Private equity fund sponsors are facing increased litigation risk from regulators and private parties, including limited partners and stakeholders in portfolio companies. As a result, private equity firms should re-examine their professional liability insurance policies to ensure that their coverage is properly aligned with this increasing risk.
Simply put, private equity sponsors must treat their professional liability insurance as a critical risk-management component of their business. Most, if not all, private equity fund sponsors have some form of a professional liability program in place, typically in the form of a general partner liability—or “GPL”—policy. In many cases, these policies are “off-the-shelf” and are not sufficiently tailored to meet a particular fund sponsor’s specific business needs or risks, particularly as litigation and regulatory risk continues to increase.
In reviewing GPL coverage, these are some of the key questions:
Are activities by regulators covered “claims,” and if so, what specific types of activities are covered by the policy? Given the intensifying scrutiny of private equity by the SEC and other regulators, fund sponsors should consider obtaining insurance coverage for regulatory investigations, enforcement actions, and other activities. If such coverage is in place, sponsors also should conduct a cost-benefit analysis based on whether the coverage is triggered only by certain “formalities” of the enforcement process (e.g., receipt of a Wells Notice or subpoena from the SEC). Often, responding to a regulator’s “informal” or “voluntary” requests for broad categories of a general partner’s or management company’s emails—which is not uncommon—can cost well into the six-figures.
Are the “insured versus insured” exclusions from coverage too broad? Professional liability policies typically exclude from coverage claims brought by one insured against another insured. In the private equity context, however, it is essential that these exclusions not negate coverage for claims by limited partners against the general partner or the management company. In assessing this risk, it also is important to consider whether “derivative” claims brought by limited partners on behalf of the fund are “insured versus insured” claims that are excluded from coverage. Furthermore, sponsors should consider adopting a policy with express language stating that whistleblower actions are not excluded “insured vs. insured” claims.
Is there a clear order of priority between and among insurance policies and indemnification rights? Sponsors should also evaluate the “priority” of the GPL coverage relative to other insurance coverage, whether at the portfolio company level or the management company level, as well as the priority of the insurance coverage relative to indemnification obligations of the fund (i.e., the limited partnership that the sponsor advises), the management company, and the portfolio companies.
A comprehensive review of a professional liability insurance program may uncover numerous other issues including, for example, vague “conduct” exclusions from coverage for things like “dishonest acts” or violations of “public policy” by insureds, or a definition of “defense costs” that does not include work performed before a lawsuit is filed.
As a more general matter, sponsors also should consider whether insurance coverage is appropriate for the limited partnership that the sponsor advises (in addition to coverage for the general partner, the management company, and their affiliates).
There are many other potential pitfalls to consider. For the sake of brevity here, suffice it to say that what may appear to be very minor drafting decisions can have real and significant effects on the scope of the coverage, and we recommend that private equity sponsors work with insurance brokers and outside counsel who are familiar with the private funds industry and insurance issues in assessing their existing coverage.