Private equity tax strategies investigated in NY – insurance coverage under the D&O or E&O policies?
New York Attorney General Eric Schneiderman recently announced an investigation that has sparked what is being seen as an attack on the Private Equity community. The practice in question here is whether some firms convert certain management fees into investments that are eligible for more favorable tax treatment. Some PE firms have used this practice for years, while others have taken a pass due to its risky nature and potentially illegal ramifications. The IRS has not contested the practice, giving some confidence in the acceptance of the practice. But others argued that the IRS has failed to do its job in regards to this matter and that the silence on behalf of the IRS has been improperly interpreted by the PE firms.
While the topic will be hotly debated and argued for the foreseeable future, an issue has arisen on the insurance front as to whether this type of investigation would be covered under a Directors’ & Officers’ / Private Equity Professional Liability (D&O/E&O) policy. Some interesting issues arise with possible coverage for this investigation; here we take a look at a couple of the more important ones:
First, what is most certainly true for all of the insurance policies potentially implicated is the matter of taxes due and potential fines and/or penalties related to late payment or under payment of those taxes. All management liability policies specifically state that taxes, fines and penalties are not covered under the definition of a “loss” so the best that any Insured could hope for is coverage for Investigations Costs and/or Defense Expenses. And the matter of coverage for Investigation or Defense Costs is certainly not a simple one. There are a number of stumbling blocks that could prevent an Insured from having coverage for these expenses. First, in a number of standard, off-the-shelf policies, the definition of Insured will not include the Insured Entity under the Directors and Offices insuring agreement. If we speculate that this investigation is targeting the Entity itself and not Individual Insured’s, the D&O policy would not respond.
Second, if the definition of Claim does not include Investigations for all Insureds, as is often the case with a standard policy, we are once again looking at a gap in coverage – if only the Entity is the target of the investigation. Also, within the definition of Claim and Investigation, there needs to be careful attention to when an Investigation commences. In this particular instance, it appears as though the subpoenas were for information and may not have alleged any Wrongful Acts needed to trigger the policy.
As we have seen with other state Attorneys’ General investigations, there is often a bevy of copy-cat actions in other states. The complexity of these types of investigations and how they can be covered, or not covered, within the framework of a D&O/E&O policy requires technical expertise and experience. We will continue to monitor the developments in New York and other states if they start to follow suit.
About the Author
Myles Reagan is Vice President at William Gallagher Associates (WGA) and a member of the ExecutiveRisk team. He has extensive knowledge and expertise in all areas of Management Liability, and specializes in managing Financial Risks – mainly hedge funds , PE/VC funds, mutual funds , community banks, and asset managers.
617.646.0329 MReagan@wgains.com Connect with Myles on LinkedIn