Touched by Madoff? - You may be…

As has been widely reported in recent news, on 11 December 2008, the US Securities and Exchange Commission issued proceedings in New York against Bernard Madoff and his broker-dealer and investment adviser business, Bernard L Madoff Investment Securities LLC (BMIS). The proceedings are based almost entirely on Madoff's own frank admissions of guilt to senior personnel at BMIS. According to the claim documents, filed in support of an urgent freezing injunction and related relief, Madoff admitted that the entire investment advisory business was “basically, a giant Ponzi scheme” and that “he had for years been paying returns to certain investors out of the principal received from other, different, investors”. Madoff claimed the business was insolvent and that he intended to use the remaining $200 – 300m of assets to distribute to selected employees, family and friends.

Clearly, these admissions will make the prosecutor’s job far easier. It will also help the victims of the fraud pursue successful claims. However, the available pot of funds is going to be inadequate and any trustee appointed to collect and distribute assets to creditors will almost certainly look to those who have received returns under the fraudulent scheme to repay them. Assuming the claimed losses of $50bn is correct and that the funds were obtained from a wide range of hedge funds, wealth managers, private banks and family offices, there will be few institutions in the City of London unaffected by this issue. As a consequence, there will be a lot of finger pointing and investors will seek to blame others for their losses. High on the list of those in the firing line will be the banks, asset managers and funds of funds that recommended investment in Madoff’s vehicle or otherwise invested their clients’ monies with him.

Those likely to be parties to claims arising from the affair may include the following (some of which may find themselves on both sides of the proceedings):

Trustee

The New York court is likely to appoint a trustee in the near future to liquidate the assets of BMIS for distribution to creditors – i.e. principally investors. Clearly, the trustee will be looking to Madoff himself and any others within the business involved in the fraud as a source of recovery, together with the auditors of the business and the insurers of any of the above. However, the trustee is also likely to pursue investors who cashed out early or otherwise benefited from the fraudulent scheme. This means that investors who have received returns in the past, even though they had no knowledge of the fraud and may now be out of pocket themselves, could find themselves subject to claims for recovery of those returns to be pooled for a more egalitarian distribution between all investors. As a result, the ultimate losses suffered by those making the headlines may actually be significantly more or less than is currently being reported.

Present and past investors

Investors in the funds are the most obvious claimants against Madoff and BMIS, but as there is little point in suing they will simply look to prove their debt in the bankruptcy/liquidation. However, they may find themselves defending claims by the trustee for the return of “gains” received in the past, which were themselves fraudulent payments under the Ponzi scheme. Investors who cashed out early may also be subject to claims by the trustee for recovery of fraudulent returns. The trustee need not prove dishonest knowledge of the investor; it is enough to prove that the return was itself a fraud on the newcomers to the scheme.

On the other hand, while they may find themselves looking to recover a proportion of their investments in the insolvency and/or facing claims for returns by the trustee, wronged investors may also seek to pursue a host of third party advisers and/or managers who recommended investment in the Madoff funds or chose to invest their clients’ money in those funds.

Managers & Advisers

Those who have invested in Madoff funds following recommendations or introductions by brokers, or investment advisers or who invested via their discretionary managers may look to those professionals for compensation for their losses. This is likely to be on the basis of allegations of negligent advice, unsuitability and other breaches of duty relating to perceived failures in due diligence conducted on Madoff and BMIS before recommending or investing client monies with them.

Crucial to any claim will be the terms of engagement between client investor and manager/broker/adviser and, in particular, the extent of any advisory obligation assumed by the latter and the existence and reasonableness of any contractual disclaimers and limitations or exclusions of liability. The court will also look at the fee structures to consider whether they are consistent with the service the manager purports to provide (and not to provide). In light of the recent Springwell decision, the level of sophistication of the investor may also be a relevant factor.

Investor claims may also rely on allegations of conflict of interest against the advisers if the bases on which they were rewarded did not reflect industry practice or were otherwise unusual in their structuring or size. We have already seen claims brought against credit rating agencies in the US in connection with failed SIVs and SIV-lites, which rely in part on the operation of fee structures that it is claimed placed them in serious conflicts of interest when rating products. If it appears, as reported in the press, that the fees charged to investors on investments in the Madoff funds exceeded the industry norms, then this might form a ground for challenge.

