Wingecarribee Shire Council v Lehman Brothers Australia Ltd

GENERAL DIVISION NSD 2492 of 2007

AND: LEHMAN BROTHERS AUSTRALIA LIMITED (IN LIQUIDATION) (ACN 066 797 760)

REASONS FOR JUDGMENT (REVISED FROM THE TRANSCRIPT) 1 Lehman Brothers Australia Limited (in Liq) issued a subpoena to Standard & Poor's (Australia) Pty Limited on 2 September 2010. The subpoena was initially returnable before the Registrar. Standard & Poor's applied by notice of motion filed on 21 September 2010 to set the subpoena aside. As initially formulated, the subpoena sought a very large number of documents in relation to 39 financial products described in the second further amended application as "synthetic collateralised debt obligations" or SCDOs. After the motion came before me and the parties engaged in some discussion on 1 October 2010, the parties agreed to a reformulation of the schedule to the subpoena. It now seeks, relevantly, the following three categories of documents in respect of the 39 identified SCDOs: "1. Documents within the possession, custody or control of Standard & Poor's (Australia) Pty Ltd (S&P Australia) falling within the following categories: (a) Published materials relating to any of the financial products listed below that were rated by S&P Australia. (b) Published materials relating to any of the financial products listed below that were rated by S&P Australia's related bodies corporate. (c) Any files (meaning a collection of documents in electronic or physical form) or collections of workpapers relating to any of the financial products listed below." 2 The first two categories comprise documents that at relevant times were published by Standard & Poor's and were thus publicly available. For the purposes of the argument, Standard & Poor's reserved its rights to contend that the third category of documents in par 1(c) was not legitimately the subject of a subpoena on the basis that the production of the documents sought lacked a proper forensic purpose or that the documents were not relevant.

The relevant issues in the principal proceedings 3 These are group proceedings under Pt IVA of the Federal Court of Australia Act 1976 (Cth): see Wingecarribee Shire Council v Lehman Brothers Australia Limited (No 3) [2010] FCA 747. It is convenient to refer to the applicants as the Councils, for the representative parties are, in fact, local government councils and many of the group members are also such bodies. 4 The argument concentrated on a number of paragraphs in the second further amended statement of claim ("the statement of claim"), and one paragraph in Lehman Bros' defence. Relevantly, the statement of claim alleged that the 39 SCDOs: "14.13 were risk rated and assigned a rating not equivalent, as regards risk profile, to other types of financial products carrying the same ratings; PARTICULARS Ratings are only an indicator of credit risk in terms of the expectation of the first dollar of loss and provide no information about the expectation of the amount of loss given default ('LGD') (for example, a security with a 1% chance of losing 5% and a security with a 1% of losing 100% would be given identical ratings). 14.14 were exposed to unusual risks including: … (j) modelling risk - the risk arising from the fact that SCDOs prior to and during the Claim Period were subject to more complicated financial modelling and assumptions for the purpose of such modelling as compared to traditional FRNs and small deviations from modelling assumption could result in significant changes in the value of SCDOs." 5 The statement of claim also alleged that Lehman Bros had breached its duty of care to the Councils as a financial adviser, because it did not advise them that: · the 39 SCDOs were not equivalent, as regards risk, to other types of financial products carrying the same ratings (par 22.3); · the modelling used to assess risk attaching to the 39 SCDOs was limited by: (1) the relatively short period during which SCDOs had been available as investment products (par 22.4(a)); (2) the circumstance that market conditions had been favourable to the SCDOs since their inception, and the risk modelling for them had not been tested by adverse market conditions (par 22.4(b)). (The particulars for this allegation asserted that, first, the models were subject to shortcomings of data used to construct them, including the use of historical data to predict future behaviour, in circumstances where the performance history upon which ratings agencies, such as Standard & Poor's, had relied, had developed under very benign conditions; secondly, ratings agencies had an inherent conflict of interest in rating SCDOs, because the issuer of each product had commissioned the rating agency to rate it and, on an ongoing basis, would commission the ratings agency to provide updates; and, thirdly, the ratings did not reflect the potential impact of all risks related to the structure, market and other factors that might affect the value of the notes and, in particular, the level of correlation between credit events, that is, events that might give rise to a default.) 6 Next, the Councils pleaded that contrary to assurances allegedly given by Lehman Bros, the 39 SCDOs were not: · equivalent, as regards risk profile, to other types of financial products carrying the same ratings and had a significantly higher risk profile than other such products carrying those ratings (par 31.4); and · did not have risk profiles equivalent to traditional floating rate notes (par 31.5). 7 Lehman Bros' defence repeated, without admission, pars 14.13, 14.14, 22.3, 22.4 and 31.4 of the statement claim, and alleged that if those matters were established, then the ratings agencies, including Standard & Poor's, responsible for these ratings of the 39 SCDOs, had engaged in conduct that was misleading or deceptive or likely to mislead or deceive, because: · the ratings were not equivalent, as indicators of risk or risk profile, to the same rating when applied to other financial products; · those ratings did not disclose that the risk profile of the 39 SCDOs was significantly different from, and higher than that of, other financial products carrying the same rating; and · models used to perform ratings assessments had the limitations alleged by the Councils, in pars 14.14 and 22.4 of their statement of claim (par 64(b) of the defence). 8 Lehman Bros then pleaded in par 64 a defence that its liability should be reduced to the extent of the responsibility of the ratings agencies. This defence was based on the provisions of s 12GP of the Australian Securities Investments Commission Act 2001 (Cth) ("the ASIC Act"), and s 35 of the Civil Liability Act 2002 (NSW). Those provisions enable a respondent to allege that it should only be liable for the proportionate amount of the applicant's claimed loss or damage attributable to that respondent's responsibility, where one or more others, has or have also contributed to the causation of the loss or damage. Thus, a respondent can plead a basis to limit its liability to an amount, reflecting the proportion of the loss or damage claimed, that the Court considers just, having regard to the extent of that respondent's responsibility for the damage or loss. 9 The Councils pleaded in their reply that the defence did not disclose a basis to justify Lehman Bros obtaining any limitation of its liability as pleaded in par 64 (see par 8 of the reply). At the moment, the Councils have not applied to strike out par 64 of the defence. In any event, it appeared to be common ground on the motion, that if Lehman Bros were unable to establish that it had a legitimate forensic purpose in seeking the class of documents in par 1(c) of the amended schedule to the subpoena or that such documents were not relevant in respect of the identified paragraphs in the statement to claim, then par 64 of its defence did not advance the argument further. Thus, I need not consider this defence separately for present purposes.

