Professional Negligence and Liability

Edited by Mark Simpson KC

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Chapter 26 FUND MANAGERS

I. SCOPE OF THIS CHAPTER

26.1 The term “fund manager” is here used to describe a person, company or firm managing a portfolio of investments on behalf of a client under a mandate which is subject to English law. 26.2 The majority of funds under management in the UK are from institutional clients, such as pension funds. Private client assets account for a smaller share.1 The service provided is usually that of discretionary fund management, where the manager is tasked with exercising judgement in managing the investment portfolio, with a view to achieving a particular investment objective. Less frequently, the service is solely advisory and/or executory and consists in making recommendations and/or executing the client’s instructions. Advisory or executory services may well be one-off or intermittent in nature; whilst discretionary fund management is necessarily a continuing service, which will end only when the mandate is terminated and responsibility for the assets under management is transferred to another fund manager. 26.3 The fund manager’s mandate is usually governed by a written contract, an Investment Management Agreement (“IMA”). However, the term “mandate” has a broader sense: namely, the authority given to the fund manager to act on the client’s behalf. Whilst the IMA will be the main source for the scope of that authority, also relevant will be general principles of agency law and any express instructions given by the client. 26.4 The duties owed by the fund manager to the client in relation to the professional services provided will derive from the terms of the contract establishing the mandate, the nature of the relationship between fund manager and client (which will generally be such as to give rise to a duty of care in tort, as well as duties as agent and fiduciary),2 and the regulatory regime applicable to fund management. The content of those duties will vary considerably depending on the type of client and the nature of the mandate. After a short introduction to fund management, this chapter explores:

(a) the source and content of the duties owed by a fund manager to the client when marketing and supplying fund management services;
(b) whether and in what circumstances a fund manager might owe a duty of care to a third party, other than the client who has engaged and agreed to remunerate their services;
(c) ways in which these duties may be breached;
(d) defences (including exclusion or limitation of liability and limitation periods);
(e) damages and the issues that arise when seeking to establish causation and loss in the field of fund management;
(f) questions of contributory negligence and contribution; and
(g) complaints to the ombudsman.

26.5 The focus of this chapter is on fund management as a professional service supplied to a client and on the duties and liabilities of the fund manager in marketing and supplying that service to the client. The client may be the beneficial owner of the assets under management or may be the trustee of those assets, with duties of their own in respect of them, as in the case of the trustee of a corporate pension fund. 26.6 There are still relatively few decided cases specifically about the professional liability of fund managers when supplying advisory or discretionary portfolio management services. However, the numbers have gradually increased, since this chapter was first published, and are liable to grow more rapidly in the medium term, as disputes arising out of the market collapse of late 2008 come to trial. There are, moreover, some cases dealing more generally with the duties of banks, brokers or other advisers when managing or advising in relation to investments, from which guidance can be drawn, and there have been some widely publicised claims or threatened claims against fund managers which have had an impact on market practice despite never having gone to judgment. Any analysis of the law applicable to the client relationship therefore has to look beyond the as yet quite limited body of case law that is specific to fund management and must include typical contractual terms, relevant regulatory obligations and principles of general law derived from cases concerned with other types of professional services. 26.7 Whilst this is a field which has not, to date, been productive of decided cases, it does not follow that it is not productive of disputes. Blaming the fund manager if losses are made is an all too common human reaction, justified or not. Clients perhaps unsurprisingly feel that fund managers cannot credibly take credit for their successes whilst claiming that losses are always and invariably sheer bad luck, which tends to be the stock response. Clearly, there must be cases where the law can and would impose liability on a fund manager for investment losses, even if these are the exceptions rather than the rule, and the skill lies in identifying those exceptions. As the scope and intensity of financial services regulation increases, so does the potential for regulatory breaches to lead to civil disputes. Trustees of a pension fund have their own duties to consider and may feel obliged to pursue redress if they are not given good grounds for concluding there is no legal basis for a claim. A cogent analysis of the applicable law is as important in assisting the parties to resolve those disputes, as in litigating any that prove not to be capable of resolution. 26.8 Clearly, there are many forms of investment which do not involve the investor having a client relationship with the fund manager of the kind that is under consideration in this chapter. Pooled investment funds can take a wide range of different legal forms. In many of these (as, for example, in the case of collective investment schemes), the structure of the arrangements is such that there is no direct contractual relationship between the investor and the person or entity responsible for investment management decisions in relation to the fund. 26.9 What, exactly, the investor has bought will vary according to the type of pooled investment fund: it may be shares in the investment vehicle (such as a closed-ended company) or a life policy whose value is linked to the value of underlying investments (as in the case of unit linked life policies) rather than a proprietary interest in the underlying investments themselves, or it may be a proprietary share in the investment portfolio (as in the case of unit trusts or limited partnerships). However, in essence, the investor is in such cases buying a financial product, rather than professional services. In these scenarios, the task of fund management is usually delegated to a fund manager whose professional services are supplied to the trustee of the unit trust (for example), rather than to the unit holders, and the professional duties and liabilities discussed in this chapter will apply as between that trustee, as the client, and the fund manager. The regulatory regime, similarly, distinguishes between regulation of “packaged products” (such as collective investment schemes) or other forms of pooled investment and regulation of portfolio management (defined as “managing portfolios in accordance with mandates given by clients on a discretionary client-by-client basis where such portfolios include one or more financial instruments”).3 26.10 The extent to which the fund manager might, in the absence of a direct contractual relationship, owe a duty of care in tort to investors in such schemes is considered at paragraph 26.87 et seq., below. Chapter 21 above (professional trustees) will be relevant to the duties owed by the trustees of such schemes and hence to any contributory negligence claim against them. For a description of the different types of pooled investment scheme, the regulatory regime applicable to them and discussion of the obligations and duties which apply as between the provider of pooled investment products and investors in such products, the reader is referred to standard texts on financial services.4 26.11 This chapter focuses on the core service fund managers provide in managing investment portfolios. Firms which supply fund management services will often provide other, related, financial services. They may, for example, act as broker (indeed this is the paradigm for investments in futures or derivatives), or they may provide custody services, or transitional services facilitating the transfer of assets from one fund manager to another. Equally, they may give financial advice. This may include advice as to what sort of investment mandate is appropriate for the client’s needs. The complaint against them may then be that the type of fund management service sold to the client was unsuitable for the client’s needs (a form of misselling) rather than that the fund management service was, per se, poorly carried out. For the general principles that apply when a firm gives a client or prospective client advice on the suitability of its own financial services and products, see Chapter 12 above. Some issues specific to marketing services and advising clients in the fund management context are addressed below.

