Cayman Islands: Primeo Fund v HSSL And Another: "If It's Too Good To Be True, Then It Probably Is"

Last Updated: 12 September 2017
Article by Peter McMaster QC

A Cayman fund that was "to a very substantial degree, the author of its own misfortune" has lost its USD$2 billion suit to recover Madoff related losses from its custodian and administrator. The custodian and administrator did not, however, escape unscathed, after the judge made carefully explained findings of breach of contract, negligence and even gross negligence against them.

The judgment provides useful guidance as to the duties and responsibilities of administrators, custodians and service providers when faced by a unique and often high-risk business model. It also contains important guidance on the application of the principle of reflective loss in funds disputes involving overlapping structures.

Whilst the Cayman attorneys for both parties have published articles reporting on the outcome, this article provides an objective analysis of the judgment and the key legal issues that the Court has raised.


The Primeo Fund ("Primeo") was a Cayman Islands incorporated investment fund that invested with Bernard L Madoff Investment Securities LLC ("BLMIS"). Primeo appointed Bank of Bermuda (Cayman) Limited ("BBCL") as administrator and HSBC Securities Services (Luxembourg) SA ("HSSL") as custodian. Both BBCL and HSSL were later acquired by HSBC.

Primeo's claim centred on the sophisticated and elaborate infrastructure and operation for deceit and deception that served to protect an underlying fraud scheme – the infamous Madoff Ponzi Scheme – worth over US$60 billion. The company in which Bernard Madoff perpetrated his crime offered equity-like returns with bond-like volatility purportedly produced by Madoff's investment strategy – described as "the Holy Grail". In pursuit of this Holy Grail, the judge found that Primeo "accepted the uniquely high operational risk inherent in BLMIS's business model". The judge was referring to the concentration of functions by BLMIS, acting in a triple capacity as broker-dealer, investment manager and custodian in the context of a business "owned, controlled and managed by one dominant individual" who had a known "penchant for confidentiality".

Although the judge found that these risks were known to and accepted by Primeo, they were "red flags" and ought to have been equally obvious to the service providers. It was, in large measure, this knowledge that led the judge to conclude that procedures followed and structures put in place, that in other circumstances might have been defensible, were seriously lacking in this case. The judgment is of interest to the industry and to practitioners as demonstrating that it is not possible to take a one size fits all approach to risk management and the discharge of duties of care.

Findings against service providers

Custodian: Custody was provided by HSSL under an arrangement with BLMIS as sub-custodian. HSSL, as custodian, was held to be strictly liable for the wilful default of BLMIS in its capacity as sub-custodian. This "no fault liability" was imposed despite the presence of a clause in HSSL's custody agreement excluding liability for anything other than fraud, negligence or wilful breach of duty.

HSSL was also found to have fault-based liability. The judge found that as custodian it should have recommended to Primeo that it require separation of assets within BLMIS's (as its sub-custodian) accounts at the Depository Trust Company and at the Bank of New York. The judge found that whilst it is not standard commercial practice for custodians to segregate assets, the particular circumstances of this case warranted a reasonably competent custodian to do so; the judge went on to state that "when the normal procedure is known to be ineffective, failing to apply a readily available alternative is negligent".

Administrator: BBCL, as administrator, was held to be negligent in relying on single-source reporting in relation to investment assets in the years leading up to 2005. However, that reliance was mitigated by the fact that Ernst & Young provided clean audit reports in that period which were based on the work of Friehling & Horowitz ("F&H") (Madoff's own auditor who were subsequently found to be complicit in the fraud). Simple negligence was below the threshold for liability provided for in the administration agreement.

BBCL was held to be grossly negligent in determining Primeo's net asset value relying on single source reporting in relation to assets in the years 2005 onwards, since Ernst & Young had flagged concerns with the audit work being performed by F&H, suggesting that it would need to do the work itself or else rationalise the audit opinions or resign. That scenario was only avoided by HSSL issuing a custody confirmation to Ernst & Young with respect to the assets purportedly held by BLMIS as sub-custodian.

Dismissal of Primeo's claim

Despite these findings, the judge held against Primeo, dismissing its claim entirely, as the judge found that Primeo had failed to prove causation. Quite separately, he found that the rule against reflective loss barred the claim entirely. Limitation was also, he decided, a reason why many of the claims were time-barred.

Primeo lost on causation because as plaintiff it had the burden of proving that it had suffered loss due to the breaches and negligence found by the judge. It argued that had the service providers discharged their duties, Primeo would have pulled out of its investment in BLMIS. The judge examined a range of possible outcomes which might have flowed if the HSBC defendants had acted differently and found that Primeo was "firmly committed to Madoff" and pronounced that he was not persuaded that Primeo would have terminated its managed account with BLMIS and re-invested the proceeds in some other way.

Primeo was also defeated by the rule against reflective loss. In 2007, Primeo began investing indirectly through two other Madoff feeder funds, Herald Fund SPC (In Official Liquidation) ("Herald") and Alpha Prime Fund Ltd ("Alpha"). When Primeo invested in Herald, it assigned its balance at BLMIS to Herald in exchange for the issue of shares in Herald. The relationship between Herald and Alpha on the one hand and Primeo on the other became such that "they acquired the essential economic characteristics of master/feeder structures".

The rule against reflective loss means that, in general, a shareholder cannot sue to make good a diminution in the value of its shareholding where the diminution merely reflects a loss suffered by the company. The judge found that this rule barred any recovery of loss by Primeo because the claimed loss was a diminution in the value of its shareholdings in Herald and Alpha. Pursuant to this rule, the proper plaintiffs would be Herald and Alpha with any recovery being passed on to Primeo as shareholder in proportion to its shareholding.

After deciding the claims entirely against Primeo, the judge further ruled that a significant majority of the causes of action concerned breaches before February 2007 and so were statute-barred.

The judge's lack of overall sympathy for Primeo is evident in his statement at the end of his judgment that even if Primeo had made out its claim, a very substantial reduction of 75% would have been made to reflect Primeo's own contributory negligence "because it was, to a large extent, the author of its own misfortune".

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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