The factual context 10 Standard & Poor's is part of an international group of companies, ultimately controlled by McGraw Hill Inc, some of which bear a similar name and are well known in the financial world by the generic name "Standard & Poor's". Thus, it is possible that other related companies of Standard & Poor's may have rated some of the 39 SCDOs and that the Australian company may have documents that might otherwise fall within the terms of par 1(c) of the subpoena. 11 Standard & Poor's tendered the publicly available documents relating to two of the 39 SCDOs, namely, the Nexus4 Topaz Notes and the Mahogany Capital Limited Series II Notes. The general counsel of Standard & Poor's informed its solicitor on the record, Mr McGuinness, that these were only two of the 39 SCDO's that it had rated. Lehman Bros contended that there was other material to show that Standard & Poor's rated additional SCDOs. Lehman Bros tendered two letters that suggested that Standard & Poor's had some involvement with rating two SCDOs identified in the schedule to the subpoena, namely an SCDO in the Select Access Investments Series 2003/2004, and another issued by Corsair (Jersey) No 2 Limited. 12 Standard & Poor's publicly available global credit portal report for the Nexus4 Topaz Notes described the rating rationale for the attribution of the "AA-p N.R.i" preliminary rating it gave to those notes that were to be issued, in June 2005. Nexus Bonds Limited was to issue those notes. The report indicated that the issuer had a very strong capacity to repay the principal of the notes in full to investors by the final maturity date in June 2015. The report explained that the rating was based on a guarantee provided by Deutsche Bank AG to repay the note holders the principal amount of the notes on the maturity date, 10 years after their issue. The report stated that although the notes also paid interest linked to the credit performance of a managed reference portfolio of companies, "… such interest is not rated by Standard & Poor's". I infer that this meant that the credit risk associated with the right of a note holder to be paid interest had not been rated by Standard & Poor's. Under the heading, "What does the AA-p N.R.i rating on the Notes Reflect?" Standard & Poor's wrote: "The rating on the notes reflects Standard & Poor's assessment of the credit risk of Deutsche Bank, specifically in its provision of the guarantee to repay the principal amount of the notes upon the maturity date. As long as the principal only rating on the notes is outstanding, it will be equal to the long-term rating assigned to Deutsche Bank." 13 Later in the report, Standard & Poor's asserted that its preliminary principal only rating was based on the probability, implicit in Deutsche Bank's "AA-" long-term credit rating, that it would not default on its obligations in the transaction and "… does not address the ultimate return to investors should there be an event of default". 14 Standard & Poor's report for the $50 million Mahogany series notes issued in March 2006 also assigned them a similar rating of AAp NRi. That report stated that the interest on the Mahogany notes was not rated. There was a complex underlying series of transactions connected with those notes. These involved the proceeds raised by the issue of the Mahogany notes being invested in a series of notes issued by Saphir Finance plc, a special purpose company incorporated in Ireland. The report stated that the principal of the Saphir notes was also rated AAp NRi, but, again, the interest on the Saphir notes was not rated. The report asserted that the rating on the principal of the Mahogany notes reflected the rating on the principal of the Saphir notes. It explained that the Saphir notes were debt securities for which payment of principal and interest were linked, through a credit default swap, to the credit performance of "corporates" in three separate portfolios during the term of the notes. Standard & Poor's had rated the Saphir notes in a separate report. 15 The Mahogany report stated that because the interest payable on the Mahogany notes was not rated, Standard & Poor's would not discuss the interest component or the interest portfolios. The report asserted that, poor credit performance, for the purpose of assessing the impact on the principal repayment on the Saphir notes, had been limited to certain significant credit events as defined. A credit event was defined for corporates in the capital portfolio in the Saphir notes as occurring only if a corporate became bankrupt or insolvent, failed to pay a minimum of USD1 million, or its equivalent, of its debt obligations, or adversely restructured at least USD10 million, or its equivalent, of its debt obligations due to a deterioration in its creditworthiness or financial condition. 16 The report explained that, in effect, when a note holder invested in the Mahogany notes, that money was then invested in Saphir notes, which were in turn invested in complex credit default swap arrangements, with the aim of producing, ultimately, some return for the investors. One part of the arrangement provided that a credit default swap counterparty for the Saphir notes had agreed to absorb any losses arising from corporate defaults up to a total limit of AUD195 million. That represented 3.9% of the total value of the corporate capital portfolio. The report explained that this had the consequence that investors in the Mahogany notes would not be exposed to a risk of capital losses for corporate defaults that were less than a net amount of AUD195 million.