Investors who invested through “feeder” funds managed by funds of funds may have particular concerns in this regard, as they will have paid additional management fees by investing through such structures. It has been reported that some of these feeder funds charged twice the norm for the hedge fund industry in connection with investments in Madoff funds. Part of the purpose for investing through such vehicles, and paying additional fees, is that they should provide some additional comfort to the investor because the funds of funds are supposed to perform due diligence on the funds they allocate monies to. Therefore, investors using these structures are likely to rely particularly heavily on allegations of negligence with respect to this due diligence function.

European banks appear to be among the largest losers from the fraud. However, they may find themselves subject to yet larger losses still, if some attracted investments in their own-managed funds that on-invested in Madoff funds by contracting with clients on terms that guaranteed no losses – a commitment that could yet prove extremely costly.
Bases of claim do not, of course, fall into watertight compartments, but relevant areas are likely to be:

For an investment adviser

• Was adequate due diligence performed?
• Did the adviser carefully assess the investment offered, or merely pass on the fund material?
• Why was the adviser satisfied as to suitability?
• How was the risk profile assessed and matched to the customer profile?
• What benefits and inducements did the adviser receive for the recommendation?
• Were proper records kept of all discussions and warnings?

For an investment manager

All of the above, plus

• What were the manager’s relevant systems and controls?
• Was the investment within the terms of the mandate?
• How was performance monitored after investment?

Auditors

As indicated above, BMIS’s auditors will be in the spotlight. However, these auditors are reported to be a small firm with only three employees, suggesting they will be a poor source of funds to compensate victims.

In the US, claimant investors are already looking to the bigger pockets of the large accountancy firms that audited the funds of funds (in particular, feeder funds) who invested their money in Madoff funds. The claim will be that the auditors were remiss in failing to detect the fraud. If such a claim were brought in England, it would raise complex issues of assumption of responsibility and reliance. However, the auditors may also face claims from the client funds themselves for failing to detect the fraud and at least one of the feeder funds reported to have suffered significant losses has already indicated it is considering its rights in this regard.

Insurers

Of course, if claims are made against fund managers or advisers in connection with these investments, this is likely to lead to claims by those defendants under their insurance policies. Claims involving fraud, as here, will likely raise coverage issues that may well be complicated in themselves. The insurers of Madoff’s auditors are likely to be a key potential source of recovery for the trustee. Affected firms will be well advised to review the terms of their coverage and make early notification to their insurers.

Regulators?

The regulators will inevitably come in for criticism over this most recent failure. The SEC appears to be vulnerable, but not the FSA owing to the minimal Madoff footprint in the United Kingdom. Even then, a regulator will usually – and rightly – argue that it is a supervisor rather than a micro-manager of firms and cannot be expected to detect what management and investors are themselves unable to spot. While it is now reported that concerns were raised over Madoff’s business at various times in the last decade, a regulator is further protected by statutory immunity from suit unless bad faith can be shown.

A separate aspect, and the converse of the preceding point, is that firms that exposed their clients to Madoff are likely to receive detailed regulatory scrutiny. “I was duped” is no answer, and a firm must be prepared to justify, by reference to the points listed above, among others, how it risk assessed a potential investment of client funds and satisfied itself that this was suitable both initially and on a continuing basis.

How we can help

There are three ways that we can help firms with Madoff exposure

• Issues with investors – we have extensive experience in relation to claims involving fund managers and other financial institutions, including acting on one of the leading pension fund mandate liability cases and defending a major fund manager in a breach of mandate claim.
• Issues with insurers – we have a prominent insurance practice familiar with assisting in complex claims.
• Issues with regulators – we can help a firm that is challenged by the FSA or (through our US colleagues) the SEC in relation to its or its clients’ exposure to Madoff. We have helped many firms to address and resolve regulatory concerns in difficult situations.