Cayman Islands: CDR – Primeo Fund v HSBC: On reflection

Last Updated: 20 September 2019
Article by Andrew Pullinger and Shaun Tracey

The Cayman Islands Court of Appeal has dismissed the USD2 billion appeal by Primeo, a Madoff feeder fund. Andrew Pullinger and Shaun Tracey of the Cayman Islands office of Campbells discuss the wider significance of the judgment, particularly on the law concerning the rule against the recovery of reflective loss.

Despite more than a decade now having passed since Bernard Madoff’s arrest, litigation resulting from Madoff’s infamous Ponzi scheme continues. In Primeo Fund v Bank of Bermuda (Cayman) and HSBC Securities Services (Luxembourg) S.A. (HSBC), the Cayman Islands Court of Appeal (Justices Birt, Beatson and Field) has delivered the latest significant judgment in a recovery action by a Madoff feeder fund.

In a 184-page judgment, the Court of Appeal dismissed Primeo’s appeal against the judgment of the Cayman Grand Court, which had in 2017 dismissed Primeo’s USD2 billion claims against HSBC as its administrator and custodian.

The Court of Appeal’s wide-ranging judgment is of interest on a number of fronts touched upon in this article, particularly the rapidly developing area of the law concerning the rule against the recovery of reflective loss; the United Kingdom Supreme Court has recently heard and reserved judgment in another reflective loss case, Garcia v Marex.

In the Primeo v HSBC litigation, the Court of Appeal upheld the first instance ruling barring recovery by Primeo because the loss claimed represented the diminution in the value of its shareholdings in two other Madoff ‘feeder funds’, known as Herald and Alpha Prime, in which Primeo was invested at the time Madoff’s fraudulent scheme collapsed.

As Herald and Alpha Prime had also engaged HSBC entities as their administrator and custodian, both courts determined that they are the proper plaintiffs in respect of any such loss – indeed Herald and Alpha are suing HSBC in separate proceedings in other jurisdictions.

Any loss suffered by Primeo is therefore “reflective” of the loss suffered by Herald and Alpha, and barred by the long-standing but evolving rule against the recovery of reflective loss. In its judgment, the Court of Appeal confirmed the broad ambit of the rule against reflective loss, which can have major practical implications, and clarified its application in the novel circumstances of this case, as discussed below.

BACKGROUND

Primeo was a Cayman Islands investment fund run by Bank Austria that placed monies with Madoff for investment on a discretionary basis from 1993 until 2008. Madoff operated a ‘managed account’ for Primeo, which purportedly generated consistently strong returns over many years, and always satisfied Primeo’s redemption requests. In 2003, Primeo began investing some of its investors’ money with Madoff indirectly, via shareholdings in Herald and Alpha. Following an in specie transfer in May 2007, whereby the balance of Primeo’s managed account was transferred to Herald, Primeo’s entire exposure to Madoff became indirect as its sole assets were shares in Herald and Alpha. Those funds, in turn, unwittingly placed money with Madoff that was used to sustain his giant Ponzi scheme. Following Madoff’s arrest, Primeo’s shares in Herald and Alpha – thought to be worth hundreds of millions of dollars – were potentially worthless.

Following the discovery of the fraud, Primeo entered liquidation and its liquidators brought claims in contract against Primeo’s administrator and custodian, companies within the Bank of Bermuda group (which had been acquired by HSBC in 2004) to recover sums placed with Madoff, as well as lost profits.

As against the custodian, Primeo alleged breach of contractual duties concerning the appointment and supervision of Madoff as HSBC’s sub-custodian, and that HSBC was in any event strictly liable under the terms of the Custody Agreement for the wilful default of Madoff.

As against the administrator, Primeo alleged breach of duties to maintain its books and records and determine its net asset value (NAV) per share; notably, that the administrator should not have relied upon single-source data provided by Madoff (albeit in his separate capacities as broker-dealer, investment manager and custodian). In each case, Primeo alleged that if HSBC had complied with its duties, Primeo would have withdrawn its investments with Madoff and reinvested the proceeds elsewhere, generating a significant profit.

FIRST INSTANCE JUDGMENT

During a 12-week trial in 2016/17, Mr Justice Jones QC heard 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. In summary, Primeo succeeded in establishing certain breaches of duty by HSBC, including negligence and later gross negligence by the administrator in calculating the NAV.

