Cayman Islands: Primeo Fund v HSBC: Grand Court Rules That Madoff Feeder Fund Was "The Author Of Its Own Misfortune"

Last Updated: 30 August 2017
Article by Andrew Pullinger, Shaun Tracey and Hamid Khanbhai

In a landmark judgment of the Grand Court of the Cayman Islands delivered on 23 August 2017 in Primeo Fund (in Official Liquidation) ("Primeo") v Bank of Bermuda (Cayman) Ltd ("BBCL") and HSBC Securities Services (Luxembourg) S.A ("HSSL"),1 Mr Justice Jones QC dismissed the claim brought by Primeo, a Madoff feeder fund, against its custodian and administrator seeking damages of approximately US$2 billion. Following a twelve-week trial, the Judge found that Primeo was "to a very substantial degree the author of its own misfortune". Even though the defendants were found to be liable to Primeo in respect of the defendants' own acts or omissions as well as, in the case of the custodian, for the wilful default of BLMIS in its capacity as sub-custodian, Primeo failed to establish the relevant causal link between such acts or omissions and the loss that was allegedly suffered. Primeo's claim also failed on other grounds including limitation and because it infringed the rule against reflective loss. Notwithstanding the dismissal of the claim, the case illustrates the risks of providing services to funds that have an abnormal business model and provides guidance to fund service providers, particularly custodians and administrators, concerning the scope of their obligations.

Background

Primeo, a Cayman Islands investment fund, was established and managed by Bank Austria. From 1993 until December 2008, Primeo invested with Bernard L Madoff Investment Securities LLC ("BLMIS"), the company through which Bernard Madoff perpetrated his infamous Ponzi scheme.

BLMIS's 'holy grail' of equity returns with bond-like volatility came with strings attached: Madoff insisted upon BLMIS performing the triple functions of investment manager, broker, and de facto custodian to its clients. Many institutional investors were willing to accept this concentration of responsibilities (and therefore risk) in exchange for the stellar returns that Madoff was apparently able to generate consistently for decades.

In 2003, Primeo began investing some of its funds with BLMIS indirectly, through two other Madoff feeder funds: Alpha Prime Fund Ltd ("Alpha") and Herald Fund SPC ("Herald"). Following an in specie transfer on 1 May 2007, all of Primeo's investments with BLMIS were indirect, through Primeo's shareholding in Herald and Alpha.

Primeo appointed BBCL and HSSL as its administrator and custodian respectively (together, the "Defendants") at a time when both of those entities were part of the Bank of Bermuda group of companies, which was subsequently acquired by HSBC in 2004.

Upon Madoff's arrest, Primeo entered liquidation but it was not until 2013 that the liquidators of Primeo sued the Defendants for the alleged losses suffered by Primeo as a result of the fraud.

Claims and defences

As against the custodian, Primeo alleged that HSSL breached its contractual duties concerning the appointment and supervision of BLMIS as its sub-custodian. As against the administrator, Primeo alleged that BBCL breached its obligations in connection with the maintenance of books and records for Primeo, and in determining the net asset value ("NAV") per share at the end of each month. In his judgment, Mr Justice Jones QC observed that "at the core of the administration claim is a dispute about the role of independent fund administrators". Primeo alleged that, had the Defendants complied with their obligations, Primeo would have withdrawn its investments with BLMIS prior to the fraud being uncovered and reinvested elsewhere.

The Defendants denied they had breached their contractual obligations to Primeo. The Defendants contended further that Primeo was well aware of the risks associated with BLMIS and that it would have continued to invest with BLMIS in any event. The Defendants argued that Primeo was in any case not the proper claimant for the loss because Primeo's losses were merely reflective of the losses suffered by Herald and Alpha, in which Primeo was a shareholder at the time of Madoff's arrest. The Defendants also argued that Primeo's claim was time-barred insofar as it sought to recover losses arising from a cause of action which accrued prior to 20 February 2007 (i.e. six years prior to the issue of the writ by Primeo against the Defendants). If Primeo succeeded in making out its claim for damages, the Defendants argued that a very substantial reduction would have to be made to reflect the contributory negligence on the part of Primeo.

