IB4AI Llc v Auriel Capital

This is the trial of a preliminary issue as to the proper construction of clause 7.2 of a written Marketing Agreement made between the claimant (“IB”), and the defendant (“Auriel”) on 29 July 2005. Auriel is the manager of a hedge fund known as Auriel Global Macro Fund (“the Fund”). IB is a company which provides marketing services to hedge funds so as to encourage investors to subscribe for shares in such funds.

The point of construction arises thus: the Fund, comprising its shareholder/investors, pays management fees to Auriel. Auriel in turn pays fees to IB for its marketing services. Clause 7.2 permits Auriel to terminate the market agreement early if certain targets in relation to management fees from those shareholders introduced to the fund by IB were not met. On 1 November 2006 Auriel terminated the Marketing Agreement early on the basis that clause 7.2 entitled it to do so because the fee target had not been met. IB claimed that upon a proper construction of that clause the target had been met and accordingly the termination was wrongful.

On 17 January 2008 IB issued proceedings against Auriel for damages for breach of the Marketing Agreement. A Defence was served on 15 February 2008. The construction issue lies at the heart of this claim. If resolved in IB’s favour, it was wrongful and damages will have to be assessed. If Auriel is correct about the interpretation the claim fails.

On 6 May 2008 Master Moncaster gave directions for the hearing of this preliminary issue. There is also an application for summary judgment by Auriel but that is now redundant since I am to decide the issue of construction finally, one way or the other.

For the purpose of this hearing I have one witness statement from Thomas Wolf, the Managing Partner of IB, and two witness statements from Lawrence Abele, a director of Auriel. I also have two expert reports, one from Ms Lloyd-Coombes of Ernst and Young on behalf of the Claimant, IB, and one from Mr Julian Korek of Kinetic Partners on behalf of Auriel. Mr Goldring, Counsel for Auriel submitted initially that I should disallow the expert report of Ms Lloyd-Coombes on the grounds that it was inadmissible. Had I done so he would not have pressed for the inclusion of Mr Korek’s report. I allowed both reports in, de bene esse, save for some parts of Ms Lloyd-Coombes report which appeared to me to consist of pure argument.

Both Ms Lloyd-Coombes and Mr Korek attended the hearing and each was cross-examined briefly. Both parties reserved their position in relation to the admissibility as well as the relevance or weight of such evidence. There were various aspects to that evidence and I deal with each in context below.

By clause 7.1 of the Marketing Agreement, it was to last for 30 months unless terminated, inter alia under clause 7.2. IB’s remuneration is defined in schedule 1. Paragraph 2 thereof provides as follows:

“The manager shall pay fees to the marketing agents as follows: an amount equal to 3.0 % of the Management Fees and Performance Fees (or equivalent) paid to the manager by the fund and attributable to Tagged Investor Assets.”

A Tagged Investor, in summary, is a shareholder in the Fund which was introduced by IB and whose name appears on a list of potential investors set out in schedule 2 the Marketing Agreement, which list could be added to by IB from time to time. Tagged Investor Assets has a complex definition. For present purposes the essential point is that IB’s 3 % is defined by reference to management fees and performance fees attributable to the shareholdings of the Tagged Investors and their performance. In this way, unsurprisingly IBs remuneration is tied to the fees generated by those whom it has introduced to the fund.

Clause 7.2 of the Marketing Agreement reads as follows:

“The manager reserves the right to terminate the contract at the end of the 18th month, if at the start of month 16, the marketing agent does not have ‘Tagged Investors’ (as defined in schedule 1) whose total base fees have exceeded $500,000 plus the greater of zero and $10 million times the total net performance over the trailing 15 months. In other words, the total base fees collected from Tagged Investors at the end of 15 calendar months needs to exceed:

$500,000 plus max (0 trailing 15 month net return x $10 million).

For the sake of clarity, if the fund returns 6 % in the first 15 months of this contract the management base fees for Tagged Investors must exceed $1.1 million or the manager has the option to terminate at eighteen months with not less than 45 days written notice. The trailing 15 month net return is capped at 22.5 %.”

The essential question which arises before me is whether the expression “total base fees” is or is not net of any rebate of fees paid back to the relevant investor. This is critical to the success or otherwise of the claim. It is common ground that the target which must be met for the purpose of clause 7.2 is $1,056,265. The total management fees received by Auriel from the relevant investors were $1,101,841 if no account is taken of any rebate. On that footing IB would have exceeded the target by a small margin, but if the total base fees are net of any rebates the figure drops to $832,967. On that footing, contended for by Auriel, IB failed to meet the target and the Marketing Agreement was lawfully terminated early.

