AIFMD, Negligence and the Insurance Gap

Bank Vault

As we know, the Alternative Investment Fund Managers Directive (AIFMD or ‘Directive’) includes a provision that requires the Alternative Investment Fund Managers (‘AIFM’) to hold either (further) additional own funds or professional indemnity insurance (‘PII’) to cover professional liability risks.

Such risks are outlined in the regulation, which also states that they should arise out of negligence and for which the AIFM is legally responsible. Cover provided by a PII policy is based on a legal liability existing with the party seeking compensation and most policies available already cover risks that go beyond the scope of ‘negligent’ activities.

Therefore, although some further policy amendments will be required to ensure compliance with the Directive, an AIFM who chooses the insurance route should at least find this section of the Regulation relatively easy to deal with.

However, could there be a more fundamental conflict between what the Directive requires and the practice amongst some alternative investment managers who agree a higher ‘gross negligence’ standard with the fund via contractual terms?

Whilst it is not specifically stated that legal liability cannot be avoided in this way, the focus on avoiding conflicts of interest in the regulation, together with the FSA’s recent public comments relating to its concerns in this area, perhaps indicates that the regulator will be concerned if parts of the regulation relating to professional liability can be seemingly circumvented by the AIFM contracting out of its responsibilities for negligence.

Legal Responsibilities

Does this indicate that contractual legal responsibilities toward the fund are an area likely to require review by alternative investment fund managers? Their recent “Dear CEO” letter related to conflicts of interest between asset managers and their customer’s highlights the FSA’s interest in this area.

The document published in November 2012 noted concern that some firms, mostly hedge fund managers, relied on clauses to remove liability for the cost of errors and omissions other than in the case of ‘gross negligence’.

Drivers are not only regulatory but also come from investor demands. We have noted an increased focus by investors relating to responsibility of the investment fund manager for ‘negligent’ trade errors in particular and therefore similar interest from insured investment fund managers regarding their PII policy response.

What is the solution?

Whilst we may need to wait for further developments and clarification on these areas, Willis has designed an insurance policy solution to make clear that liability for covered acts, errors or omissions of the AIFM is catered for by a Willis PII policy, notwithstanding that the clauses in the investment management agreement, offering memorandum or other contract between the investment manager and the fund may seek to avoid or limit such legal liability.

This addresses the fundamental flaw inherent within PII policies, and in particular those issued to hedge funds, that require legal liability to be present to trigger the coverage when, in fact, such liability for negligence may not exist due to the contractual terms agreed with the investor.

This solution not only provides certainty and a higher-level of protection to our investment manager clients and their investors, but also provides an insurance policy that meets the Directive’s negligence standard regardless of a higher ‘gross negligence’ standard that may be agreed in contract.

With the Regulation for the first time including the use of PII as an alternative to capital for alternative investment managers we believe this is an important and appropriate response to address the developing needs of investment fund managers.

About Paul Richards

Paul is Executive Director and Co-FI Practice Leader in Willis Towers Watson's FINEX Global division. Based in Lon…
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