Critical Areas of Liability Coverage for Hedge Fund Managers and Directors

By Richard A. Maloy, Jr, CIC CRM, CEO Maloy Risk Services, Inc.

 

In the fourth quarter of 2008, several marquee funds and many smaller funds closed their doors due to poor performance, which became the first in a string of prominent fund closures over the next three years. Many of the funds were suffering from redemptions and reallocations by their investor base and were forced to shut down during 2008 and 2009. As the markets recovered in mid-2009 and 2010 many fund managers simply felt the time was right to walk away. Having recouped much of their losses during 2010, they could return the assets to investors on solid terms and not have to deal with the regulatory scrutiny and reporting that was coming with the passage of Dodd Frank.

 

Why deal with the regulatory environment when you can open up a family office and invest your own billions? Why deal with the headache of investors, who have to reallocate exposure during every downturn, leaving the fund with limited assets and leverage? Why add all of the additional costs for the added infrastructure and reporting requirements for registration? What was the point of being subjected to the scrutiny of a revamped SEC targeting the industry? So many veterans simply decide to take their ball and go home. So what does all of this mean for the remaining hedge fund managers and their exposure as Directors?

 

First let’s provide a backdrop of the past. The litigation cost estimates due to failed banks, the implosion of mortgage REITs and the CDO meltdown were in the hundreds of billions of dollars, which sent prices skyrocketing for Directors and Officers and Professional liability. The price for the first $5M of coverage was $20K per million in 2007 and moved to $30-35K in 2008; especially for any fund that showed poor performance and large redemptions. After the headlines died down in 2009 and the claims for hedge funds were less than expected, rates dropped to below 2007 levels to about $15K per million. Fast forward to 2012 and a slew of insider trading cases during the past two years have once again hardened the market and rates have steadily moved up since late 2012 and have continued to steadily climb through 2013 but a more modest pace. Today the rates are $20K to $25K back to 2007 levels but not quite crisis pricing of 2008.

 

With the appointment of Mary Jo White as SEC Chairman, President Obama is continuing his pressure on the financial industry “it’s not enough to change the law…we need cops on the beat to enforce the law.” The continuation of a prosecutor as the head of the SEC keeps hedge funds and private equity firms in the crosshairs. Since the D&O policies provide protection for regulatory investigations, insurers are increasingly concerned about their exposure to high cost litigation from whistleblowers and expert network insider trading cases. The insurers are returning to the position that only formal investigations are covered, crafting language that funds must receive a Wells Notice, Subpoena or Target Letter to trigger the policy. The problem is that the SEC is now using Matters Under Inquiry (MUIs) that look and smell like a full blown investigation however do not use any of those formal triggers to force managers to provide information, leaving managers and funds without coverage for those costs. Carefully crafting policy language can provide an opportunity for coverage under the MUI scenario, but it is difficult and costly.

 

Beyond regulatory investigations funds need to be concerned with fund closure, use of expert networks and insider trading, bankruptcy, stepping outside of the strategy, fraud, trade errors, miscalculation of the NAV, breach of fiduciary duty, as well as employment related issues surrounding wrongful termination, discrimination, and sexual harassment. All contribute to D&O, E&O or Employment Practices Liability claims. The use of expert networks has become one of the most scrutinized areas of a hedge funds’ compliance and due diligence by the insurers.

 

The following are several critical areas that need to be carefully reviewed, but a full blown list is beyond the scope of this article.

 

1. The Definition of Claim needs to be scrutinized with an attention to the claim triggers, you can work in certain wording to help position coverage for informal investigations that look like full SEC investigations but do not have the formal triggers of a Wells Notice, Target Letter or Subpoena.

2. The Fraud and Personal Profit definition must include final Non-Appealable adjudication language, which means that the policy will defend you against allegations of fraud or ill gotten personal gain until a final verdict has brought including any appeal.

3. Definition of Professional Services must be broad enough to encompass all aspects of the management company and fund activities. Many older policies have limiting language, which states that only the services performed for the fund are covered.

4. Definition of Insured should be very broad and include independent contractors, temporary or leased employees, GC, CCO, Tax Director and other specialty positions.

5. Definition of Insured Entity is often narrowly defined and does not contemplate the complex structures of hedge funds. Allow much better now the older policies were set up as a parent and subsidiary relationship which leaves many uncovered entities within General Partnership and LLC structures. Be mindful of the Insured Entities.

6. The Contract Exclusion needs to have a carve back (puts coverage back in) for the activities defined in the LP agreements and should also include a carve back for defense costs for breach of a contract.

7. Insured Vs. Insured exclusion needs several carve backs: Pollution for derivative suits, Advisors Committee, Bankruptcy Trustees and Whistle blowers. (With the passage of Dodd Frank, whistle blower claims are going to be on the rise since the Act now allows whistle blowers to be paid 10-30% of any fines or penalties levied. The SEC is currently inundated with Insider Trading tips and trying to ferret out real cases.)

8. The newly created fund threshold should be large enough to gain automatic coverage for potential new funds during the policy period.

9. Amend the definition of claim notice to the CFO and GC.

 10. Make sure there is severability wording as it relates to the completion of the application, so that the knowledge or acts of one cannot be imputed to others.

11. Cost of Corrections coverage is available. The professional liability insuring agreement can be endorsed to include trade errors. Previously to gain coverage an investor or outside third party would need to bring a suit against the management company to gain access to coverage…the policy needed a claim trigger. By adding the CoC endorsement you no longer need litigation to trigger the policy, the trade error is now covered.

 

In a similar article I published in 2010, I stated that the rates of 2011 would continue to be modestly lower but the whistleblower activity may turn the market in 2012. In the last quarter of 2012 and through the first quarter of 2014 we see a definite hardening of the market with increases of 7-12% but have begun to see a leveling off, more flat renewals have been achieved so far in 2014. As the market continues to pull back on coverage terms and conditions, manuscript policy language (negotiated language with the insurer and your attorneys) are becoming less prevalent with only a handful of players willing to do them. Those policies command much higher premiums and retentions (deductibles) usually 25-35% more in cost than insurer based policies.

 

 

 

Maloy Risk Services, Inc. is a leading provider of liability insurance and risk management services to hedge funds, venture capital funds, life sciences and technology companies. To learn more about Maloy Risk Services, Inc., please visit their web site, http://www.maloyrs.com