The question of rebate arises in this way. Put simply the Fund as a whole paid a management fee to Auriel of 2 % of the net asset value of each class of share. It also paid an incentive fee based upon the performance of the fund at a rate of 20 % per quarter. It is not necessary to describe how the 20 % is calculated. In the case of one relevant investor called OTTP, Auriel agreed that it would be rebated an amount which would mean that the effective management fee paid by it was not 2 % but 1.5 %. The rebate was not paid back to OTTP by Auriel but rather by Auriel Capital Management LLP (“ACM”), an associated company which acts as an investment manager to the fund. It does this by performing certain services which are the responsibility of Auriel, as against the Fund, but are then delegated to ACM under a separate agreement. It is this rebate which makes the difference between the target in clause 7.2. being met or not.

Before construing the relevant words of clause 7.2, I set out some of the relevant background facts which, in my judgment, can clearly be taken into account as part of the factual matrix. Auriel and ACM are in common ownership. This is set out in a diagram produced by Mr Korek. There is no reason not to accept it is accurate. It also shows that Auriel General Partner Limited, itself owned by Auriel, is the general partner in the Fund. The Offering Memorandum for the Fund also shows that the directors of the Fund are also the directors of Auriel. In this case, Auriel, the manager, is offshore, being a Cayman Islands company. Its associated company ACM, performing some of Auriel’s services on a delegated basis, is onshore, being incorporated here. This form of structure is not unusual for hedge funds such as this. Unsurprisingly there are tax and regulatory considerations at work.

As at the date of the making of the Marketing Agreement, the fees payable by the Fund to Auriel were provided for in a Management Agreement made on 9 July 2004. The fees set out in schedule 1 (US Management Fee) and schedule 2 (US Incentive Fee) were calculated at 2 % and 20 % respectively. There is an important difference between the management fee and the performance fee from Auriel’s point of view, as Mr Abele explained at paragraph 25 of his second witness statement: “The performance is contingent on performance of the fund in the market. The management fee is calculated by reference to the capital invested so that it is payable whatever the performance of the fund in the market. This difference is important because it is the management fee that is crucial to Auriel’s ability to secure a minimum or base income for itself. Auriel’s entitlement to compensation would otherwise be entirely dependent on the performance of the fund which is not in all respects within its control.”

The scheme of fees payable by investors is then described to potential investors in the fund in its Offering Memorandum dated 3 August 2004. The memorandum’s summary of terms states the following against the heading Management Fee and Incentive Fee:

“Pursuant to the Management Agreement the Fund will pay to the manager a monthly management fee in arrears equal to 0.166 % (2 % annualised) of the net asset value of each class as at each valuation day. The Fund will also pay to the manager an incentive fee in respect of each calculation period, calculated on a share by share basis subject to the operation of a high water mark mechanism. In respect of each share the incentive fee will equal 20 % of the increase in net asset value per share of the relevant class during the calculation period above the reference net asset value per share of that share...”

The last part of this section then reads as follows:

“The fund may establish other classes of shares which may differ in terms of the fees charged among other things. The manager may, at its sole discretion, rebate fees to shareholders or pay a portion of such fees to a third party. The manager is responsible for the fees of the investment manager.”

Much the same thing is said later in this document, in its detail section dealing with management and incentive fees. That is to be found at page 129 of bundle 2. It is not necessary for me to recite that passage, save to note that here it is stated that both the manager and the investment manager had the discretion to rebate fees.

The notion that fees might be rebated is thus firmly stated as part of the description of management and performance fees. IB’s remuneration is, of course, calculated by reference to the management fees paid by the Fund as noted above.

It is also common ground that in this particular area of business it not uncommon for rebates to be paid to particular investors. The obvious commercial reason is to persuade a potential investor to join that particular fund. One might have thought that instead of a rebate the manager would simply agree with an investor that it should pay a discounted rate at the outset, i.e. 1.5 % and not 2 %. But in fact, that direct rate is often not available to funds such as this. That is because it is the fund as a whole which pays the 2 % management fee and all investors of a particular class must be treated equally. To effect a discount for any particular investor therefore requires either (a) a specific rebate to it, usually agreed in a side letter, or (b) the issue of a new class of shares just for that investor. The latter course can be costly and time consuming. I take these facts from the evidence of Mr Korek which evidence was not challenged on these points.

As to who pays the rebate, Mr Korek stated that in a conventional hedge fund structure it is typically the onshore investment manager which will make the rebate payment to the investor and not the offshore manager. As I shall explain below, that is exactly what happened here in relation to OTTP. The upshot of all of this is that the means by which an effectively discounted management fee was payable by a particular investor would often be through the making of a separate rebate from an entity which is not necessarily the same corporate entity as that which takes the 2 % from the fund, although associated with it.

