In a recent article, we argued that the use of placement agents by hedge fund managers – especially smaller and start-up managers – is likely to continue and grow in the near term, for both macro and micro reasons. At the macro level, we identified four rationales for this anticipated trend: (1) many new investments are going to larger managers; (2) many institutional investors plan to increase their hedge fund allocations in the next three to five years; (3) a noteworthy percentage of institutional investors plan to increase their allocations to new managers; and (4) manager reputation weighs heavily in the allocation decision-making of institutional investors. And at the micro level, we suggested that the use of placement agents by hedge fund managers will continue and grow because placement agents provide a range of potentially valuable services to managers, including: marketing and sales expertise; division of labor between portfolio management and marketing; credibility; contacts and access; strategic and other services; geographic and cultural expertise; and the ability to avoid the question of whether the manager’s in-house marketing department must register with the SEC as a broker. For a fuller discussion of each of these points, see “What Is the ‘Market’ for Fees and Other Key Terms in Agreements between Hedge Fund Managers and Placement Agents?
,” Hedge Fund Law Report, Vol. 3, No. 35 (Sep. 10, 2010). Another point we made in that article – and a large part of the reason why we have undertaken this article – is that while the business case for the use by hedge fund managers of placement agents is compelling, the recent regulatory attention focused on placement agent activities and hedge fund marketing more generally is unprecedented. See, e.g., “Three Significant Legal Pitfalls for Hedge Fund Marketers, and How to Avoid Them
,” Hedge Fund Law Report, Vol. 3, No. 36 (Sep. 17, 2010); “Third-Party Marketers that Solicit Public Pension Fund Investments on Behalf of Hedge Funds May Have to Register with the SEC within Three Weeks
,” Hedge Fund Law Report, Vol. 3, No. 35 (Sep. 10, 2010); “Key Elements of a Pay-to-Play Compliance Program for Hedge Fund Managers
,” Hedge Fund Law Report, Vol. 3, No. 37 (Sep. 24, 2010); “The Four P’s of Marketing by Hedge Fund Managers to Pension Fund Managers in the Post-Placement Agent Era: Philosophy, Process, People and Performance
,” Hedge Fund Law Report, Vol. 2, No. 45 (Nov. 11, 2009). Accordingly, hedge fund managers are increasingly sensitive to the prospect that retaining placement agents can involve burdens as well as benefits. At best, placement agents can dramatically increase assets under management, revenues and profits. But at worst, placement agents can materially expand the range and severity of liabilities to which hedge fund managers are exposed. At the same time, marketing and selling hedge fund interests can expose placement agents to liability. In short, the exposure created by the relationship is reciprocal, but not necessarily symmetrical: in most cases, and as explained more fully below, placement agents have more opportunities to harm managers than vice versa. Sophisticated hedge fund managers and placement agents recognize that their relationships may create these reciprocal, asymmetrical liabilities, and, to the extent possible, seek to allocate the burden of such liabilities ex ante, by contract. Specifically, the indemnification provisions included in agreements between hedge fund managers and placement agents theoretically aim to allocate a particular category of liability to the party best situated to avoid it. (Practically, they often allocate more liabilities to the party with less bargaining power.) By allocating (in theory) liabilities to the “least cost avoider,” indemnification provisions also seek to affect behavior in a manner that mitigates the likelihood of loss. The idea is that a party is more likely to take precautions against a loss if it is required to internalize the cost of that loss; and the party best situated to take such precautions is the party that can do so at the lowest cost. This article explores a question that frequently arises in the negotiation of agreements between hedge fund managers and placement agents: who should indemnify whom? Or more particularly – since the answer is not so absolute – for what categories of potential liability should placement agents indemnify managers, and vice versa? To answer that question, this article discusses: the activities of placement agents that can give rise to claims (by regulators or investors) against or can otherwise adversely affect managers; the activities of managers that can give rise to claims against or can otherwise adversely affect placement agents; how indemnification provisions in placement agent agreements are drafted to incorporate the various categories of potential liability; other mechanics of indemnification provisions (including the relevant legal standard, term, advancement of attorneys fees and clawbacks); the inevitable insufficiency of indemnification; the consequent heightened importance of due diligence and monitoring (including a discussion of ten best compliance practices and procedures for broker-dealers); and the interaction in this context among indemnification, directors and officers (D&O) insurance and errors and omissions (E&O) insurance.