Alternative Asset Managers And D&O Insurance…To Hedge Or Not To Hedge?

Jun 2 2011 | 3:22pm ET

By Scott Davidoff, William Gallagher Associates -- Do hedge funds need directors and officers (D&O) liability insurance? That’s a tough question to answer. Let’s start with another question…

Do most hedge fund managers understand the reasons for purchasing D&O insurance? No. 

While a D&O policy will pay for defense costs, judgments and settlements rendered against a fund and its directors, officers, general partners, and investment advisors for a wrongful act, the way a manager should think about coverage is in respect to defense costs only. A D&O policy is not intended to provide catastrophic coverage and should not be viewed as such.

In order for a manager to make the right call on whether or not to buy D&O insurance (which also incorporates errors and omissions coverage), a hedge fund manager needs to understand both the tangible and intangible cost factors such as: how much money will it cost me to defend a regulatory claim? An investor claim? An employee claim? Can I or do I want to self-insure or pass along the costs to investors? And in the event of a claim, how will that hurt investor returns, my reputation, and my capital raising efforts?  After determining a course of action, your insurance broker should be able to guide you in obtaining appropriate limits. 

Is there a regulatory requirement in the new Dodd-Frank Law to obtain D&O insurance? No.

However, Dodd-Frank has upped the ante on exposure to hedge fund managers, so that the potential for increased claims is more evident now than ever. Mary Schapiro, chairperson of the SEC, has been tasked with weeding out corporate malfeasance and has set her sights on hedge funds. In addition to the creation of an Asset Management Unit that will focus on hedge funds, newly-empowered SEC auditors have subpoena capability, obviating the need for lengthy committee reviews, which creates an effective weapon in the SEC’s arsenal.

While a D&O policy will not provide coverage for general SEC sweeps, a well-worded policy can provide formal and informal investigation coverage. It is anticipated that once Dodd-Frank takes effect on July 21, the sub-billion dollar SEC registered hedge funds will be targeted initially for surprise examinations by auditors. 

Do investors require D&O insurance?  Some do.

Savvy institutional investors understand that going “bare” is troubling since in the event of a claim, a manager is permitted (as per the Private Performance Memorandum) to liquidate fund positions  in order to provide for a manager’s defense, which can be devastating to fund returns. Further, more institutional investors are asking the D&O question of managers, while others are mandating D&O coverage prior to an allocation as investors like the comfort of a backstop should a manager not live up to expectations. 

Do independent directors require D&O insurance?  Again, some do. 

Obtaining the best independent directors to sit on a fund’s board to guide growth is vital. An independent director will usually require either a formal contract to provide protection against a claim or in lieu of a contract, require a D&O policy for said protection.

Is this a good time to buy D&O insurance?  Yes. 

D&O insurance premium rates that should have increased after the economic debacle of 2008 have paradoxically plummeted by 25% or more. Why? Contributing factors such as a lack of claims resulting from Madoff, Bear Stearns and the sub-prime fiasco, coupled with the once rich premiums, which enticed insurance carriers to jump into the market, have since pushed down rates drastically. 

So, back to my original question…

Do hedge funds need Directors and Officers liability insurance?  You already know the answer.

Scott Davidoff is an insurance broker at William Gallagher Associates, in the Financial Risks Practice Group, where he works with hedge funds to create professional liability (D&O/ E&O) programs.  Scott can be reached at 212-784-5630 or sdavidoff@wgains.com.

 


In Depth

JOBS Act Propels Real-Estate Crowdfunding Platform

Oct 21 2014 | 2:57am ET

If D.J. Paul were a real estate development, he would be described as “multi-use...

Lifestyle

Strippers Accused Of Robbing Hedge-Fund Manager Face Jail

Oct 20 2014 | 9:20am ET

A group of alleged stripper-thieves—whose victims include a hedge-fund manager...

Guest Contributor

PAAMCO: European Equity Exposure - Challenging Year, But All is Not Lost

Oct 16 2014 | 4:12am ET

European equity hedge fund managers have had a tough time so far this year. The...

 

Videos

Editor's Note

    Must Attend Hedge Fund Charity Events For October

    Sep 30 2014 | 9:29am ET

    The crisp Autumnal days of October are upon us, and so are a few of the hedge fund industry’s favorite charitable events. If you have never been to Rocktoberfest, well, you are missing out. And for a quieter evening of sipping and socializing, stop by HFC’s Wine Soiree. Read more…

 

Futures Magazine

October 2014 Cover

Deeply flawed risk benchmark

Most traders agree that proper risk management is the key to successful trading. However, many traders depend on the deeply flawed measure of standard deviation as a benchmark of risk. Here we put it ...

The Alpha Pages

TAP July/August 2014 Cover

The Alpha Pages Interview: Senator Rand Paul

Senator Paul sat down in the debut series of the Alpha Pages Interview to discuss the broken tax code, regulation surrounding Bitcoin, and his plans for the 2016 Presidential election.