Nov. 17, 2011

Hedge Fund D&O Insurance: Purpose, Structure, Pricing, Covered Claims and Allocation of Premiums Among Funds and Management Entities

Directors and officers (D&O) liability insurance can be an expensive proposition for hedge fund managers, particularly given the growing costs of doing business.  However, a number of factors make purchasing such coverage increasingly compelling for hedge fund managers.  Such factors include enhanced market volatility, heightened regulatory scrutiny of fund managers, more demands for such coverage from fund investors and greater competition among insurance carriers which has resulted in moderate price reductions for D&O insurance.  To assist hedge fund managers in evaluating whether to purchase D&O insurance, how much, at what cost and under what structure, this article starts by identifying nine discrete reasons why hedge fund managers may consider purchasing D&O insurance.  The article then discusses: what D&O insurance is; what related categories of insurance hedge fund managers typically purchase; who is covered under a D&O policy; what types of claims are covered under a D&O policy; what types of claims are typically excluded; applicable legal standards; situations in which costs may be advanced and clawed back; the market for retentions or deductibles; “hammer” clauses; the differences among Side A, Side B and Side C coverage; and the current market for pricing of D&O insurance, including pricing of the primary layer of coverage and additional layers in the “tower.”  This article concludes with a discussion of how hedge fund managers are allocating the cost of premiums among management entities and funds, and the interaction between D&O policies and indemnification provisions in fund or management company documents.

Richard Chen Joins Hedge Fund Law Report as Editor in Chief

On November 14, 2011, Richard Chen joined the Hedge Fund Law Report as its Editor in Chief.  Most recently, Chen was a Counsel in Arnold & Porter’s corporate and securities practice group where he advised hedge fund sponsors on the structuring of fund products as well as operational, marketing, regulatory and trading issues.  Prior to joining Arnold & Porter, Chen was an associate at Schulte Roth & Zabel, where his practice focused on structuring fund products and compliance programs for hedge fund and private equity fund sponsors, advising hedge fund and private equity fund sponsors on a wide range of operational, regulatory and trading matters, advising fund sponsors on seeding arrangements and negotiating service provider arrangements on behalf of fund sponsors.  Chen has worked with a wide range of fund managers including those with billions in assets under management as well as entrepreneurial start-up funds.  Chen also has experience representing investment advisers and broker-dealers in SEC and FINRA examinations, investigations and enforcement actions as well as guiding investment advisers through the SEC registration process.  Chen began practicing law after he graduated from Harvard College in 1995 and Harvard Law School in 1998.  “I am honored and excited to join the Hedge Fund Law Report as its Editor in Chief,” Chen said.  “During my years in practice, I came to relish the sophisticated commentary and market color offered by the Hedge Fund Law Report and am impressed at how it has already made such a large imprint on the hedge fund industry.  I look forward to contributing towards the tradition of excellence that is the hallmark of the Hedge Fund Law Report and to creating an ongoing dynamic dialogue with the hedge fund industry.”  Mike Pereira, Founder and Publisher of Hedge Fund Law Report, said: “Rich is a luminary in the hedge fund law industry, widely known and deservedly well-regarded.  He has a profound grasp of the legal issues that drive business decision-making, a unique ability to discern regulatory trends and a gift for clear communication.  Rich has worked on cutting-edge legal issues at the best firms for the most innovative clients.  As a result, Rich knows what is market, why certain terms or practices are market, how the market is changing and how those changes will affect structuring, drafting, marketing, due diligence, taxation, portfolio management and a range of other relevant topics.  We are thrilled to have Rich on board.  The HFLR will serve its subscribers even more effectively under Rich’s editorial stewardship.”

U.S. District Court Evaluates FINRA Arbitration Decision in High-Stakes Severance Dispute Between UBS and Former Portfolio Manager

Plaintiff Stephen P. Finkelstein (Finkelstein) was a portfolio manager for Dillon Read Capital Management (Fund), a hedge fund operated and owned by defendants UBS Global Asset Management (US) Inc. and UBS Securities LLC (together, UBS).  In early 2007, Finkelstein received a bonus in the amount of $25 million based on the Fund’s 2006 performance.  During the financial crisis that unfolded during 2007, the Fund showed losses of more than $300 million attributable to Finkelstein’s trades.  Finkelstein’s trading authority was suspended.  UBS closed the Fund and eventually terminated Finkelstein.  UBS had an ERISA-governed severance plan in place and adopted a “Supplemental Program” for Fund employees who might not otherwise be eligible for bonuses due to the timing of the Fund’s closure.  Eligible employees could receive a bonus equal to 25% of their 2006 bonus.  Finkelstein put in a claim for a bonus in the amount of $6.25 million, which UBS denied based on the huge trading losses incurred by the Fund as of April 2007.  Finkelstein submitted the claim to arbitration through FINRA Dispute Resolution.  The arbitration panel denied his claim.  Finkelstein then commenced an action in U.S. District Court seeking to overturn the arbitration decision.  We summarize the District Court’s decision with respect to Finkelstein’s claim and the Court’s legal analysis.

