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Potential claim scenarios - how your directors' and officers', and professional indemnity policies respond in potential claim scenarios
Brian Horwell and Francis Kean, respectively
Miller Insurance Services Ltd. and Barlow Lyde & Gilbert, respectively
2007
There is often a misunderstanding as to which forms of liability insurances cover which type of claim. As one leading law firm observes, “it is possible to buy both professional indemnity insurance and directors and officers liability insurance separately and on an ‘off the shelf’ basis”. The danger with this approach is that when a claim or investigation hits, you may find insurers arguing among themselves as to which (if either) of the two policies will respond. Indeed, it is entirely possible that there may be a gap in cover somewhere in the middle.
He continues; “a better approach is to start with a ‘real world’ analysis of your likely exposureThe extent to which a hedge fund is vulnerable to changes in a given financial market. Exposure can be measured on a net or gross basis. See Gross exposure. See Net exposure. to legal liabilities and losses. From there, it should be possible to consider what types of cover and what levels of indemnity are best suited to meeting the exposures you have identified. The old maxim applies - you don't always get what you pay for”.
Bearing this in mind, listed below are possible claim scenarios for investment managers relating to directors and officers (D&O) insurance and professional indemnity (PI) insurance, which are typical of recent or current claims. We describe how the policy could respond and the pitfalls to avoid.
Trading errors
In theory, all trading errors should be reimbursed to the fund and this has recently become a UK Financial Services Authority (FSA) requirement. In practice, the size of the errors, the possibility that errors can result in gains and losses and the fact that it is often very difficult to account for these errors means most losses are not reimbursed. The FSA has decided this process is unacceptable and needs to be clarified.
Should an error be made, the management entity has two choices, either to reimburse the fund for its losses or go to the board of the fund entity to seek their agreement not to reimburse.
A PI policy is otherwise known as errors and omissions insurance. Depending on how the policy is set up, it should be able to reimburse any loss to the fund where an error or omission has been made which resulted in a financial loss to the fund.
What are the pitfalls?
• The excess (otherwise known as retention or deductible). The policy will only reimburse any loss over and above the manager’s excess and the application of each claim may result in losses falling below the excess.
• The policy is set up to cover the funds and the management entities. Professional indemnity insurance is third party insurance; consequently any claim must come from a third party. If the fund is named under the policy, it cannot be a third party for insurance purposes. Under the exclusions of a policy there will be a so-called insured versus insured exclusion, aimed at preventing claims between insureds being funded by insurers. Certain important exemptions and exceptions to this exclusion should always be sought.
• Notification provisions. Most policies will only allow coverage where the insured seeks prior written agreement to any settlementThe act of fulfilling the delivery requirements of a securities or futures contract. or admission of liability being made, from the insurer, having first notified the claim “as soon as practicably possible”. Failure to do so would result in the claim not being covered. Often investment managers make decisions and look to insurers to reimburse them after the fact.
Redemptions
Traditionally, investors, dissatisfied with the performance of open-ended funds, have redeemed their investment. Several claims have been made as a result of redemptionLiquidation of shares or interests in an investment fund. lock-ups being forced on investors due to liquidityThe ease with which an investment product/fund can be sold/redeemed from, without impacting its price. Hedge funds typically offer quarterly or annual liquidity, meaning that they allow investors to redeem their shares that often. issues.
While this is a recognised practice, investors do not always find it acceptable. This can lead to claims against the directors of the fund, who ultimately make the decision to close the fund to redemptions. Bear Stearns is an example of this. These types of claims can result in litigation in several jurisdictions. From press comments in the case of Bear Stearns, the following jurisdictions have been mentioned: the US, Caymans and the UK. Managers can be involved, as can professional advisers. Legal representation in each jurisdiction can be very expensive for directors. D&O policies are set up to provide defence costs for directors in such scenarios, where action is brought against them in more than one jurisdiction.
What can you do?
• Make sure you have a high enough limitThe maximum price advance or decline from the previous day's settlement price permitted during one trading session, as fixed by the rules of an exchange. In some futures contracts, the limit may be expanded or removed during a trading session a specified period of time after the contract is locked limit.! It can be easy to underestimate the costs of multi-jurisdictional litigation affecting several directors who may each need separate and independent legal advice. Since insurance costs are at their lowest for a number of years; now is the time to increase the limits you buy.
• Keep your insurers advised. Even if there is no litigation, policy wordings often require you to make a notification if the “insured becomes aware of any fact or circumstance which may reasonably be expected to give rise to a claim”. If you renew the policy period or change insurers with such an issue outstanding and do not advise your current insurers, it is likely that the claim will not be covered.
Settlements
In our experience most investors do not want their day in court. If sophisticated investors, hedge funds and other financial institutions are involved, a fast settlementThe act of fulfilling the delivery requirements of a securities or futures contract. and a return of remaining funds can be a strong incentive to seek settlementThe act of fulfilling the delivery requirements of a securities or futures contract.. Your policy should allow indemnity payments.