HSBC’s fault lay in relying solely upon data received from Madoff, where HSBC as custodian had also been providing Primeo’s auditors, EY, with ‘custody confirmations’ based upon the same data, such that there was no independent verification of the existence of the managed account assets. The custodian was also found to have acted in breach of duty by failing to recommend to Primeo that certain additional safeguards be put in place, including that Madoff be asked to open a separate account for Primeo at the DTC, the US securities depository.

Further, the custodian would have been strictly liable for the wilful default of Madoff as its sub-custodian. However, Madoff had not been in wilful default in that capacity (since it had honoured all redemption requests made by Primeo). In any event, the judge held that no loss had flowed from any such default, since Primeo had received full value for its investments when its managed account was transferred to Herald in May 2007 in exchange for Herald shares.

Despite these findings of breach of duty, Primeo’s claims were dismissed in their entirety on three bases. First, the rule against reflective loss barred the recovery of all of Primeo’s alleged losses. Secondly, Primeo failed to establish causation, since the judge was unpersuaded that Primeo’s directors would, in fact, have withdrawn Primeo’s investments with Madoff to invest elsewhere. Primeo and its directors had the same knowledge of the ‘red flags’ associated with Madoff as HSBC, but the lure of equity-like returns with bond-like volatility was too good to forego. Thirdly, parts of the claims were statute-barred. The judge also determined that he would in any event have reduced any damages awarded against the administrator by 75% due to Primeo’s contributory negligence, since Primeo was “to a very substantial degree, the author of its own misfortune”.

Primeo appealed against the judge's dismissal of its claims, and HSBC sought to uphold the first instance judgment, while seeking to overturn certain adverse findings at first instance.

COURT OF APPEAL JUDGMENT

The Court of Appeal upheld the judge’s dismissal of Primeo’s claims on the ground that they infringed the rule against ‘reflective loss’; put simply, Primeo was not the proper plaintiff for the losses claimed. This dispositive aspect of the judgment clarifies the application of the reflective rule in important respects discussed below.

The Court of Appeal’s other findings were obiter, but are also of interest. The Court upheld the judge’s rulings on ‘breach of duty’, save for finding that the judge had erred in concluding that Madoff had not wilfully defaulted as sub-custodian to HSBC and that, in any event, no loss flowed from any such default.

On ‘causation’, the judge had rightly found that Primeo had failed to prove its case in relation to the pre-2005 period, but was found to have applied the wrong legal test in reaching the same conclusion post-2005. The judge should have applied a “loss of chance” analysis, since causation depended upon the possibility of actions being taken by Primeo and third parties (notably, its auditors) in hypothetical scenarios.

The question of causation would therefore have been remitted to the Grand Court if Primeo had otherwise succeeded on its appeal. As to ‘contributory negligence’, HSBC succeeded in establishing that this defence was also available to the custodian, although the Court of Appeal reduced the proportion of any hypothetical reduction of Primeo’s damages from 75% to 50%. On ‘limitation’, the Court of Appeal upheld the judge’s finding that the administrator claim was partially statute-barred, but overturned the judge’s equivalent finding in respect of Primeo’s strict liability custodian claim.

REFLECTIVE LOSS – ESTABLISHED PRINCIPLES

The rule against the recovery of reflective loss has been a feature of English law since the early 1980s. In Prudential Assurance, it was established that where a person’s loss consists of the diminution in the value of a shareholding in a company then, if the company also has a cause of action against the same defendant with a real prospect of success, the company is the proper plaintiff. As a matter of public policy, the shareholder’s claim is barred since they should not be permitted to bring an action to recover loss which is ‘reflective’ of that suffered by the company.

The rule was subsequently affirmed by the English Court of Appeal in 2004 in Johnson v Gore Wood, where solicitors had settled a negligence claim brought by their client – the company – only for the company’s owner to sue them again. Unsurprisingly, the owner’s claim was barred as a matter of principle, since the reduction in value of his shareholding simply reflected the loss suffered by the company.

The potential harshness of the rule has been mitigated by an exception, per Giles v Rhind (2003), whereby the rule does not bar a reflective claim where the wrongdoer has disabled the company from pursuing its claim against him. Plainly, any such bar would be unjust.

However, the general and accelerating trend has been towards an expansion in the scope of the rule. In Gardner v Parker (2004), the rule was extended to losses claimed in the capacity as employee of a company. The Court of Appeal held that the critical factor was not the capacity of the plaintiff, but rather whether they would be made whole if the company’s claim succeeded. The rule is not concerned with barring causes of action, but with barring recovery of certain types of loss.

