An unprecedented court battle has begun between one of the world's biggest investment managers and one of Britain's biggest pension funds.

Trustees of the pension fund of Unilever, the consumer products giant, want �130m in compensation from the US-owned investment house Merrill Lynch.

They claim Merrill Lynch was negligent in the way it managed more than �1bn from Unilever's pension fund between 1996 and 1998. Merrill Lynch has said the claim is groundless.

The battle has caught the City's imagination because it pits two of the City's most powerful women against each other.

Inherited dispute

Merrill Lynch inherited the dispute when it bought Mercury Asset Management (MAM) for �3.1bn in 1997 - a takeover that made millions for the two executives who then ran Mercury's hugely successful investment operation, Stephen Zimmerman and Carol Galley.

Since the 1970s, most of the country's biggest pension funds entrusted their assets to MAM, which built a reputation for excellence in making high returns.

By the late 1990s, MAM was managing around �100bn of assets and exercised considerable power as a major shareholder in Britain's leading companies.

Ms Galley was nicknamed "the Ice Queen" of the City after using MAM's shareholdings to clinch Granada's hostile takeover bid for the Forte hotels group.

Earlier this year, she departed from Merrill Lynch to pursue other interests.

Below target

In 1996 Unilever's pension fund - whose chief operating officer Wendy Mayall is another of the City's most successful female executives - negotiated terms for MAM to manage more than �1bn.

MAM's success at investing the money would be measured against an agreed "benchmark" based on the growth of a basket of UK and US shares. The fund manager agreed to try to beat the benchmark by 1% and to avoid under-performing it by more than 3%.

In 1997, MAM fell way behind its target. It had invested the money defensively in sectors such as building materials when other asset managers had more of their money on banks, insurers and pharmaceuticals.

After a few months it was more than 10% beneath its target. In spite of attempts to correct its performance, MAM finished by undershooting its target by 8%.

Sacked

In early 1998, Unilever sacked MAM as a fund manager. And in 1999, Unilever announced its intention to pursue its claim against MAM.

Unilever claims MAM took on too much risk in its investment decisions - more than its contract with the pension fund would imply - and is claiming negligence. MAM denies the claim.

If Unilever wins, further legal actions will be launched, with serious implications for the City's highly-paid fund managers.

They are already under fire for their lack of success in beating the performance of passive "tracker funds" which use computers to mimic the movements of the FTSE-100 and FTSE All Share indices.

MAM and other fund managers point out that it is in the nature of fund management for successful fund managers to go through periods of under-performance.

They also believe it is unfair to judge a fund managers performance over a short period - especially when they are expected to take a long-term view of prospects.

Ramifications

Lawyers believe that if fund managers can be sued for poor investment decisions - as well as sacked - it may boost the coffers of pension funds, but would ultimately force fund managers to charge more.

Robin Ellison, a prominent pensions lawyer with the City legal firm Eversheds, says: "If this battle goes to the bitter end then it will change the way City fund managers operate.

"If they think they can be sued then pension funds might benefit in the short term. But fund managers will be more reluctant to take the sort of risks in their investment decisions that they have to take to perform well.

"And their charges may go up because they'll have to cover legal costs when they didn't have to before."

The two parties may ask the High Court to adjourn the case if they believe an out-of-court settlement is possible.

But so far, all attempts at settlement have failed. If a settlement involves a substantial sum - tens of millions of pounds - then other pension funds may still feel obliged to follow with their own legal actions.