With enforcement actions and investor lawsuits on the rise, Timothy Spangler, Partner, Berwin Leighton Paisner LLP, outlines the benefits of liability insurance.
Over the past five years, the number of hedge funds has increased to over 8,000, with assets under management exceeding USD 1 trillion. Generally speaking, hedge funds operate with few constraints in order to achieve the absolute return, or 'alpha', that they seek. As the funds themselves are largely unregulated, the investor relies primarily on the directors of the fund to oversee the arrangements entered into with third parties, such as the investment manager.
By contrast, unless particular exemptions apply, the investment manager will often be subject to regulation by an onshore regulator such as the US Securities and Exchange Commission (SEC) or the UK Financial Services Authority (FSA).
Unsurprisingly, enforcement actions and investor lawsuits have also been steadily on the rise. In the United States, the SEC filed more than 20 enforcement actions against hedge funds last year. The FSA has also begun proceedings against hedge funds and their portfolio managers under the new market abuse regime. Significant fines have been handed out in recent months.
The question of fraud or malfeasance in hedge funds is an issue both for investors and fund managers. Perhaps most importantly, though, it is an important concern for the directors of the hedge funds themselves. Of particular relevance are allegations involving any of the following circumstances:
- improper valuations;
- failure to supervise; or
- trading errors.
Certain operational procedures can be adopted to reduce the risk of fraud, negligence and reputational damage, including:
- comprehensive screening and vetting procedures for all new personnel;
- regular training on anti-money laundering procedures and fraud prevention;
- confidential whistle-blowing procedures;
- codes of ethics; and
- appropriate compliance procedures.
A regular review of the systems and controls of a hedge fund will enable the directors (as well as the investors) to identify and adequately address unacceptable risks. However, no matter how comprehensive the procedures or how frequent the review exercise, some risk will inevitably remain.
Directors of hedge funds, therefore, should consider the desirability of two different types of liability insurance:
- directors' and officers' liability insurance (D&O);
- professional indemnity insurance (PI).
D&O policies cover the exposure of an individual company director to personal liability for 'wrongful acts', which include acts or omissions that are negligent, outside their authority or in breach of duty or breach of trust committed in the capacity of a director.
Although indemnities from the fund to the directors are often included in the constituent documents (eg memorandum and articles of association, prospectus), there can be no guarantee that at the time a director may need to enforce the indemnity, there will be assets available.
PI provides protection to an investment manager when he is faced with claims for negligence or breach of contract relating to the professional services provided by him. By providing advice for a fee, a manager owes a duty to provide his advice to a certain standard, and may be liable for any shortcomings.
As the hedge fund and the fund management firm are separate legal entities, where an individual serves both as a director on the hedge fund's board and as a fund manager, he must be aware at all times of potential conflicts of interest and ensure that he represents the interest of fund shareholders above his own in the discharge of his fiduciary duties.
If the fund and the manager can be issued under the same policy, there can be substantial cost savings. In practice, a claim by an investor is likely to name both the fund directors and the fund manager. A single policy can be more efficient, but it needs to be remembered that when all parties are insured under the same policy, the level of indemnity under the policy is likely to be available only once for all claims arising for the same circumstance.
D&O policies cover directors for claims arising from a 'wrongful act', which is the common wording used in D&O policies as the trigger for a claim under the policy. Some policies include as part of this definition a list of categories of claim; others have no further definition. Coverage normally includes all past, present and future directors.
Where a claim made by a regulator (eg FSA, SEC) involves an identifiable 'wrongful act', such claim should be covered by a D&O policy. There can also be an extension of coverage for legal costs to include situations where directors are required to submit to a regulatory investigation, even when no 'wrongful act' is yet identified.
PI policies can provide that claims by regulatory authorities will only be covered when:
- the regulator is making the claim on behalf of clients of the investment management firm; and
- such claim would otherwise have been covered by the policy.
Fines by regulators are not generally covered, as it is contrary to the public interest. The FSA has issued a specific notice prohibiting authorised bodies from insuring against such fines.
In recent years, both D&O and PI have seen significant premium increases and expanding restrictions on coverage. This has led to difficulties for hedge funds in obtaining sufficient coverage, although at present there seems to be sufficient insurance capacity available to meet most requirements.
Fund directors and investment management firms can improve an underwriter's understanding of the relevant risks by demonstrating the following:
- good risk management structure and culture;
- adequate information transparency on the funds;
- profitability/strong performance data;
- proven track record of fund management firm;
- investor profile.