With the prospect of nearly $2 billion in professional liability claim payments looming from the litigation fallout of a Ponzi scheme orchestrated by Bernard Madoff, directors and officers insurers were eager to pinpoint potential sources of exposure during a recent industry gathering.

“It’s certainly going to have an impact on [insurers'] underwriting procedures,” said Stephen Mildenhall, head of Aon Benfield’s Actuarial and Enterprise Risk Management practice, which developed a $1.8 billon best estimate of direct insurance losses that could be paid out on behalf of asset management firms, banks and other firms being sued in the aftermath of the Madoff scandal.

“It is astonishing that something of this size and scale managed to proceed…for a number of years without being detected,” Mr. Mildenhall said.

As a result, “I would imagine that there would be some heightened underwriting within this class,” he added, referring to the financial institutions D&O and errors and omissions class already “pretty much under the microscope” as a result of the subprime/credit crisis.

The Madoff case was a prime topic of discussion at the Professional Liability Underwriting Society’s D&O Symposium late last month, which took place before Mr. Madoff entered a plea last week to criminal charges. (On March 12, Mr. Madoff pleaded guilty to all fraud charges against him and was sent to prison to await sentencing.)

During a discussion of developments in securities litigation, Boris Feldman, a partner with Wilson Sonsini Goodrich and Rosati in Palo Alto, Calif., asked plaintiffs’ attorneys to gauge the odds of recovering lost investments through litigation.

“While these cases are very difficult, there are possible sources of recovery,” said Sherrie Savett, of Berger & Montague, P.C. in Philadelphia. She explained that the main source of recovery cannot be Madoff Investment Securities “because there’s very little left there and trustees will be collecting those assets and distributing them.”

Instead, plaintiffs’ attorneys will have to find out, “How did someone get into a Madoff investment? Was it through a hedge fund? Is the hedge fund still solvent? Is the fund backed up by an insurance company?”

“The theory is there was a lack of due diligence by those funds, and that they’re responsible for that reason,” she said.

Accountants that audited the hedge funds are another potential target, she noted. “How could they have done a proper audit of the assets of a hedge fund if assets weren’t really there? We now know that Madoff didn’t even trade for the last 13 years, so there was a real lack of due diligence on the part of the hedge funds and their auditors.”

In the same vein, she said there are also good cases to be brought against bank custodians that were supposed to make sure the assets were there.

While Ms. Savett said the parties with the dimmest hope of substantial recovery are those that dealt directly with Madoff through brokerage accounts, Professor John Coffee of Columbia University also foresees obstacles for those who invested in feeder funds that put assets in Madoff investments.

Direct investors, Ms. Savett said, are limited to a $500,000 recovery from the Securities Investor Protection Corp. or a tax benefit for writing off a theft loss.

Mr. Coffee, while agreeing that funds are the deep pockets to be tapped in Madoff-related litigation, said the funds’ defenses are bolstered by a 2007 district court ruling in South Cherry Street LLC vs. Hennessee Group, currently on appeal in the Second Circuit.

In that case, an investment advisory firm, Hennessee, gave a sophisticated hedge fund known as Bayou Group “an absolutely strong rating,” Mr. Coffee said, adding that Bayou was the last big Ponzi scheme before Madoff.

Judge Colleen McMahon in the Southern District of New York ruled, however, that as long as Hennessee did not know that the Bayou Group was a total fraud, and so long as they only made misstatements about their own due diligence, they could not be on the hook for liability, he reported.

Indeed, he said, the advisor may not have looked even at other funds when it advised investors to put all their money in Bayou, but the case is dismissed because the judge held that “the real loss causation event was the fraud at Bayou and not lack of due diligence of the advisory group.”

Should the decision be upheld on appeal in the next few months, that could be a controlling force in limiting liability for the Madoff feeder fund litigation, Mr. Coffee predicted.

He said another obstacle to plaintiffs in New York, where many cases will be brought, is a state law known as the Martin Act, which preempts suits alleging breaches of fiduciary duty and does not permit private actions. The law gives exclusive jurisdiction over state law claims involving the purchase or sale of securities to the attorney general.

Mr. Coffee predicted that in spite of the obstacles, there will be some recoveries against the feeder funds, although he noted that such funds have limited assets–amounting to, at most, $200 million, in his view.

Stuart Grant, managing director of Grant & Eisenhofer, P.A. in Wilmington, Del., whose firm is already representing “a substantial number of people with losses of over nine figures” in Madoff-related cases, agreed that feeder funds are the “low-hanging fruits” among possible defendants.

“If you have a fund that’s taking 1 percent of assets under management and 20 percent of the profits, and you find out that they’ve done no due diligence [and] just acted as a conduit, that’s the kind of thing that ticks people off,” he said.

Embellishing his argument with potential stories of fund managers with houses in affluent areas like Greenwich, Conn., Mr. Grant said “that’s the type of story I want to tell to a jury. It’s an attractive case.”

Countering Mr. Coffee’s assertion about shallow pockets, Mr. Grant added that the funds have a surprising level of assets. “I don’t think we’re talking about millions, but billions or tens of billions combined.”

One interesting debate to be played out in the Madoff cases will be over the issue of damages. “If you invested $10 million 15 years ago, and thought you made $100 million, did you lose $10 million or $100 million?” he asked. “Had you put it in the stock market, you would have $8 million now, so maybe the loss is only $8 million,” he said, giving an alternative view that defendants might offer.

