SEC proposed rules on GP indemnification cause jitters with insurers

Proposed SEC regulations that would prohibit the practice of fund managers seeking indemnification from LPs for certain claims have drawn the focus of insurers who 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 go to pay for any settlement, damages, defense fees and other costs related to charges brought against a fund manager by an LP, third party or portfolio company.

But in practice, many funds purchase insurance policies to cover any indemnification costs. And GPs also purchase insurance policies in many cases.

Funds and GPs largely purchase General Partnership Liability (GPL) insurance, sources said.

Insurers and other industry insiders say the SEC’s proposed indemnification rule, combined with other potential regulations outlined in the agency’s February announcement, will impact this corner of the industry.

However, no one knows exactly how.

“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,” said 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 being introduced in February. As well, some sources said the SEC’s proposed language is unclear.

“They’re sort of half-assed,” said one attorney, who works on behalf of both LPs and private equity firms, about the SEC’s proposed rules.

Another wildcard at play comes through the wording of the SEC’s regulations, which states that the indemnification prohibition would include negligence as opposed to gross negligence.

Negligence requires a lower hurdle to clear than gross negligence, according to Steven Cooperman, an attorney with Morrison Cohen who focuses on private equity.

“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,” Cooperman said.

Attorneys and insurance brokers say that most side-letter agreements and LPAs don’t indemnify GPs for the most severe actions. However, GPs have grown more aggressive over time seeking indemnification over breaches of fiduciary duty and connected rules, according to the SEC in its proposed rules.

“Generally speaking, anytime 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,” said Scott Kegler, a senior vice president at insurance advisory firm CBIZ.

Insurers have three options, Kegler said.

“They can say no, we won’t offer these types of policies anymore. 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,” Kegler said.

GPL insurance policies provide protection for funds and managers for actions like investment decisions, due diligence, and daily oversight of the firms, Patlis Walsh said.

“GPL insurance is a backstop of the indemnification obligation,” Patlis Walsh said.

According to Luke Parsons, a partner in the private equity practice group 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 said that through 2022, rates have not increased to the same degree as 2021, but insurers are still looking to “right the ship.”

Patlis Walsh added that claims, discovery, investigation and settlement costs have dramatically increased over the years.

Other experts also state that there is a good chance the proposed rules won’t 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,” said one attorney.

[Correction: Kimberly Patlis Walsh’s name was misspelled in an earlier version.]