Private investments funds (hedge funds, PE firms, venture capital funds and the like) are a significant part of the U.S. economy. From a management liability insurance perspective, private investment funds present unique underwriting and claims issues. In the following guest post, David Topol, takes a detailed look at these kinds of enterprises, and considers the relevant claims and insurance issues. David is a partner in the insurance practice at Wiley. He has substantial experience over the past fifteen years representing insurers as monitoring counsel and in coverage litigation on policies issued to investment advisers, private funds and broker-dealers. A version of this article will be published in a forthcoming issue of the Wiley law firm’s Executive Summary blog. I would like to thanks David for allowing me to publish his article as a guest post on this site. I welcome guest post submissions from responsible authors on topics of interest to this blog’s readers. Please contact me directly if you would like to submit a guest post. Here is David’s article.
Private investment funds, including private equity and hedge funds, play a large role in our capital market structure. According to data from the SEC, in 2019, there were more than 30,000 private funds, and they had over $14 trillion of assets under management.
The large dollars invested in private funds have led to substantial litigation in recent years driven by the size of the funds and the scope of transactions into which private funds enter. Moreover, over the past decade, the SEC has placed much greater scrutiny on examining, investigating and bringing claims against private funds. The current market turmoil will only exacerbate these litigation risks.
This article presents an overview of claims against private funds and their investment advisers from an insurance perspective. The first two sections discuss the relevant terminology and the size of the market. The next section examines who is likely to bring a claim against a private fund and the most common types of high dollar claims. The final section analyzes some of the key insurance coverage issues that arise from private fund claims.
What Is a Private Fund?
The SEC defines a private fund as one that would be an investment company but for the fact that it falls into the exemptions of either Section 3(c)(1) or 3(c)(7) of the Investment Company Act of 1940. Section 3(c)(1) exempts non-public funds with fewer than100 accredited investors, which is currently defined as an investor with an annual income of at least $200,000 and a net worth of at least $1 million. Section 3(c)(7) exempts funds that are only open to qualified investors, who are investors with at least $5 million in investments; however, there is no limitation on the number of such investors in a fund exempt under Section 3(c)(7).
The categorization of private funds is not always precise. In its Form PF, which investment advisers who manage private funds with more than $150 million in assets must file, the SEC identifies seven categories of private funds: (1) hedge funds, (2) private equity funds, (3) securitized asset funds, (4) liquidity funds, (5) real estate funds, (6) venture capital funds, and (7) other types of private funds. Summary data reported by the SEC’s Division of Investment Management, Analytics Office, reports that approximately two-thirds of private funds are hedge funds or private equity funds.
In its Glossary for the Form PF, the SEC defines a hedge fund as one (i) where the investment adviser may be paid a performance fee based on unrealized gain, (ii) that may borrow in excess of 50% of its net asset value, or (iii) that may enter into in short sale transactions. The Glossary defines a private equity fund as “[a]ny private fund that is not a hedge fund, liquidity fund, real estate fund, securitized asset fund or venture capital fund and does not provide investors with redemption rights in the ordinary course.”
In simpler terms, a key distinction between the two principal types of private funds is that hedge funds generally invest in liquid capital, such as stocks and bonds, and it is easier for investors to sell their interests in such funds. Private equity funds normally buy stakes in actual companies, and investors are often required to tie their money up for a number of years in order for gains (or losses) on their investments to be realized.
For purposes of this article, the precise difference between the types of private funds is less important than their common attributes, which also drive the claims risks they face:
- Private funds are pooled investments;
- They are available only to high net worth investors;
- They are managed by an investment adviser, who is also registered with the SEC; and
- They generally pay the investment adviser a fee plus a percentage of profits.
The Size of the Private Fund Market
The SEC’s Division of Investment Management, Analytics Office, tracks and reports data on private funds based on registrations with the SEC. Its January 29, 2020 publication reported that as of the second quarter of 2019, there were 32,620 private funds, including 12,957 private equity funds and 9,486 hedge funds. The SEC also identifies a number of other categories of funds, including “Other Private Funds” (4,715), “Real Estate Funds” (2,851) and “Securitized Asset Funds” (1,577). These private funds reported to the SEC collectively more than $14 trillion of gross asset values and $9 trillion in net asset values as of the second quarter of 2019.
Registered investment advisers manage private funds, and many advisers manage more than one fund. In total, the SEC reports that as of the second quarter of 2019, there were 3,147 registered investment advisers for private funds, including 1,258 for private equity funds and 1,738 for hedge funds.
