Two service providers to Primeo, a fund that invested all of its money with Ponzi scheme fraudster Bernard Madoff, were negligent in their duties as administrator and custodian, according to the Cayman Islands Grand Court.
But in his Aug. 23 judgment, Justice Andrew Jones concluded that any liability by the service providers for the $2 billion in losses claimed by the liquidators of Primeo was partly time-barred and that it was not established that the conduct of the administrator and the custodian had caused the fund’s losses. In relation to the claim against the administrator*, the judge noted, “If I had found in favor of Primeo, I would have concluded that its damages be reduced by 75 percent because it was, to a large extent, the author of its own misfortune.”
The judge concluded that Primeo’s administrator had adopted grossly negligent procedures to calculate the value of the assets of the fund, and that the custodian had failed to ensure that Bernard L. Madoff Investment Securities (BLMIS) was suitable to act as sub-custodian and failed to give any consideration or make any recommendations to Primeo in relation to safeguarding the assets of the fund.
Despite the dismissal of the liability claim, the decision is relevant to the responsibilities of Cayman services providers to hedge funds, especially those that service funds with unusual or high-risk investment structures.
Madoff, who was sentenced to 150 years in prison for the infamous fraud in 2009, admitted that he had not traded at all since the early 1990s and that all his returns since then had been fabricated.
Because Madoff’s wealth management firm BLMIS acted as investment adviser, broker and de-facto custodian for all its clients, other professional service providers for those clients had to rely on a single source of information to perform their duties: Madoff.
“[Madoff Investment Securities’] unique business model was essential for the purposes of running a Ponzi scheme, but this is of course one of the reasons why it was (and still is) conventional practice for the core functions involved in the management of hedge funds to be segregated amongst multiple independent professional service providers,” Justice Jones wrote in his judgment.
The plaintiffs in the case alleged that Bank of Bermuda (Cayman) Ltd., which later became HSBC, and HSBC Securities Services (Luxembourg) SA (HSSL) had been grossly negligent in their duties as administrator and custodian of the fund.
Although HSSL was appointed as the custodian, Primeo’s assets were held by Madoff, who had a sub-custody agreement with the Luxembourg-based firm. Under the agreement, Primeo’s custodian HSSL had a contractual duty to assess the ongoing suitability of the sub-custodian and to ensure that effective safeguards were in place at the sub-custodian to protect the assets.
The custodian breached these duties, according to the court, because it failed to recommend that Madoff Investment Securities establish a separate account for Primeo’s securities at the Depository Trust Corp. and to establish a separate sub-account at Bank of New York to hold Primeo’s Treasury bills. In addition, “HSSL was in breach of contract when it failed […] to give any consideration or make recommendations to Primeo about safeguards which were readily available and, if implemented, would have been effective to safeguard Primeo’s assets.”
Justice Jones also held that HSSL became liable to Primeo under a 2002 sub-custody agreement for any willful default of Madoff Investment Securities as sub-custodian.
Meanwhile, the fund’s administrator, BoB Cayman, was not required to independently confirm the correctness of the information it received from Madoff. But when the administrator was unable to reconcile the information received from Madoff with any information received from an independent source, it could no longer rely on the unqualified opinion of Madoff’s auditor, the judgment noted.
“The relatively high risk of fraud or error inherent in the [Madoff] business model must have been manifestly obvious to all concerned,” Justice Jones noted.
“The procedure adopted by BoB Cayman in April 2005 remained unchanged and was, in all circumstances, grossly negligent, with the result that BoB Cayman is in breach of contract in respect of the NAV per share calculations performed in April 2005 and every month thereafter.”
Cause of losses
Despite the negligence of the service providers which made it, in the opinion of the court, easier for Madoff to perpetrate his Ponzi scheme, the judge argued that “Primeo has not established that the defendants’ breaches of contract were an effective or dominant cause of its lost investment.”
The legal argument hinges in part on the 2007 restructuring of Primeo’s investment from a direct investment with Madoff into an indirect one through the Madoff feeder fund Herald. The judge argued that at the time that Primeo fully realized its investment and reinvested it with Herald even though in practical terms the investment was merely reassigned.
“Primeo’s claims against the defendants in respect of the breaches of contract occurred prior to Feb. 20, 2007, and are statute barred,” the judge ruled.
Justice Jones also held that Primeo’s loss claim is irrecoverable because it infringes on the rule of reflective loss, which states that only a company, in this case Herald, can sue for a loss it incurred, but not its shareholders.
Primeo’s liquidators have until Sept. 6 to file an appeal.
Author of its own misfortune
Justice Jones made plain that the fund as the investor rather than the negligent service providers should shoulder most of the blame.
“Primeo, like all the other Madoff feeder funds, accepted the uniquely high operational risk inherent in [Madoff Securities Investments’] business model as the price to be paid for Madoff’s uniquely consistent investment performance and they did so for almost 20 years,” he said.
Even if the fund’s custodian had not issued any custody confirmations to Madoff’s auditor and the auditor had been unable to perform the audit in a satisfactory way, the judge wrote, Primeo would, in all likelihood, “still have continued with the same investment strategy by investing in the shares of one or more Madoff feeder funds.
* Editor’s note: The article was amended from the original to reflect that the judge only would have applied a 75 percent discount to the liability claim against the administrator. The fund’s custodian would have been strictly liable for the losses, if the court had found in favor of the plaintiff.