The burden of proof

Financial advisers are in the firing line as more people lose money from their investments, but Charles Hewetson and Aamir Khan say that proving a case is not as easy as it might seem

The successive annual falls in the financial markets over the past three years have had serious consequences for investors. The financial journals and broadsheets are full of stories of investors or savers suffering substantial losses because of poorly performing investments or pension fund deficits, as well as of 'scandals' relating to mis-sold endowment policies, split capital investment trusts and high income bonds. As the downturn continues, it seems that more investors are looking for potential targets from which to seek compensation.

Potential targets

Those who have provided advice and are responsible for managing the wealth of others may become prime targets. Investors are likely to target stockbrokers, independent financial advisers and fund managers, claiming that they have provided poor advice, mismanaged funds, or made negligent mis-statements about the performance or suitability of a particular investment product. Accountants and actuaries that have advised on investment and funding decisions on the basis of the prediction of the growth of a fund against a future requirement, for example pension funds, may also be targets. There seems to be a prevailing view that where there has been a financial loss, someone must be to blame and there must be a claim. Whether such claims will be successful is not as straightforward as many seem to think and those looking for compensation may find a number of obstacles in their path. The following cases assume that the investor will not have a claim in misrepresentation under the Misrepresentation Act 1967.

Common law claims

The majority of claims likely to be brought by investors will include claims for breach of contract and/or breach of a tortious duty of care owed by advisers and/or fund managers.

Regulatory claims

The introduction of the Financial Services and Markets Act 2000 (FSMA) established a matrix of regulations, principles and business rules, some of which will enable investors to bring civil claims. The Financial Services Authority (FSA) has at its disposal wide and far-reaching powers and its regulations are designed to protect consumers, promote public understanding of the financial system and maintain market confidence.

Under Section 150 of the FSMA there is a statutory right of action for an individual investor for a contravention by an authorised person of any rule in the FSA rule book. The numerous requirements imposed on those selling, promoting or advising on financial products are likely to give rise to claims by investors who have suffered losses.

Duty of care

In most cases it will be accepted that an independent financial adviser, or fund manager, owes an investor a duty of care to advise/manage funds with reasonable skill and care. However, there will be two principal hurdles to overcome. First, the scope of duty must be established. This will vary from investor to investor and experienced investors will be entitled to considerably less protection than inexperienced ones. Second, breach of duty will require careful consideration. For example, if a fund manager has followed the market, or used industry standard risk ratings when making investment decisions, can they be criticised or liable for the losses that have followed? If an independent financial adviser has advised their client to invest in popular shares or investments that all so-called experts are recommending, is that advice negligent?

The standard of care

The starting point is the 'Bolam' 1 test, expounded by Mr Justice McNair. He stated: “The test is the standard of the ordinary skilled man exercising and professing to have that special skill. A man need not possess the highest expert skill; it is well established law that it is sufficient if he exercises the ordinary skill of an ordinary competent man exercising that particular art… there may be one or more perfectly proper standards; and if he conforms with one of those proper standards, then he is not negligent.

“[A doctor] is not guilty of negligence if he has acted in accordance with a practice accepted as proper by a responsible body of medical men skilled in that particular art… a man is not negligent, if he is acting in accordance with such a practice, merely because there is a body of opinion who would take a contrary view.”

A fund manager or independent financial adviser who can demonstrate that their investment strategy or advice was in line with that of respectable or responsible practitioners in their specialist area will be in a strong position to refute that there was any breach of duty. Not only would an investor have to show that a mistake was made, but also that no reasonably competent independent financial adviser or fund manager with the same skills would have made such a mistake. The fact that one or two other fund managers or independent financial advisers did not follow a similar strategy, or made the same assumptions and appeared to get it right, will not mean that the original person is negligent.

A fund manager or independent financial adviser whose actions have led to a loss would need to demonstrate that they were not alone in dispensing such advice or recommending such an investment strategy and that, although the advice or strategy ultimately turned out to be a bad one, there was a reasonable basis for the approach taken.

Quantum

In order to recover damages by way of compensation, investors will not only have to establish that their losses were the result of negligent decisions by fund managers and advisers, they will also have to prove their losses.

Investors will have to establish that they would have invested their funds differently if they had been properly advised or had been informed of all the risks, and that their

funds would have achieved better results had they been placed in alternative investments. The amount the investors would be able to recover would be the difference between the performance of their actual investment and the alternative investment. The test for fund or pension fund management is somewhat different – it would require a comparison of the actual performance of their fund against the performance of the fund if it had been properly managed.

In the current market, where most investment products have decreased in value, and where interest rates have fallen steadily, investors may struggle to find a comparable investment product alternative that has fared substantially better than their actual investment. If investors can demonstrate that if it had not been for the negligent advice or mis-statement they would not have invested at all and would have kept their money in the bank, then they may be in a better position. However, this is likely to be a difficult position to substantiate in most cases.

Investors will also face a difficult choice of whether to 'crystallise' their loss by cashing in their investments. Unless the investment was specifically for the short term, investors will need to demonstrate that their actions are reasonable and that they are effectively mitigating their losses. Even then, investors could face further difficulties recovering any additional losses that follow the change in investment, as they could be considered too remote.

The timing of claims brought by investors may also be important. Many investors may find that by the time their claims reach a trial, the value of their investments has recovered and they may have to face the argument that the losses they are claiming to have suffered have been reduced, even if this will not necessarily be a good argument in every case.

Many investors will consider bringing claims as the value of their investments continues to fall. In most cases, establishing a duty of care may be straightforward. However, it will often be difficult for investors to demonstrate that the actions, or inactions, of their potential targets amount to a breach of that duty. Even where a breach can be established, investors will still have to establish that the loss they suffered was caused by the actions of their potential targets and not an unforeseen and sustained downturn in the market.

One possible ray of light for investors is hindsight. Although the law requires decisions or representations to be viewed in the context in which they were made, human nature being as it is, one can envisage many experts, or even judges, being more sympathetic to an argument that an investment decision made in late 1999 was an unsuitable one, given what they now know has happened to the markets in the past few years. We have not heard too many market experts recently admitting that they thought that the bull run of the late 1990s was going to continue into the new millennium.

Charles Hewetson is a partner and head of the commercial disputes group, and Aamir Khan is an associate, at Richards Butler