CITY OF LOUISVILLE AND JOHN H. NEVIN v. POLICEMEN'S RETIREMENT FUND OF THE CITY OF LOUISVILLE; BOARD OF TRUSTEES OF POLICEMEN'S RETIREMENT FUND; BOBBY W. BRANHAM; THOMAS H. CARRICO; BILLY R. EPPERSON; JOHN L. WINSTEAD, SR.; AND BRENT O. HARDIN
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RENDERED: December 23, 1999; 2:00 p.m.
NOT TO BE PUBLISHED
C ommonwealth O f K entucky
C ourt O f A ppeals
NO.
1998-CA-001070-MR
CITY OF LOUISVILLE AND
JOHN H. NEVIN
APPELLANTS
APPEAL FROM JEFFERSON CIRCUIT COURT
HONORABLE THOMAS J. KNOPF, JUDGE
ACTION NO. 90-CI-03253
v.
POLICEMEN'S RETIREMENT FUND
OF THE CITY OF LOUISVILLE;
BOARD OF TRUSTEES OF
POLICEMEN'S RETIREMENT FUND;
BOBBY W. BRANHAM;
THOMAS H. CARRICO;
BILLY R. EPPERSON;
JOHN L. WINSTEAD, SR.; AND
BRENT O. HARDIN
APPELLEES
OPINION
AFFIRIMING IN PART - VACATING AND REMANDING IN PART
** ** ** ** **
BEFORE:
BUCKINGHAM, GUIDUGLI AND SCHRODER, JUDGES.
GUIDUGLI, JUDGE.
John H. Nevin and the City of Louisville (the
City) appeal from several opinions and orders of the Jefferson
Circuit Court which denied the City’s motion to enforce a
settlement agreement reached between it and the Policeman’s
Retirement Fund of the City of Louisville (the Fund).
The Fund was established in 1949 to provide retirement
benefits to retired city police officers and their families.
Due
to changes in the Fund’s structure in May 1986, policemen on
active duty with the City were given the option to either remain
with the Fund or transfer to the County Employees Retirement
System (the County fund).
Many of the active duty officers chose
to switch to the County fund.
Due to the large shift to the
County fund, the Fund now receives very few new contributions and
is, for the most part, static.
As a direct result, the Fund is
now required to pay out approximately 12% of its principal each
year in order to meet its benefit obligations to its retirees and
their survivors.
Because of this fact, proper management of the
Fund is of utmost importance.
In April 1990, the Fund filed an action against the
City claiming that it had improperly transferred $4,000,000 from
the Fund to the County fund.
In response to the Fund’s suit, the
City filed an action against the Fund alleging in part that the
Fund’s trustees had mismanaged the Fund by failing to monitor the
actions of R. Keith Cullinan and Cullinan Associates, Inc.
(Cullinan), the Fund’s investment manager.
The City alleged that
the Trustees’ inattention to Cullinan’s activities cost the Fund
over $5,000,000.
Shortly before the trial on the City’s claims, the City
and the Fund entered into a “Release and Settlement Agreement”
(the Agreement) on April 7, 1995.
The trial court approved the
Agreement and incorporated it in full in an order entered
April 10, 1995.
Under the terms of the order, however, the trial
court chose to “maintain supervisory jurisdiction over this
action” in order to oversee enforcement of the Agreement.
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For
purposes of this appeal, the relevant portions of the Agreement
are as follows:
6.
FINANCIAL ADVISOR
a. Within sixty (60) days after the
Effective Date of this Agreement, counsel for
the City and counsel for the Trustee
Defendants shall agree upon the names of
three persons, firms or corporations who
shall agree to make presentations to the Fund
to serve as the Financial Advisor to the Fund
in accordance with the requirements of this
paragraph. Within thirty (30) days of the
selection of the three presenters, the Board
of Trustees shall conduct a meeting, at which
time the three presenters shall make their
presentation and, at that meeting, the Board
of Trustees shall select one of the three to
serve as the Financial Advisor to the Fund.
. . .
7.