The parties' submissions 17 Lehman Bros argued that the class of documents in par 1(c) of the amended schedule to the subpoena related to the claims that the Councils made against it in the paragraphs in the statement of claim to which I have referred. It contended that the material sought, consisting of any internal files that Standard & Poor's had relating to any of the 39 SCDOs, may provide material that was relevant for the purposes of assisting it to meet the case the Councils seek to make against it. 18 In contrast, Standard & Poor's argued that the only material to which Lehman Bros at the relevant times either had access, or could have had access had it chosen to refer to it, was the publicly available material that Standard & Poor's had agreed to provide in answer to the uncontested parts in pars 1(a) and (b) of the amended schedule to the subpoena. Standard & Poor's argued that this publicly available material, such as that for the Nexus4 Topaz notes and Mahogany notes demonstrated that it had rated only the credit risk in respect of the repayment of the principal due on the SCDOs. Standard & Poor's argued that this publicly available material also showed that it had not rated credit risks on SCDOs in respect of interest; had neither done anything to ascribe any value to any SCDOs, at the time of their issue or later; nor to quantify any loss that might later be occasioned were the issuer of the SCDOs to default. It then argued that the statement of claim asserted matters that should be determined to be true or not only from the publicly available material. Alternatively, Standard & Poor's argued that the statement of claim should be read as confined to assertions of what Lehman Bros had told, or failed to tell, the Councils about the true characteristics of the SCDOs when it advised them. Standard & Poor's then argued that any of its internal assessments of the SCDO's could have no relevance to the quality, accuracy or otherwise of what Lehman Bros may have advised the Councils based on the publicly available material. 19 Standard & Poor's argued that, for example, par 14.14(j) should be read as alleging solely that SCDOs were exposed to an unusual risk as to their value. This argument was put despite the terms of the allegations in par 14.14(j). These were that the risk arising from the fact that prior to and during the period complained of SCDOs were subject to more complicated financial modelling and assumptions, for the purposes of such modelling, as compared to traditional floating rate notes and that small deviations from modelling assumptions could result in significant changes in the value of the SCDO.

