Negotiating fund management agreements 1

Imagine that you just returned to your desk after a rather good lunch. Feeling relaxed you are beginning to wonder whether you could get a slightly earlier train home. On your desk is a letter from a fund manager that your fund has recently selected following a beauty parade. It goes on for a few pages of what looks like some rather pedantic legalese. The letter ends:

“Thank you for appointing us. I enclose our letter of appointment. It is in the usual standard form. I look forward to a mutually successful relationship. Please sign and return one copy to me.”

The reference to being in a “standard form” carries the implication that there is no need to read it as no changes can, or need, be made. However, as you will be all too aware, as a result of the Pensions Act 1995, the “usual standard form” may no longer be appropriate. Over the next 20 or 30 minutes I shall attempt to remind you of the key points to remember when reading through the small print or if you find yourself negotiating terms with the fund manager.

Capacity

When entering into a new discretionary fund management agreement, the most important issue to check is that the fund has the ability to enter into the agreement and, in particular, to confer the powers of investment, indemnities etc. which are set out in it. In practice, this shouldn't be a problem. But do consider whether the appointment may also confer on the manager particular powers for example to lend stock or borrow against the funds assets which may not have been previously discussed during the beauty parade presentation.

Custody

Custody services are provided in a number of different ways. Some managers will have arrangements with a particular bank or another part of their own group to provide custody. For larger funds with several managers - a separate single custodian will be appointed. The fund will need to decide which of the functions the manager or the custodian as the case may be, will carry out, and who will be liable if there is a failure to do so.

Typically, custody will cover:

• safekeeping of customer assets

• settlement of transactions and registration of investments

• handling cash associated with customer’s assets, such as collecting, and dealing with, dividends and any other income associated with the assets

• reclaiming taxes

• providing reports and valuations

• carrying out corporate activities such as voting

• appointing sub-custodians to provide custody services, particularly in overseas markets.

For example, if the custodian is part of the same group as the fund manager, the manager will, typically, accept liability for the defaults of the in-house custodian. On the other hand, if the fund is appointing a separate custodian, at the request of the fund manager, then the manager would, as I suspect many of you will have found out, generally not accept liability for the default of the outside custodian.

It is important to ensure that where there is a separate agreement relating to custody, that that agreement fits seamlessly with the fund management agreement.

The Barings debacle underlined the fact that consideration will also need to be given to the ramifications of the insolvency of not only the custodian but also sub-custodians. When appointing one of the large US Global custodians, it is worth checking what the position would be if the custodian becomes insolvent. US bankruptcy laws may apply and some interesting legal issues can arise depending on the way the Global custodian is constituted.

There is frequently a lively debate between the fund's advisers and the compliance department of the fund manager or as the case may be, the custodian, as to who will accept liability for sub-custodian default. Some custodians will - many won’t. Often the compromise is along the lines of that the fund manager agrees to use reasonable care in the selection and monitoring of sub-custodians.

This is relevant not merely to how cash is handled, but also where the custodian is holding securities in a dematerialised form. For example, a decision will also have to be taken as to whether assets will be in segregated accounts or pooled with those of other customers

Fees

How clean is the ‘clean’ fee? For example, does it include commissions, management charges for manager’s in-house unit trusts and custodial fees? These are all questions to raise if the position is not clear to you!

Recently, performance related fees have been discussed more and more, particularly in relation to specialist portfolios. Under this fee structure, if the manager attains specific performance targets, it is entitled to an additional fee.

While some managers will only work on a performance related fee, others are less enthusiastic.

One might think that where there is a limited stock available a performance fee will create a temptation (and I put it no more strongly than that) for the manager to allocate the stock to funds which are subject to performance related fees as opposed to those which are not. In practice the UK fund managers compliance officer would “stamp” on such behaviour.

Other managers point out that having a performance fee is only superficially attractive for the fund. Yes - the manager will suffer some of the “pain” for underperformance - but in the long term will the manager manage the fund in any different way than if he was on a standard fee.

If you are being asked to negotiate a performance fee - consider what you are trying to achieve:- security of assets, searching out performance - or what? Stepped thresholds may be more appropriate to an “all or nothing” fee.

Some investment consultants question whether such fees provide a real incentive - or merely reward luck. From the legal perspective, it is important to ensure that the benchmark which triggers the additional performance fee is clear. There are arguments for using an official index, such as the FT All Share or the S&P 500, rather than an industry index (for example, CAPS or WM).

Another issue is what happens if the manager fails to achieve the performance target? Is there to be a clawback of the fee?

Most Managers would resist any clawback of the basic management fee - but might concede a clawback on previously paid performance fees.

E-mail

Increasingly, those who do not espouse e mail are described as “Luddites”. In a world where paper is going out of fashion increasingly, the vogue is to give instructions by e mail. This is not without its risks for both parties. Some managers will insist on a indemnity for loss. Before giving the indemnity give some thought as to how the instructions of one (or more of the trustees) are going to be delivered to the manager by e mail. It's worth reading the particularly obscure paragraph in the small print entitled "Notices". What may work for one fund may not for another.