FINDINGS OF THE FINANCIAL ADVISOR
a. The Financial Advisor shall have the
following duties:
(1) Within ninety (90) days after he or she
is first selected, prepare and present in
person to the Board written reports (the
“Initial Reports”) on the following subjects:
(a) An historical evaluation of the
performance of existing Fund investment
managers for each time period that the
Financial Advisor deems appropriate,
including but not limited to, the trailing
three-year and five-year periods. In
addition to any other factors that Financial
Advisor considers relevant, the evaluation
shall include an analysis of (i) the
performance of existing Fund investment
managers as compared to such other investment
managers as determined appropriate in writing
by the Financial Advisor. The historical
evaluation shall also indicate whether each
Fund investment manager is among the top onehalf of appropriate investment managers for
the trailing three-year and five-year periods
and such other longer periods as may be
deemed advisable by the Financial Advisor.
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. . .
(3) For each calendar quarter beginning after
he presents the Initial Reports, the
Financial Advisor shall present a written
report on the following subjects (the
“Quarterly Report”) and appear in person at a
meeting of the Board to discuss the Quarterly
Report:
(a) An updated evaluation of the performance
of the Fund investment managers as of the
date of the Quarterly Report for such periods
of time as the Financial Advisor considers
appropriate and which must include the
specific factors identified in subparagraph
7a.(1).
. . .
(5) At any time the Financial Advisor shall
make such other recommendations as the
Financial Advisor may deem appropriate for
the good of the Fund and its beneficiaries.
. . .
c. After providing the investment manager
with an opportunity to submit written
comments relating to the recommendations of
the Financial Advisor, the Board shall remove
any Fund investment manager under the
following procedure:
(1) The Financial Advisor shall recommend
removal of any Fund investment manager who
the Financial Advisor determines in his
Initial Report, or thereafter in a Quarterly
Report, is not among the top one-half of
appropriate investment managers for either
the trailing three-year period or the
trailing five-year period. An opportunity to
submit written comments shall be allowed to
any affected investment manager with respect
to such determinations.
(2) The Board shall remove any Fund
investment manager whose removal is
recommended by the Financial Advisor,
provided this recommendation is accompanied
by a written certification from the Financial
Advisor providing the reason therefore,
unless two-thirds of all of the Trustees of
the Fund find and set out in the minutes of
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the Board detailed facts supporting a
conclusion that special circumstances exist
to disregard the recommendation of the
Financial Advisor. Any such findings shall
be forwarded to the Court, to the Mayor and
to the President of the Board of Aldermen.
After a rather tedious selection process, James Garrels
(Garrels) of Fiduciary Capital Advisors was appointed by the
trial court to serve as the financial advisor pursuant to Section
6 of the Agreement.
On February 24, 1997, Garrels presented his
initial report as required by Section 7a.(1) of the Agreement.
In his cover letter, Garrels indicated:
We have analyzed the results on a riskadjusted basis and also without adjusting for
risk. The results should be judged primarily
on a risk-adjusted basis due to the
extraordinary circumstances regarding this
fund and its need to pay out such a large
portion of its assets every year in benefits.
Reviewed in this manner, the results, I think
one would agree are quite good.
In regard to Cullinan specifically, Garrels’ report stated as
follows:
When compared to the stock market (S&P 500)
and our universe of over 1600 equity (stock)
funds, Cullinan did not fare well. For the
year, Cullinan was up +17.1% (72nd
percentile) vs. +22.9% for the S&P 500 (24th
percentile). For the three years, Cullinan
was up +10.7% per year (85th percentile) vs.
19.6% (9th percentile) for the S&P 500. The
five year period was similar, with a +11.5%
per year (86th percentile) vs. +15.2 (26th
percentile) comparison. The bulk of the
damage occurred in 1995 and 1996, as Cullinan
outperformed the market in 1992 and 1993, and
trailed slightly in 1994.
Comparing Cullinan to a universe and policy
portfolio adjusted for risk, however,
produces a much more favorable comparison.
