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After the Madoff Scandal

How To Manage The Risk To Your Investments

Are your invested funds secure? We’re not talking about possible market losses (you’re willing to assume those risks – it’s part of the game), but rather losses from fraud. You’ll be amazed to know that those losses are not necessarily recoverable. It depends on whom you’re doing business with, what type of contractual arrangement you have with them, and what type of insurance they carry. As usual, the risks need to be managed.

What follows is an actual letter- report we issued to a client a couple of years ago (scrubbed of all names of course). If you or your clients have funds invested, we think you will find it very interesting and very important:

Re: Security of Invested Funds

Dear _________:

We reviewed the issue of security of funds in custody of various investment advisors, and have comments and recommendations.

Our review did not consider market risk, but rather focused on two areas of concern: (1) insolvency of the firms which have custody of the funds and (2) theft or fraud.

We asked the following firms for information re their insurance coverage and reviewed their contracts with you: xxxxxx, xxxxxx and xxxxx. Xxxxx never did provide any information to us, while the other two organizations were very cooperative in trying to accommodate our requests. We discussed with them contract changes which would be possible if we requested same. In addition we approached the following organizations on a no-names-given basis to determine what insurance they carry and to discuss their contract terms, to serve as a benchmark: xxxxx, xxxxx and xxxxx.

Overview

In general, it is best to break the invested assets into small packets, with the funds distributed among as many different firms as possible. For example, breaking $100 million into ten packets of $10 million each would reduce the amount subject to any single loss. However, we understand there may be issues of cost or control that argue in the other direction. If the funds are not divided, the risk has to be managed.

The risk of insolvency is the more easily handled issue of the two, in that funds can be put in segregated (fiduciary) accounts and/or that very high SIPC and Excess SIPC insurance limits are generally carried by the investment firms. With fiduciary accounts, the investor money is not commingled with general assets, and so should be secure in the event of a failure of the institution, and SIPC (the Securities Investor Protection Corporation) insures investor funds against loss due to insolvency of investment firms. Because this risk is more easily mitigated than the fraud risk, we think it’s best to focus on the fraud risk at this time.

The funds could be stolen via some fraudulent scheme. It is interesting that, contrary to the risk of insolvency, this risk does not get managed at all from the point of view of the investor, if left to usual and customary practice. Also there are reported cases where theft has occurred, and the firms have not stepped up to make their clients whole

This risk could addressed in two ways: (1) via Crime Insurance which is carried by the investment firm, and (2) via the contract between the firm and the investor.

Crime Insurance Carried By Investment Firm

Crime insurance terms and conditions, and limits, varied drastically among the firms we looked at, but all had one thing in common: the named insureds under the policies are the investment firms, not the investors. In other words, the coverage is for the benefit of the firm, not the individuals whose funds are at risk. The policies do cover loss of investor funds to the extent that the firm is legally liable for the loss, but again only for the benefit of the firm. If the contract with the investment firm effectively limits the firm’s liability, that would prevent the insurance coverage from being triggered. Thus, the contract language is important and ties in with the insurance issue.

The crime insurance limits carried by the various firms are as follows:

xxxxx:           $5 million

xxxxx:           $15 million

xxxxx:           $20 million

xxxxx:           $100 million

xxxxx:           $125 million

The limits shown above are aggregate limits which are limits which apply to all loss in total within the one year policy period. Therefore, the limits are not dedicated to any one customer’s funds or to any one event.

It would be ideal for the investment firm to provide first party crime coverage for our benefit, at their expense. Such first party coverage, depending on its terms, could provide us reasonable protection without considering the question of liability. We asked xxxxx to quote insurance on that basis. The quote was not helpful in that limits were too low and price was unrealistically high. They did not offer to absorb the premium.

Terms and conditions delineating coverage are also an important issue, of course. We have only reviewed the actual policies of xxxxx and xxxxx. The xxxxx policy appears to have gaps; the xxxxx policy provides what we consider adequate coverage.

The insurance is important to us because it can provide a fund out of which the firm can make the investor whole, if they are not allowed to escape liability via the contract terms.

The Contracts Between You and The Investment Firms

Below are the relevant sections of the contracts with the existing firms:

xxxxx

On page two the following language appears:

“The Investment Manager shall not be under any liability for acting upon Client instructions or communications, whether written , verbal or via facsimile, that it believes to be correct.”

This attempts to relieve the Bank from liability for accepting fraudulent instructions, even if the Bank is negligent.

The paragraph following the one quoted above reads as follows:

“The Investment Manager will not be under any liability for any act or failure to act with respect to investment management or other services pursuant to this Agreement except in the case of bad faith, gross negligence or willful disregard of its duties. In addition, the Investment manager will not be subject to liability to the Client, the Account, or any other party with respect to any act or omission of any broker, dealer, custodian or other agent, provided that the Investment Manager exercised reasonable care in selecting such party.”

This language is a general release of liability, except for egregious acts. We would have no recourse in the event of ordinary negligence with respect to the Investment manager’s own acts. With respect to acts of others named, there is an attempt to limit the Bank’s liability. xxxxx did agree to amend the above standard from gross negligence to ordinary negligence.

xxxxx

Article 9 is a limitation of liability which is not as harsh as the one demanded by xxxxx, in that xxxxx will accept liability for their own negligence. To succeed in a claim against xxxxx, we would have the burden of proving negligence.

xxxxx

The contract is silent with respect to liability. The lack of a limitation of liability can be an advantage, possibly allowing us recourse due to their custody of the funds, absence of negligence notwithstanding.

Below is a summary of the treatment of the issue by specimen contracts provided by three other firms, after negotiation by us:

xxxxx

Not liable except for gross negligence or willful misconduct. However, xxxxx understands our request for amendments and pledges to achieve same; they want a meeting with the client.

xxxxx

The contract is silent with respect to liability. Similar to xxxxx.

xxxxx

Similar to xxxxx, except xxxxx agrees to provide an exception for fraud. This could be the broadest of all the agreements with respect to fraud in that the burden of proving negligence is absent. xxxxx also pledges to meet our requirements with respect to contract language, but requests a meeting.

The above comments address the issues in summary. The contracts may need discussion/amendment in various other areas to make them tight. We defer to your attorneys, of course, with respect to the last word on contract language. Alternatively, we could involve attorneys who work with us on a daily basis.

In summary, the insurance coverages and contract terms vary widely. If the funds are not split into smaller bundles, more attention should be paid to managing the risk. There are options out there, some much better than others in this respect. We believe some changes should be made to effect better security for the funds. I look forward to discussing it at our upcoming meeting.

Sincerely,

Frank Licata

CC: ________, _________

 

Jan 07, 2009

Licata Risk Licata Risk & Insurance Advisors, Inc.
137 South Street, Second Floor
Boston, MA 02111-2848
617-451-2140     [email protected]
LicataRisk Advisors is an independent risk management and insurance consulting firm. We are not brokers and we do not sell insurance. We are not connected to any insurance company or product in any way and do not receive commissions. This is an important difference as you will have an expert on your side who is only committed to you.