Law Commission Consultation on Fiduciary Duties of Investment Intermediaries with Hogan Lovells

Yesterday I attended a Consultation Workshop at Hogan Lovells LLP on the Law Commission's Consultation on Fiduciary Duties of Investment Intermediaries. The event was attended by a variety of people from different backgrounds including trustees, academics, lawyers and fund managers to name a few. The Panel consisted of three members, David Hertzell - Law Commissioner; Nick Cray - Chief Operating Officer at Hogan Lovells; and Dominic Hill - Partner in the financial services department at Hogan Lovells.

The Consultation was a result of the Kay Review - see here for Consultation paper and Kay Review - that stated that a series of recommendations, particularly recommendation 9 that stated 'The Law Commission should be asked to review the legal concept of fiduciary duty as applied to investment to address uncertainties and misunderstandings on the part of trustees and their advisers'.

I hope to respond to the Consultation in detail but below I outline some initial observations that I wish to explore further at a later date. I intend this blog post to initially be putting my thoughts down from what I know and most would require further investigation to reach substantive conclusions.

From Kay Review and Consultation Paper two areas could be discussed. First, who in the investment chain owes fiduciary duties. This the Law Commission sees as a difficult question given the flexibility of fiduciary duties, but I believe this is caused by a misconception and a need to separate the two elements of a fiduciary that are first, when does the duty of loyalty arise and second, if so, what is the scope of that duty. This approach can be seen in University of Nottingham v Fishel [2000] I.C.R. 1462, 1494. Failing to do that it can often lead to erroneous statements such as those cited from Henderson and Others v Merret Syndicates Ltd and Others [1995] 2 A.C. 145, 205 that not all fiduciaries will owe the same duties in the same circumstances. This cannot be correct given Lord Millet's judgment in Bristol and West Building Society v Mothew [1998] Ch. 1 that the duty peculiar to fiduciaries is the duty of loyalty. If the duty peculiar to fiduciaries is the duty of loyalty then all fiduciaries must owe the duty of loyalty. Whilst not endorsed specifically, this seems to be supported by Sedley LJ in Plus Group Ltd v Pyke [2002] EWCA Civ 370 at [80]. To ascertain when the duty of loyalty arises one must consider three questions. What is the duty of loyalty, what is the purpose of it and finally when is that purpose fulfilled. If someone is determined to owe the duty of loyalty they are subject to the full expanse of fiduciary jurisdiction. If someone owes the fiduciary duty of loyalty one can turn to the second issue as to the scope of that duty. With this application to investment intermediaries it may become apparent who does and does not owe fiduciary duties in the investment chain.

This leads to another area that needs further consideration in respect of Kelly v Cooper [1993] AC 205, discussed 11.28-11.38, which considers terms of a contract may limit the scope of fiduciary duties. In essence this is true. This limiting of scope is on the basis that equity cannot alter the terms of a contract validly entered in to. As seen in Ranson v Customer Systems plc [2012] EWCA Civ 841 at [68] equity needs something to be "hung from". Therefore the duty is circumscribed by what the parties agree as someone cannot be loyal for something they did not take responsibility for. However, the courts must be careful as to what they imply in to contracts between parties as they did with Kelly v Cooper. There needs to be some differentiation between conflicts and interests in proposed transactions as is the case in the Companies Act 2006 with ss. 175 and 177. s. 177 breaches may be excused where a principal ought reasonably to have been aware of the conflict but s. 175 breaches require full disclosure with authorisation to act. Implied terms that the estate agent is authorised to act for multiple principals is unlikely to amount to full disclosure with authorisation.

The second issue in respect of the Law Commission's consultation concerns best interests. The question/statement I raised was how to promote best interests beyond short-term financial gain? The Commission looks at whether the law allows financial intermediaries and trustees to consider the long-term interests of the ultimate beneficiary through investment beyond the short-term interest of financial gain through transactions. The answer to this question seemed to be a resounding yes that the law does allow intermediaries to consider wider, long-term interests. This was evidenced in Chapter 10 of the Consultation paper by cases such as Cowan v Scargill [1985] Ch. 270; Harries v Church Commissioners [1992] 1 W.L.R. 1241; Martin v City of Edinburgh District Council [1989] Pen. LR 9, 1988 SLT 329; and Buttle v Saunders [1950] 2 All E.R. 193. Whilst this is the status of the Common Law the legislation in this area is not entirely reflective of this ability to consider wider, long-term interests. The Occupational Pension Scheme (Investment) Regulations 2005 SI 2005 No 3378, reg 4 provides that the investment of assets is 'in the best interests of the beneficiaries' and in a manner 'calculated to ensure the security, quality, liquidity and profitability of the portfolio as a whole'. The wording would seemingly focus most people's minds on profit in the short term.

