Lehman Unit Held Liable for Failed CDOs Sold to Australian Towns

Lehman Brothers Holdings Inc.’s Australian unit must repay three towns that invested in failed securities backed by U.S. subprime mortgages, a judge ruled. The lawsuit’s sponsor said the case is the first of its kind to complete a trial.

Lehman’s unit “engaged in misleading and deceptive conduct,” Federal Court Justice Steven Rares said. The unit “is liable to compensate the councils for their losses,” he said in issuing the decision in Sydney today, more than a year after the trail’s conclusion.

Grange Securities Ltd., which was bought by Lehmans, invested the towns’ money in securities whose value collapsed along with the U.S. housing market. The synthetic collateralized debt obligations in 2008 played a role in the worst financial crisis since the Great Depression, as world-wide credit froze and the $330 billion market for auction-rate securities collapsed.

The damage from the failures of complex derivatives extended from Wingecarribee, a town southwest of Sydney, to Alabama’s Jefferson County, which filed for bankruptcy last year and Harvard University, which paid hundreds of millions of dollars to cancel interest rate swaps.

The three Australian towns that invested A$37.3 million ($39 million) in securities sold by Grange sued in 2009 to recover their losses. Today’s decision signals that about 70 councils, church groups and charities in Australia which made similar investments may be more likely to recover about A$200 million.

AAA Ratings

The towns and organizations have claimed the securities were sold with the safest credit rating, AAA, which didn’t reflect their actual risk.

“It really depends on what they were told about the product,” Moira Saville, a partner specializing in class actions at King & Wood Mallesons in Sydney, said ahead of the ruling.

Wingecarribee, about 140 kilometers (90 miles) southwest of Sydney, sued to recover A$21.4 million, claiming Grange ignored explicit instructions to avoid CDOs. Two other towns, the West Australian city of Swan and Parkes Shire Council, northwest of Sydney, claimed to have lost A$15.9 million on their investments.

“It’s the first time that a claim against an investment bank has gone through a full trial,” said John Walker, executive director of IMF (Australia) Ltd. (IMF), which funded the litigation.

Seeking Fees

Grange, which became Lehman Brothers Australia, bought synthetic collateralized debt obligations on behalf of clients to collect fees and commissions that were greater than it would have earned from investing in term deposits for the customers, the towns have claimed.

Lehman Brothers Australia appointed a voluntary administrator under the country’s bankruptcy laws on Sept. 26, 2008, nine days after Lehman Brothers Holdings, the fourth- biggest investment bank in the world, filed for the biggest bankruptcy in U.S. history.

U.S. lawmakers had accused ratings companies of mishandling their assessments of mortgage-backed securities, at the heart of the 2008 financial crisis, and Congress sought to reduce their influence as part of the Dodd-Frank Act of 2010.

Unions in the U.S. won a $40 million settlement in a lawsuit in which they claimed people associated with Lehman misrepresented the credit quality of billions of dollars worth of mortgage pass-through certificates. U.S. District Judge Lewis Kaplan in New York approved the settlement in June.

Investment Assurances

Douglas Neville, financial services manager at Wingecarribee’s shire council, testified in March, 2011, that he received assurances the council’s money would only be invested in floating rate notes and felt “betrayed” when he found out in July 2007 much of the money was put into CDOs.

Grange “had very wide powers” under an agreement signed by Wingecarribee’s council for investment decisions, the company’s lawyer John Sheahan said at the trial. The Lehman unit followed the agreement in buying the CDOs, he said.

The synthetic collateralized debt obligations, which invest in credit default swaps or other non-cash assets linked to pools of debt comprising mortgages, car loans or credit card payments, weren’t the type of investments municipalities were allowed to make by law, Tony Meagher, the lawyer for the towns, said before today’s ruling.

“We only wanted to invest in floating rate notes. No CDOs,” Neville, who has worked for Wingecarribee for 30 years, testified. “These were community funds. We could not put them at risk.”

The trial in Sydney federal court began March 2, 2011, and concluded on June 9, 2011, with post-trial submissions and motions carrying through to February.

The case is Between Wingecarribee Shire Council and Lehman Brothers Australia Ltd. NSD 2492/2007. Federal Court of Australia (Sydney).

To contact the reporter on this story: Joe Schneider in Sydney at jschneider5@bloomberg.net

To contact the editor responsible for this story: Douglas Wong at dwong19@bloomberg.net

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