At a separate conference, a Web-based event sponsored by NERA Economic Consulting in January, another plaintiffs’ lawyer, Gerard Silk, a partner with Bernstein Litowitz Berger & Grossmann LLP, described legal hurdles facing limited partner investors in funds whose investments were put into Madoff vehicles.

Those limited partners who file suit against general partners of the funds investing with Madoff “will have to demonstrate that general partners acted with a standard of conduct that is either grossly negligent or something beyond,” such as recklessly or fraudulently.

In addition, he said, in most partnership agreements, there is language governing litigation against the general partner (GP), there are provisions for indemnification of the GP, and provisions allowing the GP to use fund assets to defend against litigation.

“That presents an interesting twist because with limited assets remaining, LPs could be suing the GP and, in fact, their own assets could be going to defend the cases,” Mr. Silk noted.

Beyond that, he said, for cases being filed as class actions, there are added hurdles. For example, class actions alleging breach of fiduciary duty against GPs could be subject to preemption under the Securities Litigation Uniform Standards Act of 1998–a law requiring certain securities class actions to be brought in federal court.

To make a federal claim, he continued, plaintiffs cannot plead that GPs or others were grossly negligent. “You would have to demonstrate that they acted with scienter–a state of mind of recklessness or greater than that,” he said. “You’d also have to prove that parties you’re suing made false statements.”

Mr. Silk said private lawsuits that are not brought as class actions will face fewer hurdles–allowing claims that plead only gross negligence and allowing plaintiffs to bring third parties into suits as defendants for aiding and abetting.

Fund-of-fund investors “have more avenues for recovery than direct investors,” but “they are not easy avenues,” he concluded.

Discussing the challenges to direct investors on the same Webcast (presented by Securities Docket at www.securitiesdocket.com), Brad Friedman of Milberg LLP said that beyond the Securities Investor Protection Corp., the only other real avenue of recovery is as creditor in the bankruptcy of Madoff Investment Securities.

SIPC, which maintains a special reserve fund authorized by Congress to help investors at failed brokerage firms, has already mailed out more than 8,000 customer claim forms to Madoff investors, SIPC announced in a Jan. 5 statement.

In a recent press advisory, Marshall Gilinsky, a policyholder’s attorney with Anderson Kill & Olick, suggested a third potential avenue of recovery for investors. “Some blue-chip homeowners policies…include limited coverage for losses like those arising out of investments in Madoff’s hedge funds,” he said.

On the Webcast, Mr. Friedman also addressed concerns of some investors hesitant to file claims for recovery of amounts invested with Madoff because they have redeemed money over the years and fear that trustees will come after them to return that money.

Mr. Friedman said he believes too much attention has been given to this issue in the business press, suggesting that only the largest investors would be subject to demands–often referred to as clawbacks.

At Aon Benfield, Mr. Mildenhall noted that the maximum potential insurance limits exposed to the Madoff scandal are estimated at more than $6 billion, but he said the range of direct insured D&O and E&O losses will be a far smaller number–most likely somewhere between $760 million and $3.8 billion, with a best estimate of $1.8 billion.

“The numbers all are derived from two dimensions of uncertainty,” Mr. Mildenhall said, highlighting “uncertainty around the particular limits and attachment points that insured parties would have purchased” as the first element of uncertainty, and questions surrounding the degree of liability of different policyholders as the second.

Separately, Kevin LaCroix, an attorney who authors “The D&O Diary,” an Internet blog site with information on securities litigation trends and D&O insurance, is keeping track of securities class-action lawsuits against Mr. Madoff, his firm, or the feeder firms that invested their clients’ funds with Madoff. Through March 3, Mr. LaCroix tallied 13 separate federal securities class actions.

Mr. LaCroix also keeps a running count of state actions against the same parties and additional cases against related defendants.

These include a recent case filed against Tremont International Insurance Limited. This case alleges that the insurer, an entity owned by Tremont Capital Management, breached its duties by offering Tremont-related funds as investment options for the variable investment account component of the policies, and that the Tremont-related funds were heavily invested with Madoff, Mr. LaCroix explained on a blog entry.

In a Jan. 12 blog entry at www.dandodiary.com, Mr. LaCroix–a partner for Oakbridge Insurance Services, a Beachwood, Ohio-based insurance brokerage–also discussed potential obstacles lawsuit defendants might face in securing coverage from their D&O and E&O insurance policies.

Conduct exclusions, particularly personal profit and fraud exclusions, may be asserted as coverage defenses by insurers, he said, noting that while the fraud exclusions might only apply to insurance for Mr. Madoff, the personal profit exclusion could come into play in other cases.

“Investors have already claimed that the feeder funds inappropriately exacted management fees or other compensation without conducting appropriate due diligence or otherwise earning their fees. However, an adjudicated determination of these allegations would be required for the profit exclusion to preclude coverage,” Mr. LaCroix wrote.

He said that based on his experience, he believes many investment advisory firms and hedge funds buy relatively lower limits of insurance coverage. He pointed to a factor beyond exclusions that could restrict the total insurance losses.

“In many cases, the available insurance involved…could quickly be exhausted by defense costs alone,” Mr. LaCroix said.