Whilst the law seems to accommodate wider interests, there is an 'accountability gap' in ensuring wider, long-term interests are considered. This was discussed at 3.31-3.32 of the Consultation paper that trustees did not want to dictate to the investment manager what to invest in, but the investment manager believed it was the trustees who should instruct them to consider wider, long-term interests. Arguably the burden should lie with the managers who are the professionals but the incentives have to be right for them to apply the long term interests. Therefore it seems the law has reached a dead-end, and only a few subtle changes may be necessary such as a restatement of Regulation 4 and perhaps a statutory statement of duties for clarity similar to Part 10 of the Companies Act 2006. The law requires the intermediaries, if classified as fiduciary, to remove any self-interest in the performance of their functions to the ultimate beneficiary, and allows the freedom of the intermediary to assess what they believe to be in the best interests of the beneficiary. How to create the right incentives may not be an easy answer but there seems to be strong focus on better shareholder engagement to create trust and confidence in the businesses that are invested in so long-term plans can be supported rather than questioned, but equally there should be appropriate monitoring to prevent that trust being misplaced. Whilst the duties may deter trust being abused such duties are only reactive and some controls ex ante may need to be assessed.

My final point is that the Law Commission must be careful not to classify best interests as a fiduciary duty based on remedial result. Not to go in to great detail but loyalty is about removing the risk of self-interest by banning conflicts of interest. Best-interests is wider than this in that someone may not act in the best-interests of a principal but the decision may have been free from self-interest. This confusion may be seen in ODL Securities Ltd v McGrath [2013] EWHC 1865, which I blogged about here. However, incorrect classification may have wider implications as discussed in Chapter 5, particularly 5.46-5.54. The decision in Mothew discusses the implications of considering all breaches by fiduciary a fiduciary breach. A remedy for breach of fiduciary duty is normally a restitutionary one. This is much more favourable to the claimant than a compensatory one. Whilst compensatory remedies may be available for breach of fiduciary duty as seen in Item Software (UK) Ltd v Fassihi [2004] EWCA Civ 1244, restitutionary remedies may not be used for breaches of best interests.

Thesis: A wordle

Now my thesis is typed up I thought a wordle would be a good way to sum it up.

Unsurprisingly, to me at least, the common words appearing are company, director, non-executive and fiduciary. The last word fiduciary links with the most popular case cited of Bristol and West Building Society v Mothew [1998] Ch. 1.

I look forward to submitting this now! 

New publication

I have recently had published my book review of two key textbooks on company law. The review can be found via the following citation:

D Gibbs, 'David Kershaw, Company Law in Context: Text and Materials' (2013) 47(3) The Law Teacher 433

The review covers Kershaw's textbook as well as the 29th Edition of Mayson French and Ryan's (links to 30th edition) textbook on company law.

Fiduciary Duties of Investment Intermediaries

The Law Commission has published its Consultation Paper regarding 'Fiduciary Duties of Investment Intermediaries'. I blogged about the project initially here. The consultation paper and a summary can be found here and here respectively.

The consultation paper, according to para 1.1, sets out to: '... investigate how the law of fiduciary duties applies to investment intermediaries and evaluate whether the law works in the interests of end investors'.

I have only given it a cursory read so far but have initial observations in regards to defining of terms such as fiduciary - however, it is noted that the consultation now seems to have gone wider than fiduciary duties of investment intermediaries in to duties generally of investment intermediaries (see paras 9.15, 14.62 and 14.64). Fiduciary duties prevent any self-interest in the performance of the undertaking. The duty moulds itself to the particular undertaking of the financial intermediary to temper any self-regard in respect of that undertaking. Thus, if they act or omit to act because they are personally interested in what they are doing for their principal, any benefit obtained will be held for the principal. In short all other interests to the undertaking of the fiduciary (financial intermediary) must be subservient to the interests of the principal.

This seems as though it would be in the interests of end investors that there interests are placed first and the fiduciary must remove any self-interest or otherwise before acting. The principal's interests are therefore exclusive. It may be that the specific duties of the financial intermediary are not beneficial to the interests of the investors, which is why I think the consultation is now looking at duties generally, but first impressions would suggest that fiduciary duties are not the issue. However, continued recommendations on fiduciary duties would need a closer consideration regarding the defining of terms and when such a duty is owed.

