The recent case of SPL Private Finance v Arch Financial Products does not generate new law and is very fact-specific. However, it provides a useful illustration of the kind of claims faced by investment management companies and the personal liabilities of business leaders. It may therefore be of interest to fund managers, their directors, and those who insure them.
Arch Financial Products (Arch) was an investment manager. It managed funds held within cells made up of multiple companies (the Cells). An Investment Management Agreement (IMA) governed the contractual relationship between Arch and the Cells.
In late 2007, Arch and Foundation Capital Limited (FCL) entered into a joint venture. They would arrange the purchase of ClubEasy group, a student housing business, through finance invested by the Cells. As part of this, Arch and FCL would share between them a substantial part of the monies invested. When the investment took place, Arch and FCL simply extracted £6 million from the £21m purchase price, which they described as a ‘structuring fee’. Over the next couple of years, additional sums were invested by the Cells to fund ClubEasy’s operational costs.
After suffering a huge loss on this investment, the Cells brought a claim against Arch. They also brought a claim against its CEO, Mr Farrell, personally, on the basis that he was responsible for the overall operation of Arch, acted as a dominant person in the organisation and was instrumental in driving the particular investment.
The Cells claimed that Arch's decision to make the investment was driven by their financial interest in obtaining illegitimate payments, rather than by a proper consideration of the merits of the transaction and the interest of the Cells. The Cells alleged that Arch had acted in breach of: (a) its fiduciary duty to avoid conflicts of interest and make unlawful profit; and (b) its contractual duty under the IMA to take reasonable care in managing the portfolio in relation to the Cells' investments. The Cells also claimed that Mr Farrell had dishonestly assisted or induced these breaches. Finally, the Cells alleged breach of investment mandate.
The judge found for the Cells on all counts except the breach of mandate.
Breach of Fiduciary Duties
The judge held that there was a fiduciary relationship between the Cells and Arch since Arch had exclusive control of the Cells assets, and the particular circumstances gave rise to a relationship of trust and confidence. That required Arch to give preference to the Cells' interests over its own and manage any potential conflict of interest fairly. Arch might have had a defence had the Cells had consented to its conduct. However, there would have to have been full disclosure as to the nature and extent of Arch's interest. In this case, the Cells had no knowledge of the agreement by which Arch and FCL received (in the judge's words) a share of "the meat". The Cells had not authorised payments that were quite clearly something other than fees. None of the money went towards transactional costs, and the payments were in fact a way for Arch to "turn a profit" of such a size that it would "turn heads".
Breach of contractual duties
The IMA required Arch to take reasonable care in managing the portfolio. As such, before entering the investment, Arch needed to satisfy itself that the prospects of receiving the promised benefits would outweigh the risk that the Cells' money would be lost, and to take reasonable care in evaluating these prospects. The judge held on the evidence that there was a lack of risk / reward analysis or due diligence on the initial investment, which Arch knew (or should have known) was uneconomic at the outset. Further, Arch gave no proper consideration as to whether subsequent investments were in the best interest of the Cells, as the focus was merely on keeping the company afloat with no further risk / reward analysis undertaken.
Claims against Mr Farrell
Dishonesty requires an awareness of the elements of a transaction that make participation in that transaction transgress ordinary standards of honest behaviour. A dishonest state of mind does not require actual knowledge. A suspicion will be sufficient if combined with a deliberate decision not to make enquires. On the facts, the judge found that Mr Farrell had suspected that the relevant elements of the transaction were wrong and chose not to make enquires which would have resulted in him learning things that would make it wrong to proceed. The judge held him personally liable for Arch's breaches of fiduciary duty.
The judge also found that Mr Farrell had induced the breach of contract by Arch. On the facts, he knew the IMA, he intended to induce a breach of it, and there was in fact a breach caused by his conduct.
Breach of Mandate
Given the findings above, the judge addressed this allegation with only brief comments. He noted that the IMA described the investment objective of the funds as "…to provide Shareholders over the medium to long term with capital appreciation though an economic exposure to a diverse range of investments…" The Cells had argued that this required the fund manager only to make investments where it was objectively more likely than not to result in capital appreciation. The judge considered that this construction was unworkable in practice, and would generate an unreasonable level of risk for fund managers and those dealing with them. It was in any event unnecessary to restrict the mandate in this way, where there was already a duty to take reasonable care. He went on to reject those allegations.
The facts of this case may be exceptional, and therefore of limited direct application to the fund management industry generally, other than as a cautionary tale. However, it still has some value for those who seek to learn from others' mistakes. At the very least, the case serves to highlight the following (perhaps rudimentary) points:
- The clear benefit of a robust conflicts policy;
- The personal economic risk to business leaders who put their organisation's interests ahead of their principals', or who knowingly ignore suspicious circumstances.
- In any circumstances where full and frank disclosure is required to manage a conflict, anything less than that may render that protection worthless. Any disclosure that is limited or presented in a certain way because of concerns about how the recipient might react to it may, in itself, be a red flag about the potential inappropriateness of the transaction in question.
- The value of being able to evidence the proper analysis of risk/reward on an ongoing basis, in case investment decisions are later challenged.