Speculation over regulation mounts as Madoff lawsuits rack up

In its report published yesterday, the High Level Group on Financial Supervision in the European Union (EU) - chaired by Jacques de Larosière, former managing director of the International Monetary Fund and ex-governor of the Bank of France - recommended developing "common rules for investment funds in the EU, notably concerning definitions, codification of assets and rules for delegation".

The report came on the day that Adair Turner, chairman of the UK Financial Services Authority (FSA), suggested that large hedge funds may need to be subject to "bank-style" regulations. Testifying before the UK parliament's Treasury Select Committee as part of its inquiry into the banking crisis, Turner warned that hedge funds would in future need to provide more information to regulators so that their risks can be properly assessed. "If at any time we believe they have become sufficiently bank-like in their activities or large in their scale that they are systemically important, then we should extend bank-style capital and liquidity [requirements] to their activities," he said.

"I think we are going to see some regulation, at least at the European level - I understand there are some semi-informal groups working on that. I think we're going to see more regulation on mutual funds, and definitely more regulation on hedge funds and funds of funds," said the head of risk at a major European bank, who spoke on condition of anonymity.

Several European financial institutions have revealed exposure to losses connected to Madoff's investment scheme, often through third-party funds. HSBC's exposure was £1 billion as a result of providing "financing to a small number of institutional clients who invested in funds with Madoff". Royal Bank of Scotland had losses of £400 million through trading and collateralised lending to funds of hedge funds invested with BMIS. French banking giant BNP Paribas attributed a €345 million loss to Madoff to similar reasons. Meanwhile, Banco Bilbao Vizcaya Argentaria announced losses of €302 million through "structured products for financial entities and institutional investors that were linked to third-party mutual funds which invested via Madoff".

The de Larosière report noted the Madoff scandal had raised pressing issues with respect to the quality of due diligence processes in different market participants. "Delegation of investment management functions should only take place after proper due diligence and continuous monitoring by the 'delegator'," the report stated.

Several lawsuits against funds that channelled substantial amounts of client money into Madoff's fund - Bernard Madoff Investment Securities (BMIS) - have alleged the funds in question did not carry out adequate due diligence despite claiming to do so.

Tremont Group Holdings, a feeder fund to Madoff that lost $3.3 billion, is the defendant in one such lawsuit. Two class action lawsuits have also been filed in the US against Banco Santander, whose Geneva-based investment management subsidiary, Optimal Investment Services, lost €2.33 billion of clients' money investing in BMIS.

Mark Raymond, managing partner at Florida law firm Broad and Cassell's Miami office, says he is currently advising 15 clients with assets invested in Optimal of about $30 million. "It's a breach of fiduciary duty and negligence: the failure to follow-up on red flags, and also the failure to provide adequate disclosure to customers," he said.

The de Larosière report also suggested "tighter supervisory control over the independent role of depositories and custodians".

"One of the main problems we had with HSBC and UBS was that they reported to feeder funds and the end investors that they were holding that amount of money on their accounts, when in truth they had wired the money to Madoff; he apparently didn't have an independent custodian for the assets," explained a chief executive of a European hedge fund due diligence firm.

Yesterday, Luxembourg's financial regulator, the Commission de Surveillance du Secteur Financier (CSSF), demanded UBS pay compensation due to not fulfilling its due diligence obligations, constituting "a grave failure in its surveillance duties as depository bank". The statement from the CSSF demands UBS review its due diligence processes and pay damages within three months.

UBS was the depository bank for Luxembourg fund Luxalpha, a fund specifically conceived for wealthy clients to invest with Madoff. UBS defended itself against the accusations, saying investors were made aware of the purpose of the Luxalpha fund and "the fund documentation made it very clear that UBS was not expected to be responsible for the safekeeping of the assets".

Regardless of where the blame lies, it seems the respective roles of market participants need to be defined more clearly. "Right now, there is a big debate in the industry as a whole about the different roles and responsibilities of the custodian banks, the asset managers, etc. I think this is going to change and we're going to see a better clarification of the different roles and responsibilities of each participant," the head of risk commented.

See also: De Larosiere calls for ECB to lead European macro supervision

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