Cullinan’s beta (or volatility relative to
the market’s volatility) was .4 for the five
year period, meaning that their portfolio
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return was produced with 40% of the market’s
risk or volatility. This means that when the
market goes up, the expectation would be that
Cullinan’s portfolio would only go up 40% as
much. Conversely, and perhaps more
importantly, when the market goes down over a
long period of time, the expectation would be
that this portfolio would go down only 40% as
much, a potentially critical factor for a
fund such as this one with such a high annual
payout. In addition, Cullinan’s risk
adjusted return produced a positive alpha of
+1.3% during the 5 years which means that
when adjusted for risk, the return was better
than the beta alone would indicate. The
covered call writing activity was the primary
driver of the phenomenon.
In layman’s terms, the gist of Garrels’ report is that when
looking at Cullinan’s performance on a non risk-adjusted basis,
Cullinan was “not among the top one-half of appropriate
investment managers for either the trailing three-year period or
the trailing five-year period” as required for his retention
pursuant to Section 7c.(1) of the Agreement.
However, when
looking at Cullinan’s performance on a risk-adjusted basis,
Cullinan’s performance was within the upper one-half.
Garrels’ report also contained a section entitled
“Statement of Investment Policy Guidelines and Objectives.”
Sections VII and VIII of that section of Garrels’ report read as
follows:
VII.
MANAGER PERFORMANCE
1. Manager performance shall be monitored
using a three to five year moving average and
performance will be compared to:
a.
An unmanaged market index fund.
b. A relative return target of the
top 50% of the Consultant’s manager
universe, (or other representative
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universe approved by The Board)
with some consistency.
c. An absolute return target of
the Consumer Price Index plus 4%
compounded annually.
VIII.
MANAGER TERMINATION
Investment managers will be considered by
termination if one or more of the following
occur:
a. Major changes in professional
personnel.
b. Major changes in the investment
process.
c. There appears to be minimal
probability of the manager
achieving long-term investment
objectives.
d. The trend of the managers [sic]
percentile ranking versus the
consultant’s universe is down.
e. The trend of the manager’s
ranking versus his own peer group
is down.
It is clear that these sections are completely at odds with the
termination provisions contained in the Agreement.
It is interesting to note that aside from evaluating
Cullinan’s performance, Garrels makes no recommendation in this
report as to whether Cullinan should be retained or terminated as
investment manager.
On April 1, 1997, the City filed a motion with the
trial court seeking to enforce the Agreement.
Specifically, the
City sought an order compelling Garrels to recommend the
termination of Cullinan pursuant to Section 7 c.(1) due to his
failure to meet the performance requirements outlined in the
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Agreement.
The City alleged that the Agreement called for a
direct comparison in evaluating Cullinan’s performance as opposed
to one adjusted for risk, and maintained that because Cullinan’s
performance in the direct comparison did not meet the
expectations contained in the Agreement Garrels was bound to
recommend his removal.
The City also sought a declaration by the
trial court that Sections VII and VIII of Garrel’s initial report
be deemed to be improper as they constituted additional
requirements not otherwise included in the Agreement between the
City and the Fund.
The trial court held two hearings on the City’s motion.
Subsequent to the May 5, 1997 hearing, Garrels submitted his
quarterly report for the quarter ending June 30, 1997.
It is
clear from this report that even after adjusting Cullinan’s
performance for risk, he was not meeting the performance
requirements set forth in the Agreement.
As to whether Cullinan
should be removed as investment manager, Garrels stated:
Investment Manager Termination
Over the past five years, Fidelity Capital
Advisors, Inc. has recommended the
termination of at least one investment
manager for each of its clients. The reasons
for termination were the same as the ones
listed in our current statement of investment
policy, guidelines, and objectives:
1.
Change in key people.
2. Substantive change in
investment process.
3. A perception that the
investment manager had
underperformed to such a degree
that achieving the objective was
highly unlikely within a reasonable
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time frame without the investment
manager taking undue risk.
4. The trend of percentile
rankings for the investment manager
was down when compared to all other
investment managers in the general
universe.
5. The trend of percentile
rankings was down for the
investment manager when compared to
a universe of that investment
manager’s peers.
In each case, the reasons for termination
varied, and in some cases, more than one of
the reasons applied. In no case were these
conditions applied arbitrarily in the sense
that as soon as one of the conditions applied
the manager was terminated, but rather the
manager became subject to review for
termination.
