuous monitoring of the
performance of the investments and its ability to advise about whether to retain or sell them
and the liquidity of Grange’s SCDOs. Whatever attention Mr O’Dea or Grange gave to the
risk of capital loss in these presentations was likely to have been fleeting and overwhelmed
by the positive virtues of investing in what it was selling. I accept that Mr Senathirajah
genuinely understood that the effect of defaults was as he said in his evidence and that he did
not understand that the Council could lose its capital. However, I also find that Mr O’Dea
did inform him about the number of defaults that the product could withstand before investors
would lose capital.
257 As I have found in section 4.2.4 above, Mr Senathirajah understood that there was a
theoretical possibility of loss associated with every investment. However, he said that the
risk was minimal with a highly rated institution. He also understood that generally the
products that he caused Swan to invest in had a lower return if their ratings were high. But,
he also understood that for investments with ratings of about A or AA, the yields were only
marginally higher.
258 In April 2005, Mr O’Dea sought to interest Swan in appointing it to manage the
Council’s portfolios. He sent an email offering to provide Swan with Grange’s monthly
reports of its investments on a six month free trial. He named three other local government
bodies in Western Australia that had engaged Grange to do so. Mr O’Dea met Mr
Senathirajah soon after to discuss the IMP agreement service Grange was offering. Mr
O’Dea said that this was an enhanced service that involved Grange actively examining the
Council’s portfolio to give it a better return. The service would involve switching
investments and regular management reports, like the sample, showing what Grange had
done and its effect. On about 18 April 2005, Grange sold Swan another SCDO, Granite AA-
at a face value of $1,000,000. Around this time, Mr Kay began attending meetings with Mr
O’Dea and assisting him with Grange’s relations with Swan.
259 On 18 July 2005, Mr Kay emailed Mr Senathirajah with a switch proposal, suggesting
that Swan sell its Nexus AA+ holding at a yield of BBSW+ 0.80% and use the proceeds to
buy a new SCDO, Wentworth AA- with a coupon of BBSW+ 1.5%. Mr Kay said the offer
for the Nexus AA+ product would give Swan a good profit. He also said that the “… cons to
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this switch” involved extending the maturity date from December 2007 to September 2010
but added “… these are liquid so unlikely that they will be held to maturity anyway”
(emphasis added). He added that the new product had a lesser credit rating but Swan would
get a good profit and “… it is, after all, still AA-”. On 22 July 2005, Mr Senathirajah emailed
Mr Kay declining that offer. He did not recall the reason for that decision when asked in
evidence.
260 In August 2005, Mr Senathirajah received a slide presentation for an SCDO called
Quartz AA. Swan agreed to purchase $500,000 worth of that product on about 30 August
2005. By this time Mr Senathirajah and, I infer, his superiors, had sufficient confidence in
Grange’s selection of products as suitable for Swan that it was not necessary for Mr O’Dea or
anyone from Grange to go through a slide presentation or other selling process. Mr
Senathirajah was not concerned that the slides for the Quartz AA notes indicated that their
term was 5.35 years and they had call dates at three and four years. He said that Swan did not
intend to hold the investments for more than about one to one and a half years at most, so that
a longer call or maturity date was of no consequence. I find that he and Swan came to that
understanding because of, first, Grange’s representations about the lack of risk of loss,
liquidity and existence of an active secondary market for the SCDOs it sold and, secondly,
Grange’s ongoing demonstration of that by recommending and effecting switches allowing
sales of SCDOs by Swan at face value or better.
261 Then, on about 27 September 2005, Swan switched its $1,000,000 investment in
Flinders AA for an SCDO called Wattle, rated Aa3 by Moody’s, equivalent to a AA- rating
by Standard & Poor’s. The Wattle Aa3 notes had a first call date of 20 September 2008 and a
final maturity of 20 September 2012. The coupon was BBSW+ 1.3%, a drop of 0.2% on the
Flinders AA. The yield in the sale price of Flinders AA was BBSW+ 1.3% so Swan, as Mr
Senathirajah understood it, made a small profit from the switch.
262 This was an example of an important feature of Grange’s business model. Swan had
bought the Flinders AA product in late January 2005 and so, at the time of the switch, had
held it only for eight months. Swan sold the SCDO for better than its face value. Grange
was able to persuade the Councils to engage in these switches that sometimes involved them
buying a lower yielding and lower rated SCDO than the one they sold. Thus Swan, here, sold
a AA rated higher yielding SCDO for a lower rated, lower yielding one on Grange’s
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recommendation. As I will discuss later in these reasons, Grange made similar
recommendations to Parkes and also used its mandates under IMP agreements to effect
similar switches.
263 The switches reinforced to the Councils that their investments in Grange’s SCDO
products were liquid, could be sold quickly in an active secondary market and at no less than
face value. This confirmed that Grange’s representations about those matters were supported
regularly by actual transactions and offers of switches in which the Councils could see that
the proof of Grange’s pudding was in the eating.
4.2.9 Grange’s “no haircut repos”
264 On 4 January 2006, Mr Kay emailed Mr Senathirajah with an offer labelled as a
“short term opportunity”. He described the opportunity as Grange having “some short term
funding available (secured by the CDO Wentworth, which has a AA- S&P [i.e. Standard &
Poor’s] rating) at 6%”. In fact, this was a request by Grange to borrow $500,000 from Swan
for any term from 7 to 30 days secured by the SCDO. Mr Senathirajah declined the offer
later on the same day. In substance, this proposal represented a cognate offer by Grange to
sell and then, later, repurchase at the same price the SCDO with a yield of 6% interest for the
number of days agreed so as to have the use of the Council’s money for that period. Grange
financed itself when it required cash by borrowing from its Council clients at a rate of interest
or on terms as to security that Grange was not likely to achieve in an informed, arms length
transaction with a commercial financier.
265 This method of dealing demonstrated that Grange was fully aware that its clients, like
each of the Councils, had no real appreciation of the true risks of SCDOs or the financial
wisdom of its recommendation. That is revealed by the fact that the Councils accepted the
SCDOs proffered by Grange as having a security value of about 100% of its face value – i.e.
as good as cash or nearly so. Ordinarily, commercial lenders do not lend 100% of the value
of an asset offered as security for a loan but instead lend only a portion of that value. The
value of security almost always exceeds the value of any loan when first made. That is to
guard against the very real possibility that the asset will realise less than the value, if the
borrower defaults. Lenders employ loan to valuation ratios to ensure that if forced to sell the
security, they will have a margin of protection to recover the debt if the sale of the security
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does not realise the valuation amount, as often happens when a lender is taking enforcement
action under its mortgage.
266 Mr Vincent, in an internal email to Mr Portlock of 10 November 2006, explained the
improvidence, and commercial naivety, of Grange’s Council clients in entering into these
transactions, that were highly advantageous to Grange. That email was written when Grange
was concerned about its own exposed position from holding SCDOs that it had to purchase
from clients to meet its assurances to them of liquidity and an active secondary market. Mr
Vincent wrote:
“The situation is analogous to our no haircut repos with Councils. In reality although these guys have no haircut, they have the defence that if we don’t buy the stock back from them that we knowingly took advantage of them and they would have a case against our deep-pocketed Directors. If we did repos with haircuts, this case of being uninformed would be severely weakened as the haircut is defacto an acknowledgement of the risk of price movement and counterparty being caught short with Grange going bust and the stock post haircut being worth less than their investment. However obviously the informed institution makes the haricut [sic] so large that is [sic] covers their “mpl” [scil: maximum potential loss] scenario that makes funding stock with informed investors prohibitive for us.” (emphasis added)
267 In other words, Mr Vincent and Grange were well aware that an informed client
would never lend on the basis of the “no haircut repos” (“repo” being an abbreviation for
“repurchase transaction”) but would demand significantly more security to reflect the risk. If
Grange were to have advised the Councils of this, as it had to if it were a fiduciary, they
would have been made aware that the SCDOs were risky, illiquid and if sold might realise far
less than their face value: i.e. the very kinds of risk factors highlighted by the issuers’
documentation. An example of a contract note for a “repo” is at [653] below.
268 Mr Vincent’s assessment was supported by Mr Finkel who explained that a lender
might lend 99 or 98 cents to the face value dollar on a government security, such as a United
States federal agency, the “haircut” there being one or two cents. However, he said that the
“haircut” on a AA rated SCDO could easily be between 10% and 30% of its face value.
Neither Professor Harper nor Dr Bewley had ever heard of “no haircut repos” before they
gave concurrent evidence with Mr Finkel. In his first report, Mr Finkel explained that a
“repo” financing was a term meaning a, generally shorter term, reverse repurchase
arrangement in which a lender would purchase a portfolio of bonds or loans and agree to sell
it back to the borrower at a higher rate, the differential being the cost of financing the
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transaction. I accept Mr Finkel’s evidence. I also accept Mr Vincent’s assessment of
Grange’s knowledge that the Councils with which it dealt had no real conception of the risks
of SCDOs as investments. As his email showed, Grange was aware that such explanations as
it had given to the Councils to which it suggested “no haircut repos”, were inadequate to
convey to financially unsophisticated Council officers, such as those who gave evidence in
these proceedings, any proper understanding of the nature of SCDOs and their risks.
4.2.10 Grange’s next dealings with Swan
269 Mr Kay emailed Mr Senathirajah on 13 and 17 January 2006 seeking to interest him
in Grange’s next latest SCDO offering, Newport AAA, attaching a term sheet. He wrote that
it was “… an extremely good deal” rated AAA by both Standard & Poor’s and Fitch.
Mr Kay said that it had a coupon of BBSW + 100 bps and a term of seven years, “… callable
after 3 years (we expect that it is extremely likely to be called after 3 years)”. (emphasis
added) And he effused:
“I think this is an exceptional deal and encourage you to consider it strongly for any surplus funds you currently have.” (emphasis added)
The term sheet specified that the product was for professional investors only and set out the
same referral to the full terms and conditions under the heading “Documentation” that I have
set out at [115].
270 A similar statement, including the reference to “Risk Factors” featured in subsequent
Grange terms sheets. It echoes what Lord Macnaghten said about the authors of a prospectus
giving a hint to its meaning in Gluckstein [1900] AC at 251-252. Mr Senathirajah did not ask
for that documentation because, as he said, “we expected Grange to look at all those details
and to recommend to us only what they thought was in line with our investment policy”. On
19 January 2006, Mr Senathirajah emailed Mr Kay saying that Swan would invest $500,000
in the Newport AAA product. A contract note was issued by Grange on 31 January 2006.
271 Next, on 20 March 2006, Grange sent a contract note to Swan for an investment of
$500,000 in a new SCDO squared called Esperance AA+. Both Standard & Poor’s and Fitch
had given it a rating of AA+. The term sheet sent to Swan specified that the product was for
wholesale investors only and contained the same statement about documentation as was in
the term sheet for the Newport AAA product set out in [115] above. The risk factors in the
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supplemental information memorandum for the Esperance AA+ product extended well over
four closely printed pages. These repeated substantially the descriptions of investor
suitability and the risk of no secondary market as in the descriptions of risk factors for
SCDOs that I have described earlier, such as for the Flinders AA product. Mr Senathirajah
said that he was not shown those risk factors or told about them by Mr O’Dea or Mr Kay. He
said that had he been, Swan would not have invested in the Esperance AA+ product. I accept
that evidence.
272 On 24 March 2006, Grange issued contract notes to Swan recording a switch as
follows:
Grange selling notes in the Blue Gum Claim SCDO rated AA- by Standard &
Poor’s and Aa3 by Moody’s with the face value of $500,000 at a coupon of
BBSW+ 140 bps. (The contract note for this sale had a maturity date of 22
December 2010 and a final maturity date of 22 June 2013. In fact, the first of
those dates was a call date and gave the issuer of the Blue Gum product an
option to pay out the note holders at that time. If the issuer did not exercise
that option, the product would only mature in 2013.)
Grange buying half of Swan’s holding of the Argyle AAA notes with a face
value of $500,000 at a yield recorded as BBSW+ 55bps. (Swan had invested
$1,000,000 in Argyle AAA notes in October 2003 with maturity in October
2007 with a coupon of BBSW+ 110 bps: see [209]-[214] above).
273 Under the switch Swan was paid a net sum of $9005. Mr Senathirajah said that the
switch had been recommended to him by Grange. There was no documentary evidence of
how that occurred. I have set out some of the risk factors in the information memorandum
for the Blue Gum SCDO in [122]-[123]. Mr Senathirajah said, and I find, that Mr O’Dea did
not say to him anything to the effect of the sections in the information memorandum headed
“Investor suitability” and “No secondary market” that I set out in [122]-[123]) above.
4.2.11 Mr Senathirajah is succeeded by Mr Downing
274 As he was preparing to leave Swan, Mr Senathirajah discussed with Mr O’Dea and
Mr Kay whether the Council should enter into an IMP agreement. On 23 March 2006,
Grange wrote to him describing the differences between its then current advisory service of
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ad hoc broking to what the letter called its “comprehensive” IMP service that included all
tactical and strategic aspects of portfolio management and administration. I have set out at
[227]-[228] the relevant portion of this letter and Mr Senathirajah’s memorandum to
Mr Poepjes of 31 March 2006 recommending that Swan enter an IMP agreement with
Grange. Subsequently, in the next week Grange sent him two drafts.
275 In cross-examination Mr Senathirajah was asked about the apparent disconformity
between a clause (cl 2.3(c)) in the draft IMP agreement he recommended and his evidence
that Grange would always buy back an SCDO at its face value or better. That clause
provided that the client could request Grange in writing to remove any asset in the managed
portfolio and gave Grange 30 days to remove it “at the prevailing market price”. Mr
Senathirajah recognised that this was different from the representations that he had said
Grange had made about the pre-existing position if Swan wished to sell an SCDO. But he
said that the clause dealt with a situation in which Swan would be exercising a right to
interfere in Grange’s management so that any loss incurred was, in effect, to be borne by the
Council. He also pointed out that the draft IMP agreement provided that there had to be an
active secondary market for all securities. However, Mr Senathirajah could not give an
example of a situation in which the draft cl 2.3(c) would operate, because, he said, it had not
happened in his time at Swan.
276 The apparent difference between the representations and draft clause must be
considered in the context of a proposed change from an ad hoc, largely oral contractual
relationship to that of a formal overarching contract that had the appearance of being drafted
by Grange’s lawyers. What Mr O’Dea and his colleagues said or represented in discussions
and presentations need not have been reflected necessarily in the draft of cl 2.3(c).
Nonetheless, there is an incongruity in Mr Senathirajah recommending that Swan enter the
draft IMP agreement without requiring an explanation for, or change to, cl 2.3(c). It is
difficult to think that Grange would expose itself to an open ended obligation to buy back
SCDOs at no less than face value in the ad hoc arrangements but exclude such an obligation
in draft cl 2.3(c) or that Mr Senathirajah, if he appreciated the significance of the change,
would not have raised it.
277 After all, in both contexts, pre- and post- the draft IMP agreement, Grange had to
monitor each SCDO actively, in the first, so as to warn Swan so that it could take corrective
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action well in time and in the second, because such monitoring was a significant benefit to
Swan in having Grange manage its portfolio with a view to achieving a targeted return over
each rolling yearly period (cl 2.1). If active monitoring always would achieve what
Mr Senathirajah asserted, namely sufficiently timeous notice so that a vulnerable SCDO
could be sold before its value went below face value, how could any asset to which draft
cl 2.3(c) might apply be sold at a lesser value? Thus, if draft cl 2.3(c) would operate
differently from what Mr Senathirajah understood was the existing position, and an
investment were sold at a loss in an active secondary market, it is hard to see why he thought
that Swan, not Grange, ought to have borne that loss.
278 In fairness to him, he was not able to envisage how the loss scenario I have discussed
could occur, particularly in light of his experience of dealing with Grange over more than two
and half years without any such losses. In addition, as he noted in his memorandum of 31
March 2006, Grange had to manage the portfolio in accordance with the 2003 Swan Policy.
Mr Senathirajah’s understanding was that this policy also did not permit loss of capital. That
understanding was also reflected in a letter dated 6 June 2006 written to his successor, Mr
Downing, by Grange through both Mr O’Dea and Mr Kay, where they explained the way in
which IMP agreements operated, giving as examples the City of Geraldton (which like Swan
did not then have an IMP agreement) and Town of Kwinana (which did have one). Both
were Western Australian local government bodies. There Grange described the constraints
on investments for those clients as follows:
“This client is a local government authority with short term (municipal) funds and medium term (reserve) funds. Investments used must be extremely secure, highly liquid and comply with the relevant state legislative requirements. … … Investment Guidelines The City of Geraldton portfolio invests in Australian Banks (rated investment grade or better), along with AAA and AA rated structured credit securities. Note: While the City of Geraldton is not an IMP client, and hence not strictly governed by an agreed set Investment of Guidelines, it is managed in a similar way to IMPs. The only real difference is that Grange obtains approval for each investment before including it in the portfolio. All investments are therefore, Grange recommendations.” (emphasis added)
279 The last emphasised section could equally describe the relationship to this time
between Swan and Grange with the qualification that Swan did not make investments solely
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through Grange. I am not persuaded that the way in which cl 2.3(c) was drafted reflected the
way in which Grange had dealt with Swan over the preceding period (as I have found at
[236]-[237]. I find that it did not occur to Mr Senathirajah that the reference to Swan being
able to sell an SCDO at “the prevailing market price” in the draft cl 2.3(c) referred to a
difference in the way in which the existing relationship between Grange and the Council had
operated. His experience had been that no loss had occurred on any sale. He had been told
repeatedly that Grange monitored the performance of products and simply assumed this
would enable Grange to take (or advise on) steps well in advance to avoid the risk of the
Council suffering a capital loss. Nonetheless, as I have found at [237], Mr Senathirajah
understood Grange’s oral promise to buy back products from Swan without capital loss
depended on Grange being in a financial position to do so and was not an absolute guarantee
that Grange would be able to do so if there were an unforeseeable, general economic
catastrophe. Thus, while he did not turn his mind to this, the draft cl 2.3(c) was not
inconsistent with this understanding. That state of mind was encouraged in circumstances
such as Grange’s assimilation of SCDOs into the “universe of AUD Floating Rate Debt
Investments” in graphs such as those at [230] and [246]. This made the security offered by
structured credit instruments, such as SCDOs, appear to be equivalent or nearly so to the
security offered by Government debt and significantly better than that offered by banks. This
theme was part of Grange’s pitch that its SCDOs were rated higher than the four major
Australian banks.
280 In early May 2006, Mr Downing was appointed by Swan to the newly created
position of chief financial officer. That position combined a number of roles, including that
of the previous manager of finance, Mr Senathirajah. They had had a short handover period
and Mr Senathirajah had a brief discussion with Mr Downing concerning the nature of
Swan’s investments in its portfolio, the scope of its investment powers under the 2003 Swan
Policy, and the Council’s requirement to have funds available for both its current and future
needs. The discussion did not go into detail. Mr Downing did not recall any mention of
FRNs or CDOs in this discussion.
281 Mr Downing proceeded to organise the Councils’ investments into groups, those with
terms to meet its monthly cash requirements and the balance for the Council’s trust, restricted
and reserve funds, for longer term investment, such as FRNs and CDOs which would mature
over a longer period of up to five years. He understood that the 2003 Swan Policy required
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that the latter investments had to ensure repayment of principal, fall within the risk categories
permitted by the policy and pay a good dividend or rate of interest. He had had no prior
experience of investments in structured credit products including CDOs. He then simply
understood that they were fixed term and fixed interest products. Mr Downing did not then
understand what a credit fault swap was.
282 Very soon after his appointment, Mr Downing had a meeting with Mr O’Dea and Mr
Kay, at Mr O’Dea’s suggestion. Mr O’Dea told Mr Downing that Grange had been
appointed by Swan as an investment adviser on a range of investments it had made in fixed
interest, fixed term products. Grange challenged that evidence of Mr Downing, but I am
satisfied that he accurately recounted the substance of what Mr O’Dea said. It is consistent
with a number of Grange’s own descriptions of its role for its local government clients
including a contemporaneous one of its ad hoc or broking service as an “investment advisory
services” in Mr O’Dea’s and Mr Kay’s letter of 23 March 2006 to Swan proposing that Swan
enter an IMP agreement. And, Mr O’Dea had been making similar statements for over two
years, such as in his slide presentation to the local government finance managers association
on 30 October 2003.
283 During the initial meeting with Mr Downing, Mr O’Dea and Mr Kay talked about
their and Grange’s experience and general ability. They spoke to Mr Downing of Grange’s
team of analysts who did research on products investigating their suitability before Grange
made a recommendation about them. They sought to persuade Mr Downing that because of
these factors Grange could and should manage Swan’s cash flow and investments and they
referred to a similar role that Grange had performed for some time for the City of Melville.
Mr O’Dea and Mr Kay also explained how Grange could manage Swan’s investments in
accordance with the 2003 Sway Policy. Mr Downing emphasised to them the importance
that Swan, and its investment policy, placed on ensuring that it did not lose any capital. They
discussed the levels of return and risks permitted by the 2003 Swan Policy. Mr Downing
went through with them the Council’s investment portfolio, including its use of term deposits
with Australian banks rated between AA and A (T542). Mr O’Dea and Mr Kay said that the
kinds of investments for Swan that they had in mind were in structured credit instruments,
predominantly CDOs, that had all been issued by leading American or European banks.
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284 Either at this meeting or soon afterwards, Mr O’Dea and Mr Kay explained to Mr
Downing that Grange would give Swan advice to invest or change or switch investments.
They told Mr Downing that Grange would also advise the Council to make a switch where it
believed Swan could improve either or both of its yield or credit rating on a structured
product.
4.2.12 Mr Downing’s first transaction with Grange
285 On 17 May 2006, Mr Downing sent an email to Mr Kay instructing him to effect two
switches “as discussed”, namely from, first, the Wattle Aa3 SCDO to a new SCDO squared,
Scarborough AA to be issued on 25 May 2006 and, secondly, the Granite AA- SCDO to
another new SCDO squared, Glenelg AA-, to be issued on 13 June 2006. Mr O’Dea and Mr
Kay had met with Mr Downing to discuss these switches. They explained to Mr Downing
that the issuing bankers wanted to “wind up” the Granite AA- product and would make up a
shortfall to encourage Swan to make the swap. There was no evidence of Mr Downing
having received more information about these two switches than this and an oral
recommendation for these transactions together with term sheets for each of the two new
products.
286 After he received the term sheets, Mr Downing said that he saw that they had a
section captioned “Documentation”. That was in the same terms as I have set out for the
Blue Gum SCDO ([115]). Mr Downing asked Mr O’Dea if he could have the documentation
associated with the investments. Mr O’Dea replied, saying that the documentation was at
least 80 pages long. He asked whether Mr Downing really believed that he had the capability
to understand such documentation and added, “That is what we do as your investment
adviser”. I find that Mr Downing accepted that response and did not pursue such enquiries.
However, I do not accept his evidence that he did not notice the reference to “risk factors” in
the section of the term sheet captioned “Documentation”. That reference appeared as a
visually obvious part of a four line description of the documentation. I find that Mr Downing
did not follow up the reference to “risk factors”. It is likely that this occurred because he
accepted Mr O’Dea’s description of Grange’s role as Swan’s investment adviser and because
Mr O’Dea did not give Swan the documentation in response to Mr Downing’s request.
287 The first switch was from Wattle Aa3, (equivalent to AA-) that Swan had acquired on
about 27 September 2005 (see [261] above). Scarborough AA was rated slightly higher, but
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its first call date was 23 June 2009 and final maturity was 23 June 2014, instead of those for
Wattle Aa3 of September 2008 and September 2012 respectively. The coupon for both
SCDOs was the same, BBSW + 1.3%. The term sheet specified wholesale investors as being
eligible for the Scarborough AA product. It noted that the new SCDO had 3.56% credit
support (i.e. this was the attachment point) and that there was a fixed 40% recovery. On 18
May 2006 Grange issued contract notes for settlement on 25 May 2006 buying the
$1,000,000 face value Wattle Aa3 notes based on a yield of BBSW + 128 bps for a total price
of $1,012,680 and selling Glenelg AA- notes for the price of $1,000,000.
288 The second switch was from Granite AA- that Swan had acquired at a face value of
$1,000,000 on about 18 April 2005 maturing on 22 March 2010 (see [258]) with a coupon of
BBSW + 1.25%. Glenelg AA- had a call date of 22 June 2009 and a final maturity date of 22
December 2014 with a coupon of BBSW + 1.25%. The term sheet identified Grange as the
underwriter of the issue and specified “professional only” as eligible investors. It noted that
Glenelg AA- had 5.73% credit support and a fixed 30% recovery. Mr O’Dea told Mr
Downing that Grange was the underwriter, although Mr Downing appears to have understood
this term to mean “marketing agent”. On 18 May 2006 Grange also issued contract notes for
settlement on 13 June 2006 buying the $1,000,000 face value Granite AA- notes based on a
capital price of $99.503 per $100 face value for a total price, inclusive of accrued interest of
$1,010,590.00 and selling the Glenelg AA- notes for their face value.
289 On 14 June 2006, Ms Le Lievre drew Mr Downing’s attention to a loss of $4,967.84
that Swan had incurred on settlement of the second switch. She calculated this shortfall
based on the assumption that the Council should have been repaid the face value of the notes
and interest due to 13 June 2006. Mr Downing forwarded Ms Le Lievre’s calculation to Mr
O’Dea. Mr Downing’s email referred to his having been told by Mr O’Dea and Mr Kay,
when the switch was proposed, that the issuing bankers wanted to wind up the Granite AA
product and would encourage Swan to sell it by making up a shortfall. Later that day Mr
O’Dea replied by email. He pointed out that the product had its credit rating downgraded by
Standard & Poor’s from AA- to A at the end of April 2006 saying that this gave:
“… rise to a wider margin & a reduction in capital value. At the end of April Granite was marked to market in the reports at a margin of +1.65% & was valued at $993,620.00. This margin would have been constantly adjusted with any relevant changes in the market or in Granite itself. The reason we went forward with the switch into Glenelg was to restructure a security we felt we could improve upon, in
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other words switching Granite into Glenelg was a de-risking strategy. I think we’ve done this on four or five previous occasions in one way or another and it’s the main reason we have a team of seven people watching these securities all the time. If ever a way presents to optimise returns or reduce risk, we will move on it. The buy back margin +1.40, 0.15% tighter then [sic] April valuation of + 1.65% (so a better price that last valuation). The difference Gwen refers to is the actual coupon for the quarter and the mark to market valuation of [the] sale price. If you look at the capital price on the original buy contract it is 100 (or $1m). The capital price when Grange bought it back was 99.503 (or $995,030). … … It is a pretty normal occurrence for us, its probably a bit different than the norm as we choose to do something about deals that we believe we can improve. I think [it’s] probably one of the key benefits of using Grange, the ongoing monitoring.” (emphasis added)
290 That explanation is the first in the evidence of Grange informing Swan that any
investment had realised, or was worth, less than its face value. Although Mr O’Dea enthused
in the email about Grange’s ongoing monitoring, he did not explain how this had not been
used earlier to alert Swan to the development of whatever events had led to the downgrading
of the Granite product so that it could have sold that investment before a capital loss
occurred. Additionally, Mr O’Dea explained in the email that over the period Swan had held
the Granite product its internal rate of return after taking account of the small capital loss, had
been 6.61% per annum which he said had exceeded the benchmark by 0.86% and the target
by 0.51%.
291 Mr O’Dea emphasised that, in the end, Swan had made a net gain from that
investment as a result of Grange’s “ongoing monitoring”. The explanation seems to have
assuaged Mr Downing’s concerns but did not appear to have brought home to him that the
market value of SCDOs could fall below their face value.
4.2.13 Grange’s 6 June 2006 IMP proposal for Swan
292 In between the two switches Mr O’Dea and Mr Kay had discussed with Mr Downing
the desirability of Swan entering into an IMP agreement. They told Mr Downing that he
could contact the City of Melville to find out how the IMP agreement it had had for a number
of years worked. On 6 June 2006, Mr Kay sent Mr Downing an email attaching, among
others, a letter he and Mr O’Dea wrote to Mr Downing on that day proposing that the Council
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enter into an IMP agreement and explaining its terms, together with a draft of the proposed
IMP agreement. I have already set out some of the significant matters in the letter (see [278]
above). Mr Downing read this material, including a document entitled “The ‘High Income’
Portfolio. April 2006” and considered that the draft IMP agreement was a workable model
that fulfilled Swan’s requirements. However, Mr Downing did not decide to pursue the entry
into an IMP agreement at that time.
4.2.14 Why was Grange proposing switches?
293 No sooner had the second switch been effected on 13 June 2006, than Grange
proposed a new switch in an email to Mr Downing sent on 29 June 2003 by Mr Kay at Mr
O’Dea’s suggestion. This proposed that Swan switch out of the Nexus AA+ product and buy
a new SCDO squared, Torquay AA. Since its purchase in October 2003 with a coupon of
BBSW + 1.2%, the Nexus product had been upgraded to AAA. Grange proposed buying it
from Swan at a yield of BBSW + 0.5% and “… so a good capital profit to you” and selling
the Torquay product with the same coupon (BBSW + 120 bps) as the product it would
replace but with a call date of 20 June 2009 and a final maturity date of 20 June 2013. I have
discussed in section 3.5.3 above Mr Downing’s understanding of the significance of the call
and maturity dates ([110]). The indicative term sheet for the Torquay AA product was
attached to the email. The term sheet specified that eligible investors were “wholesale only”
and that the credit support (i.e. attachment point) was at 3.30% with a fixed 40% recovery.
Settlement was expected on 6 July 2006.
294 Mr O’Dea had discussed this switch with Mr Downing before he received the email.
Mr Downing said in evidence, that Mr O’Dea told him that this proposal switch was an
example of Grange advising Swan when it could either improve its yield or the quality of its
security. In the event, Swan did not effect this switch.
295 Although, Mr Downing gave evidence in chief that this proposal appeared to be an
example of what Mr O’Dea had told him, I am unable to understand how that could be so. If
Mr Downing had paid any attention to the term sheets, and even Mr Kay’s email observation
that the “… only negative to the switch is going from AAA to AA”, he would have noticed
that Swan would be buying a lower rated security, with a maturity date seven years away and
a call date three years ahead yielding the same return: i.e. the yield was not improved nor
was the quality of the security. There was no direct evidence as to why Swan did not effect
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this proposed switch. However, it is unlikely that Mr Downing conducted any analysis, even
of the facile nature I have just discussed, since he gave no evidence of having done so for this
or any other transaction involving SCDOs. His approach, as he said in evidence was just to
scan what documentation Grange sent to him to look for information about a product’s rating
and coupon.
296 On 14 June 2006, Mr Vincent sent an internal email commenting on Grange’s
monthly management accounts for May 2006 as follows:
“… In summary, FI [sic, the Fixed Interest Division of Grange] had a very good month due to Scarborough and the Glenelg, Granite switch. This was also supplemented by large profits in secondary market trading. … Also as a reminder, this is confidential information that should not be shared outside Grange under any circumstances … May Actual FIXED INTEREST Income $4,274,657 Expenses 1,255,462 - Net Profit/ (Loss) 3,019,195 …” (italic emphasis added, original bold emphasis)
297 Thus, the two switches that Mr Downing agreed to make on 17 May 2006 (see [285]
above) involved three of the four products Mr Vincent identified. The fourth, was the Wattle
Aa3 SCDO. By May 2006, Mr Vincent and other Grange analysts had concerns over the
stability of the Wattle Aa3 product’s credit rating. These concerns were sufficiently
significant to lead to Grange arranging with JP Morgan the Wattle product’s issuer or
arranger, to buy back the issued (face value) of $51 million and issue the new Torquay
product. That arrangement was concluded on 2 June 2006 as a result of which Grange
underwrote $75 million worth of the Torquay product’s issue. Mr Clout described that deal
as an opportunity enabling Grange to:
“… switch Wattle for Torquay creating a more stable structure without penalizing the investor. …
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This is the last CDO transaction for the financial year and it is important that we market Torquay as broadly as possible to maximise the potential for this transaction given the quality of the Torquay deal.”
298 Thus, Grange arranged a transaction to circumvent a concerning degree of risk that
had developed in the Wattle product. In this way, it prevented Swan, and no doubt its other
clients, from suffering a downgrade or default in Wattle Aa3. But, there is no evidence that
Grange disclosed to Swan or Mr Downing this perception of risk about the Wattle SCDO or
how it had arisen in a product that it had marketed to Swan in another switch just nine months
earlier. Then, as I have noted, Swan gave up 20 bps on the coupon of the better rated
Flinders AA product to buy the Wattle Aa3 product ([260]).
299 Why was Grange making these, increasingly frequent, switch proposals to Swan and
others (including Parkes, as will appear later in these reasons)? To unsophisticated investors,
these proposals seemed harmless enough. The new SCDO came with Grange’s
recommendation as well as having apparently the same or similar ratings and coupons.
300 The reason that Grange proposed switches was that they formed an integral part of its
own income generating strategy. A sale of a newly issued SCDO in a switch for one that an
issuer wished to wind up, enabled Grange to earn very significant fees from the issuers of
both SCDOs. And, because Grange, in substance, made the secondary market, it could also
take profits on the switches from its clients. The switches were methodically planned. In a
revealing internal email of 9 August 2004, Mr Clout commenced his instructions to his staff
in respect of seven SCDO switches as follows:
“Below are some switch ideas based upon our axes both on and off the book. As we control the cdo market we should be able to execute any of these without issue. Please make this a priority 1. GSL [Grange] sells Balmoral @ + 120
GSL buys Octagonal @ + 110 … Good luck” (emphasis added)
301 I infer that, based on what I have emphasised, “axes” was a reference to Grange’s
asking prices rather than, as Professor Harper suggested, as parameters of the deal. The email
proceeded on the basis that Grange controlled the “market” for SCDOs, as it did. Mr Finkel
explained that “axes” were a trader’s priorties or desired positions. As Professor Harper
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accepted, Grange’s position reflected in the email was not consistent with the existence of an
active secondary market. Mr Finkel described the language of this email as “extraordinarily
disturbing”. It is. In January 2006, Grange marketed the Newport AAA product to its clients
while at the same time offering to buy back the Hotham product. Before it made this switch
proposal Grange had ensured that Hotham’s issuer would buy back that SCDO from Grange.
By 31 January 2006, Grange had arranged for its clients to purchase over $120 million worth
of the Newport AAA product including switches for nearly $43 million worth of the Hotham
product. There is no evidence that Grange suggested this switch to Swan but it proposed the
transaction to Parkes on 20 January 2006 which accepted it four days later: [565].
302 Between 14 and 15 June 2006, Grange was engaged in an email debate with JP
Morgan concerning Grange’s fees on the Torquay product and the buy back price for the
Newport product. Grange would receive a fee being a proportion of the revenue generated on
completion of the sale by JP Morgan of the Torquay SCDO to Grange or its clients. That fee
was calculated using a highly complex formula. The formula produced a percentage fee that
would vary up to the time of completion as affected by:
the correlation: i.e. the measure of the probability that if one of the reference
entities defaults, others will also default. A higher correlation implies that
there is a higher probability of multiple defaults in the SCDO’s reference
portfolio, and, of course, this implies an increase in the probability that the
SCDO itself will default. Mr Finkel explained in his expert report that
changes in market correlation are likely to affect the market value, particularly
in an SCDO that does not have an actively managed reference portfolio (as
was the case for 24 of the 39 Claim SCDOs);
the spread in the reference portfolio: i.e. the differences between the face
value of each reference entity’s debt or notes and its market value.
303 The email exchange between Grange and JP Morgan of 14 and 15 June 2006
discussed variations in Grange’s anticipated fees or profit for placing or underwriting an
additional $20 million issue of the Torquay product ranging between 1.80% and 2.50% based
on movements in the correlation and spreads for the underlying portfolio. Mr Adamou
explained the then current position he had reached with JP Morgan’s Brad Follett, in his
internal email to his Grange colleagues on Thursday 15 June 2006:
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“As of latest trading (i.e. NY close Wed) he now sees the fees circa 2.50%. Now, there is still a 0.76% differential between his and my pricing. He says this is due to the fact that (unlike with the first $75m) we are not getting any synergies from an opposing buyback (as we did with Wattle). This accounts for the 0.76%. He has a fair point. However, if we were to do an upsize in conjunction with a Newport buy-back he believes the economics will be circa 3.00% fees on the Torquay leg and $99.00 bid on the Newports. I asked him to give us a firm price where he is confident we will be set tonight on a Torquay vs Newport $20m upsize/switch as there is a small possibility we may choose to give an order tonight. He is going to revert. This is rather opportune. I recommend we do it (if the pricing ends up being similar to Brad’s prediction above).” (emphasis in original)
304 This revealed that Grange benefitted from “synergies” in relation to the buyback of
the Wattle Aa3 as a result of its promoting the switch for the initial parcel of the Torquay
product. Similarly, Mr Adamou expected that by promoting a switch of the Newport SCDO,
Grange would earn fees of about 3% on the sales of Torquay to its clients while it sold
Newport to JP Morgan for $99 per note, $1 less than the face value. This was the genesis of
the switch proposal that Mr Kay made to Mr Downing on 29 June 2006: [293].
305 Over the 11 months to 31 May 2006, Grange had earned about $15.7 million in fees
from selling new issues of SCDOs, and about $3.35 million in profits on its secondary market
trading. The secondary market trading figure was arrived at after allowing for Grange’s
financing costs of “repos” of about $6.9 million and its earnings of about $6.15 million from
securities it held.
306 Thus, from time to time, Grange needed to obtain funding, for example through “no
haircut repos”, in order to finance its own activities in supporting the secondary market that it
created for SCDOs. When this need arose, a senior Grange executive, such as Mr Hindle, or
Mr Clout, would circulate an internal email identifying the securities it had agreed to buy
from clients, their value and the period of time for which Grange had to obtain finance to
effect the transactions.
307 The switches were important to Grange as a means of ensuring turnover of SCDOs.
By mid 2005 it was marketing a new SCDO, on average, once per month, hence turnover was
essential to its own income generation.
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4.2.15 Swan’s transactions in 2006 after June
308 On 18 July 2006 Mr Kay emailed Mr Downing proposing an investment in the latest
Parkes AAA and AA- SCDO products. I have described this above ([106]-109]). Mr Kay
proposed a switch between the Blue Gum AA- or Aa3 rated SCDO that Swan had purchased
four months earlier, on 24 March 2006, for the equivalent in face value ($500,000) in the
Parkes AA- product ([272]). Once again, the term sheet for the Parkes products described
eligible investors as “wholesale only”. It noted that the issuer call date was 20 December
2009 and final maturity was 20 June 2015.
309 On 7 August 2006, Mr Kay met with Mr Downing and Ms Le Lievre. It is possible
that Mr O’Dea was also present, but since the contemporaneous emails do not suggest that he
was, it is likely that Mr Kay alone made this visit to Swan. Accordingly, although Mr
Downing referred to Mr O’Dea as making the presentation, I think he was confusing Mr
O’Dea with Mr Kay on this occasion. He discussed the Parkes AAA products, three
proposed switches of other products and an FRN. Two sets of switches related to Australian
bank issued FRNs, and the third, a switch of the Nexus product to the equivalently rated, but
higher coupon, Tasman product. Mr Kay gave Mr Downing a black and white photocopy of
a slide presentation for the Parkes AAA and AA- products as well as a Grange information
note on the Parkes AAA product. The information note contained the risk analysis table set
out in [107]. It also stated that “[s]hould the Coordinator, (Morgan Stanley) elect not to
exercise their option to buyback Parkes at 100% on 20th December 2009, the coupon steps up
to BBSW + 1.60%”. The initial coupon for the Parkes AAA product was BBSW + 100 bps.
310 Mr Kay explained the slide presentation to them only in relation to the Parkes AAA
product. It took about 20 to 30 minutes. Mr Downing’s evidence was that he understood
from the explanation that:
Morgan Stanley issued the product and that it had an active portfolio manager
with an incentive fee;
the call date was 20 December 2009 and that although a penalty increase in
interest payable occurred if the product proceeded to the final maturity date in
June 2015, Mr Kay said that no product had gone beyond the call date;
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Morgan Stanley was “the holder of the loans in the portfolio”, and Swan was
buying “a securitised tranche of that portfolio”;
if any reference entity had a credit event or rating downgrade the manager
could swap reference entities so as to maintain the overall AAA rating of the
product;
Grange had performed extensive stress testing on the structure and found that
it could withstand defaults 3.8 times greater than historical levels;
Grange’s CDOs had a proven track record of success.
311 Mr Downing said that the emphasis in Mr Kay’s presentation was that the Parkes
AAA product was highly rated and the slides showed how good it was. Mr Downing did not
absorb the information conveyed by the slide below that depicted the transaction structure
(not in colour).
312 He gave this evidence:
“So you understood from the presentation and from this document that, in the transaction structure, Morgan Stanley’s role was to act as the swap counterparty? --- I
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do now. I didn’t at the time. It wasn’t a focus of this particular attention of the presentation. Well, the fact that there was reference to a swap counterparty at two places in the middle of this page was of no concern to you. Is that right? --- It wasn’t. It’s not that it wasn’t of a concern it just wasn’t a factor that registered with me, as a potential investor, because I didn’t understand it. I was looking at what we were being advised that we could buy, which was the AAA and the AA tranche. Well, what did you think all that writing in the middle of the page that starts with swap counterparty and goes down was about? --- Again, it didn’t enter into my thinking process at the time.” (emphasis added)
313 It is not surprising that Mr Downing did not grasp the complexity of the overall
transaction. He said and I accept that there was no explanation given about what a swap
counterparty was. I infer that Morgan Stanley was also the investment bank that arranged the
creation of the product so that it could use it to obtain credit protection. The explanation of
how, generically, an SCDO works that I have written in section 3 of these reasons is
conceptually difficult. In order to comprehend this concept I was assisted by significant
amounts of expert evidence, explanations by counsel, reading one set of the transaction
documents and hearing many days of lay evidence referring to the presentations for the
Parkes AAA and similar products. Typically the full version of SCDO product documents in
evidence stated that these instruments were intended for sophisticated investors. That
description would not be apposite, as Grange appreciated, for local government financial
officers, including those of the Councils, dealing with the placement of public money in
secure investments.
314 Mr Downing was challenged about the return offered and gave this evidence in cross-
examination that I accept:
“Weren’t you ever curious, Mr Downing, as to how it was that these highly rated products also had a pretty good return? --- Highly rated products. Well, I’m not too sure if I agree with the sentiments of your question. No. I don’t - - - Which part do you not agree with? You are alluding that these had a high return. These products, AAA rated, had one per cent above BBSW, the bank bill rate, at the time. Yes? --- Which is the cash rate. Yes? --- I considered if it was a --- I did not consider that a high rate of return. It was certainly better than investing in the cash rate represented by the bank bill swap rate but, certainly, one per cent was not a mortgage fund or a managed fund or one of those other funds which may have been offering 9, 10, 11 per cent. These
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were just paying one I think one per cent above and 1.6 for the one per cent above for the AAA tranche. It was a nice return, yes, but it certainly wasn't the 10 or 11 or 12 per cent return which I think I thought you were inferring. You are right, I was. But to be more precise, what I was inferring was this, tell me if you disagree. You understood in your dealings with Grange that the products that are described as CDOs gave you a return that was materially higher than the return that you would be able to obtain from any other equivalently rated product? --- No, I don’t agree with that sentiment, no. Were you conscious of there being other products equivalently rated that gave an equal or better return? --- Well, there were other direct investment products such as floating rate notes in Australian banks, subordinated debt I think gave similar returns. Term deposits were obviously less than this. The floating rate notes did not give you anything like the returns that you got from equivalently rated CDOs, did they? --- I can’t recall now what they were but - - - It is just that you are suggesting the possibility to me, Mr Downing? --- Yes. My understanding is that there were investments that this was not considered a high yield investment. It gave us a nice return, yes, above BBSW but it certainly wasn’t, you know, three, four, five, six hundred basis points above BBSW which I would consider a high risk investment. ... It was a materially better return for an equivalently rated product, wasn’t it? --- No. That answer is false, isn’t it, Mr Downing? --- No. That was your not your belief at the time? --- No, I believed that it was a better return but certainly not a materially better return, no.” (emphasis added)
315 I see that evidence as demonstrating why persons like Mr Downing, would rely on the
apparent high credit rating and modest interest premium offered by these products under the
fundamental misconception that they were appropriate, safe investments for local government
funds. Of course, the topic of how these SCDOs produced the returns they did was not easy
to fathom, as the discussion in “The Free Lunch” emails initiated by Mr Portlock in
September 2006 showed: [133]-[141]. As Mr Downing said, the returns offered by the
SCDOs were generally better than those for similarly rated products but, in most cases they
were within 1% or 100 bps of bank or ADI issued FRNs which had equal or lower ratings.
However, the interest offered by SCDOs did not always exceed that offered by ADI issued
FRNs. For example, as will be seen at [323] below, on 7 August 2006 Mr Downing agreed to
buy an FRN issued by Elders Rural Bank rated BBB- with a coupon of BBSW + 61 bps.
(Parkes AAA offered BBSW + 100 bps.) Those two products, offering similar coupons, were
rated significantly differently but the lower rated one was part of the ordinary Australian
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financial system, regulated by Australian Government agencies, whereas the SCDO was an
instrument for sophisticated professional investors.
316 The Parkes slide presentation stated that there would need to be 10 separate credit
events for the Parkes AAA notes to suffer any impact. It dismissed that possibility with the
emphatic summary:
“Given the high quality of Parkes’ portfolio Standard & Poor’s rating agency believes that the probability of there being even 10 credit events is so remote that they are comfortable rating the Parkes Class 1A notes at “AAA”. No CDO rated “AAA” by S&P has ever defaulted.”
317 That was reinforced by Mr Kay saying to Mr Downing in the presentation that no loss
had ever happened in a AAA note and that there had only been three reference entities that
had defaulted in CDOs with which Grange had been involved. This was borne out in the
table of 28 SCDOs on the slide headed “Grange CDOs have a proven track record”. Mr
Downing agreed that, had he read the slide presentation carefully, he would have seen that it
informed him that if 11 credit events occurred an investor in the Parkes AAA product would
lose all its capital. He did not read the last page headed “Grange and Morgan Stanley
Disclaimers”. Had he, he might have noticed that Grange asserted that the presentation was
“for distribution exclusively to professional investors in Australia only. It has not been
prepared for, and must not be distributed to … anyone who is not a professional investor in
Australia”. Grange gave, and identified, no evidence of how a local government council
could meaningfully have been conceived to be a “professional” investor. Earlier in August
2003, Grange’s background note on itself distinguished “professional”, from risk averse local
government, investors (see section 4.2.4 [177]-[179] above). That distinction was justified.
Of course, a “professional investor” within the meaning of that term in s 9 of the
Corporations Act, included a person that controlled at least $10 million, so technically, Swan
met this legal description: see [527] below.
318 Early on 8 August 2006, Mr Downing emailed Mr Kay with instructions that Swan
would buy $500,000 worth of the Parkes AAA product. He also enquired of the ratio of
Swan’s bank and non bank products in its portfolio with Grange. Mr Kay responded saying
that he would arrange for the Council to acquire the Parkes AAA and needed funds for
settlement on 15 August 2006. Mr Kay said that Swan had 35% of its portfolio in bank
securities and 65% in non bank ones (i.e. SCDOs). He also referred to the email he had sent
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earlier that morning summarising the recommendations Grange had made at the meeting and
advising that it also had $500,000 worth of the Parkes AA- product available. Mr Kay wrote
that if Swan had the funds available “it would be worth while picking this up also”, noting
that the AA- note paid BBSW + 2% and also would settle on 15 August 2006. Mr Kay
attached, once again, a term sheet for the Parkes products to one of his 8 August emails
recommending that Swan buy $500,000 worth of each of the Parkes AAA and AA- notes
saying:
“We feel that this is one of the most robust transactions we have brought to the market and it also offers extremely attractive coupons for very high credit quality.”
319 Mr Downing responded late on 8 August noting that Mr Kay had not mentioned the
Parkes AA- product at the previous day’s meeting. Next day, Mr Kay replied saying that he
has subsequently learnt that a further $500,000 worth of the Parkes AA- notes were available.
Mr Kay’s email continued:
“It is basically another tranche of the same transaction but it absorbs losses earlier than the AAA tranche, hence the higher yield (BBSW + 2.00%) and the lower credit rating. It can absorb 7 credit events (i.e. capital is impacted by the 8th) and b[e]aring in mind we have only had 3 credit events across ou[r] 35+ issues over 3 years, we see this as extremely unlikely. It is a very high quality note (having the same credit rating as the bid [sic] 4 Australian banks) and is offering a very attractive yield.” (emphasis added)
320 On 10 August 2006, Mr Downing emailed Mr Kay with instructions that Swan would
also buy $500,000 worth of the Parkes AA- product and paid the total of $1 million due for
both notes on 15 August 2006. When he did so, Mr Downing appreciated from Mr Kay’s
explanation just quoted, that the higher yield and lower credit rating of the AA- tranche,
reflected the relationship between a higher risk and higher return. He also understood that the
nature of the SCDO involved a risk of loss of capital, but that this risk was, as Mr Kay said,
“extremely unlikely” and such a loss had never happened before. Mr Downing saw an
investment in the Parkes AA- product as a slightly bigger risk than the AAA notes. That
understanding was calculated to be conveyed by Mr Kay’s equation of the credit rating for
the Parkes AA- product with “the big 4 Australian banks”.
321 It is hardly surprising that, with such an assurance, Mr Downing was unconcerned
about the risk of investing in SCDOs with ratings equivalent to or better than the four major
Australian banks and did not read in detail the material Grange provided to him. That
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assurance was reinforced by the monthly portfolio reports that Grange sent to Swan. The
report for July 2006 that Grange emailed to Mr Downing and Ms Le Lievre on 9 August 2006
contained a table headed “Top 5 Securities”. The table set out the names and ratings of the
issues, security type and percentage represented by the security within the portfolio arranged
by Grange. That table listed four SCDOs, as “CDO FRNs” being Endeavour AAA,
Glenelg AA-, Scarborough AA and Nexus AAA together with an “ADI FRN” issued by one
of the four major Australian banks, ANZ Bank, which had an A- security rating.
322 Coincidentally, Mr Kay emailed Mr Downing on 9 August 2006 informing him that
Grange had an FRN issued by the Perth based Home Building Society with an interest rate of
BBSW + 0.85% available for investment. Mr Downing replied soon after saying:
“I thought for an unrated FRN, the margin was somewhat slim or am I missing the [sic] something.”
323 Mr Kay replied noting that Mr Downing had made a fair point. He said that margins
of this size were a reality within the ADI sector at that time, pointing as an example to an
Elders Rural Bank BBB- FRN with a coupon of BBSW + 0.61% that Swan had purchased
recently on 7 August 2006. Mr Downing was conscious that although Home Building
Society was unrated and was not offering a significant margin above the BBSW, it was a
permitted investment under the 2003 Swan Policy because it was an ADI. He looked at the
rating and return of products when making investment decisions for Swan.
324 Anthony Keenan of the Commonwealth Bank suggested an investment in a product
called Oasis Portfolio Notes to Mr Downing later in August 2006. Mr Downing queried in an
email why the Oasis BBB notes had a coupon of BBSW + 3.4% when the A notes for the
same product had a coupon of BBSW + 1.95% saying, “This would appear to be a sizeable
margin”. The Commonwealth Bank gave Mr Downing a 25 page long term sheet explaining
aspects of the Oasis product. This was the first time that Mr Downing had received
information about CDOs from someone other than Grange. The Commonwealth Bank had
been Swan’s banker for a long period. Mr Keenan advised Mr Downing that the Oasis A
product was a good one to buy and Swan invested $1 million in it. The term sheet concluded
with an acknowledgment and agreement page that Mr Downing signed for Swan on 1
September 2006. That page recorded that he had read and understood the provisions in the
term sheet dealing with risk disclosure and a disclaimer by the Bank. The copy of the term
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sheet in evidence has added underlining, asterisks and highlighting in various places but there
is no evidence that enables me to find that these markings were made by Mr Downing. He
could not recall having made them and I am not satisfied that he did.
325 Indeed, I think that it is unlikely Mr Downing paid close attention to the fine, or really
any, detail in the term sheet. He concentrated on the identity of the well known United States
and European banks whose names he saw including JP Morgan (an associated company of
which was the trustee) and Société Générale (an associated company of which was the
investment manager of the issue) as well as the role of the investment manager which he
understood could change reference entities in the reference portfolio to strengthen the credit
rating. In contrast to Mr Senathirajah, he was not concerned that there may not have been a
secondary market for the Council’s CDO investments. This was because Mr Downing
regarded these as having been purchased as hold to maturity products with a maximum term
of five years. He said that he tried to have a range of fixed interest products with different
maturity dates over the succeeding five years that suited Swan’s anticipated future cash flow
needs. That is how he had reorganised Swan’s portfolio when he took up his position of chief
financial officer: [280]-[281].
326 Mr Downing said that he understood that an investment in CDOs such as those sold
by Grange and the Oasis A product, were issued by reputable banks and represented a portion
of a structure comprised of securitised loans. He relied on the credit rating given to the
product because he could not examine the underlying structure of the product.
327 Mr Keenan had explained to Mr Downing in response to his email query about the A
and BBB rated tranches of the Oasis product that the difference in margins was due to the
subordination level and leverage factor. Mr Keenan said that the BBB tranche had a higher
risk because it could withstand only five credit events when the A tranche could withstand
six. He wrote that the BBB tranche was more highly leveraged, with 10.5 times leverage,
compared with eight times leverage for the A tranche, saying:
“The higher the leverage factor the higher the return. However, on the flipside, the higher the leverage, the higher the risk.”
328 Mr Downing already understood that leverage in an investment increases both returns
and risks. This came from his commercial experience and studies in gaining his Master’s
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degree. He said that he did not pay much attention to Mr Keenan’s response because he
relied on the credit rating as being, for him, “the determining factor about the quality of the
product”, as opposed to the leverage.
329 Mr Downing said that he understood, from his discussions with Mr O’Dea, that a
credit event was a downgrading of a credit rating for an entity within the CDO structure. He
understood that an active manager for the CDO would manage the portfolio to avoid such
events having an impact on the investment and that, based on what Grange had advised him,
the products had been structured so that the chance of Swan suffering a loss of capital was
negligible or nil.
330 Mr Downing gave little attention to the term sheets for the Oasis product, despite his
signing its acknowledgment to the contrary. Had he read it with any real attention, he would
have seen that its risk disclosure section singled out two risks of an investment in the product:
the “primary credit risk” being that of the reference entities, the issuer and the swap
counterparty: as well as the risk that the notes could redeem below par. The term sheet
stated on p 20 that the notes might:
“… in certain circumstances (for example following a default of a Reference Entity) be valued at a considerable discount to their par value. The Notes may redeem ZERO.” (emphasis in original)
331 I find that by the time he came to consider investing in the Oasis product, Mr
Downing had formed the state of mind that SCDOs and other structured finance products
were appropriate investments for Swan provided that they had a high enough credit rating,
coupon and an initial call date within five years of the time of investment. He arrived at his
understanding that the SCDOs were safe investments based on the explanations he had been
given by Grange and, I have inferred, the fact that Swan was already investing substantial
funds in these products when he became its chief financial officer.
332 No doubt because it was receiving its new rating income at the start of the 2006-07
financial year, in late August 2006, Mr Downing and Ms Le Lievre asked Mr Kay about
suitable ADI issued FRN investments for $2 million with at least an “A” rating. Mr Kay
initially responded with a suggestion of placing $500,000 in an FRN issued by Macquarie
Bank and depositing the balance at 11 am call with BankWest. Later, after a discussion,
Mr Kay suggested investments of $500,000 in Torquay AA with a coupon of BBSW + 1.20%
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and $1 million in Esperance AA+ with a coupon of BBSW + 1.10%, both of which could be
purchased later that week. He also suggested a new product, Blaxland AA- that would issue
on 7 September 2006, offering a coupon of BBSW + 1.45%. Ms Le Lievre responded soon
after, saying that Swan would invest $500,000 in the Torquay product and $1 million in the
Blaxland notes when it settled on 7 September 2006.
333 Mr Downing said that he decided to select the Torquay product, as the middle rated
and yielding of the three SCDOs on offer and Blaxland AA-, the lowest rated, highest
yielding, to balance risk and return. He was aware, in doing so, that the Blaxland product’s
maturity date of 30 March 2012 was 5.5 years later and that this was just outside the
maximum of five years provided in the 2003 Swan Policy. But he was comfortable with this
slight excedence. Later that week on 30 August, Mr Kay emailed Ms Le Lievre again
suggesting two SCDOs that Grange had available for sale the next day, $500,000 worth of
Wentworth AA-, maturing on 30 September 2010 with a coupon of BBSW + 1.05% (a
typographical error for what the term sheet recorded as a margin of 1.50%) and $350,000
worth of Balmoral AA, maturing on 4 March 2009 with a coupon of BBSW + 0.60%. He
attached term sheets for each although the one for the Balmoral product was indicative and
had been prepared prior to the SCDO’s issue in March 2004. Notably this document did not
identify the margin above BBSW that was offered. Mr Kay said Grange also had a number
of highly rated bank issues, including the Commonwealth Bank, Westpac and HSBC
available at around BBSW + 0.2%. Later that day, Swan invested $500,000 in the
Wentworth AA product.
334 The term sheet for the Wentworth AA- product specified “professional only” as the
investors eligible to buy it. The indicative term sheet for the Balmoral AA SCDO stated that
it had a (reference) portfolio of 36 asset backed securities (ABS) and three AA rated CDOs,
with recovery rates for the ABS transactions of 90% and 40% for the CDO reference entities.
Mr Downing paid no attention to the terms sheets because of his understanding that there was
no likelihood that the SCDO investments would not be repaid at maturity. On 1 September
2006 Ms Le Lievre emailed Mr Kay with instructions for Swan’s investment of $500,000 in
the Balmoral SCDO and $1 million in the Flinders product and Grange issued contract notes
for those transactions on the same day.
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335 On 27 September 2006, Mr O’Dea discussed with Mr Downing a proposal to appoint
an active portfolio manager to the Blue Gum Claim SCDO (Swan had invested in this
product in March 2006: see [272] above) and a switch from the very recently acquired
Wentworth AA- SCDO to Scarborough AA, which Mr Downing had previously caused Swan
to buy ([287]). On 27 September 2006 Mr O’Dea faxed Mr Downing a letter together with
post dated letter of consent approving amendments to the terms of the documents relating to
the Blue Gum SCDO providing for the appointment of a named portfolio manager on or
about 29 September 2006. The letter of consent stated that drafts of the amendment
documentation were available for inspection at Grange’s Sydney offices.
336 Mr O’Dea’s covering letter stated that Grange had proposed the appointment of a
manager to enhance the ongoing performance of the Blue Gum transaction and that it
considered this to be in the best interests of investors. He said that the objective of the
appointment was “to maintain or improve the transaction’s current ratings from Moody’s and
S&P”. The letter advised that Grange would forward the issuer’s notice and transaction
documents to investors in a separate email for review prior to signing the consent letter. Mr
O’Dea concluded the letter saying that Grange “strongly recommends that you approve the
amendment proposal”.
337 Soon after the letter had been faxed, Grange sent an email attaching over 145 pages of
documentation. The statement in bold script “GRANGE SECURITIES – WALGA
Preferred Supplier” appeared under the signature details in the email. This seems to have
been a reference to an endorsement of Grange by the Western Australian Local Government
Association as its preferred supplier of financial services. The attachments to this email
comprised a master portfolio management agreement dated 29 September 2006, a notice to
security holders, an amendment to trust instrument agreement, an amendment to credit
default swap confirmation agreement and a 20 page long amended term sheet issued by
HSBC. This was the only occasion on which Grange provided any underlying documentation
in respect of an SCDO to Mr Downing.
338 At the time he received these documents Mr Downing did not have any understanding
of credit default swaps. He accepted Mr O’Dea’s advice that it was in Swan’s best interests
to sign the consent letter and did so. Mr Downing was challenged in cross-examination that
he had failed to understand that Mr O’Dea was encouraging him in his letter to review the
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emailed documents prior to signing the consent letter. Grange criticised him for only flicking
through this raft of material and, in particular, for failing to notice the risk disclosures on the
penultimate page of the HSBC term sheet.
339 I do not consider that it was realistic to expect Mr Downing to have picked up the risk
disclosures or to read the documents sent with the email. First, Grange was strongly
recommending a change to the Blue Gum SCDO that appeared to have only benefits for
investors. That recommendation eschewed any reference to any pitfall or risk in the
transaction. In those circumstances a lay person, in the position of Mr Downing, would have
no reason to read anything apart from the consent letter. Secondly, and tellingly, Grange
itself did nothing to draw Mr Downing’s attention to the risk factors, no doubt for good
reason. These commenced with the following statement that would have made Grange’s
local government clients wonder how it could have sold such investments to them:
“Investment in the Notes is suitable only for financial institutions and highly sophisticated professional investors who are capable of understanding, evaluating and taking considerable risks associated with an investment linked to the credit risk of the Issuer and Reference Entities and the market risk of the Reference Swap Transaction and who can absorb a substantial or total loss of principal. The termsheet is not intended for distribution to, or use by, private customers.” (emphasis added)
340 The concluding words of the above extract referred to “private customers”, such as
the Councils. A professional, in Grange’s position, does not discharge any duty of disclosure
or adequately explain a complex transaction merely by giving its client a copy of voluminous
documentation and inviting the client to look at it, unaided by the professional identifying,
and where necessary, explaining those portions of the documents relevant to the client’s
decision in respect of them. Here, the decision that Grange invited Swan, through Mr
Downing, to make was to agree to its strong and reasoned recommendation for the
appointment of a manager for the Blue Gum SCDO in which Swan had invested previously.
Swan was not a financial institution or highly sophisticated professional investor and under
the requirements of the Western Australian legislation and its own 2003 Swan Policy could
not make investments in which there was a real possibility that it could expose itself to a
substantial or total loss of principal. It had to act as a prudent person in respect of the
investment of public money.
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341 The HSBC risk disclosures in the amendment documentation for the Blue Gum
SCDO included a statement that “a prospective purchaser” should carefully consider all the
risks associated with any investment in the SCDO including, but not limited to the following
five risks:
Credit Risk: This was described as a return linked to the credit of the issuer,
swap counterparty and reference entities but without “protection of principal
or a guarantee of interest”.
Limited Liquidity: This described the absence of any assurances of a
secondary market developing or, if developed, being maintained for the life of
the notes. It also described the possibility that if an investor needed to sell the
notes before the maturity date, it might have to do so at a substantial discount
to the outstanding principal.
“Highly Leveraged Investment – Exposure to full amount of loss for each Defaulted Reference Entity: An investment in the Notes may be riskier than a pro rata investment in a portfolio of the Reference Entities because, after aggregate losses from Credit Events exceed the Attachment Point, if any, investors will be exposed to the full amount of the loss with respect to each Defaulted Reference Entity in excess of the Attachment Point, rather than a pro rata amount of such loss.
Potential Loss of Principal and Interest: The Notes may redeem below par or may redeem at ZERO. Any early redemption amount may vary considerably due to market conditions and will likely be valued at a considerable discount to its par value.”
Conflicts of Interest: This described the possibility of potential and actual
conflicts of interest between the interests of note holders on the one hand and
the issuer and its (unidentified) affiliates on the other.
342 Also, in the morning of 27 September 2006, Mr O’Dea emailed Mr Downing an
analysis to justify his switch recommendation for the sale of the Wentworth SCDO that Swan
had purchased 27 days earlier. By selling Swan would realise a return of $3,750 on its
investment of $514,185 (being the purchase price of the notes including accrued interest). Mr
O’Dea said this represented an annualised internal rate of return of 9.8% commenting:
“Not really a good guide as its such a short period, but it does illustrate how these switches can have a positive effect over time.” (emphasis added)
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343 Mr Downing emailed Mr O’Dea later that day agreeing to the swap on the basis of Mr
O’Dea’s calculations. Mr Downing discussed with Mr O’Dea on 1 November 2006 the mix
of current investments in Swan’s portfolio with Grange. The next day, Mr O’Dea sent Mr
Downing an email informing him that Swan held about $4 million, or 28.57% in bank issued
products out of its total Grange portfolio of $14 million. Mr O’Dea then observed:
“We would see this as a bit biased away from banks but you really need to consider it alongside your total portfolio”. (emphasis added)
344 Mr Downing understood that Mr O’Dea was not in a position to advise Swan on its
overall investment holdings because Grange did not have that information. Mr O’Dea then
went on to suggest some switches. He also advised against Mr Downing’s suggestion of a
switch out of the Elders Rural Bank FRN that Swan had bought on 7 August 2006 saying that
it: “… might be better held onto as they give the best yield in the portfolio for a bank …”.
Mr O’Dea passed on a detailed analysis by Grange on Elders Rural Bank for Mr Downing’s
consideration. Mr O’Dea did not give any explanation why the bias away from the banks
might not be appropriate. Grange did not submit that this advice should have alerted
Mr Downing that banks were a safer investment than SCDOs.
345 The email of 2 November 2006 is revealing. It showed that Grange was providing
Swan with financial advice about the investments in the portfolio established with Grange,
but both parties recognised that Grange was not able to give Swan comprehensive advice
about its overall financial position. Nonetheless, from at least early 2006, Grange searched
and obtained publicly available information on its actual and potential Council clients’
financial positions to assist it in its marketing and business development strategy. Swan’s
overall financial position, including its investments, were made publicly available annually
by the time Mr Downing became its chief financial officer. Grange is likely to have been
aware of the general level of Swan’s non-current investments when its annual accounts
became public. Grange was also broadly aware that Swan, and its other Council clients, had
cash flows to accommodate based around the regular receipts of rate income and the need to
realise investments to meet regular monthly expenditures, as well as for particular projects or
purposes.
346 On 28 November 2006 Mr O’Dea emailed Mr Downing in response to his request
suggesting two switches. The first was from the Balmoral AA SCDO that Swan had acquired
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on 4 September 2006 (see [334] above) to a new SCDO called Kakadu rated AA by Fitch,
which Mr O’Dea said was equivalent to a AA rating by Standard & Poor’s. He attached a
research note on the new product and said that the main benefit was an increase in the yield
from that Mr O’Dea stated was BBSW + 0.64% (being a different margin from that in Mr
Kay’s email of 30 August 2006 of + 0.60%: see [333], to BBSW + 1.0% for the first three
years “… then, if not called, steps up to 90 day BBSW + 1.40%”.
347 Mr O’Dea wrote that Balmoral was “currently valued at BBSW + 0.58%”. The
research note for Kakadu AA commenced with bullet points, the first being “7.25 year term”.
That should have altered both Grange and Mr Downing to the fact that the product was not
authorised by the 2003 Swan Policy because it had a term exceeding five years. However, if
Mr Downing looked at this, he would have taken no notice of it because Mr O’Dea and Mr
Kay had previously convinced him that the only relevant date on which to assess the term of
an SCDO was the call date, because this was invariably the date on which SCDOs with call
dates in fact matured. The research note asserted that the product was, at 6 November 2006,
“of sufficiently high quality to achieve a AAA rating by Fitch” but Grange, which was to be
the manager of the product, had requested “an explicit rating two notches lower in order to
build in a large ‘buffer’ into the AA issue rating. This buffer will help to ensure rating
stability for the life of the transaction”. Grange vaunted in the note that this “buffer” and its
expertise in management “… will strongly enhance ratings stability of Kakadu”.
348 This neatly captured the emphasis that Grange had conveyed to Swan, through Mr
Senathirajah and Mr Downing, that ratings and rating stability of an SCDO were of prime
importance in evaluating the merit of investing in that product type. The note concluded:
“We believe Kakadu offers a very attractive yield to investors seeking yield above the cash rate with minimal risks and ratings stability over the long term.” (emphasis added)
The note had sections headed “Robustness Analysis” and “Risk Analysis”. The former stated
that the credit support of 4.05% provided:
“… a substantial cushion against any defaults. The credit support can withstand 11.5 defaults, based on an average recovery of 40% before a note holder would lose any money on their principal investment.” (emphasis added)
Mr Downing had seen similar statements in other documents but had been comforted by
Grange’s assurances that this was highly unlikely and had never happened.
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349 This and other Grange documents never explained what a fractional default was –
11.5 defaults would appear to mean that, in practical terms, if not actually, the attachment
point for the tranche would be reached by 11 defaults of reference entities, so that if there
were any more than 11 the principal began to erode. The only significance of the fraction is
that for the next default of which the fraction was part, the impact of that default on an
investor’s principal was less than a default after the attachment point had been reached: i.e.
in the example of 11.5 defaults, the twelfth default would only reduce the principal by the
value of a half default, since the other half was absorbed by the tranche below the attachment
point. The fraction was irrelevant and gave the appearance of greater robustness than
actually existed in the structure. Moreover, in the case of the Kakadu AA product, the note
said, without elaboration, that there was “a floating recovery for any defaults that might occur
within the portfolio”. The concept of “floating recovery” involves the use of the current
market value of the debt obligation of the reference entity that has suffered a credit event (see
[45] above). Thus, the use of an average 40% was an assumption in the robustness analysis.
However, both the robustness analysis and the risk analysis stated that the investor might
suffer a loss of principal.
350 The second switch that Mr O’Dea suggested in his email of 28 November 2006 was
from the Elders Rural Bank FRN into the Lawson SCDO2 that was rated AA by both
Standard & Poor’s and Fitch. Mr O’Dea said that Swan could buy the Lawson product with a
coupon of BBSW + 1.10%, resulting in an increased yield for Swan of 49 bps. Later that
day, Mr Downing emailed instructions to Mr O’Dea to effect both switches (Kakadu AA for
Balmoral AA and Lawson AA for the Elders Rural Bank FRN).
351 The next day, 29 November 2006, Mr Kay emailed Mr Downing suggesting that
Swan switch from the Newport SCDO to the Kakadu AA product. Mr Kay remarked that the
Newport product had performed below expectations had been downgraded to AA- and “has a
fair outlook at best”. Grange offered to buy the Newport product at par and, so, without loss
to Swan. Mr Kay observed that there was a possibility that it could be revalued downwards
again in the next month. He explained that switching the $500,000 principal into Kakadu
AA, would move the investment “from a portfolio with a poor outlook to a new, very robust
portfolio”. He said that he “definitely recommend[ed]” the switch and added:
“For a portfolio of your size, having a holding of $1m in a CDO which has been built as robust as Kakadu has, is fine.”
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Unsurprisingly after this encouragement Mr Downing emailed back later that day approving
the switch.
352 However, the change in fortunes of the Newport product and of Grange’s view was
dramatic. Only 10 months earlier Mr Kay had described the Newport AAA SCDO as “an
exceptional deal” and encouraged Mr Senathirajah to “consider it strongly” (see [269]). The
reality was disclosed in Grange’s business summary prepared by Mr Vincent for its board
meeting of December 2006. (The heading of the document referred to the meeting date as 1
November 2006 but the text showed that the reports included the performance of the business
for November and referred to anti-money laundering legislation passed by the Parliament on
7 December 2006). Grange had sold $105 million worth of the Kakadu product, receiving a
margin of 2.25%. That was the second largest transaction it had executed. However, as Mr
Vincent explained to the Grange board:
“… the volumes were inflated by a lot of switching for Newport (circa A$ 95 MM) which was sold back to JPM[organ] on a switch basis for Kakadu. We took a slight loss on this position buying from clients at 100 and selling to JPM at 99. Hence total fee on the combined switch were in the order of A$ 1.5 MM. A highlight of the Kakadu transaction was Grange being successfully received as manager of the transaction. This is both a “defensive” and “offensive” move from a business perspective. It is “defensive” in that to maintain ratings stability of many of our transactions going forward a manager will be required. This is simply a function of the rating agency modelling process and not a belief that managers can outperform the market significantly. It is “offensive” in that it gives us the opportunity to build another business line, that in time maybe expandable beyond our own CDO business. We obtained 20 bps running fees for management of Kakadu (A$210K per year for 7 years) so it builds a nice annuity stream.” (emphasis added)
353 Thus, Grange maintained the impression among its Council and other clientele that
the SCDOs were a safe investment – even after a significant downgrade from AAA to AA-,
with a possibility of further downgrading – Newport was repurchased by Grange at par and
switched for a new product. And Grange shielded its clients from realising the fragility of
SCDO values or the possibility that they could fall below par, by buying the Newport notes
back at par. However, as Mr Vincent noted, Grange made a loss of $1 per $100 of face value
on that purchase. By getting its clients to switch out of the deteriorated Newport product at
par, Grange maintained the impression that these products had a high degree of capital
stability and minimal risk of loss. Mr Downing’s reaction to the small loss on the earlier
switch makes it unlikely that had Grange apprised Swan and the other Councils that the only
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reason that it was possible to sell the Newport notes at par, or at any price close to par, was
that Grange had itself arranged a switch for the whole issue with JP Morgan. And, Grange
made a significant profit with ongoing management fees on that switch, not to mention its
profit on the initial sale of the Newport product of over $3 million based in its margin of
2.67% on most of the total sales of $126 million.
354 In addition, Grange’s Trading System database showed that despite the apparent
reversal of the Newport product’s fortunes in late 2006, Grange was executing “no haircut
repos” with its clients using that SCDO as security. For example, on 4 October 2006
Mr M Hindle sent an instruction to staff stating:
“We MUST fund the following stock TODAY
$3.8 m … Newport AA”
Within 20 minutes Grange, through Ms May, had effected a no haircut repo for the Newport
product, that had been downgraded from AAA to AA by this stage, with Gosford City
Council lending Grange the $3.8 million for five days.
4.3 2007: Swan enters into an IMP agreement with Grange
355 On 15 January 2007, Mr Kay emailed a draft IMP agreement to Mr Downing. This
followed a meeting in November 2006 at which Mr O’Dea invited Mr Downing and Swan’s
executive manager, Max Hunt to consider engaging Grange under an IMP agreement to
manage its entire portfolio of investments. Mr Downing said that they were interested and he
would prepare an internal paper for discussion at Swan’s management executive committee.
356 On 30 January 2007, that Committee met and agreed to arrange a briefing by Grange
to be followed by a report for a general meeting of the Council.
4.3.1 The Swan IMP agreement
357 On 9 February 2007, Swan entered into an IMP agreement with Grange. The
agreement recited that:
Grange was a provider of portfolio management services;
Swan had asked it to manage its portfolio; and
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Grange had agreed to do so on the terms set out.
The defined terms included:
“Service means those services which Grange may provide in connection with the management of the Portfolio, including investment research, analysis and advice, Securities execution and settlement services, safe custody services and reporting and administration services.”
358 Swan appointed Grange as its “… agent with all powers necessary to provide the
Service in accordance with the terms set out in this document” (cl 2.1). Grange had authority
to deal with any or all of Swan’s portfolio of cash or financial products that Grange managed.
It had power to buy, sell and exercise powers of investment in respect of, any asset in the
portfolio, as well as doing “anything else in connection with the Portfolio which Grange
considers proper or necessary” (cl 2.2).
359 Critically, cl 2.3(a) provided that unless Swan otherwise agreed, Grange had to
provide the Service in accordance with the Guidelines set out in Sch 2 of the agreement.
However, the portfolio could depart from the Guidelines in a way that was not material
(cl 2.3(d)). In addition, Swan had the right to request in writing that any portfolio assets be
removed. Grange had to remove any asset that Swan requested at the prevailing market price
within 30 days subject to Grange’s right to deduct its fees and charges under cl 2.4(d)
(cl 2.3(c)).
360 Swan agreed to pay Grange those fees and charges in consideration of its providing
the service (cl 2.4(a)). Relevantly, Sch 3 provided:
“SCHEDULE 3 FEES AND CHARGES • Nil for the first six months of the agreement. • After six months fees revert to 0.10% (excluding GST) of funds under
management up to $10 million, 0.065% of funds under management from $10 million to $50 million and 0.03% for funds under management above $50 million. This fee incorporates reporting, investment policy and strategy consulting, and administration and safe custody services.
• Grange is entitled to receive up to 0.30% (excluding GST) of the market
value of any listed securities charged on transactions placed for the portfolio. There is no brokerage for unlisted securities and no trailing commission paid on direct investments however, should Grange recommend a managed
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fund for the client, all such commission fees will be rebated to the Client. • Grange may be entitled to other fees in relation to the placement of listed
and unlisted securities. These fees will be paid to Grange by the Issuer of the security. Grange will on request, disclose any such fees that it may be entitled to receive.” (emphasis added)
361 Importantly, Sch 3 only required Grange to reveal its commissions and fees from
issues of SCDOs “on request”. In addition, cl 2.5 of the IMP agreement provided:
“2.5 Transacting as principal
To the extent permitted by the law, the Client: (a) consents to Grange, or a representative of Grange, entering into
transactions as principal on the account of Grange (or a representative of Grange);
(b) consents to Grange knowingly or unknowingly either as principal or
on behalf of another person, taking the opposite side of a transaction to the Client; and
(c) agrees to pay the appropriate fees and charges (set out in Schedule 3)
in respect of such transactions, and Grange must notify the Client of such transactions as required by the Corporations Act and the Rules.” (emphasis added)
The “Rules” were the Market Rules of the Australian Stock Exchange Ltd (ASX) applicable
to clearing of transactions entered into by Grange under the IMP agreement.
362 Grange had to provide monthly reports on the portfolio to Swan (cl 5.1). Swan
acknowledged and warranted that, among other matters:
Grange did not guarantee the payment of income or the return or repayment of
capital invested in the portfolio (cl 6.1(a)(iii));
Grange had not made any representations or warranties regarding the
performance or profitability of the portfolio (cl 6.1(a)(iv));
Swan understood the (unelaborated) risks involved in the provision of the
service and that the portfolio may decrease in value (cl 6.1(b)).
The investment guidelines in Sch 2 of the IMP agreement required the portfolio to be
invested in accordance with the 2003 Swan Policy, that was set out in Sch 4, as amended
from time to time. The performance objective was to exceed the UBS Australia Bank Bill
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Index plus 0.35% after fees over a rolling 12 month period in accordance with the investment
guidelines. Relevantly, Sch 2 limited Grange’s responsibilities to those investments it made
as follows:
“The Portfolio must be invested in accordance with the City of Swan’s current investment policy, as set out in Schedule 4 of this Agreement, as amended from time to time (the “Policy”), on the basis that: • references in the Policy to “Council’s direct investments”, and any references to
the City of Swan’s “total investment portfolio”, or words or phrases analogous thereto, shall be taken to mean the portfolio of cash and/or financial products under management by Grange from time to time (and not the total City of Swan funds available for investment), with respect to Grange’s compliance with the investment guidelines.
• Grange will not be held responsible for the allocation and exposure of City of
Swan’s total portfolio of investments on the basis that Grange will not have any control over cash and financial products held, or controlled by, or on behalf of, the City of Swan outside of Grange’s management; and
• City of Swan agrees to notify Grange in respect of any amendments to the Policy
or in the event the Policy is revoked or replaced and ensure that Grange is provided with each adopted version of its investment policy in a timely manner.” (emphasis added)
4.3.2 Grange’s dealings under the Swan IMP agreement
363 Grange used the IMP agreements it had with Councils, like Swan and Wingecarribee,
as a means of ensuring that it would be able to subscribe for new SCDOs and, where it
needed money, “no haircut repos”. While Grange had to report to its IMP client, it had the
freedom to use the mandate as it saw fit. And it did. The IMP agreement relieved Grange
from the need to explain to the client beforehand any dealings it chose to make using the
mandate. Grange’s representatives would explain what had been done, if the client enquired
about trading on the IMP account.
364 Thus, once Swan had entered into the IMP agreement, Grange continued to send
contemporaneous bought and sold notes to Ms Le Lievre, but no longer discussed the trading
with her or Mr Downing before it was effected. So, on 14 February 2007, Grange effected a
switch of $500,000 worth of a new product, Kalgoorlie AA+ for one third of Swan’s holding
in the Scarborough AA SCDO that Mr Downing had agreed to buy in May 2006 (see [287]
above). Shortly before this switch, Mr O’Dea had made a presentation to Mr Downing on the
Kalgoorlie product, using slides dated 30 January 2007. Mr O’Dea explained that this was a
new form of investment, being a managed commodities backed security: see [60]. It had a
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five year term maturing on 27 February 2012, and had a coupon of BBSW + 1.3% (A/5824).
Mr O’Dea explained that the product related to the pricing mechanisms of commodities.
Mr Downing responded that he did not understand how the product worked and was not
interested in proceeding with it. He said that he could not recall providing permission for the
switch between the Scarborough and Kalgoorlie Claim SCDOs of 14 February 2007 and was
not aware that it had happened after Swan had entered the IMP agreement on 9 February
2007. I accept Mr Downing’s evidence about his disinterest in having Swan invest in the
Kalgoorlie product and his not having given permission for the switch to occur. I infer that
the switch was effected by Grange using its authority under the IMP agreement.
365 After the IMP agreement was entered into, Grange sent Swan monthly “fundmaster
reports” that identified its portfolio holdings and what Grange said were their market values.
On 13 March 2007, Grange emailed the first report for Swan’s portfolio as at 28 February
2007. This showed, among other things, the above switch and Grange’s acquisition of about
$4 million in bank issued FRNs for Swan’s portfolio. This appears to have increased the
proportion of Swan’s investments in FRN securities issued by ADIs. However, it is not
completely clear that this was the position because there was no evidence of the exact nature
of Swan’s investments made independently or through its other advisers prior to its entry into
the IMP agreement. Nonetheless, as Grange argued, it did not use its new mandate to invest
principally in SCDOs. No doubt, some of the FRN investments were made because Swan
would need cash on a regular basis to meet its monthly or regular expenses. Grange is
unlikely to have wanted to use its IMP agreement mandates to invest only in SCDOs, lest it
be exposed to having to buy only those products back when clients, like Swan and other
Councils, would require funds to meet their ongoing cashflow needs. Indeed from early 2006
Grange had been conscious that it held a significant amount of SCDOs on its books that
created a potential risk to it. Thus in his November 2006 report to Grange’s board, Mr Hagan
noted that Grange had reduced its maximum potential loss exposure by about $20 million, to
$13.5 million largely due to a reduction in its SCDO inventory and increased hedging.
366 A revealing email exchange concerning how Grange used IMP agreements occurred
on 14 and 15 September 2006 between Cameron Rae, Grange’s director, debt capital markets
and Mr Clout. Mr Rae initially wrote to Mr Clout about the Grange board’s concern to lessen
its risk from the size of its holding of SCDOs. Mr Rae wrote:
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“The IMP pitch concerns me. We are basically flogging IMPs (from the various pitches I have heard/seen) as an alternative to a cash fund. If I recall, the genesis of this pitch was originally designed to combat those mid market (read council) clients that liked the idea of a “managed” alternative. There is no doubt this pitch (product) has been successful and will continue to be an important part of our business. My concerns lay with the aggressiveness that the liquidity of an IMP is sold. The standard line is pushed pretty hard as T+2 [trade + 2 days] for cash back or 30 days to wind up the whole portfolio. This combined with drive to keep returns up by continually showing profits on trades rather that focusing on the IRR of the investment is setting some pretty strong precedence with clients. The total funding book is now $300 mil. As IMPs grow and the expectation of instant liquidity remains, I think we are only adding to the pressures the book already has. From a risk perspective, we only need to experience a small move away from CDOs or sector wide liquidity event to put some serious pressure on the book. The risks are two fold. We either piss off clients who we told liquidity is guaranteed and undermine the reputation that has taken us years to build, or we protect our reputation and add risk to the book. Neither is a great result. ... There is no doubting the returns on the IMPs are impressive and help drive sales, however with the IMP performances being a standout I think there is room for adjustment with no long term effect on the growth of the product. At the end of the day we are providing a premium liquidity service, entirely to the risk of Grange and are not being adequately compensated. I would be happier if we came up with an alternate product/solution to meet mandate cashflows and leave the driver for trading as good trade/switch ideas that benefit both the client and Grange rather than being forced to do trades to the book for short term client liquidity.” (emphasis added)
367 Mr Clout replied accepting Mr Rae’s comments as “very valid”. However, Mr Clout
considered that most of the then Council IMPs were “long term mandates whose liquidity
requirements are relatively minor”. He noted that most drawdowns of cash by Councils were
able to be forecast well in advance. Mr Clout said that he understood the 30 day cancellation
of Grange’s mandate to be merely a notice period and that Grange did not have to liquidate
the portfolio. He concluded:
“We mustn’t lose sight of the benefit that having the IMP[s] provides for a base for underwriting trades. In terms of adequate compensation we do receive a large amount of fees, the legacy of which means we have to provide an element of liquidity as the major player in the market. It is worthwhile trying to nut out a solution to this and gather the right troops together to discuss this urgently.”
368 Mr Rae’s recognition of the risk to Grange from providing that “premium liquidity
service” was telling. That risk, inherent in the SCDOs, had been misrepresented, time and
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again, by Grange in its sales pitches for the SCDOs. As both Mr Clout and Mr Rae revealed
in the above exchange, by telling its clients that it would provide a secondary market, Grange
was, in substance, concealing the illiquidity of SCDOs and much of the associated risk from
its clients in order to make substantial profits. Moreover, Mr Clout was candid that the IMP
agreements enabled Grange to have a significant basis for “underwriting” new SCDO issues.
That was because the IMP clients did not need to be persuaded to engage in transactions;
Grange made the decision to do so for its clients and thus could be assured of having
available so much of the IMP clients’ funds as it needed to engage in the sale of new issues.
369 On 16 March 2007 Grange switched $500,000 worth of Swan’s Endeavour AAA
notes for a new product, Coolangatta AA. Each had the same coupon, BBSW + 130 bps.
The Endeavour product had a maturity date of 4 August 2011, while the Coolangatta SCDO
had a call date of 20 March 2011 and a final maturity of 20 September 2014. Swan earned a
capital profit of $10,000 on the switch. However, the final maturity date of the Coolangatta
product resulted in its acquisition breaching the 5 year maturity limit on investments in
cl 2.6(a)(ii) of the 2003 Swan Policy.
370 After Lehman Bros acquired Grange, Grange promoted SCDOs that its new parent or
group members had arranged. One of those was the Federation AAA rated credit linked note.
This SCDO was linked to the performance of a portfolio of residential mortgaged backed
securities. It had been rated by Standard & Poor’s. Mr O’Dea and Mr Vincent made a
presentation to Mr Downing in a coffee shop next to Swan’s office. Mr Vincent used the
slides, or an earlier version, that Mr Kay had emailed to Mr Downing on 2 April 2007.
Mr Downing realised the IMP agreement was then in place and indicated that Swan had no
funds to invest at that time. I infer that the reason for the presentation was that Grange
intended to use its mandate power to cause Swan to invest in the Federation product, as it
later did. The presentation served as a pre-emptive assuagement of Grange’s clients’ likely
concern if they later saw that the IMP mandate had been used to invest their funds in an
RMBS linked SCDO in circumstances that Mr Kay addressed in his 2 April 2007 email to
Mr Downing as follows:
“Federation AAA utilises similar structuring to our previous corporate credit CDOs, however the underlying credit that is referenced is in the form of US residential mortgages. It will be issued on the 2/5/2007 and will reference 40 RMB bonds (each containing approx. 7500 individual mortgages).
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There has recently been negative press/sentiment towards the housing market in the US, however Federation AAA has been built to withstand default conditions much more severe than historical averages. Our structured credit team have done a significant amount of work on this trade and feel that the market offers a very good opportunity at present – Federation AAA looks to take advantage of this. I have attached the term sheet, along with our presentation (which contains a report recently written by Moody’s which details the current situation and clearly states that they feel it is a cyclical phenomenon and is no worse at precent [sic] than it has been a number of times historically.” (emphasis added)
371 Mr Downing did not read the presentation or the Moody’s report because he did not
think Swan would invest in the product. As a result, he did not notice that, unlike earlier
slide presentations, the one for the Federation product had, in the emailed version of March
2007, a summary of risk factors that covered two pages in small print. The subsequent April
2007 version of that presentation had nearly four pages of risk factors. Some of those risk
factors were repeated verbatim from the Offering Memorandum for the Federation SCDO
and included that for “volatility” set out at [92] above. Grange added the following as its
explanation of the product’s liquidity:
“Limited Liquidity. There is currently no market for the Notes. Although Grange Securities may from time to time make a market in the Notes, Grange Securities are under no obligation to do so. In the event that Grange Securities commences any market-making, Grange Securities may discontinue the same at any time. There can be no assurances that a secondary market for the Notes will develop, or if a secondary market does develop, that it will provide the holders of the Notes with liquidity of investment or that it will continue for the life of the Notes.”
372 There is no evidence that this explanation of Grange’s role was drawn to
Mr Downing’s attention or explained to him by Mr Vincent and Mr O’Dea. That role was
radically different from its role in relation to a secondary market for SCDOs up to that time.
I am satisfied that that explanation was not drawn to Mr Downing’s notice or explained to
him. Moreover, even if it had been, it fell short of the offering memorandum’s explanation of
the same risk, which was as follows:
“There is currently no market for the Notes. Although the Initial Purchaser may from time to time make a market in the Notes, the Initial Purchaser is under no obligation to do so. In the event that the Initial Purchaser commences any market-making, the Initial Purchaser may discontinue the same at any time. There can be no assurances that a secondary market for the Notes will develop, or if a secondary market does develop, that it will provide the holders of the Notes with liquidity of investment or that it will continue for the life of the Notes. In addition, the Notes are subject to certain transfer restrictions and can only be transferred to certain transferees as described under “Transfer Restrictions” and “Certain ERISA Considerations”. Such restriction on the transfer of Notes may further limit their liquidity.
