The enormous press coverage of the High Court battle between the trustee of the Unilever Superannuation Fund and Mercury Asset Management (now taken over by Merrill Lynch), coming swiftly after the publication of the Government’s response to Paul Myners’ review of institutional investment in the UK, has put the duties of the investment manager to their pension scheme trustee clients centre stage.

Merrill Lynch paid a reported £70 million to settle the case during the course of the trial. In view of this substantial settlement, many pension scheme trustees will be considering whether they should initiate negotiations for compensation with their investment managers where there has been a prolonged period of significant under-performance against an agreed benchmark.

As the parties reached a settlement there is no legal precedent and we have no clear guidance on the issues raised. Furthermore, the terms of the settlement did not include any admission of liability on the part of Merrill Lynch. We can only guess whether the impetus to settle arose primarily from a need to limit damaging press coverage or from more substantive legal grounds. We believe that it would be unwise to deduce from the fact of settlement too strong a conclusion about the likelihood of liability in other cases.

In this briefing we consider the facts of the Unilever case and discuss in what possible circumstances trustees might want to consider following in the footsteps of the trustee of the Unilever Superannuation Fund.

The Unilever v. MAM litigation

The trustee of the Unilever Superannuation Fund (the Unilever trustee) sued Mercury Asset Management (MAM) for £130 million on the basis that MAM breached its contractual obligation to exercise the highest standards of care and expertise in its management of the Unilever fund. The Unilever trustee also asserted that MAM had negligently mismanaged the fund by failing to take sufficient account of the risk of under-performance and by failing to contain the risk of breaching the downside tolerance contained in the investment management agreement.

MAM started to manage the funds in 1987, and a new investment management agreement (the Agreement) was negotiated to take effect from the start of 1997 that set out new investment objectives and guidelines. The Agreement contained an objective for the fund to produce a return of 1% in excess of the benchmark over periods since the inception of the portfolio subject to a minimum period of three years. Unusually the Agreement contained a term that stated that in normal circumstances the return would not be expected to be more than 3% below the benchmark in any period of 4 successive calendar quarters. The Agreement also provided that MAM should exercise the highest standards of care and expertise in carrying out its duties and fulfilling its obligations under the Agreement. Between 1997 and 1998 the Unilever fund managed by MAM under-performed the agreed benchmark by a cumulative return of 10.5%. The Unilever trustee terminated the Agreement in March 1998.

The Unilever trustee asserted both breach of contract and negligence by MAM. In any contractual relationship for the provision of professional services, it will be an implied term of the contract that the services provided for management of the fund will be rendered with reasonable skill, care and diligence. This can be framed, as here, as a claim in contract and negligence. In both cases the investment manager’s conduct would be measured by the standards which it would be reasonable to expect of a comparable and competent investment manager in all the circumstances of the case. Whether there was debate over "highest standards" as referred to in the Agreement and the more usual standard of "reasonable care and skill" is not apparent from the public information on the case. Discussion in court appears to have centred around establishing whether or not MAM had failed to meet the standards of skill, care and diligence reasonably to be expected of a comparable and competent investment manager. It is important to note that it was not alleged that MAM guaranteed that the downside tolerance would not be exceeded.

Risk Control Techniques

In order to achieve a return in excess of a benchmark it is necessary for a portfolio to diverge from an exact match to the composition of the benchmark with the objective that the divergences will generate an out-performance of the benchmark to the degree desired. This divergence inevitably carries with it a risk that the portfolio will in fact under-perform the benchmark. The Unilever trustee tried to limit the under-performance by controlling the extent of the divergence from the benchmark by including the 3% downside tolerance in the Agreement.

The Unilever trustee claimed that the negligent mismanagement/breach of contract arose from MAM failing to take sufficient account of the risk of under-performance, and failing to take steps to contain that risk. In evidence of this assertion the Unilever trustee pointed to the fact that the Unilever fund’s UK equity fund had a major and disproportionate exposure to the general industries sector, and was underweight in every other sector, most notably in the financial sector. The Unilever trustee stated that "this was a substantial risk to take and left the UK equity fund heavily exposed if, as happened, general industries turned out to be the worst performing sector, while financials produced the best return."