In the case at hand, the settlement agreement
requires the Financial Advisor to recommend
the termination of any investment manager
whose investment return falls below the
median return as measured at the end of any
quarter for that manager’s universe (said
universe as determined by the Financial
Advisor), for the trailing three or five year
period. Such is currently the case with
Cullinan Associates for the past two
quarters. The settlement agreement might as
well have had this stipulation without any
recommendation by the Financial Advisor since
it, in effect, removes the ability of the
Financial Advisor to exercise any discretion
or judgment as it relates to such a
recommendation. Each of our clients operates
under its own set of circumstances. The
aforementioned conditions for review for
termination of any investment manager must be
applied within the context of each. Some of
the relevant circumstances of this fund:
Actuarial investment return
assumption is a relatively high
8.5%.
Annual payout to beneficiaries in effect
means a loss of principal value to the fund
of 11-12% per year if the fund’s return is
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zero since no new “active” contributing
participants are joining the fund. Herein
lies the crux of the investing problem since
bonds do not yield (they have not for some
time, current U.S. government long term bonds
yield around 6.5%) nor have they returned the
required 8.5%. This necessitates investment
of plan assets in the stock market. The
danger here, however, is that the stock
market’s volatility coupled with the fund’s
onerous payout requirement could create a
“double whammy”, seriously eroding plan
assets during a protracted market decline
(double digit, longer than one year).
Consequently, a lower risk method of
investing is mandated. This means that the
focus should be downside risk protection. By
definition, acknowledgment of this fact means
acceptance of significant opportunity risk,
meaning that outperformance on the upside of
a protracted market advance (the current
advance now fifteen years old) is highly
unlikely.
In the case of Cullinan Associates, they have
performed exactly as one would expect in the
current environment and have produced returns
far in excess of the actuarial requirement
with significantly lower risk, enabling the
fund’s commitment to stocks (and its return)
to be higher than it would have been with a
more traditional approach (more bonds, less
stock). Because the overall objectives of
the fund are being met and Cullinan has
managed the assets under his control
precisely as expected, both in terms of
return and risk, we cannot in good conscience
recommend their termination at this time,
particularly in light of the fact that the
stock market’s having compounded at a rate
50% higher or more than its long-term rate
(around 10%) for the past 5, 10, and 15
years.
Upon receipt of Garrels’ quarterly report, the City
moved to supplement its motion with Garrels’ second report, and
once again asked that Garrels be ordered to recommend Cullinan’s
removal due to the fact that it was not performing up to
-10-
expectations of the Agreement even when its performance was
adjusted for risk.
On February 4, 1998, the trial court entered an opinion
and order denying the City’s motion to enforce the Agreement.
so holding, the trial court focused only on Garrels’ initial
report and reasoned:
Even though Section 7a(1)(a) provides that
Garrels had to indicate in his initial report
whether an investment manager was among the
top one-half of appropriate investment
managers for the trailing three-year and
five-year periods, Garrels could also include
any additional factors he considered
relevant. While Section 7c(1) requires
Garrels to recommend the removal of any
investment manager he determined in his
initial report to not be among the top onehalf of said appropriate investment managers,
Section 7a(5) however requires Garrels to
make, at any time, any recommendation he
deems appropriate for the good of the Fund.
Based upon the language of the settlement
agreement when read as a whole and
interpreted in harmony so as to give effect
to all the provisions of Section 7, the Court
finds that Garrels had the authority and
capability to recommend that Cullinan’s
performance be adjusted for risk in order to
be evaluated. As Garrels testified at the
May 5, 1997 hearing, he felt that the use of
covered call options by Cullinan was a good
thing for the Fund, given its suspended
nature and high payout.
The trial court also stated:
To eliminate any further dispute over the
quality of Cullinan’s performance as an
investment manager for the Fund, this Court
strongly encourages the Board of Trustees of
the Fund to adopt Garrels’ recommended risk
adjusted method (Beta, Alpha, R2, and
Standard Deviation) as the stated standard to
be uniformly used in evaluating and ranking
Cullinan’s performance.
