Trustees of the Unilever Pension Fund v Merrill Lynch
The duties of investment managers to their clients hit the limelight recently in the UK. During the course of the trial, the trustees of the Unilever Pension Fund (Trustees) and Merrill Lynch Investment Managers (formerly Mercury Asset Management) (MAM) settled after two months in court, for an amount of approximately £70 million. As part of the terms of settlement, there was no admission of liability from MAM. This article will examine the potential impact of the case.

What happened?
The Trustees and MAM entered into an investment management agreement which contained an objective for the Fund to produce a return of 1% in excess of the benchmark. In addition, the agreement also specified that MAM should not, under normal circumstances, under-perform the benchmark index by more than 3% in any 4 successive quarters.

Between January 1997 and March 1998, the portfolio had under-performed by a cumulative return of 10.5%.

The Trustees claimed compensation from MAM for under-performance in the management of its funds by MAM. Approximately £1 billion of the Fund's investments had performed badly against the agreed benchmark index. Normally, fund managers who failed to perform were threatened with nothing more than the termination of their contracts. However, in this case, the Trustees took MAM to task.

Statement of claim
The Trustees asserted that MAM had breached its contractual obligation to exercise the highest standards of care and expertise in its management of the Fund. In addition, it was also asserted that MAM negligently mismanaged the Fund by failing to take sufficient account of the risk of underperformance and by failing to contain the risk of breaching the downside tolerance contained in the investment management agreement.

What were the issues?
Standard of care 
Although the agreement referred to 'highest standards' it appears that the court discussion revolved around establishing whether or not MAM had failed the standard of skill, care and diligence reasonably to be expected of a comparable and competent investment manager.

Risk management 
The Trustees alleged that this negligent mismanagement and breach of contract arose because MAM failed to take sufficient account of the risk of under-performance and also failed to take steps to contain that risk. It asserted that MAM failed to operate the risk control techniques expected of a competent manager with regard to a disproportionate exposure to the general industry sector which left the Fund heavily exposed. It was also asserted that the Fund had a high stock concentration in particular stocks which was out of proportion to the contribution on the FTSE All Share Index.

(Mis) management 
Much was made by the Trustees of the fact that the 'star' manager who initially secured the client then delegated the day-to-day management of the Fund to a junior. It was alleged that MAM failed to properly supervise the junior and there were few employee risk management checks in place.

Trustees failings 
It also transpired that the Trustees did not emerge unscathed. The chief investment officer (CIO) did not properly analyse a critical investment performance report on the under-performing Fund. The CIO also failed to inform MAM of the inconsistencies in the way that the Fund was managed against its performance objectives. Further, it was evident the Trustees did not know the details of the investment management agreement before the terms came into force.

Outcome
As the parties agreed to settle, the case does not establish a legal precedent. There is therefore no clear answer to the issues raised. The terms of the settlement did not include an admission of liability on the part of MAM. It is therefore dangerous to deduce too much from the hearing. The issues and the evidence are however undoubtedly of interest to the industry.

What is the impact?
Even though no legal precedent has been set, the Trustees' victory may encourage other trustees to start legal proceedings or seek compensation against investment managers for under-performance. Investment managers who have performed badly are vulnerable to legal action. Trustees who have suffered prolonged under-performance may feel that they have a fiduciary obligation to their members to sue. Much will depend on whether it is a term of the contract that a specific benchmark will be met. In the event the performance requirements of investment management contracts will be scrutinised more closely.

The funds management industry may also be scrutinised as to their standards, practices and procedures. Fund managers will wish to emphasise the merits of their risk control systems in pitching for business. More emphasis will be placed on a fund manager's risk management controls to minimise the danger of future negligence suits. Likewise, trustees will be more diligent in ensuring that the fund managers with whom they contract will have appropriate risk management checks and procedures in place and may require it to be a term of their contracts.

Finally, some commentators have stated that this case could precipitate the end of active funds management as we know it. Active fund managers may become much more risk adverse by making investment decisions that do not deviate too far from the benchmarks against which the active fund managers are measured. There may also be an increase in fees to take account of the perceived increase in risk and the additional risk management procedures now required.

Although we have no clearer idea of the extent of the due of care owed by investment managers to their clients, it's a timely reminder of the standard of care required of investment managers and in particular the standard of care implied under section 8(b) of the Superannuation Schemes Act, a similar standard of care to that argued by the Trustees.

This is a general summary only and should not be taken as a substitute for specific advice.


For further information please contact Alasdair McBeth, partner
email: alasdair.mcbeth@phillipsfox.com

Web site: Phillips Fox