The trend among superannuation funds to insource more of their investment operations is exposing the industry to a higher risk of legal action, lawyers have warned.

In instances of operational failure, members have a right to recover their money, delegates at the 20th Conexus Financial Investment Operations Conference in Sydney on Tuesday heard.

This is despite the law recognising a tolerance for investment strategy losses from the development of complex intermediated structures.

“What is not acceptable is risk in the operational process,” Cbus Super general manager, investments legal, Michael Guilday said. “That is where there will be significant opportunity to attack super funds and their structures.”

Class actions in response to operational failures are already happening in the public securities space, with 21 open class actions in Australia at the time of writing.

“There is a huge explosion in shareholder class actions in relation to public securities,” Guilday said.

Market failure not a defence

Squire Patton Boggs partner Amanda Banton said that as recently as this past weekend, a client had approached her to open a class action against a super fund. The client alleged that their fund had failed to meet expected return targets and had charged too much in fees.

Based on her experience of class actions against Lehman Brothers, Standard and Poor’s, ABN Amro Bank NV and Local Government Financial Services, Banton said courts did not accept ‘market failure’ as a defence.

The court’s rationale was that even though the probability of market failure was low, it was still a key risk that had to be managed. This means investment operations need to be robust.

Banton added that the top reasons she would sue were if funds made investments that did not fit with the mandate, if due diligence wasn’t done on a specific financial product, and if there were conflicts of interests.

“But you would always need to have a product where there was significant enough damages to … get someone to fund [a class action],” Banton said.

Litigious regulators

Another question the panel explored – and one that did not have a clear answer – was whether super funds have a fiduciary duty to make sure a member is in the right investment option.

Specifically, what legal liability might a super fund incur from having a wide spread of ages in a default option in the event of significant losses? Might a 60-year-old have a case to bring a class action against a fund by arguing that a single option couldn’t simultaneously cater to the risk tolerance of both them and a 20-year-old?

The panel agreed that members were likely to enact class actions against a super fund only following financial losses. However, the risk funds face of being exposed to legal action from regulators, even in cases where members incurred no material financial loss, was also on the rise.

Three separate regulators have jurisdiction over different aspects of the super industry: the Australian Securities and Investments Commission (ASIC), the Australian Prudential Regulation Authority, and the Australian Taxation Office.

King & Wood Mallesons partner Jim Boynton noted that ASIC had already taken a responsible entity to court to find out what the penalty should be, following an investment in the Cayman Islands – on the advice of a fund manager – that had turned out poorly.

“Super fund trustees have an even higher obligation in skill and prudence, so there is a higher bar,” Boynton said. “It goes back to what is acceptable and prudent risk.”

He added that processes need to be flexible to allow for the chasing down of any red flags, so that there are no questions left unanswered.

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