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Consequently, an investor in the Notes must be prepared to hold the Notes for an indefinite period of time or until the Final Scheduled Payment Date.” (emphasis added)
373 That section of the offering memorandum, headed “Risk Factors” began, tellingly:
“An investment in the Notes involves a high degree of risk. Prospective investors should carefully consider the following factors, in addition to the matters set forth elsewhere in this Offering Memorandum, prior to investing in the Notes.” (emphasis added)
374 Swan suffered no loss from a sale of its investment in the Federation product.
Wingecarribee did. However, Grange relied on the statement of risk factors in the slide
presentation as being sufficient to alert Mr Downing and, through him, Swan to the relevant
risks of SCDOs, to the extent that they were not aware of them before. I reject that
reasoning. By the time this presentation was made to Mr Downing, he had been accustomed
to receiving explanations orally through use of the presentations. He was not cross-examined
to suggest that anyone from Grange had taken him through any of the risk factors in the
Federation or any other presentation or otherwise. And, I am satisfied that none of the
Councils or their officers were told the plain, simple and true message applicable to all the
SCDOs in the introduction to “Risk Factors” in offering memorandum:
“An investment in the Notes involves a high degree of risk.”
375 Had that been said, as it should have been, none of the Councils would ever have
made an investment in the Claim SCDOs. Moreover, the statement was accurate and
demonstrated, at least for the Federation Claim SCDO, that the product was an unsuitable
investment for any of the Councils using public money.
376 On 8 May 2007 Grange sent Swan a contract note recording that Swan had bought
$500,000 in the Federation AAA product and sold $450,000 at face value of its Kakadu
SCDO holding. The Federation product had a coupon of BBSW + 100 bps and a final
maturity date in February 2047, with a call date of 9 May 2010. The issuer was Lehman Bros
Treasury Co BV. Given the final maturity was nearly 40 years later, the investment was in
breach of the 2003 Swan Policy.
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4.3.3 Mr Cameron succeeds Mr Downing in May 2007
377 Mr Downing left Swan to take up another position in about early April 2007.
Mr Cameron became Swan’s executive manager of corporate services and took over
Mr Downing’s investment responsibilities. At that time, Mr Cameron understood that an
FRN was issued by a bank and was similar to a term deposit, but with a floating interest rate
rather than a fixed rate. He had never heard of a CDO at that time.
378 On 25 May 2007, Ms Le Lievre emailed Mr Kay informing him that Swan needed
$3 million by 31 May to pay its monthly creditors. Grange sold $1 million in FRNs and
$2 million of SCDOs (Lawson AA, Quartz AA, Flinders AA and Nexus AA+) on 30 May
2007 to realise the required amount.
379 On 30 May 2007, Mr Kay emailed Mr Cameron to introduce himself saying:
“As I am sure you are aware, the City has utilised Grange as an investment adviser since 2003.” (emphasis added)
380 Grange argued that this self description was not an accurate legal characterisation of
its relationship to Swan or the other two applicant Councils. However, the description
encapsulates the way in which Grange portrayed itself to the Councils. It repeated the theme
that Grange was a financial adviser on whom Swan could rely, a theme that had been at the
forefront of its background note that Mr O’Dea had sent to Mr Senathirajah on 18 August
2003 (see [178]) above).
381 Mr Cameron reviewed the May 2007 reports that Grange sent to Swan on 7 June
2007. He understood from the executive summary report that its references to the top five
securities as “ADI FRNs” and “CDO FRNs” were to different types of FRNs. The report did
not use, or explain, the term “CDO” and he did not understand what either prefix “ADI” or
“CDO” signified. Instead he focused on the ratings. Mr Cameron left Ms Le Lievre to
maintain and reconcile the information on investments. He was not aware of who had a
delegation to make investment decisions before the end of July 2007.
382 Grange sold Swan, under its mandate, a principal protected property note for
$300,000 that was issued by Lehman Bros Treasury Co BV on 13 June 2007, called the
“Lehman Bros Property Note”. That note had a coupon of the yearly (as opposed to the
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normal 90 days) BBSW without any further margin. It matured on 15 June 2009. The last
sale Grange made to Swan was on 6 July 2007 of the Flinders Claim SCDO with a face value
of $250,000 at a yield of BBSW + 95 bps and a capital price of $100.860 per $100 of face
value. It had a coupon of BBSW + 150 bps, a call date of 20 March 2009 and a final maturity
date of 20 March 2012.
383 The reason why Grange sold Swan the Flinders SCDO amounted to an abuse of its
position under the IMP agreement. Mr Clout explained Grange’s reason in a reporting email
he wrote to James Singh of Lehman Bros on 10 July 2007. On the previous day Mr Clout
had reported in an email that Mr Hagan had asked Credit Suisse to value the Flinders SCDO.
The Credit Suisse valuation was significantly different to Mr Hagan’s and resulted in Grange
embarking in the previous week on a selldown of $10 million worth of the Flinders’ product
that it had been accumulating until then. Mr Clout anticipated in his email of Monday, 9 July
2007 that Grange would sell a further $4-6 million during the then coming week. Mr Clout
explained in his email of 10 July 2007 that:
“Over the last few weeks we had built a position in Flinders through sales and switches with customers allowing customers to take profits and gross up returns into other high quality deals. We see high turnover in this stock and we saw advantage in holding a security which we believed had significant liquidity as evidenced by the volume of turnover in this security alone. The Flinders deal was also showing a strong book reval[uation] from risk management. This was the case until a random revaluation was received from Credit Suisse which showed a valuation some $8 below our internal benchmark. We sold $11m of Flinders in the 2 days following receipt of the CSFB valuation and will complete the sales of a further 4-7m by weeks end as further evidence of Flinders’ liquidity.” (emphasis added)
384 In other words, the Credit Suisse valuation was about 8% less than the face value of
the Flinders notes. But, Grange sold them to Swan at a price greater than their face value,
and without any substantive discount to reflect both its own fear of the risk implicit in the
new valuation or its own attribution of value to that product. The only reason why the
Flinders product had, what Mr Clout called “liquidity”, was because Grange was the
secondary market. Grange had unsophisticated council officers and others as clients who had
given Grange a mandate in IMP agreements or had no access to information such as the
Credit Suisse valuation with which to judge a recommendation from Grange to buy the
product. This sale to Swan using its mandate at apparent full value without any disclosure at
all that Grange was doing so in the belief that the product was significantly overvalued was
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an abuse of Grange’s fiduciary duty. It was also illustrative of how cynically Grange could
use, or misue, the trust reposed in it by its IMP and Council clients.
385 Grange submitted that there was no evidence that the sale price to Swan of the
Flinders Claim SCDO at this time was greater than the market, or at too high a value. I reject
that submission. First, Grange’s own informed assessment was sound evidence of value. It
did not move to protect its own economic position from being exposed to holding the
Flinders SCDO out of altruism. It acted on the best information as to value available –
information it did not reveal, for obvious reasons, to those who trusted it with the IMP
agreement mandate or as a financial adviser. Secondly, on 20 August 2007 Mr Calderwood
sent an email to Mr Clout and others seeking “an official Lehman [as Grange now was]
response” to queries being made by Councils about revaluations of SCDOs that had by now
received media publicity. Burwood Council, which had an IMP agreement with Grange for
its entire portfolio of investments, had written to Mr Calderwood on 17 August seeking
background information on the Flinders notes in its portfolio “… including when acquired or
placed in portfolio and a history or its valuations since acquisitions [sic]”. Mr Calderwood
explained how he saw that query as follows:
“I believe they [Burwood Council] are being pushed into this request and may lead to very large consequences. So I don’t want my neck out on its own on this. To let those know, we sold Flinders/purchased Blaxland July 9th, then revaled it at 70 2 weeks later (while Blaxland revaled at 94). This is what Council/the Department/press/Audit or whoever it is are homing in on. (Coffs [Harbour Council] asked for the Blaxland reval last Thu for July 31st) I will await our official line on this trade which needs to be properly prepared for where it may lead.” (emphasis added)
386 The internal revaluation of Flinders to 70 (i.e. $70 per $100 face value) was a further
downgrading of Grange’s assessment of its value following the events referred to in
Mr Clout’s earlier email of 10 July 2007.
387 Grange knew more about the value of the Flinders SCDO at 6 July 2007 than its
client, Swan. It had an independent valuation that it had commissioned and acted on. It sold
about $10–16 million worth of Flinders notes to its clients for at or better than face value,
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implicitly representing to them that it was an investment that was appropriate when it
believed the product was not worth the risk of keeping on its own books.
388 On 20 July 2007, Grange purchased the Blaxland product at face value of $500,000
from Swan.
389 On 24 July 2007, Mr Kay emailed Mr Cameron with Grange’s response to press
articles that were discussing the problems being experienced by ABS and RMBS invested in
by the United States hedge fund called Bear Stearns. Ultimately the ramifications of the
collapse of RMBS securities, including those owned by Bear Stearns (that, in turn, led to its
collapse) developed into what became known as the global financial crisis of 2007 and 2008.
Mr Kay’s email commenced by referring to “a lot of negative press around structured credit
(in particular CDO’s) over the past couple of weeks”. Mr Kay asserted that much of the press
coverage was “misplaced” and had been addressed in the attached response of Stephen
Roberts, Grange’s chief economist, dated 19 July 2007. That response sought to explain
differences between the Bear Stearns CDOs, that were ABS or RMBS and, according to
Mr Roberts, of uncertain ratings. Mr Roberts said these were “in stark contrast to the vast
majority of CDOs which Grange issues, which are very senior and rated AA- or above”.
Mr Roberts referred to a recent statement in response to a question on Councils investing in
CDOs by the Governor of the Reserve Bank of Australia, Glenn Stevens. The Governor said
that Councils should be aware of the risks involved in their investments. Mr Roberts
asserted:
“Grange is aware that local government guidelines require that councils should know the risks involved in their CDO investments. In our Local Government Markets Brief dated June 2007 we included a section which defined various types of CDOs, this is attached. In the wake of issues with sub-prime mortgages in the United States and problems arising for low-rated CDOs that invested in those loans, some commentaries have sought to lump all grades of CDOs and the tranches within CDOs in a single basket. This approach is the same as taking a triple “C” rated corporate bond and a triple “A” rated Australian Commonwealth bond and saying that the risk characteristics of both bonds are the same. Clearly, this is not a valid comparison of risk. Equally, it is not valid to take the vast majority of CDOs that Grange has issued at AA- rating and better, which are predominantly backed by good corporate risks, not sub-prime mortgage risk, and say they are subject to similar risks to the very low grade CDOs that invested primarily in sub-prime mortgages. There is no linkage in the risk profile of Grange’s high grade, corporate risk-based CDOs with the risk profile of low grade CDOs that have invested in the sub-prime part of the residential MBS market.” (emphasis added)
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390 Mr Roberts also reassured Grange’s investors in the Federation SCDO that even
though it was an RMBS, it was:
“highly rated and positioned high in the capital structure. The current market events may cause some short term Mark-to-Market volatility, but this should be a non-event for our buy-and-hold investors.”
391 That explanation focused on the use of ratings as indicators of the risks and risk
characteristics of investments. The explanation did not explain that Grange was the
secondary market, nor did it explain what were the risks of the Councils’ investments in
CDOs “which Grange issues”. Instead, Grange, once again, used the current credit rating of
the products it had sold as indicative of risks, subtly inviting the Council officers who would
read it to compare these favourably with AAA rated Commonwealth Government bonds.
This reinforced the explanation of risk and its relationship to ratings that Grange had given in
its earlier sales presentations.
392 When Mr Cameron read the explanation he was struck by the reference to “CDOs”
and made the connection with what he had previously seen in the monthly investment reports.
He understood that Grange was seeking to allay Councils’ fears in relation to their
investments in the Federation product. He telephoned Mr Kay and began discussing with
him the nature of the CDO investments. Mr Cameron had such discussions for some months.
In August 2007 Mr Cameron asked Mr Kay for the contract between Grange and Swan to see
if the Federation product had been purchased in accordance with the agreement and the 2003
Swan Policy. At one point Mr O’Dea reassured him that the Council should continue to hold
its CDOs (meaning the Claim SCDOs) saying that what was happening in international
financial markets was “just market jitters” and that the CDOs would come good again.
393 In particular, Grange recommended throughout the period from late July to mid
December 2007 to Mr Cameron that Swan should hold its Federation SCDO. On
19 December 2007, Mr Kay emailed the original slide presentation for the Federation product
to Mr Cameron and followed this up with the 93 page Offering Memorandum dated 9 May
2007. Mr Cameron read through the seven pages of small type setting out the risk factors,
including those that I have quoted above. He came then to appreciate that the product had
limited liquidity, and more importantly that an investor could lose all its capital saying that
this was of great concern to him. And then he pondered “… how it could have had a AAA
rating”?
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4.3.4 Events after 2007 involving Swan
394 Grange wrote to Swan on 25 March 2008 that it would no longer perform reporting
functions for it, including valuations of its holdings, after the end of April 2008. Swan then
engaged Grove and later Oakvale to provide it with services. In early September 2009
Oakvale recommended that Swan sell its holdings in the Kalgoorlie, Blaxland (each of which
had face values of $500,000) and Flinders (with a face value of $250,000) SCDOs. Mr
Cameron said that he decided to sell because he considered that the Kalgoorlie product was a
CDO based on commodity prices at its maturity and commodity prices had been down for
some time. He was concerned that there could be a “double dip” in the global economy and
that this could lower commodity prices. He was concerned that this could cause the
Kalgoorlie product to suffer losses or fail and so had sought the advice from Oakvale as to
what Swan should do.
395 Oakvale effected a sale of the Kalgoorlie holding on 18 September 2009 for
$433,773.95 (a capital price of approximately 86.40c per $1 of face value), having given
Swan an indicative price of 85c in the dollar of face value (approximately $425,000).
Oakvale had given Swan indicative prices for the Blaxland and Flinders notes at 53c and 58c
in the dollar respectively. Mr Cameron explained that, what may have been an adventitious
delay in selling the Flinders Claim SCDO, was caused by the parcel size being below the
$500,000 minimum face value required for trading through Austraclear.
4.3.5 Other factors going to causation of Swan’s investment decisions
396 Grange referred to both Mr Senathirajah and Mr Downing having received and acted
on information from other securities vendors about CDOs. It argued that these circumstances
revealed that, first, each of Mr Senathirajah and Mr Downing was able to read what other
reputable and apparently knowledgeable financial organisations said about CDOs, their risks
and quality as investments, secondly, each of them caused Swan to invest in SCDOs sold by
other financial institutions having had those vendors explain the risk of doing so. Thus,
Grange contended any deficiencies in its explanations of SCDOs would have been cured by
the explanations, written and oral, given by the other vendors. It submitted that
Mr Senathirajah and Mr Downing made their own decisions, aware of the risks, and were not
caused to invest by any deficiencies in what Grange had told them.
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397 In late October 2003, FIIG Securities Ltd sent an unsolicited email to Mr Senathirajah
offering a new AAA CDO together with a short two page attachment explaining CDOs.
Mr Senathirajah regarded FIIG as just a broker that was not providing Swan with advice. Not
wanting to get involved with FIIG because the Council had just began its relationship with
Grange, he paid no attention to this email. I am not satisfied that Mr Senathirajah opened the
attachment, the nature or significance of which was not explained beyond “cdo.pdf” in the
text of the email.
398 Next, in early September 2004, FIIG sent an email to Mr Senathirajah offering to buy
or sell CDOs. The email, suggested that other CDOs, even if higher rated, may not be of the
quality of that being offered by FIIG. Mr Senathirajah also put this to one side as an
unsolicited communication from someone trying to sell Swan a product. He considered that
Swan had a satisfactory relationship with Grange. He thought that it was filtering out the
CDOs that were suitable for the Council so there was no reason to consider what FIIG
suggested.
399 In late August 2005, David Loder of Westpac approached Mr Senathirajah offering to
sell Swan a CDO called Beech Trust with AAA and AA tranches, and a principal protected,
hedge fund linked note. Mr Senathirajah had had other discussions with Mr Loder in the
past. Mr Loder came to Swan and went through a slide presentation with Mr Senathirajah.
Mr Senathirajah did not give Mr Loder full details of Swan’s investments but he did provide
Mr Loder with the 2003 Swan Policy. Mr Senathirajah said that he noticed the disclaimer at
the beginning of the slides that stated they had not been prepared to take account of the
reader’s objectives, financial situation or needs. Mr Senathirajah regarded this as a standard
disclaimer and was aware that Mr Loder did not know about Swan’s entire portfolio and that
Westpac was not advising Swan about its entire portfolio. Mr Loder said that Westpac would
buy the note back if Swan wanted to sell it however they did not discuss at what price.
400 Westpac’s slides had a cover page that said in large print that the CDO was “callable
after 3 Years; Coupon Step-up if Not Called”. Mr Senathirajah understood from the
presentation that the Beech Trust CDO was more complex than the structures in the
transactions he had conducted with Grange to that point. Mr Loder told him that despite this,
the product was considerably more secure than an average CDO and was appropriately
explained in the executive summary in the slides. The slides contained a discussion of base
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case ratings migration projections (ie a model that applied historical rates of default over the
life of the products to assess whether each tranche would maintain the current Standard &
Poor’s ratings). That discussion suggested that not only would the AAA tranche maintain its
rating, but the AA tranche would become AAA rated despite suffering a number of defaults.
401 The slides had default scenario analyses for both tranches that showed differently
coloured sections that were captioned “No Principal Loss”, “Partial Principal Loss” and “Full
Principal Loss”. Mr Senathirajah said that the slides were in black and white but accepted
that these showed clearly enough those three outcomes against a heading “Differing levels of
defaults in each of the pools [being two different reference portfolios that the product was
composed of] will have different effects on the notes”. This showed that over eight defaults
had to occur in one portfolio, and over 22 in the other, before any loss of principal could
occur in the AA tranche.
402 Mr Loder told Mr Senathirajah that the risk of any principal loss was minimal, just as
Grange had told him, although Mr Senathirajah accepted that there was “a theoretical
possibility of loss in every decision we make”. Mr Loder said this was because of the rating
and subordination. Mr Senathirajah understood that the extent of subordination was the
feature that made the loss of any principal unlikely and that the rating was an independent
measure of that risk.
403 Mr Senathirajah understood that Standard & Poor’s, Moody’s and other ratings
agencies measured the probability of any defaults or shortfall in payment of principal and
interest although each agency used its own nomenclature.
404 Swan purchased $500,000 worth of the Beech Trust AA SCDO on 29 November
2005.
405 Finally, Grange relied on Mr Downing’s dealings with Mr Keenan of the
Commonwealth Bank in the August 2006 purchase of the Oasis Portfolio Notes that I have
discussed at [324]-[331] above.
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4.3.6 Causation
406 I am satisfied that once Mr Senathirajah had been persuaded to invest in SCDOs in
2003, he did not consider the finer details of each product or transaction. In essence, he
considered that these were safe, prudent investments that fell within the 2003 Swan Policy
because that is what Grange advised him. He acted on the basis of Grange’s advice to him
that focused on the credit rating as the key signification about the risk of loss. In effect
Mr Senathirajah had been persuaded by Grange that investing in highly rated SCDOs was as
safe as investing in conventional ADI issued FRNs. Hence, when Mr Loder suggested
investing in an SCDO promoted by Westpac, which promised to buy it back, he saw this as
equivalent to the prudent, safe investments that Grange had persuaded him to make in its
SCDOs.
407 When Mr Downing took over at Swan, as the person responsible for investments, he
considered the SCDOs as hold to maturity investments and was unconcerned about their
liquidity. As he said “We were not buying them to trade them”. He commenced his role in
the context that Swan had been investing in these securities, through Grange, for some time.
Thus, Mr Downing continued with investing Swan’s money in SCDOs because he did not
turn his mind to looking afresh at whether the Council ought to do so. He was administering
a form of investment that the Council had been making for some time before he took up his
position. Although he did not fully understand these instruments, he continued doing what
had been done before, acting with Grange whom he saw as the Council’s financial adviser,
and usually on its advice and recommendation. It was not unnatural, in that context, for
Mr Downing to invest in the Oasis Portfolio notes, issued as they were by the Council’s
longstanding bank.
408 The commonsense cause of Swan’s investments in the claim SCDOs, and any loss
that it suffered as a result, was Grange’s initial presentation and advice that led to Swan’s
purchase of the Forum AAA SCDO in mid September 2003. At that time Mr Senathirajah,
and I infer, Mr Frewing were satisfied that Grange would only recommend an SCDO that was
a safe, prudent investment of Council funds that complied with the 2003 Swan Policy. They
were also persuaded by Grange that SCDOs with high ratings of AA- or above offered the
same security as at least the four major Australian trading banks. That is why
Mr Senathirajah and Mr Frewing, and later Mr Poepjes, continued to invest in these products.
But for that initial advice by Grange, Swan would not have invested in any SCDOs.
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409 In making these findings I am conscious that neither Mr Frewing nor Mr Poepjes, was
called by Swan and no explanation was offered by it for that omission. I infer that their
evidence would not have assisted Swan’s case: Jones v Dunkel (1959) 101 CLR 298.
However, that does not mean that Mr Frewing’s or Mr Poepjes’ evidence would have made a
difference to Swan’s case: cf Australian Securities and Investments Commission v Hellicar
(2012) 286 ALR 501 at 544-545 [168]-[169] per French CJ, Gummow, Hayne, Crennan,
Kiefel and Bell JJ. Mr Senathirajah was the person with day-to-day responsibility for Swan’s
investment decisions and interacting with Grange. I have no reason to doubt the accuracy of
his evidence on which I have made my findings, particularly since his account was
corroborated by Grange’s contemporaneous written presentations and other documents. That
material authored by Grange was persuasive, as it was intended to be. I do not consider the
absence of direct evidence from Mr Frewing or Mr Poepjes should lead me to infer that
Grange’s sales pitch failed to hit its mark with him. To the contrary, it obviously did.
410 The nature and risks of a SCDO are concepts that are beyond the grasp of most
people. Indeed, after the benefit of expert reports, concurrent expert evidence and the
addresses of counsel, I am not sure that I understand fully how SCDOs work or their risks.
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. And, Grange knew and preyed on that lack of expertise and the trust the Councils
placed in its expert advice, as Mr Vincent’s “no haircut repos” email of 10 November 2006
demonstrated beyond doubt (see [266] above).
4.4 The relationship between Parkes and Grange
4.4.1 Parkes’ personnel and investment policy before 2002
411 Bob Bokeyar began working at the front counter at Parkes in 1966 dealing with
inquiries and recording receipts for payments from ratepayers. He continued to work for the
Council for his whole career. Prior to 1984, he studied part-time for six years at Charles Sturt
University to gain an Associate Diploma in Local Government Administration. From 1984
until he retired in July 2007 he held the position of finance manager.
412 As finance manager he compiled budgets, long-term financial plans, monitored these,
assisted in the preparation of the Council’s annual accounts and managed the finance
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department’s staff of about nine. Mr Bokeyar was also responsible for investing Parkes’
surplus funds. As at about 2002, the latter function occupied about one to one and half hours
per week. But, he had no formal training in investment. In the period 2002 to 2007, Mr
Bokeyar reported to Parkes’ director of corporate services, Brian Matthews who in turn
reported to the general manager, Alan McCormack. After he retired, Mr Bokeyar was
replaced as finance manager by Peter McFarlane.
413 Prior to 2005, Parkes had no formal investment policy. Mr Bokeyar understood that
in making investments the Council, through him, had to comply with an order made by the
Minister pursuant to s 625 of the Local Government Act 1993 (NSW). That section provided
that a Council may invest money that, for the time being, it did not require for any other
purpose “only in a form of investment notified by order of the Minister published in the
Gazette” (s 625(1) and (2)).
414 Relevantly, the Minister had made an order under s 625(2) on 16 November 2000 that
the Director General of the Department of Local Government had circulated to New South
Wales Councils in late November 2000. The circular drew the Councils’ attention to a
requirement in the Code of Accounting Practice and Financial Reporting that Councils must
maintain an investment policy and, it in turn, had to comply with the Act and investment
guidelines that were attached to the circular (the Minister’s investment guidelines). The
Minister’s order provided that Councils may only invest in Australian dollar denominated
investments including:
debentures or securities issued by any Australian federal, State, Territory or
local authority and guaranteed, where the relevant Government had not issued
them, by that Government;
mortgages of any land in Australia;
interest bearing deposits, debentures or securities issued by any ADI;
certain bills of exchange with a maturity date of no more than 200 days;
certain New South Wales government investments, and
“(k) any securities which are issued by a body or company (or controlled parent entity either immediate or ultimate) with a Moody’s … credit rating of “Aaa”, “Aa1”, “Aa2”, “Aa3”, A1” or “A2” or a Standard &
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Poor’s … credit rating of “AAA”, “AA+”, “AA”, “AA-“, “A+ or “A”;
(l) any securities which are given a Moody’s ... credit rating of
“Aaa”, Aa1”, “Aa2”, Aa3”, “A1”, “A2” or “Prime-1” or a Standard and Poor’s … credit rating of “AAA”, “AA+”, “AA”, “AA-“, “A+”, “A”, “A1+” or “A1”;” (bold emphasis added)
Paragraphs (k) and (l) were amended by the Minister on 15 July 2005 by adding credit ratings
by Fitch of AAA, AA+, AA, AA-, A+ and A.
415 The Minister’s investment guidelines relevantly provided:
“• A council or entity acting on its behalf should exercise the care, diligence and skill that a prudent person would exercise in investing council funds. A prudent person is expected to act with considerable duty of care, not as an average person would act, but as a wise, cautious and judicious person would. (Ref: Trustee Amendment (Discretionary Investments) Act 1997 section 14 A (2)).
• A council should develop an investment strategy as part of its overall
financial plan. The strategy should, as a minimum consider the desirability of diversifying investments and the nature and risks associated with the investments. (For guidance see: Trustee Amendment (Discretionary Investments) Act 1997 section 14[C] (1) “matters to which trustee is to have regard when exercising power of investment”).
• A council should at least once in each year, review the performance
(individually and as a whole) of council investments and review its investment strategy.
• An investment adviser or investment dealer acting on behalf of a council,
should be licensed by the Australian Securities and Investment Commission. • Credit ratings are a guide or standard for an investor, which indicate the
ability of a debt issuer or debt issue to meet the obligations of repayment of interest and principal. Credit rating agencies such as Moody’s and Standard and Poor’s make these independent assessments based on a certain set of market and non-market information. Ratings in no way guarantee the investment or protect an investor against loss. Prescribed ratings should not be misinterpreted by councils as an implicit guarantee of investments or entities that have such ratings. Even given this challenge, ratings provide the best independent information available.” (emphasis added)
Thus, subject to compliance with the prudent person requirement, a licensed investment
adviser like Grange could use the Minister’s order to sell Councils in New South Wales “any
securities”, including SCDOs, that had a Standard & Poor’s rating greater than A1 or one
from Moody’s greater than “Prime-1”.
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416 The reason why the New South Wales Government appeared to have approved
investment in any securities, however exotic, that had a particular credit rating did not emerge
in evidence. But anyone in 2000 and later with knowledge of derivates and structured credit
instruments would have been aware of the arcane complexity and inherent risks of such
investments. How the State Minister and Treasurer could have considered that such
instruments were potentially suitable for unsophisticated local government officers and
Councils is extraordinary. Mr Bokeyar was impressed by the Ministerial Order’s use of
particular ratings as an essential criterion of investment by local government bodies. Of
course, Mr Bokeyar knew that any investment he selected had to be within those that were
acceptable under that Order. But, quite naturally, he understood that “the higher the rating,
the better the security”. However, before he dealt with Grange, Mr Bokeyar was not aware of
the ratings of the four major Australian banks. He also understood that the Council’s
investments should be made in securities that were liquid, if it needed to realise them.
417 The provisions of s 14A(2) of the Trustee Act 1925 (NSW) (which had been inserted
by the Amendment Act referred to the Minister’s investment guidelines) were relevantly the
same as its Western Australian analogue (see [157] above). Additionally, s 14C(1) provided
that without limiting the matters a trustee may take into account, a trustee had to have regard,
so far as relevant to the circumstances, to specified matters including the need to maintain the
real value of capital or income, the risk of capital or income loss or depreciation, the length of
the term of the proposed investment, and “the liquidity and marketability of the proposed
investment during, and on the determination of, the term of the proposed investment”
(s 14C(1)(d), (e), (h) and (j)).
418 Mr Bokeyar understood that in making investments for Parkes he was required to
follow the prudent person approach and act in a manner appropriate to safeguard the funds
invested. Mr Bokeyar and Mr Matthews each had been delegated authority to invest Council
funds. Mr Bokeyar had a practice of seeking Mr Matthews’ approval for each new
investment involving the Council paying money. This was because the Council’s internal
control requirements provided for two authorised signatories, first, to approve the drawing of
a cheque and, secondly, to sign the resulting cheque. Nonetheless, Mr Bokeyar had the
primary day to day responsibility and Parkes’ delegated authority for making investment
decisions. He was the point of contact between the Council and Grange. Unlike Mr
Bokeyar, Mr Matthews was not sent emails by anyone at Grange.
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419 Grange highlighted that neither Mr Matthews nor Mr McFarlane gave evidence.
Grange indicated that the only material evidence Mr McFarlane could have given as to the
position after he took over Mr Bokeyar’s role in July 2007 was in relation to the Esperance
Combo Note that Parkes purchased on 27 March 2008. I deal with this in section 4.4.10
below. Leaving that transaction to one side, by the time of Mr McFarlane’s appointment the
die had been well and truly cast for Parkes’ investment and financial positions in Claim
SCDOs. Grange had been finding its own position in relation to its book of SCDOs
increasingly difficult for the preceding year and by July 2007 it had begun to appreciate that
this had developed into a crisis. Grange did not elucidate what Mr McFarlane could have
done or did or did not do in relation to Parkes that could have made any difference to its
position. While I am satisfied that the evidence of each Mr Matthews and Mr McFarlane
would not have assisted Parkes’ case, that does not matter in relation to Mr McFarlane:
Hellicar 286 ALR at 544-545 [168]-[169].
420 Mr Matthews, however, was involved in, if not every, almost all of the decisions to
invest new funds that Mr Bokeyar also made. He was Mr Bokeyar’s superior and a necessary
signatory to authorise each new transaction recommended by Mr Bokeyar. Mr Matthews was
also at some of the slide presentations and meetings attended by Mr Bokeyar. Thus, the
consequence of Mr Matthews’ failure to give evidence requires some consideration. In the
end, I am satisfied that the findings I make in these reasons as to the investment decisions of
Parkes, based principally upon the contemporaneous documents and Mr Bokeyar’s evidence
are appropriate notwithstanding that Mr Matthews’ evidence was not given and it could not
have assisted Parkes’ case. This is principally because I am comfortably satisfied that as a
joint decision-maker for almost all of the decisions, had Mr Bokeyar not decided to proceed,
Parkes would not have invested. This reason applies, as will appear below, to the initial
decision to invest in the Forum AAA SCDO. Grange did not suggest, and Mr Bokeyar did
not give evidence that at any time he was directed or instructed by Mr Matthews to be a co-
signatory in approving any decision. Therefore, no relevant investments would have been
made at all by Parkes without Mr Bokeyar’s concurrence. Hence, his state of mind was
essential to any decision by Parkes to invest, whatever Mr Matthews knew or understood.
Had Mr Bokeyar not decided to go ahead, Mr Matthews could have directed him to sign or
bypassed him. Mr Bokeyar could not recall any occasion on which Mr Matthews rejected a
recommendation for investing available funds.
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421 The context in which they worked together reinforces the essential role that Mr
Bokeyar played in the decision-making process for investing in SCDOs. Mr Bokeyar
followed a practice when Mr Matthews had not been at a presentation or other meeting with
Ms May or another Grange representative. That practice was that he would see Mr Matthews
and inform him that Ms May, or Grange, had recommended the particular investment and
give Mr Matthews a copy of any slide presentation. Although Mr Bokeyar said that he did
not give Mr Matthews term sheets, I infer that he gave Mr Matthews the documents he had
received that he considered would be relevant to Mr Matthews. That is, if Mr Bokeyar had a
slide presentation he provided it to his superior without any other documents, but if he only
had a term sheet, then that was what he gave Mr Matthews. At the same time, Mr Bokeyar
discussed with Mr Matthews the requirements of the Minister’s order in relation to the
proposal saying:
“The ratings, first and foremost. They were always important, and any advice that I had received from [Ms May], the recommendation that I had received from her and you know, I always reminded him that they were liquid. If need be we could have the money back ... so that was sort of - just a security that came with it.” (emphasis added)
422 Mr Bokeyar was a person who worked better orally than with documents. Although
he printed off almost everything Grange sent him by email and put the paper in a file, he
almost never read it, preferring to speak with Ms May and have her explain the proposed
transaction to him. He then conveyed what he regarded as the salient points orally to Mr
Matthews. There is no evidence that Mr Matthews ever expressed disagreement with any
recommendation that Mr Bokeyar put to him. It follows that whatever Mr Matthews’ thought
processes on investing in any SCDO were, unless Mr Bokeyar was not involved, the
transaction would not have occurred without Mr Bokeyar’s agreement.
423 Prior to its involvement with Grange, from about 1997 Parkes had begun to
accumulate surplus funds having repaid its previous debts. In about August 1997, Mr
Bokeyar decided to invest some of these funds in longer term securities sold by its
established banker, Westpac. Through Mr Bokeyar, Parkes invested $2 million in a mortgage
backed security (MBS) sold to it by Westpac. This was an early form of RMBS. It was a
residential mortgage product offering a coupon of the one month BBSW + 24 bps, with an
expected term of six years, based on the average life of 5-7 years for Australian home
mortgages and a maximum term of 31 years.
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424 Mr Bokeyar said that he had been told by Westpac that if Parkes needed to realise this
security before its maturity date the bank would buy it back. However, in a contemporaneous
four page note on MBS that Mr Bokeyar received, Westpac had stated that it “… will always
endeavour to make a price to repurchase instruments subject to available credit limits”. That
note also stated that Standard & Poor’s had rated most MBS instruments and “As the
majority of issues are AAA rated they are comparable to the credit rating of Australian
Commonwealth Government bonds”. Mr Bokeyar understood in 1997 and 1998 from what
Westpac’s officers had told him that a credit rating issued by Standard & Poor’s might be
equally relevant to a MBS or Commonwealth Government bond and that, in practical terms,
there would be no difficulty in the Council selling the MBS back to Westpac. He also
understood that an MBS was issued by the bank that had lent the money to borrowers who, in
turn, had given mortgages based on a valuation of their properties. Mr Bokeyar understood
that the amount of the residential mortgage loan was a proportion of the valuation.
425 In September 1998, Mr Bokeyar caused Parkes to invest $1 million in a second (and
last) MBS instrument sold to it by Westpac. This was described in the term sheet as “Fully
amortising, mortgage-backed, pass through FRNs”. The term sheet stated that all loans were
insured and that the trustee had entered into two swaps to hedge mismatches in the variable
and fixed interest rates for the underlying loans and the coupon for the product. Mr Bokeyar
understood that this simply was an MBS based on residential property. On 21 September
1998 Westpac issued a sale note for this $1 million investment which had a coupon of the one
month BBSW + 29 bps.
426 Each of these two MBS products repaid some of the principal as the supporting loans
were redeemed – hence the description “amortising”. Mr Bokeyar understood that some
principal could be repaid from time to time over the term of these securities. In Parkes’
investment ledger as at 31 August 2000, the principal of the $2 million MBS had reduced to
about $1.8 million and the $1 million MBS to about $625,000. Neither product appears to be
comparable to any of the SCDOs. Each was backed by actual securities and paid a coupon
comparable with the coupon paid by Westpac on an FRN it issued in May 1998 of the three
month BBSW + about 25 to 28 bps. However, neither MBS was guaranteed by Westpac for
repayment of principal, performance over its term or its liquidity. The same investment
ledger also showed that Parkes held two FRNs, one for $6 million, the other for $1 million,
and a number of commercial bills and term deposits. Mr Bokeyar assumed that Westpac
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would buy the securities back for their principal sum, because Westpac’s officers had told
him that the bank would buy them back if Parkes needed the money for a new project.
However, he acknowledged that Westpac’s officers had never discussed the issue of the
repurchase price with him.
427 Between January 2000 and early 2003 Parkes invested principally in bank accepted
commercial bills, term deposits and FRNs with major Australian banks, as well as FRNs
acquired through Local Government Financial Services.
428 Grange argued that Parkes’ investment policy could not be described as
“conservative” before Grange had any dealings with it. This was because Parkes by then had
invested in the two MBS and two FRNs. Grange relied on the fact that Mr Bokeyar saw as an
“attraction” the higher interest coupon or yield of those products over commercial bills.
429 In my opinion, Parkes’ investments in the period immediately before its dealings with
Grange were reasonably characterised as “conservative”. The two MBS were directly
supported by Australian residential mortgages. Each had mortgage insurance arrangements
to support the security offered by the mortgagor’s real property. Each amortised over time.
The two FRNs were issued by Westpac itself and although they were a form of subordinated
debt, they depended on the financial viability of one of Australia’s largest, and regulated,
banks. All the four products paid a modest coupon of between about 25 to 30 bps over a
BBSW rate. While each product carried a minimal risk of capital loss, there is no evidence
that this risk was of the kinds inherent in the SCDOs.
4.4.2 Parkes’ initial dealings with Grange
430 Early in 2002 Ms May and a colleague arranged to call on Mr Bokeyar at the Council
chambers. When they attended, the Grange personnel ascertained that Parkes had no debt
and, so, concentrated their presentation on investments and investing.
431 On 11 March 2002, Ms May emailed Mr Bokeyar with a suggested investment in an
FRN issued by Bendigo Bank with a coupon of the 90 day BBSW + 200 bps. She wrote that
FRNs were “perfect in a rising interest rate environment as they allow you to participate in
the upward movement”. The email also said:
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“As a rated bank issued security, this FRN falls within the investment guidelines for local government and this security can be sold at any time to raise cash.” (emphasis added)
432 Mr Bokeyar had no recollection of that email and, consistently with his lack of
attention to written materials, is unlikely to have paid close attention to it. However, the
passage I have emphasised shows that Grange was conscious of the importance to a Council
such as Parkes of first, the Minister’s Order, for determining investments suitable for local
government in New South Wales, secondly, the significance of the rating of an investment
and, thirdly, the importance of liquidity.
433 Next, on 20 March 2002, following a discussion, Ms May emailed Mr Bokeyar with
details of two suggestions of “bank owned subordinated debt securities” that Parkes might
purchase. Mr Bokeyar made some notes on the email of a subsequent discussion with Ms
May. He recorded that the ratings of one security or its issuer, Bank of Queensland were
BBB or BBB-, and of the other, Suncorp Metway, were A- or BBB+. He also wrote that it
was generally accepted that an investment grade rating was BBB- or above. Ms May had
stated that she recommended purchasing both securities outright or on a switch basis, by
selling something Parkes already held to fund the purchase. On 22 March 2002, Grange
issued Parkes with a contract note for the purchase of a Suncorp Metway “Floating rate
subordinated debt” with a face value of $500,000 and a coupon of BBSW + 140 bps. This
appears to have been Parkes’ first purchase from Grange.
434 Within two months, in an email sent on 16 May 2002, Ms May proposed a switch to
Mr Bokeyar of the Suncorp Metway FRN for the Bank of Queensland FRN she had
recommended in March 2002. On the next day Grange issued contract notes to Parkes
reflecting that switch and an additional investment of $500,000 in the Bank of Queensland
FRNs. This followed a further email sent by Ms May on 17 May 2002 that referred to the
fact that local government assistance grants had been paid and offering FRNs, including
Bank of Queensland ones, as a means of investing the grant money.
435 Parkes’ published financial statements for the year ended 30 June 2002 showed that
the Council had about $11.5 million invested in FRNs of a total of about $14.5 million
investment funds with the balance of about $3 million held in short-term deposits and bills.
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That represented a change from the position at 30 June 2001 when the Council held about
$10 million worth of FRNs as part of its $12 million of non current investments.
436 On 28 October 2002, Ms May emailed Mr Bokeyar a document described by Mr
Clout in his email forwarding it to her as “a correct and comprehensive report relating to …
[FRNs] and their suitability as Local Government investments”. This document was an
earlier, shorter and, in some respects, different version of what Grange sent to Swan on 18
August 2003 (see [178]-[180] above). Mr Bokeyar said that he read the explanation but did
not recall any understanding he gained from it. Having regard to Mr Bokeyar’s general
approach to documents, I am not satisfied that he paid any significant attention to the
explanation of FRNs in this emailed document. However, the explanation is relevant as a
contemporaneous account of Grange’s approach, in late 2002, to marketing its services and
what it called “FRNs” to local government bodies such as Parkes. As will appear below, it
was produced two weeks before Grange began marketing the Gibraltar AA to Councils,
including Parkes, calling that product a “floating rate note issue”. The 28 October 2002
explanation made no mention of SCDOs or CDOs. Its first paragraph explained that its
purpose was as a response to a “recent publication” about FRNs and their suitability for local
government investors. It continued:
“Grange has a thorough understanding of the regulatory constraints in respect to local government investments. Grange also understands that individual local councils structure their internal investment policies on the model recommended by the Minister. … TYPES OF FRN’S When investing in the FRN market it is important to differentiate between the different types of securities and issuers of floating rate notes. … Grange Securities does not recommend ASX listed perpetual income securities as an appropriate or sensible investment for local government. … … Investments such as those described above have in part contributed to the poor performance of managed funds in recent times. Grange Securities does recommend investments in floating rate notes issued by licensed Australian banks, building societies and credit unions. We conduct comprehensive research and analysis on all issuing financial institutions that we recommend – this is our expertise.
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Furthermore, the Australian banking and non-bank financial institution sector is highly regulated. Prevailing regulations require financial institutions to maintain specific capital adequacy ratios and liquidity ratios. These regulatory requirements make the Australian banking system amongst the safest in the world. It is this level of comfort that supports the Minister’s investment policy of providing for investments in securities issued by licensed banks, building societies and credit unions. The issue of floating rate notes is a necessary and normal function of Australian financial intermediaries. The specific advantages for local government investors from investing in licensed ADI floating rate notes are numerous and include:
• Known Rates of returns
• Known (quarterly) cash flows
• Always tradeable (i.e. liquid)
• Provide protection against rising interest rates
• Offer higher returns to shorter dated securities
• Minimal administration for management
• Flexibility to hold to maturity or to sell at any time prior to maturity
• Principal is repaid in full upon maturity
• Constant out performance of benchmarks
• No fees.
The notion that the FRN’s offered to local government investors are those that have been rejected by the major fund managers is quite simply incorrect. Further, Grange is required by its client base to support issues on a secondary market basis to guarantee liquidity in any issues offered to clients. Demand for quality and suitable floating rate notes by Grange customers far exceeds supply, and as such we would be pleased to provide a market for sellers in the current environment. Grange Securities is highly specialised in Australian fixed interest markets with highly qualified analysts and executives. We are dedicated to providing secure investments that generate quality returns for our customers. Grange fully supports a diversified approach to investing by local government and respects the ability of Council representatives to determine the appropriate course of action with respect to investments, within the guidelines stipulated by the Minister for Local Government.” (original bold emphasis; italicised emphasis added)
437 I infer that Ms May orally conveyed the substance of this explanation to Mr Bokeyar
at about the time it was sent. I infer that she told him that Grange was expert in giving
investment recommendations to local government bodies on securities that complied with the
Minister’s order and the Minister’s investment guidelines and were suitable for councils. Mr
Bokeyar was averse to both stock market and managed funds investments. At this time,
Local Government Financial Services, one of Grange’s competitors, was promoting
investment in managed funds. It is likely that Ms May orally recounted to Mr Bokeyar the
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gist of the written explanation’s criticism of the performance of managed funds. This would
have struck a chord with him. Unsurprisingly after over 8 years later, he could not recall the
conversations he had with Ms May. However, I accept that Mr Bokeyar’s evidence that he
discussed with Ms May at about this time that he was not interested in Parkes’ money being
invested in managed funds because of the volatility of the stock market and the consequential
fluctuation in the capital value of the investments.
438 Soon afterwards, as evidenced in a contract note, on 8 November 2002 Mr Bokeyar
agreed that the Council would invest $1 million in an FRN issued by BankWest with a
coupon of BBSW + 75 bps. Next, on 11 November 2002 and during the following few days,
Ms May emailed her clients, including Mr Bokeyar, with details about the Gibraltar AA
SCDO. Mr Bokeyar had no recollection about this product and Parkes did not invest in it.
However, Ms May’s initial email of 11 November 2002 is useful as an example of how
Grange explained SCDOs as FRNs in its dealings with its clients such as Parkes and Swan.
Its opening paragraph read:
“Some of you may have seen a new floating rate note issue being marketed as a AAA security at a margin of BBSW + [100] bps. The issue name is Gibraltar. Grange Securities has been given the mandate to place the AA tranche at BBSW+180 bps. Given the rating of this security, the issue qualifies under the Ministers guidelines, however, we though that we should fully outline the structure and nature of this issue so that you may determine its suitability.”
4.4.3 Parkes’ first SCDO investment with Grange – the Forum AAA SCDO
439 Then, on 18 February 2003, Ms May emailed Mr Bokeyar a term-sheet for the Forum
AAA product that she said was a “5 year FRN with a coupon of BBSW + 130 [bps]”. I have
described a number of features of Grange’s marketing and explanatory material for the
Forum AAA product in dealing with Swan’s investment in it ([178]-[202]). However,
Grange did not make any slide presentation of this product to Mr Bokeyar and Grange’s sales
effort with Parkes occurred over six moths earlier than with Swan. Thus, at the risk of some
repetition, I will set out the relevant features of what Parkes received. The email of 18
February 2003 had two footers as follows:
“In preparing this document the licensee did not take into account the investment objectives, financial situation and particular needs of any particular person. Before making an investment decision on the basis of this document the investor needs to consider, with or without the assistance of an advisor, whether the advice is appropriate in light of the particular investment needs, objectives and financial circumstances of the investor.
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Disclosure: Grange Securities Limited and its employees and agents may have an interest in the above securities and may receive commissions, brokerage and other financial benefits from dealing in those securities. Grange deals as principal on secondary market transactions. Yields and prices are indicative only, and stock is subject to availability.”
440 The term-sheet for the Forum AAA product described the “instrument” as “Floating
Rate Notes”. It noted that Grange was the placement agent and that Deutsche Bank AG,
Sydney Branch was the arranger. The term-sheet continued:
“Status: Senior with security over the collateral
Instrument Type:
Collateralised Australian Bonds linked to the performance of a portfolio of 142 investment grade corporate entities
Collateral: “AAA” rated Mortgage Backed Securities
Portfolio Performance: Investors will bear any losses on the portfolio of 142 investment grade corporate entities above the subordination amount
Collateral Performance: Investors will bear any principal losses on the collateral, but not any interest rate risk as this is borne by the Arranger through the equalisation swap.
Subordination Amount: $65,000,000 (6.5% of the notional portfolio size)
Notional Portfolio Size: $1,000,000,000
Issue Rating: “AAA” (Standard and [Poor’s] Australia Pty Ltd)
Tranche Size: $35,000,000 …
Redemption Amount: 100% of Par, subject to Collateral and Portfolio Performance”
(italic emphasis added)
441 The term-sheet noted that final maturity would occur in five years and the coupon
would be BBSW + 130 bps. It stated that the minimum investment would be $500,000 or
$100,000, “if the relevant investor satisfies one of the other sophisticated investor tests (to be
verified by Grange)”. It also stated that the program documentation contained the full terms
and conditions and these would prevail in the event of any inconsistency.
442 Mr Bokeyar said that he understood that the Forum product was a AAA rated MBS
and that “the chances of it failing were virtually nil”. He also said that Ms May had given a
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verbal “guarantee or the comfort” that Parkes could sell the product back at any stage within
a couple of days. He did not know what the term-sheet item “Redemption Amount” meant.
Ms May provided Mr Bokeyar with a number of documents regarding the Forum AAA
product between 18 February and late March 2003.
443 Extraordinary as Grange contended this may be, in relation to investing $1 million of
the Council’s money, I accept Mr Bokeyar’s evidence that he did not read or pay attention to
the terms of any of this material. Rather, he relied on Ms May’s oral explanation of the
product and her recommendation of it as suitable for Parkes. I accept the following evidence
of Mr Bokeyar as encapsulating his understanding of CDOs and SCDOs at all relevant times:
“HIS HONOUR: Do you have any understanding what a CDO was? --- Yes, I don’t understand a CDO. I couldn’t give you the definition of a CDO, your Honour, and to me it was - they were products that evolve from FRNs, because we started with FRNs and then at some stage they were called a FRN and a CDO perhaps on the same - for the same transaction even and there seemed to be all sorts of variations, so I couldn’t explain to you what a CDO is. I know that it has underlying companies that - that are involved in it, but the actual workings of it, no. And I didn’t know what a synthetic was - CDO was. I may not have even noticed that when I read it. A CDO was a CDO, which was an extension of an FRN or a - or a evolution of a FRN note.” (emphasis added)
444 Mr Bokeyar’s attitude and approach was graphically illustrated when he was giving
evidence about a 10 page research note dated 4 March 2002, but obviously prepared by
Mr Vincent on 4 March 2003, that Ms May had sent him. He did not know whether he
received this before or after Parkes had told Grange that it wanted to invest in the Forum
product which occurred on or before 5 March 2003 (see [451]-[452]). This note was written
just before the commencement of the March 2003 war in Iraq. The first page of this note
contained a summary that stated, in the third paragraph, “over the shorter term, investors may
run the risk of price volatility and a temporary drop in liquidity depending on the market
reaction to the developing situation in Iraq”. It predicted that over the longer term the Forum
AAA notes would appreciate in value because, so Grange asserted in the fourth and fifth
paragraphs:
“… the pricing is anomalous compared to other similarly rated assets available to investors, the maturity of the deal shortens through time and the underlying credit default swap market rallies if the Iraq situation is resolved without a fundamental impact on global credit quality.
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This price appreciation is premised on the fact that the credit quality of Forum “AAA” does not deteriorate. Grange’s opinion is that this is unlikely following its analysis of the transaction.”
445 Mr Bokeyar gave this evidence about those matters in cross-examination, which I
accept:
“In March 2003, you would certainly have at least read the summary of this document? --- If I had read that summary, I wouldn’t have invested in that product. I can tell you that absolutely. Now, either I didn’t read it, or I didn’t have it at the time, or it was just given well, I didn’t read it. I certainly wouldn’t invest in that product if I’d have known those things. I wouldn’t invest in managed funds. I wouldn’t invest with credit unions and what’s the other one, credit unions and building societies. There’s no way I would invest in something like that, had I thought they - had I read that or had I thought they were possibilities unless it was highly recommended, and even then, at that early stage with Grange, I was not that trusting. Even if they’d have said that, I wouldn’t have invested in that. That is absolute. And what puts you off? --- What puts me off? Well, what puts me off is the paragraph 3, and 4. I’m happy with the first two things - - - Yes? --- You know, the rating AAA, I’m happy with the 130 points, and I’m happy with Grange saying that, you know, they see it favourable and they think that it’s robust and so forth, but certainly not a risk of price volatility, because that’s why I wouldn’t invest in managed funds.” (emphasis added)
446 He also said, and I accept, that he would not have agreed to buy the Forum AAA
product had Ms May told him that:
if the Council wanted to sell it before its maturity date five years later, either it
may suffer a capital loss or there may not be a market at all to buy the note
back, if Grange did not want to do so;
he should not assume that the credit risk in relation to such a product, with an
AAA or AA rating, was the same as for an equivalently rated bank.
447 Mr Bokeyar was very averse to any product that he considered had a risk of price
volatility or capital loss. He mistrusted investing Council funds in products listed on the
stock exchange or managed funds because of the risk of price and thus capital fluctuations.
Instead, he was attracted to investments that offered what, he considered was, greater
stability. He demonstrated that aversion in early 2005 when, as I will explain below, he
realised that he had caused Parkes to buy one SCDO, HY-FI, that was listed on the ASX.
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448 Mr Bokeyar was asked to assume that Ms May had shown and explained to him the
parts of the issuer’s information memorandum for the Scarborough SCDO dealing with risk
factors in relation to first, investor suitability and, secondly, no secondary market. These
were in materially similar terms to those in the equivalent document for the Blue Gum Claim
SCDO that I have quoted in [122] and [123] above. He said that if he had been given such an
explanation of each of these risk factors he “… would have politely shown her [Ms May] to
the door”, that the Council was not interested in such products at all and Parkes would not
have purchased any CDOs from Grange or anyone else. I accept that evidence. I will return
to the significance of this evidence later at [536] when it can be seen in the context of some
history of how Mr Bokeyar dealt with Grange and what he was told.
449 Mr Bokeyar understood that Grange was making money in some way from selling to,
or buying from, Parkes but he never asked and was never informed about how Grange earned
any fees or other income from the products it traded with Parkes. The topic of underwriting
fees was never raised with him by Grange’s representatives.
450 Mr Bokeyar could read all, and understand some, of the written material Grange
provided him, as he showed in giving evidence. However, I accept his evidence that to the
extent he read anything of that material, he did not arrive at any understanding from it that the
SCDO products had any of the characteristics identified above that would have led him not to
invest in them. He explained that in deciding to invest in the Forum AAA product he relied
on:
what Ms May told him orally about it, namely, its high credit rating of AAA
(that he understood meant “the chances of it failing were virtually nil”) and
that this complied with the Minister’s order;
the comfort he took from Grange’s verbal assurance that Parkes could sell the
product back at any stage within a couple of days;
his confidence in Grange as the company selling the products which appeared
to him to have a good understanding of them as conveyed in its oral, and
partly in its written, presentations, and Grange’s ability to explain the product.
451 Given the contemporaneous descriptions as an FRN that Grange gave the Forum
AAA product, it is highly likely that Ms May conveyed its nature to Mr Bokeyar as a form of
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FRN. That was consistent with the understanding he had: see [443] above. Not only did
Ms May use the description “FRN” in her email to Mr Bokeyar of 18 February 2003, Mr
Vincent used it in his research note of 4 March 2003. Grange also used it in its term-sheet
and its letter of 5 March 2003 to Mr Bokeyar confirming that Parkes had been allocated $1
million worth of the “Instrument: Floating rate Notes (FRN)” in “the CDO transaction
FORUM AAA”. That letter stated without further elaboration that Grange “is acting as the
placement agent for this issue”.
452 By 5 March 2003, Parkes had agreed to invest $1 million in the Forum AAA product.
However, the transaction was conditional on the product receiving a AAA rating by Standard
& Poor’s. On 21 March 2003, Ms May notified Mr Bokeyar and others of that rating being
awarded in an email that attached a copy of the agency’s ratings letter. Grange issued Parkes
with a contract note for the investment on 25 March 2003.
453 Thus, Mr Bokeyar, with Mr Matthews, committed Parkes to an investment of $1
million in a product that appeared to be a form of FRN. Mr Bokeyar had done so based on
his reliance on what Ms May had said, or he understood her to say, about its features and the
security it offered, being the matters I have described in [450] above. In doing so, he relied
on what a financially sophisticated licensed dealer told him about a product that, on its face,
appeared to fulfil the requirements in the Minister’s Order, provide a reasonable, and hardly
extraordinary, return and to have, at least, no greater risk than an FRN issued by an ADI.
There is no direct evidence of Mr Matthews’ understanding of the product and I infer that his
evidence would not have assisted Parkes’ case subject to the following qualifications.
454 Grange contended that when it began marketing the Gibraltar and Forum SCDO
products to Parkes, it had been careful to distinguish them from the earlier bank FRNs that it
had sold to Parkes. Grange argued that it had provided accurate information regarding the
risks of these SCDOs. It also submitted that Mr Bokeyar did not tell it or Ms May that he did
not understand these products and he did not ask about aspects of the products or materials
that Grange had provided to him. Grange contended that Mr Bokeyar’s failure to raise with it
or Ms May any such questions or issues at the inception of their dealings in SCDOs, or in the
ensuing five years of trading, had two significant consequences.
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455 First, Grange argued that it (and Ms May) was entitled to assume that Mr Bokeyar, as
well as Mr Matthews, understood the materials that Parkes had been provided. Secondly, it
contended that the facts that none of Mr Bokeyar, Mr Matthews or Parkes raised any issue
concerning his or its understanding of the SCDO products at the outset of their dealings was
relevant to the relationship between Parkes and Grange thereafter. This was because, Grange
argued, it was entitled to assume that it had no need to repeat its initial explanations since:
Mr Bokeyar and Mr Matthews continued in their roles throughout the ensuing
five years;
Parkes was comfortable with its purchase of the Forum AAA product; and
Parkes was comfortable with the other SCDO products it subsequently
purchased.
456 Both parties recognised in argument that the Forum AAA transaction had a pivotal
role in their relationship. Had Mr Bokeyar carefully read the material Ms May had sent to
him or otherwise adequately understood the risks of price volatility, lack of liquidity and
capital loss or the incommensurability of the ratings of SCDOs with those of banks, he would
not have invested, or caused Parkes to invest, in the Forum AAA product or any other
SCDOs. I do not accept Grange’s argument that Mr Bokeyar’s failure to raise issues or
questions allowed it or Ms May to believe that he fully or adequately understood the Forum
AAA products.
457 Ms May did not give evidence that she had such a belief; nor did anyone else from
Grange give evidence. I infer that evidence on these matters from Ms May and other Grange
personnel would not have assisted its case: Jones v Dunkel 101 CLR 298. Secondly, a
person’s comprehension of what he or she does or does not understand from material or an
explanation is not always self-evident. A person can think he or she understands a document
or explanation. But, such a thought process does not demonstrate either that, first, the person
actually understood what he or she read or was told or, secondly, the document or explanation
itself was accurate and complete. Indeed, sometimes a lack of information inhibits a person
developing a sufficient level of comprehension to enable him or her to identify his or her lack
of understanding of a document or explanation.
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458 The context in which Grange dealt with Parkes suggests that it was not in Grange’s
interests to highlight or draw attention to the risks of the Forum AAA product (or other
SCDO products that it sold later). After all, as Grange’s submissions emphasised, it was in
the business of trading in these products. Thus, when Ms May explained to Mr Bokeyar the
features of the Forum AAA SCDO, it is unlikely that she did so by opening up or leaving
areas of uncertainty or doubt about its suitability for the Council. Nor is she likely to have
explained fully all the risks. Certainly, Mr Bokeyar did not obtain an understanding, from
what Ms May said, of any of the risks that would have led him not to invest.
459 However, Mr Bokeyar did not tell her that he did not read, carefully or at all, what she
or Grange provided to him about the Forum AAA or other products. As he said in the
evidence to which I have referred above, if he had read even some of this material before
deciding to invest in the Forum AAA product he would never have gone ahead. Parkes
argued that because Grange had, and professed to have, expertise in these complex products
as well as investments that were appropriate for a Council such as it, it was natural for Mr
Bokeyar to rely on Ms May’s recommendation and oral explanations.
460 Ms May had set the scene for Mr Bokeyar’s understanding of the Forum AAA SCDO
in her first email about it that she sent on 18 February 2003. There she described it saying “it
is a 5 year FRN with a coupon of BBSW + 130 and will be AAA rated”. When he caused
Parkes to invest $1 million in this product Mr Bokeyar understood it to be a AAA rated
mortgage backed security with virtually no chance of failing. His understanding is consistent
with the understanding Grange was all too aware its Council clients had of SCDOs as
betrayed later by Mr Vincent’s candid “no hair cut repos” email of 10 November 2006: see
[266]. As Mr Vincent observed there, an informed investor would not lend money to Grange
on the face value of an SCDO offered as security but would require a “haircut”. That was, he
wrote, “defacto an acknowledgment of the risk of price movement and [the] counterparty
being caught short with Grange going bust and the stock post [haircut] being worth less than
their investment”. Tellingly, Mr Vincent said Grange’s “no haircut repo” Council clients
were “uninformed”.
461 When Parkes bought the Forum notes in March 2003, Mr Bokeyar’s understanding
was that the product had substantively no risk. That was because he was, and Grange knew
he was, “uninformed” of the very factors to which, over three years later, Mr Vincent referred
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in his email. Mr Bokeyar understood that Grange and Ms May had sold the product to Parkes
as a AAA rated product that was like an FRN and was a secure, effectively no risk and liquid
investment. It is also safe to infer that, despite his not giving evidence, Mr Matthews had no
reason to think that it was not a safe investment for the Council, based on the return, the
credit rating and Grange’s description of the product as an “FRN”. Moreover, if, as I infer
occurred, Mr Matthews was involved in Mr Bokeyar’s decision to sell the HY-F1 SCDO and
switch into another SCDO on 23 February 2005 because it was listed on the ASX, both men
shared the same profound lack of understanding about what the risks and nature of these
products were (see [489]-[490] below).
462 Mr Bokeyar was careless in not reading the material that Grange sent him. As he said
in evidence, had he done so then he would not have purchased the Forum AAA product, or
any SCDO. His and Parkes’ conduct in selling the HY-FI product was critical to this finding.
When Mr Bokeyar realised that HY-FI was listed on the ASX and so its price could vary,
thus potentially affecting the Council’s full return of its capital, he instructed Grange to sell
the product straight away. Mr Bokeyar did not want to invest in any product that had a risk
of price volatility. I am satisfied by that evidence that, in February and March 2003 or at any
later time, Ms May and Grange did not explain orally to Mr Bokeyar the very features and
risks of the product to which he referred when he was taken to the written material in his
evidence. Had these features and risks been explained orally to Mr Bokeyar he and Parkes
would not have proceeded any further with any investment in an SCDO. And, I infer that Ms
May did not tell him that he should read those to see and understand the risks that they
revealed.
4.4.4 Parkes’ later dealings with Grange in 2003
463 On 1 April 2003, Ms May sent an email to her clients, including Mr Bokeyar. The
email was short. It referred to “a lot of talk on CDO downgrades and defaults of late”.
Ms May attached a page from a report prepared by Standard & Poor’s in mid March 2003
that showed results, as she emphasised in her email “with no CDO rated at “A” or above
defaulting, and “AAA” and “AA” ratings being extremely stable”. She said that all
“investment grade synthetic CDO’s” including Forum AAA were included in the study. And
Ms May concluded by referring to a similar study of “corporates” by Standard & Poor’s that
showed a greater percentage of downgrades for corporate AAA and AA rated products than
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for similarly rated CDOs over the previous six years. Mr Bokeyar thought that he would
have read this because it was a short, one page email. He also said, and I accept, that there
was a every likelihood that Ms May telephoned him on this occasion, as she was wont to do,
to allay any concerns that he may have had.
464 On the next day, Ms May sent two emails to Mr Bokeyar, and other clients, promoting
the new CDO, Griffin AA. In the first email, Ms May said that it was a “3 year deal at 120
over BBSW – rated AA by S&P”. She wrote that Grange was placing $30 million and “…
again [sic] will go quite quickly as more people become comfortable with CDO’s in general
and understand WHY they are issued”. She also referred to her one page email on the default
history of CDOs “which basically says ‘No CDO rated investment grade by S&P has ever
defaulted’”. She attached an indicative term sheet for the Griffin product. This described the
instrument type as “FRNs” and stipulated a minimum investment of $500,000 or, if the
investor satisfied a sophisticated investor test, $50,000. Mr Bokeyar never discussed with
Ms May whether he was a sophisticated investor. He certainly was not. Ms May’s second
email of 2 April 2003 said: “Again this is a straight floating rate note with a coupon of 90
day BBSW + 120”. She attached a slide presentation that she described as “succinct and
compelling so please have a look”.
465 Mr Bokeyar understood a straight FRN to be like the instruments he had arranged for
Parkes to buy from its bank (Westpac) and the initial investments he had made through
Grange. He understood that these instruments were secure and nothing out of the ordinary.
He did not recall the slides sent with Ms May’s second email but said that he may have
flicked through them. However, Ms May or other Grange personnel would always telephone
him to discuss a possible investment in an SCDO after he had been sent an email or a slide
presentation, such as that for the Griffin AA product. He had no recollection of discussing
these emails or slides with her or other Grange personnel. Mr Bokeyar said that in these
discussions Ms May, or the other Grange person, told him about:
the rating of the product and that products with such ratings had never
defaulted;
the product’s compliance with the Minister’s order;
her or Grange’s recommendation in relation to the product;
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the benefits of the product explained in lay terms.
466 Mr Bokeyar said that these explanations mentioned the number of defaults that had to
occur and the number of tranches below or subordinated to the higher grade ratings of AAA
or AA that the investment involved. He said that Grange’s personnel always explained this in
a positive way saying that AAA or AA rated products had never defaulted in over 5,000
issues. The rating was of primary concern to Mr Bokeyar. He understood the rating to be the
rating agency’s attempt to measure the likelihood of the product defaulting given how it was
structured.
467 Mr Bokeyar also understood that Grange put a lot of the SCDO products together
itself and made assessments of which companies (i.e. reference entities) should be in the
tranches so as to obtain a good rating for the products. Ms May or someone from Grange
told him that if companies in the pool defaulted they were taken out of the pool and replaced.
He understood this function was performed by the product’s manager. Importantly, when
they explained an SCDO product to him, the Grange personnel told Mr Bokeyar about the
number of defaults it could “… withstand without incurring a principal loss”. But this was
coupled with reassurances that products with such ratings had never defaulted and so,
Mr Bokeyar understood, the chance of Parkes suffering any loss was “very, very remote to
the point that with a higher grade like AAs or AAAs would never happen”.
468 On 7 April 2003, Grange made a slide presentation at the NSW Local Government
Third Financial Awareness Conference held in Parkes. Mr Bokeyar did not recall who, from
Grange, made the presentation. However, Glenn Willis, then the managing director of
Grange, had prepared draft notes for his talk at the conference on 1 April 2003 and emailed
them to Mr Clout and Ms May for their feedback. I infer that Mr Willis presented the slides
at the conference. One slide emphasised the Minister’s order stating that Councils were:
expected to achieve reasonable yields otherwise expected from normal
management by prudent people;
obliged to get a sound and prudent return on their investments;
encouraged to use sound discretion in their investment decisions.
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469 Another slide was headed “Grange is a Unique Advisor to Councils”. This
commenced by stating that:
“• Grange always advocates prudent investments well within the Minister’s Guidelines and individual council’s own investment policies” (original emphasis)
This slide referred to Grange being a substantive organisation with over 30 specialised fixed
interest staff providing broad market experience and expertise and continued:
“• Grange’s service is comprehensive proving ongoing advice, …, monitoring, liquidity and liability proving ongoing advice, … monitoring, liquidity and liability management
• Grange supports all its recommendations with rigorous research and due
diligence that looks beyond the explicit credit rating or ADI status of the issuer
• Councils who have invested directly on Grange advice have consistently
outperformed those that invested in managed funds • Grange is proud of its investment record and long association with Councils
and encourages open discussion of performance of Grange recommended assets compared to alternate advisor recommendations” (original emphasis)
470 A third slide informed the audience that appropriate investment decisions should be
based on a number of factors, including “appropriate level of risk”, “financial flexibility and
liquidity” and “availability of trusted financial advisors with an understanding of Council’s
needs and a proven track record”. The slide concluded by informing the audience that
Council officers had a responsibility to the ratepayers to consider all the listed factors “when
making their investment decisions and choosing an appropriate financial advisor”.
471 The final slide drove home Grange’s self promotion as a trustworthy financial adviser
by concluding:
“• If Councils do not possess the necessary investment skills they should seek external advice from a professional financial advisor but;
• Councils should not allow professional financial advisors to avoid
responsibility for their investment decisions by hiding behind a credit rating or a fund manager” (emphasis added)
472 While he did not recall the detail of this presentation, Mr Bokeyar said that it
portrayed Grange as leaders in the area and an adviser to local government. He recalled that
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Grange would recommend highly rated investments of the robustness and kind that had never
failed and it would buy them back if need be.
473 The presentation captured and portrayed accurately the relationship Grange had
cultivated, and later continued to foster, with Parkes, and Swan: i.e. Grange acted as a
trustworthy and knowledgeable financial adviser to the Councils. That is how Mr Bokeyar
and through him, Parkes, treated Grange. He looked to Grange for its recommendations and
financial advice as to the products it should buy and sell. During the hearing, Grange argued
that it was not at all that this presentation portrayed – a financial adviser – but rather, it
sought to say that the true relationship it had with its non-IMP clients was that of simply
being an arms length vendor and purchaser of financial products.
474 I reject that characterisation. I am satisfied that Grange was, and acted as, a financial
adviser to Parkes and Swan for each product it bought or sold. Grange put itself forward to
the Councils as a financial adviser cognisant of their needs, statutory and policy
requirements. And because it 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.
Why would Grange portray itself as a financial adviser to Councils in respect of these
complex SCDO products, among others, if its true relationship was as an arm’s length trader
with the Councils that owed no duties to them as a financial adviser? The reality was that
Grange portrayed itself to Parkes and Swan as a financial adviser for each Council. That is
how Mr Bokeyar for Parkes, and each of Messrs Senathirajah and Downing for Swan,
understood Grange was acting in relation to the Councils. I find Grange’s contemporaneous
characterisation of its relationship to its Council clients as a financial adviser was accurate.
Indeed, in its expression of interest for investment advisory services for Mid-Western
Regional Council that it made in July 2007, Grange described itself as “act[ing] for” 95
councils in New South Wales, over 40 in Victoria and 12 in Western Australia. It listed
councils in New South Wales in various categories, describing Parkes as one of the “Councils
where Grange acts in an advisory capacity outside the IMP process”. Although this self
description was late in the piece, it was historically accurate from the inception of Grange’s
relationships with Parkes, and I find, Swan.
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475 That relationship was illustrated by how Ms May dealt with Mr Bokeyar in relation to
the Griffin AA product in the period before and after the 7 April 2003 Local Government
conference. Ms May provided Mr Bokeyar with a three page research note by Mr Vincent
dated 4 April 2003. The note discussed four risks on the second and third pages, namely
adverse movements in the underlying credit default swap market, credit downgrades in the
underlying portfolio, defaults in the underlying portfolio and adverse geopolitical events.
Mr Bokeyar did not recall reading this note. It contained a lengthy disclaimer in small print
at the end, that among other things told readers not to act on a recommendation without
consulting their investment adviser.
476 On 9 April 2003, Ms May had a telephone conversation with Mr Bokeyar after which
she emailed him saying that she would put Parkes down as an investor for $1 million worth
of the Griffin product. Ms May said she would put together a comprehensive email with a
switch proposal to sell Parkes’ Bank of Queensland and BankWest securities to fund the
purchase and suggested that “we can look at some scenarios next week for an extra
allocation”. A week later Mr Bokeyar and Ms May spoke about this and she followed up
with an email on 16 May 2003 saying that:
“I only have a small amount [of the Griffin AA product] to place to my very good clients!!”
Ms May proposed that the $1 million purchase be funded by the Council switching out of its
$1 million BankWest FRN purchased in November 2002 ([438]). The email continued:
“Reasons for the switch: 1. Take profits $810 2. Increase cash flow from BBSW + 75 to BBSW = 120 ($4500 over and above
current holding per year) 3. Increase in credit [rating] from A- to AA 4. Shorter term to maturity – Griffin is a 3 year deal … 5. New issue – potential again for profits 6. This is the last new CDO that we will be involved in for a little while – we
will be concentrating on trading secondary market transactions which bodes well for credit spread contractions to all those who buy them on new issue!!” (emphasis added)
477 Mr Bokeyar said that the improved credit rating would have been his principal
motivation in agreeing to the switch, together with the shorter term to maturity. He said that
it always seemed that Grange advised “a prudent way to do it”. I do not think that he could
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have understood the explanation in the sixth reason. On 30 April 2003, Grange issued
contract notes to Parkes effecting its purchase of $2 million of the Griffin AA notes financed
by the switch of $1 million for the BankWest FRN and $1 million in cash.
478 On 13 June 2003, Ms May sent an email to Mr Bokeyar among others initiating
Grange’s marketing of the Argyle AAA product (see [209]-[214] above). Mr Bokeyar had no
recollection of reading this and did not invest in the product. Nonetheless, the substance of
Mr Bokeyar’s understanding of SCDOs as a suitable investment for Parkes, and of Grange’s
financial advice to him about this product type, is reflected in the following extract from
Ms May’s email, with her own emphasis:
“Investment grade CDO’s are very attractive instruments for the more conservative investor, or for the defensive or capital-stable portion of an individual’s asset allocation. These instruments provide very attractive spreads given the low level of risk assumed, and are lowly correlated to most other asset classes, providing good diversification. Floating rate CDO’s can also be used as an alternative substitute to holding of [sic] large portfolios of bank bills. Though longer in maturity, they are priced at attractive margins above bank bills, have better ratings, and being floating rate in nature, provide a natural hedge to rises in interest rates. Grange Securities is a leading player in this emerging market.” (italic emphasis added)
479 I find that the above extract encapsulated the substance of what Grange’s
representatives conveyed as financial advice to both Parkes’ and Swan’s officers over the
years of their dealings in SCDOs, namely, the conservative nature of that class of product, its
capital stability, low risk, attractive return and its being an appropriate means for investing
public money by local government bodies. Significantly, Ms May equated floating rate
CDOs to bank bills. The email also stated:
“Secondary market liquidity: Grange distributes its deals widely, both geographically and sectorially to a large number of investors and actively promotes secondary markets in the issues on a best endeavours basis.” (bold emphasis added)
This statement contained a qualification that was unusual in Grange’s sales’ materials in
evidence, namely, that it “actively promotes secondary markets in the issues, on a best
endeavours basis”. Grange argued that this, among other examples, “implicitly drew a clear
distinction between the liquidity of bank FRNs and SCDOs … and [Grange] certainly made
more nuanced statements than [Parkes’] asserted representation that the products were simply
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“liquid””. I am not persuaded that subtle nuances, such as the concept of a “best endeavours
basis” promotion of a secondary market were explained orally to or understood by
Mr Bokeyar as derogating from the more bullish endorsement of these products as “very
attractive instruments for the more conservative investor” that Ms May emphasised in the
same email. It is much more likely that her oral explanation to Mr Bokeyar concentrated on
the less subtle concepts of liquidity and the existence of what most of its slide presentations
in evidence stated in terms such as that set out in [245] above: “Grange provides a Liquid
Secondary CDO Market”. That is reinforced by her assertion that the SCDOs were an
alternative to bank bills.
480 On 22 July 2003, Ms May emailed Mr Bokeyar advising him of a new FRN product,
the Ascot AAA CDO and attached an indicative term sheet. The term sheet described Grange
as the underwriter. It noted that final maturity would occur in 3.5 years and the coupon
would be BBSW + 90 bps. As usual, the term sheet stated that the minimum investment
would be $500,000, or $50,000 for sophisticated investors. It also had the usual clause about
program documentation. Mr Bokeyar had no recollection of this dealing, but no doubt
because Parkes had begun to receive the new financial year’s rate income, he decided to
invest $500,000, as recorded in a contract note dated 20 August 2003. The contract note
contained terms and conditions in half a page of small print that dealt with the mechanics of
purchase and sale transactions but contained no relevant qualification of Grange’s liability to
or relationship with Parkes.
4.4.5 Parkes’ HY-FI transaction
481 On 17 September 2003, Ms May emailed her clients, including Mr Bokeyar, with
details of a new CDO called HY-FI for which Grange was both the underwriter and a co-
manager. The text of the email, that was headed “New Issue FRN”, set out most of the
details usually seen in a term sheet. The email noted that final maturity would occur in five
years, and the coupon would be BBSW + 135 bps. It continued with Ms May’s emphasis:
“Listing: Listed on ASX HY-FI is the first ASX listed investment grade rated CDO and is also available to Australian retail investors. “The AA- Preliminary rating assigned to the Notes issued by HY-FI indicates that HY-FI has a very strong capacity to pay interest due on the initial face
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value of the Notes on each quarterly payment date, and repay in full to investors no later than the final maturity date” – Standard and Poors [sic] Presale report”
482 Mr Bokeyar said that it was likely he read the above statement that HY-FI was the
first ASX listed CDO. The substance of that statement was repeated in a slide presentation
that Grange made on the HY-FI product to Mr Bokeyar in person. I will return to the slides
shortly. However, he did not appreciate the significance of this description until about
January or February 2005. This was when he reviewed Grange’s portfolio valuation for
Parkes as at 31 December 2004. That showed that Parkes’ $1 million investment, as recorded
in a contract note of 1 October 2003 in the HY-FI product, as now being valued at $985,000
and recorded as an A+ rated listed CDO. (For some reason the HY-FI product was not listed
on Grange’s audit letter attaching Parkes’ portfolio as at 31 December 2003 and 2004.
However, the 2003 audit letter listed all other five investments, including four SCDOs at par
value, and the 2004 one did so too in respect of eight other SCDOs.)
483 Mr Bokeyar was not challenged on his evidence about his initial (lack of)
understanding of the significance of the HY-FI product being listed on the ASX. I accept that
evidence because it is consistent with the firm impression that I formed from seeing him in
the witness box for an extended period that he was a straightforward, honest man who was
financially quite unsophisticated and completely out of his depth when dealing with SCDOs.
He did not appreciate during the time he was working for Parkes that he did not have any real
understanding about SCDO products or their risks. He simply trusted Grange so that when
Grange made a recommendation or gave him advice, he believed that he could act on it once
he saw, as was always the case, it had a good rating, and complied with the Minister’s order.
Once he saw that these criteria were met, he trusted Grange’s advice that it was a suitable
investment for the Council and he did not even try to understand the underlying transaction or
its risks.
484 The slide presentation for HY-FI broadly followed the typical pattern I have described
above. However, one page depicted that if the HY-FI AA- (i.e. series 3) product suffered
nine defaults or the BBB (i.e. series 4) product suffered six defaults, all principal would be
lost. Although that page, which is reproduced below, refers to its use of colours to show the
impact of defaults on returns and principal, Grange’s counsel did not suggest to Mr Bokeyar
in cross-examination that the copy he was given was in colour, rather than black and white.
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485 The point about principal loss is still graphically made in the above slide. But, this
was juxtaposed with 0.0% as the chance of nine defaults in the probability of occurrence
column. In the notes, that figure was qualified by the statement “probabilities for all
outcomes are non-zero ‘0.0%’ indicates the probability is zero to two decimal places”. Mr
Bokeyar accepted that Grange’s personnel had told him that even though the rating suggested
that it was a remote possibility, if there were too many defaults in the CDO’s portfolio, the
principal would start to be lost. However, as the same slide showed the chance of 9 defaults
occurring, to two decimal places was 0.00%. To a lay person with Mr Bokeyar’s
qualifications, this chance was as good as zero, as indeed was the chance of 0.4% that the
return would be affected by the occurrence of six defaults. Mr Bokeyar was not cross-
examined to suggest that he had some understanding of the probabilistic or mathematical
significance of a 0.4% or non zero 0.0% chance of loss other than that it represented a remote
possibility. He said, and I accept, he would not invest funds in a building society even
through it was regulated by APRA because “it just didn’t seem safe enough for me”.
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Mr Bokeyar said that during an oral presentation by Ms May or Mr Clout, he was told that
the risk of loss on the highly rated products was so remote that it would never happen.
486 The slides had a disclaimer in fine print in the third of three sentences at the foot of
each page disarmingly introduced by the word in block letters “CONFIDENTIALITY”,
reading:
“Grange has taken all care and used its best endeavours in the preparation of this document, however Grange does not accept liability for any errors, omissions or inaccuracies or any losses or damages suffered or incurred by any party relating in any way to this document.”
487 The final page of the presentation was headed “Disclaimer”. It revealed that Grange
was receiving fees as a co-manager. It warned the reader to consult their investment adviser
before acting in respect of any recommendation in the slides. One paragraph contained first,
a statement that Grange did not warrant the accuracy of anything in the slides and, secondly, a
disclaimer of all liability of Grange:
“for any loss or damage suffered by any person by reason of the use by that person of, or their reliance on, any information contained in this document or any error or defect in this document, whether arising from the negligence of Grange and its Associates or otherwise.”
Grange also provided Mr Bokeyar with a research note on the HY-FI product, but he did not
read it. It is safe to infer that none of these disclaimers in any of the slide presentations had
any effect on Mr Bokeyar. He did not read them and, more importantly, did not rely on the
content of any slides. He relied on the oral advice and explanations by Ms May and other
Grange personnel in making any decisions.
488 As I have said above, in early 2005, Mr Bokeyar realised that the HY-FI product was
listed when he saw Grange’s portfolio valuation of it at less than par. He discussed this with
Mr Clout or Ms May saying that he had not realised the product was listed on the stock
exchange, it was below par, he was not happy about this and he wanted to sell it. The Grange
employee told him that if he did not feel comfortable with the investment Grange would sell
it on the Council’s behalf. Mr Bokeyar said that this was what he wanted to happen.
Whether Ms May was involved in this discussion, or not, her superior Mr Clout was.
Mr Bokeyar said that his main concern was that Parkes would not get its full capital back
because of price volatility. Mr Clout or Ms May told him that there was no hurry because the
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price went up and down. Mr Bokeyar instructed Grange to sell when the price rose to par
value.
489 On 23 February 2005, Mr Clout spoke to Mr Bokeyar and subsequently emailed a
recommendation to him to switch the $1 million invested in the HY-FI product to the new
Green SCDO product. Mr Clout proposed in the email that the sale of the HY-FI product
settle on 28 February 2005 and that Grange would place the proceeds with an ADI at an
appropriate interest rate until 17 March 2005 when the Green product offering would settle.
However, on 28 February 2005 Ms May emailed Mr Bokeyar seeking authority to use the $1
million from the sale “for the purchase of $1m of Kosciusko FRN, to the 17th March”, at an
interest rate of 5.8%. This was an example of Grange arranging a “no haircut repo” with a
council. Even though the HY-FI product was listed on the ASX, Grange did not place
Parkes’ notes on the market. It issued a contract note that stated the “trade”, all or part of
which was crossed, had occurred on 23 February 2005 for $1,006,500 with settlement on 28
February 2005.
490 This episode demonstrated a number of things. First, it illustrated Mr Bokeyar’s
aversion to the value of Parkes’ investments being exposed to market forces, such as trading
on the ASX. Secondly, it reinforced his evidence that he would not have gone ahead with any
investment in SCDOs had he been given a proper explanation of the risks described at [446]-
[448] above. The risks of Parkes’ losing any capital value of its investment, price volatility,
illiquidity and the absence of any secondary market to which SCDOs were exposed were far
less transparent than the reflex of a market price that a security listed on the ASX portrayed
to Mr Bokeyar. And, thirdly, of course, the episode also demonstrates Mr Bokeyar’s
complete incomprehension of what he was doing. He swapped the only SCDO that had any
liquidity separate from Grange for another SCDO that did not. The inherent risks in each of
the HY-FI and Green products (or any other SCDO in which Parkes invested) were relevantly
the same. Fourthly, Mr Matthews must have been equally ignorant of the misconception
under which he went along with Mr Bokeyar’s decision that Parkes should sell the HY-FI
product but continue to invest in products that had the same risks but were less liquid and
transparent than the product they were abjuring, which at least Parkes had the ability to trade
on the ASX independently of Grange. Fifthly, Mr Bokeyar, and apparently Mr Matthews,
changed the investment of $1 million of Parkes’ money from one SCDO into another for the
objectively insubstantial reason that the HY-FI product was listed on the ASX. This showed
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the fallacy in Grange’s argument that its personnel and others, such as Westpac’s, had made
Mr Bokeyar and Mr Matthews (either initially or at any time over the five years of their
dealings) sufficiently aware of the nature and risks of SCDOs as an appropriate investment
for Parkes.
491 Mr Bokeyar never understood the risks. The insubstantial reason he gave to Ms May
or Mr Clout for not wanting to keep the HY-FI product would have conveyed to Grange in
the plainest of terms that Mr Bokeyar was ignorant of the nature and risks of SCDOs. Even if
it were possible that Grange was not aware earlier, this incident must have made Grange
aware that Mr Bokeyar and Parkes were uninformed and unsophisticated investors. I am
satisfied that Grange was always aware that Mr Bokeyar and Parkes were uninformed and
unsophisticated investors on whom Grange was preying in the way Mr Vincent later
described Grange’s Council clients generally in his “no haircut repo” email. Indeed, that is
the very “investment” Grange put Parkes’ $1 million into for 17 days after the sale of the
HY-FI SCDO, despite Mr Clout’s earlier suggestion that the money would go into an ADI.
This conduct reinforced the impression Grange conveyed to its Council clients, including
Mr Bokeyar, that the SCDOs Grange recommended to them as investments were at least as
safe as one of the four major Australian banks.
492 Because Mr Bokeyar and Parkes continued to invest in SCDOs until mid 2007 it
follows that they continued to lack, and Grange continued to be aware that they lacked, any
appreciation of the nature or risks of investing in each of the claim SCDOs. Had Mr Bokeyar
or Mr Matthews become aware of the risks of capital loss that might be substantive,
illiquidity, price volatility, the lack of a secondary market and the lack of Parkes’ investor
suitability at any stage before the commencement of the global financial crisis in 2007 they
would not have continued with investment of Council funds in SCDOs.
493 This is not to diminish the significance of Mr Bokeyar’s inattention to even the
simplest written material dealing with each proposed investment of large amounts of public
money. However, this trait must have become obvious over a short time to Ms May and
Mr Clout as they dealt with Mr Bokeyar and certainly, no later than February 2005 when he
told Grange about why he wanted to sell the HY-FI product. He was not wont to seek
information about Grange’s products by sending email enquiries. As he said in evidence,
Grange would send him an email informing him of a new product or proposal but he could
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not recall ever responding. Rather, he waited until Ms May, or someone else from Grange
would ring him enquiring whether he had received the earlier email. He said that then the
discussion went along the following lines:
“And I would say, Yes, I did, and they would say, Well, what did you think? And I said, Well, I haven’t really had much time to think about it. You run me through the pros and cons of it. So that’s how things happened, and then if I was interested further, I would say, Well, I need to think about it and when does it need to you know when is it going to start and so forth, and if I didn’t have new money I would say, Well, you tell me the reasons why because initially with Grange I would look at the list of investments that we had, and if it was I would pick the lowest rated investment and say, Well, perhaps we could sell this one. But as time moved on, I would ask Grange, I would say, Well, you tell me, you have a look at the portfolio and you tell me which one to take.” (emphasis added)
494 Mr Bokeyar said, and I accept, Grange habitually followed up to see if he was
interested in a proposition. Again, this course of dealing would have made it apparent to
Ms May and Grange’s other personnel, that Mr Bokeyar had not read the written material and
always needed an oral explanation of what Grange proposed.
495 For these reasons, it is not necessary to consider in great detail each of the dealings
between Parkes, through Mr Bokeyar, and Grange or other persons who traded in financial
products with the Council. I will, however, outline those dealings below.
4.4.6 Parkes’ later dealings in 2003
496 Parkes, through Mr Bokeyar, maintained a considerable part of its investment
portfolio with Westpac throughout the period 2002 to 2007. When Parkes first had dealings
with Grange, it had around $10 million invested with the bank. Parkes continued to leave
around that sum invested with the bank over the period of its relationship with Grange but
invested more of its more recently received funds and reserves with Grange over time.
497 On 2 September 2003, Justin McFarland of Westpac Institutional Bank emailed Mr
Bokeyar informing him of a new series called Wollemi Trust of credit linked notes
describing them as “AAA rated 5 yr FRN paying 100 over 3m BBSW”. Mr Bokeyar did not
understand what a credit linked note was. Nevertheless, Parkes made an investment in this
product and, following settlement, on 10 October 2003, Westpac faxed Mr Bokeyar a letter
for him to sign. He did not recall whether he did sign it. The letter purported to confirm that
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Parkes fully understood the nature of the investment its risks and that Westpac had not given
Parkes any investment advice in connection with the investment.
498 On 5 November 2003, Ms May emailed Mr Bokeyar with news of a new SCDO
called Tungsten. They subsequently discussed this and Mr Bokeyar made some notes on the
email that indicated Ms May had told him the rating had been improved from AA- to AA and
the issue date changed from 3 to 10 December 2003. The email stated that there were 25
reference entities of which 19 were AAA rated. She sent him an indicative term sheet that
stated the coupon was BBSW + 150 bps and the term five years. The term sheet said the
product was rated AA but a footnote said that it had not yet been rated but was expected to be
rated AA or AA-, the latter being the lowest acceptable if the issue were to proceed. The
term sheet also had the usual provisions concerning a minimum investment of $500,000, or
$50,000 for sophisticated investors and the operation of the program documentation. The
attachment point (described in the term sheet as “credit support”) was 1.75%.
499 On about 2 December 2003, Mr Bokeyar agreed that Parkes would invest $1 million
in the Tungsten product and Grange issued a contract note for it on 4 December 2003 stating
that the product was rated AA-. As it turned out, one of the reference entities in the Tungsten
AA product was the Italian diary company, Parmalat. It defaulted on a €150 million principal
payment within days of 10 December 2003. Grange wrote to Mr Bokeyar on 16 December
2003 advising him of this default and the fact that Parmalat ultimately had made the payment
within the five days of grace it had to remedy its default. The letter said that the default in
making the payment on the due date had caused a deterioration in the product’s rating but that
even if Parmalat had defaulted in making the payment during the days of grace, no capital
loss would be suffered by investors. It noted that Grange as lead manager had negotiated
with the arranger for Parmalat to be removed as a reference entity “at no cost to yourself as
an investor”.
500 The Parmalat default also affected Parkes’ investments in the Ascot product, which,
as a letter from Grange to Parkes noted, was downgraded from AAA to AA+ and, the HY-FI
product, as an announcement to the ASX noted. Neither of those two communications
referred to Parmalat being removed or replaced as a reference entity in the Ascot or HY-FI
products’ reference portfolios. Mr Bokeyar received each of these three letters but appeared
to have accepted the assurances that the credit event had not caused any capital loss to
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Parkes. He understood, based on what he had discussed with someone from Grange at
around the time of the Parmalat default that, as happened with the Tungsten AA- product,
once a default occurred, the relevant company was removed from the SCDO’s reference
portfolio and simply replaced, thus restoring all the subordination as if no default had
occurred. That understanding would have been reinforced later by what occurred in March
2006 when the Green product was restructured after a significant default that would have
caused its rating to become BBB (see [567] below). He understood from the oral
explanations he received from Grange that the benefit of SCDOs having, a manager, as
became more frequent, was that “the manager [was] actually keeping an eye on it” to monitor
the portfolio and winnow out reference entities that may pose a risk of defaulting, replacing
them with others to maintain the product’s rating and investors’ capital.
4.4.7 Parkes’ dealings in 2004-2005
501 On 24 February 2004 Mr Clout had a telephone discussion with Mr Bokeyar about a
new SCDO product, Balmoral AA. During this discussion Mr Clout raised the suggestion
that Parkes should switch $1 million of its investment in the Griffin AA that had been
acquired on 30 April 2003 into funding a $1.5 million investment in the Balmoral AA
product: see [477]. Mr Clout followed this suggestion up immediately afterwards in two
emails, one reiterating the proposed switch, the second sending Mr Bokeyar an indicative
term sheet for the new SCDO. This was the first example of Grange effecting a switch of
investments by one of the Councils between SCDOs. The indicative term sheet identified
that the coupon would be BBSW + 130 bps (an increase of 10 bps over the Griffin AA
product) and final maturity would occur in 5 years time (a further 3 years beyond the time of
the Griffin AA product’s maturity). Grange also sent a slide presentation for the Balmoral
product to Mr Bokeyar who, as usual, printed it out and put it in a file without reading it.
Next on 25 February 2004, Mr Clout sent a further email to Mr Bokeyar setting out the
mechanics of the transaction and concluded saying:
“The other benefits to all of this are: 1. take profits ie approximately $3910.00 2. maintain the same credit rating ie AA 3. increase coupon cash flow from BBSW + 1.2% to BBSW + 1.3% 4. Diversify into the CDO of Asset backed securities.”
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502 The last point referred to the reference portfolio of the Balmoral product which
consisted of 36 AAA rated asset backed securities and three AA rated SCDOs. At no time
did anyone from Grange ever tell Mr Bokeyar that one reason for its recommendations of
this, or any subsequent switch, was that Grange would earn significant underwriting fees or
profits. Nor did Grange ever inform Mr Bokeyar that a reason for any recommendation it
made was that the arranger wanted to redeem the SCDO that Grange would buy back from
the Council. Thus, for example, Grange earned a profit of 2.19% of the total face value of the
issue price of $40 million for the Balmoral product: i.e. $876,000.00. Two months earlier it
had earnt a fee of $880,000, or 2%, on the Tungsten product’s total issue face value of $44
million.
503 However, Grange took an underwriting or purchaser’s risk with these products. The
evidence of the extent of those risks for the various products is incomplete. But in the case of
the Tungsten SCDO, on the issue date of 10 December 2003, Grange paid the arranger, a
related entity of Royal Bank of Canada, $43,120,000 for notes with a face value of $44
million. On that date Grange sold $42 million worth at face value to its clients, including
Parkes and placed $1.5 million worth in Grange First Provident Pty Ltd, which I infer was its
subsidiary. Thus, Grange had to cover the net shortfall in its on sales of $1.12 million by
holding notes with a face value of $2 million. It sold the $1.5 million held by its subsidiary
on 19 January 2004 and the balance of $500,000 on 21 January 2004. Thus, a little over six
weeks after the issue date Grange had earned a gross profit of $880,000 less some holding
costs on the difference in the yield for which it sold the $2 million in notes and what it earned
on them and the cost of financing the $1.12 million in the meantime. Of course, the Parmalat
default immediately after the Tungsten SCDO was issued would have made subsequent sales
of that product difficult until its reference portfolio was reconstituted. I infer that this is the
likely reason why Grange took a little over a month to sell the $2 million worth of notes it
had not pre-sold.
504 Grange also made a disclosure of sorts of its profit on the repurchase price of the
product it bought from the Council. In the case of the Griffin/Balmoral switch, Mr Clout
disclosed that although the coupon on the Griffin product was BBSW + 120 bps, Grange was
repurchasing it on the basis of it having a “yield” of BBSW + 100 bps. However, exactly
what this “yield” signified was far from clear (see [543]-[546] below). On 9 March 2004,
Grange sent Parkes contract notes for the switch.
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505 Mr Bokeyar reported to the Council that as at 31 March 2004, the Council had
investments (including accrued interest) of about $28.25 million compared with about $23.7
million at the corresponding time in 2003. About $7.25 million of the $28.25 million was in
Grange SCDO products and about $18 million was invested in Westpac products,
approximately $2.25 million in a Local Government Financial Services product and the
balance was at call.
506 On 19 May 2004, Mr Clout emailed Mr Bokeyar attaching the slide presentation for
“the last deal of the financial year”. The new product was the Bennelong AA SCDO. It had
a portfolio of 32 AAA rated asset backed securities and four AA rated CDOs. Mr Clout’s
email summarised the transaction saying that the CDO matured in five years and was “issued
as a floating rate note with a margin of BBSW + 150”. He said that Grange had performed
due diligence on the deal and would provide a research note shortly. Beguilingly, Mr Clout’s
email said that the deal size was $40 million “with potential to upsize the transaction to
$60m, We have seen strong interest in the transaction & would like to provide you with an
allocation”. He concluded saying:
“I will give you a call to discuss how we can fit it into your portfolio this afternoon.” (emphasis added)
507 Mr Bokeyar did not recall the terms of the discussions he had with Mr Clout leading
to Parkes investing $500,000 in the Bennelong AA product on 31 May 2004. However, he
described the general nature of discussions he had with Grange personnel when they phoned
him about a new product. Mr Bokeyar said that they would tell him of the new product, any
new features, its compliance with the Minister’s order, the due diligence Grange had done,
the high credit rating, often adding that it qualified for a higher one and that they had looked
at the Council’s current portfolio. Then the person would say:
“Well, we think that it is a good investment and it would be suitable … in the context of the other investments that we are holding on your behalf.”
508 Grange argued that these were part of its sales patter and were not advisory in
character. I accept Parkes’ argument that discussions of the kind described in Mr Clout’s
email of 19 May 2004 and Mr Bokeyar’s evidence involved Grange giving Parkes financial
advice. First, Grange was offering to advise on adjusting, or fitting something into, Parkes’
portfolio of investments that it, Grange, had brokered. Secondly, Grange was expressing
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opinions on matters within its expertise and recommending, as an expert, a course of action.
Thirdly, the expression of its opinion on those matters was the very service that Grange
publicly asserted it performed as a financial adviser to Councils.
509 Next on 30 July 2004, Grange issued Parkes with a contract note for a sale of $2
million worth of the new issue of the Endeavour AAA SCDO2 that had a seven year term (see
[229]-[231]). Incongruously, about two years later on 25 May 2006, Grange made a switch
recommendation to Mr Bokeyar advising that its proposal of the Council selling its
Endeavour notes and acquiring the Scarborough AA product would offer “reduced exposure
to maturity (2011 to 2009)”. In fact, the final maturity of the Scarborough notes was in 2014:
see [575].
510 On 30 August 2004, Mr Clout emailed Mr Bokeyar a term sheet and slide
presentation for the Kosciuszko AAA rated CDO2. The coupon was BBSW + 100 bps. This
was the first transaction involving Parkes that involved a call date at two years, as well as a
final maturity date after three years. Mr Bokeyar said that Ms May had told him prior to
January 2005 that the “call date” was the first date on which such an investment could be
called and that they always were paid out or redeemed on that date and not later on the date
of final maturity. The reference portfolio for the Endeavour AAA product consisted of eight
BBB + rated CDOs and it had an attachment point of 25%. Mr Bokeyar had no recollection
of ever having the concept of a CDO2 drawn to his attention. It would have been beyond his
comprehension.
511 On 3 September 2004, Mr Clout emailed Mr Bokeyar a research note on the
Koscuiszko product, noting that the Council would buy $500,000 worth on the issue date of
15 September 2004. Needless to say, Mr Bokeyar did not read any of the material on this
product that Mr Clout sent him. Indeed, he only printed two pages of the 10 page research
note. The research note stated that it sought to identify the foremost risks in the Koscuiszko
transaction and identified two: the risk of a downgrade “with possible subsequent secondary
market price deterioration” and the risk of a loss of principal and interest. It concluded that
those risks were “more than allayed, with the Koscuiszko transaction presenting as a robust
offering at a very competitive price”. Although Mr Bokeyar did not read this note, it is likely
that Mr Clout or Ms May repeated those matters as salient justifications for Grange’s
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recommendation. By 10 September 2004, when Grange issued a contract note to Parkes,
Mr Bokeyar had agreed to buy $1 million worth of the Kosciuszko product.
512 Soon afterwards Grange sent Mr Bokeyar a switch recommendation in a new,
specially formatted document that it subsequently employed for most future such suggestions.
I have set out an example at [540]. The document compared two SCDOs by placing details
of each on one line above the other including the coupon/margin, maturity date, face value,
yield, capital price, accrued interest, total price and rating. “Points to note” appeared
underneath those details on the left of the page and a cash flow analysis on the right. The
switch recommendation noted that Bennelong AA had a coupon of BBSW + 200 bps
compared to Griffin AA’s margin of 120 bps. Although nothing was made of this in
argument, I note that the contract note recording the sale of the Bennelong product that
Grange issued on 17 September 2004 recorded the coupon as only BBSW + 150 bps, not +
200 bps. The points to note included that the switch would provide “good diversity with
current CDO holdings” and diversify the maturity profile of Parkes’ “portfolio now with
Koscuiszko holding”.
513 Not long after, on 5 October 2004, Ms May emailed her clients with Grange’s latest
new issue, the Hotham AAA SCDO2. It was structured similarly to the Koscuiszko one with
a reference portfolio of 8 SCDOs rated BBB. It had three call dates, the first after three years
with subsequent ones yearly and a final maturity date 5.6 years after issue. The coupon was
BBSW + 100 bps but the margin would increase each time was not called. Later, Ms May
provided a term sheet and a slide presentation for the Hotham product on which Mr Bokeyar
made a number of notes. I infer that he did this during a meeting at which Ms May or
someone from Grange took him through the slides.
514 Mr Bokeyar noted down that the large subordination of 29% gave the SCDO its AAA
rating. Mr Bokeyar understood from what Grange personnel had told him, as was repeated in
the Hotham product slides, that the way the SCDOs were structured was to greatly reduce,
but not to absolutely eliminate, the risk of loss to investors. He agreed that this was conveyed
in substance by a slide that commenced with the heading: “Risk is low, as per Historical
Default Statistics” under which appeared:
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“To affect Hotham principal, a minimum of 3 ‘underlying’ CDO’s would ALL need to experience default rates in multiples of S&P’s worst recorded.” (emphasis in original)
515 In my opinion, this and the balance of the slides reinforced the impression that Grange
had sought to convey that the high rated (AAA and AA) transactions were safer than the
major Australian banks and, equivalent in the AAA cases, to the Australian government.
That is, there was a risk of loss, but it was so remote that it was not a substantive factor to be
taken into account when the Council was making an investment decision. Indeed, a
subsequent slide in the presentation made the statement of this already AAA rated security:
“Expectation is that Hotham’s credit quality will improve through the transaction.”
Another slide dealt with Grange providing a liquid secondary market in the following way
which is similar to, but not the same, as that for the Flinders AA product at [245] above:
516 The last three slides in the Hotham presentation contained two pages of risk factors
and one of a disclaimer. The disclaimer stated that Grange was acting as sole underwriter for
the issue of the Hotham product “and receives fees for acting in that capacity”. It did not
mention that the fee was 2.5% of the face value of $40 million on issue: i.e. $1 million. The
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risk factors stated that, among others, investors were exposed to the risk of a total loss of their
capital. However, as I have said the slides and Grange’s explanations left the impression that
this risk was merely theoretical. The factors stated baldly, and without elaboration, that
“investors are exposed to leveraged credit risk because the size of the Reference Portfolio is
significantly larger than the size of the respective investment plus subordination”.
517 Another risk factor told the reader that the arranger did not warrant that it would
provide secondary market liquidity for the notes “although it understands that Grange intends
to perform this function”. The arranger then said that it “advised that no guarantees of
ongoing liquidity in all market conditions can be assumed”. That was hardly likely to have
any impact on Grange’s clientele, given the earlier slide on Grange’s provision of a liquid
secondary market that is reproduced at [515] above and Grange’s whole marketing strategy
based around it doing so.
518 Mr Bokeyar received, printed off, but did not read, a Grange research report dated
11 October 2004 on the Hotham product. He said in cross-examination that he had no
recollection of the point put in the first sentence of the following portion of that report under
the heading “Mitigating Factors” in respect of Standard & Poor’s rating:
“S&P’s ratings are based on the risk of a $1 principal or interest loss to a given issue (not on the severity of loss). If for a given CDO we add the subordination and tranche amounts together we are able to determine what rating is equivalent to losing that CDO’s whole tranche (using S&P CDO Evaluator). When we perform this for CDOs 1 to 8 the result is AAA. Hence, the probability of one of these CDOs losing their whole tranche is equivalent to a AAA rating. This is important, as no S&P rated AA CDO has ever defaulted.” (emphasis added)
519 Mr Bokeyar said in cross-examination (and I accept) that he did not understand what
“the severity of loss” meant in the first sentence. On 29 October 2004, Grange issued a
contract note recording Parkes’ purchase of $1 million worth of the Hotham SCDO.
520 In the meantime, Grange had arranged a “free CDO Information Session” on
21 October 2004 at Orange Council’s Chambers. Mr Bokeyar attended with representatives
of four other country councils. Mr Vincent made a slide presentation there. Mr Bokeyar
made some notes on his copy of the slides as Mr Vincent spoke. One slide stated:
“CDO’s Popular as they Meet a Market Demand
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• CDO’s are attractive to investors because they offer a better ‘risk/reward’ proposition than alternative investments
• CDO’s are also very flexible instruments that can be easily tailored to investors
needs • CDO product development is rapid → market for investors is continually
improving • Higher rated CDO’s appeal to conservative investors → in Australia these are
generally institutions who are looking to out perform cash or bank bills • Lower rated CDO’s appeal to more aggressive investors → in Australia these are
generally retail investors looking for a high absolute return on the fixed interest part of their portfolio”
521 Mr Bokeyar said that Mr Vincent told the meeting what this slide also emphasised;
namely, that higher rated SCDOs were appropriate for conservative investors such as the
Councils to whom the presentation was made. This slide also asserted that those products
offered better “risk/reward” than alternative investments. The message that a person such as
Mr Bokeyar would receive from the presentation was that the products promoted by Grange
were in the same class of secure investment as cash or bank bills but offered a better return.
Another slide referred to one of the “typical attractive features” of a highly rated CDO as
being “Secondary market liquidity” and, another repeated the slide reproduced at [515]
above.
522 Mr Bokeyar said that Mr Vincent described Grange’s special expertise and the
extensive research Grange did on the products it offered. Mr Vincent told the meeting that
“there was always liquidity and ongoing support”. Mr Vincent said that Grange thoroughly
reviewed all aspects of each transaction that it approved and considered that it offered good
value as well as being appropriate for its investors.
523 In late November 2004, after an initial email, Ms May spoke to Mr Bokeyar and got
his agreement to a switch of Parkes’ holding of $500,000 of the Ascot AA product for a
National Australia Bank product. That switch was cancelled after the bank announced it was
buying back the proposed purchase and Ms May then suggested that Parkes switch instead
into holding $500,000 worth of the Octagonal AAA SCDO. She explained reasons for the
new switch in an email of 2 December 2004. These included that the Ascot product had a
lower rating, AA, and coupon BBSW + 90 bps compared to Octagonal’s AAA rating and
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coupon of BBSW + 125 bps. However, no explanation appeared in Ms May’s emails to
Mr Bokeyar as to why Grange wanted to buy the Ascot product back and had suggested two
products, successively, with which Parkes could replace it. The Ascot SCDO had been
affected adversely by the Parmalat default almost one year before (see [232]–[233], [499]-
[500] above). Mr Bokeyar agreed to the latter proposal and Grange issued contract notes
accordingly.
524 From 11 January 2005 Ms May began promoting the Flinders AA product to
Mr Bokeyar as Grange’s first CDO for 2005 (A/8330). It was an SCDO2 with a reference
portfolio of four AA- rated SCDOs offering a coupon of BBSW + 150 bps. It had an
“arranger call date” after about four years, then exercisable annually until final maturity about
seven years after its issue (A/8332). On 12 January 2005 Ms May sent Mr Bokeyar Grange’s
valuation of SCDOs Parkes held with it. That revealed to him the below par value of the HY-
FI product (see [482] above). On 17 January 2005, Ms May emailed Mr Bokeyar proposing a
switch of Parkes’ holding of the Forum AAA product for the new Flinders one. She invited
Mr Bokeyar and Parkes’ auditor, John O’Malley, to a presentation on the new SCDO at
Orange Council Chambers the next week. Ms May pointed out that the yield improved from
BBSW + 130 bps to + 150 bps saying, with her emphasis:
“No CDO rated AA – or better has ever defaulted.”
525 Grange issued contract notes effecting the switch on 31 January 2005. These
contained terms and conditions that noted (see too [254]):
“Fees & Charges Grange Securities act as principal when we buy and sell fixed interest securities in the secondary markets. The yield that we quote to you incorporates any margin that we will receive. The margin is the difference between the price at which we, as principal, buy the security and the price at which we sell the security to you. Grange Securities may also receive placement fees from Issuers for distributing securities on their behalf.”
526 As I noted in [489] above, in late February 2005 Grange switched Parkes’ $1 million
holding in HY-FI for an investment totalling $1.5 million in the new Green AA SCDO. It
was an SCDO2 with issuer call dates three years hence, in March 2008 and then annually
until final maturity seven years later. It had a coupon of BBSW + 100 bps. Grange issued a
contract note for the purchase of the Green product on 14 March 2005. However, on
16 March 2005 Grange wrote to Mr Bokeyar referring to Parkes “indication of interest” to
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purchase the Green product. The letter stated that a condition of the sale was that Parkes had
to agree to a list of 12 enumerated conditions as purchaser representations and warranties.
They were obviously matters insisted on by JP Morgan which was the investment bank
arranger and included the following:
“(h) Parkes Shire Council is a Professional Investor within the meaning of section 9 of the Corporations Act and has such knowledge, experience and expertise in financial and business matters and that it is capable of evaluating the merits, risks and suitability of the purchase of the Notes.
(i) Parkes Shire Council has made and will continue to make its own
independent investigation and appraisal of the risks, benefits and suitability of the purchase of the Notes to and for it including but not limited to the risk disclosures set out in the Termsheet and the following …”
(emphasis added)
527 Mr Bokeyar dutifully filled in the signatory names of Mr Matthews and himself, and
dated the letter that both of them signed. He then faxed it to Ms May. I have no doubt
Mr Bokeyar neither read nor understood the letter and I suspect Mr Matthews did not either.
Parkes met the criterion in par (e) of the definition of “professional investor” in s 9 of the
Corporations Act because it was a person that controlled at least $10 million. Its
investigation and appraisal of the purchase consisted of receiving and relying on Grange’s
recommendation and financial advice to buy it.
528 On 6 April 2005, Ms May emailed Mr Bokeyar with details of its new SCDO,
Granite AA-. She also sent him an information memorandum on which he noted that he had
agreed on 6 April 2005 that Parkes would buy $1 million worth of this product and would
settle on 20 April 2005. The Granite AA- product had a five year term and a coupon of
BBSW + 125 bps. Grange issued a contract note for its purchase on 15 April 2005.
529 Next on 20 June 2005, Ms May discussed with Mr Bokeyar a switch recommendation
to sell the Tungsten AA- product and buy the Flinders AA SCDO in its place. She emailed
him the next day with a written proposal. That showed that the two products had coupons of
BBSW + 150 bps, with Tungsten rated slightly lower but maturing in December 2008, while
Flinders had a final maturity four years later than that (in March 2012) and a call date of
March 2009. Ms May asserted that by engaging in the switch Parkes would receive a net sum
of $2700. On 23 June 2005, Grange issued contract notes giving effect to the switch.
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530 Grange sent Parkes a valuation of its securities as at 30 June 2005. This showed two
of its nine SCDOs, Green AA and Granite AA-, as having a capital price of $99.998 and
$99.997 per $100 of face value respectively. All the other SCDOs were valued above face
value. Mr Bokeyar worked out and wrote in the capital value of each investment. The total
amount of the reduction in value of the two affected SCDOs was immaterial, being only $60
out of a total capital price of $2.5 million. The overall capital value for the nine SCDOs was
$64,145 above their total face value of $12 million. Mr Bokeyar was content with this net
position given the very small size of the two reductions in par values. However, he was
aware that the price of SCDOs could go up and down, as this exercise showed. But he felt
reassured by two matters, first the positive overall net position reached after taking into
account the very small effect of the below par values and, secondly, information that he was
given by Grange in respect of any product that had a problem. As Mr Bokeyar said of
Grange:
“If there was a problem with something, they were always upfront. But there was always a comfort in their reply that: ‘Yes, well, that may be that, but we’re expecting this or that or something else, and we don’t see it as a great concern’. And that was so I was comfortable at that stage to, probably naively but comfortable at that stage, to continue.”
531 On 19 July 2005, Ms May emailed Mr Bokeyar with some information on Grange’s
latest SCDO, Wentworth AA-. This had a five year term and a coupon of BBSW + 150 bps.
She said with her own emphasis in the email:
“The Wentworth structure is an uncomplicated synthetic CDO referencing a managed portfolio of high yield entities. … Grange believes that Wentworth is a suitable investment for clients looking for a highly rated, low risk, ratings stable security. The margin is very attractive for an investment managed by a high calibre manager with an experienced track record in the high yield environment.”
532 Ms May’s description of an “uncomplicated” SCDO is breathtaking in its audacity.
Of course, Mr Bokeyar had, as she knew, no real idea of how complex and arcane any of
these instruments were. None was remotely capable of being described to Council officers
like Mr Bokeyar as “uncomplicated”. The fact that Ms May did so is indicative of how
Grange presented these products to its clients such as the Councils.
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533 Doubtless, Ms May emphasised in her discussion what she had highlighted in the
email, namely the suitability of this instrument for Parkes. She wrote saying that she would
forward a switch recommendation separately, which she did. However, in the end, Grange
issued Parkes with a contract note on 27 July 2005 indicating that it would pay $1 million
directly for the product. In the meantime Ms May sent Mr Bokeyar a term sheet, slides and
Grange research note for this “uncomplicated” SCDO that he did not read. Grange’s
marketing of the Wentworth issue was so successful that on 18 July 2005 it asked the issuer,
Calyon, to increase the size of the issue from $50 million to $75 million, earning a 2% profit
or $1.5 million for its troubles. Calyon agreed to the increase on 20 July 2005 noting that
although the market had tightened overnight (and so made Calyon’s profit less) it had decided
to fill Grange’s order in the hope of further deals, this being the first Grange had done with it.
534 Grange submitted that had Mr Bokeyar taken the trouble to read, for example, the
research note it had provided to him for the Wentworth AA- product, he would have seen its
analysis of risks and their mitigating factors. That document identified three risks and then
juxtaposed these with factors that suggested that the risks were very unlikely to be realised.
The risks specified were:
“ • Investors suffer a loss of either principal or interest • Wentworth is downgraded to a level where the investor is forced to sell the
notes and suffer a capital loss • General credit market movements adversely affect the secondary market
pricing of the transaction (cause an increase in the trading margin of Wentworth) and limit investor’s ability to sell Wentworth without capital loss.”
535 Grange argued that Ms May’s email to Mr Bokeyar of 19 July 2005, and her
complementary oral explanations were “a perfectly regular statement by someone trying to
sell something”.
536 As I found in [448] above, had Ms May told Mr Bokeyar of the substance of standard
risk disclosures in the information memoranda provided by issuers of SCDOs that are set out
at [122]-[123] above, he would have shown her to the door. The second and third risks
identified by Grange in its Wentworth AA- research note fell far short of a full or accurate
disclosure and were themselves misleadingly anodyne (leaving completely aside the
emollient in Grange’s juxtaposed identification of mitigating factors). First, the issuer
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warned that there may be no capacity to sell the notes at all. Thus, Grange’s reference, in its
second risk, to an investor being “forced to sell the notes and suffer a capital loss” suggested
that some market would exist in which a capital loss could, at least, be realised. That
suggestion was false, not only as the issuer warned but as has now actually occurred.
Secondly, Grange’s third risk, implied that a secondary market would exist in which adverse
price movements may “limit investor’s ability to sell Wentworth without capital loss”. That,
too, was false. It suggested that a market would exist to fix a price and that an investor could
sell, even though incurring a capital loss. The issuer’s information memoranda emphasised
that no secondary market could be guaranteed and, as the passages in [122] and [123] above
made clear, these investments had the fundamental characteristic that “it may not be possible
to make any transfer of the Securities for a substantial period of time, if at all”.
537 Accordingly, even if Mr Bokeyar had bothered to read just those risks identified by
Grange, and ignored the emollient of their accompanying mitigating factors, he would not
have been told accurately, or indeed at all, of the critical features of these products that would
have led him to show Ms May to the door.
538 Around mid 2005, Grange began proposing more and more switches to Mr Bokeyar.
This was to support its business of making significant profits from the sale of new issues of
SCDOs, sometimes combined with an arranger or issuer buying back another SCDO before
its maturity or call date. The switches gave Grange’s clients the impression that their SCDOs
were liquid and realised, almost inevitably, at least their purchase price if not a small profit.
539 On 25 July 2005, Mr Clout had emailed his colleagues with the list of holders of the
Bennelong SCDO informing them of its proposed buy back. He enquired if there was anyone
on that list “who will categorically not sell their holding with a view to reinvesting in a new
issue”. On 2 August 2005, Mr Vincent emailed his colleagues informing them that Grange
had agreed with the Royal Bank of Canada on “our latest CDO transaction, Quartz”. He
wrote that Grange had underwritten $80 million of that transaction “against buying back
$53.1 million of Bennelong”. By noon the next day Mr Clout emailed his colleagues that
Grange already had “firm commitments” to switch $23 million Bennelong for Quartz.
540 On 5 August 2005, Ms May sent Mr Bokeyar an email, following an earlier
discussion, in which she wrote:
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“I am pleased to provide you with the following switch recommendation. I will forward a term sheet and presentation separately, and have listed the economic benefits on the attached file. Benefits for the switch include, Realise a capital profit/trade up to a higher yield – you get both benefits as you have bought at two different levels .. No change in cashflow as coupon is the same and paid on the same dates as Bennelong Quartz has a similar exposure to Bennelong. In summary, we feel that Bennelong is now at fair value, and is time to take profits and reinvest in Quartz which we see as offering a greater yield and potential for capital appreciation. I will call you on Monday to discuss.” (emphasis added)
She also sent the switch recommendation document below.
541 On the following Monday, 8 August, Mr Bokeyar emailed Ms May saying “Please
proceed as discussed”. Ms May sent Mr Bokeyar a slide presentation and research note on
the Quartz product but, as usual, he did not read them. Grange issued contract notes on
25 August 2005 effecting a switch of $1.5 million worth of Bennelong AA notes for the new
Quartz AA notes.
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542 This switch is revealing. First, there is no substantive economic rationale for it. Both
products had the same rating, offered the same coupon and had a similar maturity: June 2009
for the Bennelong AA product; December 2008 as a first call and December 2010 as a final
maturity date for the Quartz product. Mr Bokeyar had agreed to buy $500,000 of the
Bennelong AA notes in late May 2004 ([507] above) and the balance in a switch in
September 2004 ([512]).
543 It is not clear what the reference in the switch recommendation document to the
“yield” was. When Parkes made its initial purchase of Bennelong AA notes for $500,000 on
31 May 2004, it paid par value for a coupon of BBSW + 150 bps. Thus, the reference to a
“yield/trading margin” of 1.30% for this parcel in the switch recommendation makes no
sense. When Parkes purchased the next parcel for $1 million, the contract note referred to it
being at a yield of BBSW + 120 bps at a capital price of $101.208 per $100 face value. So
Parkes paid $1,012,080 as the capital price for this parcel. The switch recommendation
appeared to attribute a capital price to that parcel of $100.994 per $100 face value or
$1,009,940 resulting in a capital loss for Parkes of $2140 on the $1 million parcel. Of course,
Parkes would make $3300 on the $500,000 parcel using a price of $100.660 per $100 face
value. Taking into account the different capital loss and profit on each parcel, Parkes would
make a net capital profit of $1160, not Grange’s asserted $3300. But that begs the question,
why would the two parcels of the same product be worth different amounts to the same
vendor and purchaser for a trade on the same day, 31 August 2005?
544 Mr Bokeyar gave this evidence about the switch recommendation document when I
asked him for his understanding of its purport:
“So what was the benefit of engaging in this as you understood it? --- Well, the it says there that the yields increased from 1.23 to 1.5, which seems to be a little bit of a contradiction in what it’s saying above. .... MR MEAGHER: Mr Bokeyar, the answer you have just given, does that suggest to you looking at this now, you understand that what you were getting […] on the Bennelong notes was an average of 1.23% and under the new notes you were going to get 1.5% ? --- Yes. That’s what I would understand that to be. Well, the position is that you own the Bennelong notes and the coupon rate is 1.5%, and you paid face value. Then you were getting 1.5% on the Bennelong notes. Didn’t you understand that? --- Well, I would have understood it. I just maybe I don’t know. I just I’d need to see what was actually being paid on Bennelong. When you purchased it, you mean? --- When we purchased it, yes.
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I see? --- I’m assuming that that’s, if that’s correct there. That is, you are assuming that you paid over face value for Bennelong, so you were getting a yield which was less than the coupon rate; is that what you say? --- No. No, I’m wondering if Bennelong when it was purchased was paying 1.5 per cent or was it paying 1.23 per cent, because the point is saying increase it from 1.23 to 1.5. And in any event, you understood that the effect of this transaction was that you were getting an increase in your - - -? --- That’s correct. - - - in your effective interest rate? --- Yes, that’s correct.”
545 The switch recommendation was calculated to induce Grange’s clients to agree to the
proposal even though it had no substantive demonstrable benefit. I share Mr Bokeyar’s
confusion about what the reference to “Yield” was and how it was calculated. Nor did the
documents reveal what Grange earned on any transactions. In reality, Grange simply fixed
the price at which it bought or sold a product by nominating the yield it wanted the
transaction to reflect. This was illustrated by an internal Grange email Mr Clout sent to his
team on 18 June 2007 advising that he wished to reduce the overall size of its CDO inventory
of $100 million. Mr Clout nominated the face value, name, call or final maturity date and
BBSW + a specific number of bps for each of nine SCDOs by reference to which the price
would be fixed. Thus he sought a yield of BBSW + 165 bps for $550,000 worth of the
Parkes AA- product (compared with its coupon of BBSW + 200 bps). He wrote of these:
“Below is a list of stock that is always easy to move, can we focus on the usual suspects on these issues at the nominated market levels.” (emphasis added)
546 Mr Clout also instructed his team that he was keen to effect switches to buy the
Flinders SCDO at a yield of BBSW + 105 bps in exchange for any of six other SCDOs at
nominated yields. That was because Grange had seen holding the Flinders product as being
to its advantage, as he explained to Mr Singh in his email of 10 July 2007. I have explained
the context of that email and set out its presently relevant portion at [383]-[387] above.
Importantly, Grange sold large volumes of the Flinders product from 6 to 16 July 2007 at
yields of BBSW + 95 bps and + 90 bps, it having built up that holding with purchases at a
yield of BBSW + 90 bps. The yield of BBSW + 95 bps was represented as $100.860 per
$100 of face value in contract notes despite the fact that the valuation Grange had received
from Credit Suisse was at least $8 per $100 of face value less.
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547 The switch between the Bennelong and Quartz products did not affect the economic
position of Parkes in August 2005. If the Bennelong AA product were held to maturity and
there was no relevant default, the Council would be repaid $1.5 million. The proposed
capital price would recoup that premium and provide a small profit of $1,160.
548 Mr Bokeyar also gave this evidence:
“Did Ms May tell you when she made this recommendation that Grange was seeking to persuade all of its investors in Bennelong to sell to Grange so that it could arrange for the issuer to redeem the notes and issue a new note called Quartz? --- I don’t recall that. You don’t recall her saying anything like that to you? --- No. Do you recall her saying, telling you, that a significant reason for doing this transaction was Grange’s desire to be involved as an underwriter in the new Quartz issue? --- No. Did she say anything to you as to how much money Grange might earn on that underwriting? --- Absolutely not.”
549 Grange was earning a profit from selling the Quartz product of 1.90% of the issue’s
face value; i.e. about $1.5 million . The Bennelong SCDO had only been issued on 9 June
2004, and so was being bought back by Royal Bank of Canada within about 14 months in
order for that bank to issue the new Quartz product. As Mr Adamou explained to his
colleagues in an internal Grange email on 5 August 2005 marked “NOT for External
Distribution, NO EXCEPTIONS”:
“Reasons why RBC want to buy-back Bennelong? A carefully selected CDO portfolio contains many high value names that are trading at attractive margins relative to their true credit quality. Often the value opportunity is only there for a short period of time. What has happened on Bennelong is that the individual entity names were well selected (by RBC and Grange) and many of credits have now traded back to fair value (i.e. their margins have contracted). Thus, with this rally in the credit spreads of names in the Bennelong portfolio (which has outperformed the market in general), it gives RBC the opportunity to repurchase Bennelong at a premium and unwind all the hedges on those names where the value has been realised. Names where Grange and RBC consider there is still value are being transferred across to Quartz along with new credits that Grange and RBC believe to have value today.”
There is no evidence of the premium that Grange received from the repurchase from it of the
Bennelong notes it had bought back from its clients.
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550 Soon after, Grange began marketing the next new SCDO, Wattle Aa3 (see [261]
above). On 16 September 2005, Ms May emailed a switch recommendation for Parkes to
exchange its $1.5 million holding in the Balmoral AA product for the Wattle product. Both
had identical coupons. But, the Wattle SCDO was rated with Moody’s equivalent of a AA-
rating by Standard & Poor’s and had a call date six months earlier than the Balmoral
product’s final maturity, but its own final maturity date was four years after the call date. Mr
Bokeyar had agreed to the purchase of the Balmoral AA SCDO at par value on 9 March 2004
(see [501]-[504]). However, on this occasion Grange offered Parkes a premium of about
$13,740 over the par value of Balmoral notes. The points that Ms May emphasised in her
email and oral recommendation to Mr Bokeyar included “Grange provides liquidity to all
Grange issued CDOs – others provide best endeavours basis”. On 20 September 2005,
Mr Bokeyar emailed Ms May agreeing to the switch and Grange issued contract notes
effecting it on 27 September 2005.
551 On 10 October 2005, Ms May emailed Mr Bokeyar and others with details of the
anticipated impact on eight SCDOs arising from the Ch 11 bankruptcy filing of one of their
reference entities, the American car parts supplier, Delphi. He understood that this was part
of Grange’s service and that it would draw his attention well in time to any matter involving
an SCDO about which it had a concern.
552 The next switch proposal Ms May made to Mr Bokeyar was on 27 October 2005. She
proposed switching the Kosciuszko AAA product for the new lower rated Blue Gum AA- one
(see [272]). The coupon would increase by 40 bps from BBSW + 100 bps. The Kosciuszko
product had a call date in September 2006 and final maturity a year later, while the new one
had a call date in December 2010 and final maturity in June 2013. Ms May sent Mr Bokeyar
among other documents the Blue Gum slide presentation. That contained the more extensive
elaboration of risk factors that is reproduced at [120] above. He did not read these. There is
no evidence that she drew Mr Bokeyar’s attention to these or explained them to him. I infer
she did not do so when she discussed the switch recommendation with him. On 30 October
2005, Grange issued contract notes giving effect to this switch.
4.4.8 Parkes begins developing an investment policy
553 Around the time of the Blue Gum switch, Mr Bokeyar became aware of the need for
the Council to maintain a formal investment policy. This probably occurred when he
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received updating material for the Local Government Code of Accounting Practice and
Financial Reporting. He asked Ms May if she had any sample policies that Parkes “could use
as a shell for ours” since she was dealing with many Councils. She agreed to help.
554 On 27 October 2005, Ms May emailed Mr Bokeyar a copy of the City of Newcastle’s
policy which she had adapted, at least by inserting Parkes’ name, saying in the email “Here’s
one that’s short and sharp!!”. Later, following a discussion, on 13 January 2006 Ms May
emailed him Hastings Council’s policy and strategy noting that it would need slight
amendments. She added: “I don’t think you use managed funds at all”. She said that she
would be happy to make amendments to suit Parkes’ requirements once Mr Bokeyar had read
the documents.
555 In around April 2006, Mr Bokeyar received a copy of the NSW Best Practice Guide:
see [116]. He read it. This was the first publication of its kind. Section 4 of the Best
Practice Guide was headed “The Requirement for a ‘Prudent Person’ Approach to Funds
Management”. One step was the adoption and implementation of an investment policy and
strategy. An example was given in appendix 4. That example contained a general
investment guideline stating that, except for the purpose of reducing its exposure to
investment risks, the Council would not “directly enter into any type of derivative
transactions”. Remarkably, the Best Practice Guide had a CDO checklist “for consideration
when purchasing a CDO” that failed, as did the rest of the document, to realise that CDOs
were derivative transactions. That lack of insight into the real nature of a CDO was
indicative of the general ignorance of local government employees in dealing with complex
financial instruments. While there was an issue whether SCDOs were derivatives within the
meaning of the Corporations Act, the expert evidence accepted that in commercial parlance
they were complex derivative instruments. The program documentation, for example,
dealing with the Bennelong SCDO in 2004 described it as a “Credit Derivative Transaction”.
In section 9 below, I have found that the typical Claim SCDOs were “derivatives” within the
meaning of that Act. There is no suggestion that the authors of the NSW Best Price Guide
were aware of that legal nicety.
556 The NSW Best Practice Guidelines for its “prudent person” suggested that such a
person would:
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ensure a suitably skilled employee was given day to day responsibility for the
council’s investment decisions (x);
“not invest in products you do not understand and take the time to
learn/understand available products” (xiii);
“seek independent research and advice before investing in sophisticated
investment types (e.g. … CDOs) (xv), and
“refer to appendix [5] of this guide – “CDO Checklist” before placing CDO
investments” (xvi).
557 Mr Bokeyar said when cross-examined on this material :
“Did it occur to you that you were investing in products that, perhaps, you did not understand? --- It occurred to me to some extent, but I was quite happy with the advice that I was receiving. And, given the independent rating from an independent organisation, I was happy with what I was doing. But just thinking about it now, Mr Bokeyar, it’s right, isn’t it, that as matters stood in April 2006, you knew that you didn’t understand how these CDOs worked? --- Yes, that’s pretty that’s right. Yes, that’s correct in their entirety, that’s right, yes.”
558 He said that he had no need to read or try to understand all the information that was
sent to him about CDOs “because I was getting good advice from the people that I relied on”.
559 The CDO checklist commenced by stating that it was a non exhaustive guide that had
been developed for consideration when contemplating “Purchasing a CDO”. It contained a
short explanation of the purpose of the suggested items. These included matters that
Mr Bokeyar had either already gleaned from Grange’s explanation to him or relied on Grange
to undertake, such as research into the rating, structure, overlap of reference entities with
those in reference portfolios of the Council’s other CDOs, the presence of a portfolio
manager and tranche thickness. Mr Bokeyar considered that when recommending an SCDO
for purchase by the Council, Grange attended to the functions in the checklist and that he
could act on its assurances and explanations.
560 Then on 25 July 2006, Ms May emailed a more detailed draft policy to Mr Bokeyar
together with a further copy of the Hastings Council’s investment policy, saying that they
would look at these the next time she visited Mr Bokeyar. When they met, he asked Ms May
if she had another sample to look at. The Hastings Council policy stated that derivatives
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were not permitted. But Mr Bokeyar did not know what derivatives were at that time. This
was another demonstration of Mr Bokeyar’s lack of financial sophistication and acumen. He
had been dealing in highly complex derivatives -SCDOs - worth tens of millions of dollars
for the Council during the preceding three years. Ms May did not discuss with him what
derivatives were.
561 Following that meeting Ms May went away and prepared a revised draft investment
policy and strategy for Parkes. She emailed the next version to Mr Bokeyar on 8 August
2006 saying:
“You may wish to amend but have tried to keep it fairly broad to allow opportunities without having to change the policy. Overriding this of course is your decision – just because it fits the policy doesn’t mean you have to invest in it .. eg managed funds or investing in building societies and credit unions.” (emphasis added)
562 The latter comments indicated Ms May’s awareness of Mr Bokeyar’s aversion for
investments in managed funds, building societies and credit unions as not offering him
sufficient assurance of the safety of the Council’s funds. Ms May’s draft accommodated a
requirement Mr Bokeyar had that the Council’s investments should have at least the AA-
credit rating of the four major Australian banks.
563 Eventually on 19 December 2006, Parkes resolved at a Council meeting to adopt an
investment policy. This provided, relevantly:
“Investments in corporate rated investments are restricted by the Minister’s Guidelines to a minimum rating of A, however Council will restrict the initial rating to a minimum of AA-, which is equal to the rating of the major Australian Banks. This allows for minimal ratings migration whilst still meeting the investment policy guidelines. (iii) Credit Ratings If any of Council’s investments are downgraded to such that they no longer fall within the investment policy guidelines, they will be divested as soon as is practicable.” (emphasis added)
564 The policy permitted investments for periods ranging between at call to 10 years. It
contemplated specifically that Parkes could invest in FRNs and CDOs.
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4.4.9 Parkes dealings with Grange in 2006-2007
565 Meanwhile, Grange continued to promote new issues and switches to Parkes through
Mr Bokeyar. On 19 January 2006, Ms May emailed him with details about the
Newport AAA SCDO (see [269]). She followed this up the next day by speaking to
Mr Bokeyar and then emailing a switch recommendation involving the sale of the Hotham
product held by Parkes (see also [301]). Ms May’s email recommendation claimed that
Parkes would make a $2610 profit. That varied from Grange’s formatted recommendation
that asserted the profit would be $5220. The switch involved equally rated AAA SCDOs
each with a coupon of BBSW + 100 bps but differing call dates (December 2007 and March
2009) and final maturity (June 2010 and March 2013). And the recommendation suggested
to Mr Bokeyar that “Newport is a vanilla CDO v Hotham which is a CDO squared”. Quite
why this was a reason that justified investment in either product was not elaborated.
Mr Bokeyar emailed his approval to Ms May on 24 January 2006 and Grange issued contract
notes effecting it on 31 January 2006.
566 On 14 February 2006 Ms May emailed Mr Bokeyar with a switch recommendation
that she had discussed with him earlier. This was to sell the Council’s $1 million investment
in the Blue Gum AA- product and buy a AA- rated product called Nexus 4 Topaz. There was
little evidence about the Nexus 4 Topaz product beyond the email and switch
recommendation but it was not the same product as the eponymous Nexus AA+ that matured
in December 2007 and, which by this time had been upgraded to an AAA rating (see [293]
above). Dr Arberg’s valuation disclosed that the Nexus 4 Topaz notes matured on 20 June
2015. The Nexus 4 Topaz product had a coupon of BBSW + 288 bps in contrast to Blue
Gum’s margin of + 140 bps. Unusually, Ms May’s email said that an “[i]ndependent report
by IWL rates this security as “Strong Buy”. The switch recommendation described the
product as “Nexus 4 (NXBHD)”. This product was listed on the ASX: [1029]. Mr Bokeyar
could not recall why he had not accepted the recommendation. As he said: “… there
wouldn’t be too many that I think you would find that are like that”. I infer that the reason
was his aversion to listed products and that Ms May had said something that drew his
attention to that fact.
567 On 14 March 2006, Grange wrote to Mr Bokeyar saying that the Green SCDO had
been downgraded recently from AA to A+ but would be downgraded to BBB because of the
recent default of a reference entity (see [499]). However, Grange informed him that it and
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the arranger, JP Morgan, had organised a restructure of the product that involved extending
its final maturity two years to March 2014, changing its structure “from a ‘CDO squared”
transaction to a ‘Simple CDO’” with additional credit support and changing the reference
portfolio to consist of only investment grade rated entities. The letter sought Parkes’
agreement to those changes. Mr Bokeyar and Mr Matthews signed and faxed back the
confirmatory letter on the same day. Mr Bokeyar did not give evidence about this matter.
However, the end result would have reinforced his understanding that if a reference entity
defaulted, it was replaced and Parkes’ principal would remain safe.
568 Just two days later, on 16 March 2006, Ms May emailed Mr Bokeyar, following a
discussion, confirming her switch recommendation that Parkes sell its $500,000 investment
in the Octagonal AAA product and buy $1.5 million worth of the new AA+ rated Esperance
SCDO. Parkes had purchased the Octagonal product in December 2004 ([523] above). It
matured in December 2009 and had a coupon of BBSW + 125 bps. In contrast, the lower
rated Esperance product had a call date in March 2008, a final maturity date in March 2013
and paid a lower coupon of BBSW + 110 bps. Ms May extolled the new product as “being
issued at a highly competitive margin of BBSW + 110 on a two year investment and
effectively is only a one year credit risk” apparently because, she said, “the first 12 months
from issue is immune from any defaults”. She said that the Esperance product had
“significant ratings robustness – it actually qualifies for a ‘AAA’ rating from S&P but for
ratings stability, we have sought a ‘AA+’ rating”. Ms May said that Parkes would “bank
profits of $2470 by selling Octagonal prior to maturity (profits reduce to zero if held to
maturity)”. Grange issued contract notes on 20 March 2006 for this partial switch in which
Parkes sold $500,000 worth of the Octagonal AAA product and bought $1.5 million worth of
the Esperance AA+ product. Mr Bokeyar gave the following evidence about this switch:
“Mr Meagher: Did you by this stage start to wonder why Grange was making so many switch recommendations to you? --- No, not really. I think we were - I didn’t. We were - they were suggesting that we make the switches and we were picking up a little bit in capital profits at that stage and I was looking to move the investments further up towards AAA. I know there were - did seem to be quite a few there, but I didn’t - that didn’t mean anything to me. His Honour: But if you look at [Ex A page] 8854, they are saying to sell Octagonal which is a AAA and has a coupon of 1.25% to buy Esperance, which is only AA plus and has a coupon of 1.1%. What was the economic rationale you had for going into this transaction? --- Well, I would have to just have a look and see what the recommendations were.
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In light of what you were telling me about moving up to AAA? --- Well, that was my general thrust was to move that way. And there must have been a reason for this one. Mr Meagher: Do you have a recollection as to what the reason was? --- No, I am just trying to - well, I don’t off the top of my head. I’m just looking here to see what the recommendations might have been. The number 8 says that: ‘Significant ratings robustness, currently qualifies for a AAA’.”
569 What occurred on this occasion was typical. Mr Bokeyar followed and accepted
Grange’s and Ms May’s advice because he trusted it and her. He did so without examining
the details beyond ensuring that the Council’s capital was protected, as he understood
matters, and that the transaction would comply with the Minister’s order. He and Parkes
believed that this was what Grange was doing in recommending a switch or other dealing.
570 Grange submitted that a justification for its recommendation could have been the
difference in yield between the two products recorded in its format switch recommendation
that accompanied Ms May’s email. That recorded “yield/trading margins” of 0.90% and
1.10% respectively for the Octagonal and Esperance products. However, that calculation was
based on what Grange fixed as the market prices of each purchase and sale – in Octagonal’s
case a price at which Grange offered to buy it of $101.149 per $100 of face value (i.e.
$505,745) plus $0.113 per $100 of face value for accrued interest as compared to Esperance’s
price on issue of $100 face value: see also [543]-[546]. Parkes had bought the Octagonal
product at a price of $100.844 per $100 of face value (i.e. about $504,220) and with accrued
interest of $1.605 per $100 of face value.
571 As noted at [96]-[100] above, and adventitiously for this argument, on 9 March 2006
Grange itself was concerned to examine the risks it was running and how properly to value its
own book of SCDO holdings as well as assess its market risk exposure. The price for the
Octagonal product referred to in the switch recommendation to Parkes was 0.305% more than
when Grange had sold the product to Parkes about 15 months earlier. That increase in price
suggested, as Professor Harper explained, that the Octagonal product was perceived to be
more likely to pay the full coupon and be redeemed at maturity than when it was purchased
and, therefore, less risky.
572 Mr Bokeyar did not understand or consider what the “yield/trading margin” figures on
this or similar documents represented. Grange does not appear to have provided its Council
clients with a means of understanding how it worked out the “yield/trading margin” figures
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that it gave them. I cannot follow how or why Grange stated in the switch recommendation
that the Octagonal AAA product had a yield/trading margin of BBSW + 90 bps that was
35 bps lower than its coupon margin of BBSW + 125 bps. In summary, the proposed switch
involved Parkes selling a higher rated product that would have returned 15 bps more for a
term that was predicted to be about 21 months longer than the product Grange was
recommending replace it (based on the assumption that the arranger repaid the principal due
on the new Esperance product on the first call date). Mathematically this meant that Parkes
would give up about $1,300 in interest to earn a capital profit that Grange said was $2,470.
However, the latter figure does not seem to reconcile with the $1,525 difference between
Grange’s sale and buying prices of $100.844 and $101.149 per $100 face value for the
Octagonal product. It is difficult to understand what benefit Parkes got from Grange’s
recommendation to sell its better rated Octagonal holding when the net return to Parkes was
about $200 ($1525 minus $1300) and Parkes had to buy a slightly riskier (based on ratings)
and more complex product that was an SCDO².
573 However, from Grange’s perspective the transaction had its attractions. Grange was
anxious to sell $85 million worth of the Esperance product on its issue date of 22 March 2006
to earn about $1.9 million in fees. Thus, it had a motive to encourage its clients to switch to
the new product to the extent that it could not persuade them to make an additional
investment. This course had a risk to Grange from its having to hold the repurchased product
until it could on-sell it. Importantly, such dealings reinforced to Grange’s clients, such as
Parkes, the liquidity and capital security of SCDOs as investments. The switch
recommendations always came with a bottom line that Parkes at least got its principal back,
and might even make a modest capital profit.
574 The context in which Ms May discussed the proposed switch between the Octagonal
and Esperance products was two days after the restructure of the Green product. It is
apparent that the potential for loss, that could have flowed from the catastrophic default in the
Green product that caused that restructure, had been effectively disguised from both
Mr Bokeyar and Mr Matthews. The switch resulted in Parkes investing a further $1 million
in another SCDO without any apparent realisation that loss of principal was a real possibility
and had just been narrowly averted. Given Mr Bokeyar’s aversion to the risk of such a loss,
it is inconceivable that he realised on or after 14 March 2006 that this was a possible outcome
from investing in SCDOs. It is likely that Grange knew that the successful restructure of the
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Green product would reinforce its sales pitch to Parkes and the other Councils that promoted
the safety and conservative nature of investment in SCDOs.
575 On 11 May 2006 Ms May emailed Mr Bokeyar a switch recommendation that Parkes
sell its $2 million Endeavour AAA product acquired in July 2004 (see [509] above) and buy a
new SCDO2, Scarborough AA. Each had a coupon of BBSW + 130 bps, but while the
Endeavour product matured in August 2011, the Scarborough one had a call date in June
2009 with final maturity in June 2014. As noted in [509], Ms May told Mr Bokeyar that one
justification for the Endeavour/ Scarborough switch was that Parkes would “[p]ick up the
same coupon (1.30%) with reduced exposure to maturity (2011 to 2009)”. Another
justification was that Parkes would realise a capital profit of $17,180 if it sold then, but
“profits go to zero if held to maturity”. Ms May also told him that the new product, although
rated “AA”, qualified for “AAA” and Grange provided liquidity with ongoing support.
576 It is likely that before they discussed this switch on 16 or 17 May 2006, Ms May had
also sent Mr Bokeyar another switch recommendation on 16 May to sell the Council’s
$1 million holding in the Granite AA- product and buy another new SCDO, Glenelg AA- (see
the similar recommendation to Swan at [288]). Ms May told Mr Bokeyar of the three year
call date for the Glenelg product, which attracted him. She told him that this switch could be
effected at no cost to Parkes. In fact, Parkes made a small capital loss of $90 on the sale of
its Granite product because Grange used a price of $99.991 per $100 face value for this
SCDO that had been downgraded to an A rating. However, Mr Bokeyar was happy to get out
of that investment despite the small difference and I infer that he was conscious of the
significant capital profit on the other switch he agreed to effect at the same time.
577 Mr Bokeyar emailed Ms May on 17 May 2006 asking her to proceed with both
switches and Grange issued contract notes effecting them between 17 and 19 May 2006. As
discussed at [296] Grange made over $3 million in May 2006 from the sale of the
Scarborough SCDO and the Granite/Glenelg switch and large profits in its secondary market
trading.
578 On 22 June 2006, Ms May emailed Mr Bokeyar with a switch recommendation that
Parkes sell its $1.5 million investment in the Wattle product and buy $1 million worth of the
new Torquay AA notes. I have explained the background to this switch at [297]-[298] above.
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Ms May explained that the Wattle product had been downgraded from Aa3 to A1 and could
be subject to further downgrades. She said that this justified switching to a product with a
coupon that was 10 bps lower. Her switch recommendation was amended by Mr Bokeyar
agreeing, on the same day, to reinvesting the entire proceeds of the sale of the Wattle product
in the Torquay one. On that day Grange issued contract notes giving effect to the switch.
579 As at 30 June 2006, Parkes held 10 SCDOs through Grange with a face value of
$14 million. Six of these were valued by Grange at that date at between $99.996 and $99.976
per $100 face value, resulting in a net capital loss of $1055 on a total face value for those
products of $8.5 million. However, one of those was the Wattle product that Parkes had
agreed to sell on 22 June 2006 with settlement on 6 July 2006 for $75 less than its face value
of $1.5 million. Overall, Grange’s valuation showed that Parkes’ SCDOs were worth a net
$41,785 more than their face value. Once again, as with the 2005 valuation, Mr Bokeyar was
not troubled by the immaterial differences in value see [530] above.
580 On 26 July 2006, Ms May and a Grange credit analyst, Jason Woodards, visited
Parkes and made a presentation in the Council committee room for the new Parkes AAA and
AA- SCDOs. I have set out some details about the two Parkes products and Grange’s
promotional material for them, including the slides at [107]-[109] and [308]-[320] above.
One slide contained an example of how 10 credit events had to occur “for the Parkes ‘AAA’
notes to be impacted”. That slide concluded with the emphatic summary that is set out at
[316] above.
581 Mr Bokeyar could not recall if this slide was shown or explained during the
presentation, but it is likely that it was. The summary was calculated to demonstrate to
persons in the position of Council officers just how safe and secure the product was.
582 Mr Bokeyar gave unchallenged evidence that no discussion of risk occurred beyond
what was always explained about “the level of subordination [and] the amount of downgrades
that the product would hold [sustain] before anything might happen”. He said that no
mention was made of the possibility of:
price volatility below face value between the issue and maturity of the
products; or
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a credit downturn or a number of adverse credit events resulting in the Council
not being able to sell the notes at face value or at all.
583 He said, and I accept, that Parkes would not have purchased any SCDOs had he been
informed of those matters. That was because he and Mr Matthews frequently discussed their
paramount need not to lose 1 cent of the Council’s capital. Mr Bokeyar said, and I find that
they both shared that view, and if either of them thought that there was any possibility of the
loss of capital “we wouldn’t be interested in these products at all”.
584 The final slide was headed “Grange and Morgan Stanley Disclaimers”. It was in very
small print and clearly was not part of the selling pitch in the rest of the slides. Mr Bokeyar
said, and I accept, that it was not displayed or spoken to at the presentation. The following
paragraph in the disclaimers neatly encapsulates Grange’s dilemma in these proceeding. It
read:
“This document does not purport to identify the nature of the specific market or other risks associated with the Parkes issue. Before entering into any transaction in relation to the Parkes issue, the investor should ensure that it fully understands the terms of the Parkes issue and the transaction, relevant risk factors, the nature and extent of the investor’s risk of loss and the nature of the contractual relationship into which the investor is entering. Prior to investing in the Parkes issue, an investor should determine, based on its own independent review and such professional advice as it deems appropriate, the economic risks an [sic] merits, the legal, tax accounting characteristics and risk, and the consequences of an investment in the Parkes issue.” (emphasis added)
585 First, this disclaimer made clear that the slides had not sought to identify the nature of
the market or other risks associated with the product. Secondly, it emphasised that an
investor should not rely on the presentation but rather should rely on his, her or its own
review “and such professional advice as it deems appropriate”. One of Grange’s substantive
defences was that, because they contained a disclaimer, documents such as the slides, related
written materials and oral explanations were not given as professional advice on which its
clients could rely, and accordingly Grange could not be found to have been negligent or
misleading in those documents and associated oral explanations. The disclaimer above
begged the question as to who would have given the “professional advice” to the Councils if
it was not to be Grange itself? And, the last thing Grange wanted was for the Councils to
seek other financial advice than its own that might alert them to the very factors Mr Vincent
identified in his “no haircut repos” email: [266]. There was no evidence that Grange ever
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suggested to any of the three Councils that they should seek “professional advice”. That is
because Grange had assumed the role of being the Councils’ financial adviser and provided
the very advice to them that the disclaimers exhorted them to seek.
586 On 31 July 2006, Grange issued a contract note for Parkes’ investment of $2 million
in the Parkes AA- product. Next, on 16 August 2006, Ms May emailed her clients with an
information sheet on the latest SCDO product, Blaxland AA- (see [332]-[333]). On
31 August 2006 Grange issued a contract note for Parkes’ investment of $1 million in this
product.
587 Throughout the period it dealt with Grange, Parkes, through Mr Bokeyar, was also
dealing with Westpac on a range of investments. For example, on 30 August 2006 Charles
Evans of Westpac emailed Mr Bokeyar suggesting a switch at par of $1 million worth of
Parkes’ $2.5 million investment in the Wollemi 2005-1 CDO for an investment in the new
AA- rated Principal Protected Global Property Notes. Mr Evans followed this up with a
discussion with Mr Bokeyar. Westpac guaranteed the repayment of 100% of principal
invested in the new product at maturity. Mr Evans advised Mr Bokeyar that such a switch
would reduce Parkes’ exposure in both the Wollemi product and CDOs generally.
Mr Bokeyar agreed to make that switch.
588 On 10 November 2006, Ms May emailed Kathleen Pizzi, Mr Bokeyar’s assistant with
a switch recommendation. Ms May referred to a conversation they had had and said she was
hoping to speak to her and Messrs Bokeyar and Matthews to update them on the
downgrading of the Newport SCDO from AAA to AA “through ratings migration”. Ms May
advised this was “more a function of the methodology changes by S&P” but suggested some
concern of further downgrades in the short to medium term. Ms May recommended that
Parkes sell its $1 million investment in the Newport product and buy the new Kakadu AA
product instead. She wrote that “As with all our switch recommendations Grange is looking
to actively manage the credit exposure and risk profile of your Grange issued CDOs”. Again,
this neatly captures Grange’s role as financial adviser of the Council rather than, as it argued,
an arm’s length trader. I have set out at [352]-[354] Grange’s underlying reasons for the
switch and the significant fee of $1.5 million it earned for effecting it. On 17 November
2006, Ms Pizzi emailed Ms May saying that she had spoken with Mr Matthews and Parkes
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was happy to proceed with the switch. I infer that Mr Bokeyar was on leave at this time.
Grange issued contract notes effecting those instructions on 30 November 2006.
589 On 5 February 2007, Ms May followed up a discussion by sending an email to
Mr Bokeyar recommending a switch of Parkes $1.5 million investment in the Quartz product
to a new commodity backed security called Kalgoorlie. She noted that they would have a
phone hookup the next day to discuss the new product in further detail. I have set out how
Mr Hattori described the new SCDO and the errors in Grange’s use of terminology in its term
sheet (in [60]; see too [364]). The Kalgoorlie product had been rated AA+ by Standard &
Poor’s. Its final maturity was five years after issue (February 2012). It had a coupon of
BBSW + 130 bps. Ms May told Mr Bokeyar that the Council would make a capital profit of
$7680 on the switch, Grange would provide an active secondary market and the product had a
standard FRN structure. On 8 February 2007 Mr Bokeyar emailed Ms May authorising
Grange to proceed with this switch and it subsequently issued contract notes on 15 February
2007 effecting it.
590 Next, on 16 March 2007, Ms May had a discussion with Mr Bokeyar about her next
switch recommendation, being the sale of the $2 million investment in the Flinders AA
product and the purchase of a new SCDO, Coolangatta AA arranged by Grange’s new parent,
Lehman Bros. The Flinders product had a coupon of BBSW + 150 bps, a call date in March
2009 and final maturity in March 2012, in comparison with the Coolangatta product’s BBSW
+ 130 bps, call date in March 2011 and final maturity in 2014. Ms May noted that the
Coolangatta SCDO had a manager and Parkes would make a capital profit of $10,230. In its
switch recommendation, Grange stated that the “yield/trading margin” for the Flinders’
product was 1.15%. It is not clear why this was so low. Parkes had bought $1 million worth
of its Flinders’ holding on its issue with a full yield of BBSW + 150 bps as recorded in its
contract note in January 2005 and the balance in June 2005 with a yield of BBSW + 130 bps
as recorded in the second contract note: [524], [529]. Both contract notes recorded the
coupon as BBSW + 150 bps. The difference in interest payable by the Coolangatta product
over the two years to the call date for the Flinders’ SCDO was $8,000. Grange issued
contract notes substantially giving effect to this switch recommendation but for a reduced
sum of $1.5 million. On 19 March 2007, Mr Bokeyar emailed Ms May telling her to proceed
as discussed.
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591 On 23 April 2007, Ms May visited Messrs Bokeyar, Matthews, Parkes’ General
Manager, Alan McCormack, and Ms Pizzi and made a presentation about the Federation
AAA product at Parkes. I have made some findings about that product and Grange’s conduct
in relation to its sales to the Councils at [370]-[375]. Ms May made a slide presentation. I
accept Mr Bokeyar’s unchallenged evidence that she did not deal with the risk factors set out
in two pages of fine print on Grange’s slides for the Federation product presentation (see
[92], [371]).
592 The Federation AAA product had a first call date of 2 May 2010 and annually
thereafter until its final maturity on 2 May 2037. Its expected maturity was given as 2 May
2012. The reference portfolio consisted of 40 US non-prime A to AA- rated RMBS bonds of
equal weight. The AAA tranche had an attachment point of 10% and a detachment point of
11%. The AA tranche had an attachment point of 7.5% and a detachment point of 10%. The
slides dealt with the AAA tranche. Each of the RMBS bonds in the reference portfolio had
varying attachment points. The slide presentation suggested that four of the RMBS bonds
(each representing 2.5% of the reference portfolio) had to default with no recovery, before the
10% attachment point would be reached. The presentation asserted that the average recovery
on A rated non-prime RMBS had been 75% and that, assuming historical recovery rates, 40%
of the reference portfolio “would need to be impacted before investors in Federation suffer
from principal losses”. The way in which this product worked was very complex and its
operation not easy to grasp.
593 On 26 April 2007, Ms May followed up with an email to Mr Bokeyar in which she
said:
“I have had another look at your portfolio and would recommend the following switches to participate in the high quality transaction, Federation. Sell Flinders $500k @ BBSW + 105 Receive $508,560 Sell $500k Blue Gum (keep the remaining $500k for yield) @ BBSW + 135 Receive $505,200 Reasons for recommendation include: Key Reasons – Adds diversification to the portfolio Improves credit (from AA to AAA) Bank total profits of $4635.00 on the switch and nett settlement proceeds of $13,760.” (emphasis in original)
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594 One remarkable point to be made about this recommendation is that the coupon for
the Federation product was BBSW + 100 bps, 50 bps below that of the Flinders notes. Yet
Ms May suggested that Parkes keep $500,000 of the Blue Gum notes “for yield” that had a
coupon of BBSW + 140 bps. Ms May did not explain why the higher coupon products
should be sold. Later on 26 April 2007, Mr Bokeyar emailed Ms May instructing her to
proceed with the switch (A/9721) and, on 8 May 2007, Grange issued contract notes giving
effect to it.
595 On 25 June 2007 Mr Evans, who had by now moved from Westpac to ANZ, emailed
Mr Bokeyar following up on an earlier discussion (AS/9810). Mr Evans suggested that as
Parkes had quite a few CDOs from Westpac and, he assumed, Grange, it might be worth
reducing the Council’s exposure to CDOs to give further return diversification within its
portfolio. He suggested a number of dealings involving retention of a Bank of Queensland
FRN, the sale of some CDOs that Westpac had sold to the Council and purchase of a new
product, Averon II, that worked like the non-CDO Global Property Notes already held by
Parkes. Mr Bokeyar agreed to switch the Wollemi CDO for the Averon II product. He was
happy to proceed because the capital invested in the new product would be protected.
596 Over the preceding 6 to 9 months Mr Evans had been discussing with Mr Bokeyar a
strategy of reducing Parkes’ CDO exposure. On 24 July 2007 Mr Evans wrote to
Mr McFarlane, as Parkes’ new finance manager, in response to a query about the switch of
the Wollemi and Averon II products that had just been effected. Mr Evans explained his
earlier discussions with Mr Bokeyar about the strategy of reducing the Council’s CDO
exposure. Mr Evans referred to the recent press about the US sub-prime crisis and advised
that if the Council held the Federation product it should seek to sell it if possible.
597 On 21 August 2007, Grange met with Councillors at Parkes to explain the issues with
its investments following the initial impact of events in the US sub-prime mortgage and other
financial markets. By then it had become evident to Parkes that the changed market
conditions had resulted in SCDOs not being able to be traded readily. In turn, the Council
perceived that this affected their liquidity and valuation.
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598 On 22 August 2007, Mr McFarlane emailed Ms May a copy of the Parkes investment
policy of December 2006. This appears to have been the first time that Parkes furnished
Grange with the final version of the policy. However, as noted in Section 4.4.8 above
Ms May was closely involved in assisting Mr Bokeyar in its development.
599 By 30 September 2007 Federation was trading at about 35% of its face value,
although it had retained its AAA rating and had paid the full amount of interest due in August
2007.
600 On 31 October 2007 Parkes accepted Ms May’s recommendation to sell the
Kalgoorlie product at a slight loss of $99.70 per $100 face value.
4.4.10 Parkes’ 2008 Esperance Combo Notes purchase
601 In January 2008, Mr McFarlane reported to the Council that during December 2007,
the Esperance SCDO had been downgraded by Fitch from AA- to A and been placed on
negative watch. Esperance had been rated AA+ by both Fitch and Standard & Poor’s on
issue in March 2006: see [271]. Grange had indicated to Parkes at that time that
substitutions would be made in the product’s reference portfolio so as to stabilise it against
any further ratings migrations. On 20 February 2008, Grange advised its clients that due to
recent downgrades in Esperance’s reference portfolio, Standard & Poor’s had placed it on
negative watch from its A+ rating. Grange estimated that the product would be downgraded
to A- in the near future.
602 On 10 March 2008 Ms May sought Parkes’ confirmation of whether it wished to
participate in the restructuring of the Esperance product (A/11085). Ms May discussed the
issues with Mr McFarlane the next day and he emailed her on 12 March 2008 confirming that
Parkes would switch its current $1.5 million investment in the Esperance product for a new
one called the Esperance Combo Note or Esperance 2. This was rated AAA for principal and
arranged by Lehman Bros. It had a coupon, that was not rated, of BBSW + 130 bps.
Mr McFarlane did not give evidence nor did any other employee of Parkes who was involved
in this switch. Grange argued that Parkes’ claim for damages for this investment,
accordingly, should fail because it had not explained why it was made.
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603 I reject that argument. Grange had sent a circular to its clients, including Parkes,
outlining three options for restructuring the original Esperance SCDO. The option chosen by
Parkes was described in that circular as providing “a higher degree of principal security
(relative to the existing Esperance CDO) with an expected ‘AAA’ principal only rating,
structured in a manner requiring no additional funds to be invested”. The other two options
required further investment of 23% and 250% of the original face value invested in the
existing Esperance CDO. The latter two were not commercially attractive options for
investors in the position of Parkes whose capital of $1.5 million was at risk. There is no
evidence that it was unreasonable of Parkes to have chosen one of the three options offered
by Grange. The natural inference is that Grange, at least, considered investment in the
Esperance Combo Note option to be one commercially rational and reasonable course of
action for persons who held the distressed existing Esperance CDO. Indeed on 14 March
2008, Ms May wrote to Parkes, commencing with the opening sentence:
“The high level of volatility in global credit markets over the last 3 weeks (whilst we have been marketing the Esperance restructuring options) has created some opportunities in the Esperance restructuring plan.”
The letter urged that “Given the volatility of the markets”, Parkes should respond by
17 March 2008.
604 On 20 March 2008, Grange issued a contract note reflecting Parkes’ purchase of the
Esperance Combo Note with a face value of $1.5 million for a total consideration of
$810,000. The yield was stated to be BBSW + 1779.10 bps and the capital price as $54.00
per $100 face value. Based on these facts, Grange argued that the structure of this transaction
produced no loss for Parkes. It contended that Parkes received a “discount” of the $690,000
loss in the value of its Esperance notes when they were sold for $810,000 to acquire the
Esperance Combo Note with a face value of $1.5 million. Grange said that “[i]n effect,
therefore Parkes suffered no loss in respect of its original purchase of Esperance”.
605 I reject that argument. It ignores the end result that Parkes acted in the difficult
position it faced to buy a substitute product so as to make the best of a bad lot. That purchase
was reasonable but it still left Parkes holding a financial product of a kind that it would never
have invested in had Grange not recommended and advised the original investment in the
Esperance SCDO. Of course, Grange did not offer Parkes the full face value in cash for
selling the Esperance product. The new acquisition left Parkes holding a restructured SCDO
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product with substantially the same risks to which it had been exposed, and from which it had
suffered loss, when it bought the Esperance SCDO originally. Parkes was in the position of
holding the distressed asset, being the existing notes, facing the prospect that their value
would be substantially further reduced because Grange had recommended its purchase to
Mr Bokeyar in March 2006. As Keane CJ, Barker J and I said in Construction, Forestry,
Mining and Energy Union v Australian Building Construction Commission [2012] FCAFC
44 at [69]:
“A party placed in a difficult position by reason of the breach of a duty owed to it by a wrongdoer, and who has acted reasonably in adopting remedial measures, will not be held disentitled to recover the cost of such measures merely because the wrongdoer can suggest other measures less burdensome to it: Banco de Portugal v Waterlow & Sons Ltd [1932] AC 452 at 506 per Lord Macmillan; King v Yurisich (2006) 153 FCR 78 at 103 [93] per Sundberg, Weinberg and Rares JJ.”
606 Parkes’ decision to invest in the Esperance Combo Notes was its one and only SCDO
investment after the Federation investment. The purchase of the Esperance Combo Notes in
the attempt to ward off the potential of further loss on its initial investment in the Esperance
SCDO, was a reasonable course of action by Parkes. Grange had told it that this transaction
offered a higher degree of security for what was left of Parkes’ principal than retaining the
Esperance SCDO. Grange had also told Parkes about the recent high level of volatility in
global credit markets. The only reason Parkes was faced with this choice (of buying the
Esperance Combo Notes or holding its impaired Esperance SCDO) was Grange’s earlier
recommendation and advice that Parkes buy the latter. At the trial the parties’ valuations for
the Esperance notes were between 48% and 50% of their face value: see section 7.2.4. For
these reasons, Parkes’ action in buying the Esperance Combo Notes was both connected to its
original purchase of the Esperance SCDO and was a reasonable attempt to remedy its
position and staunch its losses.
4.5 The relationship between Wingecarribee and Grange
4.5.1 Wingecarribee’s personnel and its investment policy in 2006
607 Doug Neville was the financial services manager of Wingecarribee in 2006. He had
commenced working as a cashier for Bowral Municipal Council in 1974. After Bowral and
Wingecarribee Councils were amalgamated in 1980, Mr Neville joined the latter’s staff as a
creditor’s clerk and has worked there continuously since. He occupied several clerical
positions until 1987. Then, he was appointed an expenditure accountant and commenced a
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Bachelor of Business Studies course, majoring in local government at Charles Sturt
University. He graduated with that degree in 1992. In 1996 Mr Neville became a
management accountant until he was promoted to his position as financial services manager
in 1999. As financial services manager, Mr Neville had a staff of 15. His duties included
preparation of financial and other reports for the Council and the Department of Local
Government, budgets, financial plans, overseeing payment of creditors, collection of rates
and sewerage revenue and maintaining the Council’s asset register. Relevantly, he was also
responsible for overseeing Wingecarribee’s investments and supervising a management
accountant with day to day responsibility for that function. Since about 2005 Peter Dunn
had that task.
608 Mr Dunn had worked as a loans clerk at a bank in 1982 for nine months before
joining Wollondilly Shire Council later that year. He then worked as a cashier, paymaster,
accounts clerk, senior treasury clerk, and by 1993 as manager of revenue, a position he held
until 2000. He then was employed at Wingecarribee as a management accountant, a position
he continued to hold at the time of the trial. Between 1983 and 1991 he studied by part-time
correspondence for a Bachelor of Business degree at Charles Sturt University which he was
awarded in 1991. In 2005, Mr Dunn took over responsibility for the day to day management
of investment of Wingecarribee’s surplus funds.
609 Mr Neville reported to the Council’s Director of Corporate Services, Barry Paull.
Mr Paull did not give evidence. He reported to Mike Hyde, the Council’s General Manager
from February 2006 to August 2009. Mr Hyde held a Bachelor of Engineering degree
awarded in 1975 by the Royal Melbourne Institute of Technology; and a Bachelor of
Economics degree awarded by the University of Queensland in 1985. He had a career in the
Army from 1972 until he left in 1997 holding the rank of Colonel. He then worked for the
Olympic Coordination Authority as a senior director of site services until 2001 when he
began working for the Wollongong City Council as director of city services. After leaving
Wingecarribee, Mr Hyde worked at Redlands City Council in Queensland until late 2010.
610 As a council in New South Wales, Wingecarribee was subject to the same legislation
and regulatory regime as Parkes that are set out at [413]-[415], [417] above. Mr Hyde held a
general delegation of Wingecarribee’s function of deciding to invest money under s 625 of
the Local Government Act 1993 (NSW). He had not sub-delegated that function. However,
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he left to Mr Neville and his staff the day to day activities involved in investing the Council’s
funds.
611 Wingecarribee adopted an investment policy on 26 February 2003 (the 2003
Wingecarribee Policy). Mr Neville had prepared the policy with the Director of Corporate
Services for the Council to adopt. Mr Neville was familiar with its requirements and those of
the Minister’s order. It required surplus funds to be invested in accordance with s 625 of the
Local Government Act (NSW) and the Minister’s order (cl 2(b)). The policy specified that
authorised investments had to comply with the Minister’s order and could include, but were
not limited to, bank accepted or endorsed bills, bank interest bearing deposits, deposits with
non-bank institutions approved by the Department, debentures or securities issued by a bank,
building society or credit union including, specifically, FRNs and bonds, as well as certain
managed funds that complied with s 625 (cl 2(c)(i)). The policy required that the prudent
person test be applied to the consideration of investments (cl 2(c)(ii)). The Council could
hold no more than 50% of its investments with approved non-bank financial institutions. The
policy required that quotations be obtained from at least three financial institutions to ensure
maximisation of returns on the Council’s portfolio. Additionally, Wingecarribee’s
investment strategy had to consider, first, the desirability of diversification and the nature of
and risks associated with any investment and, secondly, how to achieve the best possible
yield in accordance with the guidelines and policy (cl 3(a)). The policy relevantly required
attention to obtaining up to date ratings of any institution or funds used for investment. And,
it substantively repeated the caution about reliance on credit ratings in the last dot point of the
guidelines accompanying the Minister’s order set out in [415] above (cl 3(b)).
612 It was common ground that prior to December 2006, Wingecarribee had adopted a
conservative investment strategy for its surplus funds. It had invested in short term deposits,
bank and ADI bills and one rolling term deposit. This strategy had yielded a return of about
the 90 day BBSW.
613 Mr Neville became familiar with the NSW Best Practice Guide once it had been
issued in April 2006 (see [555]-[556] above). He was aware that the Guide dealt with
investment in CDOs. But he did not look at the Guide’s treatment of this in detail, because
the Council was not interested in investing in CDOs or structured products at the time.
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4.5.2 Wingecarribee seeks to appoint an investment adviser
614 After the 2004 local government elections, Wingecarribee’s councillors became more
involved in the Council’s financial management. In November 2005, they formed a budget
review subcommittee and undertook a detailed analysis of the budget. During this process
the committee indicated that it would like to see a better return from the Council’s
investments and suggested that the investment function be outsourced.
615 Prior to September 2006, Mr Neville had met Ms May and Mr Rosenbaum at one or
more of the annual Local Government Financial Professionals conferences. Mr Rosenbaum
had called in at the Council Chambers in November 2005 when Mr Neville met with him as a
courtesy.
616 Then in September 2006, Mr Hyde decided that Wingecarribee would call for tenders
of expressions of interest to provide it with investment advisory services. In accordance with
the committee’s suggestion, he wanted to outsource this function to improve the Council’s
returns on its investments and to free up about half of Mr Dunn’s time for other duties. The
call for expressions of interest received responses from Grange, Grove and Oakvale.
617 On 27 September 2006, Mr Neville had emailed Mr Rosenbaum with a copy of the
Council’s tender requirements for the expression of interest, its 2003 investment policy and
the proposed advertisement that would be published the next week. The Council’s tender
document explained that at 30 June 2006, it had $50 million invested in short term
commercial bills and fixed deposits and that the size of its portfolio varied between $45 and
$56 million. The tender document also required that the successful tenderer:
provide independent and impartial advice on the availability and access to new
products, taking into account Wingecarribee’s investment parameters and risk
preferences;
disclose its fee prior to a transaction being placed;
describe in detail the full cost of the Council utilising the service if fees were
to be charged directly;
describe the basis for remuneration and how it would be passed on to the
Council where the fees were not to be charged directly.
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618 In their responses, both Grove and Oakvale expressly referred to CDOs as financial
products that they could provide. In contrast, Grange said that one type of product it could
provide was “security type: structured credit”. Grange’s expression of interest also stated:
“Council IMP’s are predicated on the execution of a 30 day rolling contract. Accordingly by entering into such an arrangement with Grange, Council is not committing itself to a long term agreement unless it is satisfied, by virtue of performance, in doing so. Additionally, these IMP portfolios are highly liquid, providing a 3 day cash turnaround for portions of the portfolio and a 30 day cash turnaround for the entire portfolio.” … “Fees associated with the provision of the investment services as described in this tender are based on a sliding scale of the total value of the funds under management.
These fees are the only fees charged to Council for the provision of the services.
All fees are calculated monthly in arrears and charged quarterly in arrears. They appear in the monthly reporting provided to Council and are accordingly highly transparent.
Consistent with offers made to all local government authorities, fees are not charged for the first 6 months after contract commencement, to enable Council to gain comfort in the reporting process and the standard and level of service provided pursuant to the contract together with the high level of returns that the portfolio management service provides.
This is referred to as our ‘FEE FREE PERIOD’.” (emphasis in original)
619 That fee “disclosure” required more than careful reading of the kind Lord Macnaghten
referred to in Gluckstein [1900] AC at 251-252. Grange’s expression of interest was not
accompanied by Grange’s usual disclaimers (although there was a disclaimer in fine print in
one of Grange’s printed documents that formed an attachment to the expression of interest).
Rather it was made in the context of statements earlier in Grange’s tender that: “Grange acts
independently of any other organisation in the Australian financial markets” and that 15
identified foreign banks “represent the ‘panel’ of options currently used by Grange for the
structuring of appropriate local government products” (emphasis added). Moreover,
Grange’s tender did not include a proforma draft of an IMP agreement. Thus Wingecarribee
was not then made aware of Grange’s use of a clause such as cl 2.4(a) or Sch 3 in Swan’s
IMP agreement set out at [360]-[361] above.
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620 Grange made these assertions in response to the direct requirement of Wingecarribee
that it disclose in detail the full cost of the Council utilising its service and the basis of its
remuneration. The truth was that the 15 foreign banks to which the tender referred were the
issuers or arrangers of the SCDOs Grange dealt in and Grange received significant
underwriting fees for placing their products with its clients, including councils. Moreover,
Grange also received fees or reward on every trade it did with its clients. Thus, the reality
was that from inception of any IMP agreement, Grange knew, but did not reveal, that it
would earn fees or reward on every trade it did with Wingecarribee. Grange’s conduct in its
fee “disclosure” to Wingecarribee was hardly candid and was calculated to mislead and
deceive.
621 Mr Neville was impressed by Grange’s tender because it suggested that Grange would
structure an investment portfolio to meet the individual client’s needs and investment profile.
He also regarded as important the statement set out at [618] above concerning a three day
cash turnaround for portions of a portfolio and 30 days for the whole.
622 Prior to the presentations on 18 December 2006, Mr Hyde understood that FRNs were
issued by banks and had variable or floating interest rates. He had never heard of CDOs.
623 Mr Neville approached his investment function with a sense that he had responsibility
to protect ratepayers’ funds. At the time of the presentations Mr Neville understood that an
FRN was a product that could include a bundle of bonds or mortgages, and that it was
structured by a bank operating in Australia or an ADI that was regulated by APRA. His
understanding of even FRNs was quite unsophisticated. He understood such a product, when
sold to investors, was secure because it was effectively guaranteed by the underlying strength
of the issuing bank or ADI. Mr Neville understood, at that time, that a CDO was a derivative
or structured product. He believed CDOs were a riskier type of investment than FRNs and,
for that reason, he was not interested in having Wingecarribee invest in such products.
624 Each tenderer made a separate presentation to Messrs Hyde, Neville and Dunn on
18 December 2006. Mr Neville prepared a checklist of questions for each tenderer that he
showed to Mr Hyde before the presentations. During each presentation Mr Neville and
Mr Dunn each made notes of what was said. Grove made the first presentation to the three
Council officers. This was followed by Grange at about 10.30 am.
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625 Mr Hyde opened the meeting with Grange. He said that Wingecarribee had a very
conservative investment strategy. He stressed that the Council was a very risk-averse client.
He said that the Council required that the capital invested on behalf of the community was
not put at risk by any investments that might be made through its financial adviser. Mr Hyde
said that his team (being Mr Neville and Mr Dunn) did not have expertise in making
investments and that the reason that Wingecarribee wanted to engage a financial adviser was
to improve its return on its investments. Mr Hyde also said that the Council needed liquidity
in its portfolio and could not have more than about $10 million invested for terms of five to
seven years because it was planning to construct a leisure centre in 2008 that would cost
about $17 million.
626 Mr Rosenbaum and Mr Calderwood made Grange’s presentation. Mr Neville said
that they handed out a document that explained what an IMP agreement was. This described
the Councils to which Grange was then providing its investment service. The presentation
was similar to one that Grange used when it made a presentation to the finance committee of
the Council on 21 February 2007: see section 4.5.6 below.
627 Mr Rosenbaum and Mr Calderwood outlined that Grange had a relationship with
AMP Capital and Lehman Bros. They said that Grange had 145 staff with significant
research facilities and capabilities, as well as a large number of clients. They said that
Grange provided investment advice and services to a significant number of councils,
including about 35 councils with which it had IMP agreements. They explained that any
investments would be effected in Wingecarribee’s name and be well within the criteria
permitted by the Minister’s order. They said that, in all likelihood, Grange’s active
management under an IMP agreement would add 50 to 70 bps above the 90 day BBSW to the
return of 5.67% that Wingecarribee had earned in the 2005/06 financial year. Mr Rosenbaum
and Mr Calderwood referred to Grange’s experience in achieving such returns for other
Councils, including Gosford which had over $120 million invested under an IMP agreement
and was earning a return of about 7.2% per annum.
628 They said that all the products in which Grange would invest the Council’s funds
would be AAA or AA rated by one of the three ratings agencies. They said that these
securities would be rated as high as the four major Australian banks or the Australian
Government and would be secure. They also said that, consistently with Grange’s tender, the
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Council could turnaround any investment within three days and its entire portfolio in 30 days.
They said that there was an active secondary market for IMP agreement investments and
there would be no issues about the Council getting its money back if it needed funds.
629 Mr Hyde questioned them about the liquidity of investments, emphasising once again,
that the Council could not afford to have its funds tied up in long term securities that could
not be realised, since it would need to draw down around $15 to 25 million at short notice for
payments that it would incur when building the leisure centre. Mr Rosenbaum or
Mr Calderwood drew a diagram on a whiteboard to illustrate that the value of an investment
would fluctuate in relation to the coupon payable but would approach and reach face value as
the product came closer to and then reached maturity. They said that if the products were
held to maturity, the Council would get its capital back.
630 The Grange representatives said that it would invest in securities with a bank’s name
on them. Mr Neville asked whether Grange would return to the Council any commissions,
fees or rebates it received and how it made its margins. He had asked this from a list of
questions he had prepared before the presentations. The Grange representatives said that any
commissions would be returned to the Council and that Grange’s fees would be charged on
the basis of the value of the Council’s portfolio. Mr Rosenbaum and Mr Calderwood said
that Wingecarribee would pay $36,000 in fees based on a portfolio of $50 million, but that
the first six months under the IMP agreement would be a free of charge trial.
631 The Grange representatives said that under an IMP agreement Grange would invest in
term deposits, FRNs, bank accounts, MBS, bank bills, CDOs and growth assets. Mr Neville
said that the Council was not interested in CDOs or growth assets. Mr Hyde also said that the
Council was not interested in growth assets, but because he did not then know what CDOs
were, he did not mention them.
632 At the end of the presentation, Mr Neville reiterated that the Council only wanted to
invest in FRNs and not in CDOs. He said that he wanted to ensure that there would be no
loss of the Council’s capital and that investments were made in products that were guaranteed
to retain their capital, because they were dealing with ratepayers’ funds. Moreover, in
preparing for the presentation, Mr Neville recorded in his notes the various forms of
securities that fell within the category of direct investments. He wrote down “CDOs” and
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then struck this entry through to reflect his views and subsequent statements to that meeting
that excluded these products from the range of investments that Wingecarribee wished to
make under any IMP agreement with Grange.
633 Grange argued that I should not find that any statements were made in this meeting
about the Council not wanting to invest in CDOs. However, I have made these findings
concerning what was said specifically about CDOs at this presentation for a number of
reasons that I will explain more fully after considering what occurred subsequently.
However, I believe what each of Mr Hyde, Mr Neville and Mr Dunn said about the meeting
of 18 December 2006 in the terms that I have found above. That evidence was corroborated
by both Wingecarribee’s and Grange’s conduct prior to 16 February 2007. In particular, as
will appear, for over one month, Grange did not use its powers under the IMP agreement
made in early January 2007 to invest in any SCDO and then only did so in respect of two
seven day repo transactions (see [641] and [657] below). Instead, in that month Grange
invested in low yielding bank issued FRNs. That conduct was at odds with Grange’s own
imperative to use its IMP agreements to reduce its holdings of SCDOs. That imperative was
illustrated, for example, in an internal email from Grange’s Steven Xia, manager structured
finance, to his colleagues of 16 January 2007. He referred to “our effort to sell the CDO
stocks on the book”, referring to the Blue Gum, Esperance, Scarborough, Glenelg and
Torquay products that Grange then held.
634 It is inconceivable that Grange refrained from, or somehow overlooked, using its
power under the Wingecarribee IMP agreement to sell CDOs that Grange was otherwise keen
to dispose of from its own holdings for the first month of the Wingecarribee IMP agreement,
unless the Council had placed a very clear constraint, that Grange accepted, on Grange’s
freedom of action (see too [366]-[368] above and [654] below). There is a wealth of
evidence that Grange did not let such opportunities slip. It had just secured the IMP
agreement with Wingecarribee and, as its conduct within hours after their meeting on
16 February 2007 showed, Grange did not sit on its hands when it came to putting SCDOs
into its IMP agreement clients’ portfolios (see [666] below). Moreover, Grange did not call
any witnesses and I infer that the evidence of Mr Rosenbaum and Mr Calderwood would not
have assisted its case generally, as well as on this issue.
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635 On 21 December 2006 Mr Neville emailed Mr Hyde with his assessment of the three
tenderers. He ranked Grange as the highest, noting that it was the only one that would
actively manage the portfolio. He said that Grange would provide at least 50 bps more than
the other two advisers indicated in their presentations and, although it would cost $12,000
more, this would be more than offset by the extra return. Mr Neville had made inquires about
Grange with other client Councils and the Department of Local Government and had received
no negative comments. Mr Neville wrote: “Grange’s IMPs are based on FRNs which are
AAA and AA rated and are capital guaranteed for the term of the investment while interest
paid is guaranteed at a margin above the BBSW”. He recommended a six month trial of the
IMP agreement, noting that the Council would need to develop a new investment policy that
Grange could help draft.
636 Mr Hyde understood that the issuer of an FRN promised to pay its face value on
maturity. He understood that this was what Mr Neville had referred to as the “capital
guarantee” in his email, in the context that, as had been discussed during the presentation, the
issuer was an ADI. Mr Hyde agreed with Mr Neville’s recommendations having discussed
them with Mr Paull. Mr Hyde instructed Mr Paull (who would be dealing with the matter
when Mr Hyde was on leave) and Mr Neville to appoint Grange and use it to develop the
policies that would be put to the finance committee and the Council for consideration.
4.5.3 Wingecarribee enters into the Wingecarribee IMP agreement with Grange
637 On 27 December 2006, Mr Rosenbaum, on behalf of Grange, wrote to the Council
referring to its decision to enter into an IMP agreement. He enclosed a “final legal
agreement” together with associated account opening documents. Mr Rosenbaum noted that
the Council sought Grange’s input on a review of its investment policy. He wrote that this
was included as part of its service under the IMP agreement and that Grange would assist,
noting also that it may need to make a presentation to the Council’s Finance Committee on
21 February 2007. Wingecarribee received Mr Rosenbaum’s letter on 2 January 2007.
638 The attached IMP agreement was in much the same terms as the Swan IMP agreement
except that the investment guidelines in Sch 2 were significantly different in each (see
section 4.3.1). Under cl 2.3(a) Grange had to provide its service in accordance with those
guidelines, unless Wingecarriebee otherwise agreed. Importantly, cl 2.3(d) provided that,
notwithstanding cl 2.3(a), the portfolio could “depart in a way which is not material from the
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Guidelines (as set out in schedule 2) from time to time (but shall not be inconsistent with the
Local Government Act (NSW) as amended”. Schedule 2 of the Wingecarribee IMP
Agreement provided that:
The Portfolio is to be managed according to the following requirements:
(a) The Portfolio holdings must meet the Asset Class and Issue Credit Rating requirements as detailed below (b) Maximum exposure to any single Issuer of 20% of the Portfolio (unless the Portfolio size drops below $5 million, in which case, the maximum exposure to any single Issuer will be 35% of the Portfolio); (c) All securities must have an active secondary market.
Asset classes Total Portfolio Issue Credit Rating Requirements
Long Term Rating (Standard & Poor’s or Equivalent
Target Portfolio Structure %
AAA to AA- 0 – 100
A+ to A 0 – 70
A- to BBB - (ADI Only) 0 – 60
Unrated (ADI Only) 0 – 50
Asset Class Minimum (%)
Maximum (%)
Cash 0 100
Interest Bearing Securities Issued by an ADI 25 100
Interest Bearing Securities issued by non-ADIs 0 75
“ADI” refers to Approved Deposit Taking Institutions, as authorised by the Australian Prudential and Regulatory Authority (APRA)
“Issue Credit Rating” refers to the credit rating assigned to a particular issue of Approved Instruments, unless the issuer of such Approved Instrument is an ADI, in which case the credit rating will refer to the issuer’s credit rating. Asset classes will be subject to review if the Local Government Act 1993 (NSW) in relation to “Investments” is amended at any time. Credit Limitations
The Portfolio may not:
be issued as security for any form of loan;
be invested in Derivative Contracts; and
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be invested in ordinary shares. Approved Instruments
Short Term (< 30 day) Cash deposits Term Deposits Bank Bills Negotiable Certificates of Deposit Commercial Paper / Promissory Notes Floating Rate Notes / Bills / NCD’s / CP Mortgage & Asset Backed Securities Collateralised Debt Obligations and Credit Linked Notes Structured Products Commonwealth & Semi Government Securities / Bonds Single or Multi-Asset/Index Notes Yield Curve & Range Accrual Notes Capital Protection Notes Any other asset approved by the Client)
(bold emphasis added)
639 One relevant limitation on Grange’s investment power was the prohibition on use of
derivative contracts. “Derivatives Contract” [sic] was defined in cl 1.1 of the IMP
Agreement as meaning “a contract between two (or more) parties in respect of a derivative, as
that term is defined in the Corporations Act 2001 (Cth)”.
640 Mr Neville read through Grange’s letter of 27 December 2006 and reviewed the draft
IMP agreement. Before he did this he had received a call from Mr Rosenbaum who asked
Mr Neville to sign and return the documents as soon as possible. He took the IMP agreement
to Mr Paull to sign. Mr Neville had signed it and noted the date of doing so as 3 January
2007. They discussed the document. Mr Neville then raised his concern with Mr Paull that
CDOs were on the list of approved instruments. Mr Paull instructed Mr Neville to telephone
Grange to clarify that no CDOs would be included in Wingecarribee’s portfolio.
641 Mr Neville rang Mr Rosebaum on 4 January 2007 and said that the Council was
looking at the IMP agreement and was about to sign it. Mr Neville said that he had noticed
that it referred to CDOs and growth assets. Mr Neville said that they had previously agreed
that the Council was not going to invest in CDOs or growth assets. Mr Rosenbaum then said
Grange would only invest in the type of investments that the Council wanted it to invest in.
Mr Neville said that he then asked Mr Rosenbaum: “So that’s floating rate notes with
Australian banks” and received the reply “Yes”. Mr Neville gave several versions of the
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conversation, not all of them consistent in relation to this last portion. However, I am
satisfied that the conversation conveyed that meaning. I have reached this finding because I
consider that Mr Neville was an honest and generally reliable witness and it is consistent with
how the parties acted prior to the events of 16 February 2007: see [632]-[633] above and
[657] below.
642 Mr Neville accepted that when he read the IMP agreement prior to this conversation
he appreciated that the Council could amend it in writing and that he could have crossed
CDOs out of the list of approved instruments. He understood that the document was a
generic form for all of Grange’s IMP clients and that it contained a list of investments. But
he thought that the actual investments that Grange would make would conform to
Wingecarribee’s requirements. In particular, he was persuaded, following his telephone
discussion of 4 January 2007 with Mr Rosenbaum, that Grange had agreed that it would not
invest outside bank issued FRNs. He reported back to Mr Paull, who was satisfied with what
Mr Neville said he had discussed with Mr Rosenbaum. Mr Paull then signed the IMP
agreement and related documents. Later on 4 January 2007 Mr Neville wrote to
Mr Rosenbaum enclosing all of the signed documents but noting that a letter of delegated
authority would be sent when Mr Hyde signed it following his return from leave in mid
January 2007.
643 The IMP agreement gave Grange access to, and a significant degree of control over a
very large amount of the Council’s money. It is indicative of how commercially naïve and
trusting of Grange Mr Paull and Mr Neville were that they did not send the IMP agreement to
Wingecarribee’s solicitors for review. I infer that Mr Rosenbaum did not raise the idea with
Mr Neville of crossing anything out, because he wanted to persuade the Council later, as he
and Mr Calderwood did, that CDOs were FRNs and were safe for investment of the Council’s
funds. Grange was content to wait for the opportunity to do so.
644 After Mr Hyde’s return, I infer that once Grange had received the promised letter of
delegated authority on 19 January 2007, Mr Rosenbaum wrote to Mr Neville acknowledging
the receipt of all relevant documentation for the IMP agreement and returned copies for
Wingecarribee’s records. Then on 30 January 2007, Grange began to make investments for
Wingecarribee under the IMP agreement.
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4.5.4 Wingecarribee’s and Grange’s early dealings under the IMP agreement
645 On 30 January 2007, Grange emailed contract notes to Mr Neville recording its sale to
Wingecarribee of 2 FRNs each for $2 million with a coupon of BBSW + 28 bps. One was
issued by Royal Bank of Scotland; the other was issued by HSBC Bank Australia.
Strikingly, neither of these was a CDO and each was at a very small margin above BBSW. If
Grange felt that it had free rein under the IMP agreement it would never have made these
investments as opposed to investing in its own surplus SCDOs referred to in Mr Xia’s
internal email off 16 January 2007: [633].
646 The contract notes included a section headed “Terms and Conditions of dealing with
[Grange]”. This stated that the client had agreed to be bound by the terms and conditions that
followed including:
“Fees & Charges [Grange] acts as principal when we buy and sell fixed interest securities in the secondary markets. The yield that we quote to you incorporates any margin that we will receive. The margin is the difference between the price at which we, as principal, buy the security and the price at which we sell the security to you. [Grange] may also receive placement fees from Issuers for distributing securities on their behalf.”
647 Mr Neville paid no attention to the fine print at the end of the contract notes. They
commenced “We confirm having SOLD to you …” or “We confirm having BOUGHT from
you …”. As he said: “I just took those [as saying] that they had purchased those securities on
our behalf”.
648 On 5 February 2007 Mr Rosenbaum emailed to Mr Neville a suggested investment
strategy for Wingecarribee. Mr Rosenbaum wrote:
“At the end of the day my approach to these documents is slightly different to the general view taken by many in the industry as I am very much of the opinion that the Policy is largely set for Councils in NSW by the Minister’s Order. The strategy is how an individual Council is going to work with that Order (Policy) and implement. Accordingly the Policy itself can and should be extremely brief and in fact should be a brief one page document relating directly to the Minister’s Order. The resulting Strategy should be around 3 to 4 pages and contain much of the information that in fact many Councils currently adopt as part of their Policy.” (emphasis added)
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649 As is evident, this email carefully eschewed referring to both the one type of
investment that Mr Neville had made clear the Council wanted, FRNs and, critically, the one
it did not want, CDOs. It did so in the context of the two bank issued FRNs that Grange had
purchased the previous week, which had coupons well below Grange’s suggested return of
50 bps or more above what the Council was receiving. Of course, Mr Rosenbaum knew that
CDOs were permitted under the Minister’s order. His email and draft strategy were
calculated to keep this option firmly on the table as a contrast to the conservative investments
in the two bank issued FRNs that Grange made for the Council the previous week. The draft
strategy attached to the email was unspecific and perfunctory. Mr Neville described it,
accurately, as a half-hearted attempt at saying no more than an investment policy was up to
the Council.
650 Next, on 9 February 2007, Grange emailed a contract note to Mr Neville recording a
sale to the Council of another FRN for $500,000 issued by Macquarie Bank at an even
smaller coupon of BBSW + 19 bps. Late on 9 February 2007 Mr Rosenbaum emailed
Mr Neville with a draft presentation for the finance committee meeting to be held on
21 February 2007 asking him to review it. The draft presentation had slides explaining
Grange’s history, key personnel, local government activities, including Grange’s rates of
return, net of fees, for New South Wales Councils in the year to December 2006, showing
returns between 6.69% and 8.01%, the benefits of a Grange advised portfolio, a suggested
investment policy and strategy structure, a standard one page disclaimer and a page of
addresses. Notably, the draft presentation slides did not mention CDOs or structured finance,
except in the second of three paragraphs on the second last page headed “Disclaimer” which
was as follows:
“Grange Securities Limited (‘Grange’), its officers, employees, agents and associates (‘Associates’) may hold interests in CDOs underwritten through participation in the primary or secondary markets and may benefit from any increase in the price or value of them. Grange receives fees for underwriting new CDO issues.” (emphasis added)
651 Mr Neville reviewed the draft and returned an ameneded copy to Mr Rosenbaum on
12 February 2007. It had obviously been prepared for another Council and Mr Neville
corrected a reference to it by substituting Wingecarribee’s name. The slide dealing with the
benefits of Grange’s advice stated:
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“Security • Approved Local Government Investments (inline with minister’s guidelines) • Portfolio constructed within agreed guidelines for Wingecarribee Shire Council • ADIs (Banks, Building Societies and Credit Unions) • Highly Rated (S&P, Moodys & Fitch have Excellent Track Record) Liquidity • Grange provides liquid secondary market Ongoing Support and Reporting
Cash Withdrawals in 3 days (less by request) Total Portfolio in 30 days (for optimum return)
Return • Significant Value above 90 day BBSW”
Mr Neville had added “90 day” before BBSW.
652 The suggested investment policy and strategy slides relied again on the “prudent
person” test and the Minister’s order that was said to be “quite prescriptive”. The slides then
set out the terms of Schedule 2 of the Wingecarribee IMP agreement. However, Mr Neville
made two amendments to these. First, he restricted the suggested initial portfolio to
securities rated AAA to AA- unless issued by ADIs and secondly he suggested a 12 month
trial with six months being fee free: see [679]-[688] below.
4.5.5 The repos of 12 February 2007 and the meeting of 16 February 2007
653 Then, early on 12 February 2007 Mr Neville received two further contract notes.
These were for two “no haircut repos” (see [264]-[268] above). The first, dealing with
Scarborough, appeared as follows:
“ Confirmation Attention: Mr Doug Neville The purpose of this confirmation is to set forth the terms and conditions of the repurchase transaction entered into between us on Monday, 12 February 2007. We confirm having SOLD to and BOUGHT from you the following security:
Currency AUD
Settlement Date Monday, 12 February 2007Type Floating Rate CDOStock Issuer Helium Capital Limited Series 64 ScarboroughMaturity Tuesday, 23 June 2009Final Maturity Monday, 23 June 2014Coupon 90 day BBSW + 130.00 bps
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Coupon Frequency 4 per yearYield 90 day BBSW + 180.92 bpsFace Value $2,000,000.00Capital Price (Per $100 Face Value) 98.910Accrued Interest (Per $100 Face Value) 1.090Gross Price (Per $100 Face Value) 100.00090 day BBSW 6.5000%Swap Rate 6.5000%Bill Rate 6.5000%
Total Consideration $2,000,000.00
Repurchase Details
Term 7Rate 6.6000%Settlement Date (Leg2) Monday, 19 February 2007Consideration (Leg2) $2,002,531.51
Settlement Instructions: This transaction did not take place in the ordinary course of business at a stock market. This confirmation is issued subject to the correction of errors or omissions; it is computer generated and therefore issued unsigned. Please refer to our terms and conditions below. Thank you for transacting this business with our company.”
654 The second contract note was for a $1 million transaction with the Torquay SCDO but
while this expressed the same interest rate of 6.6000% it used different figures for yield
(BBSW + 173.41 bps), capital price per $100 face value ($98.861) and accrued interest per
$100 face value ($1.139) figures. Both SCDOs were products that Mr Xia had said in his
internal email of 16 January 2007 were stock on Grange’s book that it wished to sell see
[633]-[634] above. And when the “repos” came to an end on 19 February 2007 Grange sold
both products to Wingecarribee at very different figures (see [667] below).
655 On their face, the two repo contract notes did not appear to make sense as to the rate
of interest at which Grange was borrowing. The yield figures of 90 days BBSW +
180.92 bps and + 173.41 bps respectively do not equate to the stated rate of 6.6000%. That is
because the notes gave the 90 day BBSW as 6.5000% being 10 bps below the stated interest
rate, rather than over 180 and 170 bps above the BBSW as indicated in the yield line. And,
of course, even the three bank issued FRNs that Grange had sold Wingecarribee carried
higher margins than the meagre margin of 10 bps above BBSW that Grange appeared to be
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paying. One thing is certain, Grange was not safer than a bank so as to justify it paying a
margin of only 10 bps above BBSW to borrow $3 million from Wingecarribee on the
“security” of two SCDOs with that sum as their face values.
656 It is also striking that Mr Xia’s email had described the default resistance of the
Torquay product as “Nil, falls to AA-ˮ and the strength of its portfolio as “Moderate”. He
said that it had a low to moderate probability of a short term downgrade but because it had a
manager in place “to defend the rating … [it] can withstand multiple notch [downgrades]”.
As Mr Vincent observed in his “no haircut repos” email, no informed arm’s length dealing
would have occurred on the bases that Grange transacted those two repos using its powers
under the Wingecarribee IMP agreement.
657 As soon as Mr Neville received the two repo contract notes, he forwarded them to
Mr Dunn. About two hours later on 12 February 2007, Mr Neville emailed Mr Rosenbaum
with his changes to the draft presentation for the 21 February meeting, saying:
“Also thank you for the settlement details, its nice to see our association and portfolio with Grange starting to develop. If you could confirm one thing for me with a couple of those settlements, I noticed that some referred to Floating Rate CDO and Floating Rate Subordinated Debt. Are these CDOs? as in our discussions it was quite clear that we were only going to invest in Floating Rate Notes where the capital is 100% guaranteed if the investment is held to maturity. I’m sure this is the case, but due to our lack of experience with these products I just need to confirm this.” (emphasis added)
658 The terms of the email showed that Mr Neville, understandably, had no idea that he
was enquiring about transactions that were in substance two repos. In addition, he did not
pick up that these transactions were returning BBSW + 10bps for a loan of $3 million to the
Councils’ financial adviser. Grange made no written response to this email. Instead
Mr Calderwood rang Mr Neville and asked if he could come down to the Council Chambers
at Moss Vale to discuss it. They arranged a meeting at 10.30 am on Friday 16 February
2007. At that time Mr Calderwood met Mr Neville in his office with Mr Dunn.
Mr Rosenbaum was not there. Mr Neville reiterated that Wingecarribee was not interested in
CDOs because it could not afford to put ratepayers’ funds at risk. He said that he was
concerned because some contract notes the Council had received referred to CDOs.
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659 Mr Calderwood replied saying that these were FRNs. He said that a floating rate note
was purely a benchmark plus a margin. He went to the whiteboard in Mr Neville’s office and
gave the illustrated explanation on FRNs below:
660 Mr Calderwood said that the products could consist of asset backed securities,
residential mortgage backed securities and certain CDOs, writing their acronyms at the top
right. He said that those FRN products were mortgages or bonds held by a bank like Westpac
that were sold to investors. Mr Calderwood then wrote acronyms, lower down on the same
side of the whiteboard, for three of the major Australian banks (NAB, ANZ, CBA) and said
that those banks issued FRNs. Towards the foot of the whiteboard, he wrote the equation
“FRN = B + X” and said that FRN meant a benchmark (or BBSW) while referring to the “B”,
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plus a margin and then referring to the “X”. He drew a box on the whiteboard and wrote
“WB” as a shorthand for Westpac bank. He said, referring to ABS, RMBS and CDOs, that
these FRN products were pools of mortgages or bonds held by a bank like Westpac that were
sold to investors. He said that FRNs were products that were structured by banks, such as
Westpac. He explained that products were split into tranches of different percentages that
had different ratings and wrote AAA, B and BB underneath the product acronyms. At the
base of the box Mr Calderwood drew a line and wrote “5%” and “$100 million”. Mr Neville
understood Mr Calderwood to say that this was the equity portion of the portfolio that had to
have cash in it and that investors in that portion were paid a much higher return of between
15% to 20% due to the high risk. To make his point Mr Calderwood and wrote 20% on the
whiteboard. Mr Calderwood said that Wingecarribee’s investments had to be rated AAA to
AA- and that those tranches sat on top of that structure. He commented that the market value
of those FRNs may fluctuate from day to day, but if they were held to maturity, the investor
got its capital back). There is no evidence that Mr Calderwood (or anyone from Grange) ever
said at this meeting or at any time before July 2007, that the CDOs Grange was selling were
synthetic.
661 Mr Neville then asked whether the Council’s capital was guaranteed and
Mr Calderwood replied that it was. He also explained, in answer to Mr Neville’s concern that
there be liquid funds available for the anticipated leisure centre expenditure, what the
“maturity” and “final maturity” dates were that appeared in the contract notes for the repos.
Mr Calderwood said that the (earlier) maturity date was when the Council would get its
capital repaid. Mr Calderwood explained that the repurchase of the two repos was because
Grange had another buyer in mind to whom to sell.
662 Mr Calderwood’s explanation was calculated to make the two council officers think
that SCDOs which Grange dealt in were an unexceptional, “secure” variety of the kind of
ADI issued FRNSs with which they were familiar so that Grange could proceed on the basis
that it could now ignore the express prohibition that Wingecarribee had imposed on investing
in CDOs. Mr Neville and Mr Dunn had been led to think that these instruments were just
FRNs and not a distinct asset class, “CDOs” that Mr Neville regarded as too risky for
ratepayers’ money. Grange and Mr Calderwood had achieved this sleight of hand without
putting a word in writing about what an SCDO was (aside from the whiteboard) or the
significant and different risks that this form of investment entailed as against bank or ADI
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issued FRNs. Of course, Mr Calderwood’s explanation was not one he wanted to put in
writing. Before his “explanation” he knew that Sch 2 to the Wingecarribee IMP agreement
had given Grange the authority to invest in SCDOs despite knowing that Wingecarribee did
not want Grange to do so. Grange tested the water with the repos and, when Mr Neville bit,
he was reeled in by Mr Calderwood’s words of comfort. Mr Dunn drew the conclusion from
Mr Calderwood’s remarks that Wingecarribee had the best of both worlds: principal
protection (if like FRNs, CDOs were held to maturity) 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.
663 Following Mr Calderwood’s “explanation” on 16 February 2007 Mr Neville
understood that the CDO FRNs were structured products issued by a non ADI-bank that gave
the product a name and guaranteed its performance. He did not recall Mr Calderwood
saying, specifically, that the bank independently guaranteed the performance of the slice or
tranche but that, from what Mr Neville had been told, was what he understood from
Mr Calderwood’s “explanation” and what it was calculated to convey. He gave this evidence
in cross-examination of his (lack of) understanding:
“Now, are you saying to his Honour that your understanding was that whichever bank had created this structure would independently guarantee the performance of those slices? --- Yes. If that were true, they would all have the same credit rating, wouldn’t they? --- My understanding was that they had different credit ratings because of the they had different rates of returns that were being paid on those tranches. No, no, no, Mr Neville. The credit rating relates to the risk of default, doesn’t it? --- Yes. Yes. And if the bank, the same bank, was guaranteeing each of those slices, it would be the bank’s credit rating that mattered, wouldn’t it? --- One would presume so. So all those tranches would have exactly the same credit rating, wouldn’t they? --- Yes. I’m not sure. It just follows logically, doesn’t it, do you agree? --- Yes.” Yes. So do you agree with me that you must have misunderstood what Mr Calderwood was explaining to you? --- No, I didn’t believe that I did.”
664 Mr Neville cannot be criticised if he did not understand the “explanation”
Mr Calderwood gave merely because he did not analyse the logic of what Mr Calderwood
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said. Mr Calderwood was there to persuade Mr Neville and Mr Dunn that they should drop
their resistance to CDOs being included in Wingecarribee’s IMP portfolio. Mr Calderwood
was not there to give a careful and full explanation of the risks. Grange wanted access to the
Council’s $50 million. It wanted to use as much of those funds as the IMP agreement it had
drafted would allow. Grange wanted to remove Wingecarribee’s prohibition on investing in
CDOs (that Grange had observed since signing the IMP agreement). That is what
Mr Calderwood set out to do, having set up the opportunity by effecting the two repos on
12 February 2007 that would be repaid two days before the meeting with the Council’s
finance committee. If Mr Neville were given a proper understanding of the nature of
Grange’s CDO products, the Council would never have invested in them.
665 Mr Vincent’s telling depiction of the unsophisticated and uninformed nature of
council officers in his “no haircut repos” email was acutely and disturbingly apposite to the
position of Mr Neville and Mr Dunn on 16 February 2007: [266]. That email demonstrated
that the very repo transactions that Mr Neville was querying were made at a flagrant
overvalue of the security that an informed investor would never have accepted. And the
interest rate that Grange paid on the repos was close to the rate at which banks swapped their
bills: i.e. reflecting a financial product that was highly secure and had an almost risk free
interest rate. That rate was significantly less than the rate the SCDOs paid investors. Grange
depended on maintaining that lack of understanding in Mr Neville and Wingecarribee.
Mr Calderwood succeeded on 16 February 2007 in achieving the result Grange had set out to
obtain, but which it knew the Council was resisting, when it tendered to be Wingecarribee’s
financial adviser.
666 Once Mr Calderwood left the Council Chambers, he arranged that Grange would
proceed that afternoon to sell to Wingecarribee eight SCDOs worth a total of $9,100,000
using its powers under the IMP agreement. Four of these (Glenelg, Torquay, Blue Gum and
Esperance) were identified in Mr Xia’s email of 16 January 2007, together with the
Scarborough SCDO as products Grange was seeking to sell off its book: [633]. The eight
SCDOs were:
SCDO Name Face Value Coupon BBSW +
Maturity Final Maturity
Glenelg $1,000,000 + 125 bps June 2009 December 2014
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Torquay $1,000,000 + 120 bps June 2009 June 2013
Flinders $2,000,000 + 150 bps March 2009 March 2012
Blue Gum $1,000,000 + 140 bps December 2010 June 2013
Blaxland $100,000 + 145 bps March 2012 –
Esperance $1,000,000 + 110 bps March 2008 March 2013
Henley $2,000,000 + 80 bps June 2012 –
Kakadu $1,000,000 + 100 bps December 2009 March 2014
$9,100,000
667 Settlement of all these transactions was effected on the following Monday,
19 February 2007. Early on 19 February Grange effected a further eight day repo of the
previous $2 million Scarborough repo and also sold outright to Wingecarribee another
$2 million worth of the Scarborough product. The outright sales to Wingecarribee of the
Scarborough and Torquay products effected on 19 February were on significantly different
pricing and yields than the repo sales of seven days earlier as appears below:
Product 12 February 2007
Scarborough REPO
19 February 2007
Scarborough REPO
19 February 2007
Scarborough SALE
12 February 2007
Torquay REPO
19 February 2007
Torquay SALE
Face Value $2,000,000 $2,000,000 $2,000,000 $1,000,000 $1,000,000
Coupon BBSW+130 bps BBSW+130 bps BBSW+130 bps BBSW+120 bps BBSW+120 bps
Yield BBSW+180.92 bps BBSW+125 bps BBSW+115 bps BBSW+173.41 bps BBSW+113 bps
Capital price (per $100 face value)
98.910 100.104 100.317 98.861 100.147
Accrued Interest (per $100 face value)
1.090 1.142 1.181 1.139 1.273
90 day BBSW 6.5000 6.4167% 6.3967 6.5000 6.4150
Repo Interest Rate
6.6% 6.6% 6.6%
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Product 12 February 2007 Scarborough REPO
19 February 2007 Scarborough REPO
19 February 2007 Scarborough SALE
12 February 2007 Torquay REPO
19 February 2007 Torquay SALE
Total price: - sale - repurchase
$2,000,000 $2,002,532
$2,024,920.00 $2,027,849.80
$2,029,960
$1,000,000 $1,001,266
$1,014,200
668 The effect of these transactions was that Grange sold the Torquay notes to
Wingecarribee under the repo for $1,000,000 (inclusive of accrued interest of $11,390) on
12 February and bought them back seven days later for the same price paying 6.6% interest
on the principal. That repurchase reflected the financing transaction in which the loan was
repaid with interest. Also, on 19 February 2007 Grange sold the very product it had just
repurchased for $1,000,000 plus $1,266 in interest, outright to Wingecarribee at a price
(inclusive of accrued interest of $12,730) of $1,014,200. The accrued interest had increased
by $1,340 in the week. Mr Finkel said that the prices used for the purpose of the repurchase
and outright sale transactions were significantly different given the seven day period between
the two.
669 Additionally, on 19 February Grange sold two parcels of the Scarborough notes with a
face value of $2 million to Wingecarribee; one parcel, sold outright at a capital price of
$100.317 per $100 face value and the other, as a repo, at a lower capital price of $100.104 per
$100 face value. However, the accrued interest figures on the two sales of Scarborough on
19 February were different; the repo being at $1.142 per $100 face value while accrued
interest in the outright sale was at $1.181. The difference cannot be explained by the interest
of 6.6% paid by Grange when it borrowed $2 million for eight days on the “security” of the
Scarborough SCDO for the following reasons. First, the eight days’ interest was, or ought to
have been, paid by Grange, not the product. The accrued interest on the Scarborough repo of
12 February 2007 was 1.090 per $100 face value but when this was sold back to Grange on
19 February 2007 it had increased over the seven days to 1.142. But the latter figure (1.142)
did not have any apparent relationship to the accrued interest used in the calculation of 1.181
for accrued interest in the contemporaneous outright sale. Secondly, the capital prices of the
two parcels of the Scarborough product were also different on 19 February. That reflected
the difference between the loan and sale. Thirdly, interest should have accrued on the repo
parcel in any event and would be paid in full to whoever was the holder on the next quarter
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day. The transactions reflected that Grange could do, and did, what it liked in its dealings
with the Councils offering no transparent explanation for how it benefitted itself.
670 Thus the same vendor and purchaser did trades of equal sized parcels of the same
notes on the same day at three different prices using different accrued interest and BBSW
figures. Apart from the nature of the repo, being a loan (which was not apparent to the
Council officers), there was no apparent reason for those differences. Why would
Wingecarribee buy the Scarborough notes with a higher amount of accrued interest per $100
of face value than used in a repo sale to it on the same day? The trivial difference in price
could not have reflected an informed or bona fide assessment of the different risks of lending
on the security of the SCDOs as opposed to a market price reflection of their value. Why was
a different methodology used to calculate the repo sale price on 19 February? No explanation
was offered to Wingecarribee for these anomalies. But then, Mr Neville and Mr Dunn were
not astute to what Grange had done, as it knew, so they did not ask these questions.
Moreover, on 14 February 2007, Grange had agreed to buy $5.4 million face value worth of
the Scarborough SCDO from its client MFS Premium. That transaction settled on 19
February 2007 for $5,461,668. That price was equivalent to $2,022,840 for a face value of
$2 million. Thus, on the same day (19 February) Grange paid MFS Premium $2,080 less on
equivalent sized parcels of $2 million face value that it “sold” in the repo to Wingecarribee
and $7,120 less than on the outright sale. Grange borrowed from Wingecarribee giving its
“security” a greater value than it paid for that security (or its exact equivalent) on that day.
The only informed person in this “market” was Grange. Its clients had no idea how the
“market” operated.
671 Nor is there any explanation why the BBSW for the Scarborough repo on 19 February
is 6.4167% and for the outright sale on the same day is slightly less at 6.3967%, both being
different to the BBSW used on 12 February of 6.5000%. As with the yield calculations, I am
unable to understand how Grange arrived at these figures that it used. Nor was Professor
Harper able to offer a reason for this when giving expert evidence other than to say, as I find,
that on the face of these transactions they cannot be said to be between independent buyers
and sellers. Likewise Professor Harper was unable to indicate what Grange’s precise
methodology was in arriving at yield figures it used, other than to accept that it would have
taken into account the expected (but unidentified) duration of the notes and changes in the
spread or risk in underlying markets that informed prices between Grange and the arranger of
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the note (an increase in spread reflecting an increase in risk). Mr Finkel said that there could
only be one BBSW rate that applied to the accrual period for the SCDO interest calculation.
672 Professor Harper dealt with an example of a note with a coupon of BBSW + 100 bps
and a subsequent increase in the underlying risk since its issue. He said, and I find, that an
informed buyer or seller of the note would have expected the price to be discounted so as to
generate a higher yield than the coupon and thus reflect the increased risk. While there was a
discount in the capital prices used in the repo transactions, it was less than 1.5% and not a
genuine or commercial reflection of the borrower’s (i.e. Wingecarribee’s) risk.
673 Grange was able to manipulate the prices as it chose, free of any market constraint.
And, the outright and repo sales of Scarborough and Torquay at around face value were quite
inconsistent with Grange’s internal discount of 8% for each of those products in its internal
specific risk detail report for 15 February 2007. That explained that “the risk value is the
product of the exposure and the risk factor”. The “exposure” was said to be the cost to
Grange of acquiring the product. Indeed, the values of all but two of the nine SCDOs sold by
Grange to Wingecarribee on 16 and 19 February 2007 were discounted by 8% in that specific
risk detail report (including the additional Scarborough notes that were nonetheless sold at
about face value in the repo). The 8% discount for those seven SCDOs (excluding the repo)
would have equated to $728,000 less than the face values totalling about $9.1 million used by
Grange in the sale to Wingecarribee. That report only discounted the Blue Gum product by
1.60%. And the Esperance SCDO was given a discount of 2.25% in an internal Grange
“Issuer (Large Exposure) Risk” report as at 19 February 2007.
674 Now Mr Xia’s email of 16 January 2007 indicated that the Torquay note had a low to
moderate probability of a short term downgrade, yet Grange sold it to Wingecarribee on
19 February 2007 based on a lower yield of BBSW + 113 bps than its coupon of BBSW +
120 bps, reflected in its capital price (exclusive of accrued interest) above face value.
Professor Harper said that he would expect that in a retail market an increased perception of
risk would require a yield that was higher, not lower, than the coupon face value.
Accordingly, the informed buyer would pay a price less than face value for such a product so
as to achieve the increased yield above the coupon rate.
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675 The risk factors dealing with investor suitability and the “no secondary market” in the
issuer’s offering memorandum for the Scarborough SCDO were materially similar to those
set out at [122] and [123] above in the equivalent document for the Blue Gum Claim SCDO
([124], [448] above). Each of Mr Neville and Mr Hyde was shown the equivalent passages in
the Scarborough SCDO issuer’s offering memorandum when he gave evidence. Mr Neville
said that if he had been told that the SCDOs that Grange proposed to invest the Council’s
money in had risks outlined in either of those sets of risk factors, he would have
recommended against the Council outsourcing its investment activities. Mr Hyde said that if
he had been told of those risk factors, he would have been appalled. He considered that items
(i), (ii) and (iv) in the investor suitability risks factors at [122] above did not meet
Wingecarribee’s specific requirements. He said this was because the Council did not have
the requisite knowledge and experience, was not capable of bearing the economic risk and
wanted liquidity. He also would have refused to allow CDO purchases if he had been told the
information in the “no secondary market” risk factor at [123]. I accept their evidence.
676 Grange, Mr Rosenbaum and Mr Calderwood did not give a full, frank or any
explanation of those risk factors to Wingecarribee at any time. Importantly, Mr Calderwood
did not explain to Mr Neville and Mr Dunn on 16 February 2007 that the Scarborough SCDO
had these very characteristics when they had queried why the Scarborough repo contract note
referred to a CDO. I am satisfied that had he done so, Mr Neville would have told him that
Wingecarribee would not allow Grange to invest in CDOs of any kind, including those in the
two then current repos. Grange’s procurement of his acquiescence through Mr Calderwood’s
inadequate and misleading explanation on 16 February 2007 caused Wingecarribee to allow
Grange to transact in SCDOs under the IMP agreement.
677 In the meantime, on 14 February 2007 Mr Neville finalised the agenda and supporting
papers for the Council’s finance committee meeting of 21 February 2007. His paper
summarised the Council’s then investment policy. The paper reminded the committee that
the Council’s practice had been to minimise risk whilst attempting to seek good returns. It
stated that returns on investment were dependent on the level of risk to which an investor was
exposed. The paper then said that Grange was anticipated to be able to earn at least 50 bps or
$250,000 per annum more “even with Council’s current requirement to minimise risk and
maintain capital security”. The paper recommended that the Council’s investment policy be
amended to permit the appointment of an investment adviser to manage and/or provide
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advice to the finance committee on the optimum maximisation of the Council’s investment
portfolio in accordance with its investment policy.
678 Mr Neville believed that an investment adviser, such as Grange, would have access to
special deals with banks that could earn a better return than Wingecarribee had with the same
risk. That was not an unreasonable belief since banks offer a range of products with varying
interest rates and terms. It is a commonplace that interest rates offered by banks (and other
lenders) can vary depending on the term of the loan and market participants’ perceptions of
whether and when interest rates might vary during the term. Mr Neville had never looked at
credit ratings before December 2006 because the Council’s investments were in Australian
bank term deposits and bank bills. He did understand that the ratings were a guide as to risk
of default or loss in a general way, but had no understanding beyond that of how they worked
or what their basis was.
4.5.6 Wingecarribee’s finance committee meeting of 21 February 2007
679 At the finance committee meeting of 21 February 2007, Mr Rosenbaum and
Mr Calderwood presented the slides as amended by Mr Neville on 12 February: see [651]-
[652]. However, neither Mr Hyde nor Mr Dunn recollected the disclaimer slide being shown
or given any attention. It is unlikely that it was. I find that the disclaimer slide was not
referred to during the meeting, although it was part of the printed version of the slides.
680 During the meeting, Mr Rosenbaum or Mr Calderwood reiterated what was in the
slide that I have quoted at [651] that if Wingecarribee wanted to sell any investment in its
IMP portfolio, it would be able to do so within three days and could retire its whole portfolio
in 30 days. They said that there was an active secondary market for the products and
emphasised, as did the slide dealing with the “Benefits of Grange Advised Portfolio”, the
security and high ratings of products Grange would purchase for the Council. The Grange
representatives explained Grange’s expertise, large client base and success in achieving
enhanced returns for its local government clients. They referred to their understanding of
Wingecarribee’s conservative approach to investment of its funds.
681 At no time during the meeting did Mr Rosenbaum, Mr Calderwood or anyone else
mention CDOs or that the Council’s funds had been or would be invested in those products.
That omission by the Grange representatives was calculated to reinforce the impression that it
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was investing Wingecarribee’s funds in FRNs that were issued by banks. Literally, the
arranging banks were involved in the issue of the SCDOs. But an SCDO was a limited
recourse instrument issued by a special purpose vehicle that had been incorporated by the
arranging bank. An SCDO was quite unlike a traditional bank issued FRN that was a
promise by the bank to pay the face value of the note on maturity.
682 Mr Hyde understood from the Grange presentation that Grange would pay the face
value of any investment that the Council asked to be sold from its IMP portfolio. He was
cross-examined on that understanding. He rejected the suggestion that he understood that
Grange was not promising or guaranteeing to pay Wingecarribee face value for any
investment it sold come what may in world economic conditions. Mr Hyde accepted that no
statement to that effect had been made in his presence directly by anyone from Grange at that
meeting or before. However, there was no evidence that the Grange representatives orally
expressed any qualification on the liquidity of, or price at which, any product would be
realised in the three or 30 day periods.
683 Grange relied on cl 2.3(c) of the Wingecarribee IMP agreement that, relevantly,
provided:
“The Client may request that any Portfolio assets be removed. This request must be made in writing and, upon receipt of such a request, Grange must remove the relevant assets from the Portfolio (at the prevailing market price) within 30 days …” (emphasis added)
684 That clause was inconsistent with the express, repeated assurances Grange made to
Wingecarribee orally and on the slides that cash withdrawals could be made within three
days and the whole portfolio liquidated in 30 days. Instead cl 2.3(c) gave Grange 30, not
three, days to remove any asset from the portfolio. Moreover, cl 2.3(c) expressly referred to
the asset being removed “at the prevailing market price”. That clause had to be understood in
the context of the requirement in Schedule 2 of the Wingecarribee IMP Agreement that “All
securities must have an active secondary market”.
685 If, in fact, the only market was Grange, then there was no objectively ascertainable
market price at any time for any SCDOs sold by Grange, that was capable of being achieved
in an active secondary market. Grange’s sales method was to represent that such a market
existed and it supported that market. Grange was acutely conscious of the need to offer
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councils investments that could be turned into cash at about face value quickly. That is, the
ordinary and natural meaning of the slide and oral presentation promising, under the heading
“Liquidity”, “Cash Withdrawals in 3 days (less by request)”. So much is evident in the email
exchange between Mr Clout and Mr Rae of 14 and 15 September 2006 that I have analysed at
[366]-[368] above. As Mr Rae said: “We are basically flogging IMPs (from the various
pitches I have seen/heard) as an alternative to a cash fund”. He said that the IMPs and sales
pitch generated “the expectation of instant liquidity”. He identified Councils as the target of
the pitch. The reactions and understandings that Mr Neville and Mr Hyde had to the
substantively similar pitch made to Wingecarribee in their encounters with Grange up to and
including the meeting of 21 February 2007 were consistent with Mr Rae’s characterisation:
that is, the assets that Grange invested in an IMP portfolio could be converted to their face
value in cash as a function of “the expectation of instant liquidity”.
686 Moreover, that expectation was generated by Grange, an expert in financial matters,
in the minds of inexpert, uninformed, financially unsophisticated council officers who had
turned to Grange for advice and assistance. In this context, it is not surprising that
Mr Neville, Mr Dunn and Mr Hyde did not turn their minds to what would happen in a
market downturn. First, Grange never raised that as an issue. Secondly, Grange created the
expectation in the Wingecarribee officers’ minds of IMPs providing instant liquidity as an
alternative to cash. Thirdly, there is no evidence (except for cl 2.3(c)) that Grange ever told
Wingecarribee that the “secure, highly rated” investments it was recommending or
purchasing might realise less than face value if the Council wanted to make a cash
withdrawal. The concept of a “cash withdrawal” is that the money represented by the face
value of the investment is as good as being in a bank deposit account. It lies ill in Grange’s
mouth now to criticise them for not considering the possibilities that its own sales pitch was
designed to eschew. For these reasons I accept the following evidence of Mr Hyde as to his
understanding at the meeting on 21 February 2007:
“You did not understand them to be saying to you that the brisk trade in products that they were currently experiencing would necessarily continue during an international credit crisis? --- No, they did not say that. No. And you didn’t understand or expect that that would be the case, did you? --- I expected the products they were going to get us into was going to allow that statement to be supported. Which statement? --- The statement that they could turn it over in three days for an individual item, and our portfolio in 30.
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And you had some belief that that would happen, no matter what was happening in global credit markets? --- Because of the products they were buying.”
687 The Grange representatives acknowledged to the meeting that it understood the
Council’s conservative imperative that ratepayers’ funds not be put at risk. During the
21 February 2007 meeting one councillor had enquired about “ethical” investment products.
The other Council representatives had not expressed any enthusiasm for that type of product.
Nonetheless, Mr Calderwood investigated this issue and emailed Mr Neville with his views
on 12 March 2007. In the email, Mr Calderwood said: “The current portfolio for
Wingecarribee has been constructed conservatively”. He noted that about 50% was “held in
Australian Bank FRNs”. He referred again to this theme when emailing Mr Neville and
Mr Dunn the March 2007 portfolio report, writing of the then returns: “It seems a slow start,
but we did go conservative as we built the portfolio”.
688 The upshot of the meeting of 21 February 2001 was that the finance committee
approved the proposed amendment to the investment policy and Grange’s appointment as
Wingecarribee’s investment adviser.
4.5.7 Wingecarribee’s dealings with Grange to mid July 2007
689 Following the finance committee meeting the relationship between Wingecarribee and
Grange proceeded as had been envisaged. Grange made or realised investments and then
notified Mr Neville and Mr Dunn about what transactions had occurred. Grange sent
monthly reports to the Council. Mr Calderwood telephoned Mr Neville every so often to
touch base or tell him that the monthly reports were coming. The monthly reports listed
“Types” of securities as “ADI FRN” and “CDO FRN” as well as by name. Mr Dunn was
relieved of much of his previous investment duties. By 28 February 2007, Wingecarribee had
invested about $39 million through the IMP agreement.
690 On 1 March 2007, Grange sent Mr Neville a contract note recording the purchase of
Lawson SCDO² for $500,000 (face value). On 7 March 2007 Mr Calderwood emailed the
first monthly report for February 2007 to Mr Neville and Mr Dunn. One page of that report
was headed “Portfolio Valuation – Market Value Components”. It grouped investments
under the headings “Interest Bearing Securities (issued by ADIs)” and “Interest Bearing
Securities (issued by Non-ADIs)”, the latter listing by name and rating the SCDOs Grange
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had purchased. That listing did not identify the investment as a CDO, although the first page
of the report identified some of these as “CDO FRNs”. Mr Neville understood these non-
ADI issued securities were CDO FRNs in the sense that Mr Calderwood had explained on
16 February 2007. By 31 March 2007, Wingecarribee had about $58 million invested under
the IMP agreement.
691 On 13 April 2007, Grange published an update headed “US Sub-Prime Mortgage
Market” written by Mr Woodards. However, this update was only provided to Wingecarribee
on about 24 August 2007. The update referred to the public emergence of problems with
sub-prime lending in the United States of America in February 2007 and the subsequent
impact on credit markets. Mr Woodards wrote that the update had been prepared in response
to client queries concerning “Grange’s CDO exposure to the US sub-prime correction”. The
update commented that despite “the high level of volatility in this market over the past two
months”, no reference entity in any Grange distributed CDO had been downgraded by any of
the three major ratings agencies as a result of their exposure to the sub-prime market. The
update stated:
“… we must caution that it will be some time before the sub-prime correction is fully played out and its impact on US financial institutions is fully understood.”
692 Those words of caution did not stop Grange launching in early April 2007, and then
selling, the Federation Claim SCDO to its clients, including Wingecarribee. That SCDO was
based on an RMBS structure. However, on 13 April 2007, Mr Ackman changed the initial
presentation slides and information packages for the Federation product to include a more
extensive, but still inadequate, list of the risk factors than in other SCDO presentations see
[370]-[374]. Grange did not make a presentation or provide other information about this
product to Wingecarribee at this time. On 8 May 2007, Grange sent Mr Neville a contract
note recording a switch transaction in Wingecarribee’s portfolio involving:
$3 million purchase of the Federation product that was described simply as an
“floating rate note” (see [370]-[374], [592]-[593] above);
$1 million sale of a product called “Henley AAA” with a coupon of BBSW +
80 bps that matured in June 2012;
$1 million sale of the Scarborough notes;
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$1 million sale of the Flinders notes.
693 On 5 June 2007 Grange sent Mr Neville a contract note recording Wingecarribee’s
$200,000 sale of some Flinders notes.
694 On 6 July 2007 Grange sent Mr Neville a contract note for a purchase by the Council
of Flinders notes with a face value of $2,100,000 at a capital price of $100.864 per $100 face
value. As noted above at [383]-[387] this sale was an abuse of Grange’s mandate because it
was motivated by Grange’s desire to protect its own position after receiving an independent
valuation that the Flinders product was worth $8 per $100 face value less than Grange’s own
internal benchmark value for it.
4.5.8 Wingecarribee’s decision to sell the Federation Claim SCDO
695 On 19 July 2007 Grange emailed Wingecarribee a Structured Products Brief written
by Stephen Roberts, its chief economist. This stated “Grange is aware that local government
guidelines require that councils should know the risks involved in their CDO investments”.
The email did not, however, tell the reader of any risks. Rather, it sought to argue that the
“vast majority of CDOs that Grange has issued at AA- rating and better” were not
comparable to CDOs affected because they had United States sub-prime RMBS products in
their reference portfolios. The brief argued that not all CDOs were the same. On the same
day Mr Ackman sent out to clients, including Wingecarribee an “Important Update” arguing
the same point. Unlike the equation of CDOS to FRNs that Mr Calderwood made on
16 February 2007 when he met with Mr Neville and Mr Swan, this update tellingly stated:
“It’s very important to note that in reality, the term ‘CDO’ simply refers to type [sic] of product, but the term ‘CDO’ does not refer to a specific type of asset class.” (emphasis added)
He gave an example of two different bonds saying:
“Despite the fact both these investments are the same type of product, they both entail a completely different, largely incomparable, set of underlying risks and returns. Thus, the term ‘Bond’ simply refers to a type of product, although it does not refer to a specific type of risk. The same is the case with CDOS. The term ‘CDO’ refers to a broad range of risk profiles and asset classes in much the way the term ‘Bond’ does. The reality is that any product which has been ‘tranched’ is a type of CDO.” (emphasis added)
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696 Mr Ackman concluded by noting that although Federation “was a CDO of RMBS”
the impact of the sub-prime crisis on it to date had been “relatively minimal”. He said that
current market events “may cause some short term Mark-to-Market volatility, but this should
be a non-event for our buy-and-hold investors”.
697 By this time, the sub-prime crisis and Bear Stearns, a United States investment bank
that had a significant involvement with such products, had become significant general news
items and there were many media reports concerning these. Mr Neville had become aware of
the story in July 2007. Around this time he rang Mr Calderwood and asked him if any of
Wingecarribee’s investments were exposed to the subprime mortgage market. He replied that
there was one, Federation. Mr Neville asked why did Grange put the Council into such an
investment? Mr Calderwood said that Grange had done so to diversify the Council’s
investments. He also said that all other Council IMP clients of Grange had 5% of their
portfolios invested in the Federation product. Mr Neville said that Wingecarribee’s funds
should not have been put into an investment where its capital was at risk. Mr Calderwood
said that the product was still rated AAA and if it were held to maturity, the principal would
be repaid. He also said that there was some volatility in the financial markets but believed
that this would be short term. Mr Neville asked if the Council would get its capital invested
in Federation back on 9 May 2010 which was, he believed, the maturity date.
Mr Calderwood said that it would.
698 Mr Neville continued to press Mr Calderwood for assurances that the Council would
be repaid its principal from the Federation product in May 2010. Mr Calderwood came to the
Council on 31 July 2007 and met with Mr Neville and Mr Dunn. He reassured them that
Wingecarribee’s capital was guaranteed and it would be repaid in May 2010. Grange
repeated these assurances in a telephone meeting with several Councils on 7 August 2007.
On the same day Mr Calderwood sent to Mr Neville a Grange briefing note on Federation. It
stated that this product “has been caught in the eye of the storm” and that its current pricing
was about 40% of face value. The note went on to say:
“The current volatility reinforces the point that CDOs should generally be viewed as hold to maturity investments.”
Of course, that was the substance of risk warnings contained in the issuers’ offering
memoranda that Grange had studiously avoided giving to its Council clients in the five years
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beforehand. Rather, it had said to them, again contrary to the issuer’s warnings, that there
was an active secondary market.
699 In its monthly portfolio report for July 2007 Grange informed Wingecarribee that all
but two of the 17 SCDOs were valued at less than par, Federation being valued at just under
$1.2 million or 40% of its face value. Then, on 17 August 2007 Grange emailed Mr Neville a
copy of a term sheet and issuer’s offering memorandum for Federation.
700 On 22 August 2007, Mr Neville emailed a list of questions to Mr Calderwood in
anticipation of his attending a meeting scheduled for 24 August 2007. One question enquired
why Grange had sold Wingecarribee the US RMBS Federation product in May when issues
concerning the security of that market had already started to appear. He sought confirmation
that that product matured on 9 May 2010 when the Council could dispose of it without loss of
its capital.
701 Mr Calderwood and Mr Ackman attended the Council chambers on 24 August 2007
and met with Mr Hyde, Mr Paull, Mr Dunn, Mr Neville and the chair of the finance
committee, Cr Paul Tuddenham. Mr Calderwood said that Wingecarribee might lose some of
its capital on the Federation investment. It was now rated AA-. Mr Paull remonstrated that
the ratepayer’s funds should not have been at risk. Mr Ackman said that it was likely that the
capital would be repaid in full but that the Council should not be concerned about losing
some capital because it had made a higher return. The Grange representatives also provided
documentation at the meeting to the Council in respect of the products in Wingecarribee’s
IMP portfolio, including the 13 April 2007 update headed “US Sub-Prime Mortgage Market”
referred to in [691] above.
702 Mr Neville and Mr Dunn participated in a teleconference with representatives from
Grange and other Councils on 28 August 2007. Grange advised the Councils not to sell
Federation and that its “fundamentals” were still strong.
703 At the end of August 2007, Mr Calderwood answered Mr Neville’s request for a list
of Lehman Bros’ products that were in Wingecarribee’s IMP portfolio. Mr Neville also
asked Grange not to engage in any further SCDO trading without prior consultation with the
Council.
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704 In early September 2007, Wingecarribee engaged Ernst & Young to advise it about
whether Grange was giving the Council accurate advice about its position and the risk of loss,
including with respect to the Federation product. By then Grange had informed
Wingecarribee in its August 2007 portfolio report that its $3 million face value parcel of
Federation was now valued at $1,020,000.
705 On 24 September 2007, Mr Hyde, Mr Neville, Mr Paull and Mr Dunn attended a
meeting with other councils, Grange’s Chief Operating Officer, Ben Harding and Ms May.
Mr Hyde asked Grange to buy back Federation and two other SCDOs. He said that Grange
had told Wingecarribee that if they were kept until maturity return of the capital was
guaranteed. Mr Harding or Ms May replied that there was no such thing as a capital
guarantee. Mr Hyde said that that response was not consistent with what Wingecarribee had
been told by Mr Rosenbaum and Mr Calderwood. He asked if he could speak with them.
Ms May said that they were “on gardening leave” and could not be contacted. The Grange
representatives said that Federation could mature in seven to nine years time. One of the
Council representatives responded that they had been told it could mature in May 2010.
Mr Hyde demanded that Grange buy back the Federation product. The Grange
representatives said that the Council should make any such a request in writing. Later that
day Mr Neville emailed Grange a letter from Mr Hyde demanding that Grange repurchase the
Federation investment. His letter referred to Mr Neville’s email of 12 February 2007 that
required Grange to invest only in FRNs where the capital was 100% guaranteed if the
investment were held to maturity (see also [660] above).
706 Mr Harding replied on 26 September 2007 declining Wingecarribee’s request. He
asserted that the purchase of Federation was made in accordance with the requirements of the
Wingecarribee IMP agreement. Mr Harding referred to a telephone conversation he had had
with Mr Hyde that morning in which Mr Hyde acknowledged that the investment in the
Federation product was within those guidelines.
707 It is notable that Grange made this assertion despite, as explained at [371] above,
Grange’s April 2007 slide presentations repeating verbatim some of the offering
memorandum’s risk factors for the Federation product. That presentation stated, as was the
fact in early May 2007, that there was no market for the product and no guarantee could be
given that there would be a secondary market for it in the future. It follows that the sale to
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Wingecarribee of Federation was a breach of the IMP agreement’s requirement that “all
securities must have an active secondary market”. Moreover, as will appear in section 6.2.3
there was in fact never a secondary market for the Federation product.
708 Also on 26 September 2007 Mr Hyde participated in a workshop with a slide
presentation to the Council on its investment situation. This indicated that in the Council’s
portfolio only the Federation SCDO had direct exposure to the United States RMBS market
while two others had tranches in which reference entities had some exposure to that market.
However, the slides also stated that at that time, first, Federation retained its AAA rating, and
secondly Wingecarribee’s cash flow had not been affected.
709 And, the next day, 27 September 2007, Mr Paull emailed Ernst & Young with
instructions that the Council’s liquidity position had improved significantly since the end of
August 2007. He wrote that Wingecarribee was very confident that it would have more than
adequate cash for ongoing operations without the need to draw on hold to maturity assets (ie.
SCDOs) in the foreseeable future.
710 In early October 2007, Wingecarribee received Ernst & Young’s final report.
Mr Hyde had not been impressed with the quality of the work in that report. He had seen one
version that still had another council’s name in it where Wingecarribee’s should have been.
He said that he, the Council and senior staff did not consider the final report gave sufficient
information or guidance to enable Wingecarribee to take a decision. Mr Hyde said the report
was “too generic” and the Council required detailed advice on which it could make decisions.
711 On 20 November 2007, Grange wrote to Wingecarribee giving notice of its intention
to terminate the IMP Agreement as at 31 December 2007.
712 On 7 December 2007, Ms May sent an email to Messrs Hyde, Paull, Neville and
Dunn enclosing Grange’s valuation report as at 30 November 2007 for the Wingecarribee’s
IMP portfolio. This recorded the Federation AAA product as having a value of $480,000 or
16% of its face value of $3 million. Every other SCDO was given a capital value below its
face value ranging from about 58.4% to 98.25%. The total capital value of the Council’s
SCDO holdings was given as about $24.25 million or about 74% of their $32.8 million face
value.
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713 On 12 December 2007, Wingecarribee instructed Tony Rumble of the Savings
Factory to advise it on the underlying structure of its SCDO holdings with a view to the
Council forming an opinion as to their financial strength, likelihood of repaying the principal
in full on maturity and of paying interest due. Mr Rumble reported back on 18 December
2007. He opined that apart from the Federation product, the current Standard & Poor’s
ratings for the others were accurate and could be relied on by Wingecarribee. He considered
that there was uncertainty about the accuracy of the Federation SCDOs ratings and that it was
likely that it may suffer a sufficient number of credit events to threaten its capacity to pay
interest and repay its principal in full. He suggested that it was reasonably possible that some
or all interest might cease being paid within the next 12 months.
714 On 20 December 2007, Mr Hyde wrote to Grange informing it that Wingecarribee had
resolved to sell its Federation holding. The letter instructed Grange to remove the holding
from its IMP portfolio within 30 days pursuant to cl 2.3(c) of the Wingecarribee IMP
agreement. Wingecarribee commenced these proceedings on 20 December 2007.
715 Mr Hyde recollected that the primary reason for Wingecarribee’s decision to instruct
Grange to sell this investment was that the Council had advice that the number of defaults
was climbing and that there was a high risk of it losing all its capital. His recollection of the
nature of the advice does not accord with Mr Rumble’s less definite written advice. It is
likely that Mr Hyde’s recollection was of his interpretation of the effect of the advice given
by Mr Rumble. Mr Rumble’s advice conveyed that there was a real and imminent likelihood
that the Federation product would suffer sufficient defaults to imperil Wingecarribee’s
capital. There was no certainty of what would happen to the investment; indeed, in late 2007
and early 2008 there was considerable uncertainty about the world economy. Over the
preceding five months, Wingecarribee and Mr Hyde had seen this investment of a large
amount of its money, that it had trusted Grange to make, becoming more and more exposed
to a very uncertain future. Mr Hyde also considered that it was useful, but not essential, for
the Council to have a crystallised loss for the purposes of the proceedings it had just decided
to bring against Grange.
716 I accept Mr Hyde’s evidence that while the institution of the proceedings was a factor
in Wingecarribee’s instruction to Grange to sell the Federation product, the primary reason
for that instruction was the desire to protect the Council’s financial position from the risk of
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loss of all of its $3 million capital in that investment. Grange had created the situation in
which Wingecarribee had found itself in December 2007. Grange had sold the Council a
product that it knew was comprised of United States located RMBS investments at a time that
sub-prime RMBS investments were already vulnerable to defaults. The Federation SCDO
had a final maturity 40 years later. The product had no active secondary market, as Grange’s
own contemporaneous marketing material had warned in April 2007, contrary to the
requirement of the Wingecarribee IMP agreement that all securities “must have an active
secondary market”: [371]-[372], [638]. There was no evidence to demonstrate that, in late
2007 and early 2008, Wingecarribee’s decision to sell the Federation product was
unreasonable. Sale was one course of action open to the Council, in the very uncertain
future, to avert possible total loss caused by Grange’s investment of the Council’s $3 million
in breach of the IMP agreement, in a product that had no active secondary market. Grange’s
reported assessment of the value of this product had plummeted over the previous six months.
There was no certainity if or when it would stabilise. I am not satisfied that Wingecarribee’s
decision to sell the Federation SCDO in late 2007 and early 2008 was unreasonable:
CMFEU [2012] FCAFC 44 at [69].
717 Grange replied to Mr Hyde’s 20 December 2007 letter on 18 January 2008. By then,
the Federation SCDO had been downgraded to a rating of AA. Grange’s letter advised that
“the current indicative bid” for the SCDO was 15% clean price (i.e. exclusive of interest). It
did not reveal that Grange was the only “bidder” and was also the “market”. Rather the letter
kept up the pretence that “bid prices are subject to market fluctuations and constant change”.
It asked the Council to contact Ms May to confirm the actual sale price. Later on 18 January
2008, Mr Paull spoke with Ms May. She advised that Grange’s view was that it was not an
opportune time for Wingecarribee to sell the Federation SCDO as this would not provide the
best return. Mr Paull recorded this in an email and asked her to put Grange’s advice in
writing. Mr Paull then wrote to Grange on 21 January 2008 repeating the need for
Wingecarribee to have written reasons for Grange’s advice. On 22 January 2008, Ms May
emailed Mr Paull essentially repeating Grange’s position expressed in its letter of 18 January.
She said that although they had discussed current market events when they spoke on
18 January, she had given no advice on whether Wingecarribee should:
“buy, sell or hold Federation. [Grange] expressed no view on whether Council should sell Federation at this time as that is a matter for Council.”
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Ms May also stated that Grange was not in a position to comment on whether the Federation
product would be restructured.
718 On 22 January 2008, Mr Paull emailed Ms May asking for a firm bid price. She
replied about 40 minutes later saying: “Please be advised of bid for Federation at 15.00”.
Mr Paull responded shortly afterwards on the same day instructing Grange to sell its
Federation holding at the current indicated price of 15% face value. Grange issued a contract
note later on 22 January 2008 confirming that it had bought Wingecarribee’s Federation
SCDO at a capital price of $15.00 per $100 face value; ie. $450,000.
5. THE LEGAL CHARACTER OF THE RELATIONSHIPS BETWEEN THE COUNCILS AND GRANGE
719 The central feature of the relationships that each Council had with Grange was a
contract, either to buy or sell a particular financial product or authorising, in the case of the
two IMP agreements, Grange to undertake such sales and purchases. The terms of any such
contract will be relevant to determining:
the nature and extent of any fiduciary obligation owed by Grange;
the nature and extent of Grange’s tortious duty of exercising reasonable skill
and care in recommending or effecting transactions;
whether Grange engaged in conduct that was misleading or deceptive or was
likely to mislead or deceive (which I will simply refer to as “misleading
conduct” or “misleading or deceptive conduct”).
720 Grange acted in respect of each Council at all times relevant to these proceedings as a
financial services licensee for the purposes of s 912A of the Corporations Act 2001. Each of
its officers who had dealings with the Councils was a representative of Grange as a financial
services licensee within the meaning of s 912A. It is common ground that Grange and its
representatives had the following obligations in respect of the conduct of their dealings with
each Council, pursuant to s 912A(1), namely:
“(1) A financial services licensee must:
(a) do all things necessary to ensure that the financial services covered by the licence are provided efficiently, honestly and fairly; and
(aa) have in place adequate arrangements for the management of conflicts of interest that may arise wholly, or partially, in relation to activities
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undertaken by the licensee or a representative of the licensee in the provision of financial services as part of the financial services business of the licensee or the representative; and…
(c) comply with the financial services laws; and
(ca) take reasonable steps to ensure that its representatives comply with the financial services laws; and…
(f) ensure that its representatives are adequately trained, and are competent, to provide those financial services; …”
5.1 The relationships between Swan and Grange
5.1.1 The pre-IMP agreement contractual relationship between Swan and Grange
721 As noted in [18] above, prior to 9 February 2007 (when the Swan IMP Agreement
was made) each dealing between Swan and Grange was effected by a separate contract for
purchase or sale of a financial product. Grange was engaged to act and acted in each
transaction as a financial adviser to Swan. It provided Swan with financial advice to effect
the transaction on the terms on which it was made as one suitable and appropriate for dealing
with the investment of public money by the Council. The initial contract was formed on
15 September 2003 for the purchase by Swan of the Forum AAA product: [199]. Based on
my findings above, the following terms formed part of that contract in addition to those
recorded in the contract note in respect of the product, price and settlement details:
(1) the product had a high level of security for protection of the capital invested
by the Council ([180], [188]-[189]). I have synthesised this term and
representation from the Councils’ pleaded features of a conservative
investment strategy, namely: “investments featuring high levels of capital
security”, “debt instruments” (with a maturity of greater than one year) that
had “high levels of capital security rather than high rates of return” and
“capital protections, to the extent that this was possible”, and the suitability of
the products sold to them by Grange as possessing those features.
(2) the product was easily tradeable on an established secondary market ([180],
[181], [197], [199]).
(3) the product was readily able to be liquidated for cash at short notice ([180],
[181], [197], 199]). When Mr O’Dea first discussed Grange’s products with
Mr Senathirajah and other Swan representatives, he said that there would be a
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secondary market for them and, if there were not, Grange would buy the
product back ([181]). Nonetheless this promise conveyed that the products
were readily able to be liquidated for cash at short notice. Grange did not
qualify what it told Swan by explaining that if it could not buy the product
back it was substantively unsaleable. Mr Vincent made a related point in the
“no haircut repo” email that if Grange failed, the product would be worth less
than the lender’s investment in the “repo” (see [266], [460]). Although the
promise was understood by Mr Senathirajah to be that Grange would buy the
product back, it was not qualified by words such as “provided that Grange is
in a financial position or willing to do so”.
(4) the product was a suitable and appropriate investment for a risk-averse local
government council ([179], [208]).
(5) the product had a secure income stream ([188]-[189], [193]).
(6) Grange would exercise reasonable skill and care in making this investment
recommendation and in giving this investment advice to Swan: Astley v
Austrust Ltd (1999) 197 CLR 1 at 22-23 [47]-[48] per Gleeson CJ, McHugh,
Gummow and Hayne JJ.
722 Terms (1) to (5) were features of the particular product that Grange expressly
promised Swan that it would possess in the antecedent negotiations for its purchase. But
more than that, these promises were made by Grange in the context of its explanation of the
generic features of investments about which it would advise, and make recommendations to,
Swan as suitable and appropriate for it to buy or sell. Moreover, as I have found, the nature
of Grange’s subsequent interactions with Mr Senathirajah and Mr Downing involved Grange
repeating, with differing degrees of emphasis, and necessary adaptations to suit the individual
proposed transaction, the same substantive promises of each product’s characteristics (see
section 4.2.7). However, where Grange proposed that Swan sell a product, it did not need to
repeat promises about it reflecting terms (4) and (5), at the time of its purchase. Nonetheless,
as I have explained, by facilitating a sale, Grange reinforced the accuracy of its earlier
promise that reflected terms (1), (2) and (3). The terms formed part of a course of dealing
between Swan and Grange. While the parties may not have repeated each of those terms
verbatim when each contract was made in respect of a particular product, they were
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necessarily implicit in each contract. That follows because each was expressly identified in
substance by Grange as a significant and essential feature of the Forum AAA product. Each
was also a feature that both parties knew was, in the case of terms (1), (4) and (5), essential
for any investment made by the Council and, in the case of terms (2) and (3), promoted by
Grange as such a feature. If it were necessary to consider whether any of these terms were
implied, I would make such an implication to align, or give congruence, to the rights and
obligations of the buyer (the Council) and the seller (Grange) in each transaction and their
common intention that the product have each of those features. Each of those terms was
necessary for the reasonable or effective operation of the contract: Associated Alloys Pty Ltd
v ACN 001 452 106 Pty Ltd (in liq) (2000) 202 CLR 588 at 609-610 [44-]-[46] per Gaudron,
McHugh, Gummow and Hayne JJ. Each of those 5 terms met the five conditions for
implication of a term identified in BP Refinery (Westernport) Pty Ltd v Shire of Hastings
(1977) 180 CLR 266 at 283 per Lord Simon of Glaisdale, Viscount Dilhorne and Lord Keith
of Kinkel and approved in Associated Alloys 202 CLR at 609 [44].
723 Term (6) reflects the concurrent duty of care that exists in both contract and tort
where a professional provides a client with professional services. Concurrent duties of care
can also arise at common law and in equity in respect of the obligation of a person owing
equitable obligations to another: Nocton v Lord Ashburton [1914] AC 932 at 956 per
Viscount Haldane LC. Here, Grange offered and performed professional services for Swan
that it characterised as “ad hoc or broking … investment advisory services” in its letter to
Swan of 23 March 2006 (see [22] above). The duty of care in term (6) would apply to the
performance of its ad hoc retainers even if its services were so confined. It follows that term
(6) also applies to each contract under which Grange performed the broader advisory role that
I have found.
724 When Mr Downing took over from Mr Senathirajah, there was no variation to the
contractual terms of dealing, or the course of dealing, between Swan and Grange that I have
found as terms (1)-(6) in [721] above. Mr O’Dea had begun their interaction by telling
Mr Downing that Grange had been appointed as an investment adviser to Swan: see [282]-
[283] above. That conveyed an implication in the context that terms (4) and (6) were part of
each dealing Grange proposed for Swan (see eg. [315]-[317] above). The first substantive
presentation that Grange made to Mr Downing was for the Parkes product (see [308]-[321].
That also conveyed to Mr Downing that this product had the characteristics in terms (1) and
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(5) (see [283], [315], [321], [331]). Mr Downing approached the purchase of the SCDOs on
the basis that Swan would hold them to maturity (see [106]-[110], [325]). Nonetheless, the
repeated switches that Grange proposed and effected with Mr Downing’s agreement, created
an implication of terms (2) and (3) as is illustrated by both the first switch on 17 May 2006
(see [285]) and that proposed on 27 September 2006, which Mr O’Dea recommended saying
that its result “does illustrate how these switches can have a positive effect over time”
([342]).
725 Grange argued that the disclaimers in the product presentations that it made to Swan,
before the Swan IMP agreement, and to Parkes had the effect of negating or excluding the
implication of any contractual term that warranted the suitability for the Council of the
product the subject of each individual contract. Grange also contended that disclaimers also
relieved it of the contractual and tortious duty to exercise reasonable skill and care (see too
[113], [182], [247]-[248], [317], [399], [475], [486]-[487], [516], [584]-[585], [787], [802]).
Two typical disclaimers read:
“Do not act on a recommendation without first consulting your investment adviser to determine whether the recommendation is appropriate for your investment objectives, financial situation and particular needs.” and “You should not act on a recommendation or statement of opinion without first considering the appropriateness of the general advice to your personal circumstances or consulting your investment adviser to determine whether the recommendation or statement of opinion is appropriate for your investment objectives, financial situation or needs.” (emphasis added)
726 I reject those arguments. They depended on the assertion that the disclaimers
operated on the relationship between Grange and respectively, Swan or Parkes, because they
warned the reader not to act on the slide presentations “without first consulting your
investment adviser”. A similar disclaimer is set out at [584]. If an officious bystander asked
the parties whether Swan or Parkes had an investment adviser, everyone present would have
said that the Council did and it was Grange. The reason that the Grange representatives never
mentioned the disclaimers in any oral dealings they had with Councils was patent. It 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. As I explained in [585] the last thing Grange wanted was for
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the Councils to seek someone else’s advice, given that it had positioned itself as a trusted
financial adviser on investments for them.
727 The disclaimers would have operated to protect Grange from liability to a third party
if the slides or emails had come to the attention of that party in circumstances where Grange
had not provided them in the course of giving financial advice to that party. It would be
commercially absurd for a financial adviser to tell its client not to act on its recommendation
or advice and to get financial advice from someone else. The disclaimer has to be read, so far
as it may have had any contractual or other operation in the relationship between Grange and
Swan or Parkes or Wingecarribee, to avoid it making commercial nonsense or working
commercial inconvenience: Zhu v Treasurer of the State of New South Wales (2004) 218
CLR 530 at 558-559 [81]-[82] per Gleeson CJ, Gummow, Kirby, Callinan and Heydon JJ.
One thing is certain. Grange did not draw the disclaimers to the attention of any of the
Councils. Nor did it tell any of them that it was not acting as the Council’s financial adviser.
Importantly, Grange never suggested that it might be in a position of conflict, as the
Council’s financial adviser for the transaction it was proposing and that the Council should
obtain independent financial advice about what Grange was proposing, so that Grange could
be released from any fiduciary obligation it owed.
728 Swan (and Parkes) also pleaded and contended for a further contractual term, namely:
(7) Grange had an obligation to make a full and accurate disclosure of its interest
in the transaction (Daly v Sydney Stock Exchange Ltd (1986) 160 CLR 371 at
377 per Gibbs CJ, Dawson J agreeing, at 384-385 per Brennan J (Wilson J
agreed with both Gibbs CJ and Brennan J)) and all that Grange knew with
respect to the product, concealing nothing that might conceivably be regarded
as relevant to the making of the investment decision (Daly 160 CLR at 377 per
Gibbs CJ, 385 per Brennan J; McKenzie v McDonald [1927] VLR 134 at 145
per Dixon AJ).
729 I have found that Grange owed fiduciary obligations as a financial adviser. I will
discuss these in section 5.1.2. The posited term (7) for which Swan (and Parkes) contended
for would create a contractual term having a positive operation that mirrors the defence a
fiduciary can raise to a claim that it has breached its proscriptive fiduciary obligations. I am
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of opinion that it is not necessary to imply such a term where it has not been expressly agreed
between the parties. First, the imposition of a fiduciary obligation is an incident of particular
relationships and dealings between the parties imposed by equity to hold the fiduciary to, and
indicate, the high duty he, she or it owes to the other party: Maguire v Makaronis (1997) 188
CLR 449 at 465-466. Secondly, the terms of a contract can modify or extinguish a fiduciary
obligation that one party to the contract would otherwise owe the other because of their
relationship: John Alexander’s Clubs Pty Ltd v White City Tennis Club Ltd (2010) 241 CLR
1 at 36 [91]-[92] per French CJ, Gummow, Hayne, Heydon and Kiefel JJ. Thirdly, such an
implication is not necessary to give business efficacy to the contract between a financial
adviser and its client because, in the absence of a qualification in the contract affecting the
fiduciary character of the relationship, equity superimposes fiduciary obligations as an
incident of the particular relationship between the parties. The contract is thus effective
without such an implication.
730 Indeed, the equitable remedies for a failure to discharge a fiduciary obligation may be
greater than those available in the contract. Those remedies can require the fiduciary to
account for any profits, make good any losses arising out of a breach and do not necessarily
reflect the rules for assessment of damages in contract or tort: Pilmer v Duke Group Ltd (in
liq) (2001) 207 CLR 165 at 197-198 [74], 201 [85] per McHugh, Gummow, Hayne and
Callinan JJ. If the posited term were implied into the contract, that may have an unintended
consequence of confining the remedies available against the defaulting fiduciary: cf BP
Refinery 180 CLR at 283.
731 I am satisfied that Grange owed fiduciary obligations in equity independently of any
contractual obligation it owed to its client, Swan (and Parkes), so it is not necessary to imply
positive obligation as contended for in posited term (7) in any contract between Grange and
the Councils.
5.1.2 Did Grange owe fiduciary obligations to Swan before 9 February 2007?
732 Contractual terms and fiduciary obligations are characteristics of distinct legal
relationships although those relationships may, and often do, overlap from time to time. A
fiduciary such as a financial adviser will be under two proscriptive obligations imposed by
equity. Those obligations are, unless the fiduciary has the informed consent of the person to
whom they are owed, first, not to obtain any unauthorised benefit from the relationship and,
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secondly, not to be in a position where the interests or duties of the fiduciary conflict, or there
is a real or substantial possibility they may conflict, with the interest of the person to whom
the duty is owed: Pilmer 207 CLR at 197-198 [74], 199 [78]-[79]. Grange argued that
equitable, and particularly fiduciary obligations, ought not readily be imported into
commercial relationships. It contended that it should not be found to have assumed an
obligation of self-abnegation in its dealings with the Councils. Grange contended that such
an obligation was contrary to the commercial reality of its relationships with the Councils as
a commercial dealer in financial products: cf PA Keane: The 2009 WA Lee Lecture in
Equity: The Conscience of Equity (2009) 84 ALJ 92 at 98-100. I reject that argument.
733 Grange acted as a financial adviser to each Council. It portrayed itself to them as
having that role. By doing so, 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. That relationship attracted the above fiduciary obligations that, in the absence
of contractual or other modifications, for over two centuries have overlaid contractual
dealings between fiduciary agents in well recognised categories, such as financial advisers,
stockbrokers, real estate agents and, of course, solicitors, and their clients: Daly 160 CLR
371; Maguire 188 CLR at 463-464 per Brennan CJ, Gaudron, McHugh and Gummow JJ;
Pilmer 207 CLR at 196-197 [70]-[72]. In Commonwealth Bank of Australia v Smith (1991)
42 FCR 390 at 391 Davies, Sheppard and Gummow JJ said that where a bank gives a
customer advice upon financial affairs, then in addition to any contractual rights the customer
may have, the relationship between the parties may be such as to found either, or both, a
common law duty of care and a fiduciary duty. They observed that in many cases the bank,
as financier, has a manifest interest of its own in the matter. In such cases, the Court must
ascertain whether the bank will have assumed fiduciary obligations towards the customer in
the context of its own apparent commercial self-interest in the transaction. Their Honours
then said at 42 FCR at 391:
“A bank may be expected to act in its own interests in ensuring the security of its position as lender to its customer, but it may have created in the customer the expectation that nevertheless it will advise in the customer’s interests as to the wisdom of a proposed investment. This may be the case where the customer may fairly take it that to a significant extent his interest is consistent with that of the bank in financing the customer for a prudent business venture. In such a way the bank may become a fiduciary and occupy the position of what Brennan J has called ‘an investment adviser’ (Daly 160 CLR 371 at 384-385).” (emphasis added)
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734 It follows from what I have found about the relationship and contracts between Swan
and Grange, that Grange owed its client fiduciary obligations in its financial dealings with
Swan before they entered the Swan IMP Agreement. From the time that Mr O’Dea began his
attempts to interest Swan in changing the 1998 Swan Policy so that the Council could acquire
FRNs and SCDOs, Grange and Swan were contemplating entering into a relationship in
which Grange would provide Swan with financial advice about products in which Grange had
an interest. Swan was also seeking advice and views from others in the formulation of the
2003 Swan Policy. Each of the organisations which Swan consulted (Grange, Grove and
Oakvale) was trying to win the Council’s trust and confidence, and thus all, or a portion, of
its investment business. Of course, such negotiations are a commonplace in commercial life
and few ever create a fiduciary relationship in themselves.
735 However, Grange was negotiating with Swan expressly to offer its services of
providing professional financial and investment advice to Swan based on Grange’s professed
expertise as such an adviser to local government clients. That was the thrust of the
background note and explanation of FRNs that Mr O’Dea emailed to Mr Senathirajah on
18 August 2003 ([178]-[180] above). Mr O’Dea pursued this by presenting slides and
explaining the Forum AAA product as one that was a suitable investment for the risk averse,
and financially unsophisticated, Council (see [218] above). Grange was recommending that
Swan buy that product. As I have found at [185]-[186], Mr Frewing and Mr Senathirajah told
Mr O’Dea that they, and Swan, would depend on advice from people who knew about
sophisticated financial products, such as the Forum AAA SCDO, that Grange and Mr O’Dea
were seeking to interest them in, to help the Council make a decision about whether or not to
invest. They also told Mr O’Dea that they did not have the time or competence to monitor
the products and that, if the Council invested in them, it would expect Grange to perform that
role too. Mr O’Dea told them that all this was part of Grange’s service and expertise which it
would provide to Swan. Mr O’Dea said this role included making recommendations and
giving advice to Swan about whether or not to sell a product. Mr O’Dea said he was well
aware of the competencies in Swan and in local government generally. I find that he was, as
was Grange.
736 Indeed, as the “no haircut repo” email illustrated, Grange knew that its business
depended on winning and maintaining the trust and confidence of the financially
unsophisticated and uninformed local government officers such as Mr Senathirajah and his
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successors, Mr Downing and Mr Cameron, with whom it dealt in order to effect transactions
that would have been unachievable were the other party an informed investor. Moreover
Grange knew that Swan (as well as Parkes and Wingecarribee) had duties to act as a “prudent
person” and in accordance with State legislation, Ministerial investment guidelines (that it
accepted as part of its policy), and its own investment policies in making investments of
public money. Grange portrayed itself as having expertise in giving advice and making
recommendations about “appropriate investments for risk averse local government”, as the
2003 explanation of FRNs Mr O’Dea sent to Mr Senathirajah stated.
737 In John Alexander 241 CLR at 34-35 [87] the Court approved the identification by
Mason J in Hospital Products Ltd v United States Surgical Corp (1984) 156 CLR 41 at 96-97
of:
“the critical feature of what may be called the accepted traditional categories of fiduciary relationship – trustee-beneficiary, agent-principal, solicitor-client, employee-employer, director-company, and partners inter se. That critical feature was ‘that the fiduciary undertakes or agrees to act for or on behalf of or in the interests of another person in the exercise of a power or discretion which will affect the interests of that other person in a legal or practical sense’. From this power or discretion comes the duty to exercise it in the interests of the person to whom it is owed.” (footnotes omitted; their Honours’ emphasis)
738 In Daly 160 CLR 371, Dr Daly had approached a firm of stockbrokers and sought
advice as to shares in which he might invest money he had available. An employee of the
firm advised him that it was not a good time to buy shares and suggested that Dr Daly deposit
money at a large rate of interest with the firm until the time was right to buy shares. The
employee, who did not know otherwise, told Dr Daly that the firm was “as safe as a bank”.
In fact, though outwardly the firm appeared to be large and prosperous, its partners, but not
the employee, knew its financial position was then precarious. Dr Daly made further
deposits. The firm failed and its partners became insolvent owing Dr Daly the amounts he
had deposited.
739 Gibbs CJ, with whom Wilson J and Dawson J agreed, explained that the firm owed
Dr Daly a fiduciary duty to disclose to him the information in its possession which would
have revealed the transaction to be a most disadvantageous one from his point of view. That
was because the firm had held itself out as an adviser on matters of investment, undertook to
advise Dr Daly and he relied on the advice that the firm gave him. The Chief Justice then
held (160 CLR at 377):
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“Normally, the relation between a stockbroker and his client will be one of a fiduciary nature and such as to place on the broker an obligation to make to the client a full and accurate disclosure of the broker’s own interest in the transaction: In re Franklyn; Franklyn v Franklyn (1913) 30 TLR 187; Armstrong v Jackson [1917] 2 KB 822; Thornley v Tilley (1925) 36 CLR 1 at 12; Glennie v McDougall & Cowans Holdings Ltd [1935] 2 DLR 561; Burke v Cory [1959] 19 DLR 2d 252; Culling v Sansai Securities Ltd [1974] 45 DLR 3d 456. The duty arises when, and because, a relationship of confidence exists between the parties: see Tate v Williamson (1866) LR 2 Ch App 55 at 61,66; and see also McKenzie v McDonald [1927] VLR 134 at 144-145; Hospital Products Ltd v United States Surgical Corporation (1984) 156 CLR 41 at 67-75, 141-142.” (emphasis added)
740 Brennan J, with whom Wilson J also agreed, said that a stockbroker who had been
engaged to buy and sell shares on behalf of a client had been held to be an agent subject to a
fiduciary’s obligations in buying and selling (160 CLR at 384). He then addressed whether
the firm was in the position of a fiduciary when Dr Daly sought advice and it advised him on
the investment of his money. Like Gibbs CJ, Brennan J turned (160 CLR at 384) to the
judgment of Lord Chelmsford LC in Tate v Williamson (1866) LR 2 Ch App 55 at 61 who
had said:
“Wherever two persons stand in such a relation that, while it continues, confidence is necessarily reposed by one, and the influence which naturally grows out of that confidence is possessed by the other, and this confidence is abused, or the influence is exerted to obtain an advantage at the expense of the confiding party, the person so availing himself of his position will not be permitted to retain the advantage, although the transaction could not have been impeached if no such confidential relation had existed.”
741 Brennan J said that a fiduciary relationship may arise in respect of a transaction even
though there had been no anterior relationship between the parties and then continued (160
CLR at 384, 385):
“Whenever a stockbroker or other person who holds himself out as having expertise in advising on investments is approached for advice on investments and undertakes to give it, in giving that advice the adviser stands in a fiduciary relationship to the person whom he advises. The adviser cannot assume a position where his self-interest might conflict with the honest and impartial giving of advice. See In re a Solicitor; Ex parte Incorporated Law Society [1894] 1 QB 254 at 256; Armstrong v Jackson [1917] 2 KB at 824-825. The duty of an investment adviser who is approached by a client for advice and undertakes to give it, and who proposes to offer the client an investment in which the adviser has a financial interest, is a heavy one. His duty is to furnish the client with all the relevant knowledge which the adviser possesses, concealing nothing that might reasonably be regarded as relevant to the making of the investment decision including the identity of the buyer or seller of the investment when that identity is relevant, to give the best advice which the adviser could give if he did not have but a third party did have a financial interest in the investment to be
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offered, to reveal fully the adviser’s financial interest, and to obtain for the client the best terms which the client would obtain from a third party if the adviser were to exercise due diligence on behalf of his client in such a transaction. Such a duty has been established by authority: Haywood v Roadknight [1927] VLR 512, and the cases therein referred to at p 521, especially Gibson v Jeyes (1801) 6 Ves Jun 266 at 271, 278, 31 ER 1044 at 1046-1047, 1050 and McPherson v Watt (1877) 3 App Cas 254 at 266.” (emphasis added)
742 The Court held in Daly 160 CLR 371 that the firm had breached its (proscriptive)
fiduciary obligations not to obtain an unauthorised benefit from the relationship and not to be
in a position of conflict and that it had no defence because it had failed to obtain Dr Daly’s
fully informed consent to the dealings they had. The two fiduciary obligations are
proscriptive. They arise because the fiduciary comes under an obligation to act in another’s
interests: Pilmer 207 CLR at 197-198 [74]. In a sense, the corollary to the proscriptive nature
of the fiduciary obligations, is the need for the fiduciary to obtain the confider’s fully
informed consent to the transaction so as to ensure that the fiduciary does not do what is
proscribed. The impact of this corollary can be seen not only in Daly 160 CLR 371 but in
many other cases. Four further examples will suffice: Birtchnell v Equity Trustees,
Executors & Agency Co Ltd (1929) 42 CLR 384 at 398; Furs Ltd v Tomkies (1936) 54 CLR
583 at 592-593 per Rich, Dixon and Evatt JJ; Gray v New Augarita Porcupine Mines Ltd
[1952] 3 DLR 1 at 14-15 per Lord Radcliffe; Maguire 188 CLR at 466-467. As Brennan CJ,
Gaudron, McHugh and Gummow JJ said in the latter case where solicitors had lent money to
their clients:
“What is required for a fully informed consent is a question of fact in all the circumstances of each case and there is no precise formula which will determine in all cases if fully informed consent has been given. The circumstances of the case may include (as they would have here) the importance of obtaining independent and skilled advice from a third party. On no footing could it be maintained that the appellants had taken the necessary steps of this nature to answer the charge of breach of fiduciary duty. However, it should be noted that, contrary to what appeared to be suggested by the respondents in argument, there was no duty as such on the appellants to obtain an informed consent from the respondents. Rather, the existence of an informed consent would have gone to negate what otherwise was a breach of duty.” (emphasis added, footnotes omitted)
Thus, a defence to a claim of breach of fiduciary duty is that the person to whom the duty was
owed was fully informed as to the nature and extent of the fiduciary’s interest and or conflict
of interest or duty and then consented to the fiduciary’s conduct: see too Blackmagic Design
Pty Ltd v Overliese (2011) 191 FCR 1 at 22-23 [105]-[108] per Besanko J with whom
Finkelstein and Jacobson JJ agreed. Importantly, as Gleeson CJ, Gummow, Callinan,
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Heydon and Crennan JJ observed in Farah Constructions Pty Ltd v Say-Dee Pty Ltd (2007)
230 CLR 89 at 138-139 [107] the sufficiency of disclosure can depend on the sophistication
and intelligence of the persons to whom disclosure must be made. They said that this formed
part of the factual inquiry referred to in the first sentence quoted above from Maguire 188
CLR at 466.
743 Here, before Swan invested in the Forum AAA product, Mr Frewing and
Mr Senathirajah 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. Grange held itself out to Swan at all times from about mid 2003 (when Mr O’Dea
began offering advice about rewriting Swan’s investment policy and investing in the Forum
AAA SCDO) as an adviser on matters of investment and undertook to advise Swan on those
matters. 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
Forum AAA 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.
744 I am satisfied that Mr Senathirajah and later, Mr Downing, as the persons with the day
to day conduct of the relationship between Swan and Grange, relied on Grange’s advice and
recommendations in relation to Swan’s dealings with Grange. For the reasons I have given
earlier, I am also satisfied that despite Swan not having called Mr Frewing and Mr Poepjes, a
commonsense cause of Swan’s investment decisions in relation to buying, selling and holding
financial products traded by Grange was the reliance placed on Grange’s advice and
recommendations by Mr Senathirajah and, later Mr Downing: [162], [408]-[409] above.
745 For these reasons, I am satisfied that, in respect of their dealings prior to entry into the
Swan IMP agreement, Grange owed Swan fiduciary obligations. It could not, without
Swan’s informed consent, obtain or promote its personal interest by making or pursuing a
gain in circumstances where there was a conflict, or a real or substantial possibility of a
conflict, between Grange’s interests or the duty it owed to Swan and Swan’s interests when
giving financial advice and making recommendations about financial products (Pilmer 207
CLR at 199 [78]-[79]; Daly 160 CLR at 377, 384-385). If Grange were to relieve itself of
that obligation, equity required it to do what the posited contractual term (7) expressed,
namely to make a full and frank disclosure and obtain the Council’s fully informed consent:
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Maguire 188 CLR at 466-467; Daly 160 CLR at 377, 384-385; Blackmagic 191 FCR at 22-23
[105]-[108].
746 Grange’s contract notes from about late January 2005 contained terms and conditions
set out at [254] and [525]. These stated that “Grange Securities may also receive placement
fees from Issuers for distributing securities on their behalf”. Grange relied on these terms and
conditions as modifying or excluding any fiduciary obligation to disclose fees it received
from issuers on new issues it sold to Swan (particularly before the Swan IMP agreement) and
Parkes. In the context of what the balance of the contract notes stated, the statement that
Grange “may also receive placement fees” would have been understood, objectively, as a
disclosure or explanation of a possibility that in some cases Grange could receive such fees.
An objective reader of the contract notes would not have understood that statement to amount
to a contractual promise by a client at arm’s length that Grange “may”, in the sense of “is
given the unqualified right”, to receive any such fees. The statement followed immediately
after, and in the same paragraph, an “explanation” that the quoted yield incorporated any
margin that Grange received as seller or buyer. What the “yield” specified in the contract
note represented was far from self evident, as I have illustrated in [504], [543]-[546].
747 There was no evidence that Grange drew the attention of Swan or Parkes to the
introduction of those terms and conditions into its contract notes in late January 2005 or any
later time. Each contract note evidenced a transaction that had already been agreed orally or
by email before it was issued by Grange. Grange had acted as a financial adviser to each of
Swan and Parkes since the inception of their financial dealings in 2003. If it sought to relieve
itself of its fiduciary obligations as a financial adviser, by use of the terms introduced into the
contract notes in January 2005, Grange would have had to make a full disclosure at that time
to obtain the informed consent of its Council clients to the change in their relationship that
this would involve. There is no evidence that it did so. A person in Grange’s position should
not be allowed to relieve itself from its fiduciary obligations by relying on such a statement,
introduced without expressly explaining to its client what it was doing in introducing the new
term and what it intended to achieve, so as to obtain a fully informed consent. In any event,
although called a “contract” note, those documents were evidentiary of an earlier agreement,
being Grange’s acceptance of the Council’s instruction to effect the particular transaction.
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748 Even if I am wrong in this finding, for the reasons I have discussed in section 5.1.5 in
relation to a similar “disclosure” in Sch 3 of the IMP agreements, the mere fact that the
Councils may have given Grange contractual permission to earn “placement fees”, did not
relieve Grange of all its remaining fiduciary obligations.
749 At about the same time, in January 2005, the last slide in the presentation for the
Flinders product contained an explicit statement that “Grange is Sole Underwriter to the
Flinders Issue and will receive fees for acting in that capacity”. As I have found in [247]-
[248], first there was no evidence that Grange was the underwriter of the Flinders’ product
and secondly, Grange bought all the notes issued for the Flinders product from Credit Suisse,
at a discount of 2.38% from face value, and on sold them for face value to its clients,
including Swan. While what Grange did may have had some similarity to underwriting
issues of SCDOs, that example and those I have referred to in section 5.1.5 suggest that
Grange was simply trading with the issuers and arrangers to acquire products for on-sale to
its clients. Grange used its skill and knowledge in that trading to negotiate discounted prices
from the products’ expressed face values that it would pay to the issuers.