The Unilever fund managed by MAM had a very high stock concentration. The fund was concentrated in 43-63 stocks, with over 75% of the stock concentrated in 20 stocks. Within that concentrated portfolio there was a number of holdings of particular stocks where the size of the holding was out of all proportion to the contribution of the stock to the FTSE All Share Index. Again, the Unilever trustee asserted that this showed a failure to operate the risk control techniques that would have been expected of a competent investment manager with the same remit.

The Unilever trustee also relied on the performance of other specialist managers and funds to show that MAM’s risk control fell below industry standards. MAM were shown to be in the 100th percentile rank in respect of the performance of the Unilever fund’s UK equities fund.

Employee Management

The Unilever trustee claimed that the level of risk to which the fund was exposed increased significantly when a junior manager, Mr Lennard, took over the running of the fund.

During the hearing, the Unilever trustee tried to prove that MAM had failed to supervise Lennard properly and had few or no employee risk management checks in place.

As the parties reached a settlement there is no precedent: we have no clearer idea of the extent of the duty of care owed by investment managers to their clients as a result.

We do, however, consider below the different categories of trustees who could consider seeking compensation from their investment managers and the legal basis for doing so.

Further claims

Clearly trustees who have suffered prolonged under-performance may want to consider their legal position.

Claims in respect of liability for failure to meet a benchmark are likely to centre around breach of contract and negligence, as we have seen in the Unilever case.

If it is a term of the contract that the benchmark will be met, then there will be liability for failure to meet it and it will be irrelevant why it was that the performance fell short of the benchmark. The question of whether a benchmark forms a term of the investment management agreement is not one which can be answered in the abstract: the terms of the individual investment management agreements will have to be considered. However, agreements are unlikely to contain such a term as it would effectively operate as a guarantee that the benchmark would be met.

If it is not a term of the contract that the benchmark will be met, a failure to meet the benchmark should not of itself determine whether the manager had been negligent. However, the reasons why the performance fell short of the benchmark would have to be explored. If the rest of the market achieved much better performance for comparable funds over the same period, it may be that there is a basis for concluding that the management of the particular fund was negligent. A failure to meet the benchmark, especially if this was by an appreciable margin, could well be taken as evidence of that.

A spokesman for Merrill Lynch has stated that the "contract with Unilever was unique and it did not expect to see any further claims". The question here is how central to the Unilever trustee’s success in achieving a substantial settlement was the fact that their agreement with MAM contained a defined downside tolerance? It is important to note that, as mentioned earlier in the briefing, the Unilever trustee did not allege that MAM guaranteed that the defined downside tolerance would not be exceeded. A defined downside tolerance is a clear indicator of the level of loss that the trustees would tolerate and the level of risk that was acceptable to them, but an absence of such a term would not prevent trustees from bringing a claim for negligence on the basis that their investment manager did not manage the fund with reasonable care, skill and diligence.

Ongoing Investment Management Arrangements

To avoid litigation or disappointment, trustees must ensure that their attitude to risk has been properly understood by the investment manager from the outset. They should also ensure that their attitude to risk is properly documented. In his report on institutional investment in the UK, published last year, Paul Myners recommended that trustees should agree an explicit written mandate with their investment managers covering agreement between the trustees and managers on:

  • an objective, benchmark(s) and risk parameters that together with all the other mandates are coherent with the fund’s aggregate objective and risk tolerances;
  • the manager’s approach in attempting to achieve this objective; and
  • clear timescales of measurement and evaluation, such that the mandate will not be terminated before the expiry of the evaluation timescale for under-performance alone.

This recommendation has been adopted by the Government as constituting "best practice" for schemes.

What is clear from the Unilever case in this respect is that trustees have reason to monitor their investment managers closely, and should either actively communicate with them in order to do so, or appoint someone to do this for them.

Furthermore, trustees should remember that under the Pensions Act 1995, in order to avoid liability for the acts and defaults of their investment managers, they must take all steps as are reasonable to satisfy themselves that their investment manager:

  • has the appropriate knowledge and experience for managing the investments of the scheme;
  • is carrying out his work competently;
  • has regard to the need for diversification of investments, in so far as is appropriate to the circumstances of the scheme, and the suitability to the scheme of the description of investment proposed.

© Herbert Smith 2002

The content of this article does not constitute legal advice and should not be relied on as such. Specific advice should be sought about your specific circumstances.

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