The In-House Lawyer

THE MARKET TURMOIL OF RECENT TIMES WILL HAVE lost many institutional investors, such as pension funds, vast sums of money. For the most part, they will have no choice but to take these losses on the chin. Indeed, if they have put their funds in the hands of passive managers whose job is to track the index, those managers will have had no choice but to follow the markets down. In contrast, when a fund is actively managed, in theory at least, a fund manager can mitigate exposure to a falling equity market by structuring the portfolio in a way that favours investments, whether asset classes or types of stocks within equities, that will be less affected.

The bursting of the dotcom bubble caused many trustees to take a long, hard look at what their fund managers were doing, and in some cases to threaten legal proceedings on the basis that their fund had been over-exposed to the telecommunications and technology sector. Some trustees may, in due course, be inclined to bring similar complaints about their fund’s exposure to banks.

Clearly, no one will get far with an argument that their fund manager ought to have had perfect foresight about the extent of the problems in the banking sector or the impact these would have on the market, far less their timing. However, it might in some cases be possible to make an argument that a portfolio had excessive exposure to the fortunes of the banking sector or that the structure more generally (for example, the allocation between asset classes) was too aggressive for the mandate.

The difficulties of establishing liability would, no doubt, be formidable. However, if that hurdle could be cleared, the courts might at long last have a chance to decide the interesting question of whether loss of chance can be allowed as a basis for recovery in such claims.

There has to date been no decided case in which a fund manager has been held liable for negligent discretionary portfolio management. The novel problems posed by damages in such cases (of which the possible application of loss of chance is only one aspect) have therefore not yet been addressed by the courts.

A claim by the trustees of Unilever’s pension fund against Mercury Asset Management was settled mid-trial in 2001, amid much publicity. Unilever did not, in fact, put its damages claim on a loss-of-chance basis but claimed the whole of the shortfall against its benchmark (a weighted basket of indices). However, this is a highly problematic approach. Benchmarks based on indices or (another popular approach) on reaching the upper quartile of a peer group are designed to be challenging. Achieving such a benchmark certainly cannot be described as the ‘most likely’ result for non-negligent management (compare this situation to Lion Nathan Ltd & ors v CC Bottlers Ltd & ors [1996]), since the majority will fail to reach it. A claimant taking that approach risks failing to prove its loss (as in fact happened in Nestle v National Westminster Bank [1992], below). While there are a number of alternatives to comparison with a benchmark, they all present their own difficulties.

Recovering half the loaf via a loss-of-chance claim may therefore seem a better bet than trying to recover the whole loaf with a conventional approach to damages, risking outright failure. Sooner or later, it seems likely that the point will be put to the test.

Loss of chance is, of course, a familiar concept in the context of professional negligence claims, particularly claims against solicitors for failing to bring proceedings in time or allowing a claim to be struck out. In Allied Maples Group Ltd v Simmons & Simmons [1995] (which was concerned with whether better terms would have been achieved in negotiations with a third party had the solicitors discharged their duty of care) Stuart Smith LJ described the doctrine as applicable when:

‘… the plaintiff’s loss depends on the hypothetical action of a third party, either in addition to action by the plaintiff, as in this case, or independently of it’.

If that were right, then the doctrine ought not to apply to claims against fund managers for negligent portfolio construction. It is not the actions of third parties (or the claimant) that you need to hypothesise about. The difficulty is in identifying what a portfolio constructed without negligence would have looked like. If that can be established (and there lies the rub, because a non-negligent portfolio could have been constructed in so many different ways), then the performance of that non-negligent portfolio can be worked out from historical records of price movements in the relevant investments. It is, therefore, the hypothetical actions of the defendant that are in issue: what would the defendant have done differently if acting competently?

But is it right to limit the loss-of-chance doctrine to situations concerned with what a third party, other than the defendant, would have done? As Walker LJ pointed out in BCCI v Ali & ors [2001], in Chaplin v Hicks [1911] it was the defendant who made the final decision as to which 12 of the 50 girls selected by the newspaper’s readers would receive the theatrical engagement. Here the problem was not that the decision was in the hands of a third party, but the difficulty in knowing whom the defendant would have picked in a hypothetical circumstance (ie had the claimant been among those available to be picked).

Put in those terms, Chaplin is closely analogous to the difficulty of determining what a negligent fund manager would have done differently if acting competently.