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In
The trial court did not address the City’s concerns
regarding Garrels’ second report until it entered a subsequent
opinion and order on April 17, 1998 in response to the City’s
motion to make additional findings of fact and/or to alter or
amend its order of February 4, 1998.
recommendation from Garrels that
In finding that a
Cullinan be removed as
investment manager was still not warranted, the trial court
stated:
In the June 30, 1997 quarterly report,
Garrels stated that Cullinan has for two
quarters fallen below the median return for
the trailing three or five-year period.
However, he stated that Cullinan performed
exactly as expected in the current
environment and produced returns far in
excess of the actuarial requirement with
significantly lower risk. He further stated
that because the Fund’s overall objectives
were being met and Cullinan had managed the
assets under its control precisely as
expected, both in terms of return and risk,
he could not in good conscience recommend
Cullinan’s termination at that time,
particularly in light of the fact that the
stock market has compounded at a rate 50%
higher or more than its long-term rate for
the past five, ten, and fifteen years.
By letter dated January 27, 1998, Garrels set
forth Cullinan’s percentile rankings for the
quarter ending December 31, 1997, wherein
Cullinan was now above the median for all
time periods “reflecting the capricious
nature of relative universes and what the
addition of a good quarter and the deletion
of a relatively poor one can do.” He further
stated that with such attractive absolute
returns, it would be difficult to make a case
to terminate Cullinan at this time.
The construction, meaning, and legal effect
of a written instrument are generally matters
of law for the Court. Morganfield National
Bank v. Damien Elder & Sons, Ky., 836 S.W.2d
893 (1992). As the Court found in its prior
opinion of February 4, 1998, the settlement
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agreement requires a written report,
initially and on a quarterly basis, which
includes the percentages for the trailing
three and five-year periods and any other
factors considered relevant by the financial
advisor.[emphasis omitted] See Section
7a(3). . . . Section 7a(5) states that the
Financial Advisor shall make such other
recommendations he/she deems appropriate for
the good of the Fund [emphasis omitted].
The Court finds that based upon the language
of the settlement agreement when read as
whole and interpreted in harmony so as to
give effect to all the provisions of Section
7, Garrels had the discretion to recommend in
the March 1997 and June, 1997 quarterly
reports that Cullinan be kept as a [sic]
investment manager with the Fund if he deemed
it appropriate for the good of the Fund and
its beneficiaries.
This appeal followed.
The City contends that in refusing to compel Garrels to
recommend Cullinan’s termination as investment manager due to his
failure to satisfy the performance requirements of the Agreement,
the trial court has failed to enforce the express language of the
Agreement.
We note at the outset that in construing the
obligations of parties to a contract, “it is not the function of
the judiciary to change the obligations of a contract which the
parties have seen fit to make.”
O.P. Link Handle Company v.
Wright, Ky., 429 S.W.2d 842, 847 (1968). “It is hornbook law that
the courts will not make a contract for the parties; it will only
interpret and enforce the contract which the parties themselves
have made.”
Haldeman v. Haldeman, Ky., 197 S.W. 376, 379 (1917).
Any interpretation of the Agreement between the City
and the Fund depends on how Section 7a.(5), which allows the
Financial Advisor “to make such other recommendations as [he] may
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deem appropriate for the good of the Fund,” is interpreted in
light of Section 7c.(1), which requires that “the Financial
Advisor shall recommend removal of any Fund investment manager
who . . . is not among the top one-half of appropriate investment
managers” (emphasis added) for certain specified periods of time.
In holding that
Section 7a.(5) gives the Financial Advisor
discretion to not recommend termination of an investment manager
who has failed to meet the performance requirements of the
Agreement, we believe that the trial court has improperly changed
the obligations set forth in the Agreement.
There are several
grounds on which we base our decision.
Under Section 7a. of the Agreement, the duties of the
Financial Advisor are set forth.
Pursuant to that section, the
Financial Advisor is required to submit an initial report
followed by monthly, quarterly, and yearly reports, all of which
are required to contain certain enumerated items and
recommendations.
At the end of Section 7a. is (5), which allows
the Financial Advisor to make other recommendations “at any time
which he deems appropriate.”
We believe that the discretion
granted in Section 7a.(5) extends only to the reports allowed
under the provisions of Section 7a., and further find that it
gives the Financial Advisor the discretion to make
recommendations at any time he see fit, and not just in
conjunction with the reports he is required to issue.
