SEC rule could stop pension funds investing in hedge funds

Hedge funds need to hold insurance to win US pension plan money. New rules would make cover too dear

SEC funds barrier montage

Pension funds in the US may be unable to invest in hedge funds if a sweeping package of financial reforms by the markets regulator is passed in its current form, warn hedge fund managers and lawyers.

The US Securities and Exchange Commission is proposing a rule that aims to stop private fund managers evading legal liability for actions leading to investment losses. Hedge funds depend on this indemnity to obtain insurance.

Without indemnity, insurance premiums would soar and insurers may even refuse to offer policies, experts say. Under US Department of Labor rules, pension funds are only allowed to invest in hedge funds that are insured.

The 341-page proposal creates a “host of problematic issues” that relate to liability and how private funds are insured, says Jennifer Han, chief counsel and head of global regulatory affairs at the hedge fund lobbyist group, the Managed Funds Association. “We’re concerned that the SEC has not considered the potential costs associated with the rule and its impact on private fund advisers and limited partners alike.”

The proposal is part of a wider push by SEC chair Gary Gensler to strengthen oversight of the alternative investment sector. The new rule would prohibit a private fund adviser from seeking, directly or indirectly, “reimbursement, indemnification, exculpation, or limitation of its liability by the private fund or its investors” if it were sued for negligence or a breach of fiduciary duty.

Public sector pension schemes invest 8% of their assets in hedge funds on average, amounting to $1.2 billion per scheme, according to global figures from data provider Preqin. For private pension schemes, the figures are 11% and $440 million.

Hedge funds often require investors to sign agreements that waive personal liability for the hedge fund manager from such legal action. As part of these agreements, the manager doesn’t have to pay legal fees or the cost of a judgement or settlement even if they lose. The waivers also prevent investors from suing a hedge fund manager for simple negligence, which means the bar for legal claims is high.

The SEC says in its proposal document these provisions have become “more aggressive over time”. As a result, investors may believe “they do not have any recourse in the event of breach [of fiduciary duty]”. The proposed rule aims in part to redress the balance between fund manager and investor, and make breaches of fiduciary duty “incrementally less likely to occur”, notes the SEC document.

But the rule, insurance experts say, will also alter how the insurance cover is meant to work for legal and regulatory costs or losses from trading errors.

Professional liability coverage depends on the structure of private funds. The company shell of many hedge funds is based in an offshore location such as the Cayman Islands. Investors send their money to the Caymans and the investment manager, employed by the fund but probably trading from New York or London, manages the assets. The private fund adviser – often the investment manager – is the party covered by the insurance.

If they are sued or fined by regulators, the investment manager is protected by an indemnity clause which limits their responsibility or the amount of money they might owe. This means the fund pays the deductible, or self-insured retention – which is the portion of any claim that the policy holder must pay themselves. The insurance company reimburses the remainder of the loss.

If a hedge fund adviser was unable to indemnify themselves from a claim, this would create what the insurance industry calls a “non-indemnified loss”, or one that cannot be avoided. Under insurance practices, deductibles cannot apply to non-indemnified loss. Instead, the insurance company pays the full amount.

Such a move would “gut the whole purpose of the policy”, says Lynda Bennett, chair of the insurance recovery practice at Lowenstein Sandler. “That $500,000 to $1.5 million buffer before the insurance company would actually have to pay would be removed.”

Two hedge fund managers characterised professional liability insurance as “essential” to their business.

“If you’re managing a US [regulated] pension fund, insurance is required. Pension funds always ask if it’s in place before they’ll invest,” said a third hedge fund manager, who describes the effect of the SEC proposals on the hedge fund industry as “crazy”.

Wiggle room

There is some debate over the implications of the SEC proposal for insurers. Policy holders may be able to collect a deductible even after the rule change, argues Richard Coello, a managing director at K2 Financial, an insurance underwriter.

Once the indemnity clause is removed from investor agreements, Coello thinks it might work like this: if there is a $10 million mistake, the hedge fund manager will pay the $1 million deductible out of her own pocket and collect the insurance. Then, she’ll reimburse herself from the insurance payout, and pay the remaining $9 million to the fund.

Coello argues it wouldn’t make sense for the SEC to make a rule that barred private funds from insurance. “The investment industry would be the only one in the world prohibited from being able to buy professional liability insurance. Surgeons can do it. Lawyers can do it. Why would the interpretation be any different here?”

But Anne Beaumont, a lawyer at Friedman Kaplan, disputes this interpretation of the rule. She says that any ban on indemnification would cancel out the ability to collect a deductible. “If you pay out amounts that you can’t indemnify as a matter of law, they can’t count toward the satisfaction of the retention,” says Beaumont.

It doesn’t matter who pays who or how many shell companies the payments pass through, agrees Lowenstein’s Bennett. Self-insured retention applies to everyone and every entity that is insured.

Another underwriter worries that whatever the outcome of the rules, increased activity around the fund space means insurance companies will want to protect themselves by not covering hedge funds to the extent they did previously, particularly for regulatory expenses or investigation costs.

“If this is going to become the SEC’s latest stalking horse, you’ll see a situation where the insurers can’t bear the aggregation exposure,” says the insurer.

Bennett points out that since the outbreak of Covid-19 she has seen policy premiums rise 20–25% year on year.

“The market is already incredibly volatile as it is – this kind of a ruling would be another significant risk factor that would drive prices even higher and add further instability.”

The comment period for the SEC proposals ends today (April 25).

Editing by Alex Krohn

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