Cover Charges

Madoff fraud brings changes to liability insurance

FARAH ZUHDI, HEAD OF MARKETING, BARONSMEAD PARTNERS

While convicted fraudster Bernard Madoff sits in jail awaiting sentencing for the largest investment fraud in Wall Street history, court actions against financial institutions and fund directors for breaches of their fiduciary duties and negligence are dominating the headlines. Madoff is thought to have taken in around $65 billion over two decades and litigation and liability are now inevitably pervasive.

Investors in funds that invested in Madoff are seeking to recover money lost; they are taking actions against those people who invested their money in Madoff. Many may feel that those who had custody of the assets have failed fundamentally in conducting due diligence.

Those funds that protected themselves with a financial risk insurance policy are likely to make claims of between $2 billion and $3 billion against their insurers.

As a result of Madoff, interest in Professional Indemnity insurance for financial institutions such as banks, stockbrokers and fund of funds hasincreased substantially. There have been increases in insurance premiums in the wake of the credit crisis and the Madoff scandal is likely to lead to further increases.

All of this is likely to herald a change in the dynamics of the insurance industry, having a bearing on the cost and availability of professional indemnity and directors’ and officers’ liability insurance. Certain businesses may not be able to buy adequate cover to protect themselves and their clients at a reasonable cost.

Plaintiff actions are not focusing particularly on Madoff or his company – even if he had purchased the appropriate cover, insurers are ultimately unlikely to pay out due to various coverage defences. Instead the spotlight is on banks, funds of funds and other Madoff investors who had redeemed before the discovery of the fraud. There’s also the threat against the auditors, administrators and custodians who failed to notice the fraud. By extension this can include directors of funds who carry fiduciary liabilities and ultimately personal responsibility for the running of the fund in good order.

Many did not know of Madoff’s existence until his arrest because the smaller so-called “feeder funds” channelled funds into Madoff, meaning that a great number of investors were completely unaware that their money was being managed by Madoff. Investors will be seeking redress from those responsible on the basis that they failed in their duty of care and failed to carry out adequate due diligence.

Fraud highlights need for liability limits
The alleged fraud highlights the need for financial institutions, and in particular fund of funds, to have appropriate professional liability limits in place. The revelation of Madoff’s Ponzi scheme has led many to dust off their insurance policy and see what is or isn’t covered. It is only at this point that they may discover its shortcomings in terms of scope and exclusions. Whilst the expectation is that any damages awarded to clients against the fund of funds or its directors will be covered by insurance, the reality is more sobering and it may prove difficult for the fund to claim successfully.

There are two main financial risk insurance policies which may prove useful in the event of litigation. Professional indemnity, more commonly called errors and omissions in the US, which covers the liability of the management companies arising from the professional services they provide to their customers. There’s also directors’ and officers’ liability which covers the individuals personally whilst they are managing the affairs of the fund. This includes their responsibility for overseeing a fund’s administration, custodial services and prime brokerage, and for the content of the prospectus. Directors of funds are unfortunately exposed to litigation. They need to be sure that their own personal exposure is covered and they should also consider their duties to protect the investors’ assets. If there is no appropriate directors’ insurance in place, or the insurance does not pay because it is poorly written, then the directors will have look to the fund for an indemnity for their claim and this will come out of investors’ assets.

An off-the-shelf insurance policy that is purchased solely on price is likely to benefit only the insurance company as many of the products do not give adequate coverage. Funds and directors need to look for a policy that is broad and specific. There is not necessarily a single solution that meets the need of every client. However, in most instances the difference in cost between good and bad policies may amount to one or two basis points, if anything at all. This is a small price for the protection and the peace of mind that effective cover can bring. Where the manager, fund and directors are covered by a single composite group policy there may be problems recovering money under the policy. If the insurer is based in a different jurisdiction to the directors it can be hard for directors to enforce an indemnity under the policy. If the policy doesn’t pay the director’s indemnity payments will come straight out of investors’ assets – assuming the fund is solvent — probably at a time when there has already been a significant drawdown in the fund.

Directors may be unsecured creditors
Directors could even find themselves as one of the many unsecured creditors in the event of insolvency or without cover if there’s an insolvency exclusion. Logistically, if there is a dispute with the insurer of the group policy it is likely that the policy will have a choice of law clause which corresponds with the sponsor’s domicile. This makes for difficult and expensive negotiations for directors.

One does need to consider the insurers’ position. The credit crisis and the Madoff debacle are easily as catastrophic as a major hurricane for the insurance companies because of the barrage of claims that are likely to ensue. These claims will be complex and therefore expensive for the insurers in terms of defence costs and damages. Insurance policies are highly-leveraged instruments for the insurers who operate on tight margins. With insurers financially hurting it may be in the insurance provider’s own interests to contest and resist claims and this can only be avoided by being with the right insurer covered by a broad policy. At the moment insurance companies are suffering from an enormous aggregation of exposure and so they will be tougher than ever on uncovered or disputed claims.

Insurance should be regarded as a mechanism for transferring some of the legal, operational and regulatory risks, faced by managers and funds, to the insurer. The issues at stake aren’t just financial but reputational also. The presence of good-quality insurance provides the reassurance that there is the wherewithal, both in terms of assets and specialist knowledge, to defend your reputation and your assets, should the situation arise.

Expert advice is critical for fund managers and directors who must weigh up carefully the trade-off between price and quality. The need for a comprehensive and customised insurance policy will certainly be a legacy of Madoff and a call to arms for fund managers to protect themselves properly.

ABOUT THE AUTHOR

Farah Zuhdi is Head of Marketing at hedge fund insurance specialist Baronsmead Partners