Claims Faced by Private Funds and Investment Advisers
There are many potential claims risks – both government enforcement activity and private litigation – that investment advisers and private funds face. This section identifies the types of claims that are likely to create the most serious risks for private funds and their advisers and, as a result, for their professional liability insurance carriers.
Enforcement Actions and Investigations
The government – primarily the SEC – generates many claims against private funds. The SEC has placed increased focus in recent years on inspections of, and bringing claims against, private funds that run afoul of securities laws. And these inspections and actions can also provide a road map for private litigants.
The 2020 Annual Report by the SEC Office of Compliance Inspection and Examinations reports that the SEC examines 15% of registered investment advisers annually. This statistic encompasses all registered investment advisers, not just those who manage private funds, although the Annual Report states that 36% of registered investment advisers manage a private fund.
In choosing which investment advisers and private funds to examine, the SEC uses modeling and other strategies to identify which advisers and funds present the most substantial risks as well as which adviser activities warrant the most scrutiny. In its 2020 Annual Report, the OCIE identified investment advisers for private funds, as a priority, explaining that “OCIE will review RIAs to private funds to assess compliance risks, including controls to prevent the misuse of material, non-public information and conflicts of interest, such as undisclosed or inadequately disclosed fees and expenses, and the use of RIA affiliates to provide services to clients.”
According to the November 16, 2019 SEC Enforcement Annual Report, in FY 2019, the SEC brought 191 enforcement actions – 35 civil actions and 156 administrative proceedings – against investment advisers and investment companies. This tally accounted for 36% of the SEC’s enforcement actions and reflects an increase from FY 2018, when it brought 108 such actions, comprising 22% of its docket. The 2019 total is double the number of actions the SEC brought annually during the first decade of the century, reflecting a growing focus on this part of the investment world.
This data on examinations and enforcement actions does not fully capture the range of SEC activity. The Commission may also initiate an informal or formal investigation of a private fund and its investment advisers for violations or securities laws. SEC examinations may be one source of referrals to the office of enforcement, but investigations may also follow from public disclosures or complaints from the public or whistleblowers.
Once the government determines to initiate an investigation, the professional fees and costs of representing the respondent in the investigation can quickly escalate, often into the tens of millions of dollars. The government may demand a large volume of documents, and review and production of those documents generate enormous fees and costs. Witness interviews likewise drive attorneys’ fees and costs. The government’s emphasis on holding individuals accountable can drive up defense costs because each individual who is potentially a target will usually demand separate counsel because of potential conflicts. And, finally, if the information generated by the investigation becomes publicly available through some type of enforcement action, it may provide a road map for private litigants.
Finally, and notably, the government continues to prioritize the pursuit of charges against individuals rather than just companies. The 2019 SEC Enforcement Annual Report stated that in FY 2019, it pursued charges against individuals in 69% of the SEC enforcement actions. The SEC emphasized that “[h]olding individuals accountable is the Commission’s most effective method of achieving deterrence. Experience teaches that individual accountability drives behavior and can also broadly impact culture.”
Suits by Investors in Private Funds
Investors in private funds consistently generate litigation against investment advisers of private funds, particularly over allegedly deficient performance. According to Bloomberg, the average hedge fund returned 6.96% in 2019. By contrast, the S&P 500 returned 30.43%. To be sure, a comparison to stock indexes necessarily affords an imperfect measure of hedge fund performance, particularly since some hedge funds are designed to perform stronger in down or volatile markets and others focus on narrow segments of the economy. Nevertheless, when a private fund performs poorly, investors in the fund may seek to recoup some of their losses through litigation against the adviser, particularly if they believe that there is available insurance to tap.
Because there is no viable cause of action for mere poor performance, investors can take a couple of different angles in bringing such litigation and certainly may pursue multiple approaches in filing suit: causes of action for misrepresentation, negligence, breach of contract and/or breach of fiduciary duty.
First, investors may allege that the prospectus for investors contained material inaccuracies. For example, investors might allege that the prospectus did not adequately disclose the risks associated with the investment strategy or contained inaccurate statements about historical performance.
Second, investors may allege that the poor performance resulted from negligence. The investor might argue that the private fund did not execute on its proposed strategy, that the investment adviser did not exercise due diligence in choosing which portfolio companies in which to invest or that it did not effectively manage the fund portfolio.
