Investors whose fortunes were tied to Bernard Madoff and his firm have already been counting (and mourning) their losses. But for the insurers that provided coverage for financial firms targeted in the Madoff-related litigation, the losses have only just begun to accumulate.


How high the insurance losses ultimately may run remains to be seen, but early estimates suggest that that the insurance losses, even just for defense expenses, could be significant.


A January 9, 2008 Bloomberg article (here) reports that Madoff-related claims "may cost insurers who cover financial institutions more than $1 billion as they pay legal costs for investment managers who gave client money to Madoff." Indeed one respected industry participant is quoted as saying that a total of $1 billion "feels a little low to me."


The losses could well affect not only D&O insurers, but also insurers offering"error and omissions" E&O insurance. For many of the kinds of investment firms involved in these cases so far, the type of insurance protection they would most likely purchase provides both coverages within a single package.


The article correctly points out that how large the insurance losses ultimately turn out to be depends on how many of the Madoff "feeder funds" and other litigation targets actually have purchased these kinds of insurance. As one observer quoted in the article notes, hedge funds and other investment vehicles "often don’t buy coverage."


There are a variety of other factors that also could affect the total cost to insurers of the Madoff-related claims. The first is the question of who is insured under the policies. In many of these Madoff-related lawsuits (a complete list of which can be accessed here), the plaintiffs have named a laundry list of related defendants, often including not only investment managers and advisors, but also investment funds, offshore entities, and a squadron of associated individuals.


These claims are going to stress-test the insurance policies involved. The policyholders will find out how well put together the policies were, in light of the entities’ related structures and operations. There may well be instances where the entire family of advisors, managers and funds were not fully yoked together under the coverage umbrella.


But an even more important set of issues that potentially could affect the scope of insurance losses are the potential coverage defenses the carriers may seek to assert. In particular, insurers will be looking closely to see whether the allegations raised in these lawsuits trigger one of more of the standard conduct exclusions, particularly the personal profit and the fraud exclusions.


The conduct exclusions typically are written on an after adjudication basis, meaning that the only apply to preclude coverage only after an adjudicated determination that the prohibited conduct actually took place (as I recently noted in my discussion of the potential coverage insurance issues arising in connection with the Satyam scandal, here).


Moreover, at this point the fraud involved appears to involve misconduct of Madoff himself, rather than the feeder funds, although obviously investigators are probing the potential complicity of a wide variety and number of persons associated with Madoff.


The personal profit exclusion may prove to be the more relevant. A typical exclusion precludes coverage for loss "based upon, arising from, or in consequence of … an Insured having gained any profit, remuneration or advantage to which such Insured as not legally entitled, if a judgment or final adjudication in any proceeding establishes the gaining of such remuneration or advantage."


Investors have already claimed that the feeder funds inappropriately exacted management fees or other compensation without conducting appropriate due diligence or otherwise earning their fees. However, an adjudicated determination of these allegations would be required for the profit exclusion to preclude coverage.


Although there is currently no reported reason to suggest that the "feeder funds" were aware of Madoff’s scheme, insurers will also be looking closely at who know what and when, looking for possible bases to rescind coverage based on alleged misrepresentations in the policy application.


Yet another factor that could restrict the total insurance losses is the limitation on the amount of insurance potentially involved. In my experience, many investment advisory firms and hedge funds buy relatively lower limits of insurance coverage. Thus, in many cases, the available insurance involved could be relatively slight and could quickly be exhausted by defense costs alone. As a result, a portion of the potential defense expense and the amount of some settlements could wind up being uninsured.


I suspect that as a result of the Madoff-related events, many investment advisory firms, hedge funds and other financial firms will now need far less persuading of the value of this type of insurance or that more than just minimal limits could well be advised. Unfortunately, for the firms acquiring this insight for the first time now, this type of coverage could well become much more expensive even if otherwise available.


As noted in a December 31, 2008 publication of the Lloyd’s insurance market entitled "Madoff Scandal Poses Challenges for Directors" (here), the "sheer scale of the fallout from Madoff could seriously affect the financial insurance market’s dynamics, affecting the availability and cost of both professional indemnity and directors and officers coverage." The article quotes one source as stating with respect to this type of coverage that "prices are going to increase and cover will be restricted."


More Madoff Lawsuits: Meanwhile, the Madoff-related lawsuits continue to flood in. For example, on January 8, 2009, Pacific West Health Medical Center, Inc. Employees Retirement Trust sued Fairfield Greenwich Group and related entities and individuals in the Southern District of New York on behalf of all persons who purchased shares of the Fairfield Sentry funds, alleging that the defendants breached their fiduciary duties. The defendants are also accused of negligence, unjust enrichment and breach of contract.


A copy of the Pacific West complaint can be found here. A copy of a January 9, 2009 Bloomberg article describing the complaint can be found here.


It also looks as if overseas investors are about to get involved in Madoff litigation, which may be unsurprising give that, as the Financial Times reports (here), as much as half of the Madoff losses have been borne by non-U.S. investors.


According to a January 8, 2009 Reuters story (here), investment activist group Deminor is readying to sue UBS, HSBC, Hyposwiss and others in courts in Luxembourg and Ireland in connection with the Madoff scandal. The charge is that the defendant banks acts as depositories for sponsored funds that invested clients’ money in Madoff-related vehicles. The allegation is that the depository banks were responsible for the sponsored funds and negligently failed to check what was inside the clients’ portfolios.


According to an earlier Financial Times article (here), UBS at least sought to exculpate itself from any responsibility for clients’ assets through the subscription documents it used.


In any event, I have updated my running tally of the Madoff-related litigation, which can be accessed here.


Special thanks to David Demurjian for the link to the Bloomberg article, and to a loyal reader who prefers anonymity for the Reuters and Financial Times articles.


Can Madoff Losses Be Recovered?: In addition to all of the factors noted above that could diminish the aggregate Madoff-related insurance losses, there is also the question whether the investors’ claims are meritorious. That is, do the claimants actually have a legitimate basis upon which to try to recover their losses from the Madoff "feeder funds" and others?


These questions will be addressed in a webinar entitled "Madoff Litigation: Can the Lost Billions Be Recovered?" to be hosted by Securities Docket on January 14, 2009 at 2:00 P.M. The speakers include Gerald Silk of the Bernstein Litowitz firm, Brad Friedman of Milberg LLP, and Fred Dunbar of NERA Economic Consulting. Further background regarding the webinar can be found here. Registration for the webinar can be accessed here.


A replay of a prior Securities Docket webinar entitled "2008: A Year in Review" can be accessed here. (I was one of the speakers at this prior session.)


"Hitler Previews the Cubs’ Winter Meeting": This video is in questionable taste, contains foul language, and is very very funny, at least for those having some acquaintance with the Chicago Cubs. (The humor is more accessible if, for example, you know who Kerry Wood is.) Special thanks to a loyal reader for sending along a link to this video.