Setting a better trap for financial fixers

In contrast to a recent Storm Financial settlement, Wingecarribee vs Lehman Brothers shows that regulators can nail the perps. We must give ASIC, APRA and co more backing.

The Conversation

Justice Steven J. Rares was blunt when he handed down his judgement in the long-running class action, Wingecarribee Shire Council vs Lehman Brothers Australia, last week.
Grange Securities, a subsidiary of Lehman Brothers, had engaged in "misleading and deceptive behaviour” in promoting sub-prime derivatives known as Synthetic Collateralised Debt Obligations to three local authorities in NSW and WA, Justice Rares said.

Led by Wingecarribee Council, a regional council in Bowral in NSW’s Southern Highlands, 72 plaintiffs including councils, charities and churches were found to be entitled to millions of dollars after having been misled into buying toxic investments.

Much already has been, and will be, written about the Wingecarribee case and the judgement.

But of interest here is the fact that the matter went through the full legal process with a hearing in open court and a final judgement made by a senior judge (although there may still be an appeal to a higher court). After considering the evidence, the judge ruled that Lehman was "liable to compensate the councils for [all of] their losses incurred as a result of their investments”.

Compare this with the latest settlement in the Storm Financial case. On September 14, Commonwealth Bank agreed to provide $136 million (on top of an earlier payment of $132 million) in compensation to customers who lost money when Storm Financial collapsed in March 2009. The case, brought by the Australian Securities and Investments Commission, continues against other banks and Storm itself. Other class actions related to Storm also continue for Commbank.

The timing of the settlement is interesting. On August 20, CBA released its 2012 annual report, which contained a section on Storm Financial in which the bank noted that it was "close to finalising its resolution scheme for clients of Storm Financial who borrowed money from the Group”. Less than four weeks later, the case with ASIC was wrapped up "without any admission of liability by the Group”.

This is yet another example of banks successfully burying bad news. Doubtless at some time in the future, an enterprising journalist will publish a book on the Storm Financial fiasco when names will be named. But for now, no one has fallen on their sword or been sacked at Commbank over payments totalling some $270 million (not including legal costs) underwritten by the bank’s shareholders. In fact, the annual report shows that all board members received a nice pay rise.

Overseas, it is very different. Earlier this year, the UK banking regulator, the Financial Services Authority, undertook a "thematic review” of complaints from numerous small companies concerning mis-selling of interest rate hedging products by banks.

When the review was completed, the UK regulator ordered the major UK banks to provide redress to any companies affected by mis-selling. The banks complied immediately and apologised. Now that’s regulation.

Thematic review is the new buzzword in regulatory circles. It means looking across the financial system at abuses that may be occurring in more than one institution and is a tool of so-called macro-prudential regulation. In a long overdue report into macro-prudential regulation in Australia, jointly published by the Reserve Bank of Australia and the Australian Prudential Regulation Authority, the banking regulator has jumped on the bandwagon and announced its commitment to such cross-industry reviews.

However, APRA has not yet provided details of any areas in which such a review will be undertaken. But the many complaints aired in the recent Senate Inquiry on the banking system after the GFC might provide a useful starting point.

The form of words "without admission of liability” has become a clich whenever cases of bank wrongdoing around the world are settled, usually with a large payment by the banks concerned. So much so that last November, Judge Jed Rakoff of the US District Court in Manhattan had had enough, throwing out a settlement between Citigroup and its regulator, the Securities and Exchange Commission.

Judge Rakoff said that the regulator’s policy of settling cases by allowing a company to neither admit nor deny allegations "did not satisfy the law”. He added that the settlement was "neither fair, nor reasonable, nor adequate, nor in the public interest” because it does not provide the court with sufficient evidence on which to judge the settlement.

The judge’s point is that the regulator is not only the prosecutor, but also the judge and the jury in these settlements. Nor is there independent oversight or appeal. And, as with the Storm case, it is the shareholders, not the wrongdoers, who pick up the tab.

One can sympathise with regulators, especially the SEC, which is inundated with a huge number of cases of bank wrongdoing resulting from the GFC. Banks (correction: shareholders) have deep pockets and can keep litigation going for a long time. On the other hand, regulators must consider the public purse when pursuing cases.

But a case that is judged in court creates case law and legal precedent. For example, as a result of Justice Rares' judgement, we now know that some of the practices used by Grange were illegal and any banks involved in the same practices, now and in future, can be held to account without a long and expensive trial. Hopefully, regulators will make this point to any banks that may be tempted to follow Grange’s example.

One of the embarrassing facts that emerged from the Lehman trial was that Grange Securities sold these complex and, as it turned out, very risky products to councils and charities with misleading marketing material that praised local banking regulators whose "regulatory requirements make the Australian banking system amongst the safest in the world”. This implied that government would somehow protect the investments sold by Grange. The "safest banking system in the world” is a very powerful meme.

Following the GFC and other scandals, such as the mis-selling of Payment Protection Insurance in the UK, governments around the world have beefed up their regulatory environments. One of the key areas that governments have focused on is "financial conduct” especially as regards ordinary consumers.

In the UK, the Financial Conduct Authority has been carved out of the banking regulator, the FSA, to focus specifically on the "conduct” of financial services firms not only as regards retail customers but also commercial firms.

In the US, the Consumer Financial Protection Bureau has been created with a similar mandate, to protect consumers from "unfair, deceptive, or abusive acts or practices”.

The lesson from these regulatory innovations is that a large single regulator may be too stretched to handle the myriad of issues that can arise in a modern financial system and that smaller and more focussed regulators would do a better job. (This, of course, is a hypothesis that remains to be proven or otherwise).

The new financial conduct regulators in the US and UK have also been given a mandate to improve financial literacy to help protect against financial fraud. In Australia, financial literacy is just one of the regulatory roles assigned to ASIC, along with regulation of financial markets and company registrations.

The ASIC Moneysmart web site is primarily aimed at ordinary consumers, giving advice on investing, superannuation and retail credit, such as credit cards. However, as the Lehman case shows, with complex modern investments even finance professionals can have the wool pulled over their eyes.

If one believes that mis-selling of complex financial products could not happen in Australia, there is little need to consider changes to regulatory structures here. However, evidence to the Senate Inquiry would suggest that financial mis-selling was not limited to local councils but was widespread during the property boom of the early 2000s. If so, government should consider whether and how regulatory structures should be changed to meet such challenges.

There is also a need for case law to be clarified surrounding the practices of selling complex financial products. If necessary, the government should, where the law is unclear, be prepared to underwrite legal action by regulators against financial institutions, all the way through the courts until the matter is adjudicated. With the legal certainty of case law, both financial institutions and regulators will be able to move forward on firmer ground. And taxpayers will sleep happier at night.

In those cases where a settlement is agreed, it should be standard practice as part of, and paid for by, the settlement for an independent inquiry to be automatically set up. Since the actions of both regulated and regulator would be considered, such inquiries would be best administered by a truly independent body such as the Australian National Audit Office. To address any open legal concerns, the terms of reference of a particular inquiry would include recommendations from the judge in the settlement.

Wingecarribee shone a light onto dubious financial practices in the Australian marketplace. Such shoddy practices can only be tackled by strong and intrusive regulation, funded and supported by government. There is a need for government to learn all of the lessons from this case.

Pat McConnell is an honorary fellow at Macquarie University's Applied Science Centre. This story first appeared on The Conversation. Reproduced with permission.

Related Articles