Alert: Asset Managers and Hedge Funds Face More Scrutiny

Earlier this year, the seemingly overnight failure of Silicon Valley Bank (SVB) and collapse of Signature Bank gripped news headlines around the world. Though the news cycle has quieted somewhat, repercussions persist for asset managers and hedge funds. Here’s what you need to know.

Financial Businesses Face More Stringent Insurance Underwriting

Starting in March 2023, after the unexpected events at SVB and Signature, insurance underwriters began cautiously re-evaluating their guidelines for D&O (Directors and Officers) and E&O (Errors and Omissions) insurance. They started factoring in elements such as bank size, narrow concentrations, and bond portfolio management. Additionally, they are looking at feedback from regulatory probes, potential enforcement actions, and the sentiment of bank depositors.

Unfortunately, the liquidity issues, treasury market, and interest rate hikes that contributed to these bank failures are also affecting other sectors within the financial industry. While too early to understand the total impact, it’s likely that asset managers and hedge funds will see increased claims activity.

Disappointed Investors May Blame Advisors

The primary job of a hedge fund manager is to increase investor returns and grow overall fund assets under management (AUM). That’s true whether a fund’s investment strategy focuses on long / short equity positions, merger arbitrage, or anything in between.

When significant market events drive investment down, the managers will inevitably face backlash, no matter how “accredited” the investor. Clients may allege malfeasance or wrongdoing if there’s a mismatch between investment performance and the returns they expect.

A client of the fund may sue on grounds that the advisor misrepresented and/or omitted key factors of investment fund objectives, investment strategy, and risk factors. They also might suggest that the fund board lacked proper oversight in accordance with their duties.

Regardless of whether such claims are groundless, meritless, or not, the mere cost of litigation defense can damage your bottom line (and this is before reaching any settlement value or having the matter dismissed).

Current D&O and E&O Insurance Coverage May Be Inadequate

If a claim becomes significant before it “goes away,” it can compromise the assets of your fund, especially without insurance proceeds to pay the loss.

Foreseeing liability exposure for underperformance is only part of the equation, however. In addition, hedge funds can be under the microscope of other “interested parties.” This includes regulatory inquiries and investigations by the Securities and Exchange Commission, or other self-regulatory organizations, among others. Misleading performance results and inadequate compliance policies and procedures may be some of the target allegations.

If not funded by insurance, these investigations can place extreme strain on assets under management.

Taking a Step Back to Examine Coverage Is Vital

Consider the reasons you buy insurance today. For example, perhaps a potential board member is requiring it (above and beyond the indemnification they are entitled to). Maybe a major institutional client needs evidence of a particular type or level of insurance.

Also, look at your rationale for declining certain coverages. Some asset managers and hedge funds believe they have the personnel, expertise, controls, and procedures to avoid any claims. So, they may forego certain types of coverage or choose lesser amounts.

In this extremely litigious landscape with astronomical costs of defense, it’s imperative to procure an adequate amount of insurance as a backstop.

What is D&O / E&O Liability Insurance?

Directors and officers / errors and omissions liability is a specialized, menu-driven, packaged policy. Rather looking at it as an expense, asset managers and hedge funds benefit from viewing it as a capital source to support the overall health of the fund. It also protects personal assets of those charged with leading the organization.

Federal and state securities laws can enforce strict penalties for material omissions or misstatements, including personal liability for individual directors and officers. Without D&O coverage, individual directors and officers could be paying from their own personal assets to defend themselves.

D&O liability insurance can offer broad coverage that protects individual directors and officers as well as the fund itself from claimants who allege mismanagement.

The E&O section of the policy grants asset protection when a claimant alleges the adviser / fund has made an error / omission or miscalculation resulting in a loss. It also covers allegations of failing to act appropriately in rendering investment management services.

Matching these coverages to your particular risk profile can help you protect your business, directors and officers, and the funds you oversee.

If you have questions or need a second opinion on your coverages, please reach out.

Also, see the SEC’s 2023 Exam Priorities as you think through your risk exposures.