SMSF trustees take lessons from ruling

A recent Federal Court case has clearly illustrated the potential liability of superannuation trustees for the investment strategy of their fund. While the case concerned an employer-sponsored fund, the principles apply to all superannuation funds, including self-managed super funds (SMSF).

There are some simple lessons arising from the case, which all trustees should consider. It is also possible that the lessons will be misstated and used to argue against SMSFs. So, SMSF advisers should be aware of both the relevance and limitation of the case.

The case

The case is Kernaghan v Corrections Corporation of Australia Staff Superannuation Pty Limited & ors and the Court’s reasons for its decision were handed down in January, 2006, as [2006] FCA 2.

The case arose when a number of members (ultimately 73 in total) of the superannuation fund initiated litigation against the trustee for breaching the trustee’s investment duties. For good measure, the members also sued the two employer appointed directors of the trustee, as well as the sponsoring employer. The trustee, the two directors and the employer commenced litigation against the insurers under the superannuation trustees liability policy held by the trustee.

While the matter was settled between the members and the trustee (the trustee agreed to pay $275,000 compensation and $539,000 legal costs), the trustee’s claim against the insurer was not settled. The decision of the court is confined to the issue of whether the insurer was liable to indemnify the trustee (it held it was). The insurer accepted that the trustee breached its investment duties to the members but raised various issues based on the wording of the insurance policy to deny indemnity, such as the timeliness and adequacy of the notice of the claim provided by the trustee.

The facts of the case

The facts were relatively straightforward. The Corrections Corporation of Australia Staff Superannuation Fund had been established in 1990 and the trustee was Corrections Corporation of Australia Staff Superannuation Pty Limited.

By mid 2000, the fund was valued at about $6.5 million, of which $5 million was invested in real estate. The fund had invested in real estate both directly (by two commercial properties) and indirectly by units in a geared unit trust, the sole asset of which was another commercial property. At December 31, 1999, these real estate investments comprised 82 per cent of the market value of the fund.

The nature of the employer’s business

The nature of the employer’s business was to supply personnel to operate prisons/correction centres under outsourcing contracts with government agencies. This line of business is open to the risk that outsourcing contracts may not be renewed upon expiration of the current term of the contract and also that they may be terminated during the current term of the contract. These contracts constituted the very structure of the employer’s business. A non-renewal or termination would cause a significant portion of the business to close down and the relevant personnel would have their employment terminated.

Consequently, the employer’s business structure gave rise to a risk that significant numbers of employees would have their employment terminated at the same time, and therefore the fund would be exposed to a risk of bulk member exits.

The failure of the trustee

This was a risk that the trustee should have considered when constructing its investment strategy. This was the risk that the trustee failed to consider. This was the risk that exposed the trustee (and the directors of the trustee) to liability to the members.

Unfortunately for the trustee and its directors, this risk manifested in 2000 and, ultimately, the failure to manage this risk resulted in the payment of $275,000 in compensation to the affected members and in excess of $500,000 being paid as legal costs.

At the beginning of 2000, real estate (direct and indirect) constituted 82 per cent of the value of the fund. This concentration on one asset class was noted by auditors in respect of their audit for the 1999 year (the fund had a December 31 balance date) and they recommended that the trustee diversify the investments of the fund away from property.

In July 2000, the trustee became aware that the employer was unsuccessful in renewing a major outsourcing contract. The contract would terminate at the end of December 2000 at which time approximately 55 per cent of the fund membership would have their employment terminated and therefore be entitled to take their superannuation benefits.

Preliminary calculations undertaken by the fund’s administrator indicated that the fund would have to pay out $3.6 million in benefits in December 2000. The fund had approximately $1.5 million in liquid assets (cash and readily realisable assets). On this basis, the fund had a shortfall of $2 million, which had to be financed by means of selling one or more of the property assets. The direct and indirect property assets constituted (at book value) $5 million.

In October 2000, the Victorian Government terminated an outsourcing contract with the employer, which resulted in more employees exiting the fund.

The trustee’s response

The trustee initially responded to this liquidity crisis by reducing the book values of the properties to their estimated market values and reducing the interim-crediting rate to zero. Subsequently, the trustee deferred payment of benefits until all proceeds of the sale had been received and then applied a substantial negative crediting rate to the account balances of all members.

Given both the delay in payment of members’ benefits and the very substantial negative crediting rate that applied to all members’ accounts, the members commenced a class action, which was settled by the trustee paying in excess of $800,000 to the members.

The litigation against the insurer

The litigation continued as the trustee, employer and the employer appointed directors of the trustee company commenced cross claims against the insurer, which had issued to the trustee a “superannuation trustees’ liability” policy. The insurer did not dispute that the trustee was liable to the members in respect to the deferred payment of benefits and very substantial negative earnings. However, the insurer resisted the granting of indemnity under the policy on a variety of grounds relating to the terms of the policy.

Why the trustee was liable

While the investment strategy was clearly heavily weighted in terms of direct property, the trustee was not liable to the members because of this heavy weighting. Instead, the trustee was liable because the nature of the employer’s business clearly carried the risk of bulk member exits and an over concentration in illiquid assets did not address that risk.

The distinction is that the trustee was liable because the investment strategy adopted was not appropriate for a fund that was exposed to the risk of bulk member exits and not because of the over-concentration in property.

If the employer’s business were not subject to the risk of bulk employee exits, would the trustees be at fault? It is unlikely that the trustee would have been at fault. The fundamental issue is not the lack of diversification but the inappropriateness of the investment strategy given the membership profile of the fund.

The lessons for SMSF advisers

In the context of SMSFs, the risk of bulk member exits is unlikely to arise for a number of reasons. Firstly, the members of a SMSF usually have far greater certainty of and control over when benefits will be accessed. Secondly, the controllers of the investment strategy of the fund are generally identical to the membership.

This case is not an argument against SMSFs being heavily invested in property. The case does illustrate that the investment strategy of the fund must be appropriate having regard to when members are likely to access their benefits.

Michael Hallinan is special counsel at Townsends Business and Corporate Lawyers.