Decision

After hearing evidence from more than 25 factual and expert witnesses including three of Primeo's former directors and a number of experts in the fields of custody and fund administration, Mr Justice Jones QC dismissed Primeo's claim in its entirety, on the following grounds:

  • Causation: Primeo failed to prove that any breach of duty by the Defendants had caused its losses. In other words, even if the Defendants had acted as Primeo alleged they should have, the Court was not persuaded that the directors of Primeo would have decided to withdraw the investments placed with BLMIS and would have ceased to invest further with BLMIS. Although the custodian was also found to be strictly liable for any wilful default of BLMIS in its capacity as sub-custodian, there was no loss for which the Defendants could be held strictly liable. Primeo's loss did not flow from any wilful default of BLMIS qua sub-custodian. Following the in specie transfer on 1 May 2007, BLMIS was no longer sub-custodian to Primeo; Primeo held only shares in Herald and Alpha, and they were in the custody of the custodian, HSSL.
  • Reflective Loss: The rule against reflective loss operated to bar the recovery of any of Primeo's alleged loss, because Primeo was seeking to recover losses suffered by way of a diminution in the value of its shareholdings in Herald and Alpha. As a matter of law, Herald and Alpha were the proper claimants in respect of those losses, and any recoveries obtained by Herald and Alpha would flow to Primeo as a shareholder. In arriving at this conclusion, the Court determined that the appropriate standard against which to assess the merits of the claims by Herald and Alpha against HSSL was that such claims have 'a real prospect of success' (as opposed to being 'likely to succeed' as contended by Primeo).
  • Limitation: Causes of action accruing prior to 23 February 2007 are time-barred under the Limitation Law. This covered almost all claims arising from breaches that occurred while Primeo invested directly with BLMIS, as opposed to indirectly through Alpha and Herald.

In any case, the Judge determined that he would have reduced any damages awarded against the administrator by 75% on account of Primeo's contributory negligence.

Although Primeo's claim failed on several bases, the Judge's findings and observations concerning the roles and responsibilities of administrators and custodians will be of significant interest to the funds industry in the Cayman Islands and abroad.

Custodian: Breach of Duty

The Judge found that during the years 1993 to 2002, the custodian was not responsible for investments placed by Primeo with BLMIS. Rather, BLMIS was the legal as well as de facto custodian of Primeo's assets placed with BLMIS for investment.

However, in August 2002, the custodian entered into a Sub-Custody Agreement with BLMIS (the "2002 Sub-Custody Agreement"), which was governed by Luxembourg law. The validity, purpose, scope and effect of the 2002 Sub-Custody Agreement were vigorously contested.

The Judge found that the 2002 Sub-Custody Agreement was effective to appoint BLMIS as the sub-custodian in respect of Primeo's assets held at BLMIS, because it amounted to an "implied tri-partite agreement" between HSSL, BLMIS and Primeo to do so.

It followed, according to the Judge, that from August 2002 the custodian had contractual duties to use due skill and care in the appointment of any sub-custodian, to assess the ongoing suitability of the sub-custodian, and to ensure that the most effective safeguards were in place in relation to the sub-custodian to ensure the protection of Primeo's assets. The Judge found that the custodian was in breach of these duties.

The key issues were whether a reasonably competent global custodian would have made, and then continued, the appointment of BLMIS without requiring (or at least recommending) that BLMIS:

  1. establish a separate securities account with the central securities depository in New York, the Depositary Trust Company ("DTC"), for Primeo's benefit rather than accepting that Primeo's securities would (purportedly, because they never in fact existed) be held in BLMIS's single omnibus client account at DTC and/or make use of a DTC reporting system known as the Institutional Delivery System (the "ID System"); and
  2. establish a separate account with the Bank of New York ("BNY") for treasury bills that BLMIS claimed to hold for Primeo (which also never in fact existed).

