As hedge fund industry matures, so do its liability risks

Hedge funds are exposed to increasing risks from regulators, market conditions and the public

There are three things you can be sure will happen during your time on earth: death, taxes and plaintiff’s attorneys chasing the money.

Hedge funds have the money! However, hedge fund managers are the epitome of perfection and therefore need no insurance. Right? No matter how well run a hedge firm is, they are exposed to serious liability risks given the current regulatory environment, volatile market conditions, and the public concern regarding corporate governance. Just wait until the next market downturn occurs to see how insulated hedge funds are.

Who sues hedge funds? Try investors, limited partners, competitors, regulatory agencies, companies in which the hedge fund has invested, etc.

What are the liability risks?
The risks faced by a hedge fund include: misrepresentation, fiduciary breaches, oversight failures, negligence, fidelity or crime, and employment practices.

Misrepresentation — These involve claims that the fund misrepresented the investment risks, its performance or financial condition. For example, class actions resulting from investment strategies managers failing to disclose in their private placement memoranda.

Fiduciary breaches — If the fund acts as an administrator, or investment advisor or service provider for a pension, employee benefit, group life or medical expense plan, there could be claims that there were violations for example, of ERISA (Employee Retirement Income Security Act of 1974) or common law fiduciary obligations. Furthermore, legislation is being proposed that requires hedge funds that accept pension fund money to register with federal regulators.

Oversight failures — This involves claims based upon the alleged failure to supervise outside service providers.

Negligence — This is the professional liability cover. For example, incorrect sales executions, mismanagement, inadvertent failure to follow investor instructions, etc.

Fidelity or crime — Covers the rogue employee who steals from the “till.”

Employment practices — Encompasses sexual harassment, wrongful termination, failure to promote and the like.

Is a hedge fund immune from such liabilities? Go tell it to the founders and managers of Amasanth Advisors LLC, the hedge fund that lost $6.5 billion on the gas market, which is being investigated for alleged manipulation of gas prices.

Or think about what the eventual fallout will be for the sub-prime mortgage market.

Moreover, hedge funds are now starting to grow-up. Citadel Finance, a unit of the Citadel Investment Group, a $12 billion hedge fund, announced last December it intended to issue $2 billion in bonds. Fortress Investment Group is going public. With grown-up assets and liabilities … grown-up insurance will be needed.

What types of insurance?
Hedge funds need certain key insurance lines to protect against such risks including (among others):

1. Directors and officers liability or general partnership insurance to protect the decision makers. (Side A coverage should be a focal point.)

2.Professional liability (E&O) insurance to protect the fund and the managers.

3. Fiduciary and trustee insurance.

4. Crime/fidelity insurance.

5. Investment advisor insurance.

6. Employment practices insurance.

7. Key man life insurance in case the fund is highly dependent upon the expertise of one or several key men or women.

Hedge funds also need to think about the more mundane areas of insurance: property, casualty, workers’ compensation, excess liability, etc.

How much?
Insurance companies will often require a minimum of $150 million assets under management (AUM) and sell a $1 million policy at that level (with a $100,000 retention). We have also seen an investment fund with $10 billion AUM purchase more than $60 million in coverage. However, loss history and potential future problems are a better indication of future claims than total assets.

Of note is the fact that premiums are falling for D&O insurance while rising for property insurance.

Messy exclusions
Underwriters have a habit of sneaking in limitations to the breadth of coverage they are selling. Insurance companies are limiting regulatory investigation coverage. They are also widening the exclusions for personal profit and wrongful acts. Under older policies, the exclusions would not kick in until there was a “final adjudication” of fault. The current policies use a more nebulous “in fact” standard.

Insurers are also narrowing the severability language of their policies (which protects innocent officers from the wrongful conduct of other officers).

In addition, insurance companies are also issuing specific additional exclusions such as: fair market valuation; selective disclosure; market timing; front running; conflict of interest; laddering; late trading; and failure to maintain insurance.

Insurance brokers should review their hedge fund clients’ existing insurance coverage. The limitations listed above can be expanded through negotiation and the added exclusions can be limited. A knowledgeable buyer can beat many of these new exclusions and policy restrictions.

R. Mark Keenan is a senior shareholder in the New York office of Anderson Kill & Olick, P.C. and chair of the firm’s Financial Institutions Group. He is a lawyer in the fields of insurance, securities law and litigation and represents policyholders in insurance coverage disputes. Contact: 212-278-1888 or mkeenan@andersonkill.com.

Topics Legislation