The arrests of Bernard Madoff and Allen Stanford in December 2008 and June 2009 respectively, and the resulting litigation and investigations, have prompted a raft of notifications to D&O, PI and Fidelity/BBB policies since late 2008. At first, the market’s potential exposure to these events appeared huge, given the massive scale of the actual (Madoff) and alleged (Stanford) frauds. This Update looks at the impact of these and the issues which will affect insurers.

Insurers are understandably concerned to identify the nature and extent of their exposures as soon as possible. At first blush, that would appear relatively easy but the reality is very much the opposite.  

Many investors invested via one or more institutional intermediaries and/or offshore jurisdictions with strict privacy laws. This (often impenetrable) chain potentially leads to double or triple counting of losses. Moreover, the complex contractual arrangements underlying most investments and differing applicable laws make it difficult to establish or allocate liability in all but the most obvious cases.  

Accordingly, insurers are highly unlikely to be able to take a firm view on their overall exposures for some time yet. However, the trends emerging from Madoff/Stanford notifications below shed light on that and the coverage issues which are most likely to arise.

Vague/blanket notifications of circumstances  

The second half of 2009 saw a fl urry of vague/blanket notifications of circumstances. These were prompted by insureds wanting to “clear the decks” before renewal and to protect against possible exclusions going forward. Indeed, present statistics indicate that approximately 60% of Madoff notifications are precautionary in nature.

Under English law, if such notifications are not valid, then insureds might not get cover, irrespective of insurers’ immediate response, so notification issues might emerge if/when Madoff/Stanford claims materialise. Attachment issues will also arise where the event(s) the insured notifies straddle more than one policy year.

Early settlement of claims by insureds

We have seen insureds putting insurers under significant pressure to authorise early commercial settlements of Madoff claims. This is a catch-22 situation: insurers might not have sufficient information to decide whether to authorise a settlement, or at what level; however strict privacy laws in offshore jurisdictions, and confidentiality clauses in the insured’s contracts with their (claimant) clients, can make it difficult for insurers to obtain the information they need. So, how do they: (i) obtain that information; and (ii) assess whether the proposed deal is a good one?

Redacting sensitive information from documents and executing confidentiality agreements are tried and tested ways of resolving confidentiality issues. However, we have seen cases where the insured is not willing to disclose information to insurers even on those bases and have considered with insurers more innovative approaches such as:

  • Loading the documents onto a secure website in the insured’s home jurisdiction, although this can lead to English law data protection issues if insurers view the documents in England  
  • Obtaining an opinion from a local lawyer that disclosing information/documents to insurers will not breach local law or agreeing to refer the issue to an independent arbitrator for a binding determination
  • Instructing local lawyers to inspect the insured’s documents in situ, although this can be expensive and insureds might regard it as setting a precedent for future claims; it is therefore very much a last resort.

Considering whether the deal on the table is a good one can be particularly difficult if the notification has not reached a stage where a view can be taken on liability and quantum, as is presently the case with many Madoff/Stanford notifications. It will depend on the nature of the claimant’s allegations, their merits under the law governing their claim and the rules for calculating quantum in that jurisdiction. If in doubt, insurers should take advice from lawyers in that jurisdiction.

Quantum and reserving issues

Reserving for Madoff/Stanford notifications will remain difficult until claims are actually pursued. Although a handful of claims are continuing, the lion’s share of notifications are precautionary and are likely to stay as such for many months yet.

A complicating factor is that the US Securities Investor Protection Corporation (SIPC) has not yet taken a position regarding losses caused by Madoff and Stanford. It protects “customers” in the event of the failure of US broking firms, such as Madoff Securities and Stanford Group Co. Each “customer” can claim up to $500k for their losses.

If the SIPC defines “customer” as the named account holders with Madoff Securities and Stanford Group Co, then the total amount receivable by each insured is likely to be capped at $500k. Insureds can assert that each of their listed shareholders or even their (sometimes numerous) underlying investors are really the customers and each should therefore be compensated individually. This would result in multiple payments of up to $500k, which could impact the quantum and number of notifications significantly.

However, most of the accounts with Madoff Securities and Stanford Group Co were registered in the name of the insured. This gives the SIPC a strong argument against making multiple payments.

A further factor is that credit should be given for any redemptions received by investors which are not clawed back in the winding up of Madoff Securities/Stanford Group. In this regard, Madoff Securities’ trustee in bankruptcy has already commenced 11 actions to claw back sums paid by Madoff Securities shortly before Bernard Madoff’s arrest.

To the extent that insureds seek an indemnity for these clawback claims, then there may be coverage issues, such as whether those payments could be viewed as disgorgements and, therefore, whether they are insurable as a matter of public policy.

Moreover, causation issues will arise because investors will have to explain what they would have done with their money had they not invested with Madoff Securities/Stanford Capital. Insureds might therefore be able to assert that their (claimant) investor clients would have suffered losses in any event, given the volatility in the world’s financial markets since Bernard Madoff’s arrest.

Finally, credit should be given for any sums distributed as part of Madoff Securities/Stanford Group’s liquidations, although in reality nobody expects much (if anything) to be returned to the investors by this means.

All of this makes reserving a difficult judgement call. At RPC, we have considered with insurers adopting IBNR approaches to reserving for Madoff/Stanford notifications across a book of business and to setting up internal reserving protocols. Factors commonly built into those protocols include: the maximum possible loss; the risk of the insurer’s layer being affected; the insured’s proximity to Madoff/Stanford; and the strength of insurers’ coverage defences.

Reporting to the following market/excess layers

We have seen examples of following/excess layer insurers becoming concerned they are not receiving sufficient information from the lead on their layer and/or the underlying layer(s). The market is obviously used to encountering such issues.

The leader on each layer is responsible for keeping the following market updated (either directly or via XCS or CLASS) and the burden is on the following market to chase the lead/the brokers for updates. This can cause practical problems for following/excess insurers, although there is no one-size fits all answer when these issues arise; for example, not all the following/excess markets might want to see (or pay for) the lead’s lawyer’s coverage advice.

In our experience, the best approach is to open communications with all insurers (on all layers), the brokers and any appointed lawyers at the earliest possible stage. The end result is likely to be a variation on: (i) following/excess insurers agreeing to appoint the primary lead’s lawyers; or (ii) the primary lead releasing its reports in return for the followers contributing to the costs and/or (iii) the excess layer insurers agreeing to pay pro-rata insofar as the claim impacts their layer. Issues of privilege and confl ict of interest must also be borne in mind. Conclusion The Madoff and Stanford notifications which we have seen do not give rise to any issues which the market has not encountered many times before. However, the scale, and systemic nature, of those actual (Madoff) and alleged (Stanford) frauds mean that insurers are coming under increased pressure. Our experience suggests that insurers are stepping up to the plate by working closely, and openly, with all the relevant stakeholders and are adopting innovative approaches to be taken to resolving those issues efficiently.