One of the most valuable lessons which lawyers learn when they are studying contract law is that the first thing to do when looking at a contract is to work out how you can get out of it if things go wrong and the relationship breaks down. So termination provisions are key to any contract, but perhaps more importantly it is vital to understand what happens before that stage and how the parties can prevent such a breakdown from occurring in the first place. Hence, liability provisions, especially in the context of investment arrangements for pension schemes, are keenly negotiated. Of course, the reason that this matters for a pension scheme is that the trustees, who are required by law to act in the best interests of their beneficiaries, are also prevented from excluding or limiting their liability in the exercise of any investment functions by section 33 of the Pensions Act 1995. So trustees cannot be excused from liability under their trust deed and rules as far as this absolute duty to the members is concerned.
In the current investment market where the fragility of investment returns is such that trustees and their investment managers are likely to be under ever greater scrutiny from scheme members, it is perhaps all the more important to make sure that all parties to an investment arrangement understand which risks they are bearing should things go wrong.
Investment Management Agreements (“IMAs”): who bears the risk?
If trustees are prevented from excluding liability to members for the exercise of their investment functions, is the position of their appointed investment managers any better? Section 33 of the Pensions Act 1995 also says that a person “to whom the [investment] function has been delegated under section 34 cannot exclude or restrict his liability by any instrument or agreement”. Although this would appear to impose a standard of strict liability on fund managers whom the trustees appoint, there is a distinction to be made between excluding liability to scheme members and distributing that risk between the trustees and their fund managers under an IMA. This is certainly how fund managers approach the issue when negotiating with trustees. The other quite understandable starting point from a fund manager’s perspective is that they see themselves as the trustees’ agent and not as a fiduciary who is answerable to the members themselves.
The normal principles of agency law require that the principal (the trustee body) is liable for all the acts and omissions of its agent (i.e. the fund manager) subject to the agent acting in accordance with express or implied authority. Accordingly, all fund managers seek to be indemnified by trustees against any expenses, costs or damages that might be incurred when dealing with third parties. In an investment management context, such exposures can arise from the ordinary settling of investment trades where a counterparty might fail to deliver securities or cash or where a third party agent who is not controlled by the manager (such as a stockbroker or futures broker) fails to carry out an instruction correctly.
So far, so good
However, there are some significant differences between trustees of occupational pension schemes and other types of principal. First, trustees are generally volunteers who would not carry on doing the job of trusteeship if their personal assets were at stake. It is possible in other areas of trusteeship to provide protection via scheme assets, the employer or external insurance but because, as explained above, liability is absolute in the investment field, the trustees either need to be fully in control of their investment managers or they need to be appropriately protected if their investment managers fail to act within appropriate authorities and cause a loss to the pension scheme.
This leads us to the second distinction between trustees and other principals, which concerns the subject matter of the agency contract and the fact that the investment manager will generally require authorisation from the Financial Services Authority (“FSA”) or an equivalent overseas regulator. Although it is possible for trustees to be authorised by the FSA, very few are because of the compliance cost and the fact that most trustees have a day job which consumes most of their time. Enter the professional fund manager who, of course, will be authorised for investment management activities. Indeed, trustees cannot engage in day-to-day investment management activities (as opposed to strategic directional activities which do not involve regular intervention and for which they are not remunerated separately) without being authorised so they find themselves between a rock and a hard place when investment managers seek to limit their contractual liability to trustees.
The fund management business in the UK is a highly sophisticated and well organised industry whose trade association, the Investment Management Association, has for many years produced a template IMA which has acted as a benchmark for managers’ agreements. That agreement was last updated in July 2007 to take account of the changes made by the Markets in Financial Instruments Directive, but the liability provisions remained unchanged. Under those provisions the manager would accept responsibility for loss to its customers to the extent that such loss is due to “negligence, wilful default or fraud” of itself or any delegates appointed by the manager. All other losses (without prejudice to the FSA Rules, the Pensions Act 1995 and the Financial Services and Markets Act 2000) are excluded. By limiting the responsibility of the manager in this way, the standard IMA leaves two principal gaps in the cover that trustees may think they should have available to them if anything goes wrong.
First, if an act or omission somehow falls short of satisfying the test for negligence and is also not wilfully (i.e. intentionally or recklessly) committed or omitted, then it will not be covered. An innocent mistake that could not be reasonably foreseeable would fall within this category, even if it caused loss to the pension scheme.
Secondly, because all other causes of liability are expressly excluded, any other contractual breach is equally excluded. So, for instance, a failure to comply with an instruction or an element of the investment objectives and restrictions stipulated by the trustees could fall within this category of contractual breaches, the consequences of which were not covered by the agreement.
When confronted with the argument that losses caused to the trustees under these circumstances should also be recoverable, many fund managers will simply say that the potential scope of covering all eventualities would make their business models unmanageable. They also point to the potential risk of a contractual breach occurring that had been indirectly brought about by trustees themselves giving false information. In such cases, one can, of course, sympathise with investment managers who are simply acting within the bounds of their ostensible authority because their principals (the trustees) are the ones really at fault.
It may be a sign of the times, but in recent months we have seen some investment managers and, in the context of derivative negotiations, various investment banks, trying to argue that the limit on trustees’ liability to indemnify their agents by reference to the value of the assets of the scheme (or where there is more than one mandate, to the assets of the portfolio under management) should not apply if the trustees have been guilty of negligence, wilful default or fraud. I do not think anyone would argue that fraudulent trustees should escape with limited liability. Indeed the benchmark IMA has long recognised this principle ever since it accepted that, in all other circumstances, trustee investors should not be exposed personally once the assets of their scheme have been exhausted.
However, it is a very different proposition to suggest that trustees are themselves capable of being either negligent or wilfully in default of their duties. The reality under an IMA is that the trustees have in fact very few duties, other than to pay the fees of the appointed agent, to give instructions from time to time about investments and to provide information that ensures that the investments may be made in eligible vehicles (e.g. by not giving misleading information about their tax status). As such, the attractiveness of some form of symmetry around the basis of liability is limited. Equally, to argue that trustees are in a position where they owe a duty of care to their agents that could give rise to the possibility of being negligent is intellectually a very difficult proposition to defend. It is the investment manager who is providing the professional services to the trustees and not the other way around!
The Investment Management Association is considering the need to amend its benchmark IMA.