Posted on 20 Jan 2009
The most direct way to recover losses from securities fraud schemes, as highlighted by the alleged Bernard Madoff fraud scheme that could end up costing investors some $50 billion, is to make claims through the directors and officers or errors and omissions coverage of the persons or firms responsible for the losses.
The alleged fraud exemptions in such policies would often mean that suing a guilty perpetrator may not accomplish much, said insurance and legal professionals who deal with claims issues.
“Very often what happens in these cases is that there are settlements before they go to trial,” Michael O’Connell, managing director of the financial institutions practice at Aon Corp. “You could get at least partial recovery as part of that settlement. If the defense costs are part of the limits of liability, if the insurer can settle, they may want to do so.”
Still, a finding of fraud presents problems, said Marshall Gilinsky, an attorney and shareholder in the New York office of Anderson Kill & Olick P.C.
“A finding of fraud hurts the victims,” Gilinsky said. “It limits the insurance coverage because of fraud exclusions. You need to make allegations to establish the basis for liability, but if the only allegation you can make is fraudulent activity, and insurance is the only available asset, then you haven’t accomplished anything.”
Madoff has been accused of running a form of pyramid scheme, in which a large amount of money is taken from investors who have been promised high rates of return from what they think is a legitimate investment (BestWire, Dec. 16, 2008).
The alleged Madoff fraud will cost the insurance industry between $760 million and $3.8 billion in reimbursements and defense costs, with the most likely total around $1.8 billion, the analysis said. The industry's total exposure may be $6 billion, said Aon Benfield, the reinsurance arm of broker Aon Corp.
In most fraud cases, victims will look to the advisers, brokers and other professionals who steered then into the fraudulent scheme because there is no allegation of fraud, just allegations of sloppy work, poor due diligence and the whole panorama of what could be called not doing the job correctly -- the stuff that professional liability claims are made of.
"Investors are going to be bringing suit against their investment advisers and funds,” said Matt Schlesinger, an attorney with Reed Smith LLP. “Those advisers will have errors and omissions coverage that should respond by advancing defense costs or defending the suits. They may also have directors and officers coverage that could be triggered."
Gilinsky said there are some possible coverages under some kinds of commercial general liability and, as a last resort, umbrella coverage on a homeowners policy will likely offer a few tens of thousand of dollars for recovery.
But he said finding professional liability sources would be the best way to recover losses. He said that any financial advisers, brokers, individuals or companies that run the “feeder funds” that send money to a fraudulent operation, and accountants or other professionals involved with any of the above, could become targets.
“The idea would be to think of who it is that put you in a position to be subject to these losses,” Gilinsky said.
The Madoff case may enhance a trend of increases in D&O renewal prices for financial institutions, even as overall D&O renewals rates continue to fall, O’Connell said. The Quarterly D&O Pricing Index produced by Aon Risk Services shows that from the third quarter of 2007 to the same period in 2008, renewal rates for financials jumped 19.7% while overall rates declined 11.3%.
While there is no insurance cover that an investor can buy to protect his investments against securities fraud, the issue has been kicked around in the industry for some time, O'Connell said.
“There are folks who have been looking to do just that – to find a way to provide a true, affirmative cover,” he said. The potential exposures for such a cover “get to how do you underwrite it,” O’Connell said, and there is yet to be an answer.
But the issue has been discussed for so long that some steps have been taken, O’Connell said.
Under the 1970 Securities Investor Protection Act, a nonprofit corporation was established to aid investors in cases when securities brokers go bankrupt and investors’ securities are missing.
The Securities Investor Protection Corp. can reimburse losses of up to $500,000. It is funded through assessments from participating brokers, and only makes reimbursements to investors who utilized a member broker.
A policy known as an excess SIPC, sold primarily by Lloyd's, provides coverage above the SIPC cap, O’Connell said. The buyers are the major securities brokers, who promote the SIPC membership and excess coverage to potential investors.
“In the wake of Madoff, we are seeing some increased interest it the excess SIPC,” he said. “Several major clients have increased the limits they purchased.”