Primeo v HSBC: Madoff feeder fund claim dismissed by Cayman Court

Published September 2017

Toby Brown reports on the Grand Court’s decision in Primeo Fund (in Official Liquidation) v Bank of Bermuda (Cayman) Ltd and HSBC Securities Services (Luxembourg) SA in which Tom Smith QC, Richard Fisher, William Willson and Robert Amey also appeared.

On 23 August 2017 Mr Justice Andrew Jones QC of the Cayman Islands Grand Court delivered his judgment dismissing the claim brought by Primeo Fund against two HSBC entities, Bank of Bermuda (Cayman) Ltd (“BBCL”) and HSBC Securities Services (Luxembourg) SA (“HSSL”). Primeo was a Cayman Islands fund that invested with Bernard L Madoff Investment Securities LLC (“BLMIS”), whilst BBCL and HSSL acted as Primeo’s administrator and custodian. As explained below, whilst the Judge found that contractual duties had been breached, he found in favour of the Defendants on strict liability, causation, limitation, reflective loss, and contributory negligence (in relation to BBCL).

The Madoff fraud

On 11 December 2008, Bernard Madoff was arrested by the FBI and admitted carrying out what is now known to be one of the largest investment frauds in history. Over decades, Madoff accepted money from investment clients which he purported to invest in US equities and Treasury Bills, producing steady returns year after year. In fact, no investments were made; rather, it was a classic Ponzi scheme in which money from new investors was used to pay redeeming investors.

In their sophisticated enterprise, Madoff and his associates used computer systems to work out after the market had closed what trades should have been executed to produce the positive returns required for the numerous investment clients. Backdated individual trade slips and monthly statements were produced and mailed out or faxed to clients. Countless investors, sophisticated financial institutions and service providers were deceived. The scheme, and Madoff personally, were so convincing that neither the Securities and Exchange Commission or KPMG uncovered the fraud notwithstanding their on-site investigations at BLMIS’ offices.

The fraud was facilitated by Madoff’s insistence on BLMIS acting in a triple capacity as investment manager, executing broker and custodian of the assets (the so called “Triple Function”). Madoff also maintained a high level of secrecy regarding his purported trading strategy. The risks associated with these aspects of the BLMIS business model were seemingly accepted by thousands of clients in return for being one of the lucky few clients of Madoff (so they thought).

Currently Madoff is serving a 150-year prison sentence, whilst a number of his associates have been convicted of involvement in the fraud. The combined estate of BLMIS and Madoff continues to be liquidated in the US, with substantial payments having been made to the investors who lost money. For those interested in Hollywood portrayals, Robert De Niro convincingly played Madoff (and Michelle Pfeiffer his wife) in HBO’s recent film The Wizard of Lies, whilst Richard Dreyfuss and Blythe Danner starred in the recent ABC miniseries Madoff.


Turning to the case at hand, Primeo was established by Bank Austria in 1993 as an open-ended investment fund. From inception, it invested with BLMIS, as well as making other investments. Over time, Primeo increased the amount and proportion of its investments with BLMIS, ultimately placing substantially all of its assets directly or indirectly with BLMIS. Primeo invested “indirectly” with BLMIS from 2003 via shareholdings in other Madoff feeder funds, first Alpha and later Herald, who placed their assets with BLMIS. In May 2007, Primeo switched all of its direct investments in BLMIS for a shareholding in Herald (the “in specie transfer”), and thereafter only invested through Herald and Alpha.

From 1996, BBCL acted as the Administrator of Primeo, and was required under an Administration Agreement (in very brief summary) to maintain the books and records of Primeo, and to calculate each month the Net Asset Value (“NAV”) per share. From 1993, HSSL acted as the Custodian of Primeo pursuant to two successive Custodian Agreements, under which it was required to hold cash deposited in bank accounts and to safekeep securities delivered to it.

Soon after the collapse of BLMIS, Primeo entered liquidation. In 2013, acting through its official liquidators, Primeo issued a claim in the Grand Court of the Cayman Islands alleging BBCL and HSSL had breached their contractual duties under the 1996 Administration and Custodian Agreements respectively. It was claimed that if the Defendants had taken certain additional steps in relation to the BLMIS investments, Primeo would have withdrawn those investments prior to the fraud being uncovered, and profitably reinvested the monies elsewhere. On this basis Primeo claimed approximately US$ 2 billion in damages.

The trial was heard between November 2016 and February 2017, and involved 10 factual witnesses and 17 expert witnesses including on various issues of foreign law.

