Has someone Madoff with your money?

30 January 2009

In December 2008, the now infamous Bernard Madoff hit the headlines in what has been dubbed the world’s largest financial swindle. Further fraudulent schemes are emerging in the US.

Madoff is a former Nasdaq chairman who managed investments for hedge funds, banks and wealthy individuals. His remarkably successful operation was in fact a ’Ponzi’ pyramid selling scheme. When it imploded, losses emerged of some $50 billion.

Madoff has been charged with fraud by US prosecutors and is currently on bail awaiting trial.

What is a ‘Ponzi’ scheme?
So called Ponzi schemes are named after a frauduster from the 1920s, Charles Ponzi. Promising high returns to investors, a fraudster in a Ponzi scheme uses money from new investors to pay off the earlier investors, often with high rates of return to maintain the charade, until no new investors can be found and the whole scheme collapses.

So, what happened?
As the credit crunch bit, investors became more wary and new funding was more difficult to find. Certain investors sought a return of their capital. With declining investment and no new injections of capital, the fund’s liquidity problem was quickly insurmountable. Madoff allegedly admitted the deception to his two sons who turned him in to the authorities.

Investigations have been launched by both the Securities and Exchange Commission (SEC) and its UK equivalent, the Serious Fraud Office (SFO).

What are the implications for professionals and their PI insurers?
Allegations are emerging that fund managers and intermediaries who invested and advised others to invest in Madoff’s funds failed to take heed of, or advise investors on, the risks involved in investing in these funds.

Investors will undoubtedly say that investment advisers and fund managers failed to discharge their duty of care or fiduciary duty to investors and failed to perform basic due diligence.

Due diligence ought to involve analysis of operational risks, valuation and investment processes, off-shore structures and independent auditing. It has emerged, for example, that Madoff’s funds were audited by a very small obscure firm. Furthermore, questions should inevitably have been raised as to how Madoff made such impressive returns on investments, whatever the market conditions.

In the absence of proper due diligence, it is hard to see how intermediaries and fund managers might avoid claims. After all, their expertise in advising on sound investments is what they are being paid for.

Whilst Madoff’s scheme certainly fooled many investors and their advisers, it by no means fooled everybody. According to the Financial Times, Deutsche Bank was approached dozens of times in the last two years to lend to hedge fund investors who wanted to feed money into Madoff’s scheme, but repeatedly turned down the loans because the money manager did not pass the bank’s due diligence criteria. Similarly, Wall Street investment banks including Merrill Lynch and Goldman Sachs refused to do business with Madoff on the grounds of suspicions raised by the fund’s lack of transparency. Given the level of exposure at other institutions, this experience points to a prevailing lack of due diligence in the general market.

PI insurers and reinsurers of those who advised investors to place their money with Madoff (mainly investment fund managers and financial advisers), as well as those providing D&O and E&O cover, are bracing themselves for an influx of claims. If Madoff’s scheme would not have passed basic due diligence there will certainly be very difficult questions to answer for those who did not perform it. There are already a number of actions in the US against financial institutions, investments funds and managers.

According to The Sunday Times¹, ten wealthy investors with combined losses of around £87 million have instructed solicitors in the UK to take legal action against HSBC, UBS, Barclays and the Bramdean fund to recover all of the money they have lost as a result of the Madoff collapse. Santander have offered £1.28 billion to individual clients who invested with Madoff.

What are the implications for premiums and cover?
According to Aspen Re², D&O and E&O insurance premiums have surged by up to 50% and are expected to rise further as a result of fears that the alleged fraud will give rise to a rash of claims against UK-based financial advisors and directors of firms for failure to exercise reasonable skill and care in choosing which funds in which to invest. It remains to be seen whether current levels of cover will be adequate.

The alleged fraud has highlighted the need for financial institutions and, in particular, hedge funds to obtain adequate PI cover. There has been a significant increase in demand for D&O and E&O cover for banks, stockbrokers, investment and pension funds and indeed for insurance and re-insurance companies themselves. But the availability of cover (which is underwritten on a ’claims made’ basis) is now limited and the cost is high. No doubt insurers will be looking to put in 'Madoff' exclusions on renewal of cover and will look very closely at exclusions in policies.

Conclusion
The ramifications of the Madoff scandal will undoubtedly be far-reaching and long-lasting. Those who have suffered are unlikely to take their losses lying down.

Given the limited assets of the Madoff companies, investors will look for alternative targets in the form of their advisers. Insurers should expect to see a volume of claims against advisers, financial institutions and their directors in the coming months.

Coming hard on the heels of the lender litigation, the timing could not be worse for a hard-pressed industry. The implication for the cost of insurance is equally worrying.

If you would like to discuss any issues raised in this update or have a specific query relating to this topic, please contact Fleur Rochester or your usual Hill Dickinson representative.