Primary policy: Commercial general liability

Secondary policy: None

Items in question: Information on application

Supposed cause of loss/fraud: Omission from application

Suspicious indicators: Knowledge of Ponzi scheme

Actual cause of loss: Other claims from customers not disclosed on application but known about.

Summary

An employee of a securities firm was operating a Ponzi scheme. When the firm applied for professional liability insurance, this incident was disclosed; however potential future claims or circumstances that could lead to future claims were not disclosed. Shortly thereafter multiple claims related to the Ponzi scheme were filed against the insured, Crown Capital Securities.

Facts

Customers of a securities firm, Crown Capital Securities, were recommended certain real estate investments by a particular broker-dealer. This broker-dealer had an interest in, and operated each of the investments. This individual filed for bankruptcy in 2008, and in 2009 the bankruptcy examiner discovered that the broker in control of the properties was operating a Ponzi scheme. The Ponzi scheme had been running for eight years, and large sums of money were misappropriated from investors. The examiner claimed that the insured had failed to exercise due diligence in connection with the investment company involved, and that its brokers-dealers had sold other investments stemming from the same investment company running the Ponzi scheme to other investors.

The firm applied for liability insurance in April of 2010 and disclosed one of the claims arising from the Ponzi scheme. The firm did not disclose on the application facts that would indicate that other claims could potentially be made. The key element here is the firm's answer to question 10 of the application, which asks: Is the Applicant (after diligent inquiry of each principal, partner, managing member, director or officer) aware of any fact, circumstance, incident, situation, or accident (including without limitation: any shareholder action or derivative suit; or any civil, criminal, or regulatory action, or any complaint, investigation or proceeding related thereto) that may result in a claim being made against: (a) the Applicant; (b) its predecessors in business; (c) any subsidiary or affiliate of the Applicant; (d) any other entity proposed for coverage; or (e) any past or present principal, partner, managing member, director, officer, employee, leased employee or independent contractor of the Applicant, its predecessors in business, any subsidiary or affiliate of the Applicant or any other entity proposed for coverage?” This was answered no. One claim had already been filed against the company, and the bankruptcy examiner's letter indicated that more than one investor had been defrauded. Further, the application carried the following statement: “NOTE: It is agreed that any claim or lawsuit against the Applicant, or any principal, partner, managing member, director, officer or employee of the Applicant, or any other proposed insured, arising from any fact, circumstance, act, error or omission disclosed or required to be disclosed in response to Questions 9, 10 and/or 11, is hereby expressly excluded from coverage under the proposed insurance policy.” A policy was issued effective April 1, 2010 to April 1, 2011.

Over the course of the next year three more investors who had been defrauded filed claims against the insured. All three claims were submitted to the carrier. The carrier denied the claims and refused to defend the insured. The insured filed suit alleging bad faith, breach of contract and reformation of contract. The court found for the carrier.

Final Result

In its support of the carrier, the trial court found that the report of the bankruptcy examiner disclosed a number of investments related to the Ponzi scheme and that the new claims arose out of that scenario. The court agreed that the carrier did not owe the insured a duty to defend nor did it owe coverage for any claims. The claims arose from the Ponzi scheme which had been declared in question 9, and therefore the potential for further claims should have been declared in question 10.

Something to consider here – was this an intentional fraud, or an oversight/misunderstanding on the insured's part? The Ponzi scheme was certainly an intent to deceive, but the answers to the questions on the application could have been an oversight/misunderstanding on the insured's part. Either way it still allows the carrier to deny coverage for a loss.

Practical tips/fraud indicators: Application fraud is difficult to spot because unless the carrier has knowledge of the insured's situation, the carrier must rely on information provided to it by the insured. This makes it easy for insureds to lie in attempts to get coverage when they know a claim may be filed later. Carriers must thoroughly use the underwriting period to their advantage, and check all records, inspect property, and do what they can to determine the veracity of an application.