Custody claim

Primeo alleged that HSSL was the custodian of the BLMIS investments from inception but failed to safekeep the assets, and that HSSL appointed BLMIS as sub-custodian under an unwritten sub-custody agreement from 1993 and then formally in 2002 under a written Sub-Custody Agreement. The 2002 Sub-Custody Agreement was governed by Luxembourg law, and the Court heard evidence from three different Luxembourg law expert witnesses in relation to the contested validity and effect of the agreement.

The Judge rejected the assertion that HSSL was custodian of the BLMIS investments prior to 2002, holding instead that BLMIS was custodian directly to Primeo from 1993 pursuant to the Brokerage Agreements in place between Primeo and BLMIS. However, the Judge held that the Sub-Custody Agreement executed by HSSL and BLMIS in 2002 was effective to constitute BLMIS as sub-custodian as part of an apparent “implied tri-partite agreement” between BLMIS, Primeo and HSSL.

Primeo alleged that HSSL breached its contractual obligations in relation to the appointment and ongoing monitoring of BLMIS as a sub-custodian. The Custodian Agreement in particular required that subcustodians be required to implement the “most effective safeguards” to protect Primeo’s assets. The key issue was whether a reasonably competent global custodian would have appointed and continued to appoint BLMIS as sub-custodian without requiring that BLMIS (a) establish a separate account with the Depository Trust Corporation (“DTC”) in which Primeo’s securities would be held, (b) use DTC’s Institutional Delivery (“ID”) System to provide independent information on trades, and/or (c) establish a separate account at Bank of New York (“BNY”) in which Primeo’s Treasury Bills would be held.

Preferring the views of Primeo’s custody expert, the Judge held that these additional safeguards should have been recommended by HSSL to Primeo and therefore that HSSL breached its contractual duties. The Court acknowledged that none of these steps were standard commercial practice. The Defendants argued that none of the solutions were at the time recommended in any of the industry or regulatory materials as methods for asset protection (although the Judge found the solutions were “readily available”), nor have they been recommended since.

The Judge, however, held that the BLMIS structure was not addressed by normal commercially acceptable practices because of the unique Triple Function. He reasoned that the normal procedures were ineffective because the custodian did not reconcile information received from the manager or broker. Given the operational risks inherent in BLMIS, the Court held it was negligent not to look at procedures capable of producing the “normal result”. However, as discussed below, the breach was not causative, in particular given Primeo knew of, and accepted, the risks inherent in investing with BLMIS.

In respect of the period after the May 2007 “in specie transfer”, Primeo did not allege any breach of safekeeping duties in relation to its shares in Alpha and Herald but claimed that HSSL breached implied advisory and reporting duties. The Judge, however, accepted the Defendants’ arguments that it would be contrary to the terms of the Custodian Agreement to imply such terms.

Strict liability

Primeo also claimed that HSSL was strictly liable pursuant to the Custodian Agreement for BLMIS’ negligent or wilful breaches of duty. The Defendants argued that the parties did not intend HSSL to become guarantor for Primeo’s multi-million dollar exposure to BLMIS, especially where Primeo had selected Madoff and initially appointed BLMIS. The Grand Court, however, considered that, as a matter of construction, the Custodian Agreement did impose strict liability.

Nonetheless, the strict liability claim was rejected on the basis that no loss was suffered from a breach of duty for which HSSL was liable (to be contrasted with the loss caused by Primeo’s own decision to place funds with BLMIS for investment). In particular, BLMIS met its obligations as sub-custodian by returning cash to HSSL when requested from time to time, and in May 2007 by effecting the “in specie transfer” already mentioned. Accordingly, there was no default or loss for which HSSL was liable on or prior to 1 May 2007. Further, from May 2007, BLMIS was no longer sub-custodian of Primeo’s assets.

The result of the “in specie transfer” was subsequently recognised by the BLMIS trustee when it reached a settlement with Primeo and Herald, under which Herald was entitled to make a customer claim in the BLMIS liquidation on the basis it acquired all of Primeo’s rights. Indeed, the validity of the “in specie transfer” was upheld in other proceedings between Primeo and Herald’s additional liquidator where the Grand Court held that Primeo had validly subscribed for shares in Herald valued as at 2 May 2007 at $465.8 million.

Administration claim

Primeo claimed that BBCL as Administrator (acting through HSSL as delegate) breached its duties in connection with the determination of the NAV and in relation to the keeping of accounts and books and records. Under the terms of the Administration Agreement, BBCL would only be liable if it was grossly negligent or in wilful default of its duties.