Third, investors in a private fund may allege that the investment adviser engaged in improper conduct to maximize the adviser’s interests at the expense of investors. A common set of allegations involves performance fees for non-liquid assets. If an investment adviser is receiving fees based on both assets under management and performance, it may have an incentive to overvalue fund assets or avoid a write down of poorly performing assets.
Some private funds, such as private equity funds and real estate funds, regularly engage in transactions with third parties, including the companies that purchase the portfolio companies, real estate and other assets marketed for sale by the funds. According to data in a 2019 private equity report from Bain & Company, over the past decade, private equity firms typically account for 10-15% of global M&A activity using both a deal and dollar count. In its Annual Private Markets Annual Review, McKinsey & Company reported that in 2018, the value of private equity deals was $1.4 trillion. These transactions trigger litigation risk.
When a private equity fund sells a portfolio company – whether to another private company or to the public – it can face allegations that it failed to disclose unfavorable information and therefore owes money to the purchaser(s). These can be claims for misrepresentations and fraud in the case of a private transaction and violations of Section 11 of the Securities Act of 1933 in the case of an initial public offering. At their core, these suits center on allegations that the firm and the adviser knew of adverse facts concerning the company’s operations or finances and failed to disclose that information during the offering process.
Suits by Public Investors in Publicly Traded Companies Owned by Private Equity Funds
Private equity funds do not always own 100% of the shares of their portfolio companies. Sometimes the fund is a minority investor and other times it owns a controlling interest, but not all of the shares. Advisers and the funds face the risk of litigation by the public shareholders.
When a private equity fund buys out the minority shareholders of a portfolio company, the investment adviser and fund may face litigation alleging that the share price was inadequate. These lawsuits may assert breach of common law duties or seek an appraisal of the shares under Delaware law.
Suits Alleging Conflicts of Interest
There are a myriad of ways in which investment advisers who manage multiple funds can face exposure for potential conflicts of interest. For example, some investment advisers manage both private funds and investment funds open to the public. This can create a potential conflict, and litigation, if the fund engages in conduct that allegedly favors investors in the private fund.
Similarly, a private equity fund may own all of the stock of some portfolio companies while only own the majority of shares in other portfolio companies. This can create litigation risk for allegations that the adviser is favoring the fully private companies in how it allocates shared expense or how it decides which corporate opportunities to steer to which funds.
Employees of the investment advisers may bring suit under traditional employment practices theories, such as wrongful termination, harassment and discrimination. While any company can face risk of an EPL claim, two primary concerns exist in the private fund context.
First, compensation for employees in this industry is high. A 2019 report by Institutional Investor stated that the average total compensation for a hedge fund portfolio manager in 2018 was $1.42 million and for a research analyst was $693,000. Thus, when employees bring claims for sexual harassment, discrimination or wrongful discharge, the potential back pay and front pay damages can be substantial.
Second, Section 922 of the Dodd-Frank Act bars retaliation by employers against whistleblowers and provides whistleblowers with a private cause of action in the event that they are discharged or discriminated against by their employers in violation of the Act. This creates additional risks once an employee of a private fund has made a complaint to the SEC.
The SEC has prioritized evaluating and addressing cyber risks. In its 2018-2022 strategic plan, the Commission set a goal of examining “strategies to address cyber and other system and infrastructure risk faced by our capital markets and our market participants,” explaining:
Data collection, storage, analysis, availability, and protection are fundamental to our capital markets, the individuals and entities that participate in those markets, and the SEC. The scope and severity of risks that cyber threats present have increased dramatically, and vigilance is required to protect against intrusions and disruptions. Consistent with our legal authority, the SEC will focus on ensuring that the market participants we regulate are actively and effectively engaged in managing cybersecurity risks and that these participants and the public companies we oversee are appropriately informing investors and other market participants of these risks and incidents.
While it remains to be seen whether this will actually be a substantial risk for private funds, the SEC’s focus on the issue warrants attention and suggests that it is a potential risk area. Many private funds have access to, and responsibility for, substantial amounts of confidential data that they control directly or through portfolio companies.
Other Types of Claims
This discussion focuses on the most frequent categories of high-dollar claims. However, the list is not exhaustive. There are other categories of claims that can lead to government investigations and/or private litigation and result in high exposures. In particular:
- Insider trading allegations;
- Violations of the Foreign Corrupt Practices Act (“FCPA”); and
- Market manipulation.
