Insurance Protection for Hedge Fund Claims

Is it worth the paper it’s written on?

ROBERT KELLY, BARONSMEAD PARTNERS

Executing an investment strategy in this environment is challenging enough, but current levels of volatility have created additional difficulties and exposures. From the increased impact of errors to valuation issues and the accompanying rise in litigation risk, fund managers and directors find themselves more exposed.

Take the issue of trading errors. Everyone makes mistakes, but in a benign investment environment a currency hedging error or derivatives reconciliation infelicity is not necessarily a major issue if it is discovered and fixed relatively quickly. However, the problem becomes thornier when an error is committed in a volatile environment; the market can move away from you with indecent haste, compounding the error and crystallising real losses to the manager or the fund.

Where the blame lies
In the UK, the Financial Services Authority has been fairly uncompromising about who it thinks should shoulder the blame for errors. In its consultation paper FS06/2 (March 2006) the FSA says: “Our view is that if the trading error has been caused by the hedge fund manager’s carelessness, in the first instance we would expect liability to be established against the manager for any errors for which it is responsible.” The FSA caveated by saying, “That position can be varied or reversed, however, should the relevant contractual documents between the parties include an appropriately worded exclusion [of liability] clause.”

Where funds have a Delaware feeder there is frequently an exclusion clause in the offering documents stating that the manager is only liable if there is evidence of gross negligence, rather than merely negligence, which is the most commonly used UK standard. This is accepted practice in the US where there is greater protection generally afforded to the investment community.

So while a manager might normally be liable for any errors under English law, this may not be the case under US law. Broadly written gross negligence indemnities can have a material impact on the usefulness of the manager’s insurance cover and needs to be considered.

The inescapable conclusion is that in most claim scenarios the fund is a natural claimant against the manager for any losses. However, if the manager and fund share a single composite insurance policy, then there is a problem. If the fund brings a claim against the manager will the manager be protected by his policy? Not if there is an exclusion of claims from one insured (the fund) against another insured (the manager). The result could be that the insurer escapes without paying.

Beware the litigious investor
Another potentially thorny issue in a highly-volatile, potentially litigious environment is having US investors among the client base. With US investors in the fund, directors and managers need to think about the potential costs of litigation too and how their cover operates. The last thing anyone wants is to be sued in a US court. The memory of the NatWest Three, extradited to the US on charges relating to the Enron collapse and made to do the ‘perp walk’ will linger long in the mind. But where it does happen, hedge funds need proper cover for US exposures and an insurer to fund lawyers on both sides of the Atlantic.

Directors face a raft of other potential difficulties in the current environment. Some have had to impose gates or halt redemptions in funds that have made losses or face liquidity squeezes. The prospectus sets out the liquid strategy and may offer monthly redemptions. Can the directors reasonably decree that investors cannot redeem for another year? What flexibility does the fund document afford them? These kinds of questions are difficult and the decisions may come to be tested in courtrooms in the months and years to come.

In this climate, directors are also likely to come under greater scrutiny in how they fulfil their duties of oversight. There has been a significant shift to the appointment of professional directors over the last year or two, particularly in the Channel Islands and Ireland. But in some jurisdictions, directors are arguably overburdened with the number of fund boards they sit on, possibly leaving themselves exposed to the charge, in the case of performance problems or the emergence of operational difficulties, that they failed to discharge their oversight and fiduciary duties properly.
Valuation is another hot issue, made even hotter by market volatility. Directors are responsible for ensuring fairness when investors redeem and subscribe. Where a discrepancy is revealed, usually at a later date, the fund is likely to hear from investors who feel they have been put at a disadvantage.

Whilst the directors will seek advice they will be making difficult decisions for which they may bear the ultimate responsibility.

Getting protection
So do directors have adequate protection against any future investor action? There are certainly some holes that need plugging aside from the ones already mentioned. For one, where the indemnity is provided by the sponsor, fund directors need to consider their position if the sponsor’s viability is threatened. And where the insurer or sponsor is based overseas, it can be very be hard for the director to enforce the indemnity with an unwilling party.

The advice hedge fund managers and directors receive is critical for the future of their businesses. In particular, they need to weigh carefully the trade-off between price and quality when choosing cover. They run areal risk by changing insurance providers every year simply to shave a few percentage points off the price.

The problems are now highlighted publicly with the claims which are being made against hedge fund managers and this trend is, unfortunately, unlikely to be reversed in the near future.

Correctly executed insurance can be one of the few avenues of non-recourse cash available to managers and directors to fund their defence. Poorly executed and the whole exercise is an expensive and frustrating waste of time. English law is generally in favour of the insurers and making sure a claim is well managed can be essential for a successful outcome.

Hedge funds hardly need more warnings at this time, but unfortunately we live in uncertain times and the benchmark for the tools they need to survive has been raised a notch.