5.1.3 What representations were made to Swan?
750 In Miller & Associates Insurance Broking Pty Ltd v BMW Australia Finance Ltd
(2010) 241 CLR 357 at 384-385 [91] Heydon, Crennan and Bell JJ referred to the necessity
of making a close analysis of all of the circumstances of a transaction in order to determine
whether conduct was misleading, in contravention of s 52 of the Trade Practices Act and its
analogues. They referred back to what Gleeson CJ, Hayne and Heydon JJ had held in
Butcher v Lachlan Elder Realty Pty Ltd (2004) 218 CLR 592 at 604 [37]. The latter case
dealt with whether the conduct of a real estate agent in providing a sales brochure was
misleading or deceptive. The brochure contained both an indicative plan of waterfront land
and a disclaimer by the agent of the accuracy of the contents of the brochure which it said had
been obtained from other sources. The plan erroneously located a swimming pool entirely
within a parcel of the land to be sold partly demarcated by the mean high water marks.
Gleeson CJ, Hayne and Heydon JJ said that there, as here, the case was one:
“where monetary relief is sought by a plaintiff who alleges that a particular misrepresentation was made to identified persons, of whom the plaintiff was one. The plaintiff must establish a causal link between the impugned conduct and the loss that is claimed. That depends on analysing the conduct of the defendant in relation to that plaintiff alone. So here, it is necessary to consider the character of the particular
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conduct of the particular agent in relation to the particular purchasers, bearing in mind what matters of fact each knew about the other as a result of the nature of their dealings and the conversations between them, or which each may be taken to have known.”
751 Their Honours characterised the plaintiff purchasers in that case as apparently
“intelligent, shrewd and self-reliant”, who had been engaged in their own business and were
quite wealthy. In contrast, the defendant was a small suburban real estate agent who had
made a representation about title to land in the course of a dealing in which it was a matter of
common experience that (1) agents could not contract on behalf of their principals, (2) factual
questions as to title to land were dealt with by specialist solicitors or conveyancers (218 CLR
at 605-606 [41]-[43]).
752 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. Moreover, Grange promoted to each
Council its own expertise to act as a financial adviser to the Council about products that were
highly complex and required expert financial knowledge to assess and understand. Indeed,
that was why Grange put itself forward to the Councils as a professional financial adviser
who could recommend, monitor and advise them about investment of their funds in financial
products, including SCDOs. These matters bear upon an appreciation of what was conveyed
to the Council officers, how they understood it and what Grange knew, or perceived, the
Council officers knew.
753 I have summarised the representations on which the Councils relied in [25] above.
There was a considerable degree of overlap between the first representation (in [25(1)]
above), statutory and Council policy requirements and other terms set out in [25(2) and (4)]
above, namely:
(1) 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 pro-liquidity practices when investing on behalf of local government authorities or investing with conservative investment strategies .
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(4) Grange was active in the secondary market for SCDOs and was bound to buy back the Claim SCDOs, if requested to do so, to provide liquidity in illiquid products.
754 Those three representations, in turn, largely replicated contractual terms (1) to (5) that
I have found above at [721]. For the reasons that I found those terms to form part of the
contracts between Swan and Grange, I am satisfied that Grange made representations to Swan
to the same effect prior to each purchase. In addition, in respect of the representation in
[25(4)], Grange repeatedly told Mr Senathirajah when presenting or discussing products it
was selling, that there would be a secondary market for those and, if there were not, Grange
would buy the product back: [181].
755 I am also satisfied that Grange made representations to Swan substantially in the
terms set out in [25(3)]. However, I am not persuaded that the expression “risk profile” that I
emphasised in the extract from that paragraph set out below was itself part of any
representation to Swan or the other Councils. A representation or statement using that
expression in the senses set out in [25(3)(a), (b) and (c)] did not appear in any of the lay
witnesses’ evidence. Although the expression appeared in a small number of documents
communicated to the Council officers it does not appear to have played a role in their
investment conduct. As I understood the expression, and having regard to the substantive
issues on which the case was fought, including what the Council officers understood from
what Grange told them, the expression “risk profile” in the pleading was a technical
expression for “material risks”. Mr Finkel and Mr Hattori were familiar with the expression
“risk profile”. Mr Hattori agreed with Mr Finkel that the Claim SCDOs had risks that did not
“comport” to those of term deposits or FRNs. Mr Hattori said in his report in reply that “the
risk profiles of the Claim SCDOs are quite different to those for term deposits and FRNs.
Hence, I am satisfied that the pleaded expression “risk profile” referred to material risks in
the sense in which it was used in the pleading. Thus the representations in [25(3)] that I find
were made were:
(3) the Claim SCDOs:
(a) were, or had, risk profiles [i.e. material risks] equivalent to, traditional FRNs;
(b) were equivalent as regards risk profile [i.e. material risks], to other types of financial products with the same rating;
(c) were, or had risk profiles [i.e. material risks], equivalent to or better than the four major Australian banks;
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(d) offered excellent liquidity;
(e) were as liquid as traditional FRNs;
(f) were and would be readily redeemable in a secondary market;
(g) had maturity dates that were suitable to each Council’s needs and complied with its investment policies. (emphasis added)
This is because, first, the explanatory note about FRNs, that Mr O’Dea gave Mr Senathirajah
on 18 August 2003, conveyed that what Grange implied were higher rated, non bank “FRNs”
were appropriate investments for risk averse local governments [178]-[180]. Secondly,
having reinforced, in that note, the desirability of investing in bank and ADI issued FRNs,
Grange set about persuading Swan that a product like the Forum AAA SCDO was very
similar in key respects. The thrust of the slide and the oral, I infer, presentation was that
while that SCDO was a complex financial product:
it was “investment grade”;
it was in a “Standard Australian Dollar Floating Rate Note” format;
it had a “performance risk” rated AAA that was as good a possible, the same
as the Australian Government and better than the four major Australian banks:
[183].
The substantive message conveyed to Mr Senathirajah and Mr Frewing was that they need
not worry about the complexity of the product, because it was as safe as they could get,
liquid, readily marketable in a secondary market and it was like an FRN in paying interest
and providing for repayment of the Council’s capital at the end of its term. Grange did not
explain to Swan that the risks of the SCDO products were any different to those of the
familiar FRNs with which Swan had been dealing. Just as the employee of Patrick Partners
had told Dr Daly that his loan to the firm was as safe as a bank (in Daly 160 CLR 371),
Mr O’Dea, in presenting the Forum AAA product, conveyed to Mr Senathirajah that an
investment in it “was more secure than the big banks” (see [180]-[193], [197]).
756 Moreover, as I have found in [201]-[208] above, Grange was aware that the 2003
Swan Policy permitted the Council to invest in these products. When providing Grange’s
input to the formulation of the 2003 Swan Policy Mr O’Dea had suggested to
Mr Senathirajah that securities with a floating rate generally had maturities of 3-5 years.
Mr Senathirajah accepted this and similar general advice from Oakvale and Grove ([173]-
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[174]). It was implicit in each recommendation that Grange made to Swan to invest in an
SCDO, that the product had a maturity date suitable to the Council’s needs and complied with
the 2003 Swan Policy. That implication flowed naturally from Grange’s proffering of its
expertise, understanding of the requirements of local government bodies and the legislative
and policy matters that had to be addressed in the selection of any product it recommended,
including its knowledge of the 2003 Swan Policy that Mr Senathirajah had emailed
Mr O’Dea on 15 September 2003 (see [204]).
757 Swan decided to invest in the Forum AAA product after the initial oral and slide
presentations and Grange’s supplementation of those by emails and their attachments, such as
term sheets relating to that product (see generally section 4.2.4 above). Mr Senathirajah
acted in reliance on the representations that I have found were made by Grange. He relied on
Grange’s recommendation and advice that this new and unfamiliar product was in a class of
security in which Swan should invest. Grange’s subsequent recommendations and advice
while Mr Senathirajah was at Swan substantially repeated and reinforced Grange’s various
representations about SCDOs. Although Grange’s sales pitch may have varied, and the
particular features of each new suggested investment may have made it distinguishable from
another one to a trained, skilled financial adviser, Grange had set the scene for
Mr Senathirajah with the Forum AAA product. It had obtained his and Swan’s confidence in
both this class of security as an appropriate investment for the Council and in Grange’s
expertise as a financial adviser.
758 I have found that Mr Senathirajah, and inferred that Mr Frewing, was each satisfied
that Grange would only recommend an SCDO that was a safe, prudent investment of Council
funds that complied with the 2003 Swan Policy, and that any SCDO with a rating of AA- or
above offered the Council the same security as the four major Australian banks. I am
satisfied that Grange made the representations I have found to Mr Senathirajah. He
recommended to Mr Frewing that Swan act on Grange’s advice and recommendations from
time to time. Although Mr Frewing was present for some presentations by Grange and to
some extent may have received its written materials for particular products, Mr Senathirajah
was the key to Swan proceeding. Without his recommendation, the Council would not have
invested in SCDOs at all.
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759 When Mr Downing arrived at Swan, he became aware of Grange’s role as an
investment adviser that had been responsible for including a number of SCDOs in the
Council’s portfolio. He formed the impression that these products were appropriate, safe
investments for the Council’s funds and, when rated AA- or better, that they were as safe as
“the big 4 Australian banks” (see [315]-[320] above). I am satisfied that by its conduct in
oral and slide presentations, discussions and emails, by about the time he decided to invest in
the Parkes AAA and AA- products in early August 2006, Grange had conveyed to
Mr Downing the substance of each of representations (1)-(4) in [25] above. I am also
satisfied that he relied on those representations in following Grange’s advice and
recommendations then and subsequently (see [308]-[331] above).
5.1.4 Terms and representations not made out
760 I am not satisfied that Grange made a contractual term or a representation in terms of
those in [18(1)(g)] and [25(5)], namely that “the underlying risk exposures of any investment
that Grange made would be fully transparent in terms of their effect on the payment of the
coupon rate of interest and return of capital”. The Councils did not elaborate in their written
or oral submissions where and how such a representation was conveyed. It is one thing to say
that the Council officers did not understand what the nature or extent of the underlying risk
exposures (or material risks) of SCDOs were in respect of the payment of the coupon rate of
interest and return of capital. I am sure that none of them did, at least in respect of the return
of capital. But it is another thing to assert, as the Councils’ pleading did, that Grange had
positively contracted or represented that such risk exposures “would be fully transparent”.
761 Grange’s explanations of the risks were inadequate and misleading. Indeed, except in
May 2007 for the Federation product, it did not inform the Councils about significant risk
factors that had been stated in the issuers’ offering memoranda for each product, such as
those at [122]-[123]. But the Councils did not elaborate how the term or representation in
[18(1)(g)] or [25(5)] was made. The Councils’ written submissions in reply asserted that
because Grange represented to Wingecarribee that the products it proposed for that Council
were capital guaranteed:
“[b]y necessary and indeed obvious implication it represented it was observing capital-protective investment strategies and was accurately and transparently disclosing to the investors the underlying risk exposures in terms of their effect on return of capital to the investors.”
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762 I reject that argument. It is not necessary or obvious that a positive assertion that a
product is “capital guaranteed” comprehends within it a further implication amounting to a
promise or representation that the underlying risk exposures in respect of return of the capital
were “fully transparent”. Moreover, the Councils did not plead that Grange had made a
representation in terms that the products were “capital guaranteed”. Rather, they pleaded,
and I have found, that Grange promised and represented that the products had a high level of
security for the protection of the capital invested by the Council as an incident of a
conservative investment strategy.
763 The one forensic consequence of the underlying and undisclosed risk exposures of
SCDOs alleged by the Councils is that the products that Grange caused them to invest in did
not have the contractual or represented degree of capital security (in contractual term (1),
representations (1), (2) and (4)). But that consequence is different from a concurrent
communication to the Councils by the same means, by which that term or each representation
was made expressly, of an implication that the risk exposures of the relevant products would
be “fully transparent”. The positive term and each representation that I have found is either
correct or not. One reason each of the latter may be falsified is because of the effect of risk
exposures. And, if that is so, the implication conveyed in the pleaded term in [18(1)(g)] and
the representation in [25(5)] contradicts, or does distinct other work than, each of the express
contractual term (1) and representations (1), (2) and (4): BP Refinery 180 CLR at 283. In
other words, the concepts conveyed by those express terms and representations that Grange
communicated to Swan, did not, and could not, convey simultaneously, the separate and
distinct additional term or representation about transparency of risk exposures. Some other
words or conduct, that the Councils did not distil, were necessary to go that further step.
764 The Councils contended that it was part of a conservative investment strategy that a
financial product be transparent as to its asset backing and risk exposures in terms of their
effect on return of capital to the investor. They appeared to assert that this feature supplied
the source of the alleged implied contractual term and representation. The concept of
“transparency” in relation to financial products must depend in part on the perspectives of the
parties to the transaction and the depth of vision as to its features and operation that the
product affords to a person of any particular level of intelligence and understanding. A
deposit of money at interest with a leading and apparently prosperous firm of stockbrokers
must have seemed satisfactory enough to Dr Daly and the innocent employee who told him
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his money would be as safe as in a bank in Daly 160 CLR 371. But all was not as it seemed.
The parlous financial condition of the firm was not revealed. But, without access to the
accounts and relevant management information, it would not be possible to assess or look
through the appearance of security. That example points to the difficulty of giving the
implied contractual term and representation relied on by the Councils some clear and precise
meaning.
765 In this respect, the courts will not imply a term of a contract unless the posited term is
so obvious “it goes without saying” and it is capable of clear expression BP Refinery 180
CLR at 283. I do not think that the alleged contractual term fulfils either of those
descriptions. It is pregnant with ambiguity as the example I have drawn from Dr Daly’s
experience shows. And, for the same reason, I am not persuaded that an implied
representation to similar effect was made by Grange to any of the Councils. No witness gave
direct evidence of any written or oral statement on which the Councils relied as expressing or
conveying such a representation. It would have been quite a mouthful, but at least then the
Councils might have had an identifiable verbalisation of whatever Grange was alleged to
have represented and a context in which it could be understood. I am not satisfied that such
an imprecise implied representation was made.
766 In its submissions Grange complained that the Councils had advanced unpleaded
representations in their written submissions. Grange gave as an example the fact that the
Councils had commenced their written submissions concerning the representations made to
Swan with an introductory paragraph stating that “the following representations were made to
Swan”. This was followed by the assertion “That the SCDO products were liquid”. A
footnote referred to the representations pleaded in paragraphs of the statement of claim that I
have summarised in [25(3) and (4)].
767 As Grange accurately said, no representation was pleaded in the terms as just set out
by the Councils. I have made my findings on the basis of the pleaded case, although as noted
above, I have summarised and, in some cases, synthesised some of the overlapping
allegations such as those dealing with capital protection. I have done this on the basis of my
understanding of the substantive issues on which the trial was fought.
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5.1.5 The Swan IMP relationship
768 I have identified the relevant provisions of the Swan IMP agreement in section 4.3.1
[357]-[362] above. Grange pleaded in its defence that cl 2.5 was modified or affected by the
terms and conditions of dealing on its contract notes. I reject that contention. It is in the
teeth of cl 10.1 of the Swan IMP agreement. That relevantly provided that that agreement
could only be amended or supplemented by another document signed by the parties. Grange
had bargained for the nature and extent of its rights to transact as a principal in cl 2.5, that is
set out in full at [361]. Once the Swan IMP agreement was made, transactions were effected
between Swan and Grange in accordance with its terms. The contract notes made after that
agreement came into force were evidentiary of the purchases and sales that Grange had made
as manager of Swan’s portfolio. But the contract notes could not amend or supplement the
terms of the Swan IMP agreement as to Grange’s transacting as principal or whatever rights
Grange had to fees and charges for providing services under that agreement since Swan (and
Wingecarribee) never signed them.
769 It was common ground that under the Swan IMP agreement there was an implied term
that Grange would provide the services it performed or was required to perform with
reasonable skill and care. I find that the standard of care was that of a reasonable financial
adviser acting in accordance with s 18(1)(a) of the Trustees Act 1962 (WA) (see [157] above)
and the 2003 Swan Policy. That is because Grange was acting under the IMP agreement for
Swan and so was bound to act as a prudent person within the confines of what Swan could do
using the reasonable skill and care of a financial adviser in Swan’s shoes. Both Grange and
Swan were aware of the legislative requirements and the 2003 Swan Policy that governed the
way in which the Council could and should invest the public moneys it held.
770 Thus the investment guidelines in Sch 2 to the Swan IMP agreement required the
portfolio to be invested in accordance with the 2003 Swan Policy. That did not relieve
Grange, as manager of the portfolio, from investing it as a prudent person would, in
accordance with the standard in s 18(1) of the Trustees Act. Rather, it was Grange’s
contractual duty so to invest as agent for Swan under cl 2.1, using the reasonable skill and
care of a financial adviser investing the public funds held by its client Council. The Council
could not, and did not, give its agent, Grange, power to act other than as Swan was obliged by
law to act in investing public money.
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771 It is now necessary to consider whether and how Grange’s existing fiduciary
obligations were affected by Swan’s entry into the Swan IMP agreement. Grange argued that
cl 2.5 of the IMP agreements operated to exclude the existence of a fiduciary relationship
between it and each of Swan and Wingecarribee. That clause and Sch 3 are set out at [360]-
[361] above. It records that to the extent permitted by the law, each Council:
(a) consented to Grange entering into transactions, as a principal, with the
Council;
(b) consented to Grange knowingly or unknowingly entering into transactions,
either as a principal on behalf of another person, on the opposite side to the
Council;
(c) agreed to pay “the appropriate fees and charges (set out in Schedule 3) in
respect of such transactions”.
772 In addition, Grange was obliged to notify the Council of transactions referred to in
cl 2.5 as required by the Corporations Act and ASX Market Rules. Under s 991E(1) of the
Act, a financial services licensee, such as Grange, was prohibited from entering into a
financial product transaction on its own behalf with a client, such as the Council, that related
to a financial product which was able to be traded on a licensed market, unless the licensee
had disclosed it was contracting as a principal and its client consented. However, this section
did not prevent a licensee from entering into similar transactions with its clients as an
undisclosed principal where the financial product, as was the case with the Claim SCDOs
(except for the Nexus 4 Topaz notes), was not able to be traded on a licensed market (this
result was also produced by reg 7.8.20(1A) of the Corporations Regulations 2001 (Cth)). Its
effect was repeated in ASX Market Rule 7.3. Moreover, cl 2.5(a), (b) and (c) of the IMP
agreements were intended to disclose to the Councils, for the purposes of the Corporations
Act and ASX Market Rules, that Grange would act as a principal, and record their consent to it
doing so, as well to paying it fees and charges.
773 However, those subclauses in the IMP agreement did not have the effect of
authorising Grange to effect such transactions on any terms it chose for the Councils,
however disadvantageous or improvident they may have been. Importantly, cl 2.5(c)
constituted a disclosure, and agreement by each Council, that it would be liable to pay to
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Grange “the appropriate fees and charges” disclosed in Sch 3 in respect of any transaction it
entered into with Grange. Schedule 3 stated that there were no fees and charges for the six
months. The disclosed fees and charges were modest enough. Who would think, reading
cl 2.5 as a whole, that Grange was making significant profits, beyond “the appropriate” fees
and charges in Sch 3? Significantly, however, Grange also stated in Sch 3 that it may be
entitled to fees in relation to placement of unlisted securities, such as SCDOs, that would be
paid to it by the issuer and would disclose such fees “on request”. Grange contended that if,
as happened neither Swan or Wingecarribee made such a request, it was relieved of any duty
to disclose its profits in selling and buying SCDOs. This was because, Grange argued, it had
revealed in Sch 3 that it may be entitled to placement fees for unlisted securities that it would
disclose on request. It submitted that no such request was made to it by either Wingecarribee
or Swan. In [618]-[620] I found that Grange’s response to Wingecarribee’s pre-IMP
agreement request for how Grange would be remunerated was hardly candid and was
misleading.
774 The issue is whether Grange’s revelation in Sch 3 to the IMP agreements that it may
be entitled to other fees paid by the issuer of a security in relation to its placement, and its
obligation to disclose any such fee on request, was sufficient to relieve Grange of its fiduciary
obligation owed to each Council in respect of what it earnt from placing or selling new
SCDO issues. This issue bears on two aspects of Grange’s relationship with each Council
under the IMP agreements, first, whether what was stated in Sch 3 operated contractually to
change the nature of Grange’s relationship with each Council from being or including that of
a fiduciary and, secondly, if not, whether that statement was a sufficient disclosure of the
nature and extent of any conflict of interest and duty Grange might have had in respect of
each such transaction.
775 The critical revelation in Sch 3 is that Grange may be paid a “fee” by an issuer for
placement of a security. That put the Councils on notice of the possibility that Grange would
be paid a “fee” and that they had a contractual right to require Grange to give them
information about that “fee” if they sought this. The Councils had a contractual right under
Sch 3 to request Grange to disclose the amount of any fee an issuer paid to it in relation to the
placement of SCDOs.
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776 In those circumstances, the IMP agreement attenuated the fiduciary obligation that
Grange would otherwise have owed to Swan and Wingecarribee. Grange was authorised to
be paid placement fees by issuers for products it sold to the Councils provided that, a Council
could request and require Grange to disclose any such fee. In consequence, the Councils
were not entitled to complain that Grange breached its fiduciary obligation merely by
receiving payment, gain or profit, being payment of such a fee, from its sales to them of
SCDO products.
777 Most of the material in evidence characterised the profits Grange made on the sale of
new SCDOs as underwriting “fees” when it described what Grange earned. On the other
hand, the transactional material suggests that Grange purchased each SCDO issue at a
discount and on-sold it at face value to its clients, including the Councils. The size of the
discount varied sometimes in a commercially significant sum, depending on differences or
movements in the spreads (or perceived increase or decrease in risk) of the credit markets,
between the time Grange and the issuer or arranger struck the price payable by Grange, and
the time of payment. Additionally, Grange agreed with issuers to increase the size of a
number of issues, resulting in different “issuance profits” for Grange from the original size of
the issue and the additional notes. For example, Grange arranged to increase the size of the
Bennelong SCDO² issue in May 2004, as Mr Clout had foreshadowed to Mr Bokeyar: see
[506]. Grange made an “issuance profit” of 3.34% on the initial agreed issue size of
$40 million, but this profit dropped to 2% on sales of a further $13.4 million. Most of the
issue, being $53.4 million was sold by Royal Bank of Canada to Grange on 9 June 2004 at
those different prices (i.e. $96.66 and $98 per $100 face value). When Grange on-sold the
notes at face value, it made profits on the two parcels of $1,336,000 and $268,000
respectively.
778 As I have explained in section 3.5 and [303]-[304] above, variances in these spreads
can be indicative of market price volatility of the SCDO product itself. A proper
understanding of the significance of variations in the credit spreads in the reference portfolio
and financial markets enabled financially informed participants, such as Grange, and the
issuers or arrangers, to determine when to buy or sell the products. This is illustrated in
Mr Adamou’s internal email of 5 August 2005 where he discussed the impact of a rally in
spreads in the Bennelong SCDO’s reference portfolio, that led to the issuer or arranger
seeking to repurchase the whole issue: see [549].
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779 The Bennelong sale resulted in significant differentials in the “issuance profit” as
Grange’s internal accounting material styled this gain, or underwriting fee, for two parcels of
the same product sold to Grange’s clients on the same day. The existence of these
differentials revealed that the market price and value of the product to informed market
participants had changed markedly, by over 1.34%, in a relatively short period between
Grange striking the two deals with the issuer. In this instance the changes in market price
(charged to Grange by the issuer) and market value suggested that the risks perceived in
dealing with the Bennelong SCDO² product had lessened (since the price rose) in this short
timeframe. Yet Grange did not change the price from full face value at which it sold the
product to its clients, including the financially unsophisticated Councils.
780 Mr Bokeyar did not read Grange’s slide presentation or recall the detail of what
Mr Clout told him when selling the new Bennelong product in May 2004 ([506]-[508]). But
one slide sent to Parkes, headed “Grange CDO’s and Portfolio ABS are Actively Traded”
also asserted, with an accompanying graph, “Bennelong is priced in line with recent
secondary market prices for comparable securities” (emphasis added). It may be that this
was written before the increase in issue size was negotiated. However, two points stand out
in that assertion; first, Grange referred to the pricing being in line with secondary market
prices – that is, prices it set and controlled in its dealings with uninformed Councils and other
clients; secondly, the assertion omits that the primary market, for informed participants, in
which it and the issuers traded, had priced the deal very differently – i.e. at $3.34 per $100,
being 3.34%, less than face value. The secondary market prices that Grange fixed were not
reflective of prices that informed parties arrived at, even though, closer to the time of the
initial sale to Grange’s clients on 9 June 2004, those more informed parties’ prices were
closer to, but still 2% (or $2 per $100 face value) less than, face value (see also [875]-[878]
below.
781 This example, of course antedated each IMP agreement. Its significance is that the
quantum of any “fee” that Grange earned on issuance could vary materially between its
clients for the same product on the same day. And, not all issues involved increases in the
amount of the product sold. Despite this, it follows that the obligation created by Sch 3 of the
IMP agreement for Grange to disclose, if requested, to its Council clients any fee paid by the
issuer, by itself, would not fully inform the client in relation to whether it ought to invest in a
product. Moreover, the correct characterisation of what Grange earned on a particular
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transaction may or may not have been a “fee … paid to Grange by the Issuer of the security”.
On the evidence, Grange simply bought the product at a discount from the issuer and on-sold
it for full face value. On occasion, Grange held some of the product that it purchased from an
arranger on its issue and had not been able to on sell beforehand, such as happened with the
Flinders product ([248]) and the Tungsten product ([503]). Thus, the “issuance profit” that
Grange made from its deals with issuers may not have been a “fee” but simply a profit
representing a difference in Grange’s buying and selling prices acting not as a “placement
agent” but as a principal who bought the product from the issuer for on-sale, at Grange’s risk.
782 The more general effect of each Council consenting in cl 2.5 to Grange transacting as
a principal amounted to no more than a disclosure that Grange could be the buyer from or
seller to the Council of financial products. It was no different to Patrick Partners proposing
to Dr Daly that he lend to them rather than invest in shares. He knew, and consented to the
fact, as did the Councils, that his financial adviser was the other party with whom he was
transacting. Thus cl 2.5(a) and (b) amounted to a contractual permission for Grange to enter
into transactions in the future with each Council.
783 Accordingly, while the provisions of cl 2.5 and Sch 3 of the IMP agreements affected
the fiduciary relationship between Grange and each of Swan and Wingecarribee, they did not
operate to extinguish or exclude all the fiduciary obligations Grange owed to each Council.
5.1.6 What was Grange’s duty of care to Swan?
784 Any duty of care Grange owed to Swan before they entered into the IMP agreement
had to arise out of and be consistent with their contractual relationship during that period of
time. If, as Grange argued but I have rejected, it was not acting as a financial adviser but
rather was a mere seller of financial products, its duty of care would have been limited to the
exercise of reasonable skill and care in the accuracy of any explanation or information it
provided.
785 The principles for imposing a duty of care in respect of the making of statements
providing information or advice were elucidated by Gleeson CJ, Gummow and Hayne JJ in
Tepko Pty Ltd v Water Board (2001) 206 CLR 1 at 16-18 [47]-[49]. First, the speaker must
realise, or because of the circumstances ought to realise, that the recipient intends to act on
the information or advice in respect of his property or himself in connection with some matter
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of business or serious consequence. Secondly, the circumstances must be such that it is
reasonable in all the circumstances for the recipient to seek, or to accept, and to rely on, the
speaker’s statement. The reasonableness of the recipient in accepting and relying on the
statement will be assessed in light of, among all other relevant factors, the nature of the
subject matter, the occasion of the interchange, the identity and relative position of the parties
as regards their actual or potential knowledge, as well as their relevant capacities to form or
exercise judgment about the statement.
786 Importantly here, Grange was, and held itself out as, an expert on financial products
and in the giving of financial advice to local government councils. The Council officers
were, in contrast, not expert in either field. Rather they were reliant on Grange for
information and advice about the SCDO products it was seeking to sell or buy. Grange chose
to give an explanation of FRNs and each SCDO product to Swan. Each occasion was a
serious one involving the possible investment of significant sums of public money by a
person that Grange appreciated, or ought to have realised, was financially uninformed or, at
the very least, far less informed than it about the nature of those products. Grange could
expect the Council officers to rely on what it said by way of explanation.
787 If Grange were not a financial adviser to Swan, it would not have owed any duty to
give an explanation or advice. However, prior to the Swan IMP agreement, Grange did give
explanations to Swan as to the appropriateness of the Council investing in each SCDO and
the nature and features of the product. Grange thus assumed a duty to give a full and accurate
explanation of those matters that was adequate in all the circumstances: cf Cornish v
Midland Bank Ltd [1985] 3 All ER 513 at 516i-517a per Croom-Johnson LJ, 520g-h per
Glidewell LJ and 521h-i per Kerr LJ; Beneficial Finance Corp Ltd v Karavas (1991) 23
NSWLR 256 at 276G per RP Meagher JA; see too Ferneyhough v Westpac Banking Corp
[1991] FCA 709 (18 November 1991) at p 54 per Lee J; Kocsardi v Elegant Tiles Pty Ltd
[1996] FCA 1014 (20 November 1996) at pp 56-57 per Cooper J. Grange also relied on its
disclaimers to negate the existence of its having a duty of care owed to the Councils in
respect of its explanations, recommendations and advice given to each of them about
investment in SCDOs including the Claim SCDOs. It supported this argument by referring to
IFE Fund SA v Goldman Sachs International [2007] 2 CLC 134 at 145 [28] per Waller LJ
with whom Gage and Lawrence Collins LJJ agreed at 151 [53], 156 [80]. However, this
argument must be rejected. First, the disclaimers did not apply to the relationship Grange
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had with each Council as I have explained at [585] and [725]-[727]. Secondly, Waller LJ
explained that no duty of care will be owed if the terms on which a person is prepared to give
advice or make a statement, negative an assumption of responsibility by that person (IFE
[2007] 2 CLC at 145 [28]). However, in that case the disclaimer was in very different, and
standard, terms used in a syndicated finance transaction information memorandum that had
been read by the plaintiff which itself used those terms in transactions it proposed (see at 136-
137 [1], 140-141 [13]-[14]).
788 Grange portrayed itself as “a Unique Advisor to Councils” [469]. Its disclaimers told
their readers not to act on a recommendation or opinion without first consulting the reader’s
financial adviser. There is no doubt that the Council officers did exactly this. They received
subsequent recommendations and advice from the Council’s financial adviser, Grange, to
invest in the particular product. The disclaimer said nothing that denied Grange’s assumption
of responsibility for the accuracy and appropriateness of the subsequent recommendation and
advice it gave to the Councils. The Councils did not act on the slides and documents. They
acted on Grange’s subsequent recommendations and advice, given in its capacity as their
financial adviser, to make the particular investment. A reasonable person in the
circumstances of each Council would have understood that Grange was acting as its financial
adviser and that the disclaimers did not apply to Grange’s advice and recommendations,
given in that capacity, on which it sought each Council to act: cf McCullagh v Lane Fox &
Partners Ltd [1996] PNLR 205 at 237A-F per Hobhouse LJ, 243A-B per Sir Christopher
Slade, 243F-244 per Nourse LJ; see too Butcher 218 CLR at 605 [39].
789 I should add that if Grange were not acting as a financial adviser to the Council, it had
no duty to advise Swan or explain the products to it. However, if and when it proffered
advice or an explanation, any such advice or explanation had to be full and accurate: cf
Potts v Westpac Banking Corporation [1993] 1 Qd R 135 at 138 per Macrossan CJ, 145 per
Dowsett J, see too at 143-144 per de Jersey J. And, of course, as Meagher JA observed in
Commonwealth Bank of Australia v Mehta (1991) 23 NSWLR 84 at 92C-D, a person in
Grange’s position (if it was a mere seller and not as a financial adviser) would assume
liability if, and only if, the particular advice proffered was inaccurate. Meagher JA said that
if the person in that position represented that fragmentary advice he or she proffered covered
the field or was complete, he or she would have engaged in misleading or deceptive conduct
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(see too per Samuels JA at 87E-F). Moreover, if, as I have found, Grange was acting as
Swan’s financial adviser, then it had a positive duty to give full and accurate advice.
790 Given the subject matter involved, the prudent investment of public money, I am
satisfied that Grange owed to the Council a duty of care in respect of the information,
recommendation and advice it gave the Council concerning investment in each SCDO. As I
have found in section 4.2.6, Mr Senathirajah told Grange’s Mr O’Dea in October 2003 that
Swan was not a sophisticated investor and Mr O’Dea accepted this. Grange also knew that
this was true of Councils generally and of each of the three applicant Councils. Thus, Grange
had a duty of care to exercise reasonable skill and care in making each recommendation and
in giving advice on each investment decision about which it dealt with Swan. That duty was
coextensive with Grange’s contractual obligation for each particular dealing. Once again, the
standard of care was that of a reasonable financial adviser acting in accordance with s 18(1)
of the Trustees Act 1962 (WA) and the 2003 Swan Policy in respect of each investment
Grange recommended or advised Swan to make. Grange knew the legislative and policy
constraints that Swan was under and it had professed skill and knowledge in meeting the
requirements of risk averse local government bodies.
5.2 The legal consequences of the relationship between Parkes and Grange
5.2.1 The contractual relationship between Parkes and Grange
791 Parkes was in a similar position in respect of its dealings with Grange to that of Swan
before its IMP agreement was made. Each dealing between Parkes and Grange 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 Parkes in each transaction as a
financial adviser. As with Swan, Grange provided Parkes with financial advice to effect each
transaction on the terms on which it was made as a transaction suitable and appropriate for
dealing with the investment of public money by the Council. As later occurred with Swan,
the initial contract relating to an SCDO was formed on 5 March 2003 for the purchase by
Parkes of the Forum AAA product ([452]). Based on my findings in respect of Parkes in
section 4.4 above, I am satisfied that the same terms that I found were made with Swan,
formed part of the contract between Parkes and Grange for the purchase of the Forum SCDO
in addition to those recorded in the contract note issued on 25 March 2003 in respect of the
product, price and settlement details, see [721], namely:
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(1) the product had a high level of security for protection of the capital invested
by the Council ([417], [442], [450], [460]-[461], see too [478]);
(2) the product was easily tradeable on an established secondary market [436]-
[438], [443], [457]). I infer that when Ms May orally conveyed the substance
of Grange’s explanation of FRNs that she emailed to Mr Bokeyar on
28 October 2002, she made a point to him that, as it stated, “Grange is
required … to support issues on a secondary market basis to guarantee
liquidity in any issues offered to clients”. There is no direct evidence that this
assurance was reflected orally or in writing at the time they discussed the
proposed Forum product purchase by Parkes. However, I infer that it formed
a basis for that dealing because, first, the assurance of existence of a secondary
market was an important selling point for Grange and provided a foundation
for its further assurance of liquidity for the SCDOs it sold (see eg. [479],
[522]), secondly, Mr Bokeyar had a crude understanding that a CDO was some
kind of evolution of an FRN and so it is likely he considered that what he had
been told earlier would apply to that evolution and thirdly, his evidence that,
had he been informed of the risk factor in the offering memoranda that no
secondary market was expected to develop and its consequential effect on
liquidity ([123]-[124], [448]), he would have politely shown Ms May to the
door;
(3) the product was readily able to be liquidated for cash at short notice ([442],
[450], [460]-[461]). When Ms May spoke to Mr Bokeyar about the Forum
AAA product she told him that Parkes could sell the product back to Grange
within a couple of days ([442], [450]). For the same reasons as I have given in
respect of why term (3) should be found in respect of Swan (before its IMP
agreement) in [721] this term formed part of the contracts between Parkes and
Grange;
(4) the product was a suitable and appropriate investment for a risk-averse local
government council ([436]-[437], [450], [460]-[461], [478]-[479]);
(5) the product had a secure income stream ([436]-[437], [460]-[461], [478]-
[479]);
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(6) Grange had exercised reasonable skill and care in making this investment
recommendation and in giving this investment advice to Parkes: Astley 197
CLR at 22-23 [47]-[48].
792 I have found that the contracts between Parkes and Grange contained the same six
terms as those between Swan and Grange before the Swan IMP agreement was made.
Grange was in the business of selling the same products to risk-averse local government,
represented by persons it knew to be generally financially uninformed and unsophisticated,
particularly in respect of this class of product. Thus it is unsurprising that Grange portrayed,
initially, the Forum product and, later, other SCDO products, to both Swan and Parkes as
having substantially the same important characteristics that would address the Councils’ risk
averse approach to the investment of public money.
793 In Parkes’ case, the parties recognised in argument that the transaction in respect of
the Forum product was pivotal in their relationship as were the requirements of the Minister’s
order: [413]-[417], [456]. Grange’s representatives who dealt with Mr Bokeyar, principally
Ms May and Mr Clout, were aware that they always had to talk him through the features of
any product or transaction that Grange was proposing (see [493]-[495]). The promises in
terms (1) to (5) first made in the Forum transaction were reinforced in, and formed the terms
of, the subsequent dealings and transactions between Parkes and Grange: eg. [520]-[522]. If
it were necessary I would imply each term for the reasons I gave at [722]. Very soon after
Parkes had paid for the Forum product, Mr Bokeyar attended the conference on 7 April 2003
at Parkes’ Council Chambers when Mr Willis of Grange made a presentation. He reiterated
the prudence of investments that Grange recommended to Councils and the comprehensive
service, including ongoing and trustworthy financial advice, that it provided to them: [468]-
[474].
794 And, as in the case of Swan, Grange’s ready facilitation of sales and switches over the
course of its dealings with Parkes, reiterated the promises in terms (1), (2) and (3). Term (6)
was implied by law and operated as I have found above in respect of Swan at [723], except
that the Minister’s investment guidelines would apply to the formulation by Grange of its
recommendations and advice to Parkes.
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5.2.2 Did Grange owe fiduciary obligations to Parkes?
795 Grange acted as a financial adviser to Parkes at all times, during and in respect of,
their dealings ([468]-[474], [508], [585], [588]). I am of opinion that Grange owed Parkes
the same fiduciary obligations as I have found in respect of Swan in section 5.1.2 above for
the same reasons.
5.2.3 What representations were made to Parkes?
796 Given that I have found that Parkes’ contracts with Grange had terms (1) to (5) above,
I am satisfied that Grange made representations in terms of those set out in [25(1), (2) and
(4)] and [753]). As in Swan’s case, those contractual terms and representations have a
considerable degree of overlap and the evidence supporting the findings in respect of the
contractual terms also supports the findings of those representations.
797 I am also satisfied that Grange made representations to Parkes in the terms set out in
[25(3)] and [755]. Mr Bokeyar had been investing Parkes’ funds in Australian bank issued
FRNs and FRNs issued by Local Government Financial Services before dealing with Grange
([427]). He, thus, had some experience and understanding of “traditional” FRNs or products
issued by a debtor with a floating interest rate when, in about late October 2002, he received
Ms May’s oral explanation of the appropriateness for local government bodies to invest in
ADI issued FRNs and other FRNs sold by Grange, as I have found in [436]-[437]. Very soon
after this Ms May described the Gibraltar SCDO in an email to Mr Bokeyar, and, I infer
orally as well, as “a new floating rate note issue” ([438]). Next, critically, she described the
Forum product as a “5 year FRN with a coupon of BBSW + 130 bps” ([439]).
798 Mr Bokeyar considered the CDOs to be an extension or evolution of FRNs ([443],
[451], [465]). In effect, to the limited extent he could understand these products, he thought a
CDO was a form of FRN – just as Grange had promoted them to its Council clients. Grange
had also promoted itself to Parkes and Mr Bokeyar as understanding the requirements of
conservative, risk-averse Councils, such as Parkes. Grange’s use of the description of the
Forum product as a “5 year FRN” was calculated to convey, as I find it did, to Mr Bokeyar
and Parkes that the new product was a very safe, AAA rated, FRN and that the chances of it
failing were virtually nil ([442], [450]). There is no evidence that Grange explained to
Mr Bokeyar that there was any difference in material risks or risk profiles between FRNs and
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the SCDOs it sold to Parkes. Mr Bokeyar said that Ms May had said to him, from time to
time, what she stated in her email of 10 November 2006 in relation to Grange’s switch
recommendations, namely that it was “looking to actively manage the credit exposure and
risk profile of your Grange issued CDOs”. He did not elaborate in evidence on what he
understood by the expression “risk profile” in this context. During the course of the
relationship, and certainly by the time in July and August 2006 when she was assisting
Mr Bokeyar in drafting an investment policy, Ms May made him aware that the credit rating
of the four major Australian banks was AA-: [562]. When he learnt this, he appreciated that
the credit ratings of SCDOs at the time of purchase from Grange were better than or equal to
those of the four banks.
799 In February 2003 Ms May told Mr Bokeyar that Parkes could sell the Forum product
back to Grange at any stage within a couple of days. That statement conveyed that the
product offered excellent liquidity and, that the product was as liquid as traditional FRNs:
[442]. These impressions were reinforced in Mr Bokeyar’s mind by Ms May’s subsequent
statements to him that Grange provided a liquid secondary market for its CDO products:
[479]. Moreover, at the Grange CDO Information Seminar Grange held in Orange in October
2004, Mr Bokeyar heard Mr Vincent say that a typical feature of highly rated CDOs was
secondary market liquidity and the products Grange offered always had liquidity and ongoing
support ([521]-[522], [575]).
800 Mr Bokeyar also said that the Grange representatives told him that the capital would
always be repaid on the first call date for those products that had a call date before final
maturity. Moreover, his experience was that no Grange product ever reached its call date and
Grange always traded (ie. bought) products before their call date or maturity. He thus
focused on the call dates and what was implicit in Grange’s recommendation of a product,
namely, that would be repaid on the call date and, so, its term was suitable for Parkes. Had
he been told that an investment would have to be held for six to 10 years before it was
repayable, he would have probably rejected it. Mr Bokeyar was aware that Grange knew of
the requirements of the Minister’s order. He took a recommendation of a product by Grange
as conveying, as I find it did, that it complied with the Minister’s order.
801 While Mr Bokeyar understood that there was an increase in the interest payable after
the call date, he accepted Grange’s assurances that the products were always repaid on the
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call date. He also appreciated, after a time, that the capital value of the products could vary
above or below face value within a narrow range. However, as explained in [530], the
variations below face value were trivial, amounting to small fractions of 1 cent. Grange
would inform Mr Bokeyar about any perceived problem and explain to him why it was of no
concern.
802 Grange argued that any representation as to liquidity for the SCDO products it sold
was not in unqualified terms and did not involve a repurchase or capacity to sell at face value.
Grange made general, and usually, unqualified assertions about the liquidity and secondary
market activity for its products, subject to the mostly fine print disclaimers that appeared in
its slides, product information and at the end of its emails. Moreover, Grange never
suggested to the Council witnesses in cross-examination (and none of them suggested) that
Grange’s representatives made any oral disclaimers or qualifications of their spoken
assertions that conveyed or reinforced what was in the written material. After all, an oral
disclaimer or qualification would have come directly to the listener’s notice and significantly
detract from the persuasive force of the disclaimed oral assertions. Similarly, while the slides
and other written material had disclaimers, these were not prominent, in the same font or
given with the same emphasis as Grange’s more bullish assertions. There was no red hand
pointing to, or other attempt to highlight, any written disclaimer to draw the reader’s attention
to it, to adopt Lord Denning MR’s approach to giving notice by exclusion clauses on tickets
in Thornton v Shoe Lane Parking Ltd [1970] 2 QB 163 at 170D. An expert who gives an
unqualified oral assurance of an important matter to a client can expect that the client will act
on it unless the client’s attention is specifically drawn to a written disclaimer or they make a
contract that contains a term excluding the expert’s liability for the assertion.
803 Nonetheless, Mr Bokeyar understood that Grange was not promising that an economic
depression could not occur. As he said:
“And what I’m suggesting is that they didn’t go on and give you some guarantee that that past experience would continue into the future? --- Well, I suppose if I put my money in the Commonwealth Bank and there’s a depression and the bank closes up, well, that's gone too, hasn't it? It has? --- You know, I mean, it’s they’re pretty you know, they’re a little bit hypothetical.”
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804 The representations that I have found were conveyed to the Councils have to be
understood in context. They were made by Grange. It had negotiated with arrangers the
terms of the SCDOs it sold. Grange was fully aware that the risk factors in the issuers’
offering memoranda highlighted inherent features of the products, for instance, the lack of
any secondary market, lack of liquidity and the need for the investor to be capable of bearing
the economic risk of the investment for an indefinite time: see [122], [123]. Those risk
factors included the statement set out in [123] above that:
“in the unlikely event that a secondary market in the Securities does develop, there can be no assurance that it will provide the Securityholders with liquidity of investment or that it will continue for the life of such Securities.”
805 Here Grange was, and controlled, the secondary market. Its economic capacity, not
world, even or local Australian economic conditions, was critical to the continuance of
provision of liquidity and a secondary market for the SCDO products it sold. But, with few
exceptions in its written material, Grange did not qualify its bullish assertions about those
matters by disclosing the risk factor just quoted or any other. There is no evidence that it
made oral qualifications of this nature to dilute the terms of the representations (or
contractual terms) that I have found.
806 I am satisfied that Grange made the representations that I have found above to
Mr Bokeyar, and to Parkes, and that he and Parkes, relied on them in making and continuing
to hold investments in the SCDOs until he left Parkes.
5.2.4 What was Grange’s duty of care to Parkes?
807 Grange’s duty of care to Parkes was the same as that I have found in respect of Swan
in section 5.1.6 above save, that the provisions of ss 14A and 14C of the Trustee Act 1925
(NSW) identified the (substantially identical) standard by which a prudent person would be
guided in making investment decisions on behalf of the Council and such a person would also
have regard to the Minister’s investment guidelines.
5.3 The legal consequences of the relationship between Wingecarribee and Grange
808 All investment dealings between Wingecarribee and Grange occurred after the
Wingecarribee IMP agreement was made in January 2007. However, the negotiations
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leading to the formation of that contract are relevant to Wingecarribee’s non-contractual
claims.
5.3.1 The Wingecarribee IMP relationship
809 The same considerations, relating to the Swan IMP relationship, addressed in section
5.1.5 above are relevant to the contractual and fiduciary relationships between Wingecarribee
and Grange under their IMP agreement. But as explained in [638]-[639] above, Sch 2 of the
Wingecarribee IMP agreement had different investment guidelines to those of Swan.
810 Critically, cl 2.1 appointed Grange as Wingecarribee’s “agent with all powers
necessary to provide the Service in accordance with the terms set out in this document”.
Both parties contracted on the basis that Wingecarribee could only invest its funds in
accordance with the Local Government Act (NSW). Indeed, Sch 2 provided that the asset
classes it specified would have to be reviewed if that Act were amended. As explained in
[413]-[417], s 625 of the Act provided that a Council might invest money that it did not need
immediately “only in a form of investment notified by order of the Minister published in the
Gazette”. Grange was also aware that Wingecarribee had adopted the 2003 Wingecarribee
investment policy as the basis for investing its surplus funds. That policy repeated, in
cl 2(c)(ii), the following Minister’s investment guideline:
“(ii) A council or entity acting on its behalf should exercise the care, diligence and skill that a prudent person would exercise in investing council funds. A prudent person is expected to act with considerable [sic] duty of care, not as an average person would act, but a wise, cautious and judicious person would. (Ref: Trustee Amendment (Discretionary Investments) Act 1997 section 14A(2)).” (emphasis added)
811 Of course, Grange was “an entity acting on behalf of” Wingecarribee.
Mr Rosenbaum’s covering letter to Wingecarribee of 27 December 2006 that enclosed the
draft IMP agreement for signature referred to the Council having sought Grange’s input into a
review of its 2003 investment policy ([637], [648], [652]). Thus, when Grange acted as agent
for the Council in financial transactions, it was bound to act within, not only the terms of
Sch 2, but also Wingecarribee’s investment policy that the Council had adopted to govern
investment of surplus funds.
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812 The other important feature of Sch 2 of the Wingecarribee IMP was its express
requirement that “all securities must have an active secondary market”.
813 I will deal in section 9 with the arcane issue, created by the myriad of definitions in
the Corporations Act, that broadly define a “derivative” in s 761D, before creating a plethora
of exceptions with their own complexities. In broad terms, Grange argued that each relevant
Claim SCDO was not a “derivative” as defined because it was a security, being a “debenture”
of the issuing SPV within the definition of that term in ss 9 and 764A(1)(a) or an interest in
an unregistered managed investment scheme within the meaning of s 764A(1)(ba).
5.3.2 What representations were made to Wingecarribee?
814 At the risk of further repetition, I will set out again the substance of the
representations the Councils, including Wingecarribee, alleged that Grange had made that I
have taken from [25(1)-(5)] above. Based on my findings above, I am satisfied that each of
the following representations was made, namely:
(1) 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 ([628],
[641], [648], [686]-[687]); and
(b) complied with statutory and Council policy requirements ([627], [641], [648]-
[649], [658]-[662]).
(2) Grange observed prudent, conservative income defensive, capital protective and pro-
liquidity practices when investing on behalf of local government authorities or
investing with conservative investment strategies ([631]-[632], [641], [651], [658]-
[659], [662], [685]).
(3) the Claim SCDOs:
(a) were, or had, risk profiles (i.e. material risks) equivalent to, traditional FRNs
([631]-[632], [657], [659]-[622]);
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(b) were equivalent as regards risk profile (i.e. material risks), to other types of
financial products with the same rating ([628], [659]-[662]);
(c) were, or had risk profiles (i.e. material risks), equivalent to or better than the
four major Australian banks ([628]);
(d) offered excellent liquidity ([618], [628]);
(e) were as liquid as traditional FRNs ([628]-[629], [659]-[662], [681]-[687]);
(f) were and would be readily redeemable in a secondary market (see (4) below);
(g) had maturity dates that were suitable to each Council’s needs and complied
with its investment policies ([629], [661]);
(4) Grange was active in the secondary market for SCDOs and was bound to buy back the
Claim SCDOs, if requested to do so, to provide liquidity in illiquid products (cl 2.3(c)
and Sch 2 of the IMP agreement, [618], [628]-[629], [651], [685]).
815 I have explained in section 5.1.4 why I am not satisfied that Grange ever made a
representation in terms summarised in [25(5)].
816 Grange’s two presentations to Wingecarribee on 18 December 2006 and 21 February
2007 and their intervening interactions, conveyed the representations to Wingecarribee that I
have found.
817 Mr Calderwood’s “explanation” of FRNs, using the whiteboard on 16 February 2007,
produced the effect in the minds of Mr Neville and Mr Dunn that I found in [662]-[663],
namely, that CDOs were just FRNs of the kind the two Council officers had dealt with and
knew. Grange knew that Wingecarribee was risk averse, not willing to put its funds at risk
and needed its investments to be liquid enough to apply for the expenditure needed on its
planned leisure centre. Grange created the impression that it would invest the Council’s
money in products that were like, and as safe as, bank or ADI issued FRNs.
818 Once Mr Calderwood had persuaded Mr Neville and Mr Dunn on 16 February 2007
that the “CDOs” in the two 12 February 2007 repos were essentially FRNs with a bank
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guarantee of their performance, and only then, did Grange later that day use its powers to
invest over $9 million in SCDOs. Grange had beguiled the two Council officers into thinking
that what Mr Neville did not want to invest in, was similar to and as safe as a bank issued
FRN. Grange had also persuaded Wingecarribee that the SCDOs were liquid and could be
bought back or sold in an active secondary market.
5.3.3 What was Grange’s duty of care to Wingecarribee?
819 Grange’s duty of care to Wingecarribee was the same as that I have found in respect
of Parkes in section 5.2.4 (adapting that duty in respect of Swan in section 5.1.6 above).
6. DID GRANGE BREACH ANY OBLIGATION, DUTY OR STATUTE?
820 Not all the 39 Claim SCDOs held by the Councils have been redeemed in full. Three
have been “wiped out” so that the whole sum invested in them was lost: Blue Gum AA,
Torquay AA and Scarborough AA. Seven have experienced actual losses of invested capital
so far: Mahogany 2, Lawson AA, Quartz AA, Wentworth AA, Green AA (which repaid
64.95% of face value), Flinders AA and Henley BBB). In addition, although the Federation
AAA, Kalgoorlie AA and Blaxland AA notes have by now been redeemed in full the
Councils had sold some of their holdings in these earlier, resulting in a loss as, e.g. happened
in Wingecarribee’s sale of the Federations notes: [718].
821 I will now analyse whether Grange is liable to each Council in respect of each aspect
of my findings. However, before doing so, it is necessary to explain one significant issue that
has arisen as a result of the collapse of the Lehman Bros Group. This concerns 11 of the
Claim SCDOs known, perhaps appropriately, as the “Dante notes”. At present, 10 of the
Dante notes cannot be redeemed because of a controversy between the English and United
States Courts as to whether the noteholders or a Lehman Bros company is entitled to such
collateral as remains in them. I will discuss the particular values of each unredeemed SCDO
later in these reasons.
6.1 The Dante notes problem
822 The 11 Dante notes had been issued from time to time since October 2002 in a multi
issue secured obligation program established by Lehman Bros International (Europe) Ltd
(LBIE). The parties agreed the primary facts concerning these SCDOs. They were the
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products: Coolangatta AA, Coolangatta BBB, Coolangatta Combo Note, Endeavour AA,
Esperance Combo Note (also called Esperance 2), Global Bank Note AAA, Global Bank
Note 2 AAA, Kakadu Combo Note, Merimbula AA, Merimbula BBB and Miami AA. The
Esperance Combo Note has now returned 19.37% of its face value to noteholders in cash and
has left them holding the balance of their investment simply as Esperance AA+ notes. The
Esperance AA+ notes are not part of the Dante series.
6.1.1 The Dante notes in general
823 Each Dante note was governed by, amongst other contractual documents, a principal
trust deed, a base prospectus, a series prospectus (that included a schedule setting out the
terms and conditions of each note) a supplemental trust deed, a drawdown agreement and an
agency agreement. I will describe these compendiously as the Dante transaction
documents. A term in the Dante transaction documents and each of the Dante notes
provided that they were governed by English law.
824 The swap counterparty for each of the Dante notes was Lehman Brothers Special
Financing Inc (LBSF). Lehman Brothers Holdings Inc (LBH) guaranteed LBSF’s
obligations. Both LBSF and LBH were domiciled in the United States. LBIE, as issuer,
provided the collateral for each of the Dante notes. There are conflicting decisions between
United Kingdom and United States Courts as to whether the noteholders, on the one hand, or
LBSF and LBH on the other hand, became entitled to the collateral following the event of
default created by the collapse of Lehman Bros group.
6.1.2 The relevant terms of the Dante notes
825 Under the Dante transaction documents for each Dante note (being a supplemental
trust deed and drawdown agreement that operated in conjunction with a principal trust deed)
the issuer had to apply the proceeds of the issue to purchase collateral to a specified value in
the form of specified FRNs or similar investments. The issuer then assigned all of its right,
title and interest in the collateral, by way of security, to the trustee for the Dante program
(and for each of the Dante notes), BNY Corporate Trustee Services Ltd (BNY). BNY was
incorporated in the United Kingdom and its registered office was in London. The trustee (i.e.
BNY) held the security interest in the collateral on trust for the benefit of the noteholders
(such as the Councils), the swap counterparty (relevantly LBSF), the custodian, the paying
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agents and/or the registrar as continuing security for the parties’ respective obligations under
the applicable Dante transaction documents.
826 An agency agreement (as modified by the supplemental trust deed and drawdown
agreement for each Dante note) then provided that the collateral be held by an appointed
custodian (currently BNY Mellon) in specified accounts for and on behalf of the issuer but
subject to the security granted in favour of the trustee. It is not clear from the agreed facts
whether BNY and BNY Mellon are the same company or how BNY Mellon acts as, it
appears to be, as both the trustee and custodian. However, it is not necessary to make
findings about that topic. I have assumed that BNY changed its name at some stage to BNY
Mellon (and I will use these names interchangeably as they are used in the evidence).
827 BNY Mellon now holds the collateral for each Dante note (except Esperance 2) in a
custodian account maintained in the United Kingdom. The trustee had the right to instruct
the custodian, after any event of default, or potential event of default, to debit the accounts in
which it held the collateral. The ISDA master agreement for each Dante note provided that
the filing for bankruptcy of LBSF (as swap counterparty) or LBH (as credit support provider
for the swap counterparty) constituted an event of default under the supplemental trust deed.
The agency agreement for each Dante note provided that the issuer could deposit with the
custodian securities issued by, or representing obligations of, one or more persons specified
in the supplemental trust deed). The custodian had to maintain an account in London and any
securities in book entry form had to be credited, in that account, in favour of the issuer.
828 Critically, the Dante transaction documents contained a provision known as the “flip
clause”. That clause provided that LBSF had priority over the noteholders in respect of the
collateral but that those priorities would be reversed (or “flip”) upon the occurrence of certain
events, including a bankruptcy filing by either LBSF or LBH as its guarantor. LBH filed a
voluntary petition for relief under Chapter 11 of the United States Bankruptcy Code on
15 September 2008 (Chapter 11 bankruptcy) and LBSF filed for Chapter 11 bankruptcy on
3 October 2008. Each of those filings was an event that triggered the flip clause.
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6.1.3 The English and United States judgments
829 The United Kingdom courts have held that the flip clause was valid and enforceable
so that it operated to entitle the noteholders to the collateral when LBH filed for Chapter 11
bankruptcy. Those courts held that this result followed because LBH had committed an act
of default under the Dante transaction documents. The Dante transaction documents for each
of the 12 Dante notes were relevantly the same as those examined in the English proceedings
that culminated on 27 July 2011 with the decision of the Supreme Court of the United
Kingdom in Perpetual Trustee Co Ltd v BNY Corporate Services Ltd [2012] 1 AC 383. The
Supreme Court’s decision dealt with nine of the Dante notes. But in both the English High
Court and the Court of Appeal decisions two other notes in the Dante series were also
considered before those latter proceedings were settled (see [2012] 1 AC at 403-404 [25]-[35]
per Lord Collins of Mapesbury). Sir Andrew Morritt C had upheld the validity of the flip
clause on 28 July 2009 ([2009] 2 BCLC 400). Next the Court of Appeal for England and
Wales dismissed the appeal from that decision on 6 November 2009 ([2010] Ch 347).
830 However, on 25 January 2010 in the United States Bankruptcy Court for the Southern
District of New York, Judge James M Peck held that the flip clause was an unenforceable
“ipso facto” clause under the Bankruptcy Code. He held that the Chapter 11 filing by LBH
had triggered an automatic stay on the operation of the flip clause: In re Lehman Bros
Holdings Inc 422 BR 407 (2010). As a consequence of Judge Peck’s decision, under United
States law all, or most, of the value of the collateral would be available for the creditors of
LBSF and LBH in their Chapter 11 administrations.
831 On the agreed facts, the position in the United States appears to be that while Judge
Colleen McMahon of the United States District Court for the Southern District of New York
had expressed the view, in a decision of 20 September 2010, that Judge Peck’s decision
needed “immediate review”, that has not yet occurred because of various procedural
impediments in the United States Courts.
832 In late 2010 some of the English litigation settled and the US Bankruptcy Court
approved that settlement on terms that remain confidential. However, in January 2011 LBSF
informed the Supreme Court of the United Kingdom that it would discontinue its appeal to
that Court in respect of the Esperance 2 (or Combo), notes and that it would not assert that
any termination payment or unwind costs were due to it in respect of those notes. That left
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the parties to the Esperance Combo notes free of any claim by LBSF that would have
prevented them from dealing with the collateral in unwinding those notes. The
Esperance Combo notes product was unwound in December 2011 and each noteholder
received both cash, representing 19.37% of the face value of its holding, and a return of
collateral, being Esperance AA notes (see [601]-[604]).
6.1.4 Other developments relating to the Dante notes
833 In late 2009, Henderson J of the High Court of Justice of England and Wales had
caused a letter of request to be sent to Judge Peck concerning the risk of conflicting
judgments arising in the English and Chapter 11 proceedings: Perpetual Trustee Co Ltd v
BNY Corporate Trustee Services Ltd [2010] 2 BCLC 237. In the letter of request his
Lordship invited Judge Peck to go no further than granting declaratory relief in respect of the
Dante notes. Judge Peck referred to the letter of request in his decision of 25 January 2010.
His Honor noted that the parties had agreed that it was appropriate for the US Bankruptcy
Court to determine only whether declaratory relief ought to be granted and to coordinate with
the High Court in England, should it become necessary, after a decision had been given in the
Chapter 11 proceedings.
834 As mentioned above, because of stays and other procedural hurdles, so far no
appellate proceedings have progressed in the US courts to review Judge Peck’s decision.
However, on about 1 September 2011, LBH, LBSF and other Lehman Bros companies filed a
Chapter 11 plan (the Ch 11 Plan) in the Chapter 11 proceedings. Also on 1 September BNY
Mellon, as trustee, issued a notice to noteholders headed “Collateral update”. This stated
that:
“as a result of certain conflicting claims and on-going legal proceedings, no distributions can be made to the holders of Notes at this time.” (emphasis added)
The notice also stated that, as previously notified, the swap counterparty (i.e. LBSF) had
notified the issuer and trustee that it considered that it was entitled to be paid amounts owing
to it in priority to payments to the holders of the notes and concluded: “The respective
entitlements of [LBSF] and the holders of the Notes have not been determined at the date of
this Notice”.
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835 On 14 September 2010, LBSF began proceedings in the US Bankruptcy Court for the
Southern District of New York against all the issuers and trustees of collateral in the Dante
notes program seeking declarations that LBSF had priority, as swap counterparty, to the
collateral. On 20 October 2010 Judge Peck granted LBSF’s application for a stay, for nine
months, of those proceedings and other proceedings in respect of the Dante notes. The stay
was extended subsequently with the latest stay, on the evidence, being in force until 20 July
2012. In January 2011, Grange’s liquidators and the Dante noteholders sought leave to
intervene in those proceedings. Judge Peck rejected that application on 18 February 2011
without prejudice to Grange’s right to apply again once the stay was lifted. On 21 June 2011,
Judge McMahon dismissed an appeal by Grange and the noteholders on the basis that Judge
Peck’s order was not a final order and so not capable of creating a right of appeal. Her Honor
described Judge Peck’s decision as “unprecedented yet unreviewed”. Grange has filed an
appeal to the Second Circuit Court of Appeals from that decision.
836 In early November 2011, Grange’s liquidators filed a notice objecting to the Ch 11
Plan, and soon after they filed a supplemental objection. The liquidators contended, among
other grounds, that the swap agreements had been validly terminated under their governing
law, English law, as held by the Supreme Court. On that footing the liquidators contended
that there was no basis for LBH or LBSF asserting, as part of the Ch 11 Plan, that LBSF
could “assume” the swap agreements, and hence a priority right to the collateral. Both BNY
Mellon and the Dante noteholders also filed notices of objection raising similar grounds to
those put by Grange’s liquidators.
837 On 31 January 2012, LBSF filed its brief in the Court of Appeals opposing the
attempt by Grange and the noteholders to challenge Judge Peck’s stay orders.
6.1.5 The position in respect of the collateral for the Dante Notes
838 As is apparent from the account above, the Dante noteholders would be justified in
thinking that their products were in a series that was aptly named. Dante wrote in The
Inferno, of reading the inscription on the Gate of Hell as he passed through it. That
inscription concluded: “Abandon all hope, ye who enter here”.
839 It will be some time before the United States Courts decide whether to follow the
decision of the Supreme Court of the United Kingdom on the flip clause or that of Judge
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Peck. And, depending on the result, it could be considerably longer before the potential inter-
jurisdictional conflict can be resolved. One thing is certain, namely, that the present ability of
the Dante noteholders to realise any sum from the collateral, and so be repaid any of their
invested principal, is uncertain. A lot of money is involved. As Lord Collins noted, the
appeal before the Supreme Court concerned a total of about USD 250 million under the nine
series of Dante notes still in issue: Perpetual [2012] 1 AC at 403 [26].
840 Despite this significant amount being held in a seeming legal limbo land, Grange
argued that the affected Claim SCDOs should be valued as if the final decision of the United
Kingdom Supreme Court would govern the parties’ rights. It may be that this ultimately will
occur, but despite Grange’s liquidators’ best efforts to obtain a decision in the US Courts, the
answer to this question has not appeared. I will address this valuation issue in section 7.2.5
below.
841 I am of opinion that this legal uncertainty, coupled with the fact that BNY Mellon’s
stated position is that it will not distribute the collateral because of LBSF’s claims to it,
demonstrate that valuing the Dante Claim SCDOs (other than the two Esperance products) is
problematic. However, this difficulty also raises a real question about the quality of the
security of the Councils’ capital investment in these products. A feature of the Dante
products that has now been revealed is the inability of the noteholders to receive a return of
their capital because of protracted legal proceedings, the outcome of which is uncertain, and
may result in the loss of the capital. That feature was inherent in an investment in a highly
complex financial product with cross jurisdictional legal rights that may conflict.
6.2 Contractual breaches
842 I will now examine whether the Councils have established any breaches of contract.
6.2.1 The pre-Swan IMP agreement and Parkes contractual breaches by Grange
843 Relevantly, each contract that Grange made with Swan before they entered into the
Swan IMP Agreement contained the following terms (see section 5.1.1 and [721]):
(1) the product had a high level of security for protection of the capital invested by the Council.
(2) the product was easily tradeable on an established secondary market.
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(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 had a secure income stream. (6) Grange would exercise reasonable skill and care in making this investment
recommendation and in giving this investment advice to Swan.
844 I found that the contracts between Grange and Parkes were in identical terms (save for
Parkes’ name being included in term (6) instead of Swan’s): Section 5.2.1 and [791]-[794].
6.2.2 Did the product have a high level of security for protection of the capital invested by the Council?
845 Mr Hattori wrote in his initial report that “An investor would have had expectation
[sic] of capital security commensurate with the ratings. An investment grade rating indicates
a low expectation of default over the life of the instrument”. However, that expectation was
not matched by the capital security of SCDOs. I accept what Mr Finkel wrote in his initial
report that the Claim SCDOs were not equivalent, in terms of capital security, compared to
FRNs, namely:
“The risk profile of an exposure to direct investment(s) in a AA-rated single corporate obligor is different from a AA-rated tranched exposure to a pool of lower rated credits. The direct credit gives the investor recourse to the corporation’s assets thus offering significant capital security, whereas SCDOs are leveraged derivative instruments, with enhanced sensitivity to the risk of loss of particular credits and no claim on any underlying obligor’s assets.”
846 The high rating of each SCDO product sold to each Council by Grange suggested that
the risk of loss of capital was low. However, the use of ratings to assess the risk of capital or
income loss with those structured products is not an adequate or appropriate measure of their
riskiness as both the 2005 Working Group report and Banque de France article demonstrated
(see sections 3.5.1 and 3.5.2 above). The reason that the SCDOs paid higher returns than
ADI issued FRNs was because of the higher risk of the former class of products. Indeed,
Grange sought to turn this feature of the SCDOs back on the Council officers when cross-
examining them by suggesting that they must have realised that the higher return offered by
the SCDOs reflected a higher risk. This suggestion was negated in the Council officers’
minds by Grange’s own sales materials and statements by its representatives. Those
demonstrated that Grange had equated the credit risk of the SCDOs it was selling to that of
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similarly rated ADI issued FRNs. Grange described the credit risk of its SCDO products as
being safer than the four major Australian banks, and, in the case of AAA rated notes, as safe
as the Australian Government. However, Grange did not explain to the Councils how credit
risk, expressed in this way, did not necessarily address a significant risk inherent in the
products that affected the security of an investor’s capital.
847 The SCDOs offered a lower level of capital security than similarly rated ADI issued
FRNs or corporate bonds, as the passage I have quoted from the Banque de France article in
[83] explained. Critically, the SCDOs were susceptible to a qualitatively and substantively
greater risk of unexpected loss because of their tranched structure and the products’ use of
reference entities that were significantly lower rated. As the 2005 Working Group report
explained:
“Subordinated tranches, for example, can lose their entire value if losses in the asset pool are severe enough. This would not occur with an exposure to a straight bond portfolio, assuming that recovery rates are positive. Subordinated tranches will thus have higher unexpected loss than a bond portfolio with the same expected loss or probability of default. Given that the latter criteria (expected loss or probability of default) represent the one-dimensional risk indicators embodied in credit ratings, structured finance tranches can be riskier than investments in bond portfolios with equal ratings.” (emphasis added)
848 The above comparison of an SCDO with a “straight bond portfolio”, such as an ADI
issued FRN, highlights that the latter has greater capital security. That is because the investor
has a right to direct recourse against the product issuer’s capital if a default occurs. All that
an investor has, if an SCDO defaults, is recourse to so much of the collateral held by the SPV
that has not been absorbed by paying out on a portfolio credit default swap or PCDS.
849 Thus, there was a qualitative difference in the nature of the risk to an investor’s return
of capital from an ADI issued FRN as compared to an SCDO. This can be seen by looking at
what has occurred to date in the return of capital afforded by the Claim SCDOs. There was
no suggestion in evidence that any default had occurred in any ADI issued FRN in which, or
of the kind in which, any of the Councils invested in the period in which they dealt with
Grange.
850 For present purposes, it suffices to say that seven of the 39 Claim SCDOs, or 18%,
suffered either a full or partial loss of capital and 10 others (the Dante notes, other than the
Esperance Combo note) or 26% are presently not capable of being redeemed because of an
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unresolved legal dispute. The remaining Claim SCDOs were either repaid in full or have not
yet suffered a default affecting their capital values. This capital frailty (where today 18%
have suffered full or partial capital loss and there is uncertainty involving when and to what
extent a further 26% will be redeemed) even if ultimately the Dante notes are repaid in full, is
not capable of characterisation as a feature of the SCDO product class that represented “a
high level of security for the protection of the capital invested by the Councils”. The events
that have occurred since the Claim SCDOs were acquired by the Councils have revealed
some of their inherent characteristics: see Potts v Miller (1940) 64 CLR 282 at 298-299 per
Dixon J; Kizbeau Pty Ltd v WG & B Pty Ltd (1995) 184 CLR 281 at 291-296 per Brennan,
Deane, Dawson, Gaudron and McHugh JJ; HTW Valuers (Central Qld) Pty Ltd v Astonland
Pty Ltd (2004) 217 CLR 640 at 658-659 [38]-[40] per Gleeson CJ, McHugh, Gummow,
Kirby and Heydon JJ; Trustees of the Property of Cummins (A Bankrupt) v Cummins (2006)
227 CLR 278 at 296 [50] per Gleeson CJ, Gummow, Hayne, Heydon and Crennan JJ; see
too Phillips v Brewin Dolphin Bell Lawrie Ltd [2001] 1 WLR 143 at 153 [26] per Lord Scott
of Foscote with whom the rest of the House agreed.
851 A feature of the claim SCDOs as structured products was their particular
susceptibility to extreme events events that could lead to significant loss. As the 2005
Working Group observed:
“The Working Group believes that risks associated with structured products may not have been fully grasped by some investors. Similarly, with consensus on “best practice” regarding the modelling of portfolio credit risk still lacking, “model risk” in instruments such as collateralised debt obligations (CDOs) is an issue for even the most sophisticated market participants. Use of structured finance instruments, together with the occurrence of worst case scenarios relating to mispriced or mismanaged exposures, might thus lead to situations in which extreme market events could have unanticipated systemic consequences. Given these issues and the fact that structured finance markets are still largely untested, continued growth in structured finance activity warrants ongoing central bank awareness.” (emphasis added)
852 In their joint report, Mr Finkel, Mr Hattori and Dr Bewley agreed that as the market
environment deteriorates, so that default correlations and default rates increase, the relative
protection against a complete capital loss provided by a thicker tranche will converge with
that provided by a thinner tranche. One reason that the protection of a thicker tranche will be
eroded is simply that this reflects the general economic position. But other forces are at work
as a result of the structure of SCDOs. The thickness of the tranche ordinarily protects against
the cumulative effect of occasional credit events eroding the layer(s) under the tranche’s
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attachment point. Where general or systemic extreme market events occur, many more
reference entities are vulnerable to experience a credit event. This will impact on the
investor’s capital because the structure treats each credit event as an all or nothing affair
(subject to allowing for some partial recovery in some cases: see [45]). Thus, once a credit
event occurs, the structured instrument treats it as having a permanent effect of diminishing
the subordinate, or the relevant, tranche to some degree. The more credit events, the greater
that irreversible diminution, until the whole of the investors’ capital is lost when the number
of credit events passes the detachment point of the relevant tranche. And this will remain the
case even if the reference entities survive the credit event (such as a rating downgrade) and
pay the coupon rate on their debt instruments. In other words, the mere occurrence of the
credit event has an irreversible effect on the SCDO, even if the same event is overcome by
the reference entity that suffered it. And, in bad economic times, there are likely to be more
credit events.
853 That consequence is unlike the situation in which a corporate, or ADI issued, FRN
defaults. Of course, there will be extreme situations in which the insolvent administration of
the single entity that issued such an FRN will pay no dividend to investors. But, ordinarily,
the investor can expect to recover some of its investment, because it will have recourse
against the issuer’s net assets. Moreover, the entity might experience a temporary liquidity
problem (that would be a credit event in an SCDO structure), yet recover in the longer term to
pay all its debts.
854 The claim SCDOs did not have a high level of security for the protection of the capital
invested in it by each of Swan (before the IMP agreement) and Parkes. The products were
inherently more vulnerable to a significant risk of capital loss, if extreme market events
occurred (such as the recent global financial crisis) than similarly rated products such as ADI
issued FRNs. A significant reason for this is the synthetic nature of such structured products.
The one dimensional reflex of the high credit ratings of the SCDOs used by Grange in its
marketing of the products to the Councils, suggested that they had a level of capital security
that was higher than the reality. The promise of a “high level” of capital security did not
depend on the existence of any particular economic circumstances. The caution expressed by
experts, such as the 2005 Working Group report, the Banque de France article (see [83]) and
Grange’s Mr Hagan in March 2006 (see [98]) as to systemic events having unanticipated
impacts, was well founded.
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855 Grange argued that the accuracy of its promise (and its similar representation) as to
the high level of capital security should not be assessed with the wisdom of hindsight and
without regard to the worldwide and systemic impact of the global financial crisis on the
whole range of financial markets and products. I do not accept that argument.
856 The inherent suspectibility of the claim SCDOs to loss of capital from extreme market
conditions, because of their structures, affected the quality of the capital protection that the
products had. It is almost always the case that problems with products or services are not
seen when events run smoothly. The extremity of events may be such as to show that a
particular problem was unpredictable or unforeseeable or so remote as not to warrant any
prior warning or precaution. But, this can hardly apply to financial products issued in
markets in which extreme systemic events were known risks that could affect structured
products in ways or to degrees to which less complex products were not subject. Mr Hattori
accepted that markets move in cycles. He described the development in 2007 and 2008 of the
global financial crisis as a “tsunami in the financial markets”. However, the risks of extreme
systemic events affecting financial markets have been known features of the economic cycle
for centuries. The South Sea Bubble of the 18th Century was an early example. The Great
Depression that began in October 1929 has been followed by a number of other global
systemic events over the 80 years culminating in the unfolding of the events in 2007 and
2008 that became known as the global financial crisis. Patrick Partners fell foul of the global
economic crisis caused in 1973-1975 by the significant rise in world oil prices (cf: Daly 160
CLR 371).
857 Capital protection was important to the Councils not just in good economic times, but
more importantly, in the unpredictable economic future. Of course, no one, including the
Councils, could have understood or have expected that the capital of any product would be
proof against any economic crisis. Banks have failed in such crises in the past, and they also
did as a consequence of the recent global financial crisis. The aphorism “safe as a bank”
reflects an assurance of a high level of protection that is less than absolute. And different
banks will offer investors or creditors varying levels of capital protection depending on their
own financial positions as well as different national and international regulatory and
economic circumstances that affect them.
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858 Grange’s promise that the Claim SCDOs had a high level of protection for the
Councils’ capital was not an absolute guarantee that their capital could not be at risk
regardless of what happened in the world economy. However, as Mr Finkel identified, the
structure of those products created a synthetic and leveraged relationship between the
noteholder and its capital investment. Grange carefully analysed its own likely profits or fees
when it negotiated pricing with issuers (see e.g. [777]-[778], [875]-[877] below, [303]-[305],
[352]-[353], see too [549]). Those profits or fees varied with movements in credit spreads
and changes in the proposed reference entities in the reference portfolio that were occurring
during the negotiations between Grange and the issuer. Even subtle movements or reference
entity changes affected the ultimate price or fee struck between Grange and the issuer or
arranger. At the negotiation stage, these features allow informed parties (such as Grange and
the issuer or arranger) to engage in arbitrage calculations and opportunities (see [71]-[74]).
859 To some extent, movements at the negotiation stage, and their explanation, were
illustratiave of how the unexpected loss properties of structured finance products could
appear in a magnified way, if an extreme market event occurred. As the passage I have
quoted from the Banque de France article in [83] above explained, the risk of loss of the
entire capital invested in a corporate bond (or ADI issued FRN) on the occurrence of an
extreme event is very low. In contrast, a fairly low proportion of losses in the reference
portfolio for a tranche of a structured product, like the Claim SCDOs, can cause the loss of
the whole of the investor’s capital. And that is so, even if the credit events that caused it had
no longer term relevance to the ability of the affected reference entities to repay their
creditors in full: e.g. a rating downgrade may not cause the debtor to default at any time, or a
failure to make a scheduled payment on time may cause no ultimate loss, if the debtor later
pays in full.
860 The Council officers understood that the SCDOs had the characteristic that losses or
credit events in the reference portfolio could cause loss of the invested capital. They also
broadly understood that ratings reflected the risk of loss similarly for SCDOs as for other
classes of financial products with which they were more familiar, like ADI issued FRNs (as
to Mr Senathirajah [187]-[188], [207], [217], [219], [230]-[231], [233], [255]-[256], [406]-
[408]). Mr Downing was aware that Swan had suffered a small capital loss from a ratings
downgrade of an SCDO in June 2006: [289]-[291] but he did not have the sophisticated
appreciation of the lack of relevance of ratings in respect of assessing the risk of unexpected
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loss discussed above: see [314]-[321], [347]-[349], [352]-[353] (see too: as to Mr Cameron:
[389]-[392], [410]; as to Mr Bokeyar: [446]-[452], [456], [461], [463], [465]-[467], [484]-
[485], [499]-[500], [514]-[515], [518]-[519], [532], [534]-[537], [568], [576]).
861 That “understanding” did not meet the point made by the 2005 Working Group, the
Banque de France article or Mr Hagan in his 9 March 2006 analysis ([98]-[99]). That point
was not appreciated internally by Grange itself, at least prior to Mr Hagan’s analysis. That is
because his analysis showed that Grange had accumulated its own significant holding of
SCDOs and exposed itself to this risk of capital loss without hitherto addressing the
consequences. And, when Grange did address them, it moved to reduce its exposure to this
risk. Those facts concerning Grange suggest two important corollaries: first, it is highly
unlikely that Grange’s salesforce were aware of this feature of SCDOs or communicated it to
the risk averse Council officers; secondly, once Grange became aware of the problem from
Mr Hagan’s analysis, its self-interest dictated that it look after its own risk minimisation and
simultaneously continue its aggressive sales of the SCDOs to its clientele, including the
Councils. There is no evidence that Grange’s sales pitch changed after Mr Hagan’s analysis
so as to explain or highlight the significance of the risk of unexpected loss on the degree of
capital protection offered by the SCDOs.
862 The passage from the 2005 Working Group report set out in [67]-[68] explains how
the factor of unexpected loss affects the riskiness of financial products. Expected loss is a
reflection of the probability of default. The subtlety of the distinction between expected loss
and unexpected loss that differentially affects single issuer bonds (such as ADI issued FRNs
or corporate bonds) and structured finance is difficult for a lay person to grasp. Credit ratings
do not address that distinction, as Mr Hattori said. He was prepared to accept the 2005
Working Group report’s and Banque de France’s conclusion (set out in [83]) that there is a
greater exposure to losses in a CDO than in an equivalently rated corporate bond, although he
had not checked the mathetical calculations himself.
863 Here, Grange’s use of the one dimensional reflex of the high credit ratings in selling
the Claim SCDOs, gave the Councils a false sense of the security of their capital in such
investments. This was particularly so in respect of the consequences of the occurrence of
extreme market events. For these reasons, I am satisfied that, by selling the Claim SCDOs to
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the Councils, Grange breached term (1) of its contracts with Swan (before their IMP
agreement) and Parkes.
6.2.3 Were the Claim SCDOs easily tradeable on an established secondary market?
864 In their joint report on secondary market and liquidity issues, Mr Finkel, Professor
Harper and Dr Bewley acknowledged that they had each proceeded to address those matters
on instructions that differed, sometimes materially. They all accepted that data from
Grange’s records, known as GTS data (or Grange Trading System data) indicated that
Grange had facilitated the buying and selling of the Claim SCDOs for certain periods of time,
thus creating a local secondary market. However, the experts disagreed about Grange’s role,
Mr Finkel considering it was a broker while Professor Harper and Dr Bewley saw Grange as
a market maker. Similarly, Mr Finkel considered that the local secondary market was not an
active one, and so he disagreed with the other two experts who considered that this market
remained active in the Claim SCDOs until at least June 2007.
865 Grange contended that the GTS data and the joint expert reports established that there
was an active secondary market in the Claim SCDOs at least until June 2007. It argued that
this evidence supported what it had promised, or represented, to the Councils about its own
role of facilitating or promoting a secondary market. It contended that there was no evidence
that all participants in the trades recorded in the GTS data were unable to undertake analytical
modelling to enable them to assess the value of an SCDO or were not otherwise informed
buyers or sellers. And Grange submitted that its local government clients would have acted
in accordance with the NSW Best Practice Guide (referred to at [116] and [555] above).
Thus, it said, those clients consequently would have acted as sufficiently informed buyers or
sellers to create a market.
866 I reject that argument. By mid 2004 Grange proceeded, as Mr Clout stated in his
email of 9 August 2004, on the basis that it controlled the market for SCDO products (see
[300]-[307]). Professor Harper said, and I find, that this email was not consistent with either
an active secondary market or a liquid market. Grange utilised that control to effect
transactions between clients who acted on the information, advice and recommendations that
Grange gave them. Grange could persuade the relatively financially unsophisticated Council
officers with whom it dealt to engage in trades of the complex SCDO products because of the
trusted position it had established with them.
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867 Grange knew which clients to approach who would be likely to act on its
recommendations. Indeed, Mr Clout described those clients as “the usual suspects” in an
email of 18 June 2007 instructing his staff to effect transactions at his nominated prices for
nine SCDOs as I have described in [545] above. There is no reason to think that the officers
of Swan or Parkes were less informed than most, if not all, of Grange’s other clients, in
respect of the value of SCDOs. There is no evidence that Grange provided any of its other
clients with any issuer’s offering memoranda. The internal email debate among Grange’s
senior personnel on 22 September 2006 captioned “Re CDOS: The Free Lunch” discussed in
[133]-[141] above, illustrates this. The way in which SCDOs functioned and how they
provided a higher return than a similarly rated FRN or note issued by a single entity, was not
explained coherently to Mr Portlock by his expert colleagues.
868 Moreover, Grange’s argument is in the teeth of Mr Vincent’s cogent and accurate
assessment of how it effected “no haircut repos” with its uninformed Council clients as
described in section 4.2.9 ([264]-[268]). Both Professor Harper and Dr Bewley had never
heard of “repo” transactions when they analysed and reported on the GTS data. They only
became aware of what those transactions were during their concurrent evidence with
Mr Finkel.
869 Thus, if one of its clients needed to realise an investment in an SCDO, unless it could
match two clients who were buying and selling, Grange had to buy it back to support its
promise of liquidity. In early March 2006, as its SCDO business developed, Grange realised
that its activity in supporting the secondary market it had created was exposing itself to
significant risk. So much is evident from the internal consideration of the risk that Mr Hagan
considered Grange had from holding nearly $100 million face value worth of SCDOs in
March 2006: see [98]-[100], [366]-[368].
870 Grange was thinly capitalised. In an internal risk management framework report
dated 25 May 2005, Grange had set $2.5 million, or 25% of its shareholders’ funds, as the
maximum potential loss that it was prepared to risk in the fixed interest division run by
Mr Clout. Subsequently, in the internal email exchange that led to Mr Vincent’s discussion
of “no haircut repos”, he raised his concerns about Grange’s capacity to deal with a
maximum potential loss (“mpl”) event. He observed tellingly as at 10 November 2006:
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“It also seems to me that Grange is a small highly leveraged company which if it were rated itself would come in at the “B” or “BB” level.”
871 Thus, Mr Vincent concluded that Grange needed to engage in the “no haircut repos”
with the uninformed Councils to obtain funds in order to enable itself to provide a secondary
market and, so, liquidity for its clients. Grange could not afford to raise these funds by
commercial borrowing. This was because an informed institutional investor would make the
haircut “so large that [it] covers their “mpl” scenario that makes funding stock with informed
investors prohibitive for us” (see [266]-[268] above). He said that if Grange gave the
Councils “repos with haircuts”, the haircut would be “defacto an acknowledgment of the risk
of price movement and counterparty being caught short with Grange going bust and the stock
post haircut being worth less than their investment”.
872 Within about eight months of this email exchange, the global financial crisis had
affected Grange and its new parent, Lehman Bros. Grange ceased to be able to buy back
SCDOs from its clients at about face value. Only then did its uninformed Council investors,
such as the three applicants, realise by experience what Mr Vincent ascribed to the effect of a
haircut in that email.
873 The internal debates within Grange about these issues stand in stark contrast to its
promises and assurances to the Councils in which it promoted the existence of a secondary
market on which the SCDOs could be traded. The reality was that Grange controlled the
trading and pricing of sales and purchases on the secondary market it ran for its clients. Until
mid 2007, it did this in a way that shielded those clients from the realisation that, first, the
“market” prices were set by Grange and, secondly, the issuers of the products had stated in
their offering memoranda that there were no guarantees that any such markets would develop
or, if made, would continue.
874 Grange also contended that it had facilitated a local secondary market, by acting as a
market maker. It argued that this conduct was not improper or artificial. Rather, Grange
submitted, its activity in doing so was consistent with its promotion of a new product in the
market place.
875 The prices at which Grange bought and sold SCDOs in trading with its clients did not
reflect market conditions see: [777]-[780]. Another revealing example of this is what
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happened when Grange negotiated to buy the Newport AAA SCDO from its issuer or
arranger and then sold this to its clients in early 2006. That product was the largest issue of
SCDO notes that Grange ever sold. On 31 January 2006, Grange bought Newport notes with
a face value of $115 million for $111,929,500 (i.e. it bought each note with a face value of
$100 for $97.33). The yield that Grange attributed to this parcel in its GTS data was 1.2405.
876 On 2 February 2006 Grange bought further notes with a face value of $20 million for
$19,721,996 ($100 face value for $98.61). However, the yield attributed to the second
transaction in the GTS data was 1.5414. Professor Harper explained that the change in the
yield reflected a reassessment in the market that marked a significant increase in the implicit
risk in the notes over the two days between the transactions. He said that the yield figure
represented the rate of return over the reference rate that the (informed) market required. The
change in the two yields is termed an increase in “the spread” in the underlying credit
markets. That change informed the prices between the arranger and Grange. Notably,
Grange paid a higher, not lower, price for the later and riskier parcel that it acquired. And,
despite the ordinary market consequence that when the spreads widen, the price falls, Grange
sold the whole $135 million worth of the Newport notes to its clients at their full face value
of $100 each: i.e. the sale price was increased over its second purchase price by Grange.
That is not the behaviour of participants in a market that operates in a natural and normal
way, as the following evidence of Prof Harper showed:
“MR MEAGHER: Well, an increased spread means or indicates increased risk, doesn’t it? PROF HARPER: Generally, yes, that’s correct. MR MEAGHER: And therefore, if you held a note with a coupon of 100, say, and there was an increase in the risk, or perceived increase in the underlying risk, then you would expect, if you were going to buy it, or to sell it, that you would have to sell it at a discount so as to generate a yield which was higher than the coupon to reflect the increased risk. PROF HARPER: That’s correct.” (emphasis added)
877 Professor Harper said that following the increase in the yield to 1.5414, he would
expect in any downstream market, such as a retail market, that the increased perception of
risk would require a yield which was higher than the coupon rate on the face value. He stated
that the way this would happen is that the buyer in the market would ask for or offer a price
less than the face value, so as to achieve the increased yield above the coupon rate.
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878 As Prof Harper said, the GTS data showed that Grange then on sold the Newport
notes to its clients at about par or face value. He drew the conclusion, and I find, that none of
those transactions that Grange had with its clients reflected underelying movements in credit
spreads. It follows that the market that Grange facilitated with its clients was not one that
reflected ordinary market behaviour. That accords with Mr Finkel’s evidence, that I accept,
that while the GTS data showed purchases and sales between multiple accounts on multiple
occasions, this activity did not represent (what he described as) “valid market making”. He
explained this in the following evidence that I accept:
“Having reviewed, you know, a great deal of this trading data, and knowing where market spreads were for CDO tranches and where they went during some of these periods, and the variability both up and down of spreads, you know, there is no reflection little or no reflection in the GTS data of that. So I just view these trades as being very close to, you know, protected, for lack of a better term, by the captive market that I believe Grange created. MR SHEAHAN: All right. So what you’re saying, and correct me if I’m wrong, is that the GTS data you observed involved for the most part clients, customers, selling to Grange at or close to par? You agree with that, first? MR FINKEL: Yes, largely, until 2007. MR SHEAHAN: Until mid-2007 when things changed. MR FINKEL: Yes.” (emphasis added)
879 To some extent Grange acted as a market maker by taking onto its book significant
inventories of SCDOs from clients who wanted to sell them, such as councils needing
liquidity. Hence, the development of the concerns exposed in its internal email debates, to
which I have referred to in this section. The capacity of Grange to control the secondary
market, even as it was unravelling, can be seen in its manipulative trading in July 2007 that I
discussed in [383]-[387] and [692]-[694]. The buyers and sellers on the other side of the
transactions in the secondary market were Grange’s clients. Those clients were not fully
informed participants in that “market”. Grange argued that it was facilitating or creating a
local market to promote the new type of investment product in the marketplace. But that
facilitation was a chimera. As Grange’s note sent by Mr Calderwood to Mr Neville on
7 August 2007 said, consistently with the risk warnings in the issuers’ offering memoranda
that Grange had not disclosed to the Councils (and, I infer from the content of all its sales
material in evidence, had also not disclosed to its other clients) (see [698]):
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“The current volatility reinforces the point that CDOs should generally be viewed as hold to maturity investments.” (emphasis added)
880 The secondary market that Grange maintained was not a market that operated with
persons who could generally be described as informed buyers or sellers, other than Grange.