Underperformance

Suddenly, after announcement of litigation by the Unilever pension trustees, underperformance is a “hot topic”. Trustees will now have to carefully consider how they will assess the relative and absolute performance of the managers against the performance criteria they lay down in the agreements.

This process throws up a number of issues. In no particular order, here are a few to mull over:

• Formulating investment policy - Make sure that the consultant who has developed the policy has explained the implications for the trustees and the preferred manager. Can it be clearly expressed in the legal agreement? Quite apart from the difficulties of clearly expressing a complex investment policy - will the trustees be able to easily monitor the performance of that policy by the manager? If not, are the trustees making a rod for their own backs?

• If the consultant recommends incorporating risk controls - remember that while they will be serving as a fetter on the manager - risk controls will not guarantee performance - and, incidentally, check that the Manager can easily monitor their implementation.

• If you do not understand the effect of the risk controls that the consultant in proposing - then get the consultant to explain the impact.

• If you have decided on a ‘passive’ strategy then check whether there are realistic limits on tracking error and what happens in volatile markets.

• For example, take volatile markets. Should there be an absolute cap on the size of a particular stock or a margin for error - or will it be sufficient simply to be kept informed by the manager when markets get volatile.

• What was agreed at the pitch? From a legal perspective, look for the “total agreement clause”. It will also be tucked away among the legal minutiae. The effect, if its there (as I’m sure it will be) is to exclude all statements made in the pre contractual negotiations not incorporated in the agreement. Hopefully, you’ll have remembered what was said to you during the pitch and what convinced you to decide to appoint that manager. If so, decide whether you want to include it in the agreement too.

Incidentally, if you haven’t got a memory take a pencil and paper to the beauty parade (and any follow up meetings). It’s amazing how the recollection of 2 or 3 different people of the same discussion can differ!

That said no amount of risk control or performance measurement clarification in the legal agreement will guarantee a level of performance of the fund!

SRI

This is something that I find rather difficult to grasp. Sadly, it is not a passing fad even though the Labour Party Pension fund may have had some politically incorrect investments. In the case of, say, cancer charities I can see why investing in tobacco companies does not appeal - however good an investment it may be. But I find pension fund trustees having to pretend that their object is other than to make cash for their members, a difficult concept.

If the trustees do not want to follow SRI then, in conjunction with the fund manager, some thoughtful drafting is required.

One approach is to ensure that clear fairly innocuous broad principles are adopted which don’t require the fund manager to actually have to do anything that it wouldn’t do on financial criteria If there is a difficult decision, for example as to whether to buy or sell Nike shares - do you want the manager to make the decision on financial grounds and not affect performance. Trustees who are being forced by members to go for a particular policy - make sure that:-

• trustees (and interested members) understand the effect on performance against the chosen benchmark; and

• the restriction is clearly drafted whether it is no alcohol, no gambling no animal testing or observing the McBride rules.

Take no gambling - does that mean that you do not permit investment in companies that write software for the Internet gambling industry?

No tobacco - do you really mean to also exclude big tobacco retailers as well as the manufacturers.

Nothing which involves testing on animals - Consider the effect on the weighting of the portfolio.

On a practical level, I’d draft these inhibitions closely in conjunction with the fund managers compliance department. It may even be possible to agree a list of prescribed companies (perhaps by reference to EIRIS) - an altogether rather more satisfactory arrangement from a lawyer’s perspective!

Despite my misgivings - this may be area where pension trustees find their members taking an interest. It would be interesting to read out at next years conference the SRI policies of the pension funds of each of the big retailers and then compare and contrast the performance of the respective funds.

Standard of Care

If the fund management agreement is silent as to the standard of care of the manager, then the law will imply a standard of care. A term will be implied into the agreement that the manager should exercise the standard of skill and care of a reasonably competent adviser in that field. The key elements are that the advice should be given carefully and that it should be reasonable. If trustees with a sufficiently large fund, seek to impose a higher standard of care, the manager will often find it difficult to resist.

Consultants

Consultants, once rather deliciously described as “fund managers pimps” will owe a duty of care to the trustees. When a manager seriously underperforms it is the trustees who will be in the firing line. Many will then look to the roles of their other advisers, for example the consultants, in the decision to appoint the underperforming manager. It is important that the consultant’s role and duties are clearly spelt out in their engagement letter with the fund. Check for example:-

• who is responsible for the asset/liability studies

• does the consultant recommend a manager or just to provide options

• did the consultant confirm that they had to expertise to advise on key terms of the fund management contract or were they just offering a “once over” without any legal responsibility.

Two final points

• Signature - Once the appointment letter has been agreed, a decision needs to be taken on who is authorised to sign. That may cause a headache, even if reading all the small print did not.

• Let’s not lose sight of the bigger picture - with the growing disparity in the performance of the big investment houses - some may argue that arguing over the small print of the contract is a side issue to getting the composition of the fund and the manager right. They may be right - but when things go wrong everybody looks at life with the luxury of hindsight - and one of the first documents they will call for, is your legal agreement.

For further information, please contact Andrew Crawford on Tel: 0171 367 2297 or e-mail: [email protected].