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News November 8, 2004 Issue

Protection for CCOs, Part 2: The Skinny on E&O and D&O Insurance

Got insurance?

From the CCOís perspective, there are two fundamental problems with E&O ("errors and omissions") insurance. First, when insurance carriers designed their policies, most did not contemplate the role of the CCO. As a result, the typical E&O policy defines "insured professional services" as the provision of financial, economic or investment advice regarding investments in securities and other investment management services, pursuant to a written contract defining the scope of the advice and services, for monetary compensation. In other words, the CCOís professional services as a compliance officer (which may have nothing to do with providing investment advice) arenít covered on the face of the policy.

Only a handful of carriers (Chubb and The Hartford are two) have added "compliance endorsements" to their E&O policies, which explicitly state that the firmís CCO is a named insured in his or her capacity as CCO under the compliance program rule. Andrew Fotopulos, executive vice president at insurance broker Theodore Liftman Insurance, said that the "initial reaction" from representatives of some insurance companies has been that they do not view compliance as an insured advisory service. But, he added, itís been difficult to obtain "something in writing" stating the insurance companyís point of view on the status of CCOs as covered insureds.

Even if CCOs are covered under their firmís E&O, thereís still a second problem: while most E&O policies will cover cost of defending claims brought by private litigants, and some might even cover the cost of defending against regulatory charges, most E&O policies specifically exclude fines and penalties imposed by regulatory bodies. Put another way, if the SEC brings charges against your firm and wins, or the suit is settled, E&O wonít cover the resulting fines and penalties.

Directors and officers insurance, or "D&O," solves the first problem but not the second. D&O covers the negligent or unintentional acts of directors and officers in their broader corporate capacity (not just in providing services under the investment management agreement). Most, but not all, carriers, offer a D&O extension on a basic E&O policy, which may cost 10 to 15 percent of the E&O annual policy premium.

Hereís where CCOs want to make sure that they are an officer of the firm. (Note: to be covered under E&O, you usually donít have to be a named officer of your firm. E&O typically covers all directors, officers, and employees of the adviser).

If your firmís bylaws specify that everyone at a certain level and above is an "officer" of the firm, ask for a promotion to "vice president" "senior v.p.," or the requisite level. Alternatively, ask your firm to name you as an officer in the firmís bylaws. Barbara Brooke Manning, CCO of Schroder Investment Management said that she requested that a fund change its bylaws to specifically name her as an officer of the fund, to make sure she was covered under the fundís D&O policy. "I knew I was covered under the adviserís D&O policy," she said, "but yet we went the whole nine yards."

However, D&O, like E&O, still doesnít cover the cost of paying fines and penalties to the SEC.

The upshot: CCOs should not rely solely on E&O or even combined E&O/D&O for protection, given the uncertainty of whether the CCOís compliance services are covered (by E&O) and the lack of coverage for regulatory fines and penalties (by both types).

At the NRS conference, consultant Ann Oglanian advised CCOs to ask insurance brokers "to come and explain" how various insurance options work. "Make sure you understand it, and if you donít, have them explain it again," she urged. By educating yourself on insurance coverage, she said, you are taking the CCO job and its attendant liability "with your eyes open." Oglanian added that including the CCO under the firmís insurance coverage is in the CEOís best interest. "If your CCO is not protected, [the CEO is] not protected," she said. She added that if she was a CEO, she would "not want my CCO wandering around with a target painted on him" or "not sleeping at night." Instead, she said that she would want the CCO to understand that he is a respected part of the team. "Itís a stature issue," she said. If the CEO, CFO, portfolio managers, and other senior officers are covered by insurance, the CCO should be, too.

LPL Financial Services v.p. of compliance Michelle Jacko noted that some of her staff have come to her and asked what their coverage is under the firmís E&O. If a CCO is delegating compliance responsibilities, she said, "it would be prudent not only to see whether or not [delegatees] are covered, but to then go to senior management if they are not covered and request coverage."

And make sure you keep abreast of changes. Brooke-Manning noted that there have been a number of changes to insurance coverage since the market timing and late trading scandals. Among other things, "rates went through the roof," and the list of exclusions from what is covered has changed. She said that after her fundís board asked for a lot more detail on changes to the fundís insurance coverage, her firm had the insurance broker come in and do a presentation before the board.

Speaking of exclusions: All policies have fraud exclusions, but most contain a "severability clause" so that to the extent that the CCO (or another party) was oblivious to the fraud being perpetrated, the policy still would cover that individual. Of course, that leads to the question of whether a violation of the compliance program rule, which is technically an anti-fraud rule, would be subject to the fraud exclusion.

Fotopulosís advice: "The first place a CCO should look for coverage is to be indemnified by their firm." In some cases, the firmís bylaws may automatically indemnify all officers, and the mere fact of being named an officer will provide indemnification. Alternatively, indemnification may be achieved by approaching your firmís general counsel and working out an amendment to your employment contract (assuming you even have one). But donít be too optimistic. Fotopulos said that heís heard of people "having a hard time receiving written assurances that they are protected."

Also keep in mind that in recent settlements, the SEC has added provisions explicitly prohibiting the settling party from seeking recourse through insurance coverage. In some cases, the SEC has imposed limits on employees seeking indemnification from their employer.

Sanjive Sabade of Marsh Affinity Group Services advised firms to call around to see if their level of coverage is in line with what similar firms are carrying. "Compare your firmís profile in terms of client size and/or asset size with other firms and assess your risk exposures for adequate limits to protect you," he said. "Call other firms" and ask "are you carrying $5 million? $10 million?"

Added Sabade: "They donít have to disclose their premium," which he said is typically considered confidential.