Negotiating Fund Management Agreements 2

By Andrew Crawford, Corporate partner

The prospect of wider investment powers contained in the Trustee Bill, which recently received its second reading in Parliament, will appeal to many trustees. As will the clear power to appoint discretionary fund managers. However, as well as containing helpful new powers, the bill also spells out, explicitly, the standard of competence for trustees.

This new provision is included to bring certainty and consistency to the standard of behaviour expected of trustees, for example, in relation to the investment of their trust's funds. However, the bill does spell out that a trustee who satisfies the standard of care in relation to the appointment of agents, which will include fund managers, will not be liable for the failings of the manager. Thus, reading and understanding the small print of the agreement will be even more important than before - when the bill becomes law.

The fund manager's "usual standard form" agreement may not always be appropriate. Among the key paragraphs, tucked away in the pages of small print, are:

Capacity

When entering into a new discretionary fund management agreement, the most important issue to check is that the charity has the ability to enter into the agreement and, in particular, to confer the powers of investment, indemnities in favour of the manager 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 fund's assets which may not have been previously discussed.

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 one or two 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 - more importantly - who will be liable if there is a failure.

Custody Arrangements

Typically, custody will cover:

• safekeeping of customer assets
• settlement of transactions and registration of investments
• handling cash associated with customers' 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.

In some cases there is a separate agreement relating to custody as well as the agreement with the manager. If so, it is essential that the separate custody 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, where larger funds are involved, sub-custodians.

As for the question of who will accept liability for sub-custodian default, some custodians will - many won't. If in doubt ask - in case your co-trustees ask you after the agreement has been signed.

This is relevant not merely to how cash is handled, but also to where the custodian is holding securities in a dematerialised form. Consider also whether the charity's 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 the manager's in-house unit trusts and custodial fees? These are all questions to raise if the position is not clear to you!

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

Just a thought - what happens if the manager fails to achieve the performance target? Is there to be a clawback of the fee?

Underperformance

Underperformance has suddenly become a 'hot topic' following the announcement of litigation by the Unilever pension trustees. Trustees will now have to carefully consider how they will assess the relative and absolute performance of the manager against the performance criteria they lay down in the agreement.

This process throws up a number of issues, such as:

• Formulating investment policy - can the policy 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?
• What was agreed in the initial discussions? From a legal perspective, look for the "total agreement clause". It will also be tucked away among the legal minutiae. The effect, if it is there, 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 presentation that convinced you to decide to appoint that manager. If so, decide whether you also want to include a reference to that assurance in the agreement.

Ethical restrictions

Trustees of certain charities may wish to restrict the Manager from investing in certain types of companies, however good an investment they may be.

Trustees who are imposing restrictions should make sure that:

• they follow the charity guidelines;
• 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 or no animal testing.

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 that involves testing on animals - consider the effect on the weighting of the portfolio.

On a practical level, consider writing in these inhibitions in close conjunction with the fund manager. It may even be possible to agree a list of specific prescribed companies.

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.

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 your conduct will be examined with the luxury of hindsight - and one of the first documents they will call for, is the legal agreement with the fund manager that you signed.