 

ODL Securities Ltd v McGrath [2013] EWHC 1865 - fiduciary duties

This case of ODL Securities Ltd v McGrath [2013] EWHC 1865 concerned "fiduciary duties" owed by a head of risk for a company. At [17] it was said that 'Although not a director of ODL, Mr McGrath was in a closely analogous position and, as such, in my judgment owed the same fiduciary duties as he would if he had been a director. These duties encompass a duty to disclose matters which it was in the interests of ODL to know, including where appropriate ... his own misconduct'.

This post expresses concerns about the number of potential issues with this statement in respect of fiduciary duties.

1) Describing Mr McGrath's position as analogous to that of a director is particularly unhelpful in respect of fiduciary duties owed by individuals. Reasoning by analogy has been described as dangerous (see Ranson v Customer Systems plc [2012] EWCA Civ 841 at [24]) since the extent or scope of one's fiduciary duties differs from case to case. To describe the head of legal risk and directors as analogous is unhelpful in determining someone's fiduciary liability.

2) The wording says that because the positions of director and head of legal risk are analogous to one another then Mr McGrath owed the same fiduciary duties as if he was a director. The issue here is that all fiduciaries owe the same duty. The duty of loyalty is universal to all fiduciaries (Bristol and West Building Society v Mothew [1998] Ch. 1, 17-18, Plus Group Ltd v Pyke [2002] EWCA Civ 370 at [80]). Whether the fiduciary is a solicitor, trustee, parent, director, partner they all owe the duty of loyalty which is the defining feature of a fiduciary relationship. The premise needs to be whether Mr McGrath owed the duty of loyalty and not simply that he owed the duty because his position was similar to that of a director. A director as a fiduciary will owe the same fiduciary duties as a head of legal risk because they are both fiduciaries.

3) The duty of loyalty is designed to regulate the problem of opportunism where one has access to another's property and affairs for the exclusive benefit of that person. It prevents the fiduciary from obtaining an unauthorised benefit from their position that would conflict with the interests of the principal. Best interests are wider than this. It is possible to not act for the best interests of the principal without being personally conflicted. As Millet LJ explained in Mothew at [18] in respect of the duty to act with reasonable skill and care that 'mere incompetence is not enough [to breach your fiduciary duty]. A servant who loyally does his incompetent best for his master is not unfaithful and is not guilty of a breach of fiduciary duty'. Thus, there is only a breach if that incompetence is based on a conflict of interest. The same applies to the duty to act in the company's best interests. It would have been accurate of Flaux J to say Mr McGrath owed similar duties to that of a director, but not fiduciary duties. As Millet LJ said in Mothew at [16] 'unless the expression [fiduciary] is so limited it is lacking in practical utility'.

As another note this confusion with respect of fiduciary duties is also noted earlier at paragraph [15] where Flaux J describes a duty to disclose as part of a duty to avoid a conflict.

4) Equally the duty is proscriptive in that it bans conflicts of interest. It is not prescriptive in requiring positive action on behalf of the fiduciary. Therefore saying there is a fiduciary duty to disclose misconduct is mudding the waters of fiduciary jurisdiction.

5) The normal remedy for a breach of fiduciary duty is for the fiduciary to disgorge any personal benefit derived from the conflict and have it held on trust for the beneficiary who has a proprietary right to the benefit obtained. Simply failing to disclose misconduct, would potentially breach the duty to act in the best interests of the company if it was its best interests to know as was the case in Item Software v Fassihi [2004] EWCA Civ 1244 which was cited at paragraph [17] in this case. But the appropriate remedy was not to disgorge the benefit because there is no benefit to disgorge. It is possible a claim may be brought for equitable compensation (and indeed was the case here) if causation can be established between failure to disclose misconduct and harm done to the company but this is not like strict liability for breach of fiduciary duty which would simply require the disgorgement of the benefit once it is established that there was a conflict.

The facts concerned Mr McGrath who made a series of commercial loans who knew, at all materials times, was not the business of ODL. The loans were made by Mr McGrath of ODL to a company, or connected to a company, called A1 Holdings Ltd, which Mr Clements was personally interested in and a substantial creditor and shareholder; but Mr Clements was also the person who operated ODL's separate corporate finance business. When A1 Holdings Ltd went in to administration, Mr Clements was owed in excess of £3m. ODL sought equitable compensation/damages for the unauthorised loans made to A1 Holdings.