The Judge stated that administrators are not expected to perform audit procedures, but are concerned to satisfy themselves that the published NAV is accurate. There was no criticism of BBCL in relation to the pricing of trades reported by BLMIS; rather it was alleged that a reasonably competent administrator would have satisfied itself about the existence of the BLMIS investments by reconciling information obtained from BLMIS to an independent source (so called “independent confirmation”).

The Judge rejected the assertion it was an implied term of the Administration Agreement that the Administrator would confirm independently the correctness of the information received from BLMIS as to transactions and assets. The parties must have known that it would not be possible to verify this information as long as the BLMIS business model remained unchanged.

Yet the Judge found that the failure of BBCL to address the fact that there was only a single source of information in relation to the BLMIS investments was negligent. This was notwithstanding the evidence of the Defendants’ administrator expert from his hands-on experience in Cayman that it was commonplace to rely upon single source reporting. The Judge decided that single source reporting for a Triple Function model such as BLMIS was unique, and the inherent high risk of fraud “must have been manifestly obvious to all concerned, including the funds’ promoters and investment managers/advisers”.

The Court found there was no gross negligence and therefore no liability until 2005. At this point HSSL as Custodian issued a “custody confirmation” to Primeo’s auditors, Ernst & Young (“E&Y”). The Judge found that E&Y (who did not give evidence at trial) were no longer willing to rely upon the work of BLMIS’ auditors, Friehling & Horowitz. He held that BBCL could no longer rely upon E&Y’s unqualified annual audit opinions because they were based to a material extent on custody confirmations issued by HSSL, who was unable to independently reconcile the BLMIS information. BBCL was therefore found to be grossly negligent in the preparation of the NAV from 2005.

As already stated, from May 2007, Primeo invested only in Alpha and Herald rather than directly with BLMIS. Ordinarily an administrator of a fund of funds will rely upon the NAVs published by the underlying funds and there will be no “look through” to recalculate their NAVs. However, the Judge found that BBCL was grossly negligent because HSSL’s work as administrator of Herald and sub-administrator of Alpha was flawed for the same reasons, and that BBCL knew or ought to have known this.

The Judge, however, rejected Primeo’s additional claims based on preparation by the Administrator of Primeo’s books and records, and in relation to alleged “advisory and reporting” duties.


Primeo claimed that if the Defendants had properly discharged their duties, Primeo’s directors would have decided to withdraw the assets managed directly or indirectly by BLMIS and would have invested them elsewhere. The Judge decided Primeo had not established that the breaches were an effective or dominant cause of the loss. Three key scenarios were analysed in the judgment.

First, in relation to the custody claim, the Court considered the position in 2002 if the Defendents had recommended to Primeo that BLMIS be required to put in place separate DTC and BNY accounts and the ID System. Primeo, however, had not tendered evidence from the key decision makers in Primeo or its investment advisers, nor obtained documents from Bank Austria. Of the three Primeo directors that gave evidence, the Judge found the evidence of the director who commented on causation to have been “unsatisfactory” and that he was far removed from the decisionmaking process. In any event, the Judge stated that the circumstantial evidence pointed to the conclusion that the directors “were firmly committed to Madoff” and that they would have “worked hard” to avoid withdrawing from BLMIS.

Second, in relation to breaches in 2005, the Court considered a scenario in which “custody confirmations” had not been issued to E&Y. The Judge considered that Madoff might well instead have permitted E&Y to access BLMIS’ books and records, given that one year later he did allow KPMG access to conduct a fraud review for HSBC. Even if Madoff had refused, the Judge decided that in all likelihood Primeo would still have continued with the same investment strategy by investing in other Madoff feeder funds.

Finally, the Court considered breaches in 2007 when the control of Primeo was soon to be transferred from BA Worldwide in Austria to Pioneer in Ireland, and therefore the decision regarding withdrawal from BLMIS would have been made by the new board. No evidence had been adduced from the new decision makers and if anything the causation analysis was “even more speculative” than that applicable to 2005. The Judge commented that an internal report showed that Pioneer was aware of the operational risks associated with BLMIS, and notwithstanding Pioneer must have had some concerns regarding the BLMIS model, it continued to maintain Primeo as a Madoff feeder fund to the very end.

Contributory negligence

In the event Primeo made out a causation case, the Defendants relied on a defence of contributory negligence under section 8 of the Torts (Reform) Law (1996 Revision). The Court held that the liability for breach of the Administration Agreement was the same and co-extensive with liability under the tort of negligence, and therefore a plea of contributory negligence was available to BBCL. However, the Judge held this was not the case with respect to HSSL in relation to the Custodian Agreement.

