LONDON - U.K. money managers are praying that Unilever's suit against Merrill Lynch Mercury Asset Management will be thrown out of court.
Regardless of the outcome, the long-rumored lawsuit is expected to lead to a more rapid shift toward specialist mandates, more carefully worded contracts, tighter risk controls and closer scrutiny of manager performance.
If successful, Unilever's lawsuit could spur waves of litigation against poor-performing managers.
Heavyweight U.K. pension funds such as J. Sainsbury PLC Pension Scheme and Surrey County Council Pension Fund are considering similar action against London-based MLMAM if the suit is successful, according to Geof Pearson, pension manager for the Sainsbury Scheme, and news reports about Surrey.
The L100 million ($165 million) negligence suit - filed by trustees of the L4 billion Unilever Superannuation Fund - has sent a chill through the U.K.'s actively managed funds industry, which has been dogged by poor performance over the last few years.
But lawyers specializing in pension law say the pension trustees will have an uphill battle proving the case against MLMAM.
Regardless of how the case turns out, the very action by Unilever will be a landmark in relations between plan sponsors and money managers in Europe and has already opened a Pandora's box of possible dangers to both parties to investment management agreements.
"There is a lot of rejigging of contracts going on at the moment," said a senior source at a U.S. money manager based in Europe.
The Unilever trustees allege MLMAM was in breach of contract, failing to take account of, or contain the risk of, underperformance on a L1 billion balanced portfolio it managed for the pension fund between January 1997 and March 1998.
They claim MLMAM did not manage the fund in line with the contractually agreed downside tolerance of underperformance of no more than 3% below the benchmark for any four successive calendar quarters. Unilever alleges MLMAM's overall portfolio underperformed the benchmark by 8% during the first four quarters of the contract, signed in January 1997. The contract was terminated in March 1998, when the underperformance fell to 10.5% over the five quarters.
Legal sources said for Unilever to win the case it will have to prove:
* either that MLMAM made an actual guarantee not to underperform by more than the agreed downside tolerance of 3%. or that
* no competent fund manager would have managed the Unilever assets in the way MLMAM did during the period of underperformance.
MLMAM has until early November to file papers in its defense, but the case is unlikely to go before a judge until 2001, said Deborah Finkler, a partner in Slaughter & May, London, which is representing Unilever.
"In our active management team we do not give guarantees of investment performance," said Charles Farquharson, chief operating officer for U.K. institutional business at MLMAM.
Investment judgment is just as important as market performance, he added.
"That's why active management is not a constant process in terms of the returns it delivers."
It is still possible, but not likely, both parties will agree to settle out of court after 18 months of fruitless behind-the-scenes negotiations. Sources close to both sides said Unilever's trustees would agree to settle only if the settlement reflected the value of its claim. Unilever's lawyer would not comment further. MLMAM would agree to a settlement only if it were not required to admit liability.
The fact that the dispute covers only a 15-month period may weaken Unilever's trustees' case as it is an unusually short time for analyzing an active manager. In addition, the specific period coincided with extreme volatility in global markets. But as the underperformance was "extreme," according to one consultant, it would justify the trustee's decision to drop Mercury but not to seek recompense through the courts.
MLMAM's Mr. Farquharson was reluctant to blame the firm's underperformance solely on the investment markets, but said 1997 was a period of sharp divergence in performance between the top 10 U.K. blue chips stocks and the rest of the market.
It may be an exaggeration to say the case is a further nail in the coffin of active management, but the suit may well hasten the death of the balanced mandate and encourage plans to make greater use of index, or tracker, funds.
"If a pension fund doesn't want the risk of underperformance, then they should move to using tracker funds," said Laurence Davanzo, managing director at Asset Strategy Consulting LLC, Los Angeles.
By using a balanced mandate, Unilever effectively surrendered control to the money manager in terms of both risk and asset management; that is why balanced mandates are not a reliable approach to asset management, said a New York-based consultant who asked not to be named.
Risk budgeting by plan trustees, while increasingly widespread in the United States, is a relatively new concept among U.K. plans. Few have begun calculating how much risk they are willing to take in different asset classes.
The Unilever case also might encourage pension executives to look more closely at the benchmarks they set for money managers. Using numerical rather than statistical limits to set levels for downside risk tolerance, as may have been the case between the Unilever fund and MLMAM, is generally at odds with practice by money managers who use tracking error to monitor risks. "Tracking error is the true measure of risk and that is how it should be measured in investment management contracts," said David Puddle, chief executive, Putnam Europe Ltd., London.
The case also may trigger a shift toward performance and investment guidelines that are tailor-made for a single pension fund rather than benchmarks based on peer performance.
More work ahead
The case also is likely to increase the workload of consultants and lawyers to ensure all parties to an investment management agreement understand and agree with what is in the contract.
The fact that Unilever trustees have taken this case to court has raised questions about whether consultants should more actively monitor money managers' internal risk controls and advise their clients on setting performance benchmarks.
Frank Russell Co. Ltd., London, and Bacon & Woodrow, London, which both act as Unilever's consultants, wouldn't comment.
But simply focusing on contract wording will not be enough, said a senior manager for a continental European pension plan.
"I fear that our contracts will be thicker and that performance will not necessarily improve. This business is about taking calculated risks. I like clear short contracts as then everybody understands what the mandate is about," he said.
He did not feel the Unilever suit was indicative of poor monitoring of money managers by pension funds. (Unilever is known for daily monitoring of its investment portfolios.)
Rather, the case is about an interpretation of a contract, he said.
Mr. Davanzo said he believes an elemental part of the case is whether MLMAM, as Unilever claims, agreed to guarantee underperformance of no more than 3%.
U.K. money managers said no manager or firm would ever agree to guarantee levels of underperformance or overperformance in an investment management agreement.
"Any manager that would agree to anything that specific has got to be out of his mind," said Mr. Davanzo.