Unilever pension fund's decision to sue Mercury Asset Management over alleged negligence in managing its funds in 1997-98 was the landmark event of 1999 for the UK fund management industry.

Mercury emphatically rejects the charge. But Unilever is convinced that Mercury failed to structure its mandate to avoid serious underperformance risk. The problem developed from the beginning of 1997, when the brief of Mercury's original balanced mandate was changed. Unilever wanted to ensure that underperformance should never be more than three percentage points below a new index-based benchmark in four successive quarters. Mercury succeeded in retaining its original £1bn (e1.6bn) in funds following a tender process. Surprisingly, in Unilever's view, it kept Alistair Lennard in day-to-day charge. He worked in partnership with team leader John Richards, supervised by investment chief Carol Galley. Unilever argues that Lennard and his colleagues did not alter the portfolio sufficiently to satisfy the new risk controls. It is believed, for example, that the managers continued to avoid large bank stocks, such as HSBC, which performed well, while taking large exposures in cyclical stocks, such as British Steel, which did not. Mercury's belief that outperformance results from concentrating on a limited number of favoured stocks was well known, and has delivered strong numbers in the past. Unilever's trustees, headed by Richard Greenhalgh, were not happy with progress after the first quarter. But they felt inhibited from intervening, having delegated investment decisions to Mercury. Richards went on to leave Mercury to join SG Asset Management. His involvement with Unilever ceased in May 1997. Around the same time Galley became involved in Merrill Lynch's negotiations to buy Mercury, finalised in November. In May, Mercury also discussed ideas for a recovery plan with Unilever. Paul Harwood took over as account manager from Lennard. But performance not only failed to recover, it became worse. The mandate had underperformed by eight percentage points by the end of the year, and 10.5 by the end of March 1998, when Mercury was sacked. Unilever gathered evidence about the situation, including minutes of meetings and portfolio profiles, with a view to seeing if compensation could be extracted from Mercury. Mercury is believed to have made a notional offer of around £3m (E4.8m). But Unilever ended up deciding that a claim of £100m would be more appropriate. Niall FitzGerald, the Unilever chairman, is understood to have felt that a settlement of £40m would have been acceptable. Mercury did not want to make a settlement of even this size. It feared this could create a dangerous precedent. More important, it firmly believes that it had not been negligent. Every fund manager can get "stuck' from time to time, and subsequent underperformance is an occupational hazard, particularly if markets are volatile. Unilever's response would be that it expects all its managers working to a risk-limited benchmark to take steps to avoid continuing severe underperformance. It was also aggrieved because Mercury's underperformance put a dent in its long-term performance record.Advised by lawyers Slaughter & May, it decided that it had no option but to take legal action, despite the potential unpopularity of this move in the industry. Many consultants and pension funds still fear that threats of legal action are capable of forcing active managers to become too cautious, and pushing up fees. Unilever, however, reckons that legal action is healthy for the industry because it would remind managers of the need to listen to their clients more closely. Legal action against auditors has not affected their fees in the slightest – they have actually fallen in recent years – and Unilever believes that the same would hold true for investment management. Following the issue of a writ last October, the judge appointed to the case will be urging both sides to settle out of court. Arbitrators suggest that out-of-court settlements can be reached nine times out of 10, and the betting is that some form of compromise will be reached. Galley would certainly not relish appearing in court, nor would the Unilever camp, including its investment chief Wendy Mayall. It may be that an out-of-court settlement can be reached in such a way that the settlement will be viewed as case specific. But Mercury will be concerned that other suffering clients – such as Sainsbury's and Surrey – might take action to protect their interests. Unilever believes that the loss of a court case would impact more seriously on Mercury's reputation than on Unilever.However, Merrill Lynch, Mercury's owner, is used to hanging tough in the US courts, and Unilever will not want to be unreasonable. Following the Unilever affair, Mercury has recently been working hard to tighten its risk controls and boost its client liaison efforts. Many individuals within the firm retain a strong reputation. Galley and co-chief at Mercury, Stephen Zimmerman, have been handed an important global role, though not Merrill Lynch's cherished executive vice-president status. Mercury's Peter Gibbs now runs Europe. Unilever has not changed any investment managers since the changes which coincided with Mercury's sacking. Its performance is likely to have been strong in recent months, aided by an 11% asset allocation to the Pacific and emerging markets. Unilever's corporate presence on its pension fund investment committee has been strengthened. Patrick Cescau, Unilever's finance director, was appointed as its chairman in March, and can be expected to keep a close eye on future events.