A prime example of the discretion allowed the Financial
Advisor under this section is Garrels’ decision to use a riskadjusted basis for evaluating Cullinan’s performance.
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Contrary
to the City’s assertion, there is nothing in the language of the
Agreement which requires the Financial Advisor to utilize a
direct heads-on comparison with other financial investment
managers.
In fact under Section 7a.(1)(a), the evaluation
analysis is to include an evaluation of “the performance of
existing Fund investment managers as compared to such other
investment managers as determined appropriate in writing by the
Financial Advisor.” [emphasis added] Hence, under the terms of
the language it was appropriate for Garrels to recommend that
Cullinan’s performance be evaluated on a risk adjusted basis if
that is what he believed to be appropriate for the good of the
Fund.
Because the initial report prepared by Garrels showed that
Cullinan met his performance requirements under the Agreement
based on the risk adjusted measurement, the trial court was
correct
in holding in its opinion and order of February 2, 1998
that a recommendation calling for Cullinan’s removal was not
warranted.
However, the discretion granted by the Financial
Advisor under Section 7a.(5) does not extend so far as to allow
him to avoid recommending termination of an investment manager
whose performance does not meet the requirements set forth in the
Agreement.
Furthermore, it does not allow the Financial Advisor
to ignore the performance requirements of the Agreement in favor
of
his own criteria in determining whether to recommend removal
of an investment manager as it appears Garrels has done in this
case.
Under Section 7c.(1), it is clearly stated that “[t]he
Financial Advisor shall recommend removal of any Fund investment
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manager” [emphasis added] once he determines in either an initial
or quarterly report that the person is not meeting the
performance requirements set forth under the Agreement.
We
believe that the use of the word “shall” in the Agreement
dictates such a result.
In fact, it appears that even Garrels
recognized that this recommendation requirement was not
discretionary in his quarterly report.
Further support for our conclusion can be found in
Section 7c.(2), which clearly places the discretion as to whether
to remove an investment manager with the Fund’s Board of
Trustees.
As provided by that section, once the Financial
Advisor has recommended the removal of the investment manager, it
is the Board who must decide whether or not to accept the
recommendation.
The Board is not compelled to accept the
recommendation of the Financial Advisor, and may choose to retain
an investment manager in light of the Financial Advisor’s
recommendation to the contrary if it so chooses.
We recognize that the trial court has taken an active
interest in doing what is best for the Fund and its beneficiaries
and commend the trial court for its handling of what has truly
become a contentious and highly technical case.
We also agree
with the trial court’s reasoning that the removal of Cullinan as
Fund investment manager is more than likely not in the best
interest of the Fund based on the analysis set forth in Garrels’
quarterly report.
However, this does not alter the fact that
under Wright and Haldeman, the trial court is not permitted to
substitute what it feels is the proper solution for what is
-16-
clearly called for under the terms of the Agreement.
Because the
terms of the Agreement clearly and unequivocally call for Garrels
to recommend Cullinan’s termination when he is not meeting the
performance requirements contained in the Agreement between the
City and the Fund, the trial court erred in finding otherwise in
light of the findings contained in Garrels’ quarterly report.
Because we find that the trial court erred in not
enforcing the terms of the Agreement between the City and the
Fund, we need not address the City’s arguments considering the
propriety of the trial court’s refusal to consider the testimony
of its expert witness as presented at the May 5, 1998, hearing on
the City’s motion.
The testimony presented by the expert has no
bearing on the outcome of our decision.
Having considered the parties’ argument on appeal, the
opinion and order of the Jefferson Circuit Court entered
February 2, 1998, is affirmed to the extent that it finds that
Garrels was not required to recommend the termination of Cullinan
as investment manager based on his initial report.
The opinion
and order of the trial court entered April 17, 1998, is vacated,
and this matter is remanded for further proceedings in accordance
with the terms of this opinion.
ALL CONCUR.
BRIEF FOR APPELLANT:
BRIEF FOR APPELLEES:
Donald L. Cox
Mary Janice Lintner
Louisville, KY
O. Grant Bruton
John W. Bilby
Louisville, KY
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