VARIOUS newspapers have been reporting on a number of town councils' (such as Holland-Bukit Panjang Town Council, Pasir Ris-Punggol Town Council, etc) investments in Lehman Brothers' Minibond Series 3 Notes, Pinnacle Notes Series 6, etc.

As a result of Lehman's bankruptcy and other credit events relating to structured products, about seven town councils (TCs) now have a potential exposure of $16-19 million. Members of the public have voiced their concern over the investment of their housing estates' sinking funds in such high-risk financial products.

The question that must be on many peoples' minds, regardless of whether they live in the affected town councils, is: how did the town councils end up investing in structured deposits (instead of taking the safer option of placing the funds in fixed deposits in banks)?

It may be of interest to the public to know that town councils in England entered into all kinds of derivative transactions with banks in the 1980s. Seventy-seven of the 450 principal local authorities in England entered into 400 swap transactions between 1987 and 1989. The most famous and most authoritative case is Hazell v Hammersmith & Fulham Borough Council & Others (the 'Hammersmith case') which was decided by the House of Lords, the highest court in England.

Briefly, the facts of this case are as follows: In 1983, the Hammersmith Borough Council established a capital market fund for the purpose of conducting transactions involving interest rate movements. Between 1987 and 1988, it entered into interest rate swaps, swap options, caps, floors, collars, forward rate agreements, gilts and cash options with Midland Bank, Security Pacific National Bank, Chemical Bank, Barclays Bank and Mitsubishi Finance International.

In the majority of these transactions, Hammersmith Borough Council would benefit if the interest rates fell but it would incur substantial losses if interest rates rose. In 1988, the district auditor of Hammersmith Borough Council, Mr Hazell, challenged the legality of these derivative transactions on the grounds that they amounted to speculative trading, rather than hedging.

The entire case was decided on one key point: whether Hammersmith Borough Council had the legal capacity or power to enter into these derivative transactions. To address this legal issue, the court had to examine the all-important provision: Section 111(1) of the Local Government Act, 1972.

Based on the wordings of this statutory provision, the House of Lords held that Hammersmith Borough Council did not have the legal capacity or power to enter into these derivative transactions. They were declared to be 'ultra vires' transactions (that is, exceeding the powers of Section 111(1) of the Local Government Act. Hence, all these derivative transactions were void and unenforceable. This landmark decision triggered a string of 'restitution' cases in which the courts had to decide what could be recovered from such unenforceable transactions.

Learning from the Hammersmith case, the question is: do the town councils in question in Singapore have the legal capacity or power, under the Town Councils Act, to invest in structured deposits?

Tan Sin Liang
Compliance and derivatives lawyer
Principal, SL Tan & Co

This article was first published in The Business Times on November 27, 2008.