Adviser failed to check right to sell notes, court told

S&P did not 'step away' from the rating it gave the notes in 2006.

By InvestSMART · 11 Oct 2011

By InvestSMART ·
11 Oct 2011

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THE financial adviser that sold loss-making Rembrandt Notes to 13 local councils made no effort to work out whether its licence permitted it to do so, the Federal Court heard yesterday.

If Local Government Financial Services had disclosed the structured financial products it was selling, they would have been excluded from its liability insurance policy, the barrister for Chartis Australia Insurance, Simon Couper, QC, said.

LGFS, owned by the NSW local government superannuation scheme, holds an Australian Financial Services Licence that does not allow it to sell financial derivatives.

It is defending a $16 million claim by the councils, who lost 93 per cent of their capital when the Rembrandt Notes, a type of Constant Proportion Debt Obligations, failed in 2008.

LGFS is in turn suing the arranger of the notes, the investment bank ABN Amro, and the agency that assigned them a AAA rating, Standard & Poor's. The councils are also suing the bank and the agency for negligence and misleading and deceptive conduct.

In his opening address, Mr Couper said the point was not whether the Rembrandt Notes were derivatives, but whether LGFS ever considered they might be.

"The reasonable financial adviser would have said to himself, these notes look like they might be derivatives I should tell my insurer because it's obvious to me that my insurer will want to know whether I have been acting outside my licence," Mr Couper said.

LGFS's barrister, Guy Parker, SC, said in his opening submission last week there was no evidence that any LGFS employee "had any inkling that there was even a question as to the relevant scope of its licence at the time of the [insurance] renewal".

In any event, the legal definition for the licence said that if a financial instrument was "a security" it was not "a derivative", Mr Parker said.

The Rembrandt Notes were debt instruments that fell under the definition of debentures, which fell under the definition of securities, he said.

On Friday the barrister for S&P, Steven Finch, also said LGFS should never have sold the Rembrandt Notes to the councils. "If it's not suitable for their purposes, who's to blame? The person who didn't find out that it wasn't suitable for their purposes," Mr Finch said.

"There is no doubt at all that the councils should not have purchased these notes for reasons completely unrelated to its rating. They didn't comply with the guidelines [issued by the minister for Local Government] or their individual policies."

Mr Finch said S&P did not "step away" from the AAA rating it gave the Notes in 2006, which he said meant "the prospects were that the likelihood of the interest and capital being repaid in respect of this note were extremely strong".

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Frequently Asked Questions about this Article…

What were Rembrandt Notes and why did they cause big losses for local councils?

Rembrandt Notes were structured debt products described in the case as a type of Constant Proportion Debt Obligation (CPDO). According to the article, 13 local councils that bought the notes lost about 93% of their capital when the notes failed in 2008.

Who sold the Rembrandt Notes to the councils and did their licence allow it?

Local Government Financial Services (LGFS) sold the Rembrandt Notes to the councils. The Federal Court was told LGFS held an Australian Financial Services Licence (AFSL) that did not allow it to sell financial derivatives, and counsel for the insurer said LGFS made no effort to check whether its licence permitted the sale.

Why is Chartis Australia Insurance involved and what did it argue about disclosure?

Chartis Australia Insurance is the insurer involved in the case. Its barrister, Simon Couper QC, told the court that if LGFS had disclosed it was selling structured financial products the insurer would have excluded those products from the policy. He also argued a reasonable adviser would have told the insurer if the notes looked like derivatives.

Who are the other parties named in the lawsuits related to the Rembrandt Notes?

LGFS is pursuing legal action against the arranger of the notes, ABN Amro, and the ratings agency Standard & Poor's (S&P). The councils are also suing ABN Amro and S&P, alleging negligence and misleading or deceptive conduct. S&P is the agency that assigned the Rembrandt Notes a AAA rating.

Were the Rembrandt Notes legally derivatives or securities?

The article reports a legal dispute over that question. LGFS's counsel argued the licence wording meant that if an instrument was a 'security' it was not a 'derivative', and that the Rembrandt Notes were debt instruments falling under the definition of debentures and therefore securities. Chartis and other counsel questioned whether LGFS ever considered that the notes might be derivatives.

What did Standard & Poor's say about the AAA rating and suitability of the notes?

S&P's barrister, Steven Finch, told the court LGFS should never have sold the Rembrandt Notes to the councils and said the councils did not comply with ministerial guidelines or their own policies. He also said S&P did not 'step away' from the AAA rating it gave the notes in 2006, which S&P argued indicated the prospects for interest and capital repayment were extremely strong at that time.

What financial stakes are involved in this litigation over the Rembrandt Notes?

The article says LGFS is defending a $16 million claim brought by the councils. The councils suffered approximately 93% losses on their capital when the Rembrandt Notes failed in 2008, and LGFS is suing ABN Amro and S&P in turn.

What practical takeaways does this case offer everyday investors about structured products, ratings and adviser licences?

Based on the issues raised in the article, everyday investors should note three practical points: confirm your adviser is licensed to recommend the specific product type, check whether a product is suitable for your needs rather than relying only on a credit rating, and understand that ratings or paperwork may not remove the need to confirm regulatory and insurance implications before buying complex structured products.