The Alternative Investment Management Association

Alternative Investment Management Association Representing the global hedge fund industry

Excluding liability in an investment management agreement

By James Tinworth, Partner, Stephenson Harwood LLP (London)

Q4 2012 edition


A fund manager accepting liability under an investment management agreement only for negligence, wilful default or fraud is probably the industry standard. This article considers this standard in general and its application to investment restrictions in particular.

The fund manager's perspective

Generally in an investment management agreement, just like any agreement for the provision of services, the fund manager (as the supplier of the services) would want to exclude and/or limit its liability as far as possible. The starting point in any investment management agreement would be that the manager would accept liability for loss (including any loss arising from a breach of an investment restriction) only to the extent that such loss is due to its negligence, wilful default or fraud. This standard would be consistent with tortious liability under English law. In the absence of a contract, a fund manager would owe a standard of care to the fund and would therefore be liable for failing to meet this standard (e.g. by being negligent, wilfully defaulting or committing fraud).

This standard is also generally consistent with the FSA rules. Principle 2 provides that a "firm must conduct its business with due skill, care and diligence". COBS 2.1.2 provides that a firm "must not, in any communication relating to designated investment business seek to: (1) exclude or restrict; or (2) rely on any exclusion or restriction of; any duty or liability it may have to a client under the regulatory system". The standard approach taken in an investment management agreement, where the manager accepts liability for loss only to the extent that such loss is due to its negligence, wilful default or fraud is a reasonable standard.

The client's perspective

The client, on the other hand, would want (like any customer under a supply of services contract) to extend the investment manager's liability as much as possible. This is particularly the case for managed accounts, where the investment manager is often asked to accept strict liability for (material or simple) breaches of investment restrictions and other investment parameters. Sometimes the investment manager is asked to accept strict liability for "material breaches" of any of the terms of the investment management agreement.

"Passive" breaches of investment restrictions

One can see why a client would want the investment manager to accept strict liability for breaches of investment restrictions - the client wants the manager to manage the portfolio in accordance with those investment restrictions so why should the manager not be liable for any loss arising from a breach? On the other hand, one can also see why a fund manager would not want to accept strict liability for breaches of investment restrictions - what if the breach was not the fund manager's fault? In the case of breaches of investment restrictions and other investment parameters it is therefore common to exclude liability for "passive" breaches. In other words, breaches that are beyond the control of the fund manager.

If there were scope to negotiate this point, it would be a reasonable compromise and would be consistent with, for example:

  • The Irish Stock Exchange rules, where a breach of the investment restrictions applicable to ISE-listed funds would not be a breach if it is "due to appreciations or depreciations, changes in exchange rates, or by reason of the receipt of rights, bonuses, benefits in the nature of capital or by reason of any other action affecting every holder of that investment"; and
  • UCITS law - see for example COLL 6.6.14, which gives some leeway where "the contravention is beyond the control" of the authorised fund manager and the depositary. The UCITS rules would otherwise effectively impose strict liability on the authorised fund manager for breach of the UCITS investment restrictions.

Passive breaches and force majeure

Even if excluding liability for passive breaches of investment restrictions were to be acceptable to the client, there may be difficulty in agreeing and defining what would be "beyond the control" of the investment manager. The closest concept can be found in force majeure clauses. Force majeure clauses generally entitle a party to suspend performance of the contract, and to be excused from performance of the contract, upon the occurrence of an event "beyond the control" of the relevant party. For a party to rely on a force majeure clause, it would need to prove that (1) an event beyond its control had occurred, (2) the occurrence of the event has prevented it from performing the contract and (3) there were no reasonable steps that it could have taken to avoid or mitigate the event or its consequences. The question of whether or not a party needs to prove both (1) and (3) in order to rely on an exclusion of liability for passive breach may be irrelevant given that the manager would also, presumably, be accepting liability for loss to the extent that such loss is due to its negligence. If a party did need to prove both (1) and (3), however, this would not be very different from a party having to prove that he had not been negligent.

Concluding thoughts

The concept of negligence is very well established in English law. By accepting liability for negligent breach (i.e. a breach that amounts to negligence, fraud or wilful default) in an investment management agreement that is governed by English law, the fund manager is effectively agreeing to provide the standard of care of the ordinary skilled fund manager having regard to industry practice. In the case of a breach of investment restrictions, in particular, it would be extremely difficult for an investment manager who has accepted liability for negligent breach to prove that he had not been negligent (unless the breach had been caused by an event beyond its control  - but let's not start that again!).

The exclusion of liability in a business-to-business supply of services contract will always be a key issue for negotiation and this will particularly be the case in the negotiation of an investment management agreement. The outcome of the negotiation, however, will ultimately depend on the strength of the negotiating positions of the parties and the commercial situation. Whether the outcome was worth negotiating away from the negligent breach standard is another matter.

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