Why it matters: Concluding that any claims related to a Ponzi scheme—even if they involved different investors, investments, or broker-dealers—all arose from the same scam, a California Court of Appeal determined that a securities firm was not entitled to defense in litigation brought by victims of the scheme. An investor notified Crown Capital Securities of his claim that the company allegedly failed to exercise due diligence in assessing the legitimacy and viability of certain investments that were determined to be a Ponzi scheme. Crown submitted an application for a professional liability policy and disclosed the claim. But a few months later—after the policy had been issued—three other investors launched arbitration proceedings against Crown. The insurer refused to provide a defense, arguing that the subsequent proceedings arose from the same Ponzi scheme. Crown sued the insurer, arguing that the arbitration proceedings involved different investors, investments, and broker-dealers, but the appellate panel affirmed a trial court’s grant of summary judgment for the insurer. The claims all arose out of the same Ponzi scheme, the court said, even though a different Crown investment advisor was involved and different investors were allegedly harmed.

Detailed discussion: Crown Capital Securities received a letter from investor George Bou-Sliman in October 2009. Bou-Sliman included a report from a bankruptcy examiner in the case of DBSI, Inc., an entity that filed for bankruptcy in November 2008. The letter accused Crown of failing to perform the necessary due diligence into the activities of DBSI, which was determined by the examiner to be a Ponzi scheme. Bou-Sliman alleged that Crown investors recommended investment in DBSI properties to his detriment.

The letter and report detailed the activities of DBSI over an eight-year period, when the company made marketing claims that “no investors had ever lost money” while newly raised investor funds were being used to pay off existing investors.

A few months later a Crown employee executed an application for a professional liability policy with Endurance American Specialty Insurance Company for its security broker-dealers and investment advisors. The employee answered “yes” to Question 9 as to whether the company had knowledge of any “claims, suits or proceedings” made against it over the last five years.

However, to Question 10 asking whether Crown was “aware of any fact, circumstance, incident, situation, or accident” that could result in a claim being made against it, the employee answered “no.”

The policy contained an Application Exclusion, which stated: “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 [the questions], is hereby expressly excluded from coverage under the proposed insurance policy.”

After the application was submitted, three investors initiated arbitrations against Crown Capital by filing claims with the Financial Industry Regulatory Authority (FINRA) based on investments made with DBSI projects on their behalf. Each of the three worked with a different investment advisor and their money was invested in a different project.

Crown reported all three of the claims to Endurance but the insurer refused to defend each one. The policyholder then filed suit against the insurer alleging breach of contract and bad faith based on the denial of coverage. Endurance responded with a motion for summary judgment, arguing that the Application Exclusion precluded coverage.

A trial court agreed and the appellate panel affirmed.

“The Bou-Sliman claim notified Crown Capital of DBSI’s bankruptcy,” the court said. “Like the Bou-Sliman claim, the [three arbitration proceedings] arose out of the DBSI Ponzi scheme—i.e., DBSI used new investor money to pay existing debt and payment obligations—and those claimants alleged that Crown Capital failed to exercise due diligence in assessing the viability of DBSI investments.”

From the Bou-Sliman claim and accompanying report, Crown Capital was aware that DBSI had declared bankruptcy and had allegedly been operating a Ponzi scheme, the panel noted—as well as that its broker-dealers had sold other DBSI investments to their customers that were part of the Ponzi scheme and bankruptcy proceedings.

“Thus, Crown Capital was aware of facts and circumstances that might result in a claim or claims being made against it, which awareness it was required to disclose under Question 10 of the application for the Policy,” the panel wrote. “This requirement existed even though the [arbitration claims] did not involve the same investor or the same investment that was at issue in the Bou-Sliman Claim, and none of the investments at issue in the [arbitration claims] was recommended by the same Crown Capital dealer-broker who recommended the [investment] to Bou-Sliman. The Application Exclusion applied to claims that were the subject of required disclosure under Question 10.”

Crown Capital’s alternative arguments that the Application Exclusion was ambiguous as it applied to the arbitration claims and that the “arising from” language should have been applied narrowly failed to persuade the court. California courts have consistently given a broad interpretation to the terms “arising out of” or “arising from” in insurance policies, the panel wrote.

“The trial court did not interpret the ‘arising from’ language in the Application Exclusion in such a manner that it excluded coverage for the [arbitration claims] merely because they had some relation to DBSI,” the court said.

Instead, “The trial court ruled that Endurance properly denied coverage for the disputed claims under the Application Exclusion because Crown Capital was aware that DBSI had declared bankruptcy and allegedly had been operating a Ponzi scheme; that Bou-Slimon claimed that Crown Capital had failed to exercise due diligence in connection with a DBSI investment; and that its broker-dealers had sold other DBSI investments to their customers. Thus, Crown Capital was aware of the facts and circumstances that might result in a claim or claims being made against it for any investment in a DBSI investment property. Accordingly, we do not believe there was any potential for coverage under the terms of the Policy or doubt as to Endurance’s duty to defend,” the panel concluded.

Even Crown’s contention that the arbitration claims asserted other theories of liability, bringing them within the policy’s reach, did not change the court’s mind, as “all of the causes of action” asserted in the arbitration claims “concerned the purchase of DBSI investments.”

“At the time that Crown Capital applied for the Policy, it was aware of facts and circumstances that might result in a claim being made against Crown Capital—i.e., DBSI’s bankruptcy, the alleged operation of a Ponzi scheme, and the investment by Crown Capital’s customers in DBSI investments,” the court said. “The awareness of those potential claims brought such claims within the Application Exclusion regardless of the theory upon which claims might be based.”

To read the opinion in Crown Capital Securities v. Endurance American Specialty Insurance Co., click here.