Hedge Fund Insurance: Think You Are Covered? Think Again

Oct 17 2011 | 1:26pm ET

By Richard Canter, SKCG Group -- Many hedge fund managers buy insurance coverage to protect them against lawsuits brought by investors and regulators--Directors and Officers Liability Insurance (D&O) and Professional Liability Insurance, better known as Errors & Omissions (E&O).  It’s worth reviewing these policies to make sure they reflect the hedge fund industry’s growing complexity.  Here are five important areas that deserve attention:
 
1. Make sure your policy covers the cost of a “Formal Investigation.”
 
Let’s say the SEC sends a Wells notice, a target letter with a subpoena announcing it has launched a formal investigation of your firm for misrepresenting returns and net asset values, a violation of SEC rules, or some other infraction.  If the fund’s policies only cover the costs of the defending you in a lawsuit, and not the costs of the formal investigation, you could then spend a small fortune providing documents to the regulators, only to have the investigation dropped before it reaches litigation – the point at which your insurance would have otherwise kicked in.  And by the way, the insurance carriers have greatly restricted or eliminated insurance for “informal investigations,” which can also be expensive.

2. Make sure every investment-related activity is disclosed to your insurance carrier and that the activity is covered.
 
In recent years, some hedge funds have combined their trading strategies with private equity activities or even investment banking. Be aware, however, that unless the policy specifically includes these other activities, they may not be covered by insurance in the event of an allegation of a “wrongful act.”

3. Determine whether your insurance will pay for defense against fraud allegations throughout the appeals process.
 
If an investor or a regulator sues for fraud, most insurance policies cover the litigation costs until and if the manager is found guilty. But what if the manager decides to appeal the decision? Try to obtain coverage so that the entire appeal process is covered.

And keep in mind the individual directors and officers are concerned that the personal conduct of their peers is not imputed to them for the purpose of determining available coverage.

4. Make sure each fund, including each limited partnership, is listed on the policy as a named insured.
 
Quite often, a hedge fund manager buys a policy that covers the adviser or the general partner and “its subsidiaries,” and mistakenly assumes “subsidiaries” means the individual funds structured as limited partnerships. In many policies the definition of a subsidiary does not include partnerships. 
 
Therefore, relying on the automatic subsidiary language to provide coverage for limited partnerships, which is a common fund structure, may mean no coverage at claim time.

5. And finally, if you manage retirement money, make sure you obtain Fiduciary Fidelity Coverage.
 
Some hedge funds feel they have made great strides when a pension fund invests money with them.  But there are increased responsibilities that go with managing retirement money, and hedge funds need to buy appropriate coverage. For example, the ERISA requirement is that (except in certain circumstances) you must provide a $500,000 Fiduciary Fidelity limit for each plan. The good news is that Fiduciary Fidelity coverage isn’t expensive.
 
Those are five (of many) red flags of hedge fund insurance.  Ask your insurance provider about these situations.  By asking a few questions today, you may save time, money and aggravation tomorrow. 
 
Richard S. Canter is the Chief Operating Officer of SKCG Group, one of the largest independent insurance agencies in the U.S., currently advising over 170 hedge fund clients.


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