“Choose your investment manager in haste, negotiate at leisure,” is the warning lawyers give to their investor clients when negotiating fees in investment management agreements (IMAs).

Lawyers say a common mistake is for investors and their consultants to shortlist favoured fund managers first and vet their IMAs thereafter, when the process should be the other way round.

Robin Ellison, pensions partner at law firm Pinsent Masons, says: “Investment houses’ standard IMAs vary and you need to know the standard fees at the outset as these are always negotiable. The problem is that people aren’t willing to haggle.” 

Special clauses  

Requests for Most Favoured Nation (MFN) clauses, in order to secure the best possible terms, are most likely to come from major US, Nordic and Asian investors, representing quasi-governmental organisations, Sovereign Wealth Funds (SWFs), major endowments and pension funds, but such requests are less frequent from UK-based investors.

Additional rights written into side letters might include anything from special terms on fees, carried interest, performance fees and extra reporting, to favourable terms on drawdown notice, notification of key events affecting the fund manager and automatic regulatory alerts.

That said, the FSA is not happy about certain side letters which have been granted under MFNs because they could prejudice other investors in the fund. For instance, if one investor is given preferential reporting and redemption concessions, it could give them advance notice of what is happening in the market and allow them to make an exit ahead of other investors, so fund managers need to be careful about what rights they give because it might be regarded as bad practice.

Nicholas Holman, of law firm Hogan Lovells, says that US pension funds negotiate much more aggressively than their UK counterparts. “A US pension fund nearly always secures better terms than a UK pension fund which is investing exactly the same amount of money. US funds will argue hard on every material point, although they rack up much larger legal bills in doing so.”

Holman adds that UK pension funds often fail to ask for MFN status, even though it would be in their interests to do so as it would protect them from receiving inferior terms. UK clients with pooled fund contracts tend just to check that the agreements cover all the standard risks, whereas asking for an MFN clause is an easy way for the client to avoid negotiating on all the points while ensuring that he or she automatically gets all the concessions that other clients win. MFNs are quite common in UK pooled fund contracts, but less so with segregated account mandates.

Holman says: “An investor with MFN rights gets to match any special rights secured by other investors in the same fund, but MFN rights are limited to concessions given to other investors who are putting in an equal, or lower amount only. In a pooled fund, I would typically expect between 30% and 60% of investors who ask for some kind of additional rights to ask for MFNs, so that they get the benefit of concessions given to the other investors, even though they did not negotiate these concessions themselves.”

Compliance  

Lawyers report that MFNs are difficult to monitor for compliance. A relationship manager at a major global investment house who declined to be named said: “To monitor an MFN for compliance, you need to keep a spread sheet of all the fee levels charged for that particular fund at the point of sale. With thousands of clients around the world, that is very difficult to do.”

On the other hand, for an investment house to renege on such a clause would be reputational suicide. Jeremy Bell, partner at law firm Ashurst, says: “Fund managers are pretty diligent and, in any event, they have to be very careful about breaching an agreement. They risk losing an enormous mandate and loss of reputation.” Therefore, while accepting the extreme difficulty of pro-actively monitoring compliance, there is always the possibility that a breach could become public knowledge through hearsay.

Hywel Robinson of law firm Clifford Chance says that fund managers are generally nervous about inserting non-standard clauses into IMA contracts, precisely because of the difficulty in monitoring them.

However, other lawyers say there are ways of monitoring compliance, such as requiring the fund manager to give written confirmation once a year that the contract is being honoured. Bell says: “It’s not a market standard, but it’s just a powerful tool for giving comfort to the client.”

Tim Cox, a pensions partner at law firm Linklaters, says it would be possible for a fund manager to quietly breach an MFN clause by offering another client better terms, through commission rebates, extra units or by offering other services, such as soft commissions, while officially charging the same annual management charge (AMC) as the MFN client.

Remedies for breaches 

In the unlikely event that a breach of an MFN clause were to be discovered, the client would have to prove breach of contract and quantify their loss.

Gary Cullen of law firm Maclay Murray Spens says: “If a client has agreed a specially negotiated fee [rather than an MFN] of 0.4% and the fund manager then offers the same fund to six other clients at 0.4% what is the loss? Even if the fund manager offered the fund elsewhere at 0.3%, he could argue that it was for a larger mandate.”

In such a situation, litigation would hang on the precise wording of the contract and loose terms could make the contract ineffective. Lawyers say that to be watertight, the wording would have to be along the lines that the fund manager cannot offer the same fund at a lower fee rate under any circumstances, including for larger mandates and inclusive of all backhanders, such as rebates, additional units and soft commissions.

Search for industry wide standards  

The UK pensions industry has been trying to agree on a standard IMA for institutional investors and although the Investment Management Association has its own, it is only available to its members.

The lack of an industry wide standard makes vetting IMAs difficult as fund management houses have their own bespoke agreements, whereas an industry wide standard agreement would mean that investors and their lawyers would only have to scrutinise any variations at the back of the standard agreement, rather than having to plough through an entire document.

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