Litigation involving investment funds of all kinds has traditionally been rare, with funds keen to protect reputations and more willing to settle disputes behind closed doors.
Nevertheless, the current impact on funds caused by the economic impact of the Covid-19 pandemic has led to a marked increase in redemptions accompanied by potential decreases in the value of underlying assets.
This has increased the risk of disputes arising, of reputational damage to funds and increased regulatory scrutiny. In the event a fund becomes insolvent under the weight of redemption requests, the risk of claims or enforcement action (in particular against directors) may be high as investors seek to recover the balance of their investment.
Current Situation
The widespread economic impact caused by the Covid-19 pandemic, and the uncertainty over its duration, have led to a strong demand for cash over other assets. Consequently, many investors have been withdrawing holdings from a wide range of investment funds to increase their levels of cash. It has been reported that funds of all types and across a range of asset classes have been experiencing high levels of withdrawals, with actively managed funds and bond funds among those being particularly affected. Morningstar has reported that UK actively managed funds saw withdrawals of £1.9 billion in February and around £8.7 billion from all UK-based funds was withdrawn in March 2020. If funds are unable to sell assets quickly enough to meet large numbers of redemption requests they may be forced to control liquidity by ‘gating’, or suspending withdrawals. Common to all funds is the risk of insolvency if the underlying assets of a fund decrease in value whilst there is a parallel increase in redemption requests.
Open-ended funds that offer daily liquidity to investors, allowing them to enter and exit when they wish, may be especially vulnerable if facing large numbers of redemption requests (especially so if these funds hold a significant proportion of illiquid assets which will be difficult to sell at short notice). These funds have also been the focus of increased attention from the FCA. In a recent speech given on 19 March 2020, Edwin Schooling Latter, the Director of Markets and Wholesale Policy at the FCA mentioned that whilst rules and guidance were in place dealing with liquidity risks arising for open-ended funds “recent experiences do raise the question of whether they need to be tighter.” Open-ended funds that may be at heightened risk of regulatory scrutiny or investor complaint are those that hold a high proportion of illiquid assets that are hard to sell, and which would make it difficult for a fund to meet a large volume of investor redemptions in a short time.
What are the risks if a fund limits/suspends redemptions, or cannot meet redemption requests?
Whilst funds have a number of tools at their disposal to manage their liquidity such as limiting, deferring, requiring notice periods or even suspending redemptions, these may only provide temporary relief and are not without risks. Declaring a full suspension of redemptions to investors may cause reputational harm to a fund, and potentially affect its ability to raise capital in the future. As Mr Schooling Latter highlighted in the same March speech “if investors place trust in a promise of daily redemption that is not honoured…this can damage investor confidence in an asset class that includes thousands of other funds, over a much longer time period.” Ultimately, if redemption requests reach an unsustainable level where a fund cannot sell the assets it holds quickly enough, it may run into severe difficulties.
It is worth noting that it is not only funds themselves that may face risks, but also fund platforms, or ‘supermarkets’ which host and promote funds that later face difficulty.
There is the risk that the Financial Ombudsman Service may become involved following retail investor complaints. The Ombudsman has the power to award compensation of up to £350,000 (depending on when the act or omission occurred). Complaints may be upheld where information provided to investors regarding deferrals or restrictions on redemptions was insufficient or misleading.
In the rare situations where a fund does become insolvent, there is also the risk of litigation where investors seek to maximise the recovery of their investment.
Previous cases involving insolvent funds have included claims against directors personally, including claims for breaches of fiduciary duty. In particular directors may be liable for failing to exercise reasonable care, skill and diligence in performing their duties. The test for whether a director will be liable for such a breach requires examining what a ‘reasonable director’ of a fund management company in the position of a director with that individual’s experience, actual knowledge and intelligence would have done, as well as whether they had met their duty as a director by acquiring a sufficient knowledge of the business to discharge their duties. This test was applied in Weavering Capital (UK) (in Liquidation) v ULF Magnus & Ors (2012) EWCA Civ 71, where it was found by the Court of Appeal that it was not sufficient for a director to simply repeat “what he had been given to believe” to investors and unquestioningly follow an individual who was the ‘leading light’ of the fund. Directors and senior managers may also face claims for negligence if they have performed their duties improperly.
Directors may also face claims for misrepresentations, or negligent misstatement for statements contained in investor-facing materials, including offering memorandums, due diligence questionnaires and marketing materials (including regular portfolio summaries and risk reports) -- if the picture created by these documents is considered to be misleading.
Directors and senior managers may also face liability under the Senior Managers and Certification Regime (applicable since 9 December 2019 to solo-authorised firms). In his March speech, Mr Schooling Latter highlighted that it was the “…responsibility of relevant managers in authorised firms selling and operating funds to make sure they are designed and run so that the promises made to investors are met…managing liquidity and treating investors fairly is part of obligations on relevant staff at firms operating funds to act with due skill, care and diligence.”
The cost of any claims for breaches of directors duty, negligent misstatement and misrepresentation, as well as the costs of any subsequent regulatory investigation e.g. by the FCA or PRA, may be covered by an existing D&O insurance policy. Directors should review the indemnities provided by the company that they have the benefit of, as well as the precise wording of any D&O policy to see what claims are covered.
Actions to take
Directors & funds should:
- Review measures in place to control liquidity, including whether there are any notice period requirements for redemptions, minimum values of redemptions and whether there are any pre-conditions that need to be satisfied ahead of suspending redemptions.
- Review marketing materials and other investor-facing material. Not merely on an individual document basis, but to see what impression is given to investors by all materials ‘in the round’. Even if a fund suffers losses, but has clearly signalled its risks and investment strategy to investors, then the risk of claims for misrepresentation may be lower. Closely review the disclosures made in future materials, it is likely that if claims do arise, claimants with the benefit of hindsight will review materials released at the time for evidence of any inadequate risk or financial disclosure.
- Review any existing directors & officers insurance policy in place. Some key things to check include:
- whether there is any crossover between other indemnities and the D&O policy;
- how ‘claims’ are defined and what is covered (e.g. are claims for inadequate disclosures in filings and negligent misstatements included);
- whether there are any applicable restrictions or exclusions on claims;
- if the policy limit is shared amongst other directors, or between directors and the company; and
- the precise notification requirements under the D&O policy (strict compliance with notification procedure and prompt notification of the insurer is usually necessary ahead of making any claim).
- Review and ensure that the decision making processes of directors and senior managers are sufficiently robust and not mere rubber-stamping exercises, and that the decisions of investment managers are, and have been properly scrutinised.
- As annual reporting season gets underway, consider engaging external accountants (if not already involved) to aid discussions on how to properly represent certain matters in accounts. They may be useful in making sure other disclosures are accurate, and could give insights into current market practice too.
If you have any questions concerning the material discussed in this client alert, please contact the following members of our Litigation and Dispute Resolution practice.
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