Some of the loans made were made without security, one was made to a company ran by a man Mr McGrath had only just met, and one was made with a promise of a personal payment of $1m to Mr McGrath from A1 Holdings. It is difficult to see how the failure to disclose his misconduct in authorising such loans that he was not authorised to make would be a breach of fiduciary duty. It is clearly a breach of the company's best interests to not disclose because the loans on any objective assessment were unlikely to be repaid, exposed the company to more risk when it was its business to be exposed to less risk, and it was not the nature of the company to make such loans. But without a conflict of interest it is not a breach of fiduciary duty, and even with the conflict in the third loan as to the personal benefit offered to Mr McGrath it is not the failure to disclose that gives rise to the breach of fiduciary duty but the benefit itself.

The judgment makes a series of references to dishonesty and fraud to demonstrate that Mr McGrath knew the loans were not in the interests of the company and had breached his fiduciary duty. This does nothing to add to his fiduciary liability. Liability is strict. Once there is a conflict, liability is established. It does not have to be established that the fiduciary acted fraudulently, dishonestly, acted in bad faith or did not try their hardest, for example. The fact he was dishonest and/or fraudulent in hiding the unauthorised loans did not matter. The loan where he was offered a personal benefit evidenced a conflict and he would have been in breach whether he honestly believed to be acting for the interests of the company or not. This is not to say the dishonesty and fraud does not demonstrate his breach of duty of care or best interests, but as stated, these are not fiduciary duties.

Therefore it seems in respect of breaches of fiduciary duty, Mr McGrath would have only done so in respect of those loans in which he was offered a personal benefit since he acted opportunistically for his own benefit creating the risk that he would not be loyal to the interests of ODL. The other loans, whilst breaches of his duty of care and duty to act in the best interests of the company, were not fiduciary breaches.

Derivative Claims: Where are we part II

Summer is over and I have not blogged in a while due to several holidays! I thought I would start back light with some information on UK derivative claims. Below is a table of all 14 cases brought in England and details of the significant relevant issues that were addressed by the court in applying its discretion as to whether a claim should be allowed to proceed. (see end for full citations of claims)

NB: whilst I am familiar with these cases the table below may not detail all factors considered but only those that were of significance. 

Case Name	Dismissed For/Allowed	Significant Circumstances Considered
Bamford	Dismissed at court’s discretion	Wrongdoer control
Cinematic Finance	Dismissed at court’s discretion	Majority bringing derivative claim; wrongdoer control; side-stepping insolvency rules
FanmailUK	Case adjourned	Case adjourned
Franbar	Dismissed at court’s discretion	Strength of legal claims; ratification; alternative remedy
Hughes	Permission granted	Strength of legal claims; ratification; alternative remedy
Iesini	Mandatory Bar	Weak legal claims
Kleanthous	Dismissed at court’s discretion	Independent review of whether litigation was beneficial; strength of legal claims; alternative remedy; and benefit would be small
Kiani	Permission granted	Failure of defendant to produce any evidence to the contrary; alternative remedy
Mission Capital	Dismissed at court’s discretion	Alternative remedy; little weight to a claim for wrongful dismissal of a director
Parry	Permission granted	Strength of legal claims; ratification; good faith; alternative remedy
Phillips	Permission granted	Alternative remedy; matter of urgency case was brought to recover sums taken from the company without good reason
Seven Holdings	Mandatory Bar	Claims did not relate to a breach of duty, care, negligence or default
Stainer	Permission granted	Strong grounds that there had been a breach of duty; strength of legal claims; disinterested shareholders deceived in to approving the loan
Stimpson	Mandatory Bar	The impact an action would have on the interests of the employees; claim of little value compared to cost of claim; legal claims were not realistically arguable

To raise a couple of points. Iesini is probably viewed as the most authoritative source for general interpretation of the new procedure as it has been cited in detail by most of the proceeding cases. 

A second point is that of the significance of the legal merits of a claim. Previously under the common law claim, a claim of fraud on the minority would be dismissed where legal merits did not meet a certain threshold. (see, for example, Law Commission Shareholder Remedies (Consultation Paper No 142 1996) paras 6.6, 14.1-4, 16.21; Law Commission Shareholder Remedies (Report Law Com No 246) (Cm 3769, 1997) para 6.4; Prudential Assurance Co Ltd v Newman Industries Ltd (No 2) [1982] Ch. 204; MacDougall v Gardiner (1875) 1 Ch. D. 13; Edwards v Halliwell [1950] 2 All E.R. 1064; Estmanco (Kilner House) Ltd v Greater London Council [1982] 1 W.L.R. 2).