In each case, Primeo argued that a reasonably competent custodian would have required or recommended those options, that, if they had done so, Primeo's directors would then have asked BLMIS to set up such separate accounts for Primeo, and that if BLMIS had refused to do so Primeo would have withdrawn its funds from BLMIS and stopped making further investments. The Judge accepted that a reasonably competent custodian would have made such recommendations, though (as discussed above) he rejected Primeo's causation arguments.

Separate Account at DTC or ID System

BLMIS purportedly executed large scale bulk trades for all of its investment clients on an omnibus basis, and then separate agency trades for each client's part of the bulk (i.e. the assets were purportedly segregated by BLMIS in its books and records, rather than at the DTC). A separate account at the DTC in the name of BLMIS, but designated for either Primeo or all of the custodian's clients, would have meant that the agency trade made between BLMIS (as broker) and Primeo (acting by BLMIS as investment manager) would have been settled into the separate DTC account, with the result that the DTC would have issued a settlement notification in respect of this trade, which the custodian could have required to be sent directly either by SWIFT message or through the ID System.

Alternatively, the ID System, without a separate DTC account, would have allowed the custodian to obtain trade confirmations and settlement notifications directly from the DTC. The Judge found that the custodian could have been set up to receive a notification directly from the DTC as an 'interested party' whenever BLMIS identified part of a bulk trade as being allocated to Primeo.

In either case, he held, there would have been independent confirmation of an actual trade taking place and settlement into BLMIS's account, as well as the possibility of reconciling confirmations and statements received from BLMIS with those received from DTC.

Separate Account at BNY

BLMIS's purported strategy involved investing in US treasury bills for a large part of the time, including at month-end as a means by which to protect the confidentiality of BLMIS's purported trading strategy, and timing the trading of US equities. The treasury bills were purportedly held in BLMIS's omnibus account with BNY. The Judge found that BLMIS could have established a separate account in its own name designated for each of Primeo and the custodian's other clients. BLMIS could then have instructed BNY to issue monthly statements directly to the custodian and confirm year-end balances directly to Primeo's auditors, Ernst & Young. The Judge found that there was no regulatory or practical impediment to doing so, and it would not have interfered with BLMIS's 'triple function' business model – nor necessarily prevented Madoff from defrauding the custodian's clients. However, it would have allowed the custodian to confirm the requisite value of treasury bills at each month end, making it more difficult for Madoff to perpetuate his Ponzi scheme.

Findings

The custodian argued, among other things, that these might have been possible options but they did not constitute normal commercial practice, so they could not have been required of a reasonably competent custodian, and that any failure to make such recommendations did not amount to negligence.

The Judge found that, although it was not (and is still not) normal commercial practice for custodians to segregate assets by establishing separate accounts at the DTC and at BNY for their hedge fund clients, in the particular circumstances arising out of BLMIS's business model, a reasonably competent custodian would have done so. BLMIS's performance of roles as broker, dealer, and de facto custodian introduced operational risks which were not addressed by the normal, commercially acceptable procedures. The Judge found that "when the normal procedure is known to be ineffective, failing to apply a readily available alternative is negligent".

In addition to liability for its own acts and omissions, the Judge also found that, under the Custodian Agreement, the custodian was strictly liable for any wilful default of BLMIS acting as sub-custodian. But from May 2007, BLMIS was no longer Primeo's sub-custodian. Primeo held only shares in Herald and Alpha, and they were held by the custodian. Accordingly, no loss flowed from any wilful default by BLMIS qua sub-custodian – and so there was no loss for which the custodian could be held to be strictly liable.

