In the midst of last year’s global financial crisis, many fund executives and managers were not prepared for what lay ahead. Not only were they faced with deteriorating returns but also another risk—the threat of legal action. Investors and trustees instigated legal action against several funds in desperate bids to salvage investments threatened by the credit crunch.
Then came the Madoff scandal, and many hedge funds faced litigation brought by clients, investors, or regulators in an effort to uncover fraud and protect fund assets. These suits alleged a number of failures on the part of management, including breach of fiduciary duties, fraud, negligence in the management of the fund’s assets, and failing to conduct adequate due diligence.
The financial crisis, coupled with several large fraud findings, has fueled the already increasing litigation against funds and their boards. In the event of potential litigation, both fund managers and directors can be sued, and, if there is any insolvency situation, directors can be personally liable.
Directors are critical to setting the right tone at the top, reinforcing a strong culture of compliance and monitoring. In a fund’s prospectus, the directors will normally accept responsibility for the valuation of illiquid assets.
While implementation of clear procedures, areas of responsibility, and reporting lines all help to mitigate these risks, directors also need to consider risk mitigation and insurance in tandem with the fund manager.
While a standalone Directors & Officers Liability (D&O) insurance cover is available, we firmly believe that the directors of a hedge fund are best served by having a combined policy with the fund manager.
Importantly, claims management risks increase when separate policies are maintained, as litigation is likely to name both the manager and the board, and, in such situations, it can be difficult to determine what portion of the loss is applicable to the manager versus the board when there is a settlement.
Moreover, the fund indemnifies both the directors and the mangers, so insuring the fund indemnity obligation to both parties is critical. Additionally, substantial claims efficiencies are achieved through a combined policy.
While no hedge fund manager likes to consider the possibility of a lawsuit, the fact remains that hedge fund liability exposures exist, especially in the wake of an increased focus on corporate governance and greater regulatory scrutiny, and these exposures should be addressed through a comprehensive insurance program.
A well designed program can protect the assets of the firm as well as the manager and directors, including the time and money managers may spend in court hearings defending against litigation.
Many fund managers have implemented insurance for the first time in the last year or so. In some instances, this was to satisfy investor demand, but mainly, this has been the result of an increased focus on the fund’s risk and exposures and how to best address them.
In the coming years, we see this trend only increasing, especially as institutional investors and fund-of-funds revamp their own internal due diligence processes.
Sandy Crystal, Executive Vice President at Frank Crystal & Company