II. INTRODUCTION TO FUND MANAGEMENT

26.12 Discretionary fund management takes, broadly, one of two forms. In active fund management, the fund manager typically seeks to outperform a chosen benchmark. This may, for example, be to achieve a certain ranking relative to the performance of a peer group of funds; or to outperform an index or basket of indices by a given percentage (e.g. 1 per cent over FTSE All share over a stated period); or to achieve an absolute return (e.g. achieving a given margin over the Retail Price Index or three-month LIBOR). In passive fund management, also known as “index-tracking”, the fund manager seeks to replicate the performance of a chosen index or basket of indices. 26.13 In the case of passive fund management, portfolio construction is a mathematical exercise. The fund manager will typically make use of quantitative measures to construct a portfolio whose composition is, even if not identical to the index he is to track, then close enough that its performance can, in practical terms, be expected to replicate that of the index. The content of the portfolio is dictated by the choice of the index to track, rather than being the product of the fund manager’s own judgements about the relative merits of different holdings within it.5 26.14 In contrast, such judgements are the defining characteristic of active fund management. An active fund manager who is asked to outperform an index or basket of indices must exercise judgement as to how far and in what respects the portfolio he constructs should differ from the composition of the index or indices. He cannot beat an index by replicating it. Broadly, he can diverge in three ways:

(a) Where his mandate permits or requires him to invest in more than one asset class, he may differ from the asset allocation of his benchmark (for example, choosing to hold more, or less, of his portfolio in UK equities than the proportion which the specified UK equity index represents of his benchmark’s weighted basket of indices).
(b) Within equity indices, such as the FTSE All share, shares are typically grouped in industry sectors, for example consumer goods or industrials, and subsectors, such as household goods or packaging. The fund manager may choose to under- or overweight given industry sectors (or subsectors within them) relative to their weighting in the index.6
(c) Thirdly, the fund manager may overweight an individual stock, relative to its proportion in the index, where he expects it to perform well, or underweight a stock he expects to do badly.7

26.15 Where the fund manager is asked to outperform a peer group, this exercise involves making judgements about what his peers are likely to be investing in and how he should differ from them in order to outperform them. Where he is asked to outperform the index, he is being asked, in effect, to anticipate and beat the collective wisdom of the market. As Keynes put it:

“Professional investment may be likened to those newspaper competitions in which the competitors have to pick out the six prettiest faces from a hundred photographs, the prize being awarded to the competitor whose choice most nearly corresponds to the average preferences of the competitors as a whole; so that each competitor has to pick, not those faces which he himself finds prettiest, but those which he thinks likeliest to catch the fancy of the other competitors, all of whom are looking at the problem from the same point of view. It is not a case of choosing those which, to the best of one’s judgement, are really the prettiest, nor even those which average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practise the fourth, fifth and higher degrees…”8

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