Administrator: Breach of Duty

The Judge held that an administrator's role did not extend to performance of managerial and advisory functions. Rather, the core duties were the production of accounts and determination of the NAV by the exercise of independent professional judgment. The Judge held that "administrators are not expected to perform audit procedures, but they are concerned to satisfy themselves that the published NAV is accurate." The existence of assets is verified by the process of reconciliation and the pricing of assets by reference to independent pricing services such as those provided by Bloomberg.

The Judge made no criticism of the administrator in relation to satisfying itself about the pricing reported by BLMIS, because those prices matched the publicly available sources.

Although it was agreed between the expert witnesses that administrators would normally proceed on the assumption that information received from third parties is reliable, the key issue concerned whether, and if so how, an administrator must verify the existence of reported assets.

The Defendants' expert gave evidence that it was common for an administrator to rely on single-source reporting, especially during the period from 1993 to 2008. The administrator would "tie" to the custodian's statement, and in this case the de facto custodian was the broker, BLMIS. Therefore, it was not negligent of the administrator to rely upon BLMIS's monthly statements when calculating Primeo's NAV.

However, the Judge rejected that evidence. He accepted that might have been the case within large international banking and financial services groups, promoting their own 'in-house' branded investment fund products, but, in such a case, all the various service providers, including the administrator itself, were likely to be separate entities within the same group. An in-house fund would have been marketed as such, but in the case of BLMIS it was the same entity carrying out all of the functions.

The Judge found that single-source reporting in relation to a hedge fund with the characteristics of BLMIS was unique in the hedge fund industry. He found that the "relatively high risk of fraud or error inherent in the BLMIS model must have been manifestly obvious to all concerned". The Judge found the use of single-source reporting to be negligent but not grossly negligent (the contractual standard for imposing liability on the administrator) for the years 1993 to 2005, because during that period Primeo's auditors had been content to rely upon clean (but fraudulent) audit reports from BLMIS's auditors as evidence that Primeo's assets existed.

The Judge found that from 2005, however, this factor no longer assisted the administrator because Primeo's auditors began relying upon custody confirmations provided by the custodian (which confirmations had appended BLMIS's account statements).

The Judge found that the administrator's reliance upon information solely from BLMIS in these circumstances did not account for the risks of using single-source reporting. The administrator's preparation of Primeo's NAVs from 2 May 2005 onwards was therefore found to have been in breach of contract amounting to gross negligence.

Indirect investments

By May 2007, Primeo was only an indirect investor in BLMIS because its only assets were shares in Herald and Alpha. The Defendants argued that this meant the administrator had no duty to "look through" the published NAV of Herald and Alpha, but was entitled to rely upon those NAVs unless there was any obvious error (which there was not) for the purpose of calculating Primeo's NAV.

The Judge confirmed that there is ordinarily no obligation on administrators to "look through" the NAVs published by master funds. However, HSSL also provided custody and administration services to Herald and Alpha. The Judge inferred that the NAV calculations made in respect of Herald and Alpha after May 2007 were flawed for the same reason as for Primeo's beforehand. The Judge therefore found that the administrator's reliance on Herald and Alpha's published NAVs when producing Primeo's NAVs also amounted to gross negligence.

However, the Judge also ruled that, if Primeo had made out its claim against the administrator, he would have reduced any damages award by 75% on account of Primeo's contributory negligence: Primeo was largely the author of its own misfortune because its directors and investment advisers were well aware of the risks inherent in the BLMIS structure.

Conclusion

This judgment addresses a range of issues that will be of significant interest to fund directors and service providers. For industry professionals, the headline point is the serious risks to fund service providers posed by investment structures that are abnormal or high risk.  The judgment also establishes that a fund service provider may have an obligation to recommend a course of action to its client to address abnormal risks, even when those risks are well-understood by the client, and that a failure to do so may amount to a breach of contract.