Consideration 20 I reject Standard & Poor's argument. Whether a subpoena has a legitimate forensic purpose is to be ascertained by reference to an assessment as to whether the Court is satisfied that it is "on the cards" (to use the expression of Gibbs J in Alister v The Queen (1984) 154 CLR 404 at 414) that the documents would materially assist the subpoenaing party in relation to the proceedings: see also R v Saleam (1989) 16 NSWLR 14 at 18A-F per Hunt J with whom Carruthers and Grove JJ agreed. This filter prevents the use of the subpoena as a mere "fishing expedition". In my opinion, the statement of claim alleged a number of matters that concerned changes in the value of SCDOs, each of which may or may not be ultimately determinative of a conclusion concerning such a change in value. First, par 14.14(j) alleged that SCDOs were subject to more complicated financial modelling and assumptions as compared to those applicable to traditional floating rate notes. Secondly, par 14.14(j) alleged that the small deviations from a modelling assumption could result in significant changes to the value of SCDOs. These allegations may or may not be correct. Each of those matters may or may not be able to be demonstrated from the publicly available material. However, the particular modelling that may be revealed in Standard & Poor's internal files, described in par 1(c) of the amended schedule to the subpoena, may make the allegation good or may falsify it or be relevant to that issue. 22 In the present context the nature of the relevant allegations are that the 39 SCDOs had particular characteristics, first, that were different from other securities in which the Councils might have invested or with which they might have been familiar, and secondly, that Lehman Bros either did not explain those different characteristics adequately or, in giving their explanation, it engaged in conduct that contravened s 12DA of the ASIC Act (that is, it engaged in conduct that was misleading or deceptive or likely to mislead or deceive). 23 Plainly enough, the publicly available material which Standard & Poor's has agreed to produce will be one source from which the truth or falsity of the substantive contest between the Councils and Lehman Bros on these issues can be ascertained. But, I am of opinion that the contest is not necessarily confined to that material. Standard & Poor's internal modelling or working papers concerning the creation and framing of assumptions for the purposes of determining a rating may throw light on the validity of the allegations made by the Councils. If the material is produced and either confirms or negates those allegations, the issue relating to them will most likely be speedily resolved, thus narrowing the controversy in the proceedings. 24 Moreover, the work done to ascribe a rating to those SCDOs, which Standard & Poor's itself rated, is quite likely to be relevant to the issues in the proceedings in the sense of what is required for the purposes of requiring production in answer to a subpoena. Similarly, I think it is "on the cards", that there may be internal working papers bearing on other SCDOs rated by related companies of Standard & Poor's, that would amount to material likely to be relevant, in relation to establishing or negating allegations made in the relevant paragraphs in the statement of claim. 25 Standard & Poor's did not suggest that the internal documents would not otherwise be capable of being produced or would impose undue burdens of search on it for the purposes of answering the subpoena.

Conclusion 26 I am satisfied that the documents described in par 1(c) of the amended schedule to the subpoena are sufficiently relevant to, and that Lehman Bros has as a sufficient forensic purpose in relation to the production of such documents for the purposes of, the facts in issue in the proceedings so as to warrant par 1(c) being allowed to require the documents sought to be produced, subject to any proper objections as to privilege. For these reasons, I refuse to set aside par 1(c) of the amended schedule to the subpoena.

