Investment managers: duties owed to investors

Facts

AFP was the investment manager of SPL, a close-ended investment company, and its cells between 2007 and 2009. Mr Farrell was the Chief Executive Officer of AFP. AFP invested the monies raised by each cell and managed the investments. AFP and each cell entered into an investment management agreement (IMA) that governed the scope of duties owed by AFP to the cells.

In December 2006, AFP and Foundations Capital Limited incorporated a joint venture, Foundations Holdings Limited (FHL). FHL was interested in purchasing a student accommodation business, Clubeasy Group (CEG). Lonscale Limited (Lonscale) was incorporated as the corporate vehicle for the acquisition of CEG. To finance the cost of the acquisition, AFP arranged for asset-backed notes to be issued to six cells (the Lonscale Cells). The Lonscale Cells invested £20.2 million in these asset-backed notes.

AFP and Lee Barkman (a director of FHL) received a payment of £3 million each, which SPL alleged was funded by the Lonscale Cells without their prior knowledge. Ultimately, CEG did not perform as well as hoped so, in early 2010, the Lonscale Cells sold their interests in the notes and made substantial losses.

Decision

SPL’s claim against AFP and Mr Farrell concerned four principal allegations:

1. AFP breached its tortious duty to exercise the reasonable care and skill expected of an investment manager

SPL alleged that AFP:

• failed to conduct adequate due diligence;
• failed to obtain an enforceable funding commitment from a third party prior to committing the Lonscale Cells to the investment; and
• caused the Lonscale Cells to invest when AFP knew or should have known that the investments were uneconomic and/or that they involved risks disproportionate to the likely returns.

Mr Justice Walker found that, in October 2007, leading up to completion of the acquisition:

- AFP was negligent in the reliance it placed on valuations that did not provide a market value of the properties.
- An accountants’ report stated that CEG was highly geared and needed a capital injection. Immediate steps were required to ensure that this capital was provided otherwise the Lonscale Cells would be exposed to an obviously unacceptable risk. These steps were not taken.
- The evidence pointed “overwhelmingly” to a lack of any risk/reward analysis on behalf of the Lonscale Cells.
- No reasonable investment manager could possibly have considered that the investments were in the best interests of the Lonscale Cells, and Mr Farrell knew that they were unjustifiable.

2. AFP breached its fiduciary duty not to make a secret profit

The court considered the following clauses in the IMAs:

- Clause 13 – AFP could effect transaction where there was a potential conflict provided that conflict was resolved fairly; and
- Clause 18 – fiduciary or equitable obligations were excluded “which would prevent or hinder the Investment Manager in transactions with or for the Company [i.e. cell] from acting as principal or agent, dealing with other clients and generally effecting transactions as provided above.”

Walker J noted that AFP’s fiduciary duties encompassed a duty to avoid conflicts and not to profit from the cell’s position. He said that “consideration of what to do in the best interests of the cells lay at the heart of the IMAs”.

Walker J agreed with SPL that AFP had a huge financial interest in causing the Lonscale Cells to invest, and the £3 million fee paid to AFP was funded almost entirely by the Lonscale Cells. The £3 million payment to AFP was not for assistance negotiating and structuring the transaction, as the defendants contended; the work that AFP did in that regard was to enable it to extract money from investors.

AFP’s conflict was not viewed as having been resolved fairly in accordance with clause 13 of the IMAs. The court found that disclosure to the Lonscale Cells’ directors was inadequate. Further, there was no documented rationale for the transactions and AFP did not comply with expert advice it had received on managing conflicts.

3. Mr Farrell dishonestly assisted AFP to breach its fiduciary duties and induced its breaches of contract.

The evidence against Mr Farrell was found to be “so strong and cogent” that the court had “no doubt” that Mr Farrell dishonestly assisted AFP to breach its fiduciary duty in committing the Lonscale Cells to the investments in October 2007; he was in charge of the extraction venture on behalf of AFP and ensured it went ahead. At the very least, Mr Farrell clearly suspected that relevant elements of the transaction could be wrong and did not make enquiries. He induced AFP to breach the IMAs and this primarily caused AFP’s breaches of fiduciary duty.

4. AFP breached its contractual duties owed under the IMAs

During the period January 2008 and August 2009, two of the Lonscale Cells invested additional sums to fund CEG’s operational costs. Walker J found that AFP acted in breach of clause 15 of the IMAs (“the Investment Manager will always take reasonable care in managing the Portfolio”) because there was no material improvement in the viability of the business, AFP did not consider the investments and did not act in the Lonscale Cells’ best interests. Instead, AFP’s focus was entirely on keeping CEG afloat.

Causation, remedies and recoverability

The defendants raised a number of causation defences. For example, they asserted that, in the event that AFP had fulfilled its duties, the Lonscale Cells would have made alternative investments giving rise to losses. The court did not find the defendants’ evidence sufficiently sound.
The defendants also argued that the sale and purchase agreement in 2010 disposing of the Lonscale Cells’ interest in Lonscale was premature, left the business to fend for itself and the agreement’s contingent terms left the Lonscale Cells exposed to the risks of non-payment and default. Walker J said that these criticisms were “utterly unwarranted”.

Comment

We understand that the defendants are appealing the decision. In the meantime, however, the judgment provides useful commentary on the extent of the contractual, tortious and fiduciary duties owed by an investment manager and how careful investment managers (and their directors) need to be in situations that present clear conflicts between their interests and the funds they manage.

Further reading: SPL Private Finance (PF1) IC Ltd and Others v Arch Financial Products Ltd and Others [2014] EWHC 4268 (Comm)