Footnote

1 Campbells represented the successful Defendants. The factual and legal issues raised in these proceedings are complex and go beyond the scope of this brief client advisory note. Should you have any questions, or wish to discuss any aspect of this judgment, please contact the authors below.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
 
Some comments from our readers…
“The articles are extremely timely and highly applicable”
“I often find critical information not available elsewhere”
“As in-house counsel, Mondaq’s service is of great value”

Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
 
Email Address
Company Name
Password
Confirm Password
Position
Mondaq Topics -- Select your Interests
 Accounting
 Anti-trust
 Commercial
 Compliance
 Consumer
 Criminal
 Employment
 Energy
 Environment
 Family
 Finance
 Government
 Healthcare
 Immigration
 Insolvency
 Insurance
 International
 IP
 Law Performance
 Law Practice
 Litigation
 Media & IT
 Privacy
 Real Estate
 Strategy
 Tax
 Technology
 Transport
 Wealth Mgt
Regions
Africa
Asia
Asia Pacific
Australasia
Canada
Caribbean
Europe
European Union
Latin America
Middle East
U.K.
United States
Worldwide Updates
Check to state you have read and
agree to our Terms and Conditions

Terms & Conditions and Privacy Statement

Mondaq.com (the Website) is owned and managed by Mondaq Ltd and as a user you are granted a non-exclusive, revocable license to access the Website under its terms and conditions of use. Your use of the Website constitutes your agreement to the following terms and conditions of use. Mondaq Ltd may terminate your use of the Website if you are in breach of these terms and conditions or if Mondaq Ltd decides to terminate your license of use for whatever reason.

Use of www.mondaq.com

You may use the Website but are required to register as a user if you wish to read the full text of the content and articles available (the Content). You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these terms & conditions or with the prior written consent of Mondaq Ltd. You may not use electronic or other means to extract details or information about Mondaq.com’s content, users or contributors in order to offer them any services or products which compete directly or indirectly with Mondaq Ltd’s services and products.

Disclaimer

Mondaq Ltd and/or its respective suppliers make no representations about the suitability of the information contained in the documents and related graphics published on this server for any purpose. All such documents and related graphics are provided "as is" without warranty of any kind. Mondaq Ltd and/or its respective suppliers hereby disclaim all warranties and conditions with regard to this information, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. In no event shall Mondaq Ltd and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use or performance of information available from this server.

The documents and related graphics published on this server could include technical inaccuracies or typographical errors. Changes are periodically added to the information herein. Mondaq Ltd and/or its respective suppliers may make improvements and/or changes in the product(s) and/or the program(s) described herein at any time.

Registration

Mondaq Ltd requires you to register and provide information that personally identifies you, including what sort of information you are interested in, for three primary purposes:

  • To allow you to personalize the Mondaq websites you are visiting.
  • To enable features such as password reminder, newsletter alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our information providers who provide information free for your use.

Mondaq (and its affiliate sites) do not sell or provide your details to third parties other than information providers. The reason we provide our information providers with this information is so that they can measure the response their articles are receiving and provide you with information about their products and services.

If you do not want us to provide your name and email address you may opt out by clicking here .

If you do not wish to receive any future announcements of products and services offered by Mondaq by clicking here .

Information Collection and Use

We require site users to register with Mondaq (and its affiliate sites) to view the free information on the site. We also collect information from our users at several different points on the websites: this is so that we can customise the sites according to individual usage, provide 'session-aware' functionality, and ensure that content is acquired and developed appropriately. This gives us an overall picture of our user profiles, which in turn shows to our Editorial Contributors the type of person they are reaching by posting articles on Mondaq (and its affiliate sites) – meaning more free content for registered users.

We are only able to provide the material on the Mondaq (and its affiliate sites) site free to site visitors because we can pass on information about the pages that users are viewing and the personal information users provide to us (e.g. email addresses) to reputable contributing firms such as law firms who author those pages. We do not sell or rent information to anyone else other than the authors of those pages, who may change from time to time. Should you wish us not to disclose your details to any of these parties, please tick the box above or tick the box marked "Opt out of Registration Information Disclosure" on the Your Profile page. We and our author organisations may only contact you via email or other means if you allow us to do so. Users can opt out of contact when they register on the site, or send an email to unsubscribe@mondaq.com with “no disclosure” in the subject heading

Mondaq News Alerts

In order to receive Mondaq News Alerts, users have to complete a separate registration form. This is a personalised service where users choose regions and topics of interest and we send it only to those users who have requested it. Users can stop receiving these Alerts by going to the Mondaq News Alerts page and deselecting all interest areas. In the same way users can amend their personal preferences to add or remove subject areas.

