Family offices are complicated because of the scope of services they deliver, the high number and complexity of entities they oversee and the staff they must manage. These complexities can open the door to liability.
In working with family offices and the executives who manage them, I’ve consistently been asked the following three questions relating to the executives’ roles as directors or officers:
1. What’s our exposure to liability?
2. How can we control total operating costs?
3. What’s the best approach to buying directors and officers liability (D&O) insurance?
To address these questions, I’ll first focus on primary liability exposures, more commonly referred to as “management liability,” D&O liability, employment practices liability and fiduciary liability. Then, I’ll examine why it’s important to create a process to annually evaluate the complexity of entities served by the family office. And, because many of these liability exposures are insurable, I’ll provide a process for determining what insurance to buy.
Directors and officers. Family office directors and officers establish and oversee the policies and procedures that dictate an office’s day-to-day operations. In addition, they and their boards often delegate responsibility to dedicated committees, which may utilize outside consultants to help evaluate investment opportunities or assist in manager selection and monitoring. In many cases, directors and officers are also responsible for selecting and implementing complex software systems and technologies, along with monitoring outside advisory firms, such as law firms, accounting firms and banks. This sample list highlights the diverse responsibilities of directors and officers as they oversee a number of activities on behalf of family owners.
Directors and officers have a strict fiduciary duty to family members and family operating entities. Through this fiduciary standard, they have obligations and standards of care, as well as exposure to legal liability for their actions, similar to those of a larger corporation.
To mitigate the potential liability associated with their fiduciary duties, directors and officers should follow the business judgment rule to make informed decisions and act in good faith in overseeing operations of the family office and needs of the family owners. This rule includes three duties:
• Loyalty—General duty of undivided loyalty to the company they serve.
• Diligence—Exercise care as a reasonably prudent person in the same circumstances.
• Obedience—In addition to legal requirements, directors or officers must conduct business within the powers of the corporate charter.
Employment practices. This liability represents one of the fastest growing areas of potential exposure for employers, with the median award of claims rising to $325,000.1 The most common employee lawsuits fall into the following broad categories:
• Wrongful termination;
• Harassment; and
To manage this risk, all offices should have a process for hiring and terminating staff and provide an employee handbook to staff members, reinforcing the policies established by the office. Directors and officers should make sure supervisors are trained to respond to complaints, as the negligence in not doing so creates additional liability exposure. Often overlooked is a staffing policy for managing employees who aren’t employed by the office, but who are employed directly by the family owners. In addition to domestic staff serving private residences, this may include the staff of specialty assets, such as crewed yachts, farms/ranches and general aviation operations for owned aircraft. Without strong employee oversight, a higher probability exists for potential claims for violating federal, state or local employment laws.
Employee Benefit Plans
To attract and retain highly qualified staff, family offices generally offer employees benefit plans. However, in addition to fiduciary responsibilities owed to family owners, directors and officers have fiduciary responsibility to employees when they sponsor retirement (401(k)) or group health and benefits plans. Family offices should review their plans and understand the compliance requirements under the Employee Retirement Income Security Act of 1974 (ERISA).
Managing the Complexity
Managing operational costs is a priority for most family office managers. In their 2011 research report on understanding office costs, Family Office Exchange found that “complexity includes the scope of services offered, size of the family, and entities served by the office” but also found a “proven relationship between the number of entities an office manages—including individuals, households, trusts, and partnerships—and office costs.”2
To manage complexity, many offices have established an annual review process, which can provide several benefits. First, it builds awareness of potential management and professional liability associated with overseeing and servicing complicated transactions (for example, tax compliance and planning and financial results reporting). Second, it allows a review of staffing strengths and expertise and can help identify potential outsourcing opportunities—needs that have outgrown staff expertise or areas in which new or existing advisors can take on more of the general work and leave specialty work to the family office, thereby streamlining operations and costs. Lastly, the process can aid in an insurance review to identify operating entities that should be moved off the office insurance program and placed under separate coverage.
Managing Insurance Coverage
Two common means of managing the risks associated with the types of liability exposures faced by family office directors and officers are indemnification through contractual language and the purchase of insurance. The best risk management approach is to have both.
Indemnification. Similar to their corporate counterparts, and as a consequence of their leadership role, directors and officers of family offices may be named as parties to litigation, regardless of the merits of the claim. Examine these three areas to maximize the protection of indemnification for family office executives:
1. Review the corporate charter of the family office with legal counsel to ensure that the indemnification provisions provide the maximum protection permitted by law, whether under corporate charter or by employment contract.
2. Obtain indemnification and incorporate hold- harmless agreements into contracts with outside service providers to shift responsibility of risk away from the office.
3. Ensure that the indemnification is backed with sufficient financial resources.
Insurance. Most offices buy insurance or may be required to buy it as part of establishing a family private trust company. In addition, very often, independent directors will request that D&O insurance be provided.
Insurance companies perceive family offices as a niche market. As such, in my experience, it’s vital for your insurance advisor not only to understand the complexity of your office, but also to be able to articulate your risk profile to the underwriting community. All family offices provide different services and incorporate different corporate structures. If insurance policies aren’t tailored to these specific needs, gaps in coverage will occur.
Typical family office insurance programs include the following coverage areas, which will protect against the liabilities discussed earlier:
• D&O and private company liability;
• Errors and omissions: family office and trust services liability, including vicarious liability;
• Employment practices liability; and
• Professional and management liability coverage, which can include:
• Hedge fund and private investment fund coverage;
• Pension and welfare benefit plan;
• Outside director’s liability; and
• Fidelity and ERISA bonds.
Employing consistent policies and procedures, establishing an annual entity review process, maximizing protection provided by indemnification and buying insurance are all tools to help manage the risks associated with management and professional liability.
1. Jury Award Trends and Statistics, Westlaw (2012-2013 ed.).
2. Family Office Exchange, “The Cost of Complexity, Understanding Family Office Costs 2011.”