Taking cover

Hedge funds are, by definition, unlike other financial institutions. Privately organised, exempt from most government regulation (at least for now), and commonly unavailable to the general public, hedge funds can provide greater returns to their investors, but also assume greater risks.

Since investors in most hedge funds are highly experienced, highly sophisticated investors, fund managers tend to assume this risk is understood.

And it is, until the market takes an ugly downturn and the fund starts losing money. Then come the 'shocked' investors… and the lawsuits. As pension funds and other institutional investors pile into hedge funds, litigation is bound to increase.

Fund Manager as Fiduciary

One common allegation against hedge funds and their managers is a purported 'breach of fiduciary duty.' Absent a contractual agreement stating otherwise, hedge funds act as a fiduciaries for their clients, in the sense that hedge funds are required to place their clients' interests above their own, even when the clients' interests conflict or diverge with that of the fund. (Beacon Hill CBO II, Ltd vs Beacon Hill Asset Management LLC, 249 F.Supp.2d 268, 275 (SDNY 2003)).

Breach of fiduciary lawsuits also carry the possibility of personal liability. A recent decision issued in the Southern District of New York has made it easier to bring breach of fiduciary duty claims. In the recent case of Fraternity Fund Ltd vs Beacon Hill Asset Management LLC, et al., 376 F.Supp.2d 385 (July 6, 2005), the Southern District held that individual investors have the right to bring breach of fiduciary duty claims against the hedge funds in which they have invested.

Generally, when a fund or corporation loses money, shareholders may only bring a derivative action on behalf of the fund or corporate entity. However, the court here found that certain injuries allegedly suffered by shareholders constituted a wrong to the shareholders rather than to the fund itself, and therefore allowed individual shareholders to bring direct actions against the fund.

This decision may open up the door for increased litigation against hedge funds.

Moreover, if your fund acts as an administrator, investment advisor or service provider for a pension, employee-benefit, group life or medical expense plan, the fund may be sued for fiduciary violations under ERISA (Employee Retirement Income Security Act of 1974).

See, for example, Thomas, Head & Greisen Employees Trust v. Buster, 24 F.3d 1114 (9th Cir. 1994) finding that a broker providing regular, individualised investment advice to an employee trust fund constituted a fiduciary under ERISA and was liable for breach of fiduciary duties arising out of misrepresentations to fund.

What Types of Insurance?

Given these risks, as well as the risk of numerous other types of claims, including misrepresentation, negligence, oversight failures, and even criminal charges, it is imperative that hedge funds and their managers have certain key insurance policies to protect them:

1 Director-and-officer or general-partnership insurance to protect the decision-makers;

2 Professional liability insurance to protect the fund and the managers from professional errors;

3 Fiduciary and trustee insurance;

4 Commercial crime/fidelity insurance;

5 Investment-advisor insurance;

6 Employment-practices insurance;

7 Key-man life insurance, in case the fund is highly dependent upon the expertise of one or several key men or women.

and the costs?

Ask your insurance broker. Loss history and potential future problems are more germane indicators of future claims than are total assets.

Most cases brought against hedge funds and their managers are settled well before trial, so the right to obtain reimbursement of your fund's attorneys' fees is very important. A corporation embroiled in high-stakes litigation or subject to numerous government investigations will want to submit requests for defence costs as they come due. Make sure that a clause requiring advancement of your defence costs on a current (at least quarterly) basis is included into your policy.

Market Conditions

Over the past few years, there has been a significant restriction in the insurance marketplace for hedge funds. Many insurance companies pulled out altogether, and those that remained increased their pricing and retentions significantly, while also carving out important areas of coverage.

Recently, however, the underwriting conditions have improved. Companies that had previously withdrawn from the market have stepped back in, and new entrants have begun to surface. This opening up of the marketplace has brought price reductions, somewhat lower retentions, and a willingness to consider broadening the scope of certain coverages.

Although underwriters remain stringent regarding limits to which they will commit, the addition of these markets allows for the layering of higher limits than has recently been available.

Still, the fact remains, the devil is in the detail. Policy forms vary significantly. The following is a sampling of recent insurance-industry moves to beware of. Insurance companies have been:

limiting regulatory investigation coverage.

Widening exclusions for personal profit and wrongful acts. Under traditional policies, the exclusions would not kick in until there was a 'final adjudication' of fault. Some current policies use a more nebulous 'in fact' standard, often allowing companies to deny coverage before a final adjudication is delivered - and thus refuse to fund a settlement based on an exclusion. If possible, insist on policies that provide coverage up until there is a final adjudication. Because settlements are very common in this type of case, the final adjudication provision is vital to your interests.

Narrowing 'severability' clauses, which protect innocent officers from the wrongful conduct of other officers. It is important that one bad apple (or even several) not be allowed to void coverage for everyone else.

Issuing specific additional exclusions, such as market timing and late trading.

Since policy forms, exclusions, and available endorsements are changing frequently, it is advisable that you have someone well versed in hedge fund insurance to review your current policies. An educated buyer can obtain coverage for breach of fiduciary duty claims if he does his homework.

authors:

Rory O'Brien is an area executive vice-president at the insurance brokerage firm of Arthur J. Gallagher & Co. of New York. He has many years of experience working with all major insurance carriers in designing insurance coverages for hedge funds and other alternative investment firms. He can be contacted at [phone] or [e-mail].

Mark Keenan is a senior shareholder in the New York office of Anderson Kill & Olick, PC and chair of Anderson Kill's financial institutions group. Keenan's practice focuses on insurance coverage, securities law and litigation and international commercial insurance matters. Keenan regularly represents policyholders in insurance coverage disputes involving broker/dealer, hedge funds, investment advisors and other financial institutions. He can be reached at [e-mail] or [phone].

Diana Shafter Gliedman is a member of the insurance coverage litigation practice group of Anderson Kill & Olick, PC. She routinely represents commercial policyholders in disputes with their insurance companies, with an emphasis on commercial liability, professional liability, and directors and officers' liability insurance. She can be reached at [e-mail] or [phone].

key points

Absent a contractual agreement stating otherwise, hedge funds act as a fiduciaries for their clients.

Make sure that a clause requiring advancement of your defence costs on a current (at least quarterly) basis is included into your policy.