By RICHARD A. MALOY JR., CIC CRM,
chairman and CEO of Maloy Risk Services Inc., a provider of liability insurance and risk management services to hedge funds, venture capital funds, life sciences and technology companies.
In August of 2008, a major hedge fund shuttered its flagship fund and closed several smaller funds, which became the first in a string of prominent fund closures over the next two and half years. Many funds were suffering from redemptions and reallocations by their investor base and were forced to shut down.
As the markets recovered in mid-2009 and 2010, many fund managers simply felt the time was right to walk away. Having just recouped much of their losses, 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 the Dodd-Frank financial reform law.
Why deal with the regulatory environment when they could open a family office and invest their 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 assume all of the additional costs for the "new" infrastructure and reporting requirements for registration?
So many veterans simply decide to take their ball and go home.
What does all of this mean for the remaining hedge-fund managers and their exposure as directors and officers?
In spite of insurance company concerns about regulatory investigations, insider trading and expert-network usage, insurance rates have fallen precipitously over the past few months for several reasons.
The insurers are getting a wealth of information--more transparency--from the hedge funds. This is the same information that is requested by an investor, which translates into better underwriting. Secondly, a directors' and officers' liability insurance policy is a fund expense and helps funds justify its purchase because it creates a greater spread of risk for insurers. Investors and independent directors are also requiring funds to show coverage, leading to the proliferation of policy purchasing, which gives insurers more actuarial data and more premium dollars to pay claims, lowering costs further.
As a result, more insurers have entered the space, chasing the high premium and low claims frequency of hedge fund D&O coverage and creating competition. The competitive environment has led to better pricing and better policy construction and coverage.
The D&O policy of 2011 has embraced the changes driven by manuscript policy language from lawyers, competent insurance brokers and insurers. The new policy forms that have been launched in the past four months by several major industry players have brought a wealth of new coverage and have enhanced outdated concepts and language.
The definitions, exclusions and insuring agreements must be analyzed and modified for each fund due to their unique structures, and manuscript policy language, once the privy of larger funds, has now become a more mainstream policy by several insurers.
The following are critical areas that have changed and need to be carefully reviewed; otherwise, hedge funds may end up with an older policy form that leaves many exposures uninsured:
1. The definition of claim must include Wells notices, target letters and subpoenas, which often happen prior to a formal investigation. Without these coverage triggers, you would incur defense costs to respond that would not be covered until an actual formal order was brought, which can be significant.
2. The fraud and personal profit definition must include final non-appealable adjudication language, which means that the policy will defend the hedge fund director or officer against allegations of fraud or ill-gotten personal gain until a final verdict, including any appeal. We highlight "non-appealable" because this is relatively new language.
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 that states that only the services performed for the fund are covered. The definition of fund does not include managed accounts so any managed account would fall through the cracks. It should be amended to include all service performed for any contract for a fee.
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. Most older policies are set up as a parent and subsidiary relationship, which leaves many uncovered entities within general partnership and limited liability corporate structures.
6. The contract exclusion needs to have a carve-back (which puts coverage back in) for the activities defined in the limited partnership agreements and should also include a carve-back for defense costs for breach of a contract.
7. The insured-versus-insured exclusion needs several carve-backs: pollution for derivative suits, advisors committee, bankruptcy trustees and whistleblowers.
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. That way, the knowledge or acts of one cannot be imputed to others.
11. Cost of corrections coverage is now 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 this endorsement, however, you no longer need litigation to trigger the policy.
This list provides a sample. A full-blown list is beyond the scope of this article.
This is a good time to be a buyer of hedge fund D&O and professional liability insurance. Further price reduction hinges on how aggressive the Securities and Exchange Commission, U.S. Commodity Futures Trading Commission and other regulatory agencies become over the next 12 to 18 months. Premiums were significantly lower in 2010 and continue to move lower in 2011 due to the sheer number of interested insurers. If the whistle blower claims gain their projected momentum in 2011, premiums may begin to rise and coverage may get restricted in 2012.
Only a few years ago, the litigation cost estimates due to failed banks, the implosion of mortgage real estate investment trusts and the collateralized debt obligation meltdown were in the hundreds of billions of dollars, which sent D&O and professional liability prices skyrocketing. In 2007, the average price for the first $5 million of coverage was approximately $20,000 per million. That increased to $30,000 to $35,000 in 2008, especially for any fund that showed poor performance and large redemptions.
Insurers were concerned about litigation focused on side pockets, lockups and preferential treatment during a wind down. Although there were some marquee claims--Pequot, Amaranth and Stanford (Galleon and Madoff had no insurance)--that hit insurers, the brunt of litigation that was expected did not materialize. That which did was based on insider trading or fraud and not the actual winding down of the funds.
Many of the marquee cases and the vitriol against Wall Street led to a new regime at the SEC, run by Robert Khuzami, head of SEC enforcement. Khuzami has since restructured the division and the SEC has had several major successes, Galleon being the current and most prominent. If you look at the Galleon case, the SEC's use of wiretapping signals a new aggressiveness.
The passage of Dodd-Frank and, in particular, the provision within it that extends whistle-blowing into the private sector, is projected to bring on an onslaught of claims. Whistleblowers can receive up to 30 percent of the fines and penalties, which could create a new cottage industry for plaintiffs' attorneys and their clients.
This new era of enforcement puts hedge funds in the cross hairs. Insurers will be monitoring the insider trading cases from whistleblowers and the use of expert networks because their policies now cover regulatory investigations. The use of expert networks has become one of the most scrutinized areas of a hedge funds' compliance and due diligence by the insurers.
Funds also need to be concerned with fund closure; bankruptcy; stepping outside of the strategy; fraud; trade errors; miscalculation of the net asset value; breach of fiduciary duty; and employment-related issues surrounding wrongful termination, discrimination and sexual harassment. All contribute to professional liability claims.
August 1, 2011
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