E & O Coverage Excluded for Undisclosed Potential Claims Linked by Ponzi Scheme to Actual, Known Claim

A Ponzi scheme is a fraudulent investment scheme where money pried from new investors is used directly to pay off old investors: Think chain letters enclosing money. “‘This scheme takes its name from Charles Ponzi, who in the late 1920s was convicted of fraudulent schemes he conducted in Boston.’” (People v. Williams (2004) 118 Cal.App.4th 735, 739, fn. 2 [quoted in footnote 2 of summarized opinion].) Naturally, professional liability insurers covering securities firms attempt in their underwriting application process to steer clear of responsibility for claims based on such schemes known to their prospective insureds – even going to the lengths of placing a separate coverage exclusion in the application form itself, triggered when the potential for such claims is known by the applicant.

In Crown Capital Securities, LLP v. Endurance American Specialty Ins. Co. (2015) ____ Cal.App.4th ___, decided April 10, 2015, the second district California state Court of Appeal held unanimously that facts and circumstances constituting an alleged Ponzi scheme known to a securities firm applicant should have been disclosed in its application for errors and omissions insurance with Endurance American Specialty Ins. Co. (Endurance) The facts were that customers of a securities firm, Crown Capital Securities, LP (Crown), made claims against Crown based on multiple real estate investments the firm’s salesmen recommended. When Crown applied to Endurance for professional liability insurance, it disclosed one such actual claim, but not the facts and circumstances it knew of that would support other potential customer claims arising out of similar investments, all of which were involved in the same Ponzi scheme.

Crown learned of the possibility of the other, potential claims when the one, actual claim it disclosed in the application was received by way of a letter from the investor-claimant that attached a copy of a bankruptcy examiner’s report that he had uncovered an 8 year long Ponzi scheme run by the principal of the bankruptcy debtor, DBSI, Inc., to defraud and misappropriate funds from investors.

The insurance application asked Crown to disclose any actual claims, suits or proceedings made in the preceding five years, and whether Crown was aware of any fact, circumstance, incident, situation or accident that may result in a claim against the applicant. The applicant answered the first question “yes” based on a single, actual claim, but answered the second question “no”.

The policy issued, followed by three additional actual claims, starting the day after the application was signed on behalf of Crown. The insurance company refused to defend the three additional claims, based on the application’s exclusion of coverage for claims arising from any fact, circumstance, act, error or omission disclosed or required to be disclosed in either of the two application questions. Crown sued the insurer for breach of contract and bad faith.

The trial court granted the insurance company’s motion for summary judgment, and the Court of Appeal affirmed that decision, holding that Crown’s awareness of the Ponzi scheme from the first, actual claim made it aware of facts and circumstances that might result in further claims being made against it, which awareness it was required to disclose under the application question regarding potential claims.

Along the way, the Court of Appeal rejected Crown’s contention that the application exclusion’s phrase “arising from” the matters present in the first claim was too broad a construction of that phrase and improperly allowed the insurer to preclude coverage for future claims “merely because they might have some relation to DBSI, Inc.” Crown maintained that the trial court should have instead interpreted the “arising from” language of the exclusion narrowly to exclude from coverage only those claims that involved the first claimant or his specific DBSI investment. Although there were multiple different real estate investments made by DBSI, their connection with DBSI as a single Ponzi scheme was sufficient to satisfy the language of the application exclusion so long as all claims arose from a DBSI investment.

Accordingly, the Court held, there was no potential for coverage under the terms of the policy, or doubt as to the insurer’s duty to defend any of the three additional, new claims, and the insurer did not breach any obligation under the policy.

Wolf is a partner in the Los Angeles office of the nationwide law firm of Lewis Brisbois Bisgaard & Smith LLP. He served as law clerk to Presiding Court of Appeal (later Supreme Court) Justice Otto M. Kaus and since 1970, Wolf has specialized in insurance coverage advice and litigation.