While there may have been some sophisticated investors who traded in it, there was no
evidence that any one, other than Grange, understood the risks and hence could make
informed decisions about the prices of transactions. After all, despite Grange’s belated
statement that these SCDO products were “hold to maturity investments”, as I find they were,
the GTS data painted a picture of active, if uninformed, trading in them. It exploited trusting
and financially unsophisticated Council officers, like Mr Bokeyar, by suggesting switches on
a regular basis. That activity gave the appearance that the SCDO products generally sold at
around face value without any difficulty. And even if the switch transaction appeared
objectively to have no commercial rationale for the Council, the Council officers acted on
Grange’s advice and recommendation because they trusted it (see e.g. section 4.2.14 and
[724] as to Mr Downing; [568]-[574] as to Mr Bokeyar).
881 Accordingly, there was no established secondary market on which the SCDOs were
easily tradeable. The only market was one of the insubstantial nature described in the issuers’
offering memoranda such as that set out at [123]. Thus, Grange provided a secondary market
facility but it did so only while this activity suited it, was controlled by it and was within its
limited capital resources. When Grange was itself exposed to the effects of events in the
wider economy in mid 2007, it ceased to provide a secondary market advising its clients that
products were now to be viewed as hold to maturity investments. Thus, the Claim SCDOs
lost their fungibility in the environment that Grange had created for them amongst its
clientele, because Grange could not sustain that environment.
882 For these reasons I am satisfied that Grange breached term (2) of its contracts with
Swan (before their IMP agreement) and Parkes by selling the Claim SCDOs to the Council.
6.2.4 Were the Claim SCDOs readily able to be liquidated for cash at short notice?
883 For the reasons in section 6.2.3, the Claim SCDOs were not readily able to be
liquidated for cash at short notice other than through Grange while it had the wherewithal and
preparedness to do so. There was no other market or source of liquidity. As will appear
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when considering the difficulties in valuing the Claim SCDOs, the unmatured products are
not liquid and it is difficult to realise them for cash and more so for cash in the order of face
value (see section 7 below). This inherent characteristic was demonstrated by Mr
Calderwood’s note quoted in [698] and [879] that these were hold to maturity investments.
884 Grange alone kept the products liquid for so long as it considered that this was in its
financial interest and it had the financial ability to do so as Mr Rae and Mr Clout discussed in
their emails of 14 and 15 September 2006 (see [366]-[368]). Often, this involved Grange
buying a product from one client who needed funds, and then Grange making a sale of that
product to another client as ad hoc individual transactions, or through use of an IMP
agreement mandate or by Grange raising the cash price from another client through a “no
haircut repo”. None of that trading activity detracted from the accuracy of the issuers’
offering memoranda’s risk warning that the products were inherently not readily able to be
liquidated for cash at short notice. And, of course, each of the inherent risks of lack of
liquidity and market price volatility affect the price of an SCDO when an investor seeks to
sell it, as has happened to Swan and Parkes since Grange experienced financial problems in
the second half of 2007 (see section 3.5.4 and 3.5.3).
885 The issuers’ offering memoranda correctly warned of the inherent risks that SCDOs
were “suitable only for investors who can bear the risks associated with a lack of liquidity” in
those products ([123]). Swan and Parkes were not such investors.
886 Thus, Grange breached term (3) of its contracts with Swan (before the IMP
agreement) and Parkes by selling the SCDO’s to the Councils.
6.2.5 Were the products suitable and appropriate for a risk averse local government council?
887 The Claim SCDOs sold by Grange were not suitable for risk averse local councils like
Swan and Parkes. For each of the reasons that I have found that Grange was in breach of
terms (1), (2) and (3) in sections 6.2.2-6.2.4, the product had features and risks that were
neither suitable nor appropriate for the Councils.
888 The complexities and risks of SCDOs were understood by experts. The SCDOs were
commercial derivatives (leaving to one side the issue about whether they were “derivatives”
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as defined in the Corporations Act: see too section 9.3.3). They were synthetic financial
products. Mr Finkel said, accurately, that an SCDO:
“is essentially a bet that the CDS portfolio will only have a limited amount of net losses, which can be fully absorbed by others who have taken more junior slices [i.e. tranches] of risk (up to a specified loss threshold) on the portfolio of CDS”. (emphasis added)
889 Mr Finkel also described the Claim SCDOs as being “some of the most complex and
high risk fixed income investments available in the marketplace”. Mr Hattori said that a
potential investor would normally carry out a thorough review, or due diligence evaluation,
of a potential investment to identify issues for discussion with the vendor. He made the point
that the investor had to be in a position to make use of the information available and that this
would depend on the investor’s general financial training together with any steps the investor
had taken to gain specialist knowledge.
890 As I have found at [95] the structure of Claim SCDOs inherently carried much more
risk than the same or equivalently rated FRNs or corporate bonds of the kind with which the
Council officers were familiar. That included the significantly greater risk of market price
volatility than in similarly rated investment products (see section 3.5.3).
891 The Councils did not meet the investor suitability criteria in the risks explained in the
offering memoranda ([122], [123]). The Councils were not sophisticated investors. They did
not want to put their ratepayers’ capital at risk. They could not depend on an
undercapitalised company like Grange to provide liquidity or a secondary market if financial
markets suffered extreme market events (see section 3.5.4). The products were susceptible to
the risk of price volatility (see e.g. section 3.5.3, [241]-[243]). And, as hold to maturity
investment products, they were illiquid.
892 The apparently high credit ratings of the SCDOs sold to the Councils by Grange did
not reveal the risks discussed in section 6.2.2. Thus, the seeming compliance of those
products with the rating requirements in the Minister’s Order (in Parkes’ case) was also not
sufficient to make the SCDOs suitable investments (see [416]). The products were far too
complex for the Council officers to understand their nature or their risks in a way that would
have enabled them to make any informed decision whether or not to purchase them ([410]).
As I have found, had each of Mr Senathirajah, Mr Downing or Mr Bokeyar been made aware
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of some of those material risks, he would never have caused the Council to purchase any of
the products.
893 An investment in a Claim SCDO exposed the Council to having to hold the asset to its
maturity if, for any reason, Grange could not honour its promise or assurance of there being a
secondary market or liquidity provided by Grange available to realise the asset earlier.
Moreover, the price for which it could be realised before its maturity was subject to
substantial risks of market price volatility and dimunition because of the lack of liquidity (see
sections 3.5.3 and 3.5.4). Those risks would be accentuated if extreme market events
occurred making it desirable for the investor to realise its asset for cash either before those
events affected it, or as they were affecting, the product. That is what happened when
Wingecarribee became concerned about its holding of the Federation product. The price
Grange was prepared to pay for it was 15%, a fraction of its face value ([718] see
section 4.5.8).
894 Moreover, these products had an additional feature, as emerged when the flip clause
in the Dante notes was asserted, namely, the difficulty for a noteholder to enforce its right to
be repaid the capital due on maturity against a SPV or holder of collateral located in a foreign
jurisdiction. This difficulty in enforcing repayment of capital of the Dante notes arose
because each of those SCDOs contained the “flip clause”. That has given rise to the current
interjurisdictional stalemate in the ability of investors to obtain repayment of their capital.
895 Generally, risk averse people do not take bets with substantial assets held for public
purposes. The Claim SCDOs were not suitable or appropriate for a risk averse local
government council. For these reasons Grange breached term (4) of its contracts with Swan
(before the IMP agreement) and Parkes by selling the Claim SCDOs to the Councils.
6.2.6 Did the Claim SCDOs have secure income streams?
896 Term (5) of the contracts between Grange and Swan (before the IMP agreement) and
Parkes is inter-related to term (1). The income stream was only as secure as the capital
invested. If sufficient credit events eroded part or all of the SCDO’s tranche, then the interest
receivable by the investor would be reducted or eliminated correspondingly. However,
unlike in term (1), the promise in term (5) did not include the words “high level” to
emphasise the extent of security of the income stream. I discussed in section 6.2.2 the
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particular suspectibility of SCDOs to extreme market events. The emphatic words “high
level of security for protection” in term (1) did not except the occurrence of extreme or
systemic market events as an ordinary part of economic cycles.
897 The promise in term (5) is not as emphatic as that in term (1). The income stream
from the Claim SCDOs was relatively secure. The only substantive threat to that security
was the occurrence of an extreme or systemic market event that could cause credit events to
erode the investor’s tranche in an SCDO’s reference portfolio. The income stream did not
depend on the SCDO being liquid or saleable in a secondary market. While I have found that
the Claim SCDOs did not have a high level of security for the protection of their capital, I am
not satisfied that they did not conform to the relatively less exacting promise that the income
stream that they provided was secure. The SCDOs paid their coupon interest in accordance
with their terms. That continued until some of the Claim SCDOs suffered from an erosion or
wiping out of the tranche in which the Councils had invested, following the impact of the
global financial crisis.
898 Accordingly, Swan (in respect of contracts before the IMP agreement) and Parkes
have failed to prove a breach of term (5) of their contracts with Grange.
6.2.7 Did Grange exercise reasonable skill and care in making each investment recommendation and giving that investment advice to Swan (before the IMP agreement) and Parkes?
899 It follows from my findings that Grange breached terms (1), (2), (3) and (4) that it did
not exercise reasonable skill and care in making each investment recommendation and giving
investment advice to act on it to Swan (before the IMP agreement) and Parkes. That conduct
was a breach both of term (6) of the contracts and also of Grange’s duty of care in tort to the
respective standards I found in [790] and [807]. But for that conduct, Swan (before the IMP
agreement) and Parkes would never have invested in the Claim SCDOs. And, but for that
conduct Swan would never have entered the IMP agreement so as to enable Grange to make
or continue making investments in those products. As I discuss in more detail in section
8.3.2, the provisions of s 5D of the Civil Liability Act 2002 (NSW) (set out at [1119] below)
and its Western Australian analogue created a “but for” test of liability in negligence in
contract and tort. Here, as Grange argued, s 5B has no relevance to its liability since the
claims in negligence did not depend on Grange failing to take precautions against a risk of
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harm (GWSCL 6-11). In Roads and Traffic Authority (NSW) v Refrigerated Roadways Pty
Ltd (2009) 77 NSWLR 360 at 397 [173]-[177] Campbell JA, with whom McColl JA agreed
at 365 [1], as did Sackville AJA esp at 449 [443], held that s 5B(1) only modified the
common law applicable to situations where the negligence alleged amounts to “failing to take
precautions against a risk of harm”. Both parties accepted that s 5D(1) (s 5C(1) of the
Western Australian Act) was relevant and introducted the “but for” test of factual causation
(s 5D(1)(a)).
900 In general, the degree of care required under a contractual obligation to exercise
reasonable skill and care is different from the reasonable prudence that a person in a fiduciary
position must exercise: Austin v Austin (1906) 3 CLR 516 at 525 per Griffith CJ, Barton and
O’Connor JJ. However, here, when acting for each of Swan and Parkes, Grange was their
agent and was bound to act as a prudent person exercising the Council’s powers in
accordance with the provisions of s 18(1) of the Trustees Act 1962 (WA) and having regard
to ss 14A and 14C of the Trustee Act 1925 (NSW) respectively (sections 5.1.5, 5.2.4 above).
That standard is how an ordinary, prudent business person would have acted in making
investments of public money for a Council: Austin 3 CLR at 525; Jacobs’ Law of Trusts
(7th ed) at [18.09].
901 Investments in the Claim SCDOs and SCDOs generally had each of the inherent risks
specified in sections 6.2.2 to 6.2.5 above. It was not open to the Councils to invest in
products that carried one or more of those risks or to Grange to recommend or advise such
investments as their investment adviser. It would have been a breach of trust for a trustee to
invest in the Claim SCDOs because of their inherently hazardous nature created by the risks
and matters referred to in each of sections 6.2.2 to 6.2.5: Fouche v Superannuation Fund
Board (1952) 88 CLR 609 at 636-637 per Dixon, McTiernan and Fullagar JJ; Government
Employees Superannuation Board v Martin (1997) 19 WAR 224 at 273E per Ipp J; Jacobs’
Law of Trusts (7th ed) at [18.06], [18.10], [18.12].
902 Of course, the Councils did not hold their funds in the capacity of trustee. But their
investment policies and (for Swan), s 6.14 of the Local Government Act 1995 (WA) and, (for
the New South Wales Councils), the Minister’s investment guidelines, specifically included
the need to exercise the care, diligence and skill that a prudent person engaged in the
investment of funds would exercise in managing the Council’s public funds ([157], [175],
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[415], 417]). Lindley LJ explained why investment in an asset that is inherently hazardous is
not prudent and so not open to a person bound to invest in accordance with the standard
applicable to a trustee in In re Whiteley (1886) 33 Ch D 347 at 356-357 in the following
passage, that was approved in Fouche 88 CLR at 637 and 641:
“A security of so hazardous a nature as this, though in one sense and to some extent a real security, is not a proper security for trust money; it is not in truth a real security for any sum beyond the value of the land as land. The security for more than this value is the solvency of the borrower, and the trade carried on by him.” (emphasis added)
903 The last sentence just quoted captured the imprudence of Grange’s recommendations
and advice that the Councils invest their money in products for which first, their invested
capital did not have a high level of protection, secondly, the liquidity or secondary market
was no better than Grange’s own undercapitalised solvency and, thirdly, they were not
suitable and appropriate for a risk averse local council.
6.2.8 Did Grange breach the Swan IMP agreement?
904 Swan alleged that Grange breached their IMP agreement in two ways by investing in
SCDOs. First, Swan asserted that the Claim SCDOs did not provide it with ready access to
funds for its day to day requirements without penalty, as the objective in cl 2.1 of the 2003
Swan Policy required ([175]). Schedule 2 required Grange to observe that Policy in making
investments: [362], [770]. And, it argued that the Claim SCDOs were not prudent
investments of the kind authorised by the Trustees Act. Secondly, Swan (and Wingecarribee)
contended that Grange breached its contractual obligation to exercise reasonable skill and
care by investing in the Claim SCDOs.
905 In answer to the first of those arguments, Grange contended that the objectives in
cl 2.1 of the 2003 Swan Policy had competing aims. Thus, it argued, it was necessary to
balance the objective for ready access to funds with that of “enhancing the yield to the City”.
906 I reject Grange’s argument on the first limb. The objective of enhancing the yield to
Swan was qualified by the words “through prudent investment of funds”. That reflected the
Council’s duty in cl 2.2 to invest in accordance with s 6.14 of the Local Government Act and
Pt III of the Trustees Act: [175]. The other objectives, set out in [175] above, complimented
that one, by seeking returns consistent with the 90 day BBSW or a bank bill index, a high
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level of security for the overall portfolio by using recognised ratings criteria and maintaining
an adequate level of diversification. None of these objectives justified investment in products
that lacked a high level of security. Nor was the last of those objectives qualified by the
Council’s addition in cl 2.1 of the 2003 Swan Policy of the words “using recognised ratings
criteria”. The ratings criteria, in themselves, did not provide a high level of security in the
sense that a reasonable person in the position of the parties would have understood at the time
of making the IMP agreement. For the reasons I have given in section 6.2.2, ratings for the
Claim SCDOs had a significant deficiency because of their lack of comparability with ratings
for other products. The “risk factors” set out in the offering memoranda for SCDOs, being
the subject matter of the proposed investments would have altered a reasonable person in the
position of the parties to real issues about the level of security of these products: see [92],
[122]-[123]. Moreover, informed investors and investment advisers, such as Grange, knew or
ought to have known that SCDO products were materially riskier and more susceptible to
extreme market events than similarly rated produdcts, such as ADI issued or corporate FRNs.
907 Investment in SCDOs was not prudent for Swan for the reasons I have given in
sections 6.2.2-6.2.5 and 6.2.7. However much Grange sought to assert the need to balance
the objectives in cl 2.1 in exercising its investment powers under the Swan IMP agreement, it
failed to achieve such a balance consistent with those objectives when it invested in the
Claim SCDOs. In any event, for the reasons I have given in section 6.2.7, a prudent person
could not have invested the Council’s funds in the Claim SCDOs by reason of s 6.14 of the
Local Government Act and s 18(1) of the Trustees Act.
908 Moreover, the Claim SCDOs did not meet the objective in cl 2.1 of the 2003 Swan
Policy. This was because they did not provide Swan with ready access to funds for its day to
day requirements without penalty. The Claim SCDOs were not easily tradeable on an
established secondary market for the reasons in section 6.2.3, nor were they readily able to be
liquidated for cash at short notice for the reasons in section 6.2.4.
909 In elaborating their second argument, the Councils contended that Grange was
negligent by investing in SCDOs, including the Claim SCDOs, in breach of the IMP
agreements. They asserted that Grange knew of that each of Swan and Wingecarribee had
conservative investment histories, SCDOs were highly complex and designed for
sophisticated investors, the Councils should have invested prudently and in products that
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were liquid, each was not in a position to tolerate any likelihood of price volatility in the
Claim SCDOs, and those products had risk features that made them riskier than other, more
suitable, fixed interest products.
910 Grange argued in response that the Swan IMP agreement did not require it to invest in
accordance with a conservative investment strategy. It contended that the 2003 Swan Policy
reflected the Council’s motivation to invest in products with a higher yield. It argued that
each Council was a sophisticated investor within the meaning of s 708(8) of the Corporations
Act. Grange also argued that in any event, the Council was such an investor because Grange
had those attributes and was managing the Council’s investments under the IMP agreement
on their behalves. Grange submitted that the Claim SCDOs were liquid because of its
promise to provide liquidity and investment of the Councils’ funds was not imprudent. It
argued that Mr Senathirajah understood that the market price of CDOs might be affected by
general market sentiment towards CDOs as a product or the affect of particular credit events
or ratings downgrades on a particular CDO. Grange also relied on the fact that both he and
Mr Downing understood that the market price could drop below par. Grange submitted that it
had informed Swan that the SCDOs were leveraged but Mr Downing had relied on the rating
as the determining factor as to the quality of the product. Grange argued that the Claim
SCDOs’ risk of price volatility and lack of liquidity were not inconsistent with the Councils’
conservative investment requirements. It also contended that the Claim SCDOs it invested in
carried the highest ratings, indicating that each product carried a minimal risk of loss of
capital.
911 I do not accept Grange’s arguments on the second limb. I am satisfied that Grange
was in breach of its contractual obligation to exercise reasonable skill and care in performing
its functions under the Swan IMP agreement by causing each Council to invest in the Claim
SCDOs. Grange performed extensive research and gave detailed consideration before it
decided to market each of the SCDOs it sold to its clients. It argued that this work
demonstrated that it acted reasonably. However, this argument overlooked two critical
matters, first, the failure of the Claim SCDOs (and other SCDOs) to meet the particular
investment requirements of the Council and Western Australian law and, secondly, Grange’s
own appreciation of the significant degree of risks to which investment in the Claim SCDOs
(and other SCDOs) exposed the Council as compared to the kinds of products that did not
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have the features that I have found to have resulted in breaches of contractual terms (1), (2),
(3) and (4).
912 Grange exercised the Council’s powers of investment under cll 2.1 and 2.2 of the
Swan IMP agreement. It had to do so in accordance with the Guidelines in Sch 2 that
included the 2003 Swan Policy (see section 4.3.1). The 2003 Swan Policy sought to enhance
the yield that the Council received. That objective, read in the context of the policy as a
whole, did not amount to Swan abandoning its conservative investment strategy, as I have
explained at [906]-[907] above. Grange was aware that each Council was a government body
investing public money to earn a return during a period in which the money was not required
for public purposes. It was aware that the Councils were not seeking or entitled to expose
their constituents’ money to any significant risk of loss. Grange was aware that investment in
SCDOs exposed the holder to the risks that, for example, Mr Hagan, Mr Rae and Mr Vincent
identified in their analyses in March 2006 ([98]-[100]), 14 and 15 September 2006 ([366]-
[368]) and the “no haircut repos” email ([266]-[268]).
913 Grange, as manager of the Councils’ portfolios under their IMP agreements, was the
agent of each of Swan and Wingecarribee. In that capacity, it was a person who, unlike each
of the Council officers had the necessary financial acumen and expertise to be categorised as
a “sophisticated investor” in the English ordinary usage of that expression. That is the
capacity in which each Council engaged Grange to act on its behalf.
914 Division 6D.2 of the Corporations Act required a person offering securities, such as
SCDOs, for sale in certain circumstances to make disclosure to investors in respect of such
offers. However, s 708 created a number of exceptions to this requirement, including that
provided in s 708(8). That exception applied to, among others, an investment where the
minimum amount or amounts payable by an offeree for the particular security was, or totalled
at least, $500,000 (s 708(8)(a) and (b)). The Councils did not allege any breach of Div 6D.2
as part of their case. As I have noted above, none of the terms sheets or other documents
provided to the Councils explained to them what Grange referred to as a “sophisticated
investor” was. Each Council made a number of investments for less than a total of $500,000
in SCDOs over the course of their relationships. For example, Grange bought for Swan
$150,000 worth of the Henley AAA Claim SCDO on 23 April 2007 and $300,000 worth of
the Lehman Bros Property Note on 13 June 2007. The issuers’ offering memoranda did use
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the expression “sophisticated investor” in its natural and ordinary meaning and not in the
sense of a person meeting the test in s 708(8). As I have found, the Councils were not
“sophisticated investors” ([218], [265]-[268], [407], [464], [483], [491], [557], [623], [662],
[665], [686]).
915 Moreover, a sophisticated investor charged with the responsibility of managing a
client’s portfolio in accordance with its investment policy, must observe the client’s policy, if
known to it (as it was to Grange) when making investment decisions. Grange had an
approach to its IMP agreement mandates that was accurately summarised by its director of
business development, Alison Perrott, in a risk management overview she wrote on 19
August 2005. She noted that Grange had no formal procedures for portfolio management,
including procedures for addressing any conflict of interest, compliance reviews or portfolio
reviews. Pertinently, she observed:
“We are promising “individually managed & tailored” but this was always from the clients perception, internally we intended to produce “sausages” with cash enhanced, local gov’t and high yield with little variation. We are finding ourselves in a situation where for every 2 plain sausages we have 1 variation.” (emphais added)
At the conclusion of her overview, Ms Perrott added an observation made by Mr O’Dea:
“Applying true porftolio management … ie, it is tempting to use mandates as underwriting tools, & covering unsold positions in new issues, to the point where portfolio positions get too big … a touchy subject but if we blow up we will get a tsunami of stock back at us!!!!!” (emphasis added)
916 The purchase of the Federation SCDO for Wingecarribee was an example of the
“sausage” approach Ms Perrott described. Grange failed to look at the prohibition in the
Wingecarribee IMP agreement against the acquisition of a product for which there was no
active secondary market, where its own slides stated that there was none for the Federation
SCDO: see [371]-[372], [638], [716].
917 In addition, Grange breached its contractual obligation to exercise reasonable skill and
care in making investment decisions under the Swan IMP agreement because the Claim
SCDOs did not have a high level of security for the protection of the capital invested by the
Councils, there was no established secondary market for, and there was a lack of liquidity of,
the products (see sections 6.2.2-6.2.5 above). Those matters meant that investment in the
products for the Councils was also imprudent. Mr Senathirajah and Mr Downing understood
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that the market price of SCDOs was susceptible to general market sentiment and the impact
of credit events or rating downgrades in particular products. However, neither understood
how the risks of price volatility and extreme market events applied to this particular form of
investment (see section 6.2.2 and [860] above). Mr Senathirajah understood, from what
Grange had told him, that its monitoring of the performance of SCDOs would enable Swan to
take prophylactic corrective action before any particular product became vulnerable to
causing Swan a capital loss ([236]-[237]). Mr Downing regarded, as Grange submitted,
SCDOs as being hold to maturity investments and so he was not concerned about fluctuations
in market value, since these did not affect repayment of capital by the issuer on the product’s
maturity: [406]-[410].
918 Grange’s final argument, that the Claim SCDO’s carried high ratings indicating that
each product carried a minimal risk of loss of capital, ignored the known limitation on the use
of ratings to assess risk for structured finance products in comparative terms with ADI issued
FRN’s or corporate bonds: [847] and see generally section 6.2.2. Additionally, I found in
sections 4.3.2 and 4.3.3 that a number of Grange’s investments in Claim SCDOs under the
Swan IMP agreement were in breach of its terms. These were:
the investments in the Coolangatta and Federation Claim SCDOs on 16 March
2007 and 8 May 2007 respectively, which had final maturity dates more than
five years later, in breach of cl 2.6(a)(ii) of the 2003 Swan Policy ([369]-[370],
[376];
the investment of $250,000 in the Flinders Claim SCDO on 6 July 2007 at a
price greater than face value. At that time Grange was dumping its own
holding of that product onto its clients in the belief, based on a valuation it had
received from Credit Suisse that it was worth $8 (per $100 face value) below
Grange’s undisclosed internal benchmark and materially less than face value
([382]-[387]).
919 For these reasons, and those in [899], but for Grange’s negligence, Swan would never
have invested in the Claim SCDOs, either because it would never have entered into the IMP
agreement at all, or, Grange would not have used its mandate to make these investments.
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6.2.9 Did Grange breach the Wingecarribee IMP agreement?
920 Like Swan, Wingecarribee alleged that Grange breached its obligation in their IMP
agreement to exercise reasonable care and skill (see section 6.2.8). Wingecarribee also
alleged that Grange breached their IMP agreement in two further respects. Those were that
investment in the Claim SCDOs was a breach because, first, there was no active secondary
market for them and, secondly, they were “derivatives” within the meaning of s 761D of the
Corporations Act: [812]-[813]. I will deal with the last issue in section 9. Grange argued
that it had not breached its contractual obligation to exercise reasonable skill and care
because Sch 2 to the Wingecarribee IMP agreement expressly allowed investments in CDOs,
credit linked notes and structured products ([638]).
921 However, the mere fact that these were permitted investment classes did not mean that
each and every product meeting the description “CDO” or “structured product” would fall
within the investments permissible under the Wingecarribee IMP agreement. The other
requirements in the IMP agreement governing investments also had to be met, such as the
existence of an active secondary market for the products. Any CDO or structured product
had to meet all of the relevant criteria for investment in the Wingecarribee IMP agreement.
922 Nonetheless, unlike what I have found in respect of the Swan IMP agreement, Grange
did not breach the Wingecarribee IMP agreement simply because it invested in SCDOs
including the Claim SCDOs. That form of investment was expressly authorised, subject to
the two additional requirements that the products had to have an active secondary market and
not be derivatives.
923 The 2003 Wingecarribee Policy and the Minister’s investment guidelines required the
prudent person test to be applied to the consideration of the Council’s investments ([415]-
[417], [611]). The Wingearribee IMP agreement did not refer expressly to either of those
matters. Both parties contracted by reference to the fact that Wingecarribee was a Council
constituted and operating in accordance with the Local Government Act (NSW) (cl 2.3(d),
[638], [811]). Grange acted as the Council’s agent. The IMP agreement could not be
construed to permit Granged to act, in its capacity as the agent of Wingecarribee in investing
its funds, in a manner inconsistent with its principal’s investment policies or guidelines set by
the Minsiter for the exercise of powers to invest by local government bodies.
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924 It follows that Grange was still bound to act as a prudent person when exercising its
power, as the Council’s agent, under the Wingecarribee IMP agreement if it decided to select
CDOs or structured products for investment. That is, Grange was entitled to consider
investing in SCDOs for Wingecarribee despite their inherent properties that made these
products unsuitable for Swan under the Swan IMP agreement as found in section 6.2.8.
However, in making investments in CDOs and structured products Grange was still required
to act as a prudent person.
925 Critically, cl (c) of Sch 2 to the Wingecarribee IMP agreement required Grange to
manage the portfolio to ensure that “all securities must have an active secondary market”. In
sections 6.2.3 and 6.2.4, I found that there was no established secondary market on which the
Claim SCDOs were easily tradeable and that they were not readily able to be liquidated for
cash at short notice. The only market was of the insubstantial nature described in the issuer’s
offering memoranda at [123] and Grange provided that facility only while doing so suited it
and was within its limited capital resources: [881], [884]-[885]. Grange’s investment for the
Council of $3 million in the Federation Claim SCDO was a breach of this provision. Its own
slide presentation for this product stated that “There is currently no market for the Notes”.
That went on to say that Grange might make a market for the product from time to time but
was under no obligation to do so: see the risk factor quoted in full at [371]. Grange did this
after concerns had been expressed in the international financial press about RMBS products
(see [370]). This use of its power under the Wingecarribee IMP agreement made good Ms
Perrott’s analogy of Grange’s use of the “individually managed portfolio” as being a
“sausage”. This investment indicated that Grange used the trust of the Councils to do what
suited Grange.
926 Grange’s investment of Wingecarribee’s funds in the Claim SCDOs was a breach of
cl (c) of sch 2 of this IMP agreement. A corollary of that finding is that Grange was in
breach of its obligation to exercise reasonable skill and care in making investments for
Wingecarribee under their IMP agreement because the Claim SCDOs lacked liquidity and
had no secondary market.
927 Grange argued that because each of Mr Hyde, Mr Dunn and Mr Neville understood
that there may be fluctuations in the market price of the Claim SCDOs, it had not been in
breach of its obligation to exercise reasonable skill and care by investing in products that had
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a likelihood of price volatility. It also relied on Mr Neville’s stated intention that the
products be held to maturity. It also contended, as it did in respect of the similar claim by
Swan, that the same obligation had not been breached because the Claim SCDOs were not
riskier than other fixed interest products. Grange asserted that the main concern of
Wingecarribee was the risk of loss of even a dollar of capital. It submitted that the risk of
such loss was measured by the ratings assigned by the ratings agencies.
928 The answers given by Wingecarribee’s witnesses must be understood in the context
that they had no idea, when deciding to go ahead with the IMP agreement, that contrary to
their express wishes (but not the signed agreement) the Councils would be investing in
unfamiliar products and, in particular, SCDOs. As Mr Neville said, it was consistent with his
understanding based on what Grange’s representatives had said that the market price of FRNs
might vary from time to time. However, when he referred in his evidence to FRNs, he was
not describing the SCDO products that Mr Calderwood asserted were FRNs in the meeting of
16 February 2007. Rather, Mr Neville was speaking of ADI issued FRNs that he was
familiar with from his past experience. That was also Mr Hyde’s understanding. The market
price of these could vary as interest rates changed over time. However, those variations in
market value would have no bearing, on maturity of the product, on the return of the capital
deposited with the ADI when it issued the FRN ([623], [632]-[636]). This understanding did
not begin to envisage the risk of market price volatility and the issues discussed in section
6.2.2.
929 Wingecarribee sought both capital security and liquidity, since it would need access to
substantial amounts of cash once it began the construction of its planned leisure centre. The
Claim SCDOs were not a prudent form of investment for those purposes for the reasons I
have given in sections 6.2.2 to 6.2.5 and 6.2.7. But for Grange’s negligence, Wingecarribee
would never have invested in any of the Claim SCDOs: see too [919].
930 Finally, Grange committed breaches of the Wingecarribee IMP agreement:
between 16 and 19 February 2007 when it sold 9 SCDOs at face values or
better totalling over $11.1 million when it had valued these at about $728,000
less in its own books and borrowed $2 million on a “repo” of the Scarborough
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product at face value, when it had valued this at 92% of face value in its books
([673]);
on 6 July 2007 when it offloaded onto the Council at an over value $2,100,000
worth of the Flinders Claim SCDO (see [694] and [918]).
6.2.10 Conclusions on contractual issues
931 It follows from the above that Grange is liable to each Council for damages for breach
of contract by causing the Council to invest in the Claim SCDOs. I will consider below the
extent to which Grange’s liability in damages is affected in conjunction with considering this
issue on the negligence and misleading conduct claims.
6.3 Was there a breach of fiduciary obligation by Grange?
6.3.1 Did Grange commit a breach of its fiduciary obligations owed to Swan before 9 February 2007?
932 Before they entered into their IMP agreement, Grange owed Swan the fiduciary
obligations first, not to obtain any unauthorised benefit from their relationship and, secondly,
not to be in a position where Grange’s interests or duties conflicted, or there was a real or
sensible possibility that they might conflict, with the interests of Swan: [732], [745].
However, Grange would be relieved of each obligation, if it obtained Swan’s fully informed
consent to obtain such a benefit or be in the position of actual or possible conflict. A similar
position existed in respect of Grange’s relationship with Parkes.
933 Swan and Parkes argued that Grange breached both obligations. The Councils
contended that Grange earned substantial and undisclosed fees or profits in relation to the
underwriting, structuring and selling of SCDOs that it advised or recommended them to buy.
They contended that these fees or profits were significantly greater than Grange could have
earned by selling or dealing in the more traditional FRN products that the Councils had been
familiar with before Grange persuaded them to buy SCDOs. The Councils argued that, by
selling SCDOs to them Grange was able to minimise or defray its own risks of underwriting
and holding those SCDOs on its books. They contended that in presenting, advising and
recommending SCDOs for purchase, Grange never squarely addressed with them how it
benefitted from the proposed transactions.
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934 Grange argued that it disclosed to the Council in every contract note that it was either
the buyer or seller on the other side of the transaction. It also repeated the argument that I
have rejected above, namely that it had disclosed in contract notes issues from about late
January 2005 that it earned fees, so as to obtain Swan’s and Parkes’ informed consent to this:
[746]-[740].
935 As both sides accepted in argument, the first purchase by each of Swan and Parkes of
an SCDO, being the Forum AAA, product was critical. Had the risks in such an investment
been fully and properly explained, neither Council would have invested in SCDOs at all
([206]-[207], [406]-[410] (as to Swan), [448], [456] (as to Parkes)).
936 Mr Senthirajah and Mr Bokeyer understood that Grange was the vendor of the Forum
SCDO (and was the Council’s counterparty in each subsequent transaction). Both understood
that Grange made some money for itself in those transactions ([248], [449]). Mr Senathirajah
also understood in a general way that when Grange was seeking to sell a new product that it
was an underwriter of the issue and could earn fees in that capacity ([248]). Grange’s
representatives explained to Mr Downing that its source of income, when it sold a new issue,
was a fee from the bank that had promoted the product. Mr O’Dea made him aware that
Grange was the underwriter, or as Mr Downing said “marketing agent” for some new issues.
Indeed, Mr Downing received a term sheet for the Glenelg product that identified Grange as
its underwriter. However, he had no understanding, and Grange did not tell him, of the extent
of the fees it earned (T506). Mr Bokeyar never asked and was never informed about what
Grange earned in fees or other income from its dealings. Indeed, underwriting fees were
never mentioned to him by Grange’s representatives ([449]). There is no evidence that
Grange disclosed to any of the three Councils the amount of fees or profit it earned from
selling any new or other SCDO or other product to the Councils.
937 I am of opinion 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 from which it can be inferred that any of the
Councils gave its fully informed consent to Grange obtaining such a benefit. Once Grange
came to occupy a fiduciary position in relation to each Council, it had the onus of proving
that it had obtained the Council’s fully informed consent to its obtaining any benefit from, or
acting when it had an actual, or potential conflict in, that relationship. A client in the position
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of the Councils would be likely to approach consideration of Grange’s advice and
recommendations much more cautiously, if it realised that Grange stood to gain very large
underwriting fees or other profits, sometimes totalling over $1 million, from the sale of each
new issue of SCDOs. Of course, this very consideration is irrelevant to the questions of
whether Grange breached its fiduciary obligations and, if so, what remedy should be given
against it. In Furs Ltd 54 CLR at 592-593, Rich, Dixon and Evatt JJ said:
“If, when it is his duty to safeguard and further the interests of the company, he uses the occasion as a means of profit to himself, he raises an opposition between the duty he has undertaken and his own self interest, beyond which it is neither wise nor practicable for the law to look for a criterion of liability. The consequences of such a conflict are not discoverable. Both justice and policy are against their investigation. With reference to a transaction arising out of another relation of confidence, Lord Eldon said: "The general interests of justice" require "it to be destroyed in every instance; as no Court is equal to the examination and ascertainment of the truth in much the greater number of cases" (Ex parte James (1803) 8 Ves. 337, at p. 345; 32 E.R. 385, at p. 388). His language has been applied to, and illustrated by, the case of a fiduciary agent making undisclosed profits (Panama and South Pacific Telegraph Co. v. India Rubber Gutta Percha and Telegraph Works Co. (1875) L.R. 10 Ch. 515 at pp. 523, 527).” (emphasis added)
938 Similarly Lord Radcliffe, delivering the advice of the Judicial Committee in Gray
[1952] 3 DLR at 14 said:
“There is no precise formula that will determine the extent of detail that is called for when a director declares his interest or the nature of his interest. Rightly understood, the two things mean the same. The amount of detail required must depend in each case upon the nature of the contract or arrangement proposed and the context in which it arises. It can rarely be enough for a director to say "I must remind you that I am interested" and to leave it at that, unless there is some special provision in a company's articles that makes such a general warning sufficient. His declaration must make his colleagues "fully informed of the real state of things" (see Imperial Mercantile Credit Ass'n v. Coleman (1873), L.R. 6 H.L. 189 at p. 201, per Lord Chelmsford). If it is material to their judgment that they should know not merely that he has an interest, but what it is and how far it goes, then he must see to it that they are informed (see Lord Cairns in the same case at p. 205).” (emphasis added)
939 In essence, all that Grange did was to let the Councils know that it was “interested”, in
the sense that it would make something out of dealing with them. That 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 or recommendation to purchase an SCDO. The more is this so given
Grange’s appreciation that the Councils had no real concept of some of the risks that they
were assuming, and the scale of what Grange was earning, in dealing with these products.
This is eloquently demonstrated by considering the switches proposed in Mr Clout’s email of
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9 August 2004 , the email exchange between Mr Clout and Mr Rae of 14 and 15 September
2006 and Mr Vincent’s explanation of “no haircuts repos” ([300]-[307], [366]-[368], see too
[266]-[268], [286]-307]). It follows that Grange, in selling the Claim, and other, SCDOs, was
in breach of its fiduciary obligations owed to Swan and Parkes by obtaining benefits from
each relationship that had not been authorised by either client.
940 Grange was also in breach of the second 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. Once again, Grange failed
to obtain its Council clients’ fully informed consent to its participation in each transaction
while in that position of conflict. Grange stood to benefit from each such dealing. There is
no evidence of the precise extent to which Grange benefitted from purchases and sales of
SCDOs that were not new issues, other than that these were substantial (e.g. [296]). There
was no evidence that, apart from the generality of the disclosure of its being a counterparty
and entitled to a profit or fee, Grange informed any of the Councils of how much it stood to
make from any trade. But the evidence of the scale of its underwriting fees or profit on new
issues demonstrated, first, why Grange was involved in advising and recommending SCDOs
to its clients and, secondly, why it needed to provide, what it knew the products did not
independently have – a secondary market and liquidity.
941 If Grange had wished to obtain the Councils’ fully informed consent to its acting in its
position of conflict, it had to give advice and make disclosures to the standard identified in
Daly 160 CLR at 377, 384-385, see: [739]-[742]. Grange did not do so: [182], [192], [200],
[207], see also section 4.2.14, [340], [350]-[354].
6.3.2 Did Grange commit a breach of its fiduciary duty owed to Parkes?
942 For the same reasons as I have given in respect of Swan in section 6.3.1, Grange
breached each of its fiduciary obligations owed to Parkes (see section 4.4.3, [538]-[549],
[568]-[574], [584]-[585]).
6.3.3 Did Grange commit a breach of its fiduciary duty owed to each of Swan and Wingecarribee in respect of their IMP agreements?
943 I discussed, in sections 5.1.5 and 5.3.1 esp at [782], how the provisions of Sch 3 of the
Swan and Wingecarribee IMP agreements affected Grange’s fiduciary relationships with each
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Council after it entered into its agreement. In substance, Grange continued to owe the two
proscriptive fiduciary obligations to each of Swan and Wingecarribee after entry into the
respective IMP agreements. Grange did not obtain the fully informed consent of either
Council at any time to relieve it of those fiduciary obligations for the reasons I have given in
section 6.3.1.
944 Even if I were wrong to have found that Grange owed the particular fiduciary
obligations above, it owed fiduciary duties, as each Council’s agent, in making investments
on its behalf under the IMP agreements. The specific breaches of the IMP agreements that I
have found at [918] in respect of Swan and [930] in respect of Wingecarribee amount to
conduct that was a misuse of Grange’s agency, and hence, its more limited fiduciary duties in
that role.
945 Indeed, Grange’s conduct in respect of Wingecarribee’s inquiries as to how Grange
was remunerated was, as I have found at [618]-[620], hardly candid and was calculated to
mislead and deceive. And it succeeded. Far from making a full and frank disclosure, Grange
hid the truth in answer to a direct enquiry from Wingecarribee. That conduct was
unconscientious. It would not accord with the equitable obligations Grange had to make a
full and frank disclosure of the benefits it sought to gain by entry into the Wingecarribee IMP
agreement, by permitting these to be eschewed by a combination of its false pre-contractual
assertions and Sch 3 of the Wingecarribee IMP agreement.
946 I am of opinion that Grange did not obtain any fully informed consent from either of
Swan or Wingecarribee to relieve it from the two fiduciary obligations it owed each of them
under the IMP agreements.
6.4 Were the representations made by Grange misleading or deceptive?
6.4.1 The legislative context
947 The Councils relied on the various statutory provisions prohibiting corporations from
engaging in misleading or deceptive conduct. 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. For some purpose that is not evident the Parliament decided to remove
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elegant simplicity in its statutory drafting some years ago. Now the community and the
Courts must grapple with a labyrinth of statutes, all prohibiting such conduct, in relatively
general fields (such as s 18 of Sch 2 of the Competition and Consumer Act 2010 (Cth) and
see s 131A of that Act itself) and also in particular fields, such as s 1041H(1) of the
Corporations Act and s 12DA(1) of the ASIC Act. The latter two provisions state:
1041H(1) A person must not, in this jurisdiction, engage in conduct, in relation to a financial product or a financial service, that is misleading or deceptive or is likely to mislead or deceive. 12DA(1) A person must not, in trade or commerce, engage in conduct in relation to financial services that is misleading or deceptive or is likely to mislead or deceive. (emphasis added)
948 Of course, each Act has a myriad of complex definitions of what is a financial product
or a financial service or are financial services. Each Act gives a person, who suffers loss or
damage by conduct of another in contravention of the prohibition, the right to compensation
(e.g. s 1041I(1), s 12GF) coupled with substantively identical related exceptions and
qualifications concerning proportionate liability. Since the end result of this legislative
morass seems to be the same, it is difficult to discern why the public, their lawyers (if they
can afford them) and the Courts must waste their time turning up and construing which of
these statutes applies to the particular circumstance. Here, should it make any difference
whether Grange was alleged to have engaged in conduct in relation to “financial services”
(s 12DA(1)) or “a financial product or a financial service” (s 1041H(1))? Why is there a
difference? Why does a court have to waste its time wading through this legislative porridge
to work out which one or ones of these provisions apply even though it is likely that the end
result will be the same? As Edmund Davies LJ lamented in The “Putbus” [1969] P 136 at
152:
“Were bewilderment the legitimate aim of statutes, the Merchant Shipping (Liability of Shipowners and Others) Act, 1958, would clearly be entitled to a high award. Indeed, the deep gloom which its tortuousities induced in me has been lifted only by the happy discovery that my attempt to construe them has led me to the same conclusion as my brethren.”
949 For present purposes I will assume that it is sufficient to deal under the ASIC Act with
the resolution of the issues concerning misleading or deceptive conduct. That provided, in
s 12BAB(1)(a) that, relevantly a person provides a “financial service” if they “provide
financial product advice”. Next, s 12BAB(5) provided:
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“(5) For the purposes of this section, financial product advice means a recommendation or a statement of opinion, or a report of either of those things, that:
(a) is intended to influence a person or persons in making a decision in
relation to a particular financial product or class of financial products, or an interest in a particular financial product or class of financial products; or
(b) could reasonably be regarded as being intended to have such an
influence; but does not include anything in: (c) a document prepared in accordance with requirements of Chapter 7
of the Corporations Act, other than a document of a kind prescribed by regulations made for the purposes of this paragraph; or
(d) any other document of a kind prescribed by regulations made for the
purposes of this paragraph.”
950 The parties did not suggest that any of the exceptions in s 12BAB(5)(c) and (d) was
applicable. Thus, in providing the Councils with its recommendation, advice or opinion in
respect of the Claim SCDOs and other SCDOs in evidence, Grange gave financial product
advice within the meaning of s 12BAB(5). That was because when Grange gave a
recommendation, advice or opinion it intended to influence the Council officer to buy or sell
the product or products concerned. Therefore, Grange provided a financial service on each
such occasion within the meaning of s 12BAB(1)(a).
951 When Grange recommended or advised each of Swan (before their IMP agreement)
and Parkes to buy or sell an SCDO, or invest in SCDOs as a class, it gave financial product
advice. That is because Grange intended to influence the Council to make a decision in
relation to a “security”, defined as a financial product in s 12BAA(7) but not otherwise
defined in the ASIC Act. The SCDOs were notes issued by an SPV that evidenced the debt
owed by it to the investors. An SCDO is a “security” in ordinary parlance. One sense of the
word in the Oxford English Dictionary online is:
5 e. Chiefly in pl. Originally: a document held by a creditor as a guarantee of the right to payment, or attesting ownership of property, stock, bonds, etc.; (hence) the financial asset represented by such a document. Also (orig. and chiefly U.S.): such a document issued to investors to finance a business venture.
And, the Macquarie Dictionary online gives these definitions:
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6. Law a. something given or deposited as surety for the fulfilment of a
promise or an obligation, the payment of a debt, etc. b. someone who becomes surety for another. c. an evidence of debt or of property, as a bond or a certificate of stock.
7. (usually plural) stocks and shares, etc. [Middle English, from Latin sēcūritas]
952 Grange also recommended to each of Swan and Wingecarribee, or advised each
about, the characteristics of the classes of investments it would make under the IMP
agreements if the Councils entered into them. That recommendation or advice was intended
to influence the Councils in making a decision to allow Grange to include securities in the
form of SCDOs in their portfolios under the IMP agreements (see s 12BAB(5)(a) and
s 12DA(1)).
953 The Councils alleged that each of representations (1)-(4) that I have found in sections
5.1.3, 5.2.3 and 5.3.2 that Grange made to them was misleading or deceptive. They also
alleged that representations (2), (3))(d)-(g) and (4) were made by Grange with respect to a
future matter without it having reasonable grounds for doing so, for the purposes of s 12BB
of the ASIC Act. That section provided:
“12BB Misleading representations with respect to future matters
(1) If:
(a) a person makes a representation with respect to any future matter (including the doing of, or the refusing to do, any act); and
(b) the person does not have reasonable grounds for making the
representation;
the representation is taken, for the purposes of Subdivision D (sections 12DA to 12DN), to be misleading.
(2) For the purposes of applying subsection (1) in relation to a
proceeding concerning a representation made with respect to a future matter by:
(a) a party to the proceeding; or (b) any other person;
the party or other person is taken not to have had reasonable grounds for making the representation, unless evidence is adduced to the contrary.
(3) To avoid doubt, subsection (2) does not:
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(a) have the effect that, merely because such evidence to the
contrary is adduced, the person who made the representation is taken to have had reasonable grounds for making the representation; or
(b) have the effect of placing on any person an onus of proving
that the person who made the representation had reasonable grounds for making the representation.
(4) Subsection (1) does not by implication limit the meaning of a
reference in this Division to:
(a) a misleading representation; or (b) a representation that is misleading in a material particular; or (c) conduct that is misleading or is likely or liable to mislead;
and, in particular, does not imply that a representation that a person makes with respect to any future matter is not misleading merely because the person has reasonable grounds for making the representation.”
954 There was no issue that evidence had been adduced at the trial, within the meaning of
s 12BB(2), of reasonable grounds for Grange making each of the representations as to future
matters for Grange complained of. That cast the onus onto the Councils to prove that Grange
did not have reasonable grounds for making each of representations (2), (3)(d)-(g) and (4):
North East Equity Pty Ltd v Proud Nominees Pty Ltd (2012) 285 ALR 217 at 224 [30] per
Mansfield, Greenwood and Barker JJ.
6.4.2 Were representations (1)(a) and (2) misleading or deceptive?
955 Representation (1)(a) has considerable overlap with representation (2) in relation to
whether the Claim SCDOs complied with a conservative investment strategy. Similarly
representation (1)(b) has some overlap with representation (3)(g) in relation to whether the
Claim SCDOs complied with the Councils’ policies. I will deal with the latter two in section
6.4.3. Representations (1)(a) and (2) were:
“(1) 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 …
(2) Grange observed prudent, conservative income defensive, capital protective and pro-liquidity practices when investing on behalf of local government authorities or investing with conservative investment strategies.”
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956 Each Council had a conservative investment strategy before it began dealing with
Grange. Grange promoted its SCDO products to both Parkes and Swan as “very attractive
instruments for the more conservative investor, or for the defensive or capital-stable portion”
of a portfolio, as Ms May wrote to Mr Bokeyar on 13 June 2003 ([478]), [479], see too [520]-
[521] and, in respect of Swan: [178]-[179], [208]). Mr Hyde told Grange that Wingecarribee
was a very risk-averse client at their initial presentation ([625]). Mr Rosenbaum and Mr
Calderwood told Wingecarribee’s finance committee, on 21 February 2007, of their
understanding of Wingecarribee’s conservative approach to investment of its funds ([680],
[687]). On 12 March 2007 Mr Calderwood wrote to Mr Neville saying that “The current
portfolio for Wingecarribee has been constructed conservatively” ([687]).
957 Representations (1)(a) and (2) were not correct. Investment in SCDOs was not
consistent with a conservative investment strategy. That is because, 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. Such a strategy
included the prudent person approach that the Councils took, in the sense I have explained in
section 6.2.7. For the reasons in section 6.2.2, SCDOs, including the Claim SCDs, did not
provide such a high level of protection.
958 The starkest demonstration that representations (1)(a) and (2) were not correct can be
seen in Grange’s own behaviour in the period between 16 and 19 February 2007 after Mr
Calderwood’s visit to Wingecarribee on 16 February 2007 (section 4.5.5). As I have
explained in [673] and [930] Grange sold nine SCDOs to Wingecarribee at about $728,000
more than its own contemporaneous valuation of them. In addition, on 19 February 2007
Grange borrowed $2 million on a “repo” of Scarborough product at face value, without
giving its mandate client the reduction of 8% in value at which it had this product on its own
books. That was not a conservative investment or one which a prudent person would
undertake.
959 For these reasons, representations (1)(a) and (2) were false, and hence Grange
contravened s 12DA(1) by making them.
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960 In addition, representation (2) was made as to future matters. Grange did not have
reasonable grounds to make it because SCDOs had the inherent features identified in section
6.2.2 that made investment in that class of product imprudent. The class of products being
SCDOs and the Claim SCDOs lacked a high level of security for the protection of the
Councils’ capital.
6.4.3 Were representations (1)(b) and (3)(g) misleading or deceptive?
961 Representation (3)(g) specifically asserted that each Claim SCDO had a maturity date
suitable to the particular Council’s needs and complied with its investment policies. Parkes
did not contend that representation (3)(g) was falsified in respect of its investments.
Representation (1)(b) was more general. It stated that investments including, the Claim
SCDOs that Grange recommended or made, on the Councils’ behalf, complied both with
statutory and investment policy requirements. Representations 1(b) and (3)(g) were:
“(1) investments, including the Claim SCDOs, that Grange recommended to, or made on behalf of, each Council:
…
(b) complied with statutory and Council policy requirements. …
(3) the Claim SCDOs:
(g) had maturity dates that were suitable to each Council’s needs and
complied with its investment policies.”
962 Representation (1)(b) was false because of my finding that investing in SCDOs,
including the Claim SCDOs, was not in accordance with the requirements of the prudent
person test. That test was applicable to the exercise of the Councils’ investment
powers [902]; see section 6.2.7. Moreover, Grange made the recommendations or
investments without any particular consideration of the relevant statutory or policy
requirements applicable to the individual Council. Rather, as Ms Perrott suggested in August
2005, Grange was intent on using its position to produce “sausages” by causing the Councils
to invest in whatever SCDO product it wished to sell at the time (see [915]-[916]).
963 Representation (3)(g) was also false in respect of a number of the Claim SCDOs in
which Swan and Wingecarribee invested. The 2003 Swan Policy provided for a five year
maximum term to maturity of investments (cl 2.6(a)(ii): [175]). As Grange pointed out, Mr
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Downing consciously invested in the Blaxland product knowing it had a maturity 5.5 years
later and so was for longer term than provided in the 2003 Swan Policy: [333]. Swan cannot
complain that Grange caused this investment to be made in breach of representation (3)(g).
964 However, the Blaxland product had only one maturity date. Mr Downing did not turn
his mind to the possibility that other products, such as the Torquay Claim SCDO, had a final
maturity date outside the five year limit, if their call dates were within it. That was because
he had been assured by Mr O’Dea that no product had ever gone beyond the first maturity or
call date as I have explained at [108]-[110], [347]. Thus, while Mr Downing understood that
there was a risk that the principal due from a product might not be paid on the first maturity
or call date, he acted on Grange’s advice that this was not a real risk and that he, in effect,
should treat this date as the maturity date. That advice caused Mr Downing to ignore the
provisions of cl 2.6(a)(ii) when investing in products such as the Balmoral Claim SCDO:
[347].
965 Grange had agreed to invest in accordance with the 2003 Swan Policy in Sch 2 of
their IMP agreement. Accordingly, Grange had no authority to invest, or continue an
investment, in a product that matured more than five years from the date of that agreement
(see [362]). Thus, Grange’s investments in the Coolangatta and Federation Claim SCDOs
falsified represenatation (3)(g) (see [369]-[370], [376]).
966 Additionally, I infer that Grange, itself, took the view that the relevant date was the
first maturity or call date for the purposes of compliance with the five year limit to maturiy in
cl 2.6(a)(ii) of the 2003 Swan Policy. It follows that when it represented that to Mr Downing,
it made representation (3)(g) as to how it would invest in the future and under the Swan IMP
agreement for the purposes of s 12BB of the ASIC Act. Although Grange understood that no
SCDO had ever run past the first maturity or call date, it was not reasonable for Grange to
ignore or dismiss the effect of the legal structure of the products. It was conscious of the real,
and not merely, theoretical risk of the occurrence of extreme market events for the reasons in
sections 6.2.2-6.2.5. It follows that Grange did not have reasonable grounds for making
representation (3)(g) to Swan.
967 Wingecarribee did not have an investment policy or other limitation in its IMP
agreement in respect of the term to maturity of any investment. However, it had made clear
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to Grange during the presentation on 18 December 2006, that the Council needed liquidity
and could not have its funds tied up in long term securities that could not be realised: [629].
Grange was aware from this, and the Council’s plan for the leisure centre, that Wingecarribee
needed liquid and capital secure investments. Grange acknowledged that awareness and the
requirement for its investments to be suitable for Wingecarribee’s needs, during the finance
committee meeting of 21 February 2007: [682]-[687]. Despite this Grange invested
Wingecarribee’s funds in products, such as the Federation Claim SCDO, that had maturity
dates many years into the future.
968 Accordingly, representation (3)(g) was false with respect to Wingecarribee. Since it
was made at the meetings of 18 December 2006 and 21 February 2007 it was also made with
respect to a future matter for the purposes of s 12BB. For the same reasons I have given on
this point in respect of Swan at [966], Grange did not have reasonable grounds for making
representation (3)(g) to Wingecarribee.
6.4.4 Were representations (3)(a), (b) and (c) misleading or deceptive?
969 Representations (3)(a), (b) and (c) dealt with equivalence of the risk profiles, or
material risks, of the Claim SCDOs to traditional FRNs, other financial products with the
same ratings and the four major Australian banks. Representations 3(a), (b) and (c) were:
“(3) the Claim SCDOs:
(a) were, or had, risk profiles [i.e. material risks] equivalent to, traditional FRNs;
(b) were equivalent as regards risk profile [i.e. material risks], to other
types of financial products with the same rating; (c) were, or had risk profiles [i.e. material risks], equivalent to or better
than the four major Australian banks;”
970 The Councils argued that Grange had conveyed to them that the risks of investing in
SCDOs were equivalent to the risks of investing in FRNs. They referred to Grange’s use of
its explanations of the merits of FRNs sent to each of Swan and Parkes before either Council
invested in an SCDO. The Councils contended that Grange should have given them a clear
and straightforward appraisal of the differences between the products. They argued that, for
example, Ms May’s proposal to Mr Bokeyar of a switch from a Bank West FRN (i.e. an ADI
issued FRN) to the Griffin SCDO in her emails of 2 April 2003 was misleading. There she
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described the Griffin SCDO as an “a straight floating rate note with a coupon of 90 day
BBSW + 120”: [464]. The Councils argued that because such a switch of products
represented a fundamental change in investment products, Ms May had to give Mr Bokeyar
such an appraisal.
971 Grange argued that it had only used the concept of a floating rate note to explain to
the Councils that the SCDOs provided coupon payments in a similar way to FRNs – i.e. by
paying a coupon expressed as the 90 day BBSW + specific basis points. It contended that
this was the effect, when read in context, of statements such as those in Ms May’s email to
Mr Bokeyar of 2 April 2003.
972 I reject that argument. Grange’s marketing strategy can be discerned from its
consistent representation to each of the three Councils of SCDOs as FRNs. It had sent
written explanations to each of Swan ([178]-[180]) and Parkes ([436]) before promoting any
SCDO to it, that emphasised the desirability and Grange’s recommendation that local
councils invest in ADI issued FRNs. Similarly, no-one from Grange gave a written
explanation of CDOs or SCDOs to Wingecarribee before, and more importantly after, Mr
Neville’s query about the description of “Floating Rate CDO” that appeared in the 12
February 2007 repo contract notes: [657]. Rather, Mr Calderwood attended at the meeting
on 16 February 2007 and used the whiteboard to explain to Mr Neville and Mr Dunn that
FRNs were products “structured” by banks. He asserted that an “FRN” was shorthand for an
interest rate comprised of a benchmark plus a margin. His explanation was calculated to
make the Council officers think that CDOs (he did not use the word “synthetic”) were an
unexceptional, secure variety of the kind of ADI issued FRNs with which Mr Neville and Mr
Dunn were familiar: [657]-[664].
973 I found that, in its context, Ms May’s email of 2 April 2003 and her oral explanation
hit its mark, as it was calculated to do. Mr Bokeyar understood that a “straight FRN” was
like the instruments that he had arranged for Parkes to buy from the bank and the earlier ADI
issued FRN investments it had made through Grange. He understood that FRN instruments
were secure and nothing out of the ordinary: [465]-[467]. Grange did not cross-examine Mr
Bokeyar to suggest that the distinction between an FRN and SCDO or CDO was obvious to
him. It certainly was not apparent to him and Grange’s communications with him did not
make it so.
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974 The Council officers relied on Grange’s portrayal of SCDOs as FRNs whose ratings
signified that there was no real likelihood of the products’ default or the Council suffering
any loss (see too: for Swan [219], [255]). Yet, as Mr Portlock had observed in his initial
“Re: CDOs: The Free Lunch” email of 22 September 2006, the ratings by Standard &
Poor’s (based on the probability of incurring the first dollar of loss) were “not terribly helpful
for comparing investments with substantially different pay-off profiles (the underlying
portfolio and the CDO tranches)”. He also noted that although Moody’s ratings were based
on expected loss, “comparing a Moodys rated AA single name credit with a Moodys rated
AA CDO tranche, both investments carry the same expected (default) loss so this cannot
explain the difference in coupons”: [133]-[141]. This reflected similar conclusions to those
reached by the 2005 Working Group and the Banque de France about the use of comparisons
between SCDOs and other financial products such as FRNs or products with similar ratings,
or the four major Australian banks: see section 3.5, esp [67]-[70], [83]-[84], and sections
6.2.2-6.2.5, 6.2.7, esp [846]-[847], [890].
975 Another reason why the risk profiles of SCDOs were not equivalent to the three other
product classes arises out of an argument that Grange put in cross-examination and in its
submissions. That argument was that the higher coupons offered by SCDOs sold by Grange
over coupons offered by equivalent rated products, ADI issued FRNs and the AA- rated four
major banks, indicated that the SCDOs had higher risk. The concept of higher risk of SCDOs
was studiously avoided by Grange when it made these false comparisons of safety and risk
equivalence to the Councils to persuade them to invest. The Council officers were risk
avoidant, financially unsophisticated and uninformed. Grange sold the products using the
misleading and deceptive representations that investment in the SCDOs had equivalent risk of
loss of the Councils’ invested capital to investment in “traditional” FRNs, equivalently rated
products and the four major Australian banks. 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.
976 Accordingly, I am satisfied that each of representations (3)(a), (b) and (c) was false.
6.4.5 Were representations (3)(d), (e), (f) and (4) misleading or deceptive?
977 Representations (3)(d), (e), (f) and (4) conveyed that the Claim SCDOs offered
excellent liquidity, were as liquid as traditional FRNs, were and would be readily redeemable
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in a secondary market and that Grange would facilitate this. Representations (3)(d), (e), (f)
and (4) were:
“(3) the Claim SCDOs:
(d) offered excellent liquidity; (e) were as liquid as traditional FRNs; (f) were and would be readily redeemable in a secondary market;
(4) Grange was active in the secondary market for SCDOs and was bound to buy
back the Claim SCDOs, if requested to do so, to provide liquidity in illiquid products.”
978 Those representations were false for the reasons in sections 6.2.3 and 6.2.4. Those
representations were also made about future matters. I am also satisfied that Grange did not
have reasonable grounds for making each of these representations for the reasons in sections
6.2.3 and 6.2.4. 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: see
too [98]-[100], [861], [866], [881], [884], [893], [915].
6.5 Did Grange breach its duty of care?
979 For the reasons I have given in respect of Grange’s breaches of its contractual
obligation to exercise reasonable skill and care, it was also in breach of its co-extensive duty
to tort owed to each of the three Councils: see [769], [790], [807], [819] as to the contractual
terms and tortious duties, and sections 6.2.7, 6.2.8 and 6.2.9 in respect of the breaches of the
contractual terms and tortious duties.
6.6 Grange’s claim for indemnity under the IMP agreements
980 Grange argued that cl 8 of the IMP agreements with each of Swan and Wingecarribee
contained a contractual indemnity in its favour. That required the Council to indemnify
Grange against any claim, loss, action, demand, damages and liability “… suffered or
incurred by Grange directly or indirectly in connection with … (c) anything lawfully done by
Grange under this agreement”. Grange contended that this indemnity applied to its
investment in the Claim SCDOs on behalf of each of Swan and Wingecarribee under their
IMP agreements. It claimed the right to set off the fruits of the indemnity against any
damages awarded to either Council.
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981 I reject this argument. Grange acted in breach of each IMP agreement, as I have held
in sections 6.2.8 and 6.2.9. Its conduct in so acting was not “lawfully done under” either IMP
agreement within the meaning of cl 8. That is because Grange was not authorised by the
Councils to act as it did, under the IMP agreement. A party’s breach of a contract is not an
act done under the contract but rather it is an act done contrary to, and in violation of, its
terms. The indemnity in cl 8 did not protect Grange from the consequences of its own
breach.
7. DAMAGES
7.1 The issues as to value of the Councils’ existing holdings of the Claim SCDOs
982 As at 19 September 2012, 9 claim SCDOs had not matured (being the Esperance AA+
(including any of these notes held as the residuum of the partial cash repayment of the
Esperance Combo Note), Glenelg AA, Kakadu AA, Newport, Nexus 4 Topaz, Parkes (11A)
AA, Parkes (1A) AAA and the Lehman Bros Property Note products). In addition, the fate of
the capital in 10 Dante notes was still uncertain. The Councils claimed to have suffered
crystallised losses on a further 11 Claim SCDOs that have matured (either because the
Councils sold their holding at a loss or there were defaults in the investors’ tranche that
triggered payment under the supporting credit default swap), 3 other Claim SCDOs (Blue
Gum, Scarborough and Torquay) have been wiped out by losses and 7 have matured without
any loss being suffered by the Councils (apart from a small agreed loss of $5,935 claimed by
Parkes in respect of the Octagonal product). It was common ground that on the “left in hand”
measure of damages, as a result of each of the Councils holding the 3 wiped out SCDOs, they
suffered losses of $2.5 million (Swan), $4 million (Parkes) and $6.25 million
(Wingecarribee). It was also common ground that Parkes had suffered a crystallised loss on
the maturity of the Green product of $525,750 and Swan a loss of $35,000 on the maturity of
the Flinders product. There are two relatively small issues about the assessment of loss in
respect of earlier sales at a loss by Swan and Parkes of the Kalgoorlie product, and the sale at
a loss by Parkes of the Blaxland product. Both the Kalgoorlie and Blaxland notes
subsequently matured in early 2012 and were redeemed without loss. I have already found
above that Wingecarribee is entitled to recover $2,550,000 in damages as its loss on the sale
of the Federation product in January 2008 [716]-[718].
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983 There are significant issues as to how to value the 9 unmatured Claim SCDOs and the
10 Dante notes. The parties asked that I identify the applicable principles for assessment of
damages in these reasons but not make any orders to give these effect until they have had an
opportunity to address on the relief to be ordered. I will first deal with the principles for
assessing damages under the various bases of liability. Next, I will address the assessment of
losses from the early sales of the Kalgoorlie and Parkes products. I will then deal with the
competing arguments as to valuation of the 19 products that comprise the unmatured non-
Dante notes and the Dante notes.
7.1.1 The appropriate measure of damages - principles
984 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. The Councils seek
damages in contract to compensate them for the losses that they sustained because the Claim
SCDOs:
did not have the characteristics in the contractual terms (1), (2), (3) and (4) in
respect of those sold to Swan before its IMP agreement and to Parkes;
did not meet the contractual requirement in the Swan IMP agreement of
providing the Council with ready access to funds for its day to day
requirements without penalty in accordance with cl 2.1 of the 2003 Swan
Policy: [908];
did not meet the contractual requirement in cl (c) of Sch 2 of the
Wingecarribee IMP agreement that all securities must have an active
secondary market: [925]-[926].
The Councils are also entitled to have damages assessed in respect of Grange’s breach of its
obligation in all the contracts (including the IMP agreements) to exercise reasonable skill and
care by investing, or recommending or advising that the Councils invest, in the Claim
SCDOs.
985 Grange argued, as its primary position, that the appropriate principles to measure the
Councils’ damages under each of the first three of those heads were those identified by
Dixon J in Potts v Miller (1940) 64 CLR 282 at 298 (RWS 633, 689, 692). Grange argued
that the application of those principles should result in the Councils’ damages being
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quantified by deducting from the purchase price of each Claim SCDO its “true value” at that
time, as calculated by Mr Finkel in his valuation report.
986 Grange argued that it was not appropriate to assess the Councils’ loss on their
preferred basis, namely the difference between the price paid for the Claim SCDO less its
value as presently proved: i.e. the value of what was “left in each Council’s hands”: cf
Astonland 217 CLR at 666-667 [63]. However, Grange accepted that the approach that
should be used to assess damages would depend on the basis on which it was found to be
liable. It recognised that a finding that there was no secondary market or liquidity would
make an assessment on the principle in Potts 64 CLR at 298 less justifiable. But, Grange
stressed that the actual calculation of the Councils’ damages should not be made in a way that
gave them a different result in Grange’s liquidation compared to its other creditors who have
similar claims. Grange’s concern was to avoid fixing values at a particular date (on the “left
in hand” test) that might differ from the Claim SCDOs’ values at other dates on which those
other creditors might be admitted to proof of their debts.
987 Grange’s principal argument may not have maintained the essential distinction
between the principles applicable to the assessment of damages for breach of contract and
those for the tort of deceit. It also may not have reflected the more flexible principles
provided for assessing compensation under s 12GF of the ASIC Act and its analogues. In my
opinion, for the reasons which follow, the Council’s damages should be assessed on the “left
in hand basis” for all their claims.
988 The general rule of the common law treats the starting point for the assessment of
damages for breach of contract, as requiring the innocent party to be placed in the same
situation, so far as money can do it, as it would have been in if the contract had been
performed: Robinson v Harman (1848) 1 Exch 850 at 855 per Parke B; Burns v MAN
Automotive (Aust) Pty Ltd (1986) 161 CLR 653 at 667 per Wilson, Deane and Dawson JJ.
However, Wilson, Deane and Dawson JJ explained that this general principle is limited by
the rule in Hadley v Baxendale (1854) 9 Exch 341 at 354 per Alderson B as follows (161
CLR at 667):
“These well-known principles have been discussed by Gibbs J. (as his Honour then was) in Wenham v. Ella ((1972) 127 CLR 454 at pp 471-472). His Honour reminds us that the rule in Hadley v. Baxendale was expounded in C. Czarnikow Ltd. v. Koufos ([1969] 1 AC at p 385), where Lord Reid said:
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‘The crucial question is whether, on the information available to the defendant when the contract was made, he should, or the reasonable man in his position would, have realised that such loss was sufficiently likely to result from the breach of contract to make it proper to hold that the loss flowed naturally from the breach or that loss of that kind should have been within his contemplation.’”
989 In order to give effect to these principles, the common law generally enables the
innocent party to recover two types of loss that flow from a breach of contract, namely:
reliance damages (which is similar to the usual measure of damages in tort) and expectation
damages. In Gates v City Mutual Life Assurance Society Ltd (1986) 160 CLR 1 at 11-12
Mason, Wilson and Dawson JJ explained the difference in the contractual and tortious
measures of damages. In so doing, they demonstrated a flaw in Grange’s argument that the
approach in Potts 64 CLR at 298 was the most appropriate measure for assessing the
damages suffered by each Council for each of their causes of action in contract, tort and
under s 12GF(1) saying:
“In contract, damages are awarded with the object of placing the plaintiff in the position in which he would have been had the contract been performed — he is entitled to damages for loss of bargain (expectation loss) and damage suffered, including expenditure incurred, in reliance on the contract (reliance loss). In tort, on the other hand, damages are awarded with the object of placing the plaintiff in the position in which he would have been had the tort not been committed (similar to reliance loss). The differences and the similarities between the two approaches are best illustrated by contrasting the damages recoverable for breach of contractual warranty on a purchase of goods with those recoverable for a fraudulent misrepresentation inducing entry into a contract for the purchase of goods on the assumption that the contracts are identical except that in one case the representation amounts to a warranty and in the other it is merely a noncontractual representation. For breach of warranty the plaintiff is prima facie entitled to recover the difference between the real value of the goods and the value of the goods as warranted. In deceit the measure of damages is the difference at the time of purchase between the real value of the goods, and the price paid: Potts v. Miller ((1940) 64 C.L.R. 282 at pp. 289, 297); Toteff v. Antonas ((1952) 87 C.L.R. 647 at pp. 650-651, 654); Gould v. Vaggelas ((1984) 157 C.L.R. 215 at p.220). But this has been treated as a prima facie measure only, the true measure being reflected in the proposition stated by Dixon J. in Toteff v. Antonas ((1952) 87 C.L.R. at p. 650) in these terms:
“In an action of deceit a plaintiff is entitled to recover as damages a sum representing the prejudice or disadvantage he has suffered in consequence of his altering his position under the inducement of the fraudulent misrepresentations made by the defendant.”
As his Honour then pointed out, it is a question of determining how much worse off the plaintiff is as a result of entering into the transaction which the representation induced him to enter than he would have been had the
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transaction not taken place. This entitles the plaintiff to all the consequential loss directly flowing from his reliance on the representation (Potts v. Miller ((1940) 64 C.L.R. at pp. 297-298); Doyle v. Olby (Ironmongers) Ltd. ([1969] 2 Q.B. 158)), at least if the loss is foreseeable: see Gould v. Vaggelas ((1984) 157 C.L.R. at pp. 223-224).” (emphasis added)
990 Thus, the measure of damages in tort utilised by Dixon J in Potts 64 CLR at 298 is not
prescriptive; rather it is a prima facie measure. The measure that the Court will adopt to
quantify the damages in tort will depend on how the applicant has been prejudiced as a result
of altering his, her or its position under the inducement of the misrepresentations(s) made by
the respondent. In Astonland 217 CLR at 656-659 [35]-[40], Gleeson CJ, McHugh,
Gummow, Kirby and Heydon JJ discussed the principles on which the Court acts and the
varieties of approach that the Court can adopt in arriving at a measure of damages appropriate
to compensate a person who has been induced to alter his, her or its position by a fraudulent
or misleading or deceptive representation.
991 The measure of damages provided by s 12GF(1) of the ASIC Act and its analogues for
a respondent’s contravention of the norm of conduct imposed by s 12DA(1) is more flexible.
In Astonland 217 CLR at 656-657 [35]-[36] and 666-667 [63], the Court recognised that at
least two possible yardsticks could be adopted to assess the measure of damages in such
cases. These were, first, the difference between the price paid for the asset and its “real” or
“intrinsic” value, worth or what would have been a fair price for the asset at the time of its
purchase in the circumstances and, secondly, the difference between the purchase price and
what was later left in the applicant’s hands (the left in hand test). I explained these
measures in Ackers v Austcorp International Ltd [2009] FCA 432 at [445]-[449] as follows:
“445 In Astonland 217 CLR 658-659 [38]-[40] the Court indicated that subsequent events could be used to arrive at an assessment of the real value of an asset for the purposes of calculating compensation under s 82 of the Act in respect of a claim of overpayment at the time of acquisition. Events after the date of acquisition can be taken into account but when that is done care must be taken in distinguishing among possible causes of the decline in value of what had been bought. Thus, there is a fundamental distinction between causes inherent in the property acquired, and independent or extrinsic causes. To the extent that the latter causes have affected the value, then loss flowing from them would not have been caused by the inducement of the misleading or deceptive conduct. But if the value of the property acquired was always going to fall when some inherent cause began to operate (e.g. when a competing property, not adverted to by the negligent valuer in performing the valuation for the acquisition, commenced operation) that would be indicative of the true value. Such a loss in the value was, accordingly, inherent in the nature of what was purchased namely, that it would decline in value because
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of the operation of the competing property in close proximity: Astonland 217 CLR at 660 [43].
446 Their Honours said that the rental levels and, therefore the value of,
Astonland’s property were doomed from the start because, so long as the construction of the neighbouring shopping centre continued to completion, the plaintiff’s loss would be inevitable. In such a case the court is not limited to the assessment of risk of loss at the time of purchase “… but is entitled to take account of how those risks had evolved into certainties at dates after the date on which the comparison of price and true value was being made”: Astonland 217 CLR at 661 [45]-[46]. The Court continued:
“[46] Figures worked out by analysing what willing but not anxious buyers
and willing but not anxious sellers would agree on, without taking account of subsequent events, may correspond with market value; but they do not necessarily correspond with true value because the market can operate under some material mistakes. In particular, some material factor may not be apparent to it. A mistake of this kind, it seems likely, was present here. Though the market value on 21 April 1997 was $400,000, and in July 1997 it was $375,000, one matter was not apparent then which was apparent later. The trial judge found that $130,000 was "the value of the land more or less since it became apparent that tenants were largely unavailable except at minimal rentals" (footnote omitted). That unavailability was an inevitable consequence of the Beach Road Shopping Centre once it was completed, but the perception of the likely effect of that completion was obscure in 1997, and only became clearer from the latter part of 1998 on.”
447 Gleeson CJ, McHugh, Gummow, Kirby and Heydon JJ considered an
alternative approach to the assessment of damages under s 82. That approach was to allow a plaintiff to recover the purchase price of the asset less whatever was “left in its hands”: Astonland 217 CLR at 666-668 [63]-[67]. They concluded that once the plaintiff had been induced to buy the property “… at a time when it was perceived to be valuable, and was forced to retain it because it increasingly became to be perceived as being of declining utility and value”: Astonland 217 CLR at 668 [67]. In such a situation the plaintiff’s property was not a readily marketable asset.
448 It is important for this purpose to have regard to the statutory subject, scope
and purpose of the Trade Practices Act, as Gummow, Hayne and Heydon JJ observed in Allianz Australia Insurance Limited v GSF Australian Pty Limited (2005) 221 CLR 568 at 597 [99]. Thus, s 2 of the Act states:
“The object of this Act is to enhance the welfare of Australians through the promotion of competition and fair trading and provisions of consumer protection.”
449 Their Honours explained the principles of assessment of loss under s 82 as
follows (Allianz 221 CLR at 597-598 [100]):
“[100] In I & L Securities Pty Ltd v HTW Valuers (Brisbane) Pty Ltd (2002) 210 CLR 109 at 119 [26]), Gleeson CJ said of the construction of s 82:
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‘When a court assesses an amount of loss or damage for the purpose of making an order under s 82, it is not merely engaged in the factual, or historical, exercise of explaining, and calculating the financial consequences of, a sequence of events, of which the contravention forms part. It is attributing legal responsibility; blame. This is not done in a conceptual vacuum. It is done in order to give effect to a statute with a discernible purpose; and that purpose provides a guide as to the requirements of justice and equity in the case. Those requirements are not determined by a visceral response on the part of the judge assessing damages, but by the judge's concept of principle and of the statutory purpose.’
The upshot in I & L Securities was the holding stated by Gaudron, Gummow and Hayne JJ (I & L Securities (2002) 210 CLR 109 at 128 [57] (footnotes omitted)). (See also at 121-122 [33], per Gleeson CJ; at 132 [69] per McHugh J.):
‘[T]he question presented by s 82 of [the TP Act] is not what was the (sole) cause of the loss or damage which has allegedly been sustained. It is enough to demonstrate that contravention of a relevant provision of [that] Act was a cause of the loss or damage sustained.’ (Original emphasis.)”
992 Here, the Claim SCDOs were not readily marketable assets except for so long as
Grange chose and was able to provide its own secondary market. Once it purchased a Claim
SCDO each Council was locked into holding it in that context. Thus, in the event that a
general or systemic extreme market event occurred, the Council could not sell the asset and it
was, and continued to be, peculiarly susceptible to a greater risk of loss of value than
similarly rated products, as I have explained in sections 6.2.2-6.2.5, 6.2.7-6.2.9. Grange’s
breaches of contract, negligent misrepresentations and misleading and deceptive conduct that
I have found, continued to operate after the date of acquisition of each Claim SCDO and were
calculated to, and did, induce the Councils to retain (or Grange, acting under its mandate in
each IMP agreement, retained) each Claim SCDO, or another Claim SCDO for which the
original investment had been switched. That inducement to retain or retention continued to
operate. And, as Mr Clout said in his email of 9 August 2004, Grange controlled the CDO
market: [300]-[301], [780], [805], section 6.2.3. By the time that the matters that I have
found to be breaches of contract or misrepresentations began to become manifest, as initial
effects of the global financial crisis were felt, the Councils were locked into their investments
in the Claim SCDOs: cf Astonland 217 CLR at 668 [66]-[67].
993 It would be artificial and unfair to assess the Councils’ losses by adopting the prima
facie measure in Potts 64 CLR at 298. Had each Council understood that SCDOs had the
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risks or characteristics the subject of my findings of breach by Grange, it would never have
acted on Grange’s recommendation and advice to acquire such investments (in the cases of
Swan before its IMP agreement and Parkes) or would never have entered into the IMP
agreement and so permitted such investments to be made.
994 The measure of damages in contract may provide more limited compensation in some
cases than that in tort, at least in cases of fraudulent misrepresentation or deceit. That is
because in the latter situation, which can also apply to claims for damages under s 12GF(1)
and its analogues, the injured party can recover consequential loss suffered by reason of
having acquired the assets, as Lord Denning MR explained in Doyle v Olby (Ironmongers)
Ltd [1969] 2 QB 158 at 167: see per Lord Browne-Wilkinson with whom Lords Keith of
Kinkel, Mustill and Slynn of Hadley agreed in Smith New Court Securities Ltd v Scrimgeour
Vickers (Asset Management) Ltd [1997] AC 254 at 264H-265F, Astonland 217 CLR at 666-
667 [63]; cf the caution expressed by Gibbs CJ in Gould v Vaggelas (1985) 157 CLR 215 at
223-224.
995 The compensation payable for Grange’s breaches of fiduciary duty is assessed based
on loss at the time of the trial with the full benefit of hindsight: Canson Enterprises Ltd v
Boughton & Co [1991] 3 SCR 534 at 555 per McLachlin J, applied by Gleeson CJ, McHugh,
Gummow, Kirby and Hayne JJ in Youyang Pty Ltd v Minter Ellison Morris Fletcher (2003)
212 CLR 484 at 499 [35]. The parties agreed on the principles for equitable compensation
summarised by Gordon J in Parker, In the matter of Purcom No 34 Pty Ltd (In Liq) (No 2)
[2010] FCA 624 at [23], where her Honour said:
“23 A number of principles are worth restating:
1. It is a “cardinal principle of equity” that the remedy is “fashioned to fit the nature of the case and the particular facts”: Warman International Limited v Dwyer (1995) 182 CLR 544 at 559; see also Hill v Rose [1990] VR 129 at 143.
2. Where a breach of fiduciary obligation occurs, compensation is
available in equity to make good the loss (Nocton v Lord Ashburton [1914] AC 932) and the plaintiff must elect between the remedy of equitable compensation and account of profits: Nocton [1914] AC 932 at 956-957; Warman 182 CLR 544 at 558; R Meagher, D Heydon, M Leeming, Equity: Doctrines & Remedies (4th ed, 2002) at 837.
3. Equitable compensation is assessed at the time of trial, with the full
benefit of hindsight and common sense, not at the date of breach:
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Youyang Pty Limited v Minter Ellison Morris Fletcher (2003) 212 CLR 484 at [35]; Re Dawson (deceased); Union Fidelity Trustee Co Ltd v Perpetual Trustee Co Ltd [1966] 2 NSWR 211 at 216; O’Halloran v RT Thomas & Family Pty Ltd (1998) 45 NSWLR 262 at 273 and 276.
4. The objective of equitable compensation is compensatory – to restore
the principal to the position it was in prior to the breaches and to make good any loss caused by the fiduciary’s wrongful conduct: see [75] of the Reasons; Nocton [1914] AC 932 at 952; Re Dawson (deceased) [1966] 2 NSWR 211; O’Halloran 45 NSWLR 262 at 272-273. No element of penalty is involved: R Meagher, D Heydon, M Leeming, Equity: Doctrines & Remedies (4th ed, 2002) at 837-839.
5. Unlike common law damages, equitable compensation is not limited
or influenced by common law principles of remoteness of damage, forseeability or causation: Hill v Rose [1990] VR 129 at 144; Canson Enterprises Ltd v Boughton & Co [1991] 3 SCR 534 at 556; O’Halloran 45 NSWLR 262 at 273.
6. However, there does have to be some causal connection between the
breach of fiduciary obligation and the loss for which compensation is recoverable. It is necessary for the plaintiff to establish that the loss would not have occurred but for the breach: O’Halloran 45 NSWLR 262 at 275–6. The necessary enquiry is whether the loss would have happened had there been no breach, not whether the loss was caused by or flowed from the breach: O’Halloran 45 NSWLR 262 at 276–277.”
7.1.2 How the damages should be assessed
996 Here, the parties were in a contractual relationship. Grange made a contract that
promised each Council that each financial product (relevantly, each Claim SCDO) it sold or
the services it would provide under each IMP agreement had the particular characteristics that
I have found to be contractual terms (1), (2), (3) and (4) (summarised at section 6.2.1). The
promise was a contractual warranty that each product had those characteristics. Each Claim
SCDO purchased by Swan (before the IMP agreement) and Parkes did not possess the
characteristics of terms (1), (2), (3) and (4). Accordingly, Grange’s sales of those products
amounted to breaches of contract as I found in sections 6.2.2-6.2.5. The damage suffered by
each of Swan and Parkes by reason of the total or partial impairment of a Claim SCDO arose
naturally from the breach of each of those 4 terms of the contract for its purchase. Such
damage was a loss that would have been within the contemplation of a reasonable person in
Grange’s position at the time each contract was made. So much follows from my findings of
the inherent nature of the SCDOs as well as Grange’s breach of term (6) of each of those
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contracts (i.e. that it failed to exercise reasonable care in making the recommendation or
giving the advice to the Council to purchase that product). Indeed, Grange was fully aware of
the explanations of risks in the issuers’ offering memoranda for the SCDOs it sold and
discussed these very kinds of risk in its internal emails: see e.g. [98], [854], [866]-[873].
Similarly, once Swan and Wingecarribee had given Grange the mandate to act under each
IMP agreement, Grange acquired Claim SCDOs for each of them. Those acquisitions were
breaches of contract, as well as the consequence of Grange’s breach of its duty of care in tort
and its misleading or deceptive representations: see sections 6.2.8, 6.2.9 and 6.4.2-6.4.5.
997 Moreover, once each Council purchased the Claim SCDO, and until Grange could no
longer make its secondary market or provide liquidity at or about face value, each of the
Councils was unaware of the nature or existence of the breaches of contract, and the inherent
risks of the SCDOs that I have found (see the authorities at [850]). Grange had maintained
the appearance of a secondary market, liquidity and the features of the SCDOs that I have
found them not to possess, so the Councils had no reason to exchange the Claim SCDOs for a
different investment. Once the impact of the global financial crisis began to bite, and the
reality of Grange’s breaches of contract were manifested, the Councils were locked into the
situation of holding those products.
998 Indeed, Grange’s argument about, for example, Wingecarribee’s sale of the
Federation Claim SCDO being unreasonable, shows how the Councils were then presented
with a form of Hobson’s choice: the potential of being damned in crystallised damages if
they sold at a particular point in time or damned in further, and potentially greater or lesser,
losses if they held onto these unsuitable products to see what might happen in the uncertain
future. Once the stage had been reached when Grange ceased to maintain a market and
liquidity at prices of about face value, there was no effective market or liquidity for the Claim
SCDOs. A sale of a Claim SCDO at anything like its face value was, and as the valuation
evidence shows still is, virtually impossible for a product that is not close to its maturity or
has suffered any substantive default in its reference portfolio. Those characteristics were
inherent in each product, but would only become manifest if a general or system extreme
market event occurred.
999 For the reasons above, I am of opinion that there are three scenarios in which damages
must be assessed for a Claim SCDO:
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if it has matured with a loss in the Council’s hands or has been wiped out (a
loss on maturity);
if it has been sold by the Council at a loss before it matured (a loss on sale);
if it has been retained by the Council but has not yet matured (a loss on
valuation).
Each of these scenarios is apposite because of the characteristics of the Claim SCDOs from
which each Council has suffered actual loss of their invested capital, as either a loss on
maturity or a loss on sale or, claim that it has suffered a loss on valuation. In those
circumstances, the Councils’ invested capital became vulnerable to at least one of the three
kinds of loss described above.
1000 There is a second subset of risks that should be mentioned. These could occur where
the existence of a secondary market or liquidity was important to an investor. The Claim
SCDOs were potentially also vulnerable to Grange ceasing, for whatever reason, to be able or
willing to provide those services. In the event, Grange’s inability to do so was caused by its
undercapitalisation and the impact on it of the development of the global financial crisis. It is
not necessary to explore the second alternative inherent subset of risks.
1001 The cardinal fact at the heart of the assessment process is that Grange caused the
Councils to buy the Claim SCDOs (either by recommending and advising them, or using its
IMP agreement mandate, to do so) in circumstances where they would not have done so at
all, had Grange fulfilled its contractual obligations, duty to exercise reasonable care and not
engaged in conduct that was misleading and deceptive or in breach of fiduciary duty. Thus, if
Grange had not caused the Councils to make the investments in the Claim SCDOs, they
would have invested in the classes of investments, such as bank bills and ADI issued FRNs,
as they had always done. There is no evidence that any of those forms of investment suffered
from any, let alone the actual, or still potential, substantial losses sustained by the Claim
SCDOs. The Councils would not have sustained losses on maturity and on sale, had they
made those other investments, and they would not have been at risk of sustaining their losses
on valuation in those circumstances.
1002 The subsequent event of the impact of the global financial crisis on the Claim SCDOs
can be viewed in two ways. Grange argued that this event occurred after the Councils could
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have sold earlier than June 2007 at no loss, and so should be regarded as an independent
cause of their losses. On the other hand, the Councils argued that what they understood were
conservative, risk averse investments, had an inherent flaw that would appear in such a
general or systemic extreme market event. The difference in approaches reflects
Cockburn CJ’s well known example (used in Astonland 217 CLR at 660 [43]) of a horse that
“dies of some latent disease inherent in its system at the time” of its purchase as distinct from
one that dies of a disease contracted after its purchase: Twycross v Grant (1877) 2 CPD 469
at 544-545. The purchaser can recover his outlay in the case of an inherent disease but not in
the disease contracted after purchase.
1003 In my opinion for the reasons I have given in sections 3 and 6, the Claim SCDOs were
in the nature of a potential disaster waiting to happen to the Councils because of their
inherent risks, rather than a sound investment that succumbed to an extraneous cause created
by the global financial crisis. Accordingly, the measure of contractual damages in the cases
of a loss on maturity and, subject to what I find in section 7.2.1, a loss on sale, is the
difference between the face value purchase price of each Claim SCDO and its capital value, if
any, on maturity or on its sale. Similarly, where the Councils have sustained a loss on
valuation, their damage is the difference between the price paid and the valuation arrived at
using the methodology in section 7.2.4.
1004 Grange argued that it would be necessary for the Councils to give credit for any
higher rate of interest that the Councils received from these products as compared to the
classes of investments they had previously made and would otherwise have continued to
make. Grange had the onus of proving that the Councils obtained any benefit that mitigated
the loss that they suffered. A court is entitled to look at the whole of the facts to ascertain the
result in assessing damages: British Westinghouse Electric and Manufacturing Company Ltd
v Underground Electric Railways Company of London Ltd [1912] AC 673 at 689-690 per
Viscount Haldane LC; Gull v Saunders & Stuart (1913) 17 CLR 82 at 89 per Barton ACJ,
Gavan Duffy and Rich JJ. In principle, the Councils must give credit for any betterment that
they have achieved in the calculation of their damages. However, Grange had to prove that
fact or demonstrate its actual existence on the evidence.
1005 Grange tendered no evidence to demonstrate that the Councils were better off to any
particular extent and made no substantive submissions enabling any such adjustments to be
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made. In my opinion, Grange did not discharge its onus to prove that the Councils had
achieved some better result for which they must give credit in the assessment of their
damages. In any event, such adjustments will also need to take account of the loss of any
interest income from any SCDOs that were wiped out, or reduced or ceased the payment of
interest (such as the Nexus 4 Topaz Claim SCDO).
1006 The real value of each Claim SCDO is the value that subsequent events have showed
was inherent in it at the time of its acquisition. Like the horse with the inherent disease, the
later unfolding of events (the development of the disease or, in the case of the SCDOs, the
occurrence of the risks) produced a result that would affect the products’ capacity to repay
the capital invested in them. The SCDOs lacked the financial soundness that Grange
warranted that they had to Swan (before the IMP agreement) and Parkes in contractual terms
(1), (2), (3) and (4) and to Swan and Wingecarribee in their IMP agreements. Likewise,
Grange’s breach of the contractual term to exercise reasonable skill and care resulted in each
Council investing in products with the same deficiencies. Had Grange performed its
contractual obligations, the Councils would not have lost any capital because they would
never have invested in any of the Claim SCDOs. If the damages were to be assessed on a “no
transaction” basis in tort or under s 12GF(1), a similar result must follow. Likewise, the
measure for equitable compensation identified by Gordon J in Purcom [2010] FCA 624 at
[23(6)] arrives at the same end, though by a different route: see [995].
7.2 Valuations of the Claim SCDOs
7.2.1 Swan’s and Parkes’ sales of the Kalgoorlie, Esperance and Blaxland Claim SCDOs
1007 Grange argued that Swan’s decision to sell the Kalgoorlie Claim SCDO in September
2009 was taken independently by the Council and that it was the author of its own loss. I
have explained the circumstances of the transaction in section 4.3.4. It resulted in a sale at
about $86.40 per $100 face value. Grange contended that the agreed value for the Kalgoorlie
notes at 28 January 2011 of $97.99 per $100 face value based on a sale at that date,
demonstrated that Swan’s earlier sale was unreasonable.
1008 I reject that argument. It uses hindsight to criticise Swan for acting at an earlier time
while in the position of difficulty into which Grange had placed it, by its original purchase of
the Kalgoorlie product under the IMP agreement: [364]. Swan acted on the advice of
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Oakvale in making the sale. Mr Cameron was not in the position of a soothsayer able to
predict the future in September 2009. The structure of the Kalgoorlie product was exotic. It
involved 11 commodity trigger swaps: see [60]. It was not a product that reflected an
investment that a conservative, risk averse local government body would make to place
public money. Mr Cameron was not cross-examined at all about the decision to sell. I am
not satisfied that Swan acted unreasonably. Indeed, it acted responsibly, on professional
advice, and reasonably in this sale: CFMEU [2012] FCAFC 44 at [69]; see [605].
1009 I have dealt with Parkes’ decision to exchange the Esperance Claim SCDO for the
Esperance Combo Note on Grange’s recommendation and advice in section 4.4.10. As I
found, that decision was reasonable but made in the context where Parkes had no real choice
in managing the difficult position which Grange had caused it to have. The substitute
investment kept Parkes exposed to a similar product that carried the same kinds of risks that
have subsequently been realised. In a real sense, Parkes had been “locked into” the
investment in the Esperance SCDO and its “rescue” replacement, the Esperance Combo Note.
At the time it exchanged the Esperance SCDO there was nowhere else for Parkes to sell it
and Grange informed Parkes that the Esperance Combo Note offered “a higher degree of
principal security”: [603].
1010 The losses that Parkes has suffered in dealing with the consequences of its original
investment in the Esperance Claim SCDO are losses of the kind that were in the reasonable
contemplation of the parties at the time the original contract was made to purchase the
product. Parkes’ decision to buy the Esperance Combo Note was a reasonable attempt to
mitigate its loss and avert the potential of further, greater loss, flowing from its investment in
the Esperance SCDO. Those losses arose as the probable result of the breach of that contract
containing the terms I have found: Hadley 9 Exch at 354; Burns 161 CLR at 667.
Accordingly, Parkes can recover its net losses on its investments in both the Esperance
SCDO and the Esperance Combo Note.
1011 Parkes claimed a loss of $133,146.85 on its sale of $1 million worth of the Blaxland
Claim SCDO on 28 April 2010. It had purchased this product in August 2006: [586].
Grange argued that there was no evidence called by Parkes to justify that sale and that both
parties’ competing valuations at the time of the trial were greater than the earlier sale price:
Parkes’ valuation being for $935,000 and Grange’s being for $961,300. However, Grange’s
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submission overlooked the advice to sell that Parkes had received on 23 April 2010 in an
email from Jason Coggins of CPG Advisory. I infer that he was a financial adviser. The
email referred to information from the ANZ Bank that there was an indicative bid for Parkes’
holding at 87.19 cents “clean” (i.e. without accrued interest per $1 of face value) and an
alternative offer of between 75 and 80 cents. Mr Coggins recommended a sale at 85 cents or
more to reduce the risk profile of Parkes’ investment portfolio saying:
“While the security could very well reach maturity without capital loss we believe that given the still uncertain outlook for corporate defaults in the US and Europe and a still questionable economic recovery there is at least some risk of capital loss.” (emphasis added)
1012 Parkes had been placed in a position of difficulty as a result of Grange’s breach of
contract in recommending and advising Mr Bokeyar to purchase the Blaxland product. That
difficulty was illustrated by Mr Coggins’ advice in April 2010. Even Grange’s valuation at
the time of the trial was about 4% less than the product’s face value. Indeed, in September
2009, Oakvale had given an indicative price to Swan for this product of 53 cents per dollar of
face value: [395]. These uncertainties in arriving at a value for the Blaxland Claim SCDO at
any particular point in time were a direct, foreseeable result of there being no established,
independent secondary market or liquidity for such products, as the issuers’ offering
memoranda had warned. Bid and indicative prices for the Claim SCDOs at a particular time
may provide the only means for a holder of such products to place a possible value on the
products. Because there was no active market for the Claim SCDOs after Grange failed, it
was not always possible to know from other contemporaneous arm’s length transactions how
much each was worth at any time prior to a defining event such as its being wiped out or
maturing. The volatile change in indicative prices for the Blaxland SCDO between
September 2009 and April 2010 demonstrated that whatever “market” there was for such
products was affected by uncertainty.
1013 By the time of Mr Coggins’ email, the reference portfolio in the Blaxland SCDO had
not suffered any relevant credit events to suggest that it would not be repaid in full on
maturity on 31 March 2012. However, the general uncertainty of the financial markets had
made investors more aware of the greater risks this class of product had in such an economic
environment compared to other financial products with similar ratings at the time of their
issue. I am satisfied that Parkes acted reasonably, in the circumstances of uncertainty in
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which it had been placed by Grange’s earlier recommendation and advice to buy the product,
in selling the Blaxland SCDO as it did: CMFEU [2012] FCAFC 44 at [69].
7.2.2 The issues between the valuers
1014 The lack of an active secondary market has made the task of valuing the unmatured
Claim SCDOs somewhat problematic. The two expert valuers were Mr Finkel and Dr Arberg
(a senior analyst of credit products experienced in their pricing and valuations). The experts
used different valuation approaches for the non-Dante products and the Dante notes. Since
they gave evidence, one product, the Esperance Combo Note, has matured. The parties have
agreed that the value of the Esperance Combo Note should be based on facts that the
noteholders received 19.37% of the face value of the Esperance Combo Note in cash together
with an equivalent number of Esperance Claim SCDO notes: see section 4.4.10 and [832].
Thus the critical question is the value of the Esperance AA product which has not matured
and constitutes the residuum of any interest that is held by a holder of the Esperance Combo
Note
1015 Mr Finkel and Dr Arberg agreed, and the parties accepted, that actual transactions
after the valuation dates used in their reports were the best indicator of the current value of
the non-Dante Claim SCDOs. In their joint report, Mr Finkel and Dr Arberg agreed that in
determining the present fair value of the relevant Claim SCDOs, market bids were also, in
substance, a good starting point to indicate value. However, the experts approached the
valuation exercise very differently. Broadly, Mr Finkel considered that indicative market
bids were appropriate to use in arriving at the value of the Claim SCDOs that could be sold in
the market. In contrast, Dr Arberg considered that a model based valuation was appropriate
since the relevant industry participants (dealers, investors and accounting standards) accepted
and used a well recognised model (the Gaussian Copula method) to value products and
holdings for which there was no ready market. As might be expected, these two approaches
produced some very different valuations.
1016 Mr Finkel and Dr Arberg also agreed that the valuation of the Dante notes required its
own approach that needed to take account of the uncertainty created by the current impasse
between the positions taken by the English and United States Courts and the unwillingness of
BNY Mellon to pay the collateral to anyone until that impasse is resolved: see section 6.1.
The experts, once again, took different approaches to valuing the Dante notes. Mr Finkel
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considered that, where there were market bids for the Dante notes, these were the best
indicator of value. However, he accepted that Dr Arberg’s lower valuations for the
Coolangatta Combo Note and the Kakadu Combo Note were appropriate, since there was no
evidence of any market bids for those products. Subsequently to the evidence at the trial, the
Councils have relied on bids for these two products, as will be explained in section 7.2.5
below.
1017 Dr Arberg used a model based approach to arrive at two values for the noteholders’
interest, each reflecting the different possible outcomes of the current impasse over the fate of
the collateral for the Dante notes. This produced a high value, if the collateral were to be
returned to the noteholders in accordance with the decision of the Supreme Court of the
United Kingdom, and a low value if the collateral were instead to be paid to LBSF.
Dr Arberg considered that these two values marked the upper and lower boundaries of the
value of the Dante notes. He recognised that this approach avoided arriving at a single value.
He considered that the fair value was somewhere between those two boundaries. Dr Arberg
also opined that, if a market bid approach were the appropriate method of valuation, the
lower boundary of his model values represented a reasonable sum for which the Dante
product could be sold.
1018 Mr Finkel acknowledged that Dr Arberg’s twin price model for the Dante note
valuations was open, but considered it not to be as robust an indicator of value as market
bids. The experts disagreed about Mr Finkel’s alternate view, that, if market bids were not
appropriate indicia of value, Dr Arberg’s lower values were not appropriate for 4 of the Dante
notes (the Endeavour AAA, Global Bank Note AAA, Global Bank Note 2 AAA and
Miami AA Claim SCDOs).
7.2.3 The use of bids in valuation
1019 The approach that a court ordinarily adopts for the valuation of property is to arrive at
a market value. Here, of course, the problem is that there is no substantive market at all. The
appropriate measure of each Councils’ damages is the difference between the purchase price
for each Claim SCDO and its value as “left in the Council’s hands”. That latter value is
affected by the lack of liquidity and a secondary market for each product, any existing loss of
its collateral, as well as the attendant risk that there will be future credit events that may
erode, or further erode, the collateral. Accordingly, part of the compensation presently
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payable must reflect those factors. But this must be balanced against the likelihood of the
products continuing to pay their coupon interest and being redeemed in full.
1020 In Walker Corporation Pty Ltd v Sydney Harbour Foreshore Authority (2008) 233
CLR 259 at 276-277 [51], Gleeson CJ, Gummow, Hayne, Heydon and Crennan JJ quoted
with approval what McHugh J said in Kenny & Good Pty Ltd v MGICA (1992) Ltd (1999)
199 CLR 413 at 436 [49]-[50] namely:
“Value is determined by forming an opinion as to what a willing purchaser will pay and a not unwilling vendor will receive for the property (Spencer v The Commonwealth (1907) 5 CLR 418). In determining that value, there must be attributed to the parties a knowledge of all matters that affect its value. Those matters will include the predicted impact of future events as well as the experience of the past and the rates of return on other investments. As Isaacs J pointed out in Spencer v The Commonwealth ((1907) 5 CLR 418 at 441): ‘We must further suppose both to be perfectly acquainted with the land, and cognisant of all circumstances which might affect its value, either advantageously or prejudicially, including its situation, character, quality, proximity to conveniences or inconveniences, its surrounding features, the then present demand for land, and the likelihood, as then appearing to persons best capable of forming an opinion, of a rise or fall for what reason soever in the amount which one would otherwise be willing to fix as the value of the property. (Emphasis added.)’ The market for the property is, therefore, assumed to be an efficient market in which buyers and sellers have access to all currently available information that affects the property.” (final emphasis added)
1021 The use of bids, however, creates its own problems of valuation principle. In cases
involving the valuation of land, an offer to purchase is not accorded the same significance as
a concluded sale and may not be admissible at all: Cordelia Holdings Pty Ltd v Newkey
Investments Pty Ltd [2004] FCAFC 48 at [121] per Black CJ, French and Tamberlin JJ
applying McDonald v Deputy Federal Commissioner of Land Tax (NSW) (1915) 20 CLR 231
at 238-240 per Isaacs, Powers and Rich JJ. While evidence of offers for land may be
admissible for limited or general purposes, such evidence is not admissible as direct evidence
of value: McDonald 20 CLR at 240; Cordelia [2004] FCAFC 48 at [128].
1022 In Henderson v Amadio (1995) 62 FCR 1 at 122C-123E Heerey J, following Wilcox J
in Goold v Commonwealth (1993) 42 FCR 51 at 57-60, discussed ways in which evidence of
genuine offers to purchase might be relevant and admissible without infringing the principle
in McDonald 20 CLR 231. Heerey J identified two categories of such evidence, first, market
perceptions about the present condition of the relevant market and, secondly, the performance
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of the subject property where it had already been exposed to the market. In Goold 42 FCR at
59-60, Wilcox J explained that evidence of earlier offers could be admissible on the questions
of whether later sales were forced sales and whether the potentiality of the land included a
particular purchaser who may have been willing to pay more than market value for it. His
Honour then explained that before acting on a mere offer for these purposes, a court should
carefully consider its genuineness and the circumstances bearing on why it did not produce a
sale. With respect, Wilcox J’s reasoning on these latter considerations would require the
Court to embark on the collateral enquiries that formed the ratio decidendi in McDonald 20
CLR at 239-240 for rejecting the admissibility of offers. There, Isaacs, Powers and Rich JJ
said:
“When the matter has reached the point of a concluded contract, there has been a definite concrete fact established, which not only evidences value, but to some extent helps to create or modify it. Where an owner has actually parted with his land for a fixed sum and a buyer has parted with his money for the land, a clear event has arisen, which, based on the ordinary instincts and impulses of human nature, indicates a consensus of opinion between two adverse parties in the community respecting the value of similar lands. Some advantage to justice is therefore manifestly possible from considering it, and the law presumes that up to that point the disadvantages of having to undertake the collateral inquiries as to comparison do not outweigh the possible advantages. But if the negotiations do not end in a concluded bargain, the field is at once open to a multitude of other considerations before the same point of opinion is reached. Excursions into the realm of collateral circumstances would be endless. They would so add to the cost, delay and uncertainty of litigation as on the whole to render a great disservice to the cause of justice. The Court might have to inquire whether the owner or the other party really terminated the negotiations, and, if so, for what reason. Had either of the parties discovered the true worth of the property or been misinformed by some means as to its real value? Did the owner mistrust the ability of the purchaser, or did the latter find an adverse claimant to the property, or did his circumstances change, or was there a personal quarrel? Or did he learn of a still better bargain? Or, again, was the offer a sham on either side, or both sides? Such inquiries would render litigation intolerable, and defeat the purpose for which they were permitted. Consequently, though the logical relevance may be the same when once the fact of a real firm offer is reached, whether it be accepted or not, yet to reach that point in the latter case is practically in such a different position in relation to the true function and aim of Courts of Justice, as to be placed legally in a different position also. The exception in favour of the indirect evidence ends where it fails to serve with advantage, and the line of demarcation is drawn at actual contract.” (emphasis added)
1023 Similar issues could arise if evidence of bids were used as evidence of the value of
financial products. Of course, the nature of the relevant market for that kind of product can
be very different to that in which land is to be valued. But, here unaccepted bids raise
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questions about why the bid was not acted on, whether a response was received for more or
less of the Claim SCDO than the offeror was interested in purchasing, why the bids were
made, who knew of them, or whether, for example, a person holding the product was seeking
to set some indicium for marking it to market on its books at a higher level than earlier
market sales or bids had set.
1024 Nonetheless, in MMAL Rentals Pty Ltd v Bruning (2004) 63 NSWLR 167 at 183 [86]-
185 [100], 188 [117]-[119] Spigelman CJ, with whom Mason P and Hodgson JA agreed,
followed Goold 42 FCR at 59-60. The Chief Justice distinguished McDonald 20 CLR 231
and Cordelia [2004] FCAFC 48 and held that in respect of a contract for purchase of a former
employee’s shares at “fair market value”, evidence of an offer for the sale of shares was
admissible and “cogent evidence of, at least, a minimum value to the purchaser with a special
interest and accordingly, probative evidence of at least a minimum price for Mr Bruning’s
shareholdings” (63 NSWLR at 185 [100]).
1025 I will consider the appropriate approach to valuing the non Dante notes that remain in
dispute first and then that for the Dante notes.
7.2.4 The valuation of the remaining non Dante notes
1026 The experts expressed their competing valuations of the 9 products as percentages of
their face value. However, because of their agreement that bid prices after the valuation dates
in their reports were a good starting point to indicate value, the parties prepared an agreed
updated exhibit – Exhibit W – to reflect their differing suggested values. The parties relied in
that exhibit on the evidence of recent bids, as the experts did, as providing a reasonable floor
price for the relevant product instead of the experts’ earlier valuations I have summarised
some of that material in the table below.
Product The Councils’ position
Basis Grange’s position
Basis
Esperance AA+ 48% (T) 24/12/10 50% (B) 14/3/11
Esperance Combo Note 67.37% 3/2/11 69.37% 3/2/11
Glenelg AA 33% (T) 18/2/11 35% (B) 22/2/11
Kakadu AA 25.50% (T) 4/2/11 32.00% (B) 14/3/11
Lehman Bros Property Note 16.00% (B) 8/12/10 22.00% (B) 22/3/11
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Newport 15.50% (T) 20/12/10 34.00% (B) 20/1/11
Nexus 4 Topaz 67.565% (LP) 10/3/11 72.51% (V) 30/11/10
Parkes (11A) AA 4.50% (B) 3/3/11 4.50% (B) 3/3/11
Parkes (1A) AAA 3.50% (T) 21/7/10 12.20% (B) 3/3/11
Key:
V = Valuation T = Transaction (Ex W) LP = Listed Price (mid point) B = Bid
1027 As noted above, the Esperance Combo Note has been redeemed paying noteholders
19.37% of face value in cash and leaving them holding Esperance AA+ notes ([832]). Thus,
the Esperance AA+ notes are the relevant product to consider for the purpose of valuing the
Esperance Combo Note. The Esperance AA+ notes are still exposed to the possibility of
further credit defaults and downgrades that could affect their ultimate redemption value. The
difference between the parties in posited values for the Esperance Combo Note is the
difference in posited values of the Esperance AA+ notes.
1028 There is no issue that the Parkes AA notes should be valued at 4.50% of face value.
The differing approaches of the Councils and Grange result in suggested values within 2% for
3 products (the Esperance AA+, Esperance Combo Note and Glenelg AA products), and
about 6%-9% for 4 others (the Kakadu AA, Lehman Bros Property Note, Nexus 4 Topaz and
Parkes AAA products). There is a very wide margin, however, between the suggested values
for the Newport notes of about 19%.
1029 Mr Finkel accepted that Dr Arberg’s model represented a standard basis on which the
industry valued SCDOs. He said that he would use such a model in assessing whether a
market transaction in an illiquid market reflected the best evidence of the product’s value. In
my opinion, the Claim SCDOs should be valued having regard to their nature of being, in
general, hold to maturity investments for which there was and is no ready market. That is
because almost all of the Claim SCDOs were not listed on a stock exchange, and had risk
warnings in the issuers’ offering memoranda that they had no guarantee of a secondary
market or liquidity. The Nexus 4 Topaz notes, however, were listed on the Australian Stock
Exchange.
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1030 The bid prices in evidence on which Mr Finkel relied appear to reflect, at least, the
minimum amount that an informed, willing but not anxious purchaser would pay since the
bid appears to represent an offer to whoever is in the market to buy at the stated price. But I
do not consider that such a purchaser would necessarily limit itself to that bid price if an
informed, but not anxious vendor entered the market offering to sell at a higher price.
1031 Similarly, Dr Arberg explained that the model prices arrived at a theoretical “fair
value”. As he said “and then there is a lot of business decisions around whether or not you
actually want to purchase it”. Those factors included discounting to take into account the
relatively small parcel sizes of the Councils’ holdings of each product, its bespoke nature, the
lack of liquidity and the fact that, for present purposes, there was a buyer’s market for the
Claim SCDOs. He suggested that, as a broad proposition, a transaction for the Claim SCDOs
would be likely to occur at a discount of between 5% to 15% of the model values he had
calculated. However, while he had also seen actual transactions at prices higher than his
model values for the Claim SCDOs, most of the actual transaction prices were below those
values.
1032 Dr Arberg’s model produces a value that is intended to reflect a value that can be used
as a mark to market price for a product with little or no market. And, the market that the
model addresses is one in which persons who are engaged in the trade of these products
operate. Thus, in one sense it is a fully informed market, but it is not one that has regular
trading of these products. Rather, it is a hypothetical market that does not take account of
participants, such as the Councils, who are, in a sense, involuntary holders of the products
that they want to sell. A hypothetical, model based value is all well and good, but of no
utility to a vendor if no buyers are in the market at or near a price reflecting that model based
value. The model value is likely to reflect a high offer by a vendor in a market in which retail
investors, like the Councils, are participants.
1033 So, just as the bids that Mr Finkel used reflect a minimum achievable price,
Dr Arberg’s model produces a value that reflects a maximum achievable price. However,
neither methodology arrives at an entirely satisfactory result because each represents different
points on a spectrum of possible prices that a more active market would achieve, in which
prices would tend more towards Dr Arberg’s model value.
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1034 An instructive example of the difficulties presented by each approach in arriving at an
appropriate value occurred during the experts’ concurrent evidence. They were shown some
bid information for the Newport Claim SCDO. This recorded 10 bids between 21 April 2010
and 22 March 2011. The bids ranged from 4 to 43 (i.e. percentages of face value or cents in
the dollar). However, the bid at 43 was noted as a “price error”. It had been made on 1
December 2010. The bid at 4 and another bid recorded only as a “single digit” preceded it.
Subsequently, on 13 and 15 December 2010, there were bids at 16 and 18.5 respectively. The
last bid, on 22 March 2011 was at 31. The last transaction for the Newport product occurred
on 20 December 2010 at 15.5% and is the basis of the Councils’ suggested valuation.
1035 In his report, Dr Arberg had valued the Newport product as at 30 November 2010 at
48.08 (clean). Thus, the price error bid of 43 made on the next day, 1 December 2010, was
much closer than any of the 9 other unaccepted bids to his model value. Dr Arberg suggested
that the explanation for the bid of 43 was that a dealer had used his or her model value by
mistake and then retracted it – hence the notation “price error”. He postulated that an
informed dealer would try bidding at prices markedly lower than a model value, as indeed the
subsequent unaccepted, but rising, bids for this product suggested. If Dr Arberg’s speculation
as to the source of the price error were correct, that indicates that different models can also
produce different prices one day apart, namely 48.08 on 30 November 2010 and 43 on 1
December 2010. While the bids on 13 and 15 December 2010 were much lower (at 16% and
18.5%), they were higher than the actual transaction price of 15.5% on 20 December 2010.
Moreover, by 22 March 2011, the latest bid was 31% although Grange wished to rely on a
bid of 34% for this product made the day before on 21 March 2011.
1036 For some reason, despite a bid at 18.5% only 5 days earlier, the 20 December 2010
transaction occurred at 15.5%. Both of those prices were far below Dr Arberg’s value of
48.04% less than 3 weeks earlier, while the latest bid at the time of the current evidence at the
hearing had increased to 31%, although this was less than the 34% bid two months earlier.
All of this demonstrates the problematic nature of ascribing a value to these products and
why I have concluded that neither suggested methodology is entirely satisfactory.
1037 If a product was the subject of an actual transaction close to the hearing of the expert
evidence in late March 2011, I consider that this provides a sounder basis for valuing it than a
bid or model price. However, where some time had elapsed between the transaction and the
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hearing, I consider that bids close to the hearing may be of some assistance in arriving at a
value. Such bids can be expected to have had some regard to the earlier transaction and
subsequent developments. The uncertainty of how to arrive at a present value for an SCDO
is, in part, a reflection of the nature of the product. It is a “bet” of the kind described by Mr
Finkel in the passage of his report set out at [888] above. Thus, a transaction involving it, is
the sale of such a bet. Dr Arberg’s model is an attempt to predict the ultimate outcome of the
bet and to take account of uncertainties. Bids represent a likely perception by one market
participant of the lowest value that that person would place on the bet. Not all the factors
affecting the bid are in evidence or known, including the volume of the product the offeror
was prepared to purchase at that price and why it was not accepted.
1038 Thus, in the case of the Glenelg AA product, held by each of the three Councils, an
actual sale at 33% occurred on 18 February 2011 and a bid of 35% occurred four days later
on 22 February 2011. Dr Arberg had valued it at a clean price of 48.58% at 30 November
2011. Allowing for a discount of 15% (see [1031]), his value would translate into a market
price of about 41%, about three months before the later sale and bid. The Councils, however,
did not sell or respond to the bid. They continue to hold it and to be exposed to its uncertain
future till it matures on 22 December 2014.
1039 In addition, as Grange argued, fixing a value at a date for the purposes of these
proceedings, will mean that subsequent developments bearing on the value of the product
will, or may, affect the calculation of loss or damage in respect of other creditors of Grange
with similar claims.
1040 It is patent that there is no self evidently satisfactory way to value the Claim SCDOs
that are yet to mature. By the time of these reasons, the evidence of market activity and
valuation at the trial will be out of date. In the meantime, the parties agreed to further
supplements of the evidence of value based on what occurred on maturity or earlier wiping
out of Claim SCDOs. At the re-opening application on 3 February 2012, the parties sought to
proceed on the basis of the relatively narrow differences in value exposed in Exhibit W,
which they subsequently updated on 7 June 2012 and 19 September 2012. I also allowed the
parties to reopen to prove the decision of the Supreme Court of the United Kingdom on the
flip clause and other matters concerning the Dante notes litigation that had occurred after I
had reserved judgment: see sections 6.1.3-6.1.5.
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1041 Both parties relied on bids for valuing each of the Lehman Bros Property Note and
Parkes (11A) AA products. The most recent bid is thus the best evidence of the “left in
hand” value of that product.
1042 There was a relatively short time between the Councils’ earlier transaction price and
Grange’s later bid price for each of the Glenelg AA, Kakadu AA and Newport products.
Given the proximity of the bid of 35% to the sale of the Glenelg AA Claim SCDO at 33% the
recent transaction is the most reliable indication of its value. However, the sale and bid for
the Kakadu product were about 40 days and 6.5% apart. Those for the Newport product were
about 30 days but 18.5% apart and those for the Esperance AA+ product were about 75 days
and 2% apart. The sale and bid for the Parkes AAA product was over six months and 8.7%
apart.
1043 The reasons for the discrepancies between these sales and later bids are not apparent.
The experts accepted that recent bids for these products provided a good starting point for
assessing their value. Most of those bids are higher than prior, relatively recent trades. I am
satisfied that the bids provide evidence of a floor price as perceived in the market for the
product: Amadio 62 FCR at 122C-123E; MMAL Rentals 63 NSWLR at 185 [100]. The
evidence showed that the transactions, bids and valuations for these kinds of product had
varied considerably after the commencement of the global financial crisis. All of those
indicia reflect a present value prediction of the product’s return of capital on maturity and
capacity to pay interest, discounted by the factors that Dr Arberg discussed as generally
influencing a market price reduction from his model values. By retaining the products, the
Councils continue to have the opportunity to realise the chance of achieving, on its sale or
maturity, the product’s full face value or a price and to obtain the benefit of any interest paid.
Of course, the value or price of any product in which defaults have caused the payment of
some collateral to the credit default swap counterparty, will cause a corresponding reduction
in the amount of principal that will be repaid on maturity and interest.
1044 The evidence shows that prices paid and bids offered for the Claim SCDOs varied
materially over relatively short times. The search for a value is like Lord Bowen’s
illustration of “a blind man looking for a black hat in a dark room” to which Windeyer J
referred as illustrative of a jury’s function in Australian Iron & Steel Ltd v Greenwood (1962)
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107 CLR 308 at 326 citing Goddard LJ in Mills v Stanway Coaches Ltd [1940] 2 KB 334 at
349.
1045 The higher, more recent bids are some evidence of an improved floor price since the
earlier transactions for the Kakadu, Newport, Esperance AA+ and Parkes AAA products.
The greater the period between the earlier transaction and the later, higher bid, the less
satisfactory is the transaction in providing reliable evidence of value for products with the
characteristics of the Claim SCDOs (including their lack of liquidity). The shorter period
between the transaction and bid for the Kakadu product permits the transaction to continue to
have utility in arriving at a value. However, given that the market is illiquid, and a higher bid
was offered after the latest transaction, it is difficult to identify any reason why the bid should
not be taken as a cogent indication of the lowest price that a purchaser would pay. It would
be arbitrary to use a lesser figure as the value when to do so would ignore that an apparently
genuine bid, at a higher figure, was made but not accepted. The lack of acceptance suggests
that either all vendors considered the offer in the bid too low at the time it was made or the
market was imperfect and no potential vendor was aware of the bid. The latter is possible
since the evidence of transactions and bids were obtained through subpoenas and would not
necessarily come to the notice of potential buyers or sellers. But, even so, that market
imperfection also affected the way in which the transaction price was struck.
1046 Grange relied on Dr Arberg’s opinion that the use of bids would tend to undervalue
the Claim SCDOs. This was because the unaccepted bid indicated that no willing, but not
anxious, vendor was prepared to trade its asset at that price which must, therefore, be less
than would impel a bargain to be made. Hence, Dr Arberg reasoned that his model gave a
better indication of true value.
1047 The difficulty with this attractive argument is that the real market is empty of sellers.
In a theoretical market, Dr Arberg’s values might be justified, but such a market is populated
with one or more informed buyers and sellers. The nature of the Claim SCDOs is that
identified in the issuers’ offering memoranda risks set out at [122]-[123] above. The reality
of the current empty “market” is just what those statements of risks foretold. So, to say that,
in theory, the real, but empty, “market” is undervaluing the product because the bids
represent a floor price that is lower than true value, assumes that there is a different and
higher present value for an illiquid product that, if put to the market, could realise that higher
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value. However, Dr Arberg’s model did not take account of the liquidity or capital
requirements of the buyers or sellers in making a business decision whether or not to trade in
such a market as now exists. I am of opinion that the lack of liquidity is a factor that can, and
does, affect the value of the Claim SCDOs. Indeed, the offering memoranda’s risk factors
foreshadowed that very consequence.
1048 The result of leaving the Claim SCDOs in the Councils’ hands, but awarding damages
using a bid price to reflect its present value, will provide an appropriate award of
compensation. It is not clear that any bidder would pay more for a Claim SCDO than its
current bid having regard to the commercial circumstances at the time the bid was made. The
bid is an offer to pay for the uncertain future of the Claim SCDO and its lack of liquidity on
the chance of it realising, on maturity, a larger return after taking into account the cost of
holding the asset and its acquisition. Potential sellers, in the position of the Councils, may
have no need for immediate liquidity or may not want to crystallise a certain, present loss
when there is a chance of a better long term outcome. The illiquid nature of the market
includes the lack of buyers and depth of potential purchasers: i.e. the bidder may be prepared
to buy one, relatively small, parcel but not all of the particular Claim SCDO notes held by the
Councils and others and there may be no other bidders. In such a situation, a theoretically
higher “value” is worthless. There was no evidence of any depth in the number of bidders.
That evidence would be critical to establish the availability of a higher market value than the
floor price represented by the bid. Part of the contractual expectation loss, and in my
opinion, in the present situation of the Councils, loss under s 12GF(1), was that the Claim
SCDOs were not easily tradeable on an established secondary market or able to be liquidated
for cash at short notice while having a high level of security for protection of the capital
invested by the Council. The left in hand measure assumes that the impaired assets remain
with the Councils and that they could have received the bid price had they sold in response to
the offer.
1049 As I have explained above, the latest bid for the Newport Claim SCDO was 31%
made on 22 March 2011. This was lower than the bid of 34% relied on by Grange made the
day before on 21 March 2011. Consistent with my reasons above, the bid of 34% should be
viewed as the present value of this product.
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1050 The difference of about 5% between the listed price and Dr Arberg’s higher but
earlier, valuation for the Nexus 4 Topaz product presents a different problem. That product is
now a zero coupon note: i.e. no interest is payable on it because of defaults. However,
Deutsche Bank guaranteed the repayment of its principal on 20 June 2015. Thus, Dr
Arberg’s valuation was effectively a discounted cash flow value for a relatively certain cash
payment four years into the future. Both experts agreed that this product did not require a
discount for its illiquidity. Thus, I do not regard the listed market buy and sell offers as an
appropriate reflection of the value of the Nexus 4 Topaz product. I accept Dr Arberg’s
valuation of this note.
1051 For these reasons, in the unusual circumstances of these proceedings, I consider that I
should follow MMAL Rentals 63 NSWLR at 185 [100] and use the evidence of bids as setting
a minimum value of the Claim SCDOs, other than the Glenelg AA and Nexus 4 Topaz ones,
in preference to the earlier transaction prices. Even though the bids on which I have acted
reflect prices higher than actual transactions, they provide some indication that potential
vendors have exercised a choice to hold, rather than sell at the bid price. It would not
produce a fair result to leave the products in the Councils’ hands using a valuation based on
an earlier actual transaction at a lower price than a more recent but unaccepted offer.
1052 The valuations (of clean prices) at which I have arrived are:
Product Valuation
Esperance AA+ 50%
Esperance Combo Note 69.37%
Glenelg AA 33%
Kakadu AA 32.00%
Lehman Bros Property Note 22.00%
Newport 34.00%
Nexus 4 Topaz 72.51%
Parkes (11A) AA 4.50%
Parkes (1A) AAA 12.20%
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7.2.5 The valuation of the Dante notes
1053 The parties’ competing primary positions as to valuing the Dante notes were put in the
agreed Exhibit W as follows (with the addition of Dr Arberg’s lower values).
Product The Councils’ position
Basis Dr Arberg’s higher value
Dr Arberg’s lower value
Coolangatta AA 32% (T) 4/4/11 102.50% 40.11%
Coolangatta BBB 30% (B) 1/7/11 102.61% 37.63%
Coolangatta Combo Note 17.50% (B) 11/10/11 102.92% 36.92%
Endeavour AAA 50.40% (T) 8/6/11 107.66% 71.01%
Global Bank Note AAA 18.60% (B) 11/10/11 102.52% 90.35%
Global Bank Note 2 AAA 35% (B) 22/2/11 99.51% 89.08%
Kakadu Combo Note 13% (B) 10/5/11 100.85% 10.76%
Merimbula AAA 35% (B) 31/5/11 103.19% 27.13%
Merimbula BB 35% (B) 11/5/11 103.27% 24.77%
Miami AA 40% (T) 25/5/11 104.85% 50.56%
Key: T = Transaction B = Bid
1054 Grange put as its principal fallback position that each of the Dante notes should be
valued at about 10% less than Dr Arberg’s higher value, to compensate for delay and
inconvenience but not litigation risk. The parties also agreed a schedule of bids to October
2011. These showed that on 31 May 2011 there were bids of 40% for the Coolangatta AA
Claim SCDO and of 35% for the Miami AA Claim SCDO. For the reasons I gave in relation
to the valuation of non-Dante notes, I accept that, generally, the later, higher bid for the
Coolangatta product is a more reliable indicator of a floor value than the transaction nearly
two months before. However, I consider that the later bid for the Miami AA should be
disregarded, given its proximity to a higher, very recent transaction price.
1055 The lower of Dr Arberg’s two valuations for the Dante notes reflected their value if
the ultimate result in the flip clause inter-jurisdictional contest went in favour of LBSF: i.e.
LBSF had the right to the collateral. That lower valuation made no allowance for the chance
that the noteholders might succeed. On the other hand, Dr Arberg’s higher valuation
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reflected the opposite result in the impasse (i.e. that the collateral would be returned to the
noteholders), again without making any allowance for an adverse outcome.
1056 Grange argued that the cogency of the reasoning of the Supreme Court of the United
Kingdom in Perpetual [2012] 1 AC 383, coupled with the facts that the collateral was located
in England and the transaction documents were governed by English law, meant that it was
inevitable that the noteholders will succeed in obtaining a return of the whole of the collateral
made available by the flip clause. Accordingly, Grange argued, the Councils’ interests in the
Dante notes should be valued using Dr Arberg’s higher valuation.
1057 I reject that argument. It ignores the effect of the current impasse that has caused
BNY Mellon to refuse to deal with the collateral in accordance with the decisions of the
English Courts. Indeed, Grange is having difficulty itself in even raising the issue of how the
flip clause should be treated by the United States Courts: see sections 6.1.4 and 6.1.5. It is
not realistic to value an asset that is subject to the vagaries of inter-jurisdictional litigation
risks as if it were cash in the bank immediately able to be withdrawn. The Councils’ assets in
the Dante notes are currently subject to those risks. They have a chance of recovery at either
the higher or lower of Dr Arberg’s valuations or at an intermediate figure if a settlement were
arrived at by the parties to the dispute.
1058 The present value of that chance must be less than Dr Arberg’s higher figure. His
lower figure represents a minimum payment that will ultimately be made to the Dante
noteholders. But, this lower figure does not reflect the illiquidity of the Dante notes or the
indeterminate time during which they must be held until the fate of the collateral becomes
certain. So, a fully informed, willing, but not anxious, buyer and seller of the Dante notes
would consider that each of Dr Arberg’s lower and higher values had to be affected by a
discounted cash flow analysis to reflect the uncertainty of the date on which the collateral
would be repaid. Thus, a valuation using Dr Arberg’s two values as guides to assessing the
chance of repayment on either of his assumptions needs to take account of, and be discounted
for, the uncertainty of when any payment of collateral will be made.
1059 Mr Finkel’s approach to valuing the Dante notes was not straightforward either. He
used three different methodologies to value these products. First, he used transactions and
bids as his primary method. Secondly, however, since there was no transaction or bid for the
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Coolangatta Combo Note and Kakadu Combo Note, by the time of the concurrent evidence,
Mr Finkel accepted Dr Arberg’s lower value for each of those products. Thirdly, Mr Finkel’s
“fallback” analysis accepted Dr Arberg’s lower values for all but four relevant products,
namely the Endeavour AAA, Global Bank Note AAA, Global Bank Note 2 AAA and Miami
AA Claim SCDOs. Mr Finkel valued those four Claim SCDOs by ascertaining the current
value of their collateral, ignoring unpaid interest accrued since the flip clause was triggered
(on LBH filing for Ch 11 protection on 15 September 2008: see [828]), discounting the
collateral by 50% (to reflect a 50% chance of an outcome of the impasse in favour of the
Dante noteholders) and applying a further discount of 10% for delay in payment and
uncertainty.
1060 Mr Finkel’s primary method of valuation relied on transactions and bids as the basis
for valuing the Dante notes. I am not satisfied that this is an appropriate approach that
properly reflects the difficult circumstance brought about by the current impasse in dealing
with the collateral. It is likely that, at least in respect of values given by reference to recent
transactions, the result generates a present market value. Likewise, the use of bids will
generate an indication of a floor price for the product. However, unlike the position with the
non-Dante products, the Dante notes (other than the Global Bank Note 2 AAA) are not
subject to any risk of further diminution of the collateral by credit events affecting their
reference portfolios. The only possible diminution of their collateral occurred either before
the flip clause was triggered or the swaps were terminated.
1061 Some of the Dante notes will repay a significant proportion of the collateral to
investors regardless of the outcome of the impasse. For example, the swap for the Global
Bank Note AAA was terminated by the swap counterparty on 24 March 2009. At that time,
the swap was slightly “in the money” for the arranger or swap counterparty (LBSF). That
would have the consequences that the collateral repaid to the investors will be reduced by
only 10% if the impasse is resolved so that the collateral is distributed in a way other than has
been decided by the English Courts.
1062 Dr Arberg valued the Global Bank Note AAA as at 30 November 2010 at 90.35% if
the flip clause is ineffective and 102.52% if the English Courts’ view prevails. (The 2.52%
over 100% reflected accrued interest.) As noted above, Dr Arberg’s valuations did not have
any discount for delay, inconvenience or illiquidity. Mr Finkel’s approach of using bids
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produces an incongruous result for this product’s value. Both experts considered the Global
Bank Note AAA and Global Bank Note 2 AAA to be very similar products. Dr Arberg said
that a transaction involving one of those products would be good evidence of value for the
other. The Councils sought to extrapolate, from that evidence, that a bid of 35% on 22
February 2011 for the Global Bank Note AAA was also good evidence of the value of the
Global Bank Note 2 AAA. That is why the table at [1053] still has the 35% figure as the
Councils’ posited value of the Global Bank Note 2 AAA despite a later, lower bid of 18.6%
on 11 October 2011 for the Global Bank Note AAA. No transactions have occurred for
either of those products.
1063 In these instances, the desultory bids do not reflect a good indication of the value of
either product, each of which will return at least about 90% of its principal to investors
whatever the outcome of the impasse. However, those two products do not have any
predictable time for repayment of between 90% and 100% of their principal, together with
possibly some interest for the Global Bank Note AAA. There is also some risk of adverse
credit events affecting the Global Bank Note 2 AAA, although there was no evidence that this
had occurred. But for the uncertain time of repayment, they are similar in nature to the non-
Dante Nexus 4 Topaz product that has the repayment of its principal in June 2015 guaranteed
by Deutsche Bank. In my opinion, the reason that no transactions have occurred in the two
Global Bank Note products is that the bids are commercially unrealistic and that only a
forced seller would contemplate a sale at 35% or 18.6%, when at some still uncertain time
almost all the principal will be repaid. A discounted cash flow that produced a present value
of say, 35%, would assume repayment many years after 2015 (based on Dr Arberg’s value of
72.51% for the Nexus 4 Topaz product). However difficult the present inter-jurisdictional
impasse is, the use of such an extended time frame for repayment (as reflected in the bid
prices) is unjustifiable.
1064 Dr Arberg accepted the value shown by a transaction on 10 February 2011 for the
Coolangatta AA product at 30.86%. That was below the lower of his alternate valuations of
40.11%. That concession may have been the basis for Grange’s use of a 10% discount from
Dr Arberg’s higher valuations for delay and inconvenience. However, the 10 February 2011
transaction price represents an actual discount of about 23% on Dr Arberg’s lower price. It
would not be appropriate to use Grange’s suggested 10% discount of Dr Arberg’s higher
values given the significant uncertainty in when the Councils may receive a return of any
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amount of their principal. And, unlike the two Global Bank Note products, the Coolangatta
AA Claim SCDO had two very significantly different possible principal repayment scenarios
depending on the outcome of the impasse. A number of transactions in the Coolangatta AA
product occurred at around 30% to 32%. That gives a current market value of 32% for this
product. Similarly, there have been recent transactions in the Endeavour AAA and Miami
AA products. The latest Endeavour AAA transaction at 50.4% on 8 June 2011, was at a
discount of about 30% on Dr Arberg’s lower value of 71.01%. The Miami AA transaction at
40% on 25 May 2011, was at a discount of about 20% on Dr Arberg’s lower value of
50.56%.
1065 The discounts in each of the actual transactions for the three products from Dr
Arberg’s lower valuations are material. They suggest that his theoretical model arrived at
values significantly greater than market value. Of course, the market was a very thin one and
the circumstances of each of the sellers were not known. The Councils are not in the position
of forced sellers. They can continue to hold their Dante notes until the impasse is resolved.
Therefore, the current market value may not be the only, or an appropriate, basis to use for
the purpose of assessing the left in hand value of the Dante notes.
1066 It is not possible to draw any general conclusions by comparing bids and Dr Arberg’s
lower values. The bids for the Kakadu Combo Note, Merimbula AAA and Merimbula BB
products are slightly higher than Dr Arberg’s lower values, while the bids for the Coolangatta
BBB and the Coolangatta Combo Note products are lower than his lower values.
1067 I did not find Mr Finkel’s fallback approaches to valuing the Endeavour AAA, two
Global Bank Notes and Miami AA products or in choosing Dr Arberg’s lower values
persuasive. As I have said, a valuation of the two Global Bank Note products must recognise
the certainty of repayment to investors of at least 90% of their principal at some future, albeit
uncertain, time. Mr Finkel’s 50% discount of the collateral in his fallback approach is not
justifiable. The Endeavour AAA and Miami AA products will repay investors at least 70%
and 50% of principal respectively. Once again, Mr Finkel’s 50% discount of collateral
cannot be sustained. A fully informed market would not make such a discount. I reject Mr
Finkel’s fallback values for these four products. Nor is Mr Finkel’s use of Dr Arberg’s lower
values as a fallback for the other products a satisfactory basis for valuation. That is because it
gives no recognition to the real chance that the investors, ultimately, will receive the
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repayment of their principal. Whatever the motivation of the participants and bidders in the
present market, the left in hand value must recognise the potential of a substantial return of
capital. For these reasons I reject Mr Finkel’s fallback values.
1068 However, I accept Mr Finkel’s evidence that “most market participants completely
shy away from” the Dante notes. So much is clear from the evidence of transactions and
bids. Dr Arberg’s higher values allow for some payment of interest on the collateral. Even if
the inter-jurisdictional impasse were to result in noteholders being paid the collateral in
preference to LBSF, as Grange argued, that outcome would occur some time in the future. It
is uncertain. The history to date of Grange’s attempts to cut the Gordian knot in the United
States courts suggests that LBSF sees it to its advantage to delay and obstruct that resolution.
There is no evidence that those tactics will change. Judge McMahon expressed this view,
with which I agree, in her decision of 20 September 2010 granting BNY leave to appeal from
Judge Peck’s decision on the flip clause. Her Honor said:
“In the end, it is not difficult to see LBSF’s arguments for what they really are: an attempt to … insulate Judge Peck’s decision from the appellate view for as long as possible. For many months, LBSF opposed the entry of any order memorializing the Bankruptcy Court’s decision; now it vigorously seeks to forestall any review. LBSF’s efforts to shield Judge Peck’s unprecedented and – for LBSF – extremely favourable decision from review are, of course, not surprising … LBSF’s desire to insulate Judge Peck’s ruling from appellate scrutiny only further demonstrates the need for immediate review.”
1069 In her memorandum and order of 21 June 2011 (see [835] above), Judge McMahon
said:
“There is indeed a risk that the English Court of Appeal will construe Judge Peck’s decision as not only representing a new development in US bankruptcy law (which it is) but also as settled law (which it is not, since it has never been tested a higher court). It is also the case that, to a casual but interested observer, it might appear that the stay is being used (as perhaps the many months before the order was signed was used) to keep the underlying decision from being reviewed … I have no doubt that able Counsel in England, assisted by their colleagues in this country, can make the English Court of Appeal aware of the procedural posture of this case and of the fact that, sooner or later, Judge Peck’s one-of-a-kind decision will be tested on appeal.” (emphasis added)
1070 As I found at [841], the potential for both inter-jurisdictional disputes and the loss of
some collateral, if the flip clause works in the way Judge Peck has found, were inherent in the
Dante note products. The investors now have their rights to principal (whatever they are),
and any interest, tied up indefinitely. I do not consider that a small discount from Dr
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Arberg’s upper values would reflect the present value of the future receipt of whatever
collateral is repaid to the investors. That is because, the evidence, as Judge McMahon also
found, points to LBSF continuing to seek to delay the resolution of the impasse. Despite her
Honor’s observation about Judge Peck’s interpretation of the flip clause being
“unprecedented”, it is possible that this view of United States law will prevail on appeal in
that jurisdiction.
1071 It is signal that Grange, despite its submissions in this matter, has not sought to
enforce in England its rights to the collateral of its own Dante notes. Nor, so far as the
evidence shows, has any other noteholder. Instead, Grange has pursued litigation in the
United States to achieve enforcement there of the decision in Perpetual [2012] 1 AC 383. It
may be that a commercial resolution is the ultimate outcome of the impasse. All of this
uncertainty suggests that the value of the Dante notes, left in the Councils’ hands, is
significantly less than a liquid asset. If put to the market, they trade at a significant discount
to their present lower value as calculated by Dr Arberg and, with three exceptions, attract
lower bids. If held, their value also must be significantly less than either of Dr Arberg’s
values.
1072 In my opinion, except where there are actual transactions or higher bids, Dr Arberg’s
lower and higher values should be discounted by 30% to reflect the range of possible higher
and lower present values of one or other result of the flip clause impasse. On a rough basis,
that discount is similar to what Dr Arberg arrived at, using discounted cash flow analyses, for
the Nexus 4 Topaz notes on the basis that they would be redeemed in June 2015. The actual
transaction or bid prices represent present value whereas Dr Arberg’s lower value does not
because it does not reflect a discount for delay and uncertainty. Therefore, in the table in
[1073] below I have arrived at the discounted net present left in hand value by using the
transaction or higher bid prices as reflecting an appropriate discount for arriving at the
present (lower) value and averaged that with a discount of 30% of Dr Arbert’s higher value.
Where Dr Arberg’s are the only two values I have arrived at a value by discounting both his
figures by 30% and averaging the result. (e.gs. For Coolangatta AA: 70% of Dr Arberg’s
higher value of 102.50% is 71.75%. The average of that and the transaction of 32% is about
52%).
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1073 Although it is unsatisfactory to have to arrive at a value in this way, due to the
uncertainty created by the legal impasse I consider that the Dante notes must be valued by the
arbitrary means of taking a mid point between their discounted higher and lower potential
values. It is not possible to analyse what justification BNY Mellon has for withholding
payment because there is no evidence of its reasons. Equally, Grange has led no evidence of
why it has eschewed action in England to enforce the Supreme Court’s declarations as to the
entitlement of the noteholders while seeking to proceed in the United States Courts.
Whatever the underlying, and presently untransparent, reasons for Grange’s choice, the
reality is that it sees no clear path to an answer. Since its actions, and inactions, speak louder
than its words on this problem, the best I can do is to assess the chances of the noteholders
receiving more than the lower of Dr Arberg’s values at 50%. The value arrived at must then
be discounted to reflect the likely delay in receipt of payment on the present value of the right
to that future receipt. For those reasons, the undiscounted higher and lower values I have
derived and my actual valuations appear in the following table.
Product Lower Value [1072]
Higher Value [1072]
Discounted net present left in hand value
Coolangatta AA 32% (T) 102.50% 52%
Coolangatta BBB 37.63% (V) 102.61% 49%
Coolangatta Combo Note 36.92% (V) 102.92% 49%
Endeavour AAA 50.40% (T) 107.66% 63%
Global Bank Note AAA 90.35% (V) 102.52% 68%
Global Bank Note 2 AAA 89.08% (V) 99.51% 66%
Kakadu Combo Note 13% (HB) 100.85% 42%
Merimbula AAA 35% (HB) 103.19% 54%
Merimbula BB 35% (HB) 103.27% 54%
Miami AA 40% (T) 104.85% 57%
Key: T = Transaction HB = Higher Bid than Dr Arberg’s Lower Value V = Dr Arberg’s Lower Value
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7.3 Other issues on valuation
7.3.1 The restructure SCDOs non-issue
1074 Grange argued that the Councils could not recover damages for their investments in
restructure Claim SCDOs, being the Esperance Combo Note, the Coolangatta Combo Note
and the Kakadu Combo Note. Grange contended that it played no role in causing the
Councils’ decisions to invest in rescue or restructure products that had been created after the
original product (the Coolangatta, Esperance AA+ and Kakadu AA Claim SCDOs) either
suffered portfolio credit defaults or downgrades. I have dealt with Parkes’ decision to invest
in the Esperance Combo Note in section 4.4.10. There is no evidence of any of Councils
having an existing investment in the Coolangatta Combo Note or the Kakadu Combo Note
nor do the parties’ respective positions on damages in Exhibit Y refer to any claim for those
products. Accordingly, there is no further issue to resolve in this respect.
7.3.2 The valuation issue in Grange’s liquidation
1075 The basis on which I have valued most of the unmatured products is now somewhat
dated. The market is likely to have changed. It would be desirable if all of Grange’s
creditors, or at least those who are members of the classes for the purpose of these
proceedings, were treated equally in respect of the value for which they should be admitted to
proof in Grange’s liquidation in respect of similar causes of action to those on which the
Councils have succeeded.
1076 Both the Councils and Grange expressed concerns about the possibility of transactions
or sales occurring that could be used to manipulate the value of a Claim SCDO. It was
common ground that s 554(1) of the Corporations Act did not prevent the use of a “left in
hand” valuation methodology such as that I have adopted. That section requires, in a winding
up, that the amount of a debt or claim, including interest be computed at the relevant date,
here 26 September 2008, when administrators were appointed to Grange. Subsequent events
can be taken into account in fixing a value of such a debt or claim at the relevant date: see Re
Opes Prime Stockbroking Ltd (2008) 171 FCR 473 at 488-489 [71]-[72] where Finkelstein J
explained why contingent debts have been admissible to proof and can be valued in this way.
1077 Moreover, Grange’s liquidators can refer to the Court the question of how to value
any debt or claim under s 554A(2)(b). Grange seeks an order that its liquidators apply for
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directions under ss 479(3) or 511 in relation to the proper valuation of the Dante notes. It
follows from my reasons that this order should be made. That may necessitate a revaluation
of the Claim SCDOs using the methodologies in these reasons for those that are yet to be
wiped out or mature.
8. GRANGE’S DEFENCES
8.1 The issues Grange raised as defences
1078 Grange raised three substantive defences. First, it contended that its liability to each
Council arose in a single apportionable claim for damages for economic loss under s 12GF of
the ASIC Act caused by conduct done in contravention of s 12DA (and its analogues).
Grange contended that each of the ratings agencies (Standard & Poor’s, Moody’s and Fitch)
and Lehman Asia was a concurrent wrongdoer with Grange within the meaning of
Subdivision GA of Div 2 of Pt 2 of the ASIC Act and its analogues. Grange contended that its
liability in damages should be reduced by the proportion to which any of those concurrent
wrongdoers was responsible for that loss or damage under s 12GR.
1079 Secondly, Grange contended that its liability was excluded by s 5O of the Civil
Liability Act 2002 (NSW). That provided that a person practising a profession did not incur a
liability for harm resulting from negligence (regardless of whether the claim was brought in
tort, in contract, under statute or otherwise, as provided in s 5A(1)):
“if it is established that the professional acted in a manner that (at the time the service was provided) was widely accepted in Australia by peer professional opinion as competent professional practice.”
1080 Grange argued that a number of other organisations, including banks, marketed
SCDOs in a similar way to it and that this amounted to a manner widely accepted by peer
professional opinion as competent professional practice. It did not rely on this defence in
respect of any liability it had to Swan outside the Swan IMP Agreement (since that agreement
was governed by the law of New South Wales).
1081 Thirdly, Grange contended that each of the Councils was guilty of contributory
negligence.
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8.1.1 Proportionate liability – principles
1082 The statutory defence of proportionate liability operated as follows under Subdiv GA
of Div 2 of Pt 2 of the ASIC Act and its analogues. First, there must be an apportionable
claim for damages in these proceedings. Such a claim must be made under s 12GF for
economic loss caused by conduct that was done in contravention of s 12DA (s 12GP(1)(a)).
There will be a single apportionable claim for all causes of action in the proceedings in
respect of the same economic loss (s 12GP(2)). Secondly, there must be a concurrent
wrongdoer, being a person who is one of two or more persons whose acts or omissions
caused, independently of each other or jointly, the economic loss that is the subject of the
claim (s 12GP(3)). Thirdly, if Grange is a concurrent wrongdoer with either the ratings
agencies or Lehman Asia, Grange’s liability to the Councils will be limited to an amount that
reflects the proportion of the economic loss claimed that the Court considers just, having
regard to Grange’s responsibility for that loss. That occurs in accordance with s 12GR
wthich relevantly provides:
12GR Proportionate liability for apportionable claims
(1) In any proceedings involving an apportionable claim:
(a) the liability of a defendant who is a concurrent wrongdoer in relation to that claim is limited to an amount reflecting that proportion of the damage or loss claimed that the court considers just having regard to the extent of the defendant’s responsibility for the damage or loss; and
(b) the court may give judgment against the defendant for not
more than that amount.
(2) If the proceedings involve both an apportionable claim and a claim that is not an apportionable claim:
(a) liability for the apportionable claim is to be determined in
accordance with the provisions of this Subdivision; and (b) liability for the other claim is to be determined in accordance
with the legal rules, if any, that (apart from this Subdivision) are relevant.
(3) In apportioning responsibility between defendants in the
proceedings:
(a) the court is to exclude that proportion of the damage or loss in relation to which the plaintiff is contributorily negligent under any relevant law; and
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(b) the court may have regard to the comparative responsibility of any concurrent wrongdoer who is not a party to the proceedings.
(4) This section applies in proceedings involving an apportionable claim
whether or not all concurrent wrongdoers are parties to the proceedings.
1083 Grange accepted that it had to establish that any alleged concurrent wrongdoer was
“responsible” for the economic loss claimed. In Shrimp v Landmark Operations Pty Ltd
(2007) 163 FCR 510 at 520-521 [53]-[59], Besanko J held that each concurrent wrongdoer
had itself to be liable to the applicant or plaintiff for the economic loss claimed, for the
defence to be available. He said, in a passage cited with approval by Nettle JA, with the
concurrence of Mandie JA and Beach AJA in St George Bank Ltd v Quinerts (2009) 25 VR
666 at 682 [58], (163 FCR at 522 [62]):
“The above references suggest that the mischief to which the amendments were directed was a plaintiff being able to recover 100% of his damages from any one of several wrongdoers when that wrongdoer's "fault", when compared with the other wrongdoers, was less or far less than that. In other words, the amendment was directed to what were considered to be the undesirable consequences of the joint and several liability rule. There is no suggestion that the mischief the amendments were designed to remedy was any wider than that. The definition of concurrent wrongdoer seems to be the critical subsection and, in my opinion, the word "caused" in [s12GP(3)] should be read as meaning such as to give rise to a liability in the concurrent wrongdoer to the plaintiff or applicant.”
1084 Grange did not contend that its proportionate liability defence excluded or affected its
separate liability for its breaches of fiduciary duty. Grange’s breaches of its contractual
obligation to exercise reasonable skill and care and its coextensive duty in tort, caused the
same economic loss to each Council as its contraventions of s 12DA(1) of the ASIC Act. The
Councils’ claims for economic loss, based on Grange’s other breaches of contract, were
claims in respect of the same loss or damage and, so, were apportionable claims.
8.2 Concurrent wrongdoers
8.2.1 Grange’s claims that the ratings agencies were concurrent wrongdoers
1085 Grange’s defence pleaded that when a ratings agency published a rating for a Claim
SCDO, it made the following representations:
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(A) the claim SCDO was equivalent, as regards risk profile, to other types of
financial products carrying the same rating from the same ratings agency;
(B) the ratings agency’s assessment of the risk of default or loss in respect of the
Claim SCDO, represented by the published rating for that product, had a
reasonable basis;
(C) the risk of future loss or default in respect of that Claim SCDO was at a
particular level.
1086 In substance, Grange contended that because the ratings agency knew that the Claim
SCDO would be marketed or branded with its rating that was usually incorporated into the
name of the product, the agency also knew or was aware that its rating would be published to
potential investors and that those persons would rely on the rating in making an investment
decision. The ratings agencies were engaged by the arranger or issuer of each Claim SCDO
and paid to rate the product. The arranger had permission from the ratings agency to publish
the rating to, among others, potential investors. Sometimes the ratings agency published its
own press releases that announced the rating for a particular product.
1087 Next, Grange argued that each of the Councils had relied on the product’s rating when
investing in a Claim SCDO or refraining from removing it from its portfolio. It asserted that
in Swan’s case, each of Mr Senathirajah and Mr Downing regarded the rating of a product as
his primary or predominant consideration. In Parkes’ case, Grange pointed to Mr Bokeyar’s
evidence that the rating was one of the Council’s main considerations when investing in a
product. Grange submitted that the 2003 Wingecarribee policy stated that “ratings provide
the best independent information available”. Grange noted that occasionally it had sent rating
agency documents to the Councils.
1088 Grange contended that the ratings definitions used by the rating agencies were the
same, irrespective of the type of product rated. It relied on what the Standard & Poor’s 2007
article, written in August 2007, (see [76] above) said in the following passage:
“Do ratings have the same meaning across sectors and asset classes? The simple answer is "yes." Across corporates, sovereigns, and structured finance, we seek to ensure to the greatest extent possible that the default risk commensurate with any rating category is broadly similar. "Similar," however, does not mean "the same." As we have seen, there is no precise quantification of default probability attached to
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any rating category. Let us compare the rating on a Hungarian bank, an ABS supported by credit card obligations originated in the western U.S., and a commercial real estate-backed security supported by a collection of Japanese shopping malls. Let us assume that we have rated all three of these ‘A’. When one considers the extreme diversity of factors that could lead to a default on these three different credits, it would clearly be implausible to suggest that the ‘A’ rating encapsulates exactly the same default probability, accurate to, say, two decimal places.”
1089 A little earlier in that article, Standard & Poor’s said: “our rating speaks to the
likelihood of default, but not the amount that may be recovered in a post-default scenario”.
1090 Grange contended that if I found, as I have, that it had made representation 3(b)
(namely: the Claim SCDOs were equivalent, as regards risk profile [i.e. material risks] to
other types of product with the same rating: see [755], [797], [814]), then the rating agencies
made the same representation about its own rating being (A) in [1085] above. Grange argued
that its pleaded representation (A) was implied “simply because the ratings agencies used the
same ratings scales for SCDOs and other products”. And, it submitted, the ratings agencies
did not discourage comparison between ratings of SCDOs and other products. Next, Grange
contended that its pleaded representations were as to future matters, within the meaning of
s 12BB of the ASIC Act, and the ratings agencies did not have reasonable grounds for making
them, in the absence of evidence to the contrary. It contended that the ratings agencies were
concurrent wrongdoers responsible for not less than 50% of the Councils’ losses.
8.2.2 Were the ratings agencies concurrent wrongdoers?
1091 Grange’s argument, so far as any communication with the Councils is concerned, is
that by publishing a rating for a Claim SCDO, the rating agency conveyed Grange’s
representation (A). I reject that argument. I explained why I found that Grange conveyed
representation (3)(b) to each of the Councils in [755]-[759] in the case of Swan, [797]-[804]
in the case of Parkes, and [814], [816] in the case of Wingecarribee. I based those findings
on Grange’s dealings with each Council, including what it informed, and failed to inform,
each Council about the Claim SCDOs and other SCDO products.
1092 In Swan’s case Mr Senathirajah understood that the ratings measured the probability
of any defaults or shortfall in payment of principal and interest: [403]. He and Mr Downing
understood from what Grange had told them that ratings and ratings stability were of prime
importance in evaluating whether to invest in an SCDO: e.g. [331], [348]. They were aware
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that products with particular ratings would satisfy the requirements of the 2003 Swan Policy.
Similarly, Mr Bokeyar considered that the ratings were very important in making investment
decisions: [421]. However, Grange promoted SCDOs to him and the two other Councils as
“FRNs”: see [643], sections 4.5.5 and 6.4.4. The ratings agencies did not make that
connection or assertion. Mr Neville understood that ratings were a guide to risk of default or
loss in a general way, but he had no experience or understanding of how ratings worked or
their basis: [678].
1093 In addition, in New South Wales, the Minister’s order required Councils to invest in
products with particular characteristics and permitted investments in products with specified
ratings: [414]. Grange referred to part of the 2003 Wingecarribee Policy which adopted
what the New South Wales Minister’s guidelines had told Councils, namely: “ratings provide
the best independent information available”: [415]. That was not equivalent to an assertion
about the equivalence of ratings and products rated. It did not say, nor is there any evidence,
that a ratings agency stated or conveyed to any of the Councils, that the risk profiles, or
material risks, of similarly rated products were equivalent: see too [75]-[79], section 3.5.2.
Moreover, Grange used the ratings to convey its own message to the Councils about the
relationship between them and classes of products, as, for example, the graphs reproduced at
[230], [246] and [659] showed.
1094 The mere fact that the product carried a particular rating was not the basis on which
the Council officers developed their understandings of the material risks of investing in an
SCDO as compared to other types of financial products rated by the same or another ratings
agency. Grange persuaded Mr Senathirajah and his colleagues that SCDOs with ratings of
AA- or above offered the same security as at least the four major Australian trading banks:
[408], [563], [657]-[665]. In other words, the mere rating itself did not convey that
understanding to the Council officers: they required Grange’s persuasion to inform or
change their perception of the material risks (as I have found they understood the pleaded
words “risk profile”) of the unfamiliar, new SCDO products.
1095 Representations are not conveyed in a vacuum. They are communicated in a context.
The mere publication of ratings by the rating agencies in association with, including in the
name of, a Claim SCDO did not of itself make the representation about material risks or risk
profile of one product, such as the SCDO, as compared to another class of product with the
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same rating, such as an ADI issued FRN. Grange encouraged the Council officers to use
their existing understanding of what a credit rating signified in respect of products they were
familiar with as the basis for them inferring that SCDO products with similar ratings, that
Grange promoted to them, involved similar risks ([207], [390]-[392], [463]-[473], [476]).
But, Grange knew (and a reasonable investment adviser or vendor in its position would have
known) when it was promoting to the Councils the SCDOs (including the Claim SCDOs),
that this inference was not correct. Grange’s presentation and slides for the Forum AAA
product informed Mr Senathirajah, the product had “No Credit Risk; beyond AAA level”
([189]). That was not accurate: see [82]-[84], sections 6.2.2, 6.4.4. The AAA rating was a
credit rating; not a rating of risk profile or of all material risks. This is illustrated by the
internal Grange email discussion about “The Free Lunch” at [133]-[138] and Mr Finkel’s
evidence as to the differences in risk profiles of different products with the same ratings:
section 6.2.2. Ratings were not intended to measure market implied risks as the 2007 article
by Standard & Poor’s, discussed at [75]-[99], made clear; see too: section 3.5.2 and [95].
1096 Grange described SCDOs to each of the three Councils as FRNs: section 6.4.4. That
was part of the context in which representation (3)(b) was conveyed. There is no evidence
that the ratings agencies made such a representation or conveyed it to any of the Councils.
No such representation was made by the mere publication of a product’s rating by a rating
agency. Indeed, as set out at [518], Grange informed Mr Bokeyar that Standard & Poor’s
ratings were “based on the risk of a $1 principal or interest loss to a given issue (not on the
severity of loss)”, without explaining what the risks of “severity of loss” were. That
statement did not convey representation (A): see too Cassi di Risparmio della Repubblica di
San Marino SpA v Barclays Bank Ltd [2011] 1 CLC 701 at 761 [263]-[264] per Hamblen J.
1097 In substance, Grange’s argument seeks to make the ratings agencies responsible for
the misleading way in which Grange used the ratings in promoting the SCDOs to persons
who were not fully informed of what the ratings agencies had said or done or what the ratings
did not deal with. It is important to emphasise that there is no issue about the accuracy or
appropriateness of the ratings of any of the Claim SCDOs when they were conveyed to the
Councils. The present issue is what the ratings agencies conveyed merely by allowing the
rating they had assigned to a Claim SCDO to be communicated to potential investors as the
rating for that product.
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1098 I am not satisfied that Grange’s representation (A) was made to any of the Councils
by any ratings agency. That representation (as was representation (3)(b)) was made by
Grange alone as an integral part, and in the context, of its promotion and marketing of
SCDOs (including the Claim SCDOs) to the Councils and its inclusion of the Claim SCDOs
in Swan’s and Wingecarribee’s IMP portfolios. In all the circumstances I am satisfied that
the ratings agencies were not concurrent wrongdoers in respect of representation (A).
1099 Grange did not allege that it, as distinct from the ratings agencies, had made Grange’s
representations (B) and (C) to the Councils. Grange did not elaborate how, in the context of
its promotion and marketing of the Claim SCDOs to the Councils, the ratings agencies’
publication or assignment of a rating was an independent or joint cause of the economic loss
that the Councils suffered. As I have found above, it was Grange’s use, or misuse, of the
ratings that was a cause of the Councils deciding to invest in SCDOs (including the Claim
SCDOs). Grange used the fact of the rating, and the implication of its having a reasonable
basis, to explain, promote and market the Claim (and other) SCDOs to the Councils in
combination with Grange’s own chosen context. Grange did this to persuade the Councils
that the products had the particular features that I have found to have been misleading and
deceptive representations by Grange. The ratings agencies had no control over, or
responsibility for, the way in which Grange used their ratings or what it told the Councils.
1100 Grange’s argument is fallacious in seeking to attribute responsibility for the Councils’
economic loss to the ratings agencies or what they said or did in rating the Claim SCDOs in
the context of what Grange did. The argument is as valid as if a driver were to argue that
because he bought a sports car from a manufacturer, the manufacturer was responsible for his
deliberate use of the car to drive over the speed limit, when booked for doing so. The whole
context and circumstances are critical to characterising whether a person’s conduct is
misleading or deceptive for the purposes of s 12DA of the ASIC Act and that person is a
concurrent wrongdoer to whose conduct responsibility should be attributed for a third party’s
economic loss for the purposes of s 12GR (and their statutory analogues). I am of opinion
that it would not be just to attribute any share of responsibility for the Councils’ economic
losses to any conduct of the ratings agencies. The Banque de France article quoted in [83]
noted:
“Investors in CDOs that focus on excess returns, only using ratings to assess the risk, might thus be exposing themselves to greater-than-expected losses.”
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1101 It is not as if the Councils went to Grange and instructed it to buy the SCDOs without
receiving any information from Grange other than the rating. Grange promoted and
explained the products to the Councils by using, among other information, the ratings. But
Grange did not, or did not sufficiently, put the ratings, and the use to which they could be put,
into context or explain to the Councils the limitations of the ratings in respect of identifying
all material risks of SCDOs or their risk profile. Those limitations were identified in the
Banque de France article, the 2005 Working Group report on which it drew (see [847]) and
the other material of which Grange was, or ought to have been, aware to which I have
referred in sections 3.5, 6.2.2, 6.2.5 and 6.4.4.
1102 For these reasons, I am not satisfied that Grange has established that the ratings
agencies were concurrent wrongdoers.
8.2.3 Grange’s claim that Lehman Asia was a concurrent wrongdoer
1103 Grange pleaded that slide presentations for the Dante notes (including the Esperance
Combo Note) and the Federation A and Federation AA products that it gave to various
claimants in the group in this class action, including the Councils, involved conduct by
Lehman Asia. I will refer to these as “Lehman products”. Grange contended that officers
of Lehman Asia reviewed and approved the slide presentations for those products. The
context for this allegation was as follows. On about 17 January 2007 an agreement was
entered into under which Grange would become part of the Lehman Bros group. The
ultimate holding company in that group was LBH and Lehman Asia was a member of the
group. The group’s acquisition of Grange was completed on about 7 March 2007 so that
Lehman Asia and Grange were then related bodies corporate. Grange argued that s 769B(1)
of the Corporations Act had the effect of deeming it to have been acting on behalf of Lehman
Asia in making the slide presentations of the 13 Lehman products.
1104 I reject this defence. The slide presentations were irrelevant to the issues arising
under the Swan and Wingecarribee IMP agreements, since Grange used its mandate under
those to invest in the Lehman products. Indeed, as explained in [370]-[376], Grange made a
presentation of the Federation Claim SCDO to Mr Downing. However, he was not interested
in it. Subsequently, Grange purchased the product for Swan using its mandate. But, Swan
suffered no loss from that dealing. Likewise, Grange used its mandate to invest for
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Wingecarribee in that product without making any slide presentations involving the Lehman
products or Lehman Asia to that Council: [645], [650], [653], [666]-[667], section 4.5.7.
1105 Parkes’ dealings with Grange in this period are set out at [589]-[600]. I have dealt
with Parkes’ decision to invest in the Esperance Combo Note in section 4.4.10. Parkes did
not allege that it bought that product in 2008, other than as a consequence of Grange’s earlier
conduct complained of. I found that Parkes’ purchase of the Esperance Combo Note was a
consequence of its initial purchase of the Esperance Claim SCDO and not an independent
source of complaint: [605]. In any event, Parkes did not receive a slide presentation for the
rescue product. Accordingly, whatever role Lehman Asia had in respect of the Esperance
Combo Note, it was not as a concurrent wrongdoer with Grange in respect of the economic
loss suffered by Parkes.
1106 Parkes did not suffer any loss as a result of its purchase of the Federation Claim
SCDO. Its only claim for economic loss in respect of a Lehman product was for its
investments in the Kalgoorlie AA+ and Coolangatta AA products, each of which was effected
by a switch without use of a slide presentation: [589], [590].
1107 In those circumstances, no issue appears to arise in respect of any conduct of Lehman
Asia with respect to investment in any Lehman product by any of the Councils. Grange’s
defence and written submissions focused solely on Lehman Asia’s role in relation to the slide
presentations. Accordingly, Grange’s defence concerning Lehman Asia being a concurrent
wrongdoer in respect of any of the Councils or otherwise responsible for their economic loss
as it alleged has no substance.
8.2.4 Did Grange act in accordance with peer professional opinion?
1108 Grange pleaded that in answer to the Councils’ claims that it acted as a financial
services adviser, first, in giving Parkes financial services advice and, secondly, in providing
advisory services to Swan and Wingecarribee under their IMP agreements. As noted above,
the proper law of the Swan IMP agreement was that of New South Wales. (Grange does not
rely on this argument as a defence against Swan in respect of what it did before the Swan
IMP agreement.) Grange pleaded that in advising Parkes to invest in Claim SCDOs and in
facilitating investment in those products by Swan and Wingecarribee, it acted in a manner
that at the relevant time was widely accepted by peer professional opinion as competent
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practice for a financial services adviser. The defence continued by asserting that the effect of
s 5O(1) of the Civil Liability Act excluded its liability for so acting. Section 5O provided:
“5O Standard of care for professionals
(1) A person practising a profession (a professional) does not incur a liability in negligence arising from the provision of a professional service if it is established that the professional acted in a manner that (at the time the service was provided) was widely accepted in Australia by peer professional opinion as competent professional practice.
(2) However, peer professional opinion cannot be relied on for the
purposes of this section if the court considers that the opinion is irrational.
(3) The fact that there are differing peer professional opinions widely
accepted in Australia concerning a matter does not prevent any one or more (or all) of those opinions being relied on for the purposes of this section.
(4) Peer professional opinion does not have to be universally accepted to
be considered widely accepted.” (original emphasis)
1109 Grange argued that s 5O applied to two aspects of its negligent conduct, first, by
recommending or facilitating the Councils’ investment in SCDOs in circumstances where
these products were unsuitable for local government authorities and, secondly, by
representing that the SCDOs were equivalent, as regards risk profile, to other types of
financial product carrying the same rating. It contended that its activity in marketing those
products to local government was consistent with the practice of peer financial services
advisers in Australia at the time. To make this argument good, Grange referred to:
(a) Westpac having offered or sold a number of CDOs to Parkes between
September 2003 and December 2005;
(b) ANZ having sold $1 million worth of the Averon II product to Parkes on 24
July 2007;
(c) Macquarie Financial Services having offered an SCDO to Parkes in October
2004 describing it as an FRN and asserting that this product’s AAA rating was
the “same credit risk as Australian Government Bonds”;
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(d) Local Government Financial Services having sold Parkes $3 million worth of
Community Income Constant Proportion Debt Obligation notes in November
2006;
(e) the Commonwealth Bank’s offer to Swan of a CDO called “Oasis Portfolio
Notes A” in August 2006 (see [324]-[331]);
(f) Oakvale’s assertion, in its presentation to Wingecarribee, that it had the most
experienced full time local government advisory team and included 14 large
Council portfolios among its clientele. It included “highly rated CDOs”
among its list of suitable investments;
(g) Grove’s inclusion in its material that it provided to Wingecarribee of CDOs
rated A or better as well as ABS and RMBS that complied with the Minister’s
order.
1110 Grange contended that these instances showed that its conduct in recommending the
Claim SCDOs as suitable investments for the Councils and marketing those products to them,
in particular by comparison with the ratings of other financial products, was consistent with
peer professional practice.
1111 Grange appeared to rely on s 5O(1) to negate its liability in negligence for making
representations (1) and (2)(a) (dealing with the suitability of the Claim SCDOs for local
government authorities) and (3)(b) (dealing with the Claim SCDOs being equivalent as
regards with other types of financial products with the same ratings). This defence can have
no application to Grange’s breaches of contract, other than its obligation to exercise
reasonable skill and care. Even if Grange could establish, for the purposes of s 5O(1), that
peer opinion that was not irrational and enabled it to obtain this immunity from liability under
State law, the provisions of s 12DA(1), a law of the Commonwealth, entitled the Councils to
relief for this conduct which was misleading and deceptive: see sections 6.4.3 and 6.4.4.
Accordingly, Grange’s invocation of s 5O(1) cannot excuse its liability for the conduct
complained of.
1112 In any event, I do not consider this defence to have been established. It cannot negate
the breach of each of contractual term (4) (the product was suitable and appropriate for a risk
averse local government) or contractual term (1) (the product had a high level of security for
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the protection of the capital invested by the Council): see sections 6.2.5 and 6.2.2. The
products either met the terms of the contractual promises or they did not. The section is
concerned with “a liability in negligence arising from the provision of a professional service”.
The contractual claims are founded on the failure of the products that Grange sold to meet the
contractual specification. The sale of a financial product is not the provision of a professional
service. The professional’s advice about whether or not the product will meet a contractual
requirement is different to the contractual term. Grange’s liability for breach of contract
based on the failure of the products to comply with their promised characteristics, is not a
liability in negligence at all.
1113 The defence in s 5O(1) (as was also the case with the proportionate liability defences)
was introduced as part of the implementation of the Review of the Law of Negligence
(Canberra, Commonwealth of Australia, September 2002) commonly known as the “Ipp
Report” after its Chair, Justice Ipp. The purpose of s 5O(1) was to partly reverse the
decision in Rogers v Whitaker (1992) 175 CLR 479 that professional practice could not
determine the standard of care that a professional should observe in relation to the provision
of advice and disclosure of risk: Dobler v Halverson (2007) 70 NSWLR 151 at 167-168
[59]-[62] per Giles JA with whom Ipp and Basten JJA agreed. Giles JA explained, that under
s 5O the Court determines the standard of care, guided by evidence of accepted professional
practice. He said that the defence provided by the section is that if the conduct complained of
accorded with professional practice regarded as widely accepted by professional practice as
competent, then the professional escapes liability, subject to any irrationality of the practice.
The professional carries the onus of proving the existence of a professional practice widely
accepted by peer professional opinion as competent professional practice. But, as Giles JA
said (70 NSWLR at 168 [61]; see too Sydney South West Area Health Service v MD (2009)
260 ALR 702 at 709 [21] per Hodgson JA with whom Allsop P at 715 [51] and
Sackville AJA agreed):
“Section 5O may end up operating so as to determine the defendant's standard of care, but the standard of care will be that determined by the Court with guidance from evidence of acceptable professional practice unless it is established (in practice, by the defendant) that the defendant acted according to professional practice widely accepted by (rational) peer professional opinion. To require the plaintiff to establish the negative would significantly distort the language of s 5O(1), and would not be consistent with the reference in s 5O(2) to reliance on peer professional opinion for the purposes of the section — the plaintiff does not rely on it in order to negate a liability in negligence.”
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1114 Here, Grange relied on documents and fragments of the evidence of relationships or
interactions that the various Councils had had with third parties as evidence of widely
accepted professional practice. I am not satisfied that those materials establish that what
Grange did in respect of either recommending to, advising or facilitating the Councils to
invest in the Claim SCDOs as suitable products for them or representing that those products
were equivalent as regards risk profile to other types of products carrying the same ratings,
was widely accepted in Australia by peer professional opinion as competent professional
practice. I have set out other contemporaneous documents identifying risks in section 3.7.
These do not support Grange’s argument.
1115 Ordinarily, the content of professional practice is established by calling evidence from
a professional as to what competent members of the profession do in a particular context or
situation. Here, the way in which Grange established its relationships with the Councils
established the duty and standard of reasonable skill and care that it owed to them as I have
found in sections 5.1.6, 5.2.4, 5.3.3 and 8.3. That required Grange to make recommendations
or give advice to the Councils conforming to what a prudent person would do, or to act on
their behalf as a prudent person, in accordance with established principles of law and Grange
did not, as I found in sections 6.2.7 and 6.5. Whatever other institutions may or may not have
done, or offered to the Councils or others, cannot displace the contractual requirement that
public money should only be invested in those investments that a prudent person acting in
accordance with those principles would select.
1116 In any event, considering the other products and what they provide involves
investigating other facts. These include questions as to the exact nature of the relationship,
for example, of the Councils and their banks when they dealt in or discussed some of the
examples of “peer” practice on which Grange relied: see [733] and the discussion there of
Commonwealth Bank of Australia v Smith 42 FCR at 391. The products were also different.
For example, when Westpac sold the Wollemi Trust Credit Linked Notes to Parkes in
October 2003 it asked Mr Bokeyar to sign a letter purporting to confirm that it had not given
Parkes any investment advice in connection with the investment: [497]. By August 2006 Mr
Evans of Westpac suggested Mr Bokeyar to switch $1 million of its investment in a Wollemi
product to Westpac’s AA- rated Principal Protected Property Notes, the principal of which
was 100% guaranteed by the bank [587]. When Mr Evans moved to ANZ he encouraged Mr
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Bokeyar to reduce the Councils’ exposure to CDOs and purchase the non-CDO Averon II
product that also provided “AAA principal protection on investors’ capital”: [595]-[596].
1117 This shows that the fragments that Grange referred to do not prove to any satisfactory
degree the existence of any professional practice. For these reasons, Grange failed to
establish its defence under s 5O(1).
8.3 Contributory negligence
8.3.1 The legislative schemes
1118 Contributory negligence is a defence not only to claims for damages in tort but also in
contract and under s 12GF of the ASIC Act and its analogues. In New South Wales, s 8 of the
Law Reform (Miscellaneous Provisions) Act 1965 (NSW) provided:
“wrong means an act or omission that: (a) gives rise to a liability in tort in respect of which a defence of contributory
negligence is available at common law, or (b) amounts to a breach of a contractual duty of care that is concurrent and co-
extensive with a duty of care in tort. … 9 Apportionment of liability in cases of contributory negligence
(1) If a person (the claimant) suffers damage as the result partly of the claimant’s failure to take reasonable care (contributory negligence) and partly of the wrong of any other person:
(a) a claim in respect of the damage is not defeated by reason of
the contributory negligence of the claimant, and (b) the damages recoverable in respect of the wrong are to be
reduced to such extent as the court thinks just and equitable having regard to the claimant’s share in the responsibility for the damage.
(2) Subsection (1) does not operate to defeat any defence arising under a
contract. (3) If any contract or enactment providing for the limitation of liability is
applicable to the claim, the amount of damages recoverable by the claimant by virtue of subsection (1) is not to exceed the maximum limit so applicable.”
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1119 The concept of contributory negligence under State law must be understood in light of
s 5R as it may be affected by ss 5B-5E of the Civil Liability Act which relelvantly provide:
Division 8 Contributory Negligence 5R Standard of contributory negligence
(1) The principles that are applicable in determining whether a person has been negligent also apply in determining whether the person who suffered harm has been contributorily negligent in failing to take precautions against the risk of that harm.
(2) For that purpose:
(a) the standard of care required of the person who suffered
harm is that of a reasonable person in the position of that person, and
(b) the matter is to be determined on the basis of what that
person knew or ought to have known at the time. Division 2 Duty of care 5B General principles
(1) A person is not negligent in failing to take precautions against a risk of harm unless:
(a) the risk was foreseeable (that is, it is a risk of which the
person knew or ought to have known), and (b) the risk was not insignificant, and (c) in the circumstances, a reasonable person in the person’s
position would have taken those precautions.
(2) In determining whether a reasonable person would have taken precautions against a risk of harm, the court is to consider the following (amongst other relevant things):
(a) the probability that the harm would occur if care were not
taken, (b) the likely seriousness of the harm, (c) the burden of taking precautions to avoid the risk of harm, (d) the social utility of the activity that creates the risk of harm.
5C Other principles
In proceedings relating to liability for negligence:
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(a) the burden of taking precautions to avoid a risk of harm includes the burden of taking precautions to avoid similar risks of harm for which the person may be responsible, and
(b) the fact that a risk of harm could have been avoided by doing
something in a different way does not of itself give rise to or affect liability for the way in which the thing was done, and
(c) the subsequent taking of action that would (had the action been taken
earlier) have avoided a risk of harm does not of itself give rise to or affect liability in respect of the risk and does not of itself constitute an admission of liability in connection with the risk.
Division 3 Causation 5D General principles
(1) A determination that negligence caused particular harm comprises the following elements:
(a) that the negligence was a necessary condition of the
occurrence of the harm (factual causation), and (b) that it is appropriate for the scope of the negligent person’s
liability to extend to the harm so caused (scope of liability).
(2) In determining in an exceptional case, in accordance with established principles, whether negligence that cannot be established as a necessary condition of the occurrence of harm should be accepted as establishing factual causation, the court is to consider (amongst other relevant things) whether or not and why responsibility for the harm should be imposed on the negligent party.
(3) If it is relevant to the determination of factual causation to determine
what the person who suffered harm would have done if the negligent person had not been negligent:
(a) the matter is to be determined subjectively in the light of all
relevant circumstances, subject to paragraph (b), and (b) any statement made by the person after suffering the harm
about what he or she would have done is inadmissible except to the extent (if any) that the statement is against his or her interest.
(4) For the purpose of determining the scope of liability, the court is to
consider (amongst other relevant things) whether or not and why responsibility for the harm should be imposed on the negligent party.
5E Onus of proof
In proceedings relating to liability for negligence, the plaintiff always bears the onus of proving, on the balance of probabilities, any fact relevant to the issue of causation.
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1120 In Western Australia, the Law Reform (Contributory Negligence and Tortfeasors’
Contribution) Act 1947 provided:
3A. Claims etc. founded on etc. negligence, construction of references to In sections 4 and 6 —
(a) a reference to a claim or action founded on or resulting from
negligence includes a reference to a claim or action founded on or resulting from a breach of a contractual duty of care that is concurrent with and coextensive with a duty of care in tort; and
(b) references to negligence have a corresponding meaning so far as they
relate to a defendant. 4. Contributory negligence, court may reduce plaintiff’s damages
(1) Whenever in any claim for damages founded on an allegation of negligence the court is satisfied that the defendant was guilty of an act of negligence conducing to the happening of the event which caused the damage then notwithstanding that the plaintiff had the last opportunity of avoiding or could by the exercise of reasonable care, have avoided the consequences of the defendant’s act or might otherwise be held guilty of contributory negligence, the defendant shall not for that reason be entitled to judgment, but the court shall reduce the damages which would be recoverable by the plaintiff if the happening of the event which caused the damage had been solely due to the negligence of the defendant to such extent as the court thinks just in accordance with the degree of negligence attributable to the plaintiff.
1121 The Civil Liability Act 2002 (WA) provided principles applicable to contributory
negligence in s 5K in similar terms to s 5R of its New South Wales counterpart and, in ss 5B,
5C and 5D substantially reproduced ss 5B, 5D and 5E, but not s 5C, of the New South Wales
Act.
1122 Finally, s 12GF(1B) of the ASIC Act qualified an applicant’s or plaintiff’s right to
recover loss or damage for a contravention of s 12DA(1) by providing:
(1B) Despite subsection (1), if:
(a) a person (the claimant) makes a claim under subsection (1) in relation to:
(i) economic loss; or (ii) damage to property;
caused by conduct of another person (the defendant) that was done in contravention of section 12DA; and
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(b) the claimant suffered the loss or damage:
(i) as a result partly of the claimant’s failure to take reasonable care; and (ii) as a result partly of the conduct referred to in paragraph (a); and
(c) the defendant:
(i) did not intend to cause the loss or damage; and (ii) did not fraudulently cause the loss or damage;
the damages that the claimant may recover in relation to the loss or damage are to be reduced to the extent to which the court thinks just and equitable having regard to the claimant’s share in the responsibility for the loss or damage.”
8.3.2 Principles applicable to contributory negligence
1123 The Ipp Report led to changes to the law of negligence as it applied both to contract
and tort. Thus, the defences given in s 9 of the Law Reform (Miscellaneous Provisions) Act
(the Law Reform Act) and s 4(1) of the Law Reform (Contributory Negligence and
Tortfeasors’ Contribution) Act have been qualified by the new statutory rules of causation in
the Civil Liability Acts. (For convenience, I will simply refer to the provisions of the New
South Wales Acts in what follows unless some distinct issue arises under the Western
Australian version.) Until recently, the parties had not addressed in their pleadings or
submissions whether and to what extent ss 5B-5E and 5R of the Civil Liability Act may have
affected their causes of action or defences based on negligence. Nor had they addressed
whether s 12GF(1B) of the ASIC Act interacted with those provisions. The parties’ recent
submissions have assisted in resolving those issues.
