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Unilever says Mercury underperformed an agreed upon benchmark
by more than 10% between January 1997 and March 1998. The company also alleges that
Mercury did not manage pension assets in accordance with an underperformance
tolerance of no more than 3% below the benchmark for any four successive quarters,
which was stipulated in its contract. Mercury is not commenting on the case at this
point.
Two major issues emerge from this case. The first is whether
performance standards were targets or guarantees. If they were merely targets,
failure to achieve them may not result in damages. But if they are construed as
guarantees, a failure to meet these objectives may result in damages for breach of
contract.
The second issue is whether Mercury was negligent in managing
Unilever's pension assets. To be successful--even if the targets were not
guaranteed--Unilever has to show that Mercury did not invest its assets with the
appropriate standard of care.
FINANCIAL ANALYSIS
The plan sponsor also says that the management of its funds varied from Mercury's
approach to other accounts, and questions the extent to which this difference is
attributable to a rogue manager.
In the wake of the Unilever case, pension fund administrators
and investment counsel will want to be absolutely clear on the legal status of the
performance criteria set out in their mandates. Can trustees stipulate a maximum
level of underperformance and be compensated if the manager falls below the
threshold? Or is the only purpose of the performance measure to give the manager an
indication of risk tolerance, and provide the plan sponsor with information that
helps it decide whether to terminate the manager?
The Unilever decision will also result in a renewed focus on
the internal management of investment managers. Deviations by individual managers
from firm standards may well expose the firm, and its clients, to significant
liabilities.
Most interesting will be the extent to which the court relies
on quantitative financial analysis to determine whether Mercury was prudent in its
diversification and stock selection. The introduction of this evidence suggests
that such information is playing an increasingly important role in asset allocation
and portfolio design decisions.
OUTLINING EXPECTATIONS
Expectations for managers will have to be clear going forward. Is a style that
clings to an index inappropriate because it bears no necessary relation to plan
liabilities, or is it desirable because it minimizes deviations from the benchmark?
Is active management appropriate if it targets a rate of return bearing some
relation to the plan's liabilities, or is it inappropriate because it risks
significant underperformance of broad based indexes?
Active managers are hired to outperform passive indexes. Yet,
they are not compensated on outperformance, but on their assets under management.
Performance-based compensation will clearly need a closer look.
"We are watching this case closely because of its potentially
huge implications for the way plan sponsors manage their investment professionals,"
says August Cruikshanks, investment consultant of James P. Marshall in Toronto.
There are indications that if this lawsuit is successful, other U.K. pension funds
will line up behind it. But no matter which way it goes, the Unilever case is bound
to have a significant impact on the investment management of pension funds.
BC
Murray Gold is a partner with Koskie Minksy in
Toronto. mgold@koskieminsky.com.
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