Many hedge fund managers draft their separately managed account agreements to closely track the terms found in their hedge fund governing documents. From an institutional investor’s perspective, is this the right approach? Many institutional investors would say no, particularly when it comes to the standard of care to be used by the manager in managing the account.
Current hedge fund governing documents typically strip out any implied fiduciary duty on the part of the manager and excuse the manager from liability for mere negligence in managing the fund. This standard seems to be driven by the fact that, despite the use of side letters and similar customization tools, the institutional investor community tends to view hedge funds as a “product” with relatively fixed legal terms. This view is no doubt correct as to the legal language establishing a manager’s standard of care owed to its fund—for a variety of reasons, managers should be highly reluctant to owe differing duties of care to different investors in the same fund.
With a separately managed account, though, the relationship between the manager and an investor changes. The relationship is a professional services arrangement that can be highly customized to include trading limitations and investor-specific investment guidelines. The increased transparency into a manager’s trading activities afforded by a separate account can be a mixed blessing for the governing body of an institutional investor. While generally helpful, additional information may translate into greater legal responsibility for the members of the investor’s governing body to monitor the account and take prompt action if it goes sideways. As a result, many institutional investors hold managers managing a separate account to a higher standard of care than found in typical hedge fund governing documents. Laws such as ERISA and the Uniform Prudent Management of Institutional Funds Act (UPMIFA, adopted in all states except Pennsylvania) reinforce this higher standard of care for separate account managers.
Below is typical language for the manager’s standard of care in a separately managed account relationship:
The Manager acknowledges that it is a fiduciary of the Client with respect to the investment and management of the Assets. The Manager shall discharge all of its duties and exercise all of its powers hereunder solely in the interest of the Client, using the care, skill, prudence and diligence under the circumstances prevailing that a similarly situated institutional investment management firm acting in a like capacity and familiar with such matters would use in discharging such duties and exercising such powers.
One specific area where this standard of care can make a difference is trading errors. Under most hedge fund governing documents, a trading error by a hedge fund manager would be the financial responsibility of the fund, unless the manager’s mistake was egregious enough (for example, a manager repeating the same error after having been notified of the mistake), that the error rises to the level of gross negligence. In contrast, if the manager is held to a standard of care similar to that found in the language quoted above, any trading error that would have been avoided by an institutional manager exercising reasonable care would be the responsibility of the manager, not the investor.
Trading errors can meaningfully impact performance. As an example, a recent SEC enforcement action against an institutional manager required the manager to pay $10 million to its clients affected by a trading error resulting from an incorrect software coding of their accounts.
But the heightened standard of care expected in the separately managed account context goes beyond mere trading errors. For the members of the governing body of an institutional investor, having the separate manager accept a delegation of fiduciary responsibility is valuable, since it arguably allows those individuals to limit their fiduciary duties regarding the account to periodic review of the manager and rebalancing as necessary—not daily monitoring as if the manager were an internal employee.
If hedge fund managers continue the current trend of narrowing the situations in which they have liability for manager mistakes, it will be interesting to see whether more institutional investors respond by seeking to access managers on a separately managed account basis, in an effort to tilt the manager’s standard of care back toward the investor’s favor.
 In the Matter of Western Asset Management Co. (January 27, 2014).
Luis F. Ruiz