Ms Lloyd-Coombes suggested in evidence that a rebate is not a discount to the management fee, but is something quite separate. If by this she meant that there is a formal difference, obviously that is true, but it is impossible to avoid the conclusion that the function of the rebate is to provide a means for an effectively discounted fee rate, hence the word “rebate” - and hence its location in the Offering Memorandum in the section on management fees. On this point therefore, and insofar as there is a difference between the experts, I prefer Mr Korek’s evidence.

From a commercial point of view, it is thus clear that if the management fee is 2 % and the rebate is an amount equal to 0.5 %, the effective fee received is 1.5 %. It is true that the party making the rebate is not the party receiving the management fee but, as I have said, there will no doubt be tax and fiscal reasons for this.

As explained above, aside from the issue of a new class of share, the only way to achieve an effective rate of less than 2 % is by means of a rebate, and a rebate is just that - the return of monies. It only arises if monies have already been paid which can then somehow be given back. The only monies so paid are the management fees. There can no rebates without management fees.

From the point of view of the investor it will regard itself as paying an effective 1.5 % fee. It may not be exactly that because the rebate leaves intact the full deduction of 2 % from the value of the fund, so there may be less of it to grow than if 1.5 % was taken off the top. But in practice I doubt whether there is any significant difference, and certainly no detailed evidence was adduced to me on that point. The fact that the investor does not perceive any real difference is very clearly shown by the example of OTTP itself, in this case. The commercial rate agreed was 1.5 percent but it was then given effect to by a rebate of the management fees which had been taken at the standard 2 %. This can be seen from the exchange of e-mails which is to be found at page 363 in bundle 3. In an e-mail dated 15 March from OTTP to Mr Abele when the question of fees was being negotiated, Mr Bedard of OTTP stated as follows:

“In terms of fees, all things equal, we always prefer a reduction in base fees to a reduction in performance fees (1/20 is preferable to 1.5/15).”

Pausing there, the reference to 1/20 means 1 % management fee and 20 % performance fee and the reference to 1.5/15 means 1.5 % management fee and 15 % performance fees. So those were the rates which OTTP were seeking at that point.

The response was as follows from Mr Abele:

“We are prepared to offer you 5.5 % equity for an investment in our fund of $125 million for three years at 1.5 % base fee and 20 % performance fee.”

The rebate agreement gave effect to this and was formalised in a separate side letter to OTTP dated 1 June 2006. Clause 11 of the side letter reads thus:

“The investment manager shall pay to the subscriber in respect of its investment in the shares within 15 days of the end of each calendar quarter, a cash payment in an amount equal to (A) the aggregate of net asset value of the shares at the beginning of each month of the preceding calendar quarter multiplied by (B) 0.416667 %.”

I note that this if the monthly payment was converted to equated to that the percentage of the net asset value of the shares on an annualised basis, the percentage would be 0.5 %, i.e. the difference between 2 % and 1.5 %.

Equally, from the point of view of the manager and the investment manager, if one regards them as constituting or being part of one economic unit in a non- technical sense, the fact that one entity takes the fee and the other gives the rebate makes no difference. Of course there may be tax differentials and so on but commercially for these purposes the two legal entities should be seen as one commercial unit. Otherwise it would be the case that while there was a true net fee of 1.5 % where 2 % came into the manager and it gave the rebate of 0.5 %, one could not say the same where the investment manager rebated the 0.5 %. In my judgment that is an unreal distinction.

Mr Korek says that because rebates must be taken into account when looking at the true fee income or fees actually received, in the majority of cases the marketer under a marketing agreement will have his fees calculated by reference to such actual receipts, i.e. net of rebates. He uses the commercial not legal expression “received and retained”. Ms Lloyd-Coombes says that she would tend to agree with that. The more common or usual practice, while hardly determinative on a point of construction at least reflects the general underlying point, that to see what fees are actually received regard must be had to the rebates. Against that background I turn to the Marketing Agreement itself.

No control over rebate

The Marketing Agreement does not give IB any right to dictate or influence what particular management fee arrangements are made as between Auriel and a new investor and in particular, whether there should be a rebate and, if so, how much. That is not surprising. There is no reason why it should, any more than an estate agent can dictate the price at which its vendor client ultimately sells his house. The fact is that Auriel cannot set the rebate too high in the interests of attracting an investor, because there will come a point where it makes no commercial sense to do so. This disposes of the point made on behalf of IB that if clause 7.2 was to refer to fees net of rebates, a manager could ensure that targets were not met, even though the fees from the Fund were well above the target by making a very large rebate, and in this way enabling it to terminate early. This unlikely scenario ignores the obvious point that if this was done the manager and investment manager would be left with very little fees themselves. It may be that a marketer would want to know what fee arrangement is made between the manager and the investor, and it may even seek to influence it but it still has no actual power to determine it.

The words of clause 7.2 itself

The relevant expression is the “total base fees” of the tagged investors. That expression is used twice. On the second occasion the words are “the total base fees collected from tagged investors”. At the end of clause 7.2 is the worked example, here the expression changes to “management based fees from tagged investors”. It is common ground that this latter expression refers to the same thing as total base fees. Both sides agree that the word “base” is not a standard term but there can be little doubt that it means “basic” or “standard”. In other words it is a reference to the basic fee received by the manager, which is the management fee as distinct from the performance fee. That latter is variable and uncertain, the former is the fixed minimum fee which the manager obtains in any event.

As to the word “total” IB had contended initially that this meant “gross” as opposed to “net” thereby indicating that no deductions were to be made for rebates. I disagree with that. The word “total” here clearly refers to the aggregate or sum of the management fees from all, i.e. the totality, of the investors, i.e. the total fees generated from them. In oral argument Mr Croxford for IB was disposed to accept this. Instead he concentrated on a separate point. This was that “base fees” meant “management fees” and “management fees” must mean such fees before deductions for rebates. He contended thus for the following reasons.

First, Management Fees, is a defined term in the offering memorandum. It means the management fee paid by the fund to the manager (see page 58 thereof). Then, clause 1.4 of the Marketing Agreement provides as follows:

“Unless the contract otherwise requires, and except as varied or otherwise specified in this agreement, words and expressions contained in this agreement shall bear the same meaning as in the Prospectus or the Articles provided that any alteration or amendment of the Prospectus or the Articles shall not be effective for the purposes of this agreement.”

It is common ground that the expression “prospectus” encompasses the Offering Memorandum. So it is said that the expression “total base fee” in clause 7.2 must follow that definition. I do not agree. Clause 7.2 does not actually use the expression “Management Fee” albeit at the end there is a reference to management base fees. Moreover clause 1.4 does not operate if the context otherwise requires. Here I think the context is different. It is about performance targets which are defined by reference to fees effectively earned from the relevant investors. In the Offering Memorandum the context was the generally applicable percentage fee which an investor would have to pay if it took shares in the fund subject to the question of any rebate. The Offering Memorandum was not concerned with the issue as to whether an investor, who had received a rebate, was regarded as having paid in the reduced amount. So the defined term Management Fees in the offering memorandum does not assist me in connection with interpreting clause 7.2.

Second, Mr Croxford contends that even if he is unable to rely upon Management Fees as a defined term, the ordinary and natural meaning of “Management Fee” as used or impliedly used in clause 7.2 must mean the fee paid by the investors not the fee paid net of rebate. But as to that:

Mr Croxford then says that IBs claimed interpretation is supported by expert evidence as to the meaning of the expression “management fees”. I have already referred to some of that evidence which related to industry practice. However, the expert evidence invoked by IB here relates to the meaning to be attributed to “management fees” in the industry by reference to the language said to be typically used in marketing agreements. This was adduced by IB not as evidence of custom and usage but as relevant background in the same way that expert evidence was adduced in the case of Kingscroft v Nissan Fire and Marine [1999] Lloyd’s Report 603. I need only quote from one part of the lengthy judgment of Moore Bick J, as he then was, and it gives a sufficient indication of how and to what extent such evidence might assist the court. At page 622 he says this:

“Much of Mr Outhwaite’s report in relation to the issue of retention was taken up with expressing his opinion on what a reasonable underwriter would or would not understand the wording of these particular treaties to mean. I did not find that particularly helpful. Parties and expert witnesses alike should bear in mind that questions of construction, especially those which concern the construction of the contract of which the claim is based are for the court. Expert evidence is often of great assistance in relation to such issues but it is neither helpful nor appropriate for an expert witness simply to give his own opinion on what the words mean or how a reasonable market man would understand them. An expert witness can, and indeed should, inform the court of any aspects of the commercial background which have a bearing on the construction of the contract and explain their relevance. In carrying out that task it is sometimes difficult for him to avoid giving his own opinion on the question of construction but if he does so at least the court is then in the position to evaluate, by reference to his evidence, the market background as well as that of other witnesses.”

He then deals with some of the evidence that was given and said that it did not differ greatly from those of other experts but then he continues his judgment by saying that Mr Outhwaite did draw attention to the fact that quota share treaties often contain an express liberty to effect excessive loss reinsurance and he expressed the view that where it is intended that a retention may be reinsured that will invariably be reflected in the treaty wording, and then:

“Mr Outhwaite has very great experience as an underwriter in the London market and it is right that he should draw attention to these matters. The fact that there is a recognised form of language that can be used when the parties wish to provide for a particular matter in their contract is one aspect of the background of which the court must take account, but it is also apparent from his evidence and from the evidence of Mr Williams that various different forms of words are in use which do not all appear to bear the same meaning.”

See also the observations of Walker J in The Oakwell [1999] 1LR249. This case concerned the proper construction of a P&I club’s letter of undertaking in relation to the service of proceeding. Expert evidence was adduced and Walker J observed:

“It was only in those areas in which there was agreement between the experts as to the market practice for those who conducted litigation in this field that the expert evidence was admissible at all so as to pass the test of background knowledge.”

The evidence relied upon by Mr Croxford is this: Ms Lloyd-Coombes said that from her experience there was a wide range of types of agreement that might be made between a marketer and a hedge fund manager. There was no standard practice. But agreements would typically refer to “management fees” “net management fees” and “management fees net of rebates”. She said that the expression “management fee” had a very clear meaning in the industry and that all contracts would clarify if the remuneration was meant to be net of rebates. She said that she expected glossaries of the industry and dictionaries to show that a management fee is only the fee paid by the fund to the manager, although she did not actually produce any such external materials. She would expect the Marketing Agreement to make clear if the remuneration was to be based upon management fees net of rebates. So the thrust of her evidence, I think, was that if the intention was to refer to management fees net of rebates one would have to expressly state that, otherwise management fees would simply disregard any rebates.

Mr Korek, who has spent 23 years working in all aspects of the hedge fund industry, and who has looked at 26 different marketing agreements in the last 2 weeks alone, said that in some cases one would see the question of rebates dealt with specifically, i.e. there is a reference to management fees net of rebate but mainly, he said, the expression “management fees” would not expressly refer to rebates. While that would admit of two possibilities, ie one does or does not take account of rebates, the default position would be understood to be net of rebates since his evidence is also that the principal method of remuneration for the marketer is based on actual fees received, i.e. net of rebates.

On that footing then there is disagreement between the experts as to whether for the purpose of marketing agreements the use of the expression management fees without qualification is inevitably to mean that rebates are not to be taken into account. This is an example of a reasonable disagreement between experts. It is also disagreement in a context where no detailed materials of any kind have been put before me on the question. That being so it is difficult to place any real weight on Ms Lloyd-Coombes evidence for the purpose of the hypothetical exercise of postulating what meaning would be apparent to the reasonable observer having the relevant background knowledge. There are other reasons for treating with caution the notion that there was some set industry practice whereby the use of the word “management fees” in a marketing agreement must be a reference to the gross not the net position:

Mr Croxford did not advance a positive case that the remuneration provision in the Marketing Agreement was based on management fees after rebate but neither did he contend that it was not. His main point was that if the remuneration was based on net fees it did not follow that the same applied to the target. I find that proposition very hard to accept for in such circumstances I can see no logical reason why the target criteria would then stray from the actual position, i.e. net.

One returns therefore, in my judgment, to the simple task of construing the relevant expressions in clause 7.2 against the commercial background, the crucial aspect of which is that commercially one can only ascertain the actual management fees paid by looking to see if any of them have been rebated. If they have they must be taken into account. Against that background the proper construction of the expression “total base fees” in clause 7.2. is that it means all the management fees paid by all the relevant investors less any rebates paid.

The result of this is that I find in favour of the Defendant on this issue of construction.

I think the costs of the hearing before Master Moncaster should effectively be costs in the case which means they will actually form part of the defendant’s costs. The simple reason for this is that although after the request for preliminary issue had been made by the claimants and the defendants then issues a summary judgment application, they shortly afterwards said that they would consent to have the two matters heard together. The fate of the summary judgment application was not to be determined until they at least saw some evidence in response to that application which came shortly before the hearing. Having received that evidence both parties sensibly agreed directions so that the matter went by consent. This seems to me to have been effectively a piece of case management, not out of the ordinary, and, in my judgment, the proper order to have been made at the time would in fact have been costs in the case. I am giving effect to that now.

Costs of defendants are assessed in the amount claimed of £58,935 and I will order that interest be paid at base plus 1 % from the date when the invoices were paid until 8 July.

I refuse permission to appeal. [see reasons on form].