1124 It was common ground between the parties that s 5D(3)(b) of the Civil Liability Act
2002 (NSW) and its analogue had no application to these proceedings. That was because the
subsection used the personal pronouns “he or she” and “his or hers” and the expressions
“evidence of the injured person” and “made by the person after suffering the harm” which
were inapposite to describe the Councils, as statutory bodies. Thus, the hypothetical
responses of the Council officers as to what each would have done had particular matters
been brought to his attention were admissible: e.g. [207], [240], [448], [675]. It was also
common ground that the operation of s 12GF(1B) was unaffected by the two State Acts.
This is because negligence is not a part of the cause of action under s 12DA and its
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analogues: Dartberg Pty Ltd v Wealthcare Financial Planning Pty Ltd (2007) 164 FCR 450
at 457 [21]-[22], 458-459 [32]-[36] per Middleton J; Perpetual Trustee Co Ltd v Milanex Pty
Ltd (In Liq) [2011] NSWCA 367 at [87] per Macfarlan JA, Campbell and Young JJA
agreeing on this point; Monaghan Surveyors Pty Ltd v Stratford Glen-Avon Pty Ltd [2012]
NSWCA 94 at [75]-[77] per Basten JA, McColl and Young JJA agreeing.
1125 “Negligence” is defined in s 5 of the Civil Liability Act as meaning “failure to
exercise reasonable skill and care”, and “harm” includes economic loss. The test of causation
in s 5D(1) has two elements: factual causation, which is determined by the “but for” test, and
scope of liability: Adeels Palace Pty Ltd v Moubarak (2009) 239 CLR 420 at 440 [41], [45]
per French CJ, Gummow, Hayne, Heydon and Crennan JJ: Strong v Woolworths Ltd (t/a
Big W) (2012) 285 ALR 420 at 425-426 [18]-[20] per French CJ, Gummow, Crennan and
Bell JJ. For present purposes, Grange had the onus of proving the contributory negligence of
the Councils (s 5E). And, as the majority said in Strong 285 ALR at 426 [20]:
“Under the statute, factual causation requires proof that the defendant’s negligence was a necessary condition of the occurrence of the particular harm. (As McHugh J points out in March v E & MH Stramare Pty Ltd (1991) 171 CLR 506 at CLR 529-30, the concept of a condition that is necessary to an occurrence is the lawyers’ adaptation of John Stuart Mill’s theory that the cause of an event is the sum of the conditions which are jointly sufficient to produce it. See also H L A Hart and A M Honoré, Causation in the Law, 2nd ed, Clarendon Press, Oxford, 1985, pp 68-9 and 109-14). A necessary condition is a condition that must be present for the occurrence of the harm. However, there may be more than one set of conditions necessary for the occurrence of particular harm and it follows that a defendant’s negligent act or omission which is necessary to complete a set of conditions that are jointly sufficient to account for the occurrence of the harm will meet the test of factual causation within s 5D(1)(a). (J Fleming, The Law of Torts, 9th ed, 1998, p 219; March 171 CLR at 509; per Mason CJ. See also Hart and Honoré, 1985, p 18). In such a case, the defendant’s conduct may be described as contributing to the occurrence of the harm.” (emphasis added)
1126 The contributory negligence of an applicant or plaintiff was a complete defence at
common law. This led to ameliorative legislation such as s 9 of the Law Reform Act which
permitted the Courts to apportion liability between parties where the negligence of each had
contributed to the loss or damage complained of. The purpose of s 5R of the Civil Liability
Act is to set a standard of care by which to assess the conduct of the injured party for the
purpose of determining the application of s 9 of the Law Reform Act. The Ipp Report
explained that the purpose of s 5R was to ensure that the same standard of care applied to the
assessment of each party’s responsibility. It noted a perception that a lesser standard of care
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had been applied when an injured party’s contributory negligence was being considered
([8.11]). The report identified the widely held expectation in the community that, “in general,
people will take as much care for themselves as they expect others to take of them” ([8.10]),
and continued that:
“8.12 It is important to note that applying the same standard of care to contributory negligence as to negligence does not entail ignoring the identity of the plaintiff or the nature of the relationship between the plaintiff and the defendant.”
1127 In ACQ Pty Ltd v Cook (2008) 72 NSWLR 318 at 350 [158] Campbell JA, with
whom Beazley and Giles JJA agreed, said that ss 5R and 5S of the Civil Liability Act
presupposed that someone had been contributorily negligent and operated to modify the way
in which s 9 of the Law Reform Act operated. While s 5S provides that a court can find that
contributory negligence can reduce the respondent’s or defendant’s liability by 100%, I do
not consider that either s 5R or s 5S presupposes that the injured party has been contributorily
negligent. Rather, the sections operate to establish an analytical framework in which the
Court can determine the question of whether or not a finding of contributory negligence
should be made and, if so, the basis on which and the way in which the power to apportion
responsibility should be exercised on the facts. That is why s 5R(1) imports the principles in
ss 5B-5E into the assessment of whether the injured party has been negligent at all: i.e.
whether that person had “failed to exercise reasonable care and skill” (as defined in s 5).
Next, s 5R(2)(a) identifies the legal standard of care that must be used to assess that question,
namely that of a reasonable person in the position of the injured party. And s 5R(2)(b)
requires the Court to decide the question objectively by reference to what the person knew or
ought to have known.
1128 In Astley 197 CLR at 11 [21] Gleeson CJ, McHugh, Gummow and Hayne JJ said:
“At common law, contributory negligence consisted in the failure of a plaintiff to take reasonable care for the protection of his or her person or property.”
They went on to hold that s 9 of the Law Reform Act and its analogues can operate in respect
of the injured party’s contributory negligence where the respondent or defendant, in breach of
its duty, had failed to protect the applicant or plaintiff in respect of the very event which gave
rise to the respondent’s or defendants’ employment and continued (197 CLR at 14 [29]-[30]):
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“A finding of contributory negligence turns on a factual investigation of whether the plaintiff contributed to his or her own loss by failing to take reasonable care of his or her person or property. What is reasonable care depends on the circumstances of the case. In many cases, it may be proper for a plaintiff to rely on the defendant to perform its duty (cf Trompp v Liddle (1941) 41 SR (NSW) 108 at 109-110). But there is no absolute rule. The duties and responsibilities of the defendant are a variable factor in determining whether contributory negligence exists and, if so, to what degree. In some cases, the nature of the duty owed may exculpate the plaintiff from a claim of contributory negligence; in other cases the nature of that duty may reduce the plaintiff's share of responsibility for the damage suffered; and in yet other cases the nature of the duty may not prevent a finding that the plaintiff failed to take reasonable care for the safety of his or her person or property. Contributory negligence focuses on the conduct of the plaintiff. The duty owed by the defendant, although relevant, is one only of the many factors that must be weighed in determining whether the plaintiff has so conducted itself that it failed to take reasonable care for the safety of its person or property.” (emphasis added)
1129 Thus, in order to determine whether any of the Councils was contributorily negligent,
s 5R requires an assessment on the basis of all the circumstances, including the relationship
between the parties, as well as what the Council knew, or a reasonable person in its position
ought to have known, and, in those circumstances, whether the Council exercised, or such a
person failed to exercise reasonable care and skill to take precautiouns against the risk of the
economic loss that, but for Grange’s negligence, it would not have suffered.
1130 As explained by Gibbs CJ, Mason, Wilson, Brennan and Deane JJ in Podrebersek v
Australian Iron & Steel Pty Ltd (1985) 59 ALR 529 at 532-533 (see too Nominal Defendant v
Meakes (2012) 60 MVR 380 at 399 [79]-[80] per Sackville AJA with whom McCole and
Basten JJA agreed; Smith v Zhang (2012) 60 MVR 525 at 532 [20] per AJ Meagher JA with
whom Tobias AJA agreed); once contributory negligence is found then s 9 of the Law
Reform Act requires an apportionment to be made between the parties:
“of their respective shares in the responsibility for the damage [that] involves a comparison both of culpability, ie of the degree of departure from the standard of care of the reasonable man (Pennington v Norris (1956) 96 CLR 10 at 16) and of the relative importance of the acts of the parties in causing the damage: Stapley v Gypsum Mines Ltd [1953] AC 663 at 682; Smith v McIntyre [1958] Tas SR 36 at 42–49 and Broadhurst v Millman [1976] VR 208 at 219, and cases there cited. It is the whole conduct of each negligent party in relation to the circumstances of the accident which must be subjected to comparative examination. The significance of the various elements involved in such an examination will vary from case to case; for example, the circumstances of some cases may be such that a comparison of the relative importance of the acts of the parties in causing the damage will be of little, if any, importance.”
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1131 Here, each Council used Grange as an expert financial adviser to assist it in obtaining
a better return on its public funds than the inexpert Council officers. Grange’s role was to
recommend to, and advise, Swan (before the IMP agreement) and Parkes on investments or to
exercise its powers under an IMP agreement to make investments on Swan’s or
Wingecarribee’s behalf, on the basis that Grange would exercise reasonable skill and care so
that any such investment would meet the requirements of the relevant contract that Grange
had with the Council. I have found that, but for Grange’s negligence, the Councils would
never have invested in the Claim SCDOs: sections 6.2.7, 6.2.8, 6.2.9 and 6.5. The question
is what precautions would a reasonable person in the position of each Council have taken
against the risk of economic loss from such investments or, in the case of the IMP
agreements, from Grange being able to make such investments, based on Grange fulfilling its
role? The beliefs or lack of knowledge of each Council cannot prevent a finding of
contributory negligence, if a reasonable person in the same circumstnces would have taken
precautions to protect the Council’s interests: Astley 197 CLR at 16 [35]. However, as
Gleeson CJ, McHugh, Gummow and Hayne JJ recognised in Astley 197 CLR at 11 [21],
citing Trompp v Liddle (1941) 41 SR (NSW) 108 at 109-110, in many cases it may have been
proper for the Councils to have relied on Grange to have performed its duty (or contractual)
obligation. In Trompp 41 SR (NSW) at 109 Jordan CJ, Halse Rogers and Street JJ said that a
driver was entitled to assume that other drivers would observe the rules of the road. Such an
assumption did not entitle a driver to drive in any way he or she chose or with complete
indifference to the possibility of what might happen as he or she was proceeding. However,
as the Full Court said, the assumption meant that it was not unreasonable for the driver to act
on the basis that “other drivers are obeying the rules unless there is something that should
make him realise that they are not”. (emphasis added) (The High Court dismissed an
appeal for reasons not reported: 41 SR (NSW) 326.)
8.3.3 Was Swan contributorily negligent?
1132 Grange contended Swan’s damages should be reduced by 50%. It argued that Swan
failed to act reasonably because its officers, Mr Senathirajah and Mr Downing:
failed to understand the documents that Grange provided to them concerning
the nature and risks of Claim SCDOs;
could not recall reading the documents in detail or at all;
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did not pay attention to or have any interest in the documents;
did not obtain other key documents from other Swan employees;
failed to ensure that the investments complied with the 2003 Swan Policy,
such as the decision to invest in the Blaxland product despite its term to a
maturity exceeding five years by half a year: see [333];
failed to inform Grange that investments in the Claim SCDOs did not comply
with Swan’s investment preferences.
1133 Relevantly, in contracts before the Swan IMP agreement, Grange’s contractual
obligation in term (6), and co-extensive tortious duty, was, in respect of each investment in a
Claim SCDO, to exercise reasonable skill and care in making that investment
recommendation and giving that investment advice to Swan: [721], [790]. Under the Swan
IMP agreement, Grange had a contractual obligation to perform its services with reasonable
skill and care and a co-extensive tortious duty [770]. The standard of care was that of a
reasonable financial adviser acting in accordance with s 18(1) of the Trustees Act 1962 (WA)
and the 2003 Swan Policy in respect of each investment Grange recommended or advised
Swan to make before the IMP agreement, or subsequently made on its behalf: [790].
1134 The first issue for present purposes is whether Swan was negligent in failing to act as
Grange argued it should have. Except with respect to the Blaxland product, Grange did not
point to what reading and understanding the material it had provided would have done to
cause Mr Senathirajah or Mr Downing to have rejected or not acted on Grange’s
recommendation or advice or to have questioned investments Grange made for Swan. The
basis for my finding that Grange breached term (6), the implied term in the IMP agreement
and the co-extensive duties of skill and care was, respectively, its breaches of terms (1), (2),
(3) and (4) of the contracts: section 6.2.7, and its investment under the IMP agreement, as
Swan’s agent, in the Claim SCDOs: section 6.2.8. While more careful attention to some or
all of Grange’s written material and explanations or the 2003 Swan Policy might have put Mr
Senathirajah or Mr Downing off deciding that Swan should invest in a particular Claim
SCDO or question an investment Grange had made, Grange did not prove that such attention
was likely to have done so.
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1135 After all, Grange was the expert financial adviser, familiar with the 2003 Swan
Policy, aware of its client’s requirements and the requirements of the Local Government Act
and the Trustees Act for investing Swan’s funds. Was Mr Senathirajah or Mr Downing
supposed to check everything Grange did to see if it was performing the role it said it would?
As I observed at [410], the nature and risks of SCDOs are concepts that are beyond the grasp
of most people. Grange knew that this was so for local government councils. It could never
have engaged in its dealings in the Claim SCDOs with the Councils, including its “no haircut
repos”, if it had given them the explanations necessary for the Councils to understand all
relevant risks of these financial products.
1136 While Grange explained to the Council officers, for example, that, if sufficient credit
events affected the reference portfolio of an SCDO, some or all of the capital invested could
be lost, it did so in the context that this was a minimal and remote risk and the product had a
rating equal to or higher than the four major Australian banks. However, the risks reflected
in Grange’s breaches of contractual terms (1), (2), (3) and (4), including the risk of
unexpected loss, the fragility of the secondary market and the lack of liquidity, were not risks
that a reasonable person in the Councils’ position would or should have ascertained in taking
reasonable care for its protection from the risk of economic loss.
1137 The mere fact that Swan’s officers were made aware of certain risks cannot be
divorced from the context of Grange being its financial adviser, its giving recommendations
and advice to the Council, the failings of that advice, and the unlikelihood of the Council
finding out other information as to the risks that Grange did not disclose or explain which
would have provided a fuller appreciation of the relevant risks of economic loss from any
investment in the Claim, and other, SCDOs.
1138 If a professional recommends or advises a client to take, or takes on the client’s
behalf, a particular step or decision based on the professional’s expertise, ordinarily the client
will not be equipped to analyse, and certainly not with the same degree of expertise, the basis
on which the recommendation or advice was given or the step or decision taken. Grange
knew that Swan lacked financial sophistication: section 4.2.6. After all, one might ask
rhetorically, first, if the Councils had those skills, why would they have needed to retain
Grange and, secondly, why did it see a significant commercial opportunity in positioning
itself as an expert financial adviser for local government councils?
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1139 The Councils engaged Grange as their financial adviser to make recommendations
and give advice and, under the IMP agreements exercise its mandate on their behalf,
consistent with their statutory and policy requirements for investing their funds. Grange’s
performance of this role relieved them of the need to do the detailed work in selecting and
monitoring the forms of investments. Once Grange had persuaded Mr Senathirajah that the
Forum product was a suitable kind of product for the Council, it was not essential for him or
Mr Downing to go back over each new proposal in any detail. Once a professional gains a
client’s confidence, the client is entitled to continue to repose that confidence in their further
dealings: Astley 197 CLR at 11[21]; Trompp 41 SR (NSW) at 109.
1140 In the event, Swan claimed no loss from its investment in the Blaxland Claim SCDO,
so it is not necessary to consider what consequence should flow from Mr Downing’s
conscious decision to invest in that product.
1141 I am not satisfied that but, for the failings of Swan’s officers that Grange identified in
its submissions, the Council would not have suffered the economic loss that it proved.
Moreover, I am not satisfied that it would be appropriate for the scope of Swan’s duty to take
reasonable skill and care to extend to the harm Grange caused it in the respects I have found
(s 5C(1)(b) of the Civil Liability Act 2002 (WA) or s 5D(1)(b) of the New South Wales
analogue). That harm occurred because of Grange’s breaches of contract and its tortious
duty, that were separate from whatever might have been ascertained by Swan paying more
attention to what Grange provided it. Grange’s breaches concerned what it did not inform
Swan about and its own failings in making recommendations and giving advice about, or
using its mandate to invest on Swan’s behalf in, the Claim SCDOs, being products in respect
of which it was an expert.
1142 For these reasons, I am not satisfied that Swan was contributorily negligent for the
purposes of any statutory provision in respect of the periods before and after the IMP
agreement.
8.3.4 Was Parkes contributorily negligent?
1143 Grange contended that Parkes had been contributorily negligent by delegating
responsibility for investing its surplus funds to Mr Bokeyar and by reason of his conduct in
respect of those investments. First, Grange said that Parkes failed to fulfil its duty of care by
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delegating responsibility to Mr Bokeyar by reference to the NSW Best Practice Guide that
Parkes had received in about April 2006: see [116], [555]-[559]. It contended that that
Guide recommended that Councils identify any internal gaps in knowledge required to
adequately manage their investments, ensure staff involved in that task received adequate
training and that a suitably qualified staff member was given day to day responsibility for this
task. Grange contended that Mr Bokeyar had numerous gaps in his knowledge, was not
adequately trained and did not have suitable skills for the day to day management of Parkes’
investments. It argued that he had no formal training or relevant experience in investment
management.
1144 Grange noted that Mr Bokeyar had begun purchasing structured credit products, being
the MBSs from Westpac in 1997. It contended that Mr Bokeyar had a limited understanding
of the MBS and FRN products that he had been investing Parkes’ funds in when he began
dealing with Grange. Grange said that by late 2006, even after purchasing 18 SCDOs, Mr
Bokeyar did not understand how a CDO worked. It submitted that he did not understand key
finance terminology and he was not given sufficient time to spend on managing the Councils’
investments. As a result, Grange argued, he also did not have time to understand the products
presented to him by a number of financial institutions.
1145 Additionally, Grange noted Mr Bokeyar did not read or pay much, if any, attention to
documents he was given or sent concerning financial products, including research notes,
information memoranda, term sheets, slide presentations or bulky documents. Grange
pointed to Mr Bokeyar’s reliance on only what he said Westpac’s officers had told him orally
about the bank’s willingness to buy the MBS securities back if Parkes needed the money,
even though this was not put in writing: see [423]-[427]. Grange pointed out that the term
sheet for the 1998 MBS stated that those notes would be “unsecured and subordinated
obligations of the issuer (in respect of both principal and interest) and will not constitute
deposit liabilities for the purposes of the Banking Act”. Grange also relied on Mr Bokeyar’s
inattention to detail in agreeing to acquire the HY-FI product: section 4.4.5. It argued that
the above matters showed that, contrary to the caution expressed in the NSW Best Practice
Guide, Mr Bokeyar invested in products that he did not fully understand, nor did he attempt
to understand them, and he did not refer to matters identified in the Guide’s CDO checklist:
see [555]-[559]. Grange contended that Parkes did not change its approach to investments
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after receiving the Guide or adopt its suggestions. Accordingly, it submitted that Parkes’
damages should be reduced by 50%.
1146 The Councils retorted that the NSW Best Practice Guide also stated that Councils
should “seek independent research and advice before investing in sophisticated product types
(e.g. managed funds, floating rate notes - FRNs or collateralised debt obligiations – CDOs)”.
They contended that by seeking Grange’s advice prior to investing, they, including Parkes,
were acting in accordance with the Guide.
1147 I do not consider that it is realistic to assess Parkes’ conduct, before the Guide was
sent to it in about April 2006, against the contents of the Guide. While the investment of its
surplus funds was important, Mr Bokeyar had done so in a way that was unexceptionable
before Parkes began dealing with Grange. He understood the prudent person test and
discussed investment matters with Mr Matthews: [418]. Mr Bokeyar worked better with
discussion rather than documents. The second of two MBS products that Grange instanced as
examples of his negligence was issued by Westpac itself, so that although it was a
subordinated debt, it was owed directly to Parkes by the bank. As I found, those MBS
products and the FRNs in which Parkes had invested were not comparable to the Claim
SCDOs and were conservative investments: [426]-[429]. Those conservative investments
suggest that Mr Bokeyar had adopted the prudent person approach, and discharged his duties
in his own idiosyncratic way, appropriately in relation to Parkes’ investments.
1148 Ms May initially gained Mr Bokeyar’s confidence in the first half of 2002 through
proposing that Parkes invest in bank, or ADI issued, FRNs. That accorded with the
Minister’s investment guidelines [431]-[434]. And, as I have explained at [436]-[438]
Grange was keen to emphasise to Parkes that it understood Councils’ needs and
recommended FRNs as investments for them on that basis. It did this, apparently
strategically, just before it began trying to market, as an FRN, the Gilbraltar SCDO in
October 2002. That is how Grange described the Forum AAA SCDO too. In the words of
Ms May’s email to Mr Bokeyar of 18 February 2003, that SCDO was a “5 year FRN with a
coupon of BBSW + 130 [bps]”. Mr Bokeyar did not receive a slide presentation for this
“FRN”: see section 4.4.3. I recorded his lack of understanding of what a CDO was at [443].
That state of mind also demonstrated just what Grange had set out to do - persuade
financially unsophisticated local government officials that SCDOs were just a form of FRNs,
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being products with which they were already familiar and comfortable. In section 4.4.3 I also
dealt with the causal factors that led Mr Bokeyar and Parkes to invest in the Forum product
and, thus, to trust Grange. As I found in [462] Mr Bokeyar was careless in not reading the
material that Grange sent him. But, Grange did not explain to him or Parkes all the relevant
risks that this product had. Grange knew that, by describing the Forum SCDO as an FRN
with a rating of AAA, Mr Bokeyar could understand that it apparently was a financial product
of the kind with which he was familiar, with some added complex features that created no
real risk of loss, given the high credit rating.
1149 It is in that context, where Grange was the expert, recommending and advising Parkes
through Mr Bokeyar and Mr Matthews, to invest in an “FRN”, that it becomes necessary to
analyse what was, relevantly for s 5R of the Civil Liability Act, Mr Bokeyar’s duty (on
Parkes’ behalf) to take care. He had expert advice from Grange to buy a AAA rated product
that had a good return and was an FRN. Grange did not convey to Mr Bokeyar or Parkes the
risk disclosures in the issuers’ offering memoranda set out at [92] and [122]-[123] in writing
or orally. At this point, with hindsight and the insight from Mr Bokeyar’s evidence quoted at
[445], it is easy to say that he would never have agreed to invest in the Forum SCDO had he
taken the trouble to read Mr Vincent’s research note of 4 March 2003. But, that raises the
question of why a reasonable person in his position ought to have done so. Mr Bokeyar and
Ms May had previously discussed the kinds of FRNs that Grange recommended as suitable
for local government, being FRNs issued by ADIs that were “always tradeable (i.e. liquid)”.
The material in the term sheet for this product was not very informative of any risks unless
the reader had some understanding of what an SCDO was. In her short email of 18 February
2003 attaching the term sheet, Ms May told Mr Bokeyar, in language he could understand,
that it was a AAA rated “5 year FRN with a coupon of BBSW + 130 [bps]”. This was
calculated to suggest to a reasonable person in Mr Bokeyar’s position that the product was
not unusual, but rather, was like the FRNs Mr Bokeyar and Ms May had previously
discussed.
1150 Deutsche Bank AG, Sydney branch, was the arranger for this AAA rated FRN
identified on the term sheet for the Forum SCDO [440]. There was no evidence that Ms May
informed Mr Bokeyar orally about, or told him to read, the first page of Mr Vincent’s
research note. It is not clear whether the note arrived at his office before or after Mr Bokeyar
decided to invest. The note was dated 4 March 2002, although, were it read, the
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typographical error of “2002” instead of “2003” would have been apparent. In this context,
what was it that required a reasonable person in Mr Bokeyar’s position to take extra steps,
after receiving an investment recommendation or advice from an expert, to explore the
product or read all the other material Grange might or did send him about it? The rating and
description of “FRN” suggested the product was very safe. Grange’s description of it as an
“FRN” used familiar terminology. Mr Bokeyar had an understanding that a CDO (not
SCDO) was a product that evolved from an FRN (see [443]). He understood that there was a
risk of loss from credit events or defaults in these. It appeared to fall within the Minister’s
order and investment guidelines. And Grange recommended and advised that Parkes buy it.
1151 The relevant breach by Grange of its obligation or duty to exercise reasonable skill
and care was in making recommendations and giving advice to Parkes to buy the Claim
SCDOs (in breach of contractual terms (1), (2), (3) and (4): [899]), because the products (as
found in sections 6.2.2-6.2.5):
did not have a high level of security of capital invested by the Council;
were not easily tradeable on an established secondary market;
were not readily able to be liquidated for cash at short notice;
were not a suitable and appropriate investment for a risk-averse local
government council.
1152 Mr Bokeyar was very averse to any product that had a risk of price volatility or capital
loss. His conduct revealed as much when he discovered what he carelessly had failed to read
or realise in the 15 or so months from when he decided to invest in the HY-FI product until
he realised in January 2005 that it was listed on the ASX: see section 4.4.5. That realisation
caused him to instruct Grange to sell the HY-FI product because he considered it had a risk of
price volatility. Ironically, as I found at [490]-[494], the HY-FI product actually had some
liquidity in a real market, unlike those SCDOs that could only be traded in Grange’s
secondary market. He did not understand this or the risks that Grange failed to advise Parkes
about for which it is liable for breach of contract and in negligence in respect of the Claim
SCDOs.
1153 Viewed in light of Mr Bokeyar’s actual behaviour initially in agreeing to invest in the
HY-FI product and then realising that, although it was liquid, it was exposed to the risks of
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price volatility and loss of the Councils’ capital, I have no doubt that had Grange told him of
the risk factors at [122]-[123], he would never have invested in the Claim SCDOs. Although
Mr Vincent’s research note of 4 March 2003 referred to the risks of volatility and a temporary
drop in liquidity over the shorter term, Grange did not inform Mr Bokeyar or any of the
Councils or their officers of those risk factors, orally or in writing, (except to some extent,
that is not relevant in the circumstances, in the slide presentation for the Federation product:
cf [371]). If not by March 2003, soon after, Grange knew, or it would have been obvious to
it, that Mr Bokeyar needed oral explanations, recommendations and advice because he did
not pay attention to documents or emails. He always had to discuss the matters with
Grange’s personnel. The contemporaneous documentary evidence showed that to be the
case.
1154 How did Mr Bokeyar’s carelessness in not reading what Grange sent him or in not
understanding what risks SCDOs had, based on what Grange had told him or provided him in
writing, contribute to the economic loss Parkes suffered?
1155 In March 171 CLR at 515-516, Mason CJ said:
“That said, the “but for” test, applied as a negative criterion of causation, has an important role to play in the resolution of the question. So much was conceded by Dixon C.J., Fullagar and Kitto JJ. in Fitzgerald v. Penn ((1954) 91 CLR at pp 276-277) in their discussion of the unreported decision of this Court in Skewes v. Public Curator (Qld.) (6 September 1954) where A and B were driving their vehicles at excessive speeds in conditions of poor visibility so that their vehicles collided. A was on his correct side of the road, B was not. A’s negligence was not causative of injury. Their Honours pointed out that, had the action been tried by a jury, it would have been correct for the judge to instruct the jury “to ask themselves the question whether they were satisfied that the collision would not have taken place with the same results if driver A had been driving at a reasonable speed”. See also I.C.I.A.N.Z. Ltd. v. Murphy ((1973) 47 ALJR at pp 127-128)); Duyvelshaff v. Cathcart & Ritchie Ltd. ((1973) 47 ALJR at pp 414-417, 419; 1 ALR at pp 134-135, 138, 142-143).” (emphasis added)
1156 In Strong 285 ALR at 427-428 [23]-[28] the majority discussed the use of the
expression “material contribution” (see Bonnington Castings Ltd v Wardlaw [1956] AC 613
at 621 per Lord Reid) in the identification of causation under s 5D. Their Honours said at
[26]:
“Negligent conduct that materially contributes to the plaintiff’s harm but which cannot be shown to have been a necessary condition of its occurrence may, in accordance with established principles (March 171 CLR at 514 per Mason CJ), be
- 417 -
accepted as establishing factual causation, subject to the normative considerations to which s 5D(2) requires that attention be directed.”
1157 French CJ, Gummow, Crennan and Bell JJ went on to add that the “but for” analysis
of factual causation can include cases in which there is more than one sufficient condition for
the occurrence of the applicant’s or plaintiff’s injury. But, their Honours declined to explain
how this worked in the application of s 5D(1) (285 ALR at 428 [28]).
1158 Here, of course, the only reason that Parkes was investing in the Claim SCDOs was
because Grange recommended and advised that it should. But for that conduct of Grange, Mr
Bokeyar would not have acted to cause Parkes to buy the Claim SCDOs. In my opinion, Mr
Bokeyar’s reliance on the matters I have found at [450]-[462] was reasonable in the
circumstances, even though he was careless in failing to read the material that Grange sent
him. Had he done so, he would have caused the Council not to invest in the Forum SCDO
and, subsequently in other SCDOs. Mr Bokeyar’s carelessness in this situation was like that
of driver A in Skewes as explained by Mason CJ in March 171 CLR at 515-516. The
research note dated 4 March 2002 and subsequent material that he received, but did not read,
would not have told him of the relevant risks. It is true that, had he read that research note,
he would have perceived that the, as yet unrated, Forum product had a risk, in the shorter
term, of price volatility, in the sense of the possibility of price movements like those of shares
on the ASX, and a temporary loss of liquidity: see [444]-[445].
1159 But, the risks of short term price volatility and a temporary drop in liquidity which Mr
Bokeyar referred to as his understanding of the risks described in the research note, were
substantively different from the risks of volatility in the credit markets with a leveraged
impact (i.e. unexpected loss) and lack of liquidity described in the offering memoranda set
out at [92] and [123]. As he said, had he been informed, when considering investing in the
Forum SCDO, of the risks described in the issuers’ offering memoranda at [122]-[123] he
would have shown Ms May to the door: [448], [536]-[537]. He was reacting to risks to
which he had an aversion. Ms May had not informed Mr Bokeyar, except through providing
the research note, that international events could affect the soon to be AAA rated Forum
product by reason of the existence or operation of the inherent risks of SCDOs that I have
discussed in sections 6.2.2 to 6.2.5 as the reason why Grange was in breach of its contracts of
sale of those products to Parkes.
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1160 If a client asks a professional, such as a solicitor for advice on a contract and the
solicitor gives the advice, ordinarily, the client does not need, or have a duty, to read or
understand the contract or the technical legal rationale for that advice: Astley 197 CLR att 11
[21]; Trompp 41 SR (NSW) at 109. That remains so, even if the solicitor provides copies
of, or gives references to, relevant statutes or authorities on which the advice is based that the
lay client can check if he or she wants to do so. If the advice warns the client of a problem,
the client will not usually be able to complain if it eventuates, unless the solicitor gave
further, but inaccurate, advice on that problem on which the client relied. Nor did the Court
suggest in Daly 160 CLR 371 that the client of a stockbroker had any responsibity to check or
second guess the advice the broker gave about an investment. Similarly, if a doctor advises a
patient to have an operation, the patient ordinarily does not need, or have a duty, to check
what the doctor said as his or her justification for the advice. Generally speaking, the patient
is entitled to act on the advice. The common law imposed a duty on a surgeon in the failure
to warn cases, such as Rogers v Whitaker (1992) 175 CLR 479 and Chappell v Hart (1998)
195 CLR 232, to identify risks of an operation, so that the patient could make an informed
choice about whether to undergo it at the time.
1161 By the time Parkes received the NSW Best Practice Guide in about April 2006, its
dealings with, and trust of, Grange in relation to SCDOs were well established. Moreover, as
I found at [555], the Guide itself revealed that its authors did not understand that SCDOs
were, in a commercial sense, derivatives. Nor did the Guide discuss what synthetic CDOs
were or the plethora of risks and complex considerations which these instruments involved.
And, as Mr Bokeyar said when cross-examined on investing in CDO products that he did not
understand, he was happy with Grange’s advice which he saw was confirmed in the high
ratings [557]-[559]. Grange’s last slide presentation to Parkes for the Federation Claim
SCDO included some written explanation of risk factors involving limited liquidity and
volatility ([92], [371]). However, Ms May never dealt with or explained to Mr Bokeyar any
of the risk factors set out in those slides: [591].
1162 What precautions against Parkes suffering economic loss by acting on Grange’s
recommendations and advice did a reasonable person in Parkes’ position need to take (s 5R)?
If Mr Bokeyar or a reasonable person in his position ought to have either read and
understood, or sought to understand, a particular, or every, document that Grange sent or
asked some question of Grange, only then would Parkes have been contributorily negligent in
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failing to take precautions against the risk of harm. It may have been important, for example,
for Mr Bokeyar to read the contract notes to check that they reflected the transaction that he
or Parkes had instructed Grange to make. However, if a professional financial adviser told a
client that a product had the features that Ms May told Mr Bokeyar orally, what would a
reasonable person have done? It is not as if she had told him that it had particular risks that
he ignored. Nor can a client be expected to read every circular or other document an adviser
sends him or her about a product, however long or short, technical or not.
1163 Parkes took comfort from Grange’s unqualified use of the Claim SCDOs’ high credit
ratings. These did not deal with all relevant risks, in particular, the risk of unexpected loss, of
these products: section 6.2.2. Similarly, each of the other breaches of contract that I have
discussed in sections 6.2.3-6.2.5 and 6.2.7 were not risks that were foreseeable to Parkes. It
did not know of those risks and, unless it retained another financial adviser to give a second
opinion on Grange’s recommendations and advice, those risks would not be ascertainable by
a person in Parkes’ position. Moreover, that is why it used Grange as a financial adviser –
because Grange knew and understood, or so Parkes was entitled to think, the nature, risks and
suitability of the products it recommended to and advised Parkes to buy. Grange’s role was
to advise Parkes.
1164 Leaving aside the 4 March 2003 research note, Grange’s argument on Parkes’
contributory negligence comes down to the simple proposition that Parkes should not have
taken Grange at its word when it acted as an expert in making recommendations or giving
advice. Grange’s argument has all the disingenuity of the promoter’s failed argument that
Lord Macnaghten debunked in Gluckstein [1901] AC at 251-252: see [243]. Mr Bokeyar’s
failures to read or understand what Grange provided or told him concealed from him risks
that would have made him uncomfortable with acquiring the Claim SCDOs. But those risks
and the concerns they would have raised for Mr Bokeyar were unrelated to Grange’s breaches
of contract and negligence. For example, he did not pay attention in acquiring the HY-FI
product that Grange had told him, before its acquisition, was listed on the stock exchange:
section 4.4.5. This, and other examples of Mr Bokeyar’s lack of attention to any document or
detail, has caused me to consider his evidence very carefully.
1165 I am comfortably satisfied that he and Parkes were never told of the risks (or the
substance of them) in the issuers’ offering memoranda at [92], [122]-[123] and those I have
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found as breaches of contract. That is because no evidence suggests that Grange told any of
the three Councils of these matters. It is material that Grange was the secondary market and
the sole source of liquidity for the Claim SCDOs, while being substantially undercapitalised
itself. It had to maintain the existence or appearance of this market and liquidity to interest
its clients in the products it was selling and make its profits. It was not in Grange’s interest to
tell its clients what the risks in the offering memoranda at [92] or [122]-[123] were: see e.g.
[535]-[537]. That may be why it never did so.
1166 However, Mr Vincent’s research note of 4 March 2003 came to Mr Bokeyar at a time
when there was international uncertainty brought about by the imminence of the potential for
a war in Iraq. He would have received the note, if not before 5 March 2003, soon after, and
before Parkes was informed on 21 March 2003 that the Forum product’s AAA rating had
been confirmed. Grange had not sent a research note on an FRN to Mr Bokeyar before. I am
of opinion that a reasonable person in his position ought to have looked at the document and
at least begun to read it to understand why it had been sent and what it was conveying about
the potential $1 million investment Parkes was proposing to make. As Mr Bokeyar’s
evidence showed (see [445]) had he done so, he would not have invested in the Forum
SCDO.
1167 For these reasons, Parkes failed to take reasonable care against the risk of economic
loss from investing in the Forum notes. However, it suffered no loss from that investment.
The risks that Mr Bokeyar found unacceptable in the 4 March 2003 research note and that
would have caused him not have invested in the Forum AAA product, were not congruent
with those in the issuers’ information memoranda at [92], [122]-[123]. He said that had he
known of the risks set out at [122]-[123] he would have been caused to show Ms May to the
door: [448]. Grange never informed him of those categories of risk. No other material in
evidence suggested that Grange drew any of those categories of risk to Parkes’ attention on
any other occasion. No other carelessness on Mr Bokeyar’s or Parkes’ part made any
contribution to the economic harm Parkes suffered by investing in the Claim SCDOs.
1168 In the end, it is necessary to weigh up the contributions of Parkes and Grange to that
economic loss. I consider that it was proper for Parkes to have relied on Grange to perform
its contractual obligation and tortious duty to exercise reasonable skill and care: Astley 197
CLR at 11 [21], 14 [30], citing Daniels v Anderson (1995) 37 NSWLR 438 at 568 per Clarke
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and Sheller JJA; Trompp 41 SR (NSW) at 109. I am not satisfied that the conduct of Parkes,
and Mr Bokeyar of which Grange complained, materially contributed to the economic loss
Parkes suffered. I am of opinion that it is just and equitable to require Grange to bear all the
damages despite any faults of Parkes. Grange was the expert adviser. It set about selling, for
significant profit to itself, products that were not suitable for its risk averse client, Parkes.
Grange selected what it told and did not tell Parkes. It knew that Parkes, and other local
government councils, were completely at sea with SCDOs and exploited that ignorance for its
own benefit: see [266]-[268].
1169 For these reasons, Grange’s reliance on Parkes’ alleged contributory negligence under
the Law Reform and Civil Liability Acts must be rejected.
1170 The tests for causation and contributory negligence under s 12GF(1B) are both
different to that under the State legislation. First, the economic loss must be caused by
Grange’s conduct. That involves the common sense test in March (1991) 171 CLR at 515
per Mason CJ: cf Adeels Palace 239 CLR at 440 [43]-[44]. Secondly, if Parkes suffered that
economic harm “as a result partly of [its] failure to take reasonable care”, the Court can
reduce the damages under s 12GF(1) to the extent that is just and equitable having regard to
Parkes’ responsibility for its loss and damage. Importantly, s 12GF(1B) does not extend to
affect the award of damages for negligence in contract or tort. That provision appears to have
been intended solely to overcome the result in Henville v Walker (2001) 206 CLR 459.
1171 Nonetheless, Grange still failed to identify what “reasonable care” on Parkes’ part
would have achieved beyond discussing Grange’s recommendations and advice with
Grange’s personnel. While Mr Bokeyar could no doubt have done more, he asked the
Council’s financial adviser for its recommendation and advice and acted on it. Grange did
not suggest how a person in Mr Bokeyar’s position ought to have found, by exercising
reasonable care, the risks set out at [92], [122]-[123] or that Grange had acted negligently in
the way I have found that it did. Accordingly, Grange’s claim under s 12GF(1B) and its
analogues also fails. Further, the defence under s 12GF(1B) should also be rejected for the
reasons I have given in respect of the defence contributory negligence.
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8.3.5 Was Wingecarribee contributorily negligent?
1172 Grange also contended that Wingecarribee was contributorily negligent. This was
because Wingecarribee failed to amend the permitted investments in the draft or executed
IMP agreement to remove CDOs. Grange argued that “it was clearly in Wingecarribee’s own
hands to give express instructions to Grange that only the [pre]existing range of investments
should be permitted”. Once again, Grange argued that Wingecarribee’s damages should be
reduced by 50%.
1173 I reject this claim. Wingecarribee gave Grange express instructions on 18 December
2006 that it did not want to invest in CDOs and growth assets. Subsequently, on 4 January
2007, Mr Rosenbaum told Mr Neville that, despite the wording of Sch 2 authorising
investment in CDOs, and other growth assets, Grange would only invest in assets of the kind
that the Council wanted, namely FRNs with banks [632]-[634], [641]. I have discussed
Grange’s conduct when Mr Neville queried the repos of 12 February 2007 in section 4.5.5.
1174 In my opinion, Grange’s conduct was such that it would be an affront to notions of
what is just and equitable to reduce Wingecarribee’s damages at all. Essentially, this
argument is that Wingecarribee should not have trusted Grange to do what it had been asked
to do and said it would do. Wingecarribee acted reasonably in trusting Grange. Likewise, a
wrongdoer under s 12DA cannot ask a court to reduce the damages under s 12GF(1B) that it
should pay merely because its misleading and deceptive conduct worked and the other party
acted reasonably in trusting it.
1175 Accordingly, I reject Grange’s claims that Wingecarribee’s damages should be
reduced.
9. ARE THE TYPICAL CLAIM SCDOS “DERIVATIVES” WITHIN THE CORPORATIONS ACT 2001
9.1 The “derivatives” issue
9.1.1 The general nature of the issue
1176 Grange was prohibited from investing in “derivatives contracts” under Sch 2 of the
Wingecarribee IMP agreement [638], which defined the word “derivative” as having the
meaning of that word in the Corporations Act: [639]. The parties accepted that a typical
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Claim SCDO was a derivative unless it was a “debenture” or an interest in a “managed
investment scheme”. That was because s 761D(3)(c) excluded from the definition of
“deriviative” “anything covered by a paragraph of subsection 764A(1) except paragraph (c)”,
namely a debenture. The parties used the available, but incomplete documentation for the
Blaxland Claim SCDO, as typical of the Claim SCDOs in question for the purposes of
resolving this issue.
9.1.2 The legislative scheme
1177 I will set out the relevant provisions that governed the present problem from the
version of the Act current between 13 May 2007 and 27 June 2007:
761D Meaning of derivative
(1) For the purposes of this Chapter, subject to subsections (2), (3) and (4), 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, 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.
… (3) Subject to subsection (2), the following are not derivatives for the
purposes of this Chapter even if they are covered by the definition in subsection (1): …
(c) anything that is covered by a paragraph of subsection
764A(1), other than paragraph (c) of that subsection; 764A Specific things that are financial products (subject to Subdivision D)
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(1) Subject to Subdivision D, the following are financial products for the purposes of this Chapter:
(a) a security; ... (ba) any of the following in relation to a managed investment
scheme that is not a registered scheme, other than a scheme (whether or not operated in this jurisdiction) in relation to which none of paragraphs 601ED(1)(a), (b) and (c) are satisfied:
(i) an interest in the scheme; (ii) a legal or equitable right or interest in an interest
covered by subparagraph (i); (iii) an option to acquire, by way of issue, an interest or
right covered by subparagraph (i) or (ii);
(c) a derivative;
The only requirement of s 601ED(1) that is relevant for present purposes is that in
s 601ED(1)(a) that required a managed investment scheme to be registered under s 601EB “if
it has more than 20 members”.
1178 “Security” was defined in s 761A as meaning, among other things, “(b) a debenture of
a body”. That word, in turn, was defined in s 9 relevantly, as follows:
“debenture of a body means a chose in action that includes an undertaking by the body to repay as a debt money deposited with or lent to the body. The chose in action may (but need not) include a charge over property of the body to secure repayment of the money. However, a debenture does not include: (a) an undertaking to repay money deposited with or lent to the body by a person
if:
(i) the person deposits or lends the money in the ordinary course of a business carried on by the person; and
(ii) the body receives the money in the ordinary course of carrying on a
business that neither comprises nor forms part of a business of borrowing money and providing finance; or …”
(emphasis added)
1179 Finally, “managed investment scheme was, relevantly, defined in s 9 as follows:
“managed investment scheme means: (a) a scheme that has the following features:
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(i) people contribute money or money’s worth as consideration to acquire rights (interests) to benefits produced by the scheme (whether the rights are actual, prospective or contingent and whether they are enforceable or not);
(ii) any of the contributions are to be pooled, or used in a common
enterprise, to produce financial benefits, or benefits consisting of rights or interests in property, for the people (the members) who hold interests in the scheme (whether as contributors to the scheme or as people who have acquired interests from holders);
(iii) the members do not have day-to-day control over the operation of the
scheme (whether or not they have the right to be consulted or to give directions); or”
9.1.3 The relevant features of the transaction documentation for the Blaxland Claim SCDO
1180 The Blaxland Claim SCDO was issued by CypressTree Synthetic CDO Ltd
(CypressTree), a Cayman Islands company on 7 September 2006. Initially, the issue was to
be for $40 million, but this was increased to $60 million as Grange was able to place more of
the product. Its arranger was Calyon, a French bank. CypressTree was the SPV for this
product. Calyon was the swap counterparty for the transaction. Calyon had established a
program for the issue of SCDO products under a principal trust deed and associated
documents dated 20 December 2004 that had been amended subsequently on a number of
occasions (the program documentation).
1181 The program documentation established the generally applicable terms and conditions
on which “notes” would be issued for specific transactions. The attributes of the “notes”
require some explanation which I will give shortly. The program documentation
contemplated that JP Morgan Corporate Trustee Services Ltd would act as trustee for the
purposes of any issue.
1182 On 7 September 2006, CypressTree and Calyon entered into a number of documents
including an investment agreement and a securities note. They also entered into a
supplemental trust deed with an associated company of CypressTree which would act as
manager of the SCDO and The Bank of New York, London Branch which would act as
trustee, custodian, paying agent and registrar for this product. The supplemental trust deed
and associated transaction documents (the supplemental trust deed) adopted and made
some modifications to the program documentation. Not all of these were in evidence. In
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particular, the “notes” which were sold to the Councils were not available. The supplemental
trust deed provided that:
CypressTree would issue notes in bearer form comprising a series of $60
million “Tranche B Secured Floating Rate Notes due 2012” constituted under
the principal trust deed in the program documentation (cl 3.1);
the notes would be secured and represented by a permanent global note
(defined in the program documentation as being in the form of a bearer note in
the schedule of the principal trust deed) (cl 3.2);
the notes were secured limited recourse obligations of CypressTree;
CypressTree was prohibited from selling or disposing of the “Charged Assets”
including the $60 million investment placed with Calyon pursuant to the
investment agreement (i.e. the collateral for the PCDS) (cll 1, 3.4, 4.1,
Annex 1);
CypressTree charged the Charged Assets in favour of the trustee for itself and
the secured creditors to be applied under cl 11 (cl 4);
the order of priority of payment from the Charged Assets would entitle the
counterparty, Calyon, to any amounts payable under the PCDS (cl 11(e)) in
priority to meeting, rateably, “the claims (if any) of the Noteholders in relation
to the Notes” (cl 11(f));
CypressTree, the trustee (as principal paying agent) and Calyon (as investment
provider), each confirmed that “pursuant to the terms of the Dealer
confirmation (as defined in the Dealer Agreement) [neither of which were in
evidence] the proceeds of issue of the Notes will be credited by the Dealer
[Calyon] directly to the Investment Provider [Calyon] on behalf of the Issuer
[CypressTree]”, and Calyon, as investment provider then confirmed that this
credit would constitute an “Investment” for the purposes of the investment
agreement (cl 6.1).
1183 The investment agreement required CypressTree, as investor, to agree to make, or
procure the making of, an investment of $60 million, being the net proceeds of the issue of
the notes on the date of the agreement (cl 3.1). The investment had to be made with Calyon
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(cl 1.1). Thus, the investment of the $60 million proceeds of the issue would be made with
Calyon which would use it as the collateral for the PCDS on which it was the swap
counterparty. Calyon had an obligation to pay interest on the outstanding principal (cl 4) and
to repay the outstanding principal on final maturity (cl 5.1). The underlying asset (i.e.
CypressTree’s loan of the $60 million to Calyon as the collateral) in the investsment
agreement was subject to a charge in favour of the trustee to enable it to receive payments for
distribution to persons entitled, principally, Calyon and the noteholders in the order of
priority under the supplemental trust deed (cll 4, 11). If CypressTree became liable to Calyon
under the PCDS, the trustee had the right to payment of that liability out of the collateral, (so
that the trustee could pay Calyon). Subsequently, Calyon would only owe CypressTree the
reduced balance, if any, of the collateral that it continued to hold under the investment
agreement.
1184 The securites note added a number of supplementary terms and conditions for the
notes issued for the Blaxland SCDO and provided, relevantly:
the notes would mature on 31 March 2012 unless redeemed earlier (cl 6);
the notes would be credit linked and redeemable at par, subject to any
reduction from credit events causing payments to the swap counterparty
(Calyon) (cl 8). (“Credit Linked” notes were defined in the program
documentation as having conditions in an applicable supplement, such as the
securities note, that “specify the terms of the credit linking, including details
of any credit events …”. Upon the occurrence of any credit event, the credit
linked notes could be redeemed early or the principal or interest could be
reduced in the manner provided in that applicable supplement);
for early redemption events, including credit events (cl 24) that could reduce
the amount outstanding on the notes to zero (cl 24(v));
interest was payable on a floating rate basis at BBSW + 1.45% (cl 19);
the notes would be in the form of bearer notes and there would be a permanent
global note in the aggregate sum of $60 million (cl 33) (a “permanent global
note” was defined in the program documentation as a bearer note in the form
set out in a schedule to the principal trust deed. That form entitled the bearer
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to payment of the redemption amount. No actual notes or permanent global
note were in evidence);
the notes had the same order of priority as in the supplemental trust deed
(cl 56);
a description of the underlying assets was provided by the investment
agreement (cl 62);
selling restrictions in Austrlaia requiring a minimum subscription by each
offeree of “at least $500,000 (disregarding moneys lent by the offeror or its
associates)” unless no disclosure was required by Pt 6D.2 of the Corporations
Act.
1185 The principal trust deed relevantly provided for notes to be issued under the program
(cl 2) and:
an issuer of notes had an unconditional obligation to pay to or to the order of
the trustee the amount due on the whole or partial redemption of the notes
(cl 3);
covenants by an issuer in the program, such as CypressTree, that except in
certain limited circumstances (none of which are relevant here), the issuer
“shall not
(i) engage in any business (other than acquiring and holding the
Underlying Assets (which shall include the making of loans or
otherwise providing credit) …
(iii) incur or permit to subsist any other indebtedness … other than issuing
Notes pursuant to this Principal Trust Deed …”; (cl 17(o))
the holder of any note would be deemed the absolute owner and payments
made to the holder would satisfy and discharge any liabilities of the issuer,
trustee and paying agent (cl 30). (emphasis added)
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9.2 The parties’ submissions
9.2.1 The parties’ arguments – debentures
1186 Grange argued that the Blaxland Claim SCDO was a “debenture” within the meaning
of paragraph (a) of the definition in s 9. This was because, Grange contended, the product
was, first, a chose in action and, secondly, its terms contained an undertaking by the issuer “to
repay as a debt money deposited with or lent to the body”. It contended that the money paid
for the notes created a “debt” that was repayable as money lent to the issuer. Grange argued
that the notes bore interest on the outstanding principal during their term and, on their face,
were remeemable at par on the scheduled maturity date. It noted that the issuer covenanted
unconditionally to pay the redemption amount, including interest, to the trustee, on the day
when the notes were due to be redeemed and that the trustee held the benefit of that covenant
for itself and the noteholders. It contended that the issuer had granted a charge over the
collateral and assigned the benefit of its rights by way of security to the trustee who held
those rights on trust for itself, the secured creditors, noteholders and swap counterparty.
Grange relied on the prohibition on the issuer from engaging in any other business, incurring
any other liabilities or disposing of the collateral while any of the notes remained
outstanding. It followed, so Grange argued, that the notes were a chose in action that
included an obligation of the issuer to repay as a debt the money originally lent to it by the
investors. That chose in action included the charge over the property of the issuer.
Additionally, Grange argued that the issuer received the money paid for the notes in the
ordinary course of carrying on a business that did not fall within the exception to the
exclusion in the par (a)(ii) of the definition of “debenture”: i.e., Grange argued, the issuer’s
business was to carry out the very purpose of issuing the notes under the program.
1187 Wingecarribee argued that the notes created a limited recourse obligation of the issuer
to distribute, as money held on trust, the net collateral, if any, held by it at the time of
redemption of the notes. It pointed to the fact that the collateral could be partly or completely
appropriated to meet the rights of the credit default swap counterparty. Wingecarribee argued
that this was inconsistent with the concept of an undertaking to repay as a debt money that
had been deposited earlier. And, it contended, there could not be an obligation to repay a
debt, if, as the transaction documents contemplated, the position at the time of redemption
was that nothing was owed to the investors because the collateral had been paid to the swap
counterparty. Wingecarribee argued that, when the investors paid their money, they did so to
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buy a note that was a bearer note that may or may not have entitled its holder to payment of
any particular amount at the time of redemption.
1188 Alternatively, Wingecarribee argued that, if its other arguments failed, then the
exception to the exclusion in par (a)(ii) of the definition of “debenture” worked in the
opposite way to Grange’s argument. The Council contended that this would be because, in
this situation, the issuer’s business included the business of borrowing money and providing
finance, since its role was to issue the notes under the program. It argued that, on this
alternative, a key feature of the program was for the issuer to pay the principal amount
“borrowed” from the investors to the investment provider so as to receive back payments of
interest. And so, the alternative argument went, the issuer’s business, if viewed as Grange
would have it, was to borrow money from the noteholders in order to perform its obligations
under the investment agreement.
9.2.2 The parties’ arguments – managed investment scheme
1189 Grange next contended that if it were not a debenture, Wingecarribee’s interest in the
Claim SCDOs was an interest in an unregistered managed investment scheme within the
meaning of s 764A(1)(ba). This argument only arises if Grange’s debenture argument fails,
because par (j) of the definition of “managed investment scheme” in s 9(1) excluded “the
issue of debentures or convertible notes by a body corporate”.
1190 Grange’s argument worked as follows. First, it contended that a “scheme” could
involve simply a program or plan of action. Secondly, the transaction documents for the
Blaxland SCDO disclosed a program or plan of action: namely, the noteholders paid money
to acquire their notes, the issuer undertook to repay the principal and to pay interest during
the term and entered into a swap selling credit protection on the reference portfolio to the
swap counterparty, Caylon in exchange for the swap premium, the issuer then issuing the
notes for a total face value of AUD 60 million and investing the net proceeds of the issue on
deposit with Caylon under the investment agreement. Thirdly, Grange argued that each of the
subparagraphs of par (a) of the definition of “managed investment scheme” was satisfied. It
contended that the investors paid the issuer to acquire the notes and so “contributed” money
to acquire rights to benefits produced by the scheme, namely the interest payments
(par (a)(i)).
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1191 Then, Grange argued, the noteholders’ contributors of money were pooled and
deposited with Caylon to produce for the investors, as persons who held interests in the
scheme, financial benefits, being the interest, or benefits consisting of rights or interests in
property, being the charge over the collateral (par (a)(ii). Last, Grange contended, the
noteholders did not have day-to-day control over the operation of the scheme. This was
because they had no rights to participate in the management of the scheme or management
decision-making (par (a)(iii). Grange argued that s 601ED(1)(a) was satisfied because data
summarised by Prof Harper in his report from Grange’s trading system (GST) suggested that
more than 20 persons had invested in the Blaxland SCDO. Accordingly, it argued, the
investor’s interests were in an unregistered managed investment scheme and so not a
derivative.
1192 Wingecarribee argued that there was no evidence that the noteholders had contributed
their funds with the understanding or intention that they were to be pooled or used in a
common enterprise. It contended that all that the Council did was to buy a note to hold it for
the purpose of being paid interest and principal in accordance with its terms. Wingecarribee
pointed to the absence of any cross-examination of its witnesses as to their purpose in
purchasing any Claim SCDO. They contended that Grange only raised this argument in final
submissions and had chosen not to ask any witness directly about whether Wingecarribee had
a purpose consistent with investing in a managed investment scheme for fear of an answer
unfavourable to Grange.
1193 The Council next submitted that Grange, not the investors, bought the whole of the
notes from the issuer. At this moment, so Wingecarribee contended, there was no
contribution to be pooled and Grange was the only “contributor” to the issuer in payment for
the notes. It argued that Grange’s on-sale to the investors did not involve a pooling and that
Grange’s decision, as purchaser of the financial product from the issuer, to on-sell it did not
create a managed investment scheme. Last, the Council argued that there was no, or no
sufficient, evidence that more than 20 persons had invested in the scheme. It contended that
Prof Harper’s summary of the GTS data was not a business record and the evidence was
silent as to whether the listed investors were related entities, trustees or associates who may
have counted only as one person for the purposes of s 601ED(1))(a) and (4).
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9.3 Consideration – Were the typical Claim SCDOs derivatives contracts?
9.3.1 Consideration – Were the typical Claim SCDOs debentures?
1194 Although the full contractual documentation was not in evidence, it is possible to
draw some inferences where there are gaps. That is not a particularly satisfactory means to
resolve a technical argument as to the construction of a complex array of interrelated
documents, some of which, including the notes themselves, are not available. However, the
commercial transactions creating interests in the notes were entered into in good faith and
were intended to be effectual.
1195 The parties agreed that the Blaxland Claim SCDO satisfied each of the elements in
s 761D(1), namely, it was an arrangement:
(a) under which a party, CypressTree, (the SPV) must, or may be required to,
provide at some future time consideration (coupon and principal payments) to
the noteholders;
(b) that future time was not less than the one business day prescribed after the day
on which the arrangement was entered into; and
(c) the amount of the consideration or value of the arrangement (namely the
quantum or amount of the interest and principal payable) was ultimately
derived by reference, wholly or in part, to the value or amount of something
else, namely the effect of credit events on the reference portfolio and any
consequential effect on the underlying asset or collateral.
1196 Grange paid CypressTree $60 million for the whole of the series of notes issued for
the Blaxland Claim SCDO. Should that payment be characterised as creating a chose in
action including an undertaking by CypressTree “to repay as a debt money deposited with or
lent to” CypressTree and, so, a debenture? The ordinary and natural meaning of the word
“debt” can include a contingent debt (Hawkins v Bank of China (1992) 26 NSWLR 562 at
572F per Gleeson CJ, 578A-B per Kirby P, 578F per Sheller JA). The notes acquired in that
transaction were credit linked to the performance of the reference portfolio.
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1197 In my opinion, the amount “repayable” at the time of redemption was “money
deposited with or lent to” CypressTree. The amount payable on redemption was determined
by the credit linking to the performance of the portfolio credit default swap. If sufficient
credit events occurred, nothing would be payable; if some credit events occurred, a lesser
sum than the total original consideration would be payable; and if no, or insufficient, credit
events occurred, a sum equal to the total original consideration would be payable. The
substance of the transaction as a matter of law was that the investor paid the SPV for a note
that the SPV promised would yield the investor a variable return (the coupon) over a term and
ultimately result in a variable payment of all, some or none of the original subscription. The
amounts and duration of the coupon payment, final payment and term could be reduced
depending on the performance of the reference portfolio. But, that did not detract from the
commercial and legal character of the noteholder making a limited recourse loan to the SPV.
In discussing how to characterise the “flip clause” in the Dante notes for the purpose of
bankruptcy law, Lord Collins said in Perpetual [2012] 1 AC at 422 [108]-[110]:
“Although, as a matter of law, the security was provided by the issuer out of funds raised from the noteholders, the substance of the matter is that the security was provided by the noteholders and subject to a potential change in priorities. The security was in commercial reality provided by the noteholders to secure what was in substance their own liability, but subject to terms, including the provisions for noteholder priority and swap counterparty priority, in a complex commercial transaction entered into in good faith. There has never been any suggestion that those provisions were deliberately intended to evade insolvency law. That is obvious in any event from the wide range of non-insolvency circumstances capable of constituting an event of default under the swap agreement. The offering circular supplement emphasised that, in addition to the notes being credit-linked to the reference portfolio, noteholders would also have exposure to the collateral, and impairment of the collateral might result in a negative rating action on the notes.” (emphasis added)
1198 As Sackville and Lehane JJ said in Commissioner of Taxation v Radilo Enterprises
Pty Ltd (1997) 72 FCR 300 at 313C-D: “A loan involves an obligation on the borrower to
repay the sum borrowed”. The credit linked notes created a conditional obligation to pay a
sum, calculated according to the impact of credit events affecting the reference portfolio, that
might be up to the same sum as was originally paid to purchase the notes. Some or all of the
original payment for the notes might be used by the payee (the SPV) to discharge its
obligations under the PCDS. But, the noteholders’ (or lender’s) recourse to a source of
repayment was limited to what CypressTree had in its hands at the time of redemption.
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1199 It is consistent with a transaction of loan that a borrower can promise to pay the lender
from a particular source and the lender can agree that it will have no other recourse against
the borrower than whatever is realised from that source: Commissioner of Taxation v Firth
(2002) 120 FCR 450 at 468 [73]-[74] per Sackville and Finn JJ; The King v New Queensland
Copper Co Ltd. (1917) 23 CLR 495 at 499-500 per Barton J, 501-502 per Isaacs J, Gavan
Duffy, Powers and Rich JJ agreeing; Mathew v Blackmore (1857) 1 H&N 762 at 771-772
per Pollock CB. Non-recourse loans are a commonplace. The definition of “debenture” in
s 9 of the Corporations Act and its exclusion from the definition of “derivative” by the
operation of ss 761D(3)(c) and 764A(1)(a) (which excluded a “security” that was defined in
s 761A as meaning “(b) a debenture of a body”) were intended to create obligations that were
different in kind. Obviously, as Grange argued, bank, corporate or ADI issued FRNs could
be seen as “derivatives” because, but for the exclusion of a “debenture” from that definition,
they involve each of the elements is s 761D(1) in relation to the variability of the interest rate
over the term of the note. However, that class of FRNs retains the essential characteristic of a
debenture, as defined: i.e. an undertaking to repay the principal sum borrowed.
1200 CypressTree had an unconditional obligation to pay to the trustee or its order the
amount due on the whole or partial redemption of the notes under cl 3 of the principal trust
deed. That included an obligation to pay the trustee from the collateral, for example, a sum
due to the swap counterparty as a partial or complete redemption on the happening of credit
events, as well as whatever, if anything, may be due to a noteholder on maturity.
Clause 11(f) in the order of priority, provided for in the supplemental trust deed, stated that
after any amounts due were paid to the swap counterparty, the collateral or any balance had
to be applied “rateably, in meeting the claims (if any) of the Noteholders in relation to the
Notes”. Thus, the unconditional obligation of CypressTree to pay the trustee under cl 3 in the
principal trust deed was qualified by the provisions of cll 4 and 11 of the supplemental trust
deed to an obligation, so far as the noteholders were concerned, to meet their claims rateably
with whatever collateral might be left. However, those claims were claims to be repaid,
rateably, from the source stipulated in the contract, whatever was available in the collateral
sourced from the noteholders’ initial deposit or loan: Firth 120 FCR at 468 [74].
1201 The word “repay” in the definition of “debenture” does not suggest that the concept of
“as a debt” in that definition necessarily required an equivalence between what was first paid
to the borrower and what the borrower must “repay”. There is no reason to think that the
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definition of “debenture” was intended to exclude the long standing recognition that a person
can agree to receive repayment from, and limited to, a particular source to the exclusion of
any further liability of the borrower. The potential for payment of nothing at all or a lesser
sum than originally paid, is of such a character: i.e. a limited or no recourse liability as
against the borrower (CypressTree), it having a liability only to pay from a specified source
(the balance of the collateral at the time of redemption). Thus, whatever might be payable on
redemption of the credit linked notes can be seen as “repayment of the money deposited or
lent”. In Hawkins 26 NSWLR 572F-G Gleeson CJ explained, in a different statutory context,
that a “debt may be taken to have been incurred when a company entered a contract by which
it subjected itself to a conditional but unavoidable obligation to pay a sum of money at a
future time”.
1202 Here, CypressTree’s obligation to pay depended on uncertain future events. No
doubt, at the time of redemption of the bearer notes, if a sum, including the equivalent of the
original principal, were payable, it would be a debt due to the bearer under the note. The
liability for that debt was sourced in what was originally paid for the issue of the note, but the
calculation of what would then be due would be based on the outcome of the credit linked
transaction.
1203 I am of opinion that the character of CypressTree’s obligation to the noteholders was
in substance that of an “undertaking … to repay as a debt money deposited with or lent” to it.
It was an obligation to pay such money, if any, as would be calculated later as due by
reference to the outcome of a speculative investment in a PCDS. The congeries of rights that
Wingecarribee bought when it acquired the Blaxland Claim SCDO entitled it, at the time of
redemption (which could be when credit events caused the whole collateral to be paid to
Calyon under PCDS), to be repaid whatever was calculated as payable to it, as bearer, in
accordance with the terms of the notes. That was an undertaking to repay as a debt money
deposited with or lent to CypressTree.
1204 However, CypressTree received the investors’ money in circumstances in which it
covenanted that it would not engage in any other business (including the making of loans or
otherwise providing credit: see [1185], cl 17(o) of the principal trust deed. That prohibition
meant that borrowing money and providing finance did not form part of the business of
CypressTree. So, as Wingecarribee argued, exception (a)(ii) of the exclusions from
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definition of “debenture” operated. Thus, the notes were not a debenture because cl 17(o) of
the principal trust deed had the effect of preventing CypressTree from carrying on a business
that could issue a debenture.
1205 For these reasons, a typical Claim SCDO was not a debenture within the meaning of
the Corporations Act.
9.3.2 Consideration – Were the typical Claim SCDOs a managed investment scheme?
1206 In exchange for its investment, the transaction documents gave a noteholder rights to
the payment of interest and whatever was payable on redemption. The investment of the
purchase price that Grange paid to the issuer for the initial purchase of the notes was to be
held as collateral under the investment agreement [1183]. Grange’s purchase price was at a
discount from face value of the notes, the discount representing Grange’s profit when it on-
sold. The investors did not have day to day control over the operation of the SCDO. The
question is whether par (a)(i) of the definition of managed investment scheme is satisfied by
characterising Grange’s clients’ investment as “consideration to acquire rights … to benefits
produced by the scheme”, and whether par (a)(ii) is satisfied because their contributions were
to be pooled, or used in a common enterprise.
1207 I reject Grange’s argument. The first task here is to identify the scheme and the
intention required for pars (a)(i) and (ii). In Australian Softwood Forests Pty Ltd v Attorney
General (NSW) Ex Rel Corporate Affairs Commission (1981) 148 CLR 121 at 129-130
Mason J, with whom Gibbs CJ and Stephen J agreed, discussed a statutory predecessor of the
concept of managed investment schemes. He observed that the words in the definition, there,
of “interest” in relation to “a financial or business undertaking or scheme”, were so general
and all embracing that it was impossible to say that it necessarily excluded particular
transactions that appeared covered by the general words (128 CLR at 130). Mason J referred
to the construction of the word “scheme” in tax legislation as something requiring “some
programme, or plan of action” (128 CLR at 129).
1208 The evidence demonstrated that Grange, as the investor, intended to buy, and did buy,
all issued notes from the SPV issuer. Grange made that purchase with the intention of selling
the notes to its clients at a profit. Those notes represented the only initial congeries of rights
that Grange had purchased under the transaction documents, including the right to receive
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interest and any later amount payable on redemption. Objectively, Grange, as that investor,
contracted to buy from the issuer the notes which were bearer financial products, intending
that it would own them and hold whatever interests the notes created. The Councils and
Grange’s other clients had not made Grange their agent, before it entered the contract to buy
from the issuer the whole issue of the notes, or before it on-sold its holding of notes to its
clients. Grange financed its purchase mostly from moneys provided by its clients. If there
were a shortfall, Grange made up the balance of the purchase price it had agreed to pay to the
SPV issuer for the notes. Separately, the clients intended to purchase the notes from Grange
as their vendor, at the prices Grange (not the SPV issuer) charged them.
1209 There was no scheme or plan of action for Grange’s clients to pool, or to use, their
purchase money in any common enterprise. The investors bought bearer notes from Grange
in individual transactions. Grange had previously acquired those notes itself as sole
noteholder when they were issued. Grange increased the price it charged for the notes over
its purchase price and sold the notes to the investors. Grange’s investment, that it paid to the
issuer, was not the face value of the notes but of a lesser sum than face value. That sum had
to be used as the transaction documents provided. But that payment by Grange was not a
pooling of Grange’s clients’ funds or a use of them in any scheme: cf Norman v National
Australia Bank Ltd (2009) 180 FCR 243 at 279 [148] per Gilmour J with whom Spender J
agreed at 245 [5].
1210 Grange did not cross-examine any of the Council officers about whether they intended
to pool the Council’s money or use it in a common enterprise. There was no evidence to
suggest that they had any such intention. Grange was merely the vendor of all of the bearer
notes that it had previously acquired from a single SPV issuer or vendor. Of course, Grange
did not assert that it was the operator of the supposed scheme. The subsequent purchase of
the notes from Grange by clients was not a contribution to any scheme. It was, and could
only be, a payment by each client of Grange to the vendor (Grange) for a product in a one-off
transaction. That purchase transaction did not involve the client pooling its money in any
way. It simply paid Grange for the notes a price which Grange kept for itself.
1211 It follows that the investors were not parties to a managed investment scheme. There
was no evidence that any of them, and in particular Wingecarribee, contributed its money as
consideration for the acquisition of rights or interests in any such scheme. Grange’s client
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simply bought bearer notes from their holder, Grange. The clients’ money was never pooled
or used in a common enterprise. It was paid to Grange to buy the notes from it. Grange
financed its own purchase of the notes from the SPV issuer at a discount from face value and
subsequently on-sold them to its clients at face value or more: cf Norman 180 FCR at 285
[174]-[177].
1212 It was common ground that the Councils understood Grange was their vendor. Thus,
their funds went to pay Grange, not to go into any pool or common enterprise: i.e. the
clients’ money went figuratively into Grange’s pocket. The investors never intended their
money to be pooled or used in a common enterprise. They paid Grange as their vendor.
Grange was not, and no-one intended it to be, the agent of the issuer of the notes or of its
clients.
1213 It follows that Grange’s argument that typical SCDOs were managed investment
schemes must be rejected.
9.3.3 Consideration – derivatives
1214 The investment of Wingecarribee’s funds in the Claim SCDOs breached the
prohibition against investment in derivatives contracts in Sch 2 of the Wingecarribee IMP
agreement because those products were derivatives contracts.
10. COMMON QUESTIONS
10.1 The common questions identified?
10.1.1 The role of common questions
1215 Proceedings such as these brought under Pt IVA of the Federal Court of Australia Act
must meet certain criteria that the Act prescribes. Importantly, s 33C provides:
33C Commencement of proceeding
(1) Subject to this Part, where:
(a) 7 or more persons have claims against the same person; and (b) the claims of all those persons are in respect of, or arise out
of, the same, similar or related circumstances; and
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(c) the claims of all those persons give rise to a substantial common issue of law or fact;
a proceeding may be commenced by one or more of those persons as representing some or all of them.
(2) A representative proceeding may be commenced:
(a) whether or not the relief sought:
(i) is, or includes, equitable relief; or (ii) consists of, or includes, damages; or (iii) includes claims for damages that would require
individual assessment; or (iv) is the same for each person represented; and
(b) whether or not the proceeding:
(i) is concerned with separate contracts or transactions
between the respondent in the proceeding and individual group members; or
(ii) involves separate acts or omissions of the respondent
done or omitted to be done in relation to individual group members.
1216 For the purposes of s 33H(1)(a) the Councils identified the claimants in the group as
persons who, between 28 March 2003 and 21 August 2008, acquired one or more of the
Claim SCDOs from Grange or in reliance on representations it made, as a result suffered loss
or damage and entered a litigation funding agreement with a named litigation funder before
the proceeding was constituted as a class action. The Councils were required to describe the
claimants i.e. group members (s 33H(1)(a)) in their originating application, or a document
filed in support of it, and specify:
the nature of the claims made on behalf of the claimants and the relief claimed
(s 33H(1)(b));
the questions of law or fact common to the claims of the group members
(s 33H(1)(c)).
1217 In referring to a “substantial common issue of law or fact”, s 33C(1)(c) is concerned
with an issue that is real or of substance: Wong v Silkfield Pty Ltd (1999) 199 CLR 255 at
267 [28] per Gleeson CJ, McHugh, Gummow, Kirby and Callinan JJ. It is not necessary that
- 440 -
any such issue will be likely to resolve, wholly or to a significant degree, the claims of all
group members: Wong 199 CLR at 267-268 [30].
1218 Moreover, the Court has powers in proceedings under Pt IVA to give directions in
relation to the determination of issues that are not immediately resolved under ss 33Q and
33R. Critically, s 33Z(1) relevantly provides:
33Z Judgment—powers of the Court
(1) The Court may, in determining a matter in a representative proceeding, do any one or more of the following:
(a) determine an issue of law; (b) determine an issue of fact; (c) make a declaration of liability; (d) grant any equitable relief; (e) make an award of damages for group members, sub-group
members or individual group members, being damages consisting of specified amounts or amounts worked out in such manner as the Court specifies;
(f) award damages in an aggregate amount without specifying
amounts awarded in respect of individual group members; (g) make such other order as the Court thinks just.
10.1.2 The common questions posed by the Councils
1219 The Councils pleaded that a large variety of common questions of law or fact were
raised by the proceedings. A number of these were not pressed or argued as issues. Grange
accepted that a limited number of these questions were raised as substantial common
questions of law or fact as required by s 33C of the Federal Court of Australia Act. I will
summarise and group together below those questions that I understood were pressed and are
potentially capable of resolution. The precise formation of any answers that should be given
to these questions is best left to the parties to address after these reasons have been published.
The relevant common questions are:
(1) Did the Claim SCDOs have the various and detailed features pleaded: see
[19]-[20]?
- 441 -
(2) Were the Claim SCDOs investments that were consistent with:
(a) conservative investment strategies;
(b) the investment requirements of the Local Government Acts and Trustee
Acts of Western Australia and New South Wales?
(3) Did Grange owe a duty to the claimants to exercise reasonable skill and care
as an expert in providing them with financial advice and, if so, did it breach
that duty as alleged: see [21]-[23]?
(4) Did Grange make to claimants the representations alleged and, if so, did it
engage in conduct that was misleading and deceptive: see [25]-[26]?
(5) In respect of claimants with which it did not have an IMP agreement (the non-
IMP claimants), did Grange:
(a) make contracts with them that contained the terms alleged and, if so,
did it breach those contracts: see [17]-[18]?
(b) owe them fiduciary obligations, and, if so, did it breach those
obligations or sufficiently obtain the claimant’s informed consent to
act in a position in which it had a conflict: see [27]-[28]?
(6) In respect of claimants in Western Australia with IMP agreements (the WA
IMP claimants):
(a) did Grange invest in products that were consistent with the
requirements of:
(i) the investment guidelines in Sch 2 pursuant to cl 2.3(a) of the
IMP agreements (see [359], [362]); and
(ii) the Local Government Act (WA);
(b) what did Grange have to do to discharge its obligations under the IMP
agreements;
- 442 -
(c) did Grange have a conflict, and, if so, did it sufficiently obtain the
claimant’s informed consent to its acting under the IMP agreements:
[27]-[28]?
(7) In respect of claimants in New South Wales with IMP agreements (the NSW
IMP claimants):
(a) did Grange invest in products that were consistent with the
requirements of:
(i) the investment guidelines in Sch 2 pursuant to cl 2.3(a) of the
IMP agreements (see [638]; and
(ii) the Local Government Act (NSW);
(b) were the Claim SCDOs:
(i) derivative contracts;
(ii) CDOs.
(c) what did Grange have to do to discharge its obligations under the IMP
agreement;
(d) did Grange have a conflict, and, if so, did it sufficiently obtain the
claimant’s informed consent to its acting under the IMP agreements:
[27]-[28]?
(8) What are the correct principles for measuring damages?
1220 I will deal with whether these questions arise as common questions and how to
approach their resolution below. The Councils made separate final written submissions on
the findings that ought be made on the common questions. For the most part these
submissions were unhelpful, because they repeated the Councils’ pleadings without referring
to evidence or the basis on which the matters were or had remained real issues.
- 443 -
10.2 Common questions – consideration
10.2.1 Question (1): The features of the Claim SCDOs
1221 Grange accepted that question (1) was a common question but only to the extent that
the particular features of the Claim SCDOs, that are summarised in [19] were addressed in
submissions. I accept that Grange’s qualification is appropriate for this and the other
common questions. As I noted at [20], much of the detail in the Councils’ pleading had
fallen by the wayside as the hearing progressed. They did not put any substantive argument
on these matters and it would not conduce to the efficient disposition of these proceedings to
spend any time addressing them.
1222 The substantive common issues of fact relating to the Claim SCDOs that I have
resolved in these reasons are that:
the Claim SCDOs had three key characteristics of structured finance: pooling of
assets, tranching of liabilities and de-linking of the credit risk of the reference
portfolio from that of the arranger: [39];
what the conceptual structure and operation of the Claim, and other, SCDOs were,
being described in section 3.3;
what the types of the Claim SCDOs were, being described in section 3.4;
what were the relevant risks of the Claim SCDOs (see [64]), namely market
implied risks (section 3.5.1), the risk in respect of the amount of loss (section
3.5.2), market price volatility (section 3.5.3) and liquidity risks (section 3.5.4).
These features and risks apply to each of the Claim SCDOs. Thus, each claimant will be
affected by these findings of fact in respect of its individual claim.
1223 I am of opinion that my determinations of fact in respect of these matters should bind
Grange and all the other claimants for the purposes of s 33Z(1)(b). I will hear the parties on
whether it is necessary to make declarations to give effect to those matters or whether, as I
consider may be preferable, to determine that my findings create issue estoppels that, given
the constitution of the proceedings, binds both Grange and each and every claimant: cp Blair
v Curran (1939) 62 CLR 464 at 531-533 per Dixon J. This approach will also assist in
resolving how effect should be given to the answers to any other common questions.
- 444 -
10.2.2 Question (2): Were the Claim SCDOs consistent with conservative investment strategies or investment requirements in legislation affecting local government bodies or trustees?
1224 I have determined that representations (1)(a) and (2) were made and were false in
section 6.4.2. These dealt with the first part of question (2), namely the question of whether
the Claim SCDOs were consistent with conservative investment strategies: section 6.4.2. In
addition, the findings as to why contractual term (4) was made (sections 5.1.1 and 5.2.1) and
why it was breached (section 6.2.5) are relevant to this issue. Whether one or more of the
other claimants had had a conservative investment strategy or required products, in their
dealings with Grange, that were consistent with such a strategy, may require further evidence.
On the other hand, depending on whether the parties accept my findings or the outcome of
any appeal, Grange’s liquidators may be able to be satisfied of such matters, for the purposes
of admitting a proof of debt in the liquidation or a claim in these proceedings, by examining a
claimant’s financial records and other material to justify such a conclusion.
1225 I have determined the construction of the legislative provisions governing investment
of local government council funds in Western Australia ([157], [790]; section 6.2.7) and in
New South Wales ([413]-[417], [610]; section 6.2.7) and the operation in respect of
investments by persons bound to apply the prudent person test pursuant to the Trustees Act
(WA), in Western Australia ([790]; section 6.2.7) or the Trustee Act in New South Wales
([417]; section 6.2.7). These are appropriate to treat as determinations of issues of law for
the purposes of s 33Z(1)(a).
10.2.3 Question (3): What was Grange’s obligation or duty to exercise reasonable skill and care and did it breach that obligation or duty?
1226 The determinations I have made as to Grange’s contractual obligation and tortious
duty to exercise reasonable skill and care and its breaches of those (referred to in section
10.2.2) will apply, in the absence of some unusual exclusion or circumstance, to Councils
who are claimants in Western Australia and New South Wales with such adaptions as may be
necessary to take account of any differences in the particular Councils’ investment policy
from those of Swan, Parkes or Wingecarribee.
1227 Whether Grange’s obligation or duty and any breach would be assessed differently for
claimants who were neither Councils nor trustees will need to be considered in individual
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cases. The content of the contractual obligation and tortious duty to exercise reasonable skill
and care will necessarily be dependent on the particular relationship of Grange and the
individual claimant. However, the answers to this and other questions as resolutions of
common issues under s 33Z(1)(a) or (b) may have utility, first, in resolving potential issues
that arise from similar facts if the proceedings continue for the purpose of determining each
of the remaining claimant’s rights, if any, against Grange, or secondly, in assisting Grange’s
liquidators in considering whether to admit the proofs of debt of particular claimants as
creditors in its liquidation.
1228 The evidence in the proceedings disclosed that Grange used similar themes and
engaged in similar conduct concerning the SCDOs, including the Claim SCDOs, that it sold
to each of the three Councils, either in individual sales to Swan, before the IMP agreement,
and to Parkes, or in the use of its mandate under its IMP agreements with Swan and
Wingecarribee. It portrayed itself as an “adviser” to local government councils. For
example, on 30 May 2007 Mr Kay emailed Swan’s Mr Cameron, introducing himself, saying:
“As I am sure you are aware, the City has utilised Grange as an investment adviser since 2003.”
1229 And in July 2007, Grange put, to Mid-Western Regional Council, an expression of
interest for investment advisory services. That stated that Grange, through its fixed interest
division, had been “actively involved in developing and managing investment portfolios for a
wide range of local government and private sector clients for 12 years”. The document noted
that local government councils’ “investment portfolios vary in size on a regular basis owing
to the impact of continuing cash flows”. It set out a list of Grange’s clients with IMPs and
those with “Advisory Portfolios” saying that, among a long list of others, Parkes was a
council “where Grange acts in an advisory capacity outside the IMP process”. As Ms
Perrott’s August 2005 risk management overview noted, from Grange’s perspective, it was
dealing with portfolio management of its clients as “sausages”.
1230 Thus, it is likely that there will be similar, but as with each of the three Councils, not
exact, dealings between Grange and, at least, the other Councils who are claimants. In
addition, it is likely that similar slide presentations, switch recommendations, product
information and email sales pitches were used by Grange on its broader client base for the
Claim SCDOs.
- 446 -
1231 For these reasons, determining the issues of law and fact that were common in the
three Councils’ individual cases under s 33Z(1)(a) and (b) may have substantial utility in
resolving the balance of the claimants’ cases in this group proceeding. Accordingly, my
findings of the contractual obligation and tortious duty in sections 5.1.1, 5.1.5, 5.2.1, 5.2.4,
5.3.1 and 5.3.3 and of Grange’s breaches in sections 6.2.7, 6.2.8, 6.2.9 and 6.5 ought be used,
so far as possible, as determinations of those issues of law and fact under s 33Z(1)(a) and (b).
10.2.4 Question (4): Did Grange engage in conduct that was misleading or deceptive?
1232 In sections 5.1.3, 5.2.3 and 5.3.2, I found that Grange made the same representations
to each of the three Councils and in section 6.4 I found that, by making them, it engaged in
conduct that contravened s 12DA(1) of the ASIC Act. In addition, I also made findings in
section 5.1.4 rejecting the Councils’ claims that some of the alleged contractual terms and
representations were made, which should also be treated as determinations of an issue of fact
under s 33Z(1)(b). In my opinion, the findings that I have made on these issues should also
be treated as determinations of law or fact.
1233 Grange argued that the resolution of these issues with other claimants will depend on
the particular circumstances of the relationship and dealings that each claimant had with
Grange.
1234 Once again, that argument is correct as far as it goes. But, it overlooks the common,
albeit differently nuanced, way in which the evidence revealed Grange dealt with each of the
three Councils in informing them of the matters the subject of the representations that I found
it made.
10.2.5 Question (5): What contracts were made between Grange and its non IMP claimants, what, if any, fiduciary obligations did Grange owe and what, if any, breaches were there of either?
1235 These questions deal with the incidents of the relationship between Grange and each
of Swan, before its IMP agreement, and Parkes and how they bear on the position of other
non IMP claimants. Once again, Grange correctly contended that the particular factual
setting for each individual claimant would be crucial to the determination of the contract(s) it
made with Grange and whether any particular fiduciary relationship existed.
- 447 -
1236 However, Grange approached each of Swan and Parkes for the initial sale of an
SCDO, which happened to be the same one for both (the Forum AAA product) in a similar,
but again, differently nuanced, manner. Grange sent each Council a letter but in differing
terms, explaining Grange’s approach to investment advice for Councils and the products it
recommended. It also gave different documents to each Council. For example, in Swan’s
case, Grange made a slide presentation on the Forum AAA product but did not do this for
Parkes [439]. Nonetheless, I found that, at the end of its negotiations with each of Swan and
Parkes, they made a contract for the purchase of the Forum AAA product that had the same
terms: sections 5.1.1, 5.2.1. It is likely that Grange dealt on this basis with other claimants.
1237 And, I also found that at the same time, Grange had assumed fiduciary obligations
that it owed to each of Swan and Parkes: sections 5.1.2 and 5.2.2. Given that Grange
portrayed itself as a financial adviser to each of the Councils that result was likely: Daly 160
CLR 371. It is also likely that Grange portrayed itself consistently, albeit with subtle or
nuanced variations, to the other claimants, both those with and without IMP agreements, as
the example of Grange’s expression of interest to Mid-Western Regional Council showed:
[1229].
1238 It is significant that the contractual terms, representations and fiduciary relationship I
have found in respect of Grange’s dealings with Swan, before the IMP agreement, and Parkes
were substantially the same despite the two Councils being on opposite sides of Australia.
These findings are consistent with Grange’s business model, summarised by Ms Perrott’s
“sausage” analogy. Grange’s sales pitch to each Council was similar and it is likely that this
consistency was not accidental. Moreover, Grange called no evidence from any of its former
employees who could have negated or contextualised how it dealt with any of the three
Councils to put this apparently consistent method of dealing into a different perspective. Mr
Clout’s confident instruction to his staff of 9 August 2004 to effect switches “[a]s we control
the cdo market we should be able to execute any of these without issue”, revealed that
Grange knew it had the trust and confidence of its clients [300]-[301]. And, of course, Mr
Vincent’s later “no hair cut repo” email reinforced that the very features of terms (1)-(4) of
the contracts (see [843]) underpinned how Grange could benefit itself in borrowing from its
clients, using their trust in it and its products, without offering those clients sufficient security
for the loans.
- 448 -
1239 Accordingly, I consider that the findings that I have made on the contractual terms
and fiduciary relationship should be determinations of issues of law and fact under
s 33Z(1)(a) and (b). Likewise, the findings of breach of the above contractual terms in
sections 6.2.2-6.2.5 and of there being no breach of term (5) in section 6.2.6 should be
determinations of law and fact. If the contracts with claimants contained those terms, there
could be no issue that there should also be a consistent conclusion that they were breached.
1240 Once again, the particular circumstances of a claimant may need to be examined on
the contractual or fiduciary issues. But I think that there is also utility, given Grange’s
apparent mode of conducting its business relations with its clients, in making determinations
of law and fact based on my findings of Grange’s breaches of its fiduciary obligations in
sections 6.3.1 and 6.3.2. It is unlikely that Grange would have obtained fully informed
consent from any claimant, since it seemed unaware of the need to do so.
10.2.6 Question (6): What rights did the Western Australian IMP agreement claimants have?
1241 If other claimants with IMP agreements in Western Australia contracted on identical
terms as Swan had, there would be utility in making determinations of fact and law
consistently with my findings of the terms of the Swan IMP contractual relationship and
Grange’s fiduciary obligations under it (section 5.1.5) and of Grange’s breaches
(section 6.2.8). Any Western Australian council claimants should have the benefit of the
findings of law and fact in section 6.2.8 that the Claim SCDOs were not prudent investments
for the purposes of s 6.14 of the Local Government Act and s 18(1) of the Trustees Act.
There would also be utility in making such determinations in any event in relation to the
fiduciary issues, since it is unlikely that Grange saw the need to obtain, or received, a
claimant’s fully informed consent.
10.2.7 Question (7): What rights did the New South Wales IMP agreement claimants have?
1242 I consider it appropriate to make similar determinations on these questions in respect
of New South Wales IMP claimants as in section 10.2.6, in respect of my findings in sections
5.3.1 and 6.2.9. Any New South Wales claimant council should have the benefit of the
findings of law and fact in section 6.2.9, including my findings that investments in SCDOs
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were not prudent: [929]. I also consider it appropriate to determine the issues of law and fact
in relation to whether the Claim SCDOs were derivatives as in section 9.
1243 Grange argued that Wingecarribee and the claimants ought not be permitted to rely on
the contention that the Claim SCDOs were not CDOs within the meaning of Sch 2 of the
Wingecarribee IMP agreement: [638]. It said, correctly, that no submissions were made on
this issue. I agree. There was no live issue in the trial on this point. In any event, as I found
at [921]-[922] under the Wingecarribee IMP agreement it would potentially have been
possible for Grange to invest in structured products and CDOs, including SCDOs. However,
any such investment still had to meet the prudent person test. I found that investing in the
Claim SCDOs did not: [923]-[924]. Accordingly, I do not consider that there was any
common question concerning the expression “CDO” in Sch 2 to the Wingecarribee IMP
agreement.
10.2.8 Question (8): What are the correct principles for measuring damages?
1244 Grange accepted that the principles on which damages should be measured were
appropriate common issues of law and fact. Subject to any issue as to the appropriateness of
updating the valuations, I consider that I should make determinations using the principles as
explained in section 7.
11. CONCLUSION
1245 The preparation of these reasons has taken longer than I had intended because of the
detail and complexity of the parties’ cases and the issues that required resolution.
1246 The parties should have an opportunity to consider these reasons and discuss the
appropriate orders that should be made to give effect to them, including the precise wording
of determinations of issues of law and fact under s 33Z(1)(a) and (b), the giving of directions
to the liquidators of Grange (see [1077]) and updating the valuations, if appropriate, that I
have arrived at in section 7. They should also be able to identify any oversights or errors that
can readily be corrected so as to avert any unnecessary issue in any subsequent appeal.
1247 I will direct the parties to prepare draft orders and submissions on matters on which
they have not agreed or are still to be resolved.
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I certify that the preceding one thousand two hundred and forty seven (1247) numbered paragraphs are a true copy of the Reasons for Judgment herein of the Honourable Justice Rares.
Associate:
Dated: 21 September 2012