- Fund promoters may lose their fund business without compensation.
- The best defence is to manage and to be seen to manage conflicts arising from related party agreements.
In good times, many legal questions may be academic. But when there is a crisis, whether basic legal principles have been followed becomes a vital question.
The Australian consequences of the sub-prime crisis are still unfolding. Nonetheless, we know from previous financial crises (both here and overseas) that when people lose money and lawyers and regulators get involved, the focus inevitably will turn to conflicts of interest. Conflicts are inevitable within financial conglomerate groups and related party contracts are the norm. So from a legal and regulatory perspective it is important to ensure these related party contracts were initially entered into, and continue to be managed, in conformity with the legal principles which govern the issue.
The law allows a responsible entity ("RE") of a registered managed investment scheme ("Fund") to be removed and replaced at anytime. In normal circumstances, if the responsible entity has been doing an excellent job for the investors, then the practical risk of removal is generally very low.
However, for an RE of a Fund which is a member of a larger financial conglomerate group impacted by the credit crunch with which the Fund has existing related party contracts, it can be very different. This risk of removal is increased even where there is sustained excellent Fund past performance. The best defence is to manage and to be seen to manage conflicts arising from related party agreements.
For example, two different pathways via which the removal of an RE of a Fund could occur are:
- a competitor may seek to take over the Fund by organising a sufficient number of investors to requisition a meeting of investors to pass an extraordinary resolution to remove the RE and replace it with the RE's competitor;
- existing investors or ASIC may apply to court for the removal of the RE and appointment in its place of a temporary RE, which they may do at any time. The court has power to do so if it is satisfied the appointment is in the interests of the Fund investors.
Fund promoters that recognise the risk that their fund business can be easily lost without compensation will ensure that related party contracts with a new Fund are entered into, and thereafter those contracts are managed, in conformity with the following basic legal principles (these principles apply to the RE because it is a trustee for Fund investors). Of course it is really too late to do this after the event.
Managing conflicts 1: Related party agreements
First, the RE of a Fund owes an overriding obligation of undivided loyalty to fund investors. This obligation prohibits an RE from placing itself in a position where its duties to Fund investors might conflict with its own interests or from using its position to gain a profit or advantage for itself or a related entity.
The entry by an RE of a fund into a related party contract would be a breach of this obligation. It is a strict obligation which does not depend upon detriment to investors, or the dishonesty and lack of bona fides of the fiduciary RE or upon the related party agreement not being on arm's length terms. Thankfully the law allows this obligation to be modified by the terms of the Fund constitution (there are a couple of other exceptions including obtaining the fully informed consent of each and every Fund investor). It is only by relying upon an exception that related party agreements can lawfully be entered into by an RE of a Fund.
So armed with a proper appreciation of this basic principle, it is then really important the RE drafts the constitution for a new Fund at the outset in a way which properly activates this exception. Appropriate disclosure of these conflicts in the Fund offer document to prospective Fund investors will also be important but for other reasons to do with regulatory compliance by the RE under its Australian Financial Services Licence.
Managing conflicts 2: Acting honestly and in good faith
Secondly, once the baseline prohibition is overcome to enable the RE of a Fund to actually enter into related party agreements, the RE is then subject to a prescriptive duty to act honestly and in good faith for the benefit of the Fund investors. This duty is so fundamental to the trust that it cannot be modified by the Fund constitution. This is a core obligation (which also has been effectively codified by statute) which must be complied with by the RE each time it exercises a discretion it has in relation to an existing related party contract entered into with the Fund. Examples of discretions concerning a related party contract include whether or not to exercise the contractual right to:
- terminate the contract consequent upon the occurrence of a default event in respect of the wider group;
- buy or sell assets from or to the wider group.
Managing conflicts 3: Getting your governance right
It does not end there of course. An RE needs to have a Fund governance structure (eg. appropriate board composition, separation arrangements, etc) in place to which it can point to demonstrate that these basic principles are being followed. In this way it maximises the prospects of a successful defence to any attempt to remove it as the incumbent RE of the Fund.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.