Costs 27 The matter did not proceed on 1 October 2010. During the hearing on that day I suggested that consideration be given to whether the then proposed amended terms of the subpoena ought be redrafted by Lehman Bros so as to narrow them somewhat. The draft subpoena then proposed, as among other things, called for production of all documents in the possession, custody or control of Standard & Poor's during the period from March 2003 to May 2008 including, but not limited to, a number of identified documents created by it or its related bodies corporate recording the methodology applied or relied on by Standard & Poor's, or its related bodies corporate, to rate collateralised debt obligations and floating rate notes. Thus, the then proposed subpoena effectively called for all documents used by a credit rating agency for a period of five years and two months. 28 The scope of that call was extremely broad. Accordingly, I referred the parties to the considerations that were relevant to assessing whether such a subpoena would be properly framed. In Lane v Registrar of the Supreme Court of New South Wales (1981) 148 CLR 245 at 259 Gibbs CJ, Mason, Murphy, Wilson and Brennan JJ said that: "A subpoena to produce documents is an important means of establishing the facts in issue in litigation and thereby enabling justice to be done. However, it is an instrument which may be misused. It is not right that a subpoena addressed to a person who is not a party to the action should be in such wide and general terms that it requires the witness to make a "burdensome search for evidence at his own expense", to use the words of Page Wood V.C. in Lee v Angas ((1866) LR 2 Eq 59 at p 63). To avoid putting a person who may have no interest in the suit to inconvenience and expense, a subpoena to produce documents must "specify with reasonable particularity the documents which are required to be produced": Commissioner for Railways v Small ((1938) 32 SR (NSW) 564 at p 573)."

29 In my opinion, the previous formulations of the classes of documents called for in the earlier versions of the subpoena, required revision to narrow them so as to comply with the requirements imposed by law. Thus, on 1 October 2010 it seemed to me that there were good reasons why negotiations should occur. The parties subsequently engaged in good faith negotiations, and produced a very sensible, if I may say, reformulation that enabled each party to argue the outstanding questions of principle in an efficient manner. 30 Standard & Poor's argued that because Lehman Bros had reformulated of the terms of the proposed subpoena, on 29 September 2010, Lehman Bros had caused the adjournment of the hearing on 1 October. Standard & Poor's also argued that subsequently it had undertaken some work to deal with the potential oppression to it from compliance with that draft of the subpoena, because Lehman Bros had indicated on 1 October that it would press those terms, prior to my exhortation to the parties to have regard to the overarching purpose of civil procedure provisions in Pt VB of the Federal Court of Australia Act. That exhortation only later produced fruit. 31 Obviously, where the parties have effectively agreed to an outcome, it is invidious, and not usually appropriate for judges to make orders for costs: see, e.g., Re Minister for Immigration and Ethnic Affairs; Ex parte Lai Qin (1997) 186 CLR 622 at 625. There, McHugh J said that if it appeared that both parties had acted reasonably in commencing or defending proceedings, and that reasonable conduct continued until the litigation was settled, or its further prosecution became futile, a proper exercise of the discretion to award costs would usually mean that the Court would make no order as to the costs of the proceedings. A similar approach was referred to by the Full Court of this Court in Rickus v Motor Trades Association of Australia Superannuation Fund Pty Limited (2010) 265 ALR 112 at 136-137 [117]-[119] per Jacobson, Siopis and Foster JJ. 32 Similar considerations are applicable here. However, the factor that I think distinguishes this motion from the general principle is that the negotiations undertaken to narrow the issues were both necessary and important but still left an issue to be determined that was significant for the parties. The negotiations resulted in relieving Standard & Poor's, a stranger to the proceedings, from the need to deal with the particular terms of the earlier draft subpoena that were very broad and reduced the argument to a narrower compass. Ultimately, the parties had to argue the matter. And, they had to prepare to argue it twice, albeit on different bases. 33 Doing the best I can, I think it is fair to infer that Standard & Poor's was entitled to maintain its opposition to the terms of the subpoena as originally issued and as reformulated on 29 September 2010. But, for the reasons I have given, it failed to resist the further reformulated par 1(c). In the particular circumstances of this case, I think justice will be done if I order that Lehman Bros pay 40% of Standard & Poor's costs of the motion. 34 That will reflect the fact that Lehman Brothers ultimately had success in defending the revised category in par 1(c). However, there was a protracted period beforehand in which the categories were narrowed and in my opinion, prima facie, the previous terms of the actual and redrafted 29 September subpoena seemed very wide. Standard & Poor's was entitled to be concerned about the imposition upon it, were it required to answer a subpoena in such wide terms. Nonetheless, I do not think that it is entitled to all its costs of resisting the subpoena because it failed on the issue argued today. I certify that the preceding thirty-four (34) numbered paragraphs are a true copy of the Reasons for Judgment herein of the Honourable Justice Rares.