Cookies

A cookie is a small text file written to a user’s hard drive that contains an identifying user number. The cookies do not contain any personal information about users. We use the cookie so users do not have to log in every time they use the service and the cookie will automatically expire if you do not visit the Mondaq website (or its affiliate sites) for 12 months. We also use the cookie to personalise a user's experience of the site (for example to show information specific to a user's region). As the Mondaq sites are fully personalised and cookies are essential to its core technology the site will function unpredictably with browsers that do not support cookies - or where cookies are disabled (in these circumstances we advise you to attempt to locate the information you require elsewhere on the web). However if you are concerned about the presence of a Mondaq cookie on your machine you can also choose to expire the cookie immediately (remove it) by selecting the 'Log Off' menu option as the last thing you do when you use the site.

Some of our business partners may use cookies on our site (for example, advertisers). However, we have no access to or control over these cookies and we are not aware of any at present that do so.

Log Files

We use IP addresses to analyse trends, administer the site, track movement, and gather broad demographic information for aggregate use. IP addresses are not linked to personally identifiable information.

Links

This web site contains links to other sites. Please be aware that Mondaq (or its affiliate sites) are not responsible for the privacy practices of such other sites. We encourage our users to be aware when they leave our site and to read the privacy statements of these third party sites. This privacy statement applies solely to information collected by this Web site.

Surveys & Contests

From time-to-time our site requests information from users via surveys or contests. Participation in these surveys or contests is completely voluntary and the user therefore has a choice whether or not to disclose any information requested. Information requested may include contact information (such as name and delivery address), and demographic information (such as postcode, age level). Contact information will be used to notify the winners and award prizes. Survey information will be used for purposes of monitoring or improving the functionality of the site.

Mail-A-Friend

If a user elects to use our referral service for informing a friend about our site, we ask them for the friend’s name and email address. Mondaq stores this information and may contact the friend to invite them to register with Mondaq, but they will not be contacted more than once. The friend may contact Mondaq to request the removal of this information from our database.

Emails

From time to time Mondaq may send you emails promoting Mondaq services including new services. You may opt out of receiving such emails by clicking below.

*** If you do not wish to receive any future announcements of services offered by Mondaq you may opt out by clicking here .

Security

This website takes every reasonable precaution to protect our users’ information. When users submit sensitive information via the website, your information is protected using firewalls and other security technology. If you have any questions about the security at our website, you can send an email to webmaster@mondaq.com.

Correcting/Updating Personal Information

If a user’s personally identifiable information changes (such as postcode), or if a user no longer desires our service, we will endeavour to provide a way to correct, update or remove that user’s personal data provided to us. This can usually be done at the “Your Profile” page or by sending an email to EditorialAdvisor@mondaq.com.

Notification of Changes

If we decide to change our Terms & Conditions or Privacy Policy, we will post those changes on our site so our users are always aware of what information we collect, how we use it, and under what circumstances, if any, we disclose it. If at any point we decide to use personally identifiable information in a manner different from that stated at the time it was collected, we will notify users by way of an email. Users will have a choice as to whether or not we use their information in this different manner. We will use information in accordance with the privacy policy under which the information was collected.

How to contact Mondaq

You can contact us with comments or queries at enquiries@mondaq.com.

If for some reason you believe Mondaq Ltd. has not adhered to these principles, please notify us by e-mail at problems@mondaq.com and we will use commercially reasonable efforts to determine and correct the problem promptly.