Insurance Considerations for Claims Against Private Funds
Key provisions in management liability and E&O policies issued to private funds and their advisers may address the foregoing exposures. Of course, any claim may present coverage issues that warrant careful consideration based on the language of the specific policy at issue, such as conduct exclusions, prior acts exclusions, prior knowledge provisions and issues of when a claim was first made. This section of the article focuses on coverage issues that may be significant in the private fund claim context.
Definition of “Claim” as to Government Investigations
The issue of what constitutes a “Claim” is not unique to the private fund context. Given the SEC focus on private funds in recent years, however, it is important to understand to what extent the coverage available to the investment adviser and private fund affords coverage for government investigations. There is variation in the market in coverage for informal investigations and for investigations only of the entity. Policy language is likely to control here.
E&O policies issued to investment advisers and private funds often contain a broad definition of professional services, but the terms can differ. For example, this issue can come into play when there are suits by third parties, rather than customers of the advisers. In some policies, E&O coverage may be limited to clients of the adviser.
Fines and Penalties/Disgorgement
Most management liability and E&O policies issued to private funds and their investment advisers preclude coverage for “fines” or “penalties.” This limitation can be important in cases where the government is seeking a substantial fine or penalty.
An additional issue concerns the availability of coverage for “disgorgement” or the return of funds to which an insured was not legally entitled There are two aspects to the issue: (1) whether disgorgement is insurable, and (2) whether relief in cases, particularly brought by the government, constitutes “damages,” a “penalty” or disgorgement.”
As to the first question, some policies expressly carve out disgorgement from the definition of Loss. Even absent specific policy language, many courts hold that disgorgement or the return of funds to which an insured is not legally entitled is uninsurable for public policy reasons. See, e.g., Level 3 Communications, Inc. v. Federal Insurance Co., 272 F.3d 908, 910 (2001) (“The interpretive principle for which Federal contends — that a “loss” within the meaning of an insurance contract does not include the restoration of an ill-gotten gain — is clearly right.”); Bank of the West v. Superior Court, 833 P.2d 545, 553 (1992) (“It is well established that one may not insure against the risk of being ordered to return money or property that has been wrongfully acquired.”).
The more complicated issue in the private fund context is how to characterize the relief being sought. In the case of an SEC action, parties have disputed whether the relief that the Commission characterizes as “disgorgement” is in fact a “penalty” and therefore uninsurable or whether it is really “damages” and therefore covered.
This issue came to forefront in the recent Supreme Court case of Kokesh v. SEC, 137 S. Ct. 1635 (2017). The SEC brought the case against an investment adviser, alleging that he misappropriated over $34 million from four development companies he was managing. The issue before the Supreme Court was whether the five-year statute of limitations applicable to claims in which the SEC seeks penalties applies when the Commission seeks disgorgement. The Court held that, notwithstanding the label used by the SEC, the payment was a “penalty” because it was imposed for “punitive” purposes. The Court also noted that “in many cases, SEC disgorgement is not compensatory. As courts and the Government have employed the remedy, disgorged profits are paid to the district court, and it is ‘within the court’s discretion to determine how and to whom the money will be distributed.’” Id. at 1644.
The issue of the SEC’s authority to seek disgorgement as a remedy is before the Supreme Court again this term in case captioned Liu v. SEC, No. 18-1501. In that case, which has been briefed and argued but not decided, the Supreme Court is considering a challenge to whether the SEC even has authority under securities laws even to seek disgorgement.
If the SEC does have authority to obtain disgorgement as a remedy, then a key issue will be whether, in light of Kokesh, the remedy should be treated as a penalty for coverage purposes. The 2018 decision by the New York appellate court in J.P. Morgan, Inc. v. Vigilant Insurance Co., 166 A.D. 3d 1 (2018), illustrates how the issue may play out. In that case, the SEC had brought suit against Bear Stearns alleging that it engaged in improper market timing to favor its hedge fund clients at the expense of mutual fund shareholders. Bear Stearns agreed to pay $140 million in “disgorgement,” representing the profits of the hedge fund clients. In a prior 2013 ruling, the appellate court had held that coverage might be available because the insured was being asked to disgorge a gain by its customers, not its own profits. In the interim, the United States Supreme Court decided Kokesh. Relying on that ruling, the appellate court concluded that the disgorgement was necessarily a penalty and therefore not insurable. Id. at 8 (“[D]isgorgement is a punitive sanction intended to deter. To allow a wrongdoer to pass on its loss emanating from the disgorgement payment to the insurer, thereby shielding the wrongdoer from the consequences of its deliberate malfeasance, undermines this goal.”).
