Performance fees exposing superannuation funds to legal action

Trustees risk exposure to legal action if the performance fees paid to fund managers are not reflected in the returns generated for members, writes Noel Davis.

Superannuation funds offered to the public sometimes include investment options under which the investment manager is entitled to performance fees if investment returns exceed a base level, in addition to the normal fees charged by investment managers.

Those base levels are sometimes set quite low, for example 4 or 5 per cent per annum.

Under some arrangements, the investment manager is entitled to 20 to 30 per cent of the investment return that exceeds the base level.

It is usually the case that the investment manager does not suffer any detriment (other than not receiving the performance fee) if the return is below the base level. It is, therefore, only the investors who are detrimentally affected by poor returns.

Under some arrangements, whether the investment manager is entitled to a performance fee is determined on a monthly basis.

A consequence of that in an equity fund is that if there is a spike in the share market one month and a downturn the next month, the investment manager receives a performance fee in the first month but is not required to repay any of it to the members the next month. It is arguable that such an arrangement operates unfairly for investors.

There are risks to both investment managers and trustees of superannuation funds, as well as advisers, in entering into such arrangements, which are discussed below.

Investment managers

If a member of a superannuation fund has had performance fees deducted from the members’ investment returns in past years, it is open to the member to argue that those amounts should be reimbursed to the member if any of the legislative provisions discussed below have been breached.

The ASIC Act permits a person who has suffered a loss through a breach by an investment manager of any of the provisions of the Act to claim compensation for the amount of the loss. A claim for reimbursement can be brought by a member, a group of members or by ASIC on behalf of members.

A section of the ASIC Act prohibits unconscionable conduct in providing financial services.

In determining whether there has been such conduct, a court can have regard to the relative strengths of the bargaining positions of the investment manager and the member.

Very often, the member will have had no bargaining position with the investment manager because the selection of the investment option was done by the trustee of the superannuation fund.

A court may well take the view that, in those circumstances, it was unconscionable for an investment manager to be entitled to a significant percentage of the investment return generated by the member’s superannuation money.

Another provision of the ASIC Act that may be relied on by a member is that which prohibits misleading or deceptive conduct in providing a financial product, or conduct which is likely to mislead or deceive.

Also prohibited is conduct that is likely to mislead in relation to the characteristics of a financial product.

This provision may be invoked if there has been inadequate disclosure to members of the way in which the performance fee operates.

A breach of any of these provisions of the ASIC Act constitutes a criminal offence, including by anyone who aids or abets the breach, such as an employee or an adviser.

In addition to the long-term impact on a person of a conviction, the fine that can be imposed may be significant.

However, a greater financial detriment to an investment manager may be having to reimburse performance fees to a significant number of members for a number of years, if members or ASIC succeed in arguing that the ASIC Act has been breached.

In addition to the ASIC Act, the Corporations Act also prohibits false, misleading or deceptive conduct. It creates an offence for preparing a defective Product Disclosure Statement (PDS) (one that is misleading or deceptive or omits relevant material) and for failing to provide a PDS to a person to whom it was required to be given.

These provisions could be breached in failing to adequately disclose the terms of a performance fee or in failing to give a PDS to a member to whom it should be given. A member could bring a claim for a loss that the member claims has been incurred as a result of any of these provisions of the Corporations Act being breached.

Trustees

The provisions of the ASIC Act and the Corporations Act discussed above apply equally to trustees of superannuation funds and it is open to members to seek reimbursement from trustees for losses caused to the members by performance fees having been deducted by investment managers.

An additional obligation that is cast on trustees of superannuation funds under the Superannuation Industry (Supervision) (SIS Act)is to exercise, in relation to all matters affecting the fund, the same degree of care and diligence an ordinary prudent person would exercise in dealing with a member’s money.

Another obligation under that Act is to ensure that the trustee acts in the best interests of its members in carrying out its functions.

One of the functions of trustees is to select the investment options that will be offered to fund members.

In selecting the investment options, the trustee has the SIS Act obligations mentioned above.

An issue that will inevitably arise if a member brings a claim against a trustee and an investment manager for reimbursement of performance fees in an investment option in which the member has been placed (which in the majority of cases would be a default option) is whether the trustee, in allowing that investment option to be included in the fund, acted with the required level of care and diligence and in the best interests of members.

The first mentioned obligation requires a trustee, in selecting the investment options to be offered to members, to approach it with the care that an ordinary prudent person would in looking after another person’s money.

In a decided case dealing with this obligation, the Administrative Appeals Tribunal said this obligation requires a trustee to approach each issue in the same way that an ordinary person who is careful, astute and exercises sound judgment would in looking after another person’s money, where there is an obligation to look after it.

According to the tribunal, a test that can be applied in determining whether the obligation has been met is for the trustee to ask what the members would have done to protect their own positions and to promote their own financial welfare in these circumstances.

In applying this test, it may well be arguable by a member that he or she would not have selected an investment option under which 20 to 30 per cent of the investment return, above the base level, generated by their invested money went to the investment manager rather than their superannuation account.

The separate obligation to act in a member’s best interests is an onerous one. A NSW Supreme Court judge said in a decided case that meeting it requires consideration of what the member would have done in the circumstances in selfishly looking after their own interests.

In a Victorian Supreme Court case, the judge said that the obligation would call into question whether the trustee has sufficiently pursued the members’ financial interests in making its decision.

A member, in arguing that this obligation had been breached by a trustee in selecting an investment option under which performance fees are paid, may be able to submit, with some force, that the member, in selfishly looking after their own interests, would not have knowingly agreed to giving away 20 or 30 per cent of their investment return, above a base level, to an investment manager, particularly where the investment manager makes no reimbursement if there are investment losses.

If a member’s argument that any of the above-mentioned legislative obligations have been breached is accepted by a court, the trustee may be ordered to reimburse the member for the performance fees that have been deducted from the member’s investment return.

The fact that an investment manager, rather than the trustee, has received the performance fees would not prevent a court from deciding that the trustee should pay compensation to members if the court decision is that the trustee has breached one of these Acts.

Summary

Where performance fees apply and any of the legislative requirements discussed above have been breached, both investment managers and trustees are at risk of having to reimburse the members for fees that have been deducted in the past.

The usual limitation period is not relevant.

There is also the risk that trust law obligations may have been breached, resulting in compensation being payable.

The possibility of a class action being brought by members or of ASIC bringing a claim on their behalf cannot be discounted.

In some instances, it may be appropriate to assess the risk of such claims succeeding, to determine whether the existing arrangement should be continued or whether any changes should be made.

Noel Davis is a barrister and company director. He is the author of The Law of Superannuation in Australia and editor of the Australian Superannuation Law Bulletin.