Types of cover
Participants in the hedge fund industry typically purchase, or have access to, Directors and Officers (D&O) Liability insurance and Professional Indemnity (PI) insurance. The basic characteristics of these policies are shown in Table 1.
Understand and invest in insurance
Although most people are aware that their company has a PI policy and a D&O policy, these important commercial contracts are generally given far less attention than other contracts. The most common questions from the board are: (1) have we renewed our PI and D&O policies? (2) how much did it cost? and (3) what are the policy limits?
Whilst these are important questions, they do not go nearly far enough and are potentially meaningless. Having a limit of £x million will be irrelevant if the policy does not respond to a claim. Companies often spend a great deal of money on PI and D&O policies without understanding what they do and do not cover, or the obligations which these wordings impose on them, and the potentially disastrous consequences if the terms of the policy are not strictly complied with by the policyholder. The directors of funds and managers may even be at risk of criticism or claims against themselves if there is a failure to access insurance cover due to their lack of understanding of the insurance position or how the policy operates.
PI and D&O policies are complex commercial contracts and they deserve the same attention to detail which is given to other legal contracts such as an investment management and other service provider agreements. They need to be tailored not only to the hedge fund/asset management industry, but to the specific risks and profile which your particular organisation faces including the jurisdictions from which claims – civil, criminal or regulatory – might emanate.
Not all policies are the same. Generally, they are negotiable to a lesser or greater extent but this needs the engagement of a senior person within the company with responsibility for buying insurance, professional legal advisers and the use of an insurance broker which understands the hedge fund industry and its peculiarities – performance fees, side pockets/illiquid investments, high water marks/benchmarks etc. The inter-relationship between the fund(s) and the manager (including the effect of indemnities) needs to be understood, and the insurance policy wordings may need to reflect other contractual arrangements.
As a matter of English law, insurance policies are usually treated as commercially negotiated contracts with the policyholder considered to have equal bargaining power with the insurer. Many policyholders do not use that bargaining power but purchase insurance based on lowest price, and do not give the time and effort to their insurance contracts which they would to other commercial contracts. As in so many things, you often get out what you put in.
Minor variations in wording or other clauses which may appear to be boilerplate or standard, but the consequences of which are not fully understood, can have disastrous consequences in terms of limiting coverage. PI and D&O insurance can be a lifeline for a company and/or its directors faced with allegations by aggressive investors or regulators, or a new board of directors. Too often the terms of insurance policies are not fully understood and, in particular, the consequences of failure strictly to comply with terms – such as the notification of circumstances or claims – can give insurers an opportunity to deny coverage which would otherwise have been available.
Red lights on policy wordings
There are a number of recurring problem areas with insurance policy wordings covering hedge funds which cause difficulties in making recoveries from insurers.
This is a policy which covers both the manager and the fund under a shared or combined limit of indemnity. This is a popular type of policy in the US and older forms of English policies where the manager buys its own professional indemnity cover and also arranges D&O cover for the directors of funds under management through the same policy.
Obviously there is a risk that the policy limit may be exhausted, particularly by a large PI claim against the manager, leaving the directors of the managed funds with no effective insurance cover. This risk arises because erosion of policy limits operates on a “first past the post” basis i.e. the first claim made in time is paid by insurers in full before the second claim is paid and so on.
Another difficulty with this type of policy is that claims by one insured (i.e. the fund) against another insured (i.e. the manager) may be excluded through what is known as the “Insured v. Insured” exclusion. If such exclusionary language is not properly qualified, the manager may have no insurance coverage and the fund no recourse against the insurance company, in the event that the fund does have a claim against the manager.
London market insurers are typically nervous about covering US exposures and tend to include, as standard, exclusions removing or limiting the insurance coverage available for claims brought in the US/Canadian courts or proceedings initiated by the Securities Exchange Commission or under the Securities Act 1933 and/or the Securities Exchange Act 1934.
Careful analysis should be given to any US exposures which a particular fund or manager faces in the conduct of its day-to-day business so that these aspects of policy wordings can be negotiated and tailored to ensure that there is effective insurance coverage for the risks to which a particular business is exposed.
The inter-relationship between insurance policies and any indemnities given, for example an indemnity from the fund to the manager and their respective directors, should be considered carefully. This is particularly important if the manager and the fund have separate insurance cover in place. All too often an insurance policy has proved unresponsive as the relationship between the policy and other sources of protection, such as indemnities and other insurance cover, has not been properly thought through.
Warranties/”basis of contract” clauses
Warranties and the dangers of “basis of contract” clauses also require close scrutiny. The insurance market has a language all of its own. This means that, even if you do read the policy, you may not understand the full implications. For example, a warranty in the context of an insurance policy is a very significant term indeed. Unlike in other commercial contracts, the remedy for breach of warranty is not damages according to what loss has been caused by the breach of warranty. The remedy for breach of warranty in an insurance policy is the automatic discharge from liability of insurers as from the date of the breach. It is not necessary for the breach to have been material or causative of the loss. This is a draconian consequence so policyholders need to understand what has been warranted in the context of their policies.
Insurers have a nasty habit of including a “basis of contract” clause in policies by which the truth of statements in a proposal form and supporting documents is converted into a warranty. This means that if there is any inaccuracy in the proposal form, or even any errors in the supporting documents, insurers are automatically discharged from liability from day one of the policy, as there has been a breach of warranty from the moment the policy came into force.
One of the easiest ways to lose cover which might otherwise have been available is by failure to comply strictly with the notification provisions in an insurance policy. Wordings differ but often insurers’ obligations to indemnify are subject to what is called a condition precedent (even if it is not expressed in those terms) that there has been strict compliance with the claims notification provisions. Breach of a condition precedent, as a matter of English law, entitles insurers to refuse to indemnify, however minor the breach. It is therefore essential that the notification provisions in the PI, D&O and indeed all other insurance policies, are known, understood and strictly complied with.
Notification provisions vary substantially but often impose an obligation to notify not only a claim, in the sense of an actual letter of demand from a client or third party or regulator, but also circumstances which might reasonably be expected to give rise to a claim. Often the obligation to notify is within a very short period of time – sometimes a matter of days. Such onerous notification provisions should be avoided, but they remain common.
It is easy, with the benefit of hindsight, to see that a negative press article about a product, or a complaining investor, showed all the signs of developing into a claim. At the time, however, without the benefit of that hindsight, it might not have seemed so ominous. Care needs to be taken to ensure that consideration is given to whether or not notification of a circumstance which may or is likely to give rise to a claim needs to be given. All too often, when a minor matter has blown up into a claim or investigation, insurers look back and claim that notification was not given in accordance with the policy terms and they are discharged from the obligation to pay.
Generally, in relation to notification provisions, it is important to limit whose knowledge it is which triggers the notification obligations. This should be a matter for discussion with insurers in the context of your own organisation.
There can be complex issues on whether there is coverage (and, if there is coverage, under which policy) where a claim is made against a corporate director of a fund. D&O policies typically only extend cover to natural persons who serve as directors, not corporate entities. A PI policy may exclude all claims made against any director (as PI insurers consider claims against directors to be D&O risk). The complexity of coverage issues around this area can increase where a claim is made against a natural person who is a director or a corporate director, or such an individual is called to attend an investigation into the affairs and conduct of the corporate director. D&O insurers may argue this is a PI risk and this could result in a gap in cover.
Avoiding problems with insurers
The best advice is to contact a specialist insurance broker who understands the hedge funds industry and who can appreciate the particular risks and exposures which your organisation faces in the conduct of its business. Specialist advice is particularly important for start-up funds. The dangers in simply buying an “off the shelf” insurance product are considerable.
You may wish to obtain legal advice on the fitness for purpose of proposed insurance policy wordings which factors in the effect of any indemnities which apply to the fund, its directors or the manager. An insurance broker may recommend that legal advice is taken on the effect of indemnities and the inter-relationship between indemnities and the insurance, in which event the lawyer needs to be familiar not only with contracts commonly used in the hedge fund industry, but also with how insurance policies work and with English insurance law which has a number of unique aspects.
The advice obtained at an initial stage should look beyond the adequacy of the policy wording for your particular business to consider, for example, appropriate internal procedures that your organisation should maintain to ensure that claims and circumstances which may or are likely to give rise to claims are reported to insurers in a timely manner. This is an important step in enabling access to the insurance coverage as and when a problem does arise.
Jane Harte-Lovelace is Partner and Frank Thompson is Senior Associate in the insurance coverage group in the London office of lawyers K&L Gates LLP. Both have acted for a number of hedge funds.