LAWFUEL – By James Partridge, Allen & Overy – What might managers do to reduce the risk of litigation? Some of the options available include: being clear about what their mandates require; considering their position in relation to any house controls or models; and providing explanations and documentation to ensure transparency in dealings with clients.
In last week’s “The Last Word”, Jonathan Davis quoted a value investor friend as saying he could not ” . . . in all conscience [ride the tiger] with institutional money”. A familiar (but largely untested) question that may soon resurface is whether the law and conscience coincide on this point or whether, in addition to agonising over their business models, value managers should also be worrying about litigation risk?
In particular, the complaint value managers will face is that their mandate was not to protect absolute value but to seek to achieve relative outperformance – and therefore to structure the fund in a way that was apt to do so. The irony would be that in the time it takes for litigation to run its course, the markets may have turned, tending to support Keynes’ view that “it is better for reputation to fail conventionally than succeed unconventionally”.
During a sleepless night, what might value managers (or any other style of manager for that matter) resolve to do in the morning to reduce risk of litigation?
Refresh their memory about what their mandate requires – unusual market conditions create scenarios whereby a conscientious manager may slip outside of an agreed asset allocation or control range in order to preserve absolute value. The longer the bull market continues, the more “risky” (in relative terms) the value manager’s portfolio could become. Clearly, from a business perspective, this has to be balanced against tending to a “herd” mentality and accusations that discretionary managers are closet-indexers.
Consider their position in relation to any house controls or house model. In litigation, the absence of house controls or non-compliance by a given fund manager with them, will be seized on and held up as evidence of institutional or individual negligence. In a survey conducted by PwC and reported in the FT last year, 91 per cent of fund management groups considered they did not have appropriate internal controls in place to manage risk. Again, however, there may be a need to balance litigation and business risk. Excessive tightening of controls and the imposition of restrictions can lead to stifling the most creative talent and raise questions about the benefit of employing an active manager.
Communicate clearly to clients, explain and document: (i) reasons for fund divergence from previously agreed positions; and (ii) reasons for the fund being structured as it is. Transparency with investors will be central to defending claims. However, any communications must be carefully considered. Something said, even informally, that is not then followed could give an investor a basis for alleging mis-representation.
But how much would a claim be worth? This is also largely untested and legal theories vary widely. This uncertainty, and the complexity of the calculations, makes litigation more likely. Should the damages be the difference between how the fund performed compared with how the benchmark performed? Or should it be the difference between how the fund performed and how it would have performed if it had stayed just within the relevant controls and asset allocation ranges? There are numerous other permutations, which in part depend on the legal basis for the claim. Different theories could vary the damages awarded by millions of pounds. More scope for lawyers to argue and more uncertainty for fund managers.
However, the risk of litigation is not limited to value managers at such a time. If Jeremy Grantham of GMO is right and we are watching a “slow motion train crash”, then trying to stay on the train as long as possible is obviously a risky business.
The claim against the momentum manager who crashes may, legally, be a more natural claim to make. The allegation would be, with of course the benefit of hindsight, that excessive risks were taken that were inconsistent with the investment objective.
The forthcoming third quarter fund manager/trustee meetings may provide the first indications of how things will unfold. It may be at those meetings that trustees’ focus in detail on the nature and performance of some of the more risky funds, or risky products within them, and ask themselves whether they (or their fund manager) really understood what they were getting into. A further crumb of comfort perhaps for any value manager in the midst of a “dark night of the soul”.
James Partridge and Arnondo Chakrabarti are partners in the banking & finance litigation group of Allen & Overy LLP