The next hurdle, however, is that a claimant will only be entitled to damages on a loss-of-chance basis if the lost chance can be shown to be more than speculative: a ‘real and substantial’ chance. To date, in claims relating to investments, this has proved to be fatal to all attempts to apply loss of chance.

The possible application of loss of chance to claims relating to investments has been considered in three cases. In two of them, the claimant failed on liability and so anything said about loss of chance was obiter. In the third, the claimant succeeded on liability but failed to provide evidence on the basis of which the court could assess damages or, if loss of chance were available, evaluate the chance. The claim was rejected on the basis of this failure, without the question of principle (as to the availability of loss of chance) being decided.

The first of these cases was E Bailey & Co Ltd v Balholm Securities [1973]. Kerr J considered that the chance of a better outcome from trading in commodity futures was ‘too speculative to be capable of having any monetary value placed upon it’. He distinguished other loss-of-chance cases as being concerned with whether the claimant might have been better off, without there being a risk the claimant might have been worse off:

‘In cases like the present, on the other hand, a person who is prevented from speculating in cocoa or sugar futures may have lost the chance of making money or may have been saved from losing money. A cynical view would be that there is an equal chance either way. No doubt experience and skill play a large part, and to this extent there may be said to be a better chance of winning than losing. But in my view this is not the kind of situation which the law should recognise as giving a right to damages for the loss of a chance.’

As the claim failed on liability, this was obiter.

The dicta above were referred to with approval by the Court of Appeal in ATA & anor v American Express Bank Ltd [1998], another commodity trading case. The judge at first instance in that case was Rix J, whose judgment was upheld on appeal. He had found the bank not to be liable for failing to trade its client’s open positions but added that had it done so, it would have been as likely to suffer further losses as to have made any profits, so the prerequisite for a loss of chance claim was not made out (ie a real or substantial chance that trading the positions would have made a profit):

‘… the subject matter of the bank’s discretion was pure short-term speculation on very high margin, and the essence of such speculation is, in my judgement, that it is entirely unpredictable for losses and profits alike. It seems to me that this situation is quite unlike a stockbroker’s failure to carry out specific instructions to buy or sell a particular stock on one occasion... or even to carry out a discretionary programme of medium-term investment.’

Note that last caveat. It may well be fair to say that the outcome of a handful of individual transactions in a highly speculative market, such as commodity futures, is as likely to have been worse as better, if differently handled. That is the equivalent of guessing whether a tossed coin will land heads or tails. However, the probabilities will not necessarily be equal if we change the parameters of the problem, in terms of numbers of ‘bets’ (an entire portfolio, not a few investments) and the time frame for observation.

Compare, in this respect, the robust approach taken by the courts to calculating lost profits on sales that a claimant has lost the chance of making. The probability of making any individual sale may well vary and, viewed individually, the chance in each individual case may be less than 50%, but the judge is entitled to evaluate the chances as a whole. In Gerber Garment Technology Inc v Lectra Systems Ltd & anor [1996] Staughton LJ said:

‘The contrary view, that if the judge found 25 chances of a sale, each of 49% probability, he should award nothing, is absurd.’

The Court of Appeal took a similar approach to the claimants’ prospects of landing a job in the ‘stigma damages’ case, BCCI, saying that if the trial judge concluded, evaluating the chances overall, that the job hunt would, but for the stigma, have been successful six months earlier, he could award damages even if he was unable to identify which particular job application would have been successful.

Nestle is the most intriguing of the three cases in which a claimant has sought to apply loss of chance in an investment-related claim. There, the claimant failed on damages, despite establishing that the bank responsible for managing her trust fund was negligent in failing to diversify the portfolio adequately (the bank had mistakenly believed that its powers to invest in equities were restricted to bank and insurance shares, and the equity portion of the fund was therefore limited to such shares). The claimant had argued that the performance of her equity portfolio should be compared with the BZW index (as a proxy for a properly diversified portfolio) and the shortfall in performance awarded. That was misconceived, since the evidence showed that the majority of comparable funds had also failed to beat that index, which was inherently difficult to beat, comprising as it did the leading equity shares at any given time. Dillon LJ’s judgment is somewhat ambiguous but can be read as leaving open (without deciding) the possibility that on different evidence the claimant might have succeeded on a loss-of-chance basis: