In the landmark judgment of Primeo Fund v HSSL and another delivered on 23 August 2017, the Court’s findings against the custodian and administrator are a wake-up call to fund professionals.
The findings of breach of contract, negligence and even gross negligence made against the custodian and administrator have shown that “one size does not fit all,” whereby standard commercial practice is now not enough to escape liability and an administrator’s or custodian’s duties and responsibilities must be adapted, when faced with a unique or unorthodox business model.
This article identifies why the Court found the custodian and the administrator to be in breach of their ongoing duties to Primeo and provides useful guidance on what these service providers need to be acutely aware of and how they need to be adapted when dealing with unorthodox structures.
The Primeo Fund (Primeo) was a Cayman Islands incorporated Madoff feeder fund that invested with Bernard L Madoff Investment Securities LLC (BLMIS). Primeo appointed the Bank of Bermuda (Cayman) Limited (BBCL) as its administrator and HSBC Securities Services (Luxembourg) SA (HSSL) as its custodian. Both BCCL and HSSL were later acquired by HSBC.
The discovery of the multi-billion dollar Madoff Ponzi scheme in late 2008 led to the arrest of Bernard Madoff and subsequently triggered various claims by Madoff feeder funds against their service providers for alleged breaches of duty. Primeo’s claim, instituted in 2013, sought to recover Madoff related losses in the order of USD$2 billion from BBCL and HSSL as administrator and custodian arising from alleged breaches of their contractual duties, negligence and gross negligence.
In his 173 page judgment, Mr Justice Jones QC made carefully explained findings against the administrator and custodian which serve as a stark reminder as to how fund service providers can fail to discharge their duties of care or fall foul of risk management procedures, notwithstanding that they applied standard operating procedures albeit to a high-risk business model. The Judge identified “red flags” that ought to have been obvious to service providers in dealing with a high operational risk business model and provided helpful guidance on the scope of obligations owed by administrators and custodians, which are summarised below.
The “red flags” ought to have been obvious
Whilst there was no evidence that any of those involved actually believed or seriously suspected that BLMIS was in fact a huge Ponzi scheme, there were many red flags which ought to have been obvious to any service provider in the discharge of their duties of care and in compliance with their risk management procedures. It seems however that in the pursuit of revenue, the fund, the custodian and the administrator were all seen to turn a blind eye to the red flags that existed at the time. As the head of HSSL Operational Risk in London later ruefully observed: “Always too afraid to lose the revenue, but the business should pay more attention to the view of risk”.
From the carefully explained findings of the Court, those obvious “red flags” were:
- From as early as the mid-1990s, the BLMIS business model was the subject of increasing scepticism amongst some in the hedge fund industry. Any scepticism was either discounted or ignored in the pursuit of revenue. Even amongst executives of the administrator, comments were made years before discovery of thefraud that the BLMIS could conceal a Ponzi scheme but this building scepticism was never fully investigated;
- BLMIS’ unique business model – the concentration of functions by BLMIS acting in a triple capacity as broker-dealer, investment manager and custodian – enabled it to make the investment decision in its capacity as investment manager, execute the trades with itself in its capacity as broker dealer and finally hold the securities itself in its capacity as custodian;
- Madoff’s obsession with confidentiality was a clear red flag and ought to have been obvious to service providers. Primeo, the administrator and the custodian were always willing to accommodate Madoff’s insistence upon extreme confidentiality, to the extent that BLMIS’ actual role as the investment manager was never disclosed in any of its Offering Memoranda. Nor did the Offering Memoranda disclose that any manager might perform the triple of function of investment manager, broker and custodian;
- The implausibly high level of options trading and the implausibly consistent investment returns (lack of volatility) was continually questioned by many in the industry as to whether the “holy grail” was really being achieved;
- The fee structure (no investment management fees were charged); and
- Madoff’s insistence and use of his own auditor, Friehling & Horowitz, who were subsequently found to be complicit in the fraud, was also deemed to be an obvious red flag.
However, Primeo, like all the other Madoff feeder funds, accepted the uniquely high operational risk inherent in BLMIS’ business model as the price to be paid for Madoff’s uniquely consistent investment performance and they did so for almost 20 years. Like all other Madoff feeder funds, they pursued profit while ignoring risk (they closed other, genuine investments to focus on the one that was in fact Ponzi scheme because it was the one generating a good return, all the time turning a blind eye to the red flags).
Scope of obligations owed by administrators and custodians
The significant findings of the Grand Court against the administrator and the custodian provide clarity on the professional and legal standards expected of fund service providers under the law of the Cayman Islands.
The judgment makes clear that administrators and custodians cannot just follow industry practices in all cases in order to properly discharge their duties, need to be acutely aware of the following:
- Administrators must proactively take steps on a regular basis to independently verify the existence and value of the Fund’s assets. Information must be reconciled with information received from an independent source, and particularly when dealing with a unique business model – it is not enough to rely upon information provided by or on behalf of a fund; an administrator is positively obligated to obtain confirmation from an independent source. The Judge also made clear that whilst administrators are not expected to perform audit procedures (or for that matter, perform managerial and advisory functions), an administrator’s core duties were the production of accounts and determination of the NAV by the exercise of independent professional judgment.
- The importance of an independent board is more critical now than ever before – the greater the independence to the board, the more likely building scepticism will be fully investigated. The board’s independence will also ensure effective oversight of the fund’s operations, particularly in these times of increasing regulatory and investor scrutiny.
- Administrators and custodians have a positive obligation to inform themselves of all facets concerning those unique and high-risk business models which they manage. Normal operating procedures need to be specially adapted to deal with such business models to ensure all facets of the business model are understood. Administrators and custodians need to scrutinise high-risk business models and if any aspect of the model does not make sense, they must be able to “apply a readily available alternative” to fulfil their duties. In the particular circumstances of this case, the court found that the custodian ought to have recommended to Primeo that it require separation of assets within BLMIS’s (and its sub-custodian) accounts at the Depository Trust Company (DTC) and at the Bank of New York, which would have allowed the custodian to obtain trade confirmations and settlement notifications directly from the DTC. Whilst segregating assets is not normal practice, the particular circumstances of this case required it to be done. Likewise the Administrator can ordinarily proceed on the basis of information from third party services providers, but it was not appropriate in these particular circumstances.
- In preparing NAVs the Administrator must verify the existence of the assets independently of information provided by the investment manager, requiring independent audits in appropriate cases and paying careful attention to any audit reports received and continually asking questions. In the particular circumstances of this case, Ernst & Young had flagged concerns with the audit work performed by Madoff’s auditor of choice, suggesting that it would need to do the work itself or else rationalise the audit opinions or resign. Whilst this situation was avoided (with HSSL issuing a custody confirmation), closer scrutiny of these concerns, identifying the range of possible outcomes and developing a mutually agreeable robust solution may have resulted in a different outcome for the administrator and custodian.
The implications of this judgment for administrators and custodians when dealing with non-standard business models are far reaching. Administrators in particular have a potentially significant exposure that will need to be addressed by putting in place tailor-made arrangements with additional burdens on the Administrator.