A variation of this issues arises in private litigation where the unlawful gain has already been distributed to investors or did not result in a “profit” for the investment adviser. For example, In re TIAA-CREF Ins. Appeals, 2018 WL 3620873 (Del. July 30, 2018), the Delaware Supreme Court, applying New York law, considered coverage where an insured investment adviser failed to process investors’ sell orders for private funds on a timely basis. The court rejected the argument that the payments to settle the investor lawsuits over the price differential were disgorgement, reasoning that there was no profit by the insured that it could disgorge This will frequently be an issue in private fund litigation because where a fund has earnings that were improper, the earnings have often been distributed to investors and thus cannot be returned by the individuals who retained the improper profits.
Coverage Issues Particular to Inadequate Consideration Claims
As noted above, when a private fund acquires share in a publicly traded company, it may face litigation alleging that it paid inadequate consideration. This potentially implicates a few policy provisions.
First, some policies contain “bump up” exclusions, which bar coverage for amounts paid in settlement or damages that represent consideration paid in connection with the purchase of securities or assets of a corporation. While to date there is only modest case law interpreting the provision, the plain language should bar coverage when a private fund must pay additional consideration for the purchase of securities and assets. However, those provisions often do not apply to the defense of such litigation. Even in the absence of a bump up exclusion, carriers often take the position that the payment of additional consideration does not constitute Loss based on the disgorgement principles discussed above.
Second, there is an open question as to whether there is coverage for appraisal actions under Delaware law. Section 262 of the Delaware General Corporation Law provides that, when a shareholder believes that the share price paid in a merger or consolidation is inadequate, the shareholder can have the shares appraised by the Delaware Chancery Court. Most carriers have taken the position that such suits are not covered because, among other things, they do not require any allegation or showing of wrongdoing by the purchasing company. Last year, a Delaware Superior Court rejected those arguments and ruled for the policyholder. Solera Holdings, Inc. v. XL Specialty Ins. Co., N18C-08-315 AML, 2019 WL 3453232 (Del. Super. Ct. July 31, 2019). The Delaware Supreme Court accepted the appeal, which has been briefed, and oral argument will be scheduled.
The issue of insured capacity can be important in the private fund context because of interlocking corporate relationships. For example, employees of an investment adviser may also sit on the board of the hedge fund that the adviser manages. And employees of the investment adviser often sit on the boards of directors of private equity portfolio companies.
For example, where an employee of an investment adviser sits on the board of a portfolio company of a private equity fund, and that company also has publicly traded shares, the employee has multiple duties. As an employee of the investment adviser, she is seeking to help the fund be profitable. Yet as a director of the portfolio company, she also has duties to all shareholders of the company. This issue can cause tension if the private equity fund seeks to buy out the public shareholders and take the company private. In that case, the public shareholders want to maximize the share price for the transaction while the fund wants to pay as little as possible for the shares.
E&O policies will generally address the capacity in which coverage is afforded. This is an area where policy language can vary, and analysis of the policy provisions and the structure of the relevant entities will be necessary.
The availability of other insurance is an important issue in the case of portfolio companies since employees of the investment adviser are often on the boards of portfolio companies. The coverage for the investment adviser and the private equity fund often provides that in the case of employees who are on the boards of the portfolio company, the investment adviser/fund coverage is excess to the coverage available to the portfolio company.
Most of the coverage analysis focuses on coverage available under management liability and errors and omissions coverage policies that a private fund and its adviser generally purchase. However, in some cases, other insurance coverages can provide protection, including:
- EPL coverage, and investment advisers may have stand-alone EPL coverage even if they also have EPL coverage as part of their main professional liability coverage.
- Cyber coverage.
- Representations and warranties insurance, which may afford coverage for misrepresentations in connection with the sale or purchase of a portfolio company or substantial assets.
- Cost of corrections coverage for errors in executing on trades.
At this moment in 2020, there is obviously much uncertainty about the markets. There is no doubt, however, that private funds, many of which attempt to exploit that uncertainty, will continue to play a large role in capital market structures. For this reason, there is value in understanding of the risks associated with private funds, and the insurance implications flowing from those risks.
David is a partner in the insurance practice at Wiley, where he represents insurers on a wide range of coverage matters. He has substantial experience over the past fifteen years representing insurers as monitoring counsel and in coverage litigation on policies issued to investment advisers, private funds and broker-dealers.