International insolvency regime

By Legal Eagle

The bankruptcy of Lehman Brothers investment bank will (naturally) have ramifications for those Australian investors who had dealings with the Australian arm of the bank. Wingecaribee Shire Council had already commenced proceedings in the Federal Court as a result of the loss in value of products purchased from Lehman’s in the wake of the sub-prime crisis, and the proceedings were being closely watched by other Australian Councils who had purchased the products. Apparently the products in question were collateralized debt obligations, involving special purpose investment vehicles whose portfolios often included mortgage-backed securities. They were consequently vulnerable to the decline in value of sub-prime mortgages. Wingecaribee’s argument was that the product had been sold to them in May 2007, when the Australian arm of the bank must already have known that such products were risky and that the market was volatile. According to an article in The Age:

The council’s pleadings show Lehman had issued a memo to clients in April (but not to Wingecarribee) that noted problems developing in the US subprime mortgage market. “The speed of the subprime mortgage crisis has admittedly been extraordinary,” the memo said.

The council’s claim says that some of the underlying “referenced” securities in the Federation notes such as US mortgage provider New Century were already in trouble in February but the council was not warned about this.

If I am not mistaken, these are exactly the kind of products which were priced according to the Gaussian Copula method (already criticised by Joe Cambria in an earlier post). In July 2007, Standard & Poor’s rated the CDO purchased by Wingecaribee as AAA, the highest investment rating. The value of the product subsequently plunged by 90%.

Now it looks as though the Australian creditors may have to abandon the Australian proceedings and commence proceedings in the US (the jurisdiction of the parent company). This is because Parliament has just enacted the Cross-Border Insolvency Act 2008 (Cth). The aim of this Act is to give legal effect to the UNCITRAL Model Law on Cross-Border Insolvency, a scheme which has already been adopted by the UK and the US. It aims to simplify cross-border insolvencies and avoid a multiplicity of concurrent proceedings in different jurisdictions.

The article from The Australian linked above states:

Despite the procedural difficulties that this system looks set to impose on Australian claimants, it might be worth the risk.

So long as Lehman Brothers’ Australian subsidiary enjoyed the support of its American parent, Wingecarribee [Shire Council in NSW] and other potential claimants had the comfort of knowing the subsidiary would have enough money to meet any damages order that might result from the Federal Court litigation.

The bankruptcy created a new calculus: litigating in the US might be inconvenient and costly, but there are still assets available for creditors.

And the pool might grow if $US5.7 billion ($7.2 billion) in bonuses that had been paid to Lehman executives late last year are successfully clawed back. But for a small country council in NSW, it will still be a big step. The aldermen would need to persuade ratepayers that it is in their interests to spend more money on what looks like being one of greatest feeding frenzies for US lawyers.

The National Law Journal of the United States reported on Wednesday that hundreds of lawyers eventually would be brought into the bankruptcy proceedings on the Lehman Brothers side. Those with claims against the failed bank were likely to be represented by thousands of lawyers.

There have been calls for the NSW State Government to assist the various NSW councils who are potential claimants, as they may not be well-resourced enough to bring actions in the US. I can’t help thinking of the string of equity swaps cases in which UK local councils became embroiled. The House of Lords decided that the power of local councils to enter into such speculative agreements was ultra vires. Apparently the NSW government is considering limiting the kind of investment agreements into which local councils can enter as there is a large group of NSW councils in Wingecaribee’s position.

Globalisation brings new challenges for creditors in corporate collapses. I will be fascinated to see how this latest crisis works out. About the only people who will emerge with smiles will be those thousands of lawyers mentioned above.


What did I say? Yep, the lawyers ARE smiling.


  1. Sinclair Davidson
    Posted September 23, 2008 at 7:00 am | Permalink

    Nobody seems to have realised that this means that rates were too high. Councils had so much excess cash that they could speculate in global financial markets?

  2. jose
    Posted September 23, 2008 at 8:58 am | Permalink

    I thought that argument for investing in CDOs and the like by the councils was means of parking their capital while raising funds for infrastructure projects (so they could undertake such projects without incurring a deficit).

  3. Posted September 23, 2008 at 8:21 pm | Permalink

    Beautiful. How to shaft the ratepayers AND piss them off for all time.

  4. Posted September 24, 2008 at 1:33 am | Permalink

    @ Sinclair D

    Surely this only means rates are too high if you consider that all expenses must or can be met out of current revenue? Once you allow for lumpy revenue on one side (not only from rates but from development levies, albeit now somewhat reigned in) and expenses on the other (which might not need to be met in the years when revenues are received) and further take into account the constraints on councils raising their rates which are a positive disincentive to any reduction of rates when expenses are less pressing, I don’t think that proposition is quite so self-evident as you seem to suppose.

    And now I see that is pretty much the point that jose makes.

  5. Posted September 25, 2008 at 10:20 am | Permalink

    Councils and similar bodies have lumpy cash inflows and outflows. In addition they have some quaratined monies for specific purposes or projects which may be delayed and run across financial years. So a cash surplus ( may not be a real surplus) is not necessarily evidence of rates set too high.

    It used to be that quangos were restrricted to “safe” cash investments ( or property by stealth) at around passbook rates. When this was freed up – as it should be- many of the cowboys on councils saw themselves as players. With $50+m to toss around any dickhead could pull in 12% return in the 5 years before 2006 by trusting most shysters.

    Trouble was getting high returns in good times is not evidence of brilliance and evidence that fundamentals don’t matter.

    I don’t feel sorry for the councils at all – an AAA rating is no basis for prudent investment or rather it is only one element to take into account.

  6. Bill
    Posted October 2, 2008 at 11:11 am | Permalink

    Councils are stocked with some of the dumbest people who ever get to make important financial decisions in Australia. That’s what went wrong.
    Few Australian pension funds or other professional investors bought US CDO’s. Those who did made sure it was a modest part of their portfolio.
    If a council has funds remotely approaching $50m – then of course they are overcharging ratepayers. $5m or so in the kitty is perfectly reasonable, not $50m.

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