Caught in the Crosshairs: Reducing Your Hedge Fund’s Liability & Protecting Individuals in Litigation

In a post-Dodd-Frank world, hedge funds and their managers face increased scrutiny and regulation – and as a result, litigation and regulatory investigations are a reality.

Since hedge fund managers face the same unlimited liability as any other corporate director or officer, it’s important they understand the protection available to them. Let’s look closer at that now.

Mitigating Risks to Personal Net Worth and Fund Assets

Most hedge fund limited partnership agreements have fairly broad indemnification provisions that require the firm indemnify the hedge fund manager and its partners, directors and officers for claims and expenses incurred by them in connection to their good faith performance of investment advisory activities on behalf of the fund.

However, the parties cannot be indemnified for conduct that constitutes fraud, gross negligence, willful misconduct or bad faith.

Because of this limitation, as well as the fact that indemnification would be unavailable in the case of bankruptcy or if the fund is wound down and assets distributed, additional personal asset protection is necessary.

This is where directors and officers (D&O) and errors and omissions (E&O) coverage comes into play. These policies cover the personal assets of the individuals when indemnification is unavailable, and pay on behalf of the fund its indemnification obligations to the individuals (when indemnification is available).

The coverage is triggered when a claim is first made, and protects:

• Individual directors, officers, partners and employees of the hedge fund manager/advisor
• The advisor entity itself
• The directors and officers of the fund and the fund entity

The Amount of Insurance Purchased is Dictated by Risk Appetite

There are generally three types of buyers when it comes to insurance:

1. Those who simply want to “check the box” to satisfy minimum investor or independent director requirements
2. Those who want coverage for defense only
3. Those who purchase enough to fund a vigorous defense with enough left over to pay judgment and/or settlement amounts

The cost of these types of insurance coverage is influenced by a variety of factors, including the investment strategy and total assets under management (AUM). Other factors when securing coverage include the experience and pedigree of the investment managers and prior litigation history.

Most startup hedge funds with AUM under $100 million purchase $1 million to $2 million in coverage. Those in the $200 million and higher category typically secure $3 million to $5 million in coverage (and even higher in some instances).

Once the AUM rises above $1 billion, you’ll generally purchase limits equal to 1 percent of the AUM (and more for complex, illiquid or hard-to-value strategies).

The annual minimum price per million costs about $15,000, but that rate is often discounted when purchasing higher limits.

As a hedge fund, you might also consider a couple additional types of coverage:

1. Employment practices liability (EPL): This responds to claims by employees alleging wrongful termination, sexual harassment and discrimination.
2. Trade error/cost of corrections coverage: This reimburses the fund and/or adviser for costs to correct trade errors that could have resulted in claims by clients or investors.

Remember …

All investment strategies are susceptible to claims by investors, regulatory bodies such as the Securities and Exchange Commission, and employees.

Those who don’t invest in this type of coverage often rely on the broad indemnification language in the hedge fund to protect them; but remember, any litigation costs paid out of the fund’s assets will directly impact the investment return of the fund.

That’s why it’s crucial to secure the type of coverage that can pay on behalf of the insured entity and its indemnification duties to individuals.

The aim is that D&O and E&O policies never have to be triggered, but they provide a critical safety net for hedge funds that land in situations that cannot be avoided.