It can’t be long before someone starts discussing LDI-Gate (the turmoil in the gilts market following the Government’s September mini budget), looking for parties to blame. There have been rumours about potential claims against liability driven investment (“LDI”) managers and investment consultants, and pensions celebrities have been summoned to appear before parliamentary select committees to explain the way that LDI works and the role of leverage in product design. Some of the critics of LDI (in the “accident waiting to happen” brigade) have perhaps ignored the wholesale reform of the derivatives market that happened in the wake of the Global Financial Crisis (“GFC”) of 2008-9, which were designed to address systemic risks in the banking sector by introducing central clearing of trades and strengthened margin or collateral requirements. Those reforms were necessary and have served institutional investors well, not least by creating greater contractual certainty between parties.
Did Trustees Have The Power?
Details of any claims that are made will take a while to emerge as the circumstances are fact specific and trustees may or may not have incurred a loss. However, some legal commentators have floated the possibility of a mis-selling angle: that trustees might not have had the legal power to enter into the complex financial instruments used in LDI strategies and to use the level of leverage that many employed in the first place.
Were that to be right, most defined benefit scheme trustees would have some serious soul-searching to do. The absence of a power to do something raises the spectre of acting in breach of trust and the risk of uncertainty about contractual obligations which is absolutely central to agreeing any contract, let alone a high value investment derivative contract with millions of pounds at stake. Would all the good work that hedging of inflation and interest rate risks that had been achieved by adopting LDI strategies be undone?
Those with long memories will remember the intervention of the courts in the 1992 case of Hazell v Hammersmith and Fulham LBC, which was one of a long line of cases that led to local authorities who had used derivatives for speculative purposes (and incurred significant losses on close out) effectively being rescued by the courts because they did not have the legal power (or vires) to enter such contracts in the first place. Parliament eventually laid that particular ghost to rest through a combination of the Localism Act 2011 and, for Local Government Pension Scheme (LGPS) funds, via the reforms to LGPS Investment Regulations 2015 that introduced a principles based approach to what LGPS funds could invest in, by referring expressly to derivatives (and not just futures and options) for the first time in statute.
This brought public sector schemes into line with private sector pension fund trustees, within a prudential framework. Private sector schemes have enjoyed the freedom to invest as if they were the absolute owners of their fund assets, subject to any restrictions in the trust instrument itself, since the Pensions Act 1995 came into force in 1997 (before LDI became popular). So a basic statutory power to use derivatives could be established as far as 1997.
Fast forward to the 2005 Investment Regulations, which were brought in under the Pensions Act 2004 to ensure that the UK complied with the IORP Directive and we have clear authority by which pension funds may use derivatives:
“Investment in derivative instruments may be made only in so far as they—
(a) contribute to a reduction of risks; or
(b) facilitate efficient portfolio management (including the reduction of cost or the generation of additional capital or income with an acceptable level of risk),
and any such investment must be made and managed so as to avoid excessive risk exposure to a single counterparty and to other derivative operations.”
Those 2005 Regulations also contained important constraints on borrowing, which can only be used for providing liquidity to the scheme and on a temporary basis.
Building on Statutory Rocks
LDI as an investment strategy was built on these statutory rocks of risk reduction and efficient portfolio management. The first LDI mandates (pre the GFC) were structured as over-the-counter arrangements (i.e. bilateral contracts negotiated between pension funds and banks). Initially, there was no linkage to borrowing in such arrangements, but leveraged LDI funds became popular when LDI managers and investment consultants created pooled fund structures to capture enhanced returns from return-seeking asset classes in other structures. That made sense, especially in the low interest rate environment that followed the GFC, but in the wake of the September mini-budget that created the liquidity crisis, it begs the question again about whether any borrowing was indeed temporary and for liquidity only.
At one level, such an analysis will always be fact specific. But it is important to ask who was actually doing the borrowing too. Where a pension scheme uses an LDI pooled fund solution, the counterparty to any derivative transaction that has been entered into will be that fund, not the scheme (which is a investor in the fund). That principle applies to all financial instruments (however they are technically structured and whatever they are called).
Should pension funds who are conducting reviews of their LDI programmes therefore worry about having run the risk of acting illegally in entering into derivative transactions under an LDI mandate? In my opinion that seems an extremely remote risk.
Points to Consider
Leaving aside the strategic investment questions about restoring or maintaining hedging levels and associated investment allocation decisions, we suggest that it is better to spend energy (and legal costs) on the operational issues that the LDI liquidity crisis exposed, such as:
- Did the trustees understand what they were investing in and how/to what extent their liability was limited by the LDI programme?
- Were communications between managers, trustees and their advisers clear?
- Were instructions followed in a timely way, on terms that were fair as between investors (and can managers confirm that to trustees)?
- Can improvements be made to execution of instructions, for example, by use of powers of attorney?
- What did all the movements of money to restore liquidity actually cost?
The opinions expressed are those of the author and do not necessarily reflect the views of the Firm, its clients, or any of its or their respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice.