A recent article in the Economist suggested that if a fund manager’s chances of raising new money evaporate halfway through a fund’s life, “spending its remaining cash willy-nilly becomes rational. There is always the hope of making up for past losses if new ventures pay off. Moreover, buying something (anything!) prolongs the fund’s life, and thus the period during which [the manager] gets to collect management fees.”
What remedies do investors have if such a scenario arises? Mr Justice Walker provided some answers during the week before Christmas in his judgment in SPL Private Finance (PFI) IC Ltd v Arch FP LLP  EWHC 4268 (Comm). In addition to concluding one part of a lengthy saga with a finding in favour of the claimants, the decision in Arch provides a rare restatement of the liability of investment managers in English law.
We have set out below the top 10 points arising from Arch which are, in our view, the most significant for fund and other investment managers. These are not new, and others may take a different view on what is most significant about Arch. However, with the Financial Conduct Authority’s recent focus on the importance of the agency principle, Arch shines a useful light on regulatory as well as legal risk for firms who manage investments for third-party clients.
Background to Arch
Arch managed the Arch-Cru funds which were constituted as cells of a Jersey-incorporated cell company. A number of those funds brought claims against Arch and its CEO in connection with investments made by Arch on behalf of the funds in a student housing business known as Club Easy. The funds claimed that the decisions to make these investments were driven by Arch’s financial interest in obtaining illegitimate payments, in the form of £6 million of fees on a £20 million investment, rather than proper consideration of the investments’ merits. They also alleged that Arch acted in breach of fiduciary duty, in breach of contract and negligently, and that the CEO dishonestly assisted Arch to breach its fiduciary duties and induced its breaches of contract. Upholding the claims, the judge found that Arch and the CEO were liable to pay damages in excess of £22 million plus interest and costs to the funds.
1. The agency principle is the founding principle in determining a manager’s duties and includes a duty to use due care when exercising discretion
In the absence of any contractual term to the contrary, a firm’s role as agent carries with it a duty to exhibit such a degree of skill and diligence as is appropriate to the performance of the duties accepted. This includes a duty to exercise discretionary powers with due care and in the interests of its client. The necessary degree of care requires a risk/reward analysis. In Arch, no evidence was produced of a risk/reward analysis. As there was no such analysis, the judge found that Arch was negligent in relying on property valuations without taking account of obvious problems within the Club Easy business.
2. The duties of loyalty are central to the agency principle
Where a firm, as agent, undertakes to act for its client in circumstances giving rise to a relationship of trust and confidence, that firm owes duties of loyalty to give preference to the client’s interests over the firm’s own interests.
3. The anti-conflicts and no secret profits duties supplement the duty of loyalty
There are two supplemental duties which reinforce the duty of loyalty. These are the duty of the firm, as agent, to avoid conflicts, or potential conflicts, of interest, and the duty not to profit from its position. These are special fiduciary duties which operate strictly, without proof of intentional wrongdoing or even fault.
4. As a matter of contract, exclusive control over assets gives rise to a fiduciary relationship
The firm/client relationship has to be understood in the context of the contractual documentation between the parties per J.P. Morgan Bank v Springwell Navigation Corp  EWHC 1186 (Comm). Unlike Springwell, which concerned a commercial transaction with no expectation that the firm would act in the best interests of its client, the Investment Management Agreement between the funds and Arch governed Arch’s exclusive control of the funds’ assets. Acting in the best interests of the funds lay at the heart of the agreement.
5. Regulatory principles underpin the exercise of contractual duties
A contractual provision which seeks to limit a firm’s fiduciary or equitable obligations to its client and gives a firm the freedom to act for other clients in situations which may give rise to a conflict of interest is subject to (what is now) FCA Principle for Businesses 8 which requires a firm to manage conflicts fairly.
6. Only full disclosure will provide an answer to a claim for breach of loyalty
A client’s consent to a firm’s acts will be a defence to claim for breach of the duties of loyalty. However, this will only be the case if the firm has made full disclosure of all the material facts and the nature and extent of the firm’s interest.
7. Making bad investments is not necessarily the same as breach of mandate
Although it depends on the scope of the mandate set out in an IMA or elsewhere, a mandate which is determined by reference to, for example, “medium to long-term… capital appreciation through an economic exposure to a diverse range of investments in private finance selected by the Investment Manager” should not be read as including a requirement that the mandate be confined to investments which are “likely to” produce such a result. Rather, the question of adherence to such a mandate is an objective one determined by asking whether or not a particular investment would provide capital appreciation over the medium to long term. In this case, although other claims succeeded, a claim for breach of mandate failed.
8. An individual investment manager may be liable for inducing the firm’s breach of contract
An individual manager employed within a firm will be personally liable where: (a) he/she knows there is a contract; (b) he/she intends to induce a breach of the contract; and (c) his/her conduct causes an actual breach of the contract. As to (b), if the manager acts in good faith as part of his relationship with the firm and within the scope of his/her authority, then a claim for inducing breach will not succeed.
9. If a client’s loss is within the scope of the firm’s duty, the client will be able to recover the entire loss
Following South Australian Asset Management Company v York Montague  AC 191, this will include including any element arising from matters unconnected with the breaches of duty but is subject to: (a) the actual loss exceeding any losses that would have been made on alternative investments had the firm discharged its duties; (b) the client having taken reasonable steps to mitigate its loss – the standard of reasonableness not being high; and (c) a causal relationship between the breach of duty and the loss suffered existing as a matter of fact.
10. Where a firm breaches a fiduciary duty, a client may also have equitable claims against the firm
Equitable compensation can be recovered for breach of the fiduciary duties, provided that it is shown that, but for the breach, the beneficiary would not have acted in the way which has caused loss. The firm may also be subject to equitable claims based on proprietary interest, accounts and enquiries and restitutionary claims.