How Hedge Fund Managers Can Use Technology to Enhance Their Compliance Programs

Heightened regulatory scrutiny and investor expectations in today’s hedge fund environment have prompted many fund managers to look to technology solutions to increase the effectiveness and efficiency of their compliance programs.  Lori Richards, principal of PricewaterhouseCoopers LLP (PWC) and former Director of the U.S. Securities and Exchange Commission’s (SEC) Office of Compliance Inspections and Examinations, recently published a report (Report) entitled “Integrating technology into your compliance program to improve effectiveness and efficiency.”  The Report states that maintaining manual compliance processes can be time-consuming, costly and prone to error while technology enhancements can provide numerous benefits for a fund manager, including: enhancement of the efficiency, accuracy and consistency of data gathering; scalability of technology infrastructure for firm growth that is resistant to staff turnover; demonstration of a compliance culture to regulators and investors; reduction in the burden of inspections with easily generated reports; and overall cost efficiencies.  For a similar argument in favor of automation, see “Spreadsheets Can Stunt a Hedge Fund Manager’s Growth,” Hedge Fund Law Report, Vol. 4, No. 31 (Sep. 8, 2011).  The Report also cautions that piecemeal automation of compliance processes can lead to nonintegrated systems that are costly to maintain and unable to provide a consolidated risk assessment across the firm.  Additionally, firms that do not appropriately utilize technological solutions to modernize their compliance programs may not be able to meet industry standard practices.  The crux of the Report surveys the types of technology solutions that can enhance a hedge fund manager’s compliance program and details the process fund managers should use in selecting vendors.  See “Hedge Fund-Specific Issues in Portfolio Management Software Agreements and Other Vendor Agreements,” Hedge Fund Law Report, Vol. 4, No. 26 (Aug. 4, 2011).  This article details the contents of the Report and highlights the lessons most critical to hedge fund managers looking to apply best technology practices to their compliance policies and procedures.

How Do Courts Assess Civil Monetary Fines in Insider Trading Cases Against Hedge Fund Managers?

On November 8, 2011, Judge Jed S. Rakoff of United States District Court for the Southern District of New York imposed a record civil penalty of $92,805,705 on Galleon Group founder Raj Rajaratnam.  Judge Rakoff’s opinion analyzes the civil penalty provisions of the Securities and Exchange Act of 1934 in a civil insider trading action against a hedge fund manager that has been convicted of insider trading in a parallel criminal case.  The opinion illustrates the factual and legal considerations that influence the calculation of civil penalties; the public policy purpose of civil penalties; whether civil penalties should be based on gross trading profits of a hedge fund or net fees and profits personally gained by the individual defendant; and the time during which relevant profit gained or loss avoided should be measured.  For hedge fund managers, Rakoff’s ruling serves as a reminder that profits from insider trading, if discovered, are in effect a loan from the government with usurious terms.  You have to pay it back, and the interest includes whatever you gained, the full value of your management company and the entirety of your reputation.

Second Circuit Decision Addresses the Ability of Hedge Funds to Attach Sovereign Property

A recent Second Circuit decision addressed the circumstances in which a hedge fund may attach property of a sovereign in satisfaction of defaulted sovereign debt.  See also “United Kingdom’s High Court Finds Argentina’s Sovereign Immunity Doctrine Cannot Prevent a Hedge Fund from Seeking to Enforce an American Judgment against Argentina in English Courts,” Hedge Fund Law Report, Vol. 4, No. 25 (Jul. 27, 2011).  The opinion is particularly relevant to the hedge fund community today, when many distressed debt managers are actively raising funds to invest in what they anticipate will be a wave of sovereign debt defaults or near-defaults in Europe.  See generally (on the market for trading in European secondary corporate loans) “Regulatory, Tax and Credit Documentation Factors Impacting Hedge Funds’ Trade Risk in European Secondary Loans (Part One of Two),” Hedge Fund Law Report, Vol. 4, No. 37 (Oct. 21, 2011).  In the event of an actual sovereign default, this opinion will help clarify the ability of hedge funds to, in effect, foreclose on sovereign collateral – a process that is typically more involved, more time-consuming and more risky than foreclosing on private collateral in a U.S. bankruptcy or a UK administration.  See “Liquidity for Post-Reorganization Securities Under Section 1145 of the Bankruptcy Code,” Hedge Fund Law Report, Vol. 3, No. 26 (Jul. 1, 2010).

SEC Commences Fraud Action against a Purported Hedge Fund Manager for Providing False Background Information and Including False Information on a Website

On October 26, 2011, the Securities and Exchange Commission (SEC) filed suit against Andrey Hicks and the hedge fund manager he ran, Locust Offshore Management, LLC (LOM), alleging that they defrauded investors by fabricating the existence of a British Virgin Islands-incorporated pooled investment fund.  The SEC’s complaint (Complaint) also names the purported fund, Locust Offshore Fund, Ltd. (LOF), as a relief defendant.  The Complaint, among other things, sheds new light on an old due diligence verity – the imperative of thorough background checks.  See “In Conducting Background Checks of Hedge Fund Managers, What Specific Categories of Information Should Investors Check, and How Frequently Should Checks be Performed?,” Hedge Fund Law Report, Vol. 2, No. 36 (Sep. 9, 2009).