Reform wished to do away with having claims assessed on their legal merits and allow claims based on all relevant circumstances (see Consultation Paper at para 16.22 and Report at para 6.73). However the Commission noted that it would be inappropriate to allow a completely hopeless claim to proceed (See, Commission Report Para 6.71). Thus whilst they wished to do away with having claims assessed on the legal merits it seems they still form part of the assessment.

The cases heard so far have taken differing views as to how significant the legal merits are to a claim. Franbar and Stimpson have dismissed claims on the basis, inter alia, that there was no obvious breach of duty and that claims were not realistically arguable. Iesini has said "something more" was needed when the court applies its discretion than when deciding whether there is a prima facie case. Cases such as Stainer, Hughes and Kleanthous have dissented from Iesini to the extent a claim has to show sufficient legal merit although it is considered by this author that these three cases did not carefully consider the wording of Iesini but the cases do raise interesting points on the assessment of legal merits to a claim. 

As a result, whilst the reform wished to remove claims being assessed on the merits it seems that this still forms a significant part of the court's discretion as to whether they will allow a claim to proceed. 

Bamford v Harvey [2012] EWHC 2858 (Ch); [2013] Bus. L.R. 589; Cinematic Finance Ltd v Ryder [2010] EWHC 3387 (Ch); Fanmailuk.com Ltd v Cooper [2008] EWHC 2198 (Ch); [2008] B.C.C. 877; Franbar Holdings Ltd v Patel [2008] EWHC 1534 (Ch); [2008] B.C.C. 885; Hughes v Weiss [2012] EWHC 2363 (Ch); Iesini v Westrip Holdings Ltd [2009] EWHC 2526 (Ch); [2010] B.C.C. 420; Kleanthous v Paphitis [2011] EWHC 2287 (Ch); (2011) 108(36) L.S.G. 19; Kiani v Cooper [2010] EWHC 577 (Ch); [2010] B.C.C. 463; Mission Capital Plc v Sinclair [2008] EWHC 1339 (Ch); [2008] B.C.C. 866; Parry v Bartlett [2011] EWHC 3146 (Ch); Phillips v Fryer [2012] EWHC 1611 (Ch); [2013] B.C.C. 176; Re Seven Holdings Ltd  [2011] EWHC 1893 (Ch); Stainer v Lee [2010] EWHC 1539 (Ch); [2011] B.C.C. 134; Stimpson v Southern Landlords Association [2009] EWHC 2072 (Ch); [2010] B.C.C. 387 

Majority Rule: But not as you know it

In company law those who hold the majority of shares "rule" the company. This has been the case since the court in Foss v Harbottle (1843) 2 Hare 46 recognised the principle. If the majority have made a decision to take or not take certain action, that will be respected. Even if they are yet to make a decision no minority shareholder can take that action because the proper person to do so is the company which is recognised as the majority shareholders.

However, all that seems to have changed with litigation decisions concerning derivative claims. Derivative claims are in place where a minority shareholder is allowed to enforce the company's rights because those in control of the company were the wrongdoers themselves. Therefore the majority who "rule" the company are not going to sue themselves. If the minority could not enforce the company's rights there would be a wrong without a remedy. However, whether it is the majority or minority bringing the action the proper claimant is still the company. 

Before 2006, wrongdoer control needed to be proved before a claim would be allowed to proceed to an action. If wrongdoer control could not be established by the minority then the fundamental principle of majority rule would be respected since the majority had not taken any decision as to whether to enforce. If the illegal act could be rectified by the majority then litigation is pointless because 'the ultimate end will be that a meeting will be held, and the majority wishes will be granted'. MacDougall v Gardiner (1975-6) L.R. 1 Ch. D. 13 CA

The Companies Act 2006 now provides a statutory procedure for bringing a derivative claim. The requirement that there is wrongdoer control is not mentioned as a bar to a claim.

Therefore the legislator has chipped away at a fundamental principle of company law that majorities rule the company and no minority can interfere with their decision or lack of one. The Act's procedure now allows a derivative claim to be brought by a shareholder in respect of an action vested in the company.

Such a fundamental shift away from established principles certainly deserves attention and the courts have so far offered some insight in three cases since 2006, see here, here and here. Looking forward I hope to draw some analogies with the Unfair Contract Terms Act 1977 and the reasons behind the reform to explain this shift.