HEDGE FUNDS’ LIABILITY EXPOSURES ARE AT RECORD LEVELS

Merger and acquisition activity drives growth in assets under management (AUM) and fund performance for nearly every type of hedge fund, whether a fund’s investment strategy focuses on long/short equity positions, merger arbitrage or event-driven investments. With record M&A deal volume in 2018, hedge funds’ exposure to shareholder liability arising from merger-and-acquisition investments is correspondingly high.

To say that hedge funds and other financial institutions operate in a litigious environment is an understatement. According to the Securities Class Action Clearinghouse (SCAC), a collaboration of the Stanford Law School and Cornerstone Research, 2018 is on pace to have a near-record number of lawsuit filings relating to securities and other investments. 2017 was a record year, with more than 400 class actions filed. In the first half of 2018, the SCAC reported that 204 class actions had been filed.

The expenses of defending ongoing litigation can mount quickly, and continue to add up until courts eventually decide cases. According to the SCAC, of securities class action suits filed in 2016, 43% are still continuing, while 15% have settled, 3% have been remanded to lower courts, and 39% were dismissed. In 2017, 72% of such suits are continuing, and 24% were dismissed. An overwhelming majority of securities class actions filed in 2018, 94%, are still in litigation, with 6% dismissed.

Geographically, securities class action suits relating to mergers and acquisitions are filed nationwide, but in the first half of 2018, three federal circuits saw 61% of total M&A-related filings, according to the SCAC:

Lloyd’s of London underwriting agency Pioneer Underwriters, which has a specialty focus on financial institutions, reported that for the third quarter of 2018, shareholder actions against hedge funds increased in frequency and common claims involving hedge funds include:

Hedge funds not only face liability exposure for underperformance and the actions of management, but they also continue to be targets of regulatory investigations by the Securities and Exchange Commission or a self-regulatory organization (SRO), such as the Financial Industry Regulatory Authority, according to the Hedge Fund Law Report. Alleged deficiencies cited most frequently in SEC investigations include: fee billing based on incorrect account valuations, billing fees in advance or with improper frequency, applying incorrect fee rate, omitting rebates and applying discounts incorrectly, disclosure issues involving advisory fees, misleading performance results and inadequate compliance policies and procedures.

One example of a high-profile lawsuits involving hedge funds and private equity firms, Kentucky Retirement Systems is suing Kohlberg Kravis Roberts & Company L.P. and Blackstone Group L.P. over returns on hedge fund investments. The Kentucky pension plan’s lawsuit also seeks to force KKR and Blackstone to disclose hedge fund materials that previously have been closed to public scrutiny. If the court mandates such disclosure, it could trigger additional litigation against hedge funds that contract with government-sponsored pension plans and other entities.

BY THE NUMBERS

MORE SECURITIES CLASS ACTION SUITS ONGOING

PROTECTING ASSETS UNDER MANAGEMENT

In addition to generating returns for their investors, hedge funds want to protect – and grow – their assets under management (AUM). But keeping AUM from eroding is no easy task, especially in a litigious environment where unfunded liability exposures can eat into hedge funds’ assets. Having the right liability insurance is an important way to protect and preserve assets, and two coverages that are particularly valuable are Directors & Officers (D&O) and Errors & Omission (E&O) coverage.

D&O liability insurance can offer broad coverage that protects individual directors and officers as well as the fund itself. Federal and state securities laws provide strict penalties for material omissions or misstatements, including personal liability for individual directors and officers.

Without D&O insurance, individuals named in a lawsuit against the hedge fund could have to pay for defense costs and judgments out of their own personal assets. That possibility is a serious disincentive to accepting an invitation to serve as a director or officer.

E&O liability insurance, provides financial protection when a fund makes an error or its failure to act results in a loss for their clients. Miscalculations sometimes happen, as do omissions in disclosures.

In the case of M&A investments, hedge funds can lose large amounts of money if a deal unravels, potentially triggering shareholder lawsuits.

It’s important to note that insurance provides a separate, contingent source of capital for hedge funds, enabling them to reduce or avoid paying judgments and settlements with assets under management. Hedge funds generally have agreements to indemnify directors, officers and employees, but the expenses related to regulatory investigations and private litigation can add up quickly – even when a hedge fund has done nothing wrong. D&O and E&O insurance can both provide valuable reimbursement, or even advance payment, of defense costs.

If a hedge fund must pay for a lawsuit and any resulting awards from its own assets, the fund’s overall financial performance will suffer. D&O and E&O insurance can therefore help funds to protect their assets. Premiums paid for liability insurance, a fraction of potential defense and settlement costs, can be allocated as an expense between the hedge fund and its manager.

BOTTOM LINE

The D&O and E&O marketplace continues to have a strong appetite for hedge fund risks. Liability insurers that insure hedge funds, however, are largely holding steady on rates and retentions. Generally, insurers are requiring hedge funds to maintain self-insured retentions of at least $150,000. Major increases or decreases in premiums or retentions are very unusual to see in the current insurance market, though insurers tend to react to bad news by adjusting rates. Insurers will seek to increase rates if a hedge fund grows significantly or underwriters believe the account has become riskier. Risks that most insurers are shying away from include hedge funds investing in cryptocurrencies or cannabis-related activities; the majority of the marketplace is specifically excluding coverage for these.

Hedge funds are a specialized niche for retail agents placing professional liability and management liability. Navigating the marketplace for D&O and E&O coverage can be challenging, and retailers should consult an expert wholesale partner to obtain the broadest terms and conditions available.

To learn more about D&O and E&O coverage for hedge funds and how to help policyholders better manage their risks and protect their businesses, please contact your CRC producer.

Contributors:

Jason White is a Managing Director and Co-National Practice Leader in the Professional and Executive Practice in CRC’s Los Angeles office.

Mike Robison is a Senior Broker and Co-National Practice Leader in the Professional and Executive Practice in CRC’s Dallas office.

Dirk Vanderwall is a Director in the Professional and Executive Practice in CRC’s Los Angeles office.

Gregg Godde is a Senior Vice President and Professional Services Director – Eastern Region and is based in CRC’s Atlanta office.

END NOTES:

1. https://www.ft.com/content/b7e67ba4-c28f-11e8-95b1-d36dfef1b89a

2. http://securities.stanford.edu/research-reports/1996-2018/Cornerstone-Research-Securities-Class-Action-Filings-2018-MYA.pdf

3. https://www.bloomberg.com/news/articles/2018-11-30/kkr-blackstone-lose-bid-to-dismiss-kentucky-pension-lawsuit

4. https://www.wsj.com/articles/it-was-easy-for-new-hedge-funds-to-raise-money-in-2018-making-it-was-harder-11545055200?mod=djemCFO_h