Insurers and other insiders criticize SEC’s indemnification rule

The proposed regulations could alter how insurance would be provided, but uncertainty over the final rules has frustrated stakeholders.

Proposed SEC regulations that would prohibit the practice of fund managers seeking indemnification from LPs for certain claims have drawn the focus of insurers that provide coverage for the private equity industry.

The SEC has proposed a rule that would prohibit private fund managers from seeking indemnification against claims related to breaches of fiduciary duty, negligence, bad faith and similar charges.

In theory, this means money from the fund itself would cover the cost of any settlement, damages, defense fees or other charges brought against a fund manager by an LP, third party or portfolio company. In practice, many funds purchase insurance policies to cover any indemnification costs. GPs also purchase insurance policies in many cases. Many funds and GPs take out General Partnership Liability (GPL) insurance, sources say.

Unclear language

No one knows exactly how the SEC’s proposed indemnification rule, combined with other potential regulations, will play out. “These rules potentially change the way insurance may be structured or provided, and we’re trying to figure out what it all means and the magnitude of the impact,” says Kimberly Patlis Walsh, president and managing director of Corporate Risk Solutions, which provides risk management advisory services.

The confusion stems from the uncertainty around the final rules, which have been in a public comment period since they were introduced in February. Some sources say the SEC’s proposed language is unclear. “They’re sort of half-assed,” says one attorney, who works on behalf of both LPs and PE firms, of the proposed rules.

The wording of the SEC’s regulations, which states that the indemnification prohibition would include negligence as opposed to gross negligence, is one of the wild cards at play.

Negligence is a lower hurdle to clear than gross negligence. “That has raised a lot of eyebrows. If it turns out that a manager made a bad investment in the fund, the GP’s behavior could come under much greater scrutiny under the definition of ordinary negligence,” says Steven Cooperman, an attorney with Morrison Cohen.

“We’re trying to figure out what it
all means”

Kimberly Patlis Walsh
Corporate Risk Solutions

“Generally speaking, any time there are increased regulations, there are increased risks of making mistakes. If you put more rules in place, there’s more of a chance someone will mess up,” says Scott Kegler, a senior vice-president at insurance advisory firm CBIZ.

Insurers have three options, Kegler says: “They can say no, we won’t offer these types of policies any more. Or they will underwrite policies, but charge more in premiums because of the perceived higher risk. Or they will underwrite policies, but limit coverages in order to protect themselves.”

GPL insurance policies provide protection for funds and managers for actions such as investment decisions, due diligence and daily oversight of the firms, Patlis Walsh says. “GPL insurance is a backstop of the indemnification obligation.”

‘Pie in the sky’

According to Luke Parsons, a partner at insurance advisory firm Woodruff Sawyer, the GPL insurance market was soft for several years until 2021, when large claims against upper mid-market firms, covid-19’s impact on portfolio companies and other issues caused premiums to rise. Parsons says that rates have not increased to the same degree as in 2021, but insurers are still looking to “right the ship.”

Other experts state that there is a good chance the proposed rules will not come into place as currently written due to the lobbying efforts from both private equity and insurance industry trade groups. “It’s not going to happen. It’s pie in the sky. People are indemnified all of the time in the banking industry or in estate planning,” says one attorney.