The law in this area is not new – but it is worth fresh consideration in the current climate.
What claims might arise?
If an investment has not performed as well as anticipated, then the claims commonly considered are:
a. Breach of contract.
b. Misrepresentation - such as inaccurate/misleading sales information.
c. Breach of duty/negligence - such as failure to carry out proper due diligence on the investment asset being acquired, speed of response to dealing with market conditions and/or ineffective risk management processes.
d. Claims under the Financial Services Association rules (are the documents 'clear, fair and not misleading'? Have investors been treated 'fairly'?).
e. Breach of fiduciary duty - these duties are broad in scope, but can be reduced by contract.
f. Fraud - have monies been taken from the fund without authority and for personal gain?
As a fund manager - what action can be taken to avoid claims?
As a practical measure, ensure at the outset that all fund documentation is in order – check in particular that the investment strategy is described accurately and that all risks are clearly and carefully explained. After fund launch, ensure that appropriate compliance procedures are in place to monitor regularly whether the promises and assurances set out in the fund documentation are being satisfied. The decision by Standard Life to reimburse its Pension Sterling Fund is a notable example of this. Standard Life established and operated the Pension Sterling Fund. Its attraction to most investors was its low risk – it was marketed as being as safe as cash. However, instead of being invested largely in cash (as some investors had been told), much of the fund was invested in riskier mortgaged-backed assets. While Standard Life insisted that these were largely AAA rated the value of the mortgage-backed securities had fallen and this wiped out value of the fund. Standard Life accepted that 'in hindsight some of the literature supporting the fund fell short of our own high standards and it is important that we put this right'. A payment of £100million was made into the fund.
Take heed of the various best practice guides – in particular regular, clear updates to investors are crucial. Keep investors informed about the fund's performance and any changes in investment policy thought necessary. A fund is dynamic in nature, with the fund manager having a certain amount of discretion concerning the assets to be acquired. The investors should be kept regularly informed – particularly if significant changes in strategy are contemplated. Consider whether or not consent of the investors (or any investor/advisory committee) should be obtained (whether it is contractually required or not)?
A scrupulous document management and retention policy should be adopted. There have been a number of cases in which a fund manager would have a stronger defence if key meetings and telephone calls were properly recorded.
Investigate complaints seriously - they could reveal early warning signs of issues that can be resolved before legal action is commenced.
Ensure that your exclusion clauses are up-to-date and as effective as they can be. This certainly proved useful for JP Morgan Chase Bank in the Springwell case. The banks' standard form disclaimers were held to be effective and prevented certain duties of care and contractual responsibilities arising.
Monitor the position of your investors - if they are experiencing financial difficulties it may be an early warning sign that they will not be able to meet a drawdown request. While a fund may have a claim against its investors for failure to meet drawdown requests - it is not an action to be taken lightly. If it is known that funds are no longer available then this may affect the decision to acquire further assets into the fund or to bring on board a replacement investor.
Monitor how a fall in the value of assets may affect other fund documents - in particular any facility agreements. If a breach of any covenant is looking possible then consider immediately the options available for dealing with this. Is an equity call possible? Could you limit redemption rights or make other constitutional changes? Will the banks be open to re-negotiating the terms of the facility? Can a refinancing exercise be undertaken? This is a particularly common issue facing a number of funds in the current challenging environment.
As an investor – what action can be taken to ensure that your investment is being managed and invested as agreed?
Practical measures are:
a. Ensure that all key fund documents are reviewed carefully and understood before any investment is made. If you are unhappy with any provision – discuss it with the fund manager. It may be possible to obtain a side letter to confirm/clarify how an issue will be dealt with.
b. Ensure that you have the right to receive or access information which will confirm whether or not the fund is investing in the manner anticipated so that you can monitor compliance. Often investors in private investment funds are only entitled to limited financial information - is this enough?
c. Consider the terms of the fund/asset management agreement - what level of service is required from the manager? In what circumstances can the manager be dismissed - and who is involved in this decision? In particular, can the fund manager be dismissed for poor performance? The investors are often not in direct contract with the fund manager - instead the fund manager is appointed by the fund vehicle (and investors may have little control over the actions of the fund vehicle). When is investor approval required? Ensure that there is a clear route for the fund manager to be held accountable.
d. Consider how the fund manager is incentivised? Do the promote payments ensure that the fund manager's compensation is linked inextricably with success of the fund (measured by the returns investors receive)?
e. Consider whether key man provisions are required in the asset management agreement - are certain individuals critical to the due performance of the fund? If yes - then the documents should reflect this.
f. Know your rights - if, for example, you receive monies out of a fund, are there any circumstances when you may be required to return the funds if a subsequent valuation of the fund shows a substantial fall in net asset value? Can the fund claw back these distributions?
If you believe you have grounds for a claim - what should you do?
Often a considerable amount of management time will be taken up by any litigation. Although some management time might be recoverable (and you should have in place some form of record to provide evidence of the time spent) inevitably, much of it won't be. The cost and the disruption to the business incurred by having to be involved in litigation should not be underestimated. This is one of the factors to bear in mind when considering whether to mediate at an early opportunity.
As a fund manager, if you feel you may be faced with a claim, you should carry out a thorough analysis of the evidence to determine whether there are any grounds for the claim. If there are, options for dealing with the claim need to be identified and considered as soon as possible. In the first instance there is likely to be an internal complaints procedure which will need to be followed within the relevant time frame and in accordance with Financial Services Association rules (where applicable) on complaints. As litigation may be "in prospect" – no documents should be destroyed and ideally all communications on the issue should be routed through the legal team in order to maintain privilege.
As an investor, if you feel you have grounds to make a claim, then bear in mind the following:
a. Rarely will a fund's performance be guaranteed. Typically investment documents will contain the usual caveat "investment values can fall as well as rise".
b. One bad investment decision does not automatically mean that the fund manager is negligent.
c. Causation can be difficult to prove when the market is volatile and unpredictable - did the fund manager's actions (or inaction) cause the loss or is it simply a consequence of the credit crunch?
Notwithstanding the above, the Standard Life settlement shows that risk can fall on those responsible for managing and operating a fund and result in significant payoffs/settlements. An investor should as a result ensure all relevant paperwork is to hand and not destroyed and obtain an experts' view on the claim as soon as possible.