By R. Mark Keenan and Craig M. Hirsch
Will losses from securities backed by subprime mortgages lead to litigation against my hedge fund and its managers? If so, will my directors and officers (D&O) insurance policy or other lines of coverage protect my firm and its individual directors and officers?
Certainly, many fund managers that suffered steep losses in the unraveling subprime marketplace need to prepare for the high probability of litigation. According to the Office of the Comptroller of the Currency, more than $1 trillion in securitized subprime debt is on the balance sheets of institutions outside the lending industry. These securities will likely take further hits as hundreds of billions of dollars in adjustable rate mortgages reset over the next year. Pending plans to freeze rates on large swaths of subprime mortgages may stabilize the housing market to a degree, but will also lead to further writedowns in the value of securities held by many alternative managers.
Already, at least 30 securities litigations have been filed against the subprime lenders, investment banks and now hedge funds that placed highly leveraged bets on packages of subprime mortgage derivative products. Investor-plaintiffs have even begun to prey upon directors and officers in their individual capacities, alleging untoward conduct and egregious mismanagement. These claims target the stewardship of hedge and private equity fund managers for failing to diversify the fund’s investments or touting the subprime security as an unassailable investment opportunity.
Will insurance companies cover the losses arising from the subprime debacle? In some cases, yes. According to Reinsurance broker Guy Carpenter, total subprime-related losses for D&O insurers alone could top $3 billion. However, those firms that do obtain defense and indemnification from their insurance providers are likely to have to fight for that coverage every step of the way. In this volatile climate, it is essential to know what insurance coverage is available to your firm and how the insurance companies may attempt to deny coverage.
Which Insurance Provides Coverage?
The most obvious protection will be found in your directors and officers (“D&O”), professional liability (“E&O”), and Financial Institution Bond (“FI Bond”) insurance coverages. D&O and E&O policies protect the fund and its managers, officers or general partners against losses due to an unintentional (negligent) act, error, omission, and/or breach of duty that could give rise to a claim. D&O insurance typically covers the directors and officers and the corporate-policyholder (where entity coverage is present). Similarly, standard form E&O insurance policies protect the fund and its various directors, officers, employees and affiliates, including securities brokers and dealers working for financial institutions and investment banks, for loss arising from alleged wrongful acts committed in their capacities as managers, representatives or agents of the fund. Finally, FI Bond coverage fills the void left by D&O and E&O insurance, covering hedge funds and private equity funds experiencing direct loss for their employee’s fraud and dishonesty, as well as losses caused by forgery, false pretenses and the like. All three lines of coverage may respond to subprime litigation.
D&O and E&O Insurance Coverage
The Importance of Notice
Notice of claim is an obligation the insured or policyholder must complete before seeking coverage. Most D&O and E&O policies put a specific time limitation on how late notice can be provided after the claim is filed, while others require notice “as soon as practicable.” It is vital that this notice obligation is satisfied or you could jeopardize your entire insurance claim from day one. Many D&O and E&O policies may contain a “notice of circumstances” provision permitting the fund to report informal complaints as to its subprime practices to lock into the policy period if a subsequent lawsuit develops from these circumstances.
Many D&O and E&O policies encompass “investigations by any governmental entity into possible violation of law” in the policy’s definition of “claim.” The insurance policies normally cover “defense costs” incurred from responding to a government or regulatory examination as well. The definition of “loss” will also include coverage for settlements and judgments arising from the underlying claim. Be careful – insurance companies often argue (and at least one court has upheld) that an informal document request from the Securities and Exchange Commission regarding your hedge fund or private equity fund’s subprime activities -- as opposed to a formal investigation with the exercise of subpoena power -- will not be considered a “Claim” as defined by most D&O and E&O policies.
One of the most prominent exclusions found in D&O and E&O policies is a “bad acts” exclusion. The insurance companies will attempt to deny coverage for liability based on allegations of fraud, criminal acts or intentional conduct arising from improper subprime practices. However, in the vast majority of cases, the exclusion is not triggered merely because a fraud is alleged. Only after the underlying claim is adjudicated in a court of law may the insurance company rely upon the exclusion. The insureds are entitled to advancement of legal costs, subject to recoupment by the insurance company only if a final adjudication shows the claim is not covered.
Other exclusions may have an “in fact” trigger (a more amorphous term than “final adjudication”) – whether fraud, gaining an illegal personal profit, or violating a statute, etc. Even under this type of exclusion, courts have held insurance companies must prove that the wrongful conduct actually occurred before coverage can be denied.
It often makes economic sense for your fund to settle a subprime litigation. If the settled suit alleges fraud or some other act that triggers an exclusion, the insurance company may contend that the claim is not covered. This is wrong, because when a suit is settled there is no “final adjudication” or “in fact” finding of excluded wrongdoing. This coverage defense does not entitle the insurance company to relitigate the settled action in the subsequent coverage dispute with its insured.
If your D&O or E&O insurance policy was procured based on alleged misrepresentations within the application for insurance, the insurance company may seek to rescind the policy in its entirety. Many subprime litigations and investigations could yield a finding that the hedge fund or private equity fund made misstatements in its public financial filings, overestimating the value of its subprime loan assets. The insurance company may assert that such misrepresentations provide grounds for policy rescission. However, the burden to prove a rescission case is a heavy one. The insurer must show that any misrepresentation was material to the decision to issue coverage and the misrepresentation was in fact made by the policyholder. Most rescission actions are unsuccessful.
Other Insurance Coverage
FI Bond insurance could provide shelter from the subprime storm for a fund that suffered a first party loss from the sinister acts of a deceptive employee or manager who committed fraud and looted the fund’s assets. FI Bond coverage may also apply to an investment bank or larger fund that issued securities backed by an inauthentic subprime asset, including a mortgage containing a forgery, created by fraud or simply counterfeit.
While D&O, E&O and FI Bond coverage may be the “first responders” to your subprime loss some Commercial General Liability (“CGL”) policies may also apply. If the CGL policy has a broad definition of “advertising injury” and narrow exclusions, a subprime loss recovery may be possible. Fiduciary liability insurance may apply if a pension or retirement fund is largely invested into subprime securities that go sour, especially when your fund administers or serves as trustee of the pension fund. When facing a subprime litigation, check the policy language of all lines of insurance to keep open as many avenues to coverage as possible.
If your hedge fund or private equity fund is fortifying its defenses against subprime litigations or investigations against itself and its managers, it is vital that you consult with an insurance expert to assess what insurance policies are in place and how much potential coverage is available. Look to your insurance policies first and seek out help immediately when allegations of mismanagement, fraud and wrongdoing begin to surface. Insurance may be your last defense against the plaintiff hoards.
R. Mark Keenan is a senior shareholder in the New York office of Anderson Kill & Olick, P.C. and Chair of Anderson Kill’s Financial Institutions Group. Mr. Keenan’s practice focuses on Insurance Recovery, Securities Law and Litigation and International Commercial Insurance matters for corporate policyholders.
Craig M. Hirsch is an attorney practicing in the New York office of Anderson Kill & Olick, P.C. Mr. Hirsch practices in the fields of insurance recovery litigation with an emphasis on D&O liability, professional liability coverage, products liability and commercial litigation.
Substantial contributions to this article were made by Rizwan Qureshi from Anderson Kill & Olick’s New York office, admission to the bar currently pending.