Based on his assessment of the evidence, the Judge decided that “Primeo was, to a very substantial degree, the author of its own misfortune”. Primeo’s directors were industry professionals, and decided to establish Primeo Select with BLMIS having the Triple Function even though the “relatively high operational risks inherent in the BLMIS business model were obvious”. The directors accepted Madoff would not change his business model, even after the risk of single source reporting was brought to their attention. The Court accordingly would have reduced any award of damages against BBCL by 75 percent.


The Defendants relied upon section 7 of the Limitation Law, which they contended barred causes of action that accrued prior to 20 February 2007 (i.e. 6 years before issue). Primeo’s first response was that the Defendants were in continuous breach of their duties. Whilst the Judge held that certain duties were of a continuing nature in the sense of being performed periodically, there was no continuing breach in the sense it occurred on a daily basis. In any event, the principle of continuing breach could only enable Primeo to recover damage caused after 20 February 2007.

Primeo’s second response was to allege deliberate concealment and deliberate breach of duty in order to extend the limitation period under section 37 of the Limitation Law. The Judge rejected Primeo’s contention there was positive concealment on the facts, and also rejected there was any concealment by omission, including because there was no duty to report matters to Primeo and given there was an “equivalence of knowledge” regarding the operational risks inherent in the BLMIS model.

Primeo argued that the Defendants recklessly breached their duties and that this was to be treated as deliberate concealment. Applying the House of Lord’s decision in Cave v Robinson Jarvis & Rolf [2002] UKHL 18, the Judge held that deliberate rather than reckless breach was required, and that the Defendants had not deliberately breached their duties. Causes of action that accrued prior to 20 February 2007 were therefore statute barred.

Reflective loss

The Defendants relied on the rule against reflective loss on the basis that Alpha and Herald, the funds in which Primeo invested, were the proper parties to bring claims in relation to the loss claimed by Primeo. The rule is that a shareholder (Primeo) may not recover loss that is merely reflective of a loss suffered by the company (Herald/Alpha), i.e. loss which would be made good if the company enforced its rights in full against the defendant wrongdoer (HSSL). This principle stems from the Court of Appeal’s decision in Prudential Assurance Co Ltd v Newman Industries Ltd (No. 2) [1982] Ch 204, subsequently considered by the House of Lords in Johnson v Gore Wood [2002] 2 AC 1.

The rule is designed to guard against double recovery and to ensure the company is able to prosecute its claims for the benefit of all its shareholders and creditors. The Judge accordingly held that the principle does not depend on the plaintiff being a shareholder at the time the cause of action arose. Rather, the rule must be applied to claims actually made in the shareholder’s action that are reflective of the company’s loss. Accordingly, the rule is capable of application to Primeo even though prior to May 2007, Primeo invested directly with BLMIS.

The principle requires the Court to consider the merits of the company’s (i.e. Herald’s and Alpha’s) claims. The Judge rejected the suggestion that he must be satisfied on the balance of probabilities that the claims would succeed, as Primeo argued, holding rather that the claims needed to have “a real prospect of success”, as the Defendants contended.

Herald in fact has an ongoing claim in Luxembourg for approximately US$ 2 billion against HSSL, who acted as its custodian and administrator. The parties’ Luxembourg law experts agreed that Herald has a real prospect of success in relation to its breach of duty claim. Alpha has issued ongoing proceedings in Luxembourg against HSSL, who acted as its sub-custodian and sub-administrator, claiming US$ 346 million. Alpha has also issued cross-claims in the US Bankruptcy Court and proceedings in Bermuda in which HSSL is a defendant.

Having heard the evidence at trial, the Judge decided it was “clear that the factual circumstances relating to the claims of Herald and Alpha (the company claims) are practically the same as those relating to Primeo’s claim (the shareholder claim)”. Further, he decided that the merits of the claims of Primeo, Herald and Alpha are comparable even if they cannot be said to be identical. The Judge accordingly held that the claims of Herald and Alpha have a realistic prospect of success and therefore Primeo’s claims are barred by the rule against reflective loss.


For the reasons summarised above, the Grand Court dismissed Primeo’s claim. Shortly before the Digest went to press, Primeo filed a notice of appeal with the Cayman Islands Court of Appeal.

The content of the Digest is provided to you for information purposes only, and not for the purpose of providing legal advice. If you have a legal issue, you should consult a suitably-qualified lawyer. The content of the Digest represents the views of the authors, and may not represent the views of other Members of Chambers. Members of Chambers practice as individuals and are not in partnership with one another.
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Toby Brown
Toby Brown
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