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The job of directors' and officers' liability underwriters is going to get a lot tougher as unexpected risks sprout from the further deregulation of financial markets, according to former Securities and Exchange Commission Chairman William Donaldson.

"It seems to me that the escalating challenge you face is to assess the governance and risk control measures in place with your clients as clearly there will be unexpected risks that will appear," said Donaldson, also formerly the CEO of the New York Stock Exchange.

"Clearly as the globalization of financial markets and as the cross-border nature of investing accelerates, we're increasingly faced with an inadequacy of our current regulatory entities in the jurisdiction framed in a simpler past period," he said. The Sarbanes-Oxley Act of 2002, for example, was an attempt to update compliance regulations dating back to the mid-1930s.

Donaldson cited the registration of the growing hedge fund industry as an example of a segment of the financial services sector that needed more oversight, particularly since the industry is expected to grow, according to one estimate, to $21 trillion in 2012 from $6 trillion today.

"It's such a shifting environment that you'll be forced to assess the risks and determine the pricing of D&O insurance that will be sought," said Donaldson, the keynote luncheon speaker at the annual gathering of the Professional Liability Underwriting Society on February 6 in New York.

What used to be a routine assignment for underwriters--covering directors and officers of private equity firms for those seeking it--has become more difficult as these funds use borrowed capital or form separate companies to buy other companies.

"Risk profiles are varied and we need the underwriter to understand the business," said Nicolas J. Conca, managing principal of Integro Insurance Brokers. Many of the top managers running private equity funds today are highly educated, love numbers and understand risk; and these managers will expect the same of their broker, he said.

For example, funds often buy the minimum amount of coverage, reasoning that their management teams will not be at fault should a plaintiff slap them with a class-action suit, said Conca. By contrast, a corporate risk manager for a Fortune 500 company tends to be more risk averse, and is more likely to buy the maximum D&O coverage.

Even trickier for underwriters is the liability of a director serving in two roles: as the director of an investment portfolio, and as a partner of a separate firm that invests in that portfolio.

Carl E. Metzger, a partner at Goodwin Proctor LLP in Boston, said class action suits are beginning to name the individual director as a plaintiff and the private equity firm as well.

A deregulated financial services world, while it has made access to capital easier and cheaper, has also meant more risk.

"The immediate repackaging of mortgage instruments for sale has obviated much of the responsibility for restrictive covenants since the instruments will be resold immediately," said Donaldson.

As a result of the subprime mortgage meltdown, banks, brokerages and bond insurance companies are facing a raft of professional liability-related litigation.

April 1, 2008

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