Many managers believe that if they face too much litigation, they can just walk away and “hand back the keys”. This is not the case. Litigation can drag on for a number of years and it is not always easy for individuals affected to start again. Having the funds to make a full and final settlementThe act of fulfilling the delivery requirements of a securities or futures contract. might be the only way out of the situation.
What are the pitfalls?
• Be aware that these are legal liability policies with an aggregate limitThe maximum price advance or decline from the previous day's settlement price permitted during one trading session, as fixed by the rules of an exchange. In some futures contracts, the limit may be expanded or removed during a trading session a specified period of time after the contract is locked limit. of liability for both costs and indemnity. Underwriters’ attitude to a commercial settlementThe act of fulfilling the delivery requirements of a securities or futures contract. tends to be based on a strict assessment of exposureThe extent to which a hedge fund is vulnerable to changes in a given financial market. Exposure can be measured on a net or gross basis. See Gross exposure. See Net exposure. to legal liability, rather than protecting the reputation of the management entity. They will rarely settle for the total limitThe maximum price advance or decline from the previous day's settlement price permitted during one trading session, as fixed by the rules of an exchange. In some futures contracts, the limit may be expanded or removed during a trading session a specified period of time after the contract is locked limit. of liability.
• The limitThe maximum price advance or decline from the previous day's settlement price permitted during one trading session, as fixed by the rules of an exchange. In some futures contracts, the limit may be expanded or removed during a trading session a specified period of time after the contract is locked limit. of liability. With the costs of legal representation and the fact that the total limitThe maximum price advance or decline from the previous day's settlement price permitted during one trading session, as fixed by the rules of an exchange. In some futures contracts, the limit may be expanded or removed during a trading session a specified period of time after the contract is locked limit. may not always be available for a settlementThe act of fulfilling the delivery requirements of a securities or futures contract., it is worth reviewing the limits you buy.
Regulatory claims
These are becoming more and more common place. Many policies, both D&O and professional indemnity policies provide an extension for representations at investigations and examinations. These cover “any reasonable and necessary fees, costs and expenses incurred attributable to any official investigation, examination, inquiry or other similar proceeding in relation to the affairs of the insured entity or any other attendance required of the director or officer by virtue of his position as director or officer of the insured entity which does not qualify as a claim under the definition of claim within the policy”.
If the regulators seek to investigate the management entity or any of its directors or officers without making any specific allegations, the extension will respond by paying for the costs of legal representation. Under all PI and D&O policies, there must be a specific allegation made against the insured for the policy to respond, so this extension provides coverage in the more likely scenario where regulators are simply fact finding.
Today, many regulators are looking very closely at the transactions surrounding any major stock market movements. This has resulted in a substantial increase in claims related to regulatory investigations.
What are the pitfalls?
• This extension will often be sub limited. The full policy limitThe maximum price advance or decline from the previous day's settlement price permitted during one trading session, as fixed by the rules of an exchange. In some futures contracts, the limit may be expanded or removed during a trading session a specified period of time after the contract is locked limit. will not always be available to such claims.
• Industry-wide investigations, as opposed to individual investigations, tend not to be covered.
• Confidentiality agreements usually surround these investigations but this will not negate the requirement of the insured to advise underwriters prior to incurring any costs. Seek the regulators agreement to advise insurers prior to incurring any costs, as insurers may not be liable for costs incurred without agreement.
• The excess may or may not apply. That will depend on whether the investigations specifically name individuals and whether the entity indemnifies those individuals.
Claims for market abuse or insider trading
Your policy should pay the costs of defence until such time as the firm or an individual within the firm is found guilty either by admission, court judgement or other adjudication.
What are the pitfalls?
• If the individuals or the firm are found guilty, insurers have the right to seek reimbursement against those individuals perpetrating, participating or condoning such acts.
• Not all policies provide coverage.
• Fines and penalties cannot legally be covered.
Current insurer claims concerns and the potential effects on the liability insurance market
Sub-prime issues: now a well-known phrase and one that has, in fact, been in the financial markets for some time, is becoming a real issue for the liability insurance markets.
There is already a substantial amount of litigation surrounding sub-prime lending and a recent report estimated that there is a potential for D&O insurance claims totalling $3.5 billion. Add to this the potential for professional liability claims against advisers, mortgage brokers, investment bankers and originators and this becomes a major issue for liability insurance underwriters that are not yet priced into the markets.
Losses do not necessarily increase the price of insurance, the lack of capital does. Again, sub prime has the potential to affect markets. Insurers are some of the largest holders of residential mortgage loans with a substantial element of sub-prime debtSee Junior debt, Mezzanine debt, Secured debt, Senior debt, Subordinated debt.. Failure in these markets could cause substantial capital losses which will eventually affect pricing of insurance markets. Insurance pricing tends to be reactive and we would not expect any substantial increases in the short term - but watch this space!
In summary, it is not easy to predict how a claim will develop, thus it is crucial to ensure that your insurance programmes consider all the issues highlighted in this article, to ensure your business and personal reputation is adequately protected.