Most recently, in Garcia v Marex, the English Court of Appeal last year confirmed that the rule also applies where the reflective loss is suffered by a creditor rather than a shareholder. Any distinction between the two capacities would be arbitrary and unprincipled. The Court also confirmed that the exception in Giles v Rhind is narrow: it only applies where the wrongdoer has caused the company’s claim to become impossible as a matter of law (rather than simply due to a lack of funds). An appeal by Garcia was heard in May by the UK Supreme Court – the first time a reflective loss case has been heard at the highest appellate level – and judgment is expected in the coming months.

PRIMEO’S APPEAL ON REFLECTIVE LOSS

In this context, Primeo appealed against the judge’s dismissal of its claims on the grounds that they were reflective of the loss suffered by Herald and Alpha. First, Primeo argued that the rule did not apply because Primeo was not a shareholder in either Herald or Alpha at the time it invested directly with Madoff. Primeo’s case was that it was irrelevant that it later became such a shareholder, and remained so when Madoff’s fraud came to light and its claims were commenced against HSBC. Secondly, Primeo argued that for the rule to apply the company’s hypothetical claim against the defendant must be a good (i.e. more likely than not to succeed) claim, rather than the lower threshold of having a real prospect of success.

Both arguments failed. The Court of Appeal reviewed the authorities, notably Garcia v Marex, and emphasised the gradual expansion of the scope of the rule on a principled basis. The rule upholds the principle of company autonomy, ensures that the company's creditors are not prejudiced by the action of individual shareholders, and prevents a party from recovering compensation for a loss which another party has suffered.

Otherwise, where the company is in or near insolvency, there would be prejudice to the company’s unsecured creditors if a shareholder (or creditor) could sue directly, subverting the principle of collective insolvency and the pari passu rule. In other words, a shareholder or a creditor cannot ‘scoop the pool’ by bringing its own competing claim against a defendant, where the company;s claim has a real prospect of success.

The Court of Appeal confirmed that the operation of the rule does not depend on the capacity in which the plaintiff brings the proceedings, but rather on whether their loss would be made good if the company were successfully to pursue its claims. The object is to ascertain whether the loss claimed is one which would be made good if the company had enforced its rights. This has to be tested at the time the plaintiff’s claim is made. Therefore, it is irrelevant that Primeo only became a shareholder in Herald and Alpha after making its initial investments with Madoff.

Likewise, before applying the bar, the judge had correctly evaluated whether Herald’s and Alpha’s claims had a real prospect of success, rather than apply any higher threshold, since that question would usually be determined in proceedings to which the company would not be a party. On the facts, the Court of Appeal found no reason to interfere with the judge's findings that the claims brought by Alpha and Herald against HSBC had a real prospect of success.

In reaching its conclusion on reflective loss, the Court of Appeal also rejected Primeo’s submission that Primeo should simply give credit for recoveries received by Primeo from Herald or Alpha. That is not how the law operates where a claim is reflective.

IMPLICATIONS

The significance of the Court of Appeal’s ruling on reflective loss is that it confirms that the rule remains broad and principled, and that it can provide a complete defence.

For prospective plaintiffs and their attorneys, this means there is a need to consider carefully whether the losses claimed are reflective, both at the outset of the litigation and as it progresses. This question arises not merely where the plaintiff has always been a shareholder in a company that has suffered loss, but also where the plaintiff has become such a shareholder later. Likewise, the losses could be reflective even if they are owed to a creditor or employee. If a claim is pursued for reflective loss, it is liable to be struck-out at the interlocutory stage. Even if that does not happen, the result might be a pyrrhic victory for the plaintiff. They may have proven their claim at trial, yet still be barred from recovering the loss claimed – and have to pick up the costs bill for the litigation. This will be a particular concern to liquidators of an insolvent estate.

For defendants and their attorneys, the latest Primeo judgment provides welcome confirmation that the courts will uphold this established rule of law, in the face of novel but unprincipled attempts by a shareholder to ‘scoop the pool’.

Primeo has appealed to the Privy Council and the UK Supreme Court will shortly deliver its decision in Garcia, determining whether the rule against reflective loss applies to claims by creditors. The progress and outcomes of both appeals will be watched with interest as this important area of the law continues to develop.

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.

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