By Julian Bajkowski

Councils in New South Wales and Western Australia burned by the collapse of merchant bank Lehman Brothers could recoup around 45 cents in the dollar after liquidators attempted to broker a deal to litigants to settle litigation.

While creditors and the Federal Court must still approve the deal, the compromise is a major step forward in the settlement in the landmark case that has come to symbolise how conservative investors were duped by banks into buying junk and sub-prime financial products that were stamped as AAA class investments.

According to litigation funder IMF, litigants – which include councils, churches and charities in the class action could be able to access $211 million of a pool of around $300 million.

(Developments in another separate legal case involving ratings agency Standard&Poors over its liability for damages suffered by other councils from AAA rated toxic products are also anticipated today.)

For the Lehmans settlement process to proceed, the deal, known as a ‘scheme of arrangement’, would first need to gain the support of 75 per cent of value of each class of creditor.

Should that occur, the next step would be a Federal Court hearing on the 7th May followed by more meetings in June.

Councils involved in the Lehman litigation include Wingecarribee (NSW), Parkes (NSW) and the City of Swan (WA) that have pursued a class action through litigation funder IMF. Another 69 councils, which cannot be named, were also joined in the action.

The likelihood of a successful result by IMF has raised an obvious question as to why state governments were not prepared to pursue their own legal action against Lehman to recover ratepayers’ money.

The councils’ battle against Lehman is an important test case of where liabilities rest over the sale of synthetic collateralised debt obligations that were linked to sub-prime mortgages that were sold through Grange Securities.

At the heart of the matter is whether councils were effectively duped into buying derivative financial products well beyond their stated risk appetite, largely because they represented soft targets for unscrupulous salespeople over more sophisticated investors.

In September 2012 Justice Steven Rares of the Federal Court handed down an excoriating judgement against Lehmans that squarely saddled the blame for the losses with the defunct bank.

In that decision, Justice Rares said the question of how “relatively unsophisticated Council officers came to invest many millions of ratepayers’ funds in these specialised financial instruments” was the fundamental question in the case.

He found Grange had essentially tricked the local governments into taking up the derivatives against their instructions and intentions.

“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,” Justice Rares said.

That decision was then followed by decision by Justice Jayne Jagot of the Federal Court that found that another group of councils were entitled to seek damages from ratings agency Standard&Poors (S&P) because toxic products were deceptively marketed to them using a AAA rating issued by the ratings.

Justice Jagot said it was accurate to describe the financial products sold to councils as “grotesquely complicated” and labelled their marketing by ABN Amro subsidiary Local Government Financial Services as “hopelessly deficient in alerting councils to the risks of this investment.”

“S&P’s rating was hopelessly deficient too,” Justice Jagot said.