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The long and the short of it

Short squeeze implications on your investment management liability insurance policy.

Risk & Analytics|Corporate Risk Tools and Technology|Financial, Executive and Professional Risks (FINEX)
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By Conor R. Hampel and Henry Carrat | February 1, 2021

Speculative retail investment trends introduce liability concerns for investment managers.

On April 13, Allnews.ch published an interview with Henry Carrat (Account Director, Corporate Risk & Broking) who discussed whether hedge funds are exposed to a higher risk of loss. You can read the article in full below.

Hedge funds and other investment vehicles should realize that bruised equity short positions are not the only ways that the speculative retail investment trend can adversely impact them and there are liability concerns to consider.

Introduction

Hedge fund investors have been on the wrong side of several highly publicized stock swings caused by often unsophisticated investors buying shares and driving up prices of companies trending on social media platforms such as Reddit and Twitter. Investment management firms have benefitted in certain situations, but the headlines have been dominated by retail investors and hedge fund managers being on opposite sides of a David vs. Goliath conflict in which retail investors are winning big. What’s bad for hedge funds is also bad for their investors and could also raise alarm bells with regulators.

Fiduciary Duty

While the term “hedge fund” has evolved from its original reference to using short investments in order to minimize risk or “hedge” against the exposure to long positions, many firms still employ long/short equity strategies with an objective of being market neutral. To the extent that such firms are straying from the investment mandates set forth in their offering documents/private placement memorandums and risky short positions result in poor performance, hedge funds are susceptible to breach of fiduciary duty and potentially mismanagement suits from investors.

Regulatory

The Biden Administration is widely expected to take a more aggressive approach to regulation and enforcement activity. While this may be the case, these recent events come at a challenging time for the SEC which is in a transitionary period. Despite this hurdle, regulatory intervention is expected to commence in reaction to these recent momentum-fueled rallies and it will likely impact all of the involved parties. Market manipulation, retail brokerage trade restrictions and hedge fund disclosures are just some of the topics gaining regulatory attention.

Liquidity

The size of potential damages associated with losing short positions can be substantial if they are not closed in a reasonable timeframe, but they can be exponentially worse if leverage is utilized. While the use of leverage is common and allowable under most hedge fund investment mandates, it can be a double-edged sword to the extent that short positions go haywire. The perfect storm of irregular market movement and overexposure to levered short positions could result in a liquidity crunch pushing hedge funds out of business.

Volatility

Trading volume is exploding in early 2021 and we are reaching levels not seen since 2008. While the increase in retail investment activity on electronic brokerage platforms is certainly contributing to these figures, we are also seeing a major uptick in institutional investment volume as reflected in strong trading revenue at global banking institutions. More trading means more potential for trading errors, an increasingly common source of liability for investment managers.

Insurance

Management (directors & officers “D&O”) and professional (errors & omissions “E&O”) liability insurance for hedge funds is readily available in the market and many of the claim scenarios contemplated herein should be covered under a well-constructed policy. Certain policy provisions such as the extension of cost of corrections (trade error reimbursement) and formal (and often informal) regulatory investigations coverage will be increasingly valuable to policyholders. To preserve coverage under these policies, it will also be important for policyholders to fully understand and comply with claim notification provisions, which can vary depending on the nature of a given claim.

Insurance underwriters assessing potential hedge fund insureds will be increasingly focused on short positions, both in terms of their size and what percent they comprise of the overall investment portfolio. Use of leverage will also be closely considered as part of their review. As always, it is critical that applicants for coverage are accurate about their exposure given that misrepresentations made in the application process can potentially void coverage.

Conclusion

We urge investment managers with exposure to equity short positions to develop a firm understanding of how their insurance can help mitigate their potential liability. We also urge them to confer with their insurance brokers to review their D&O/E&O liability insurance program structures and policy wordings. Such proactive measures can enhance the likelihood of comprehensive policy recovery should a claim arise.

Authors

East Team Leader, Financial Institutions, FINEX

Account Director, CRB Romandie

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