Why it matters: In a coverage dispute arising out of the Madoff debacle, a financial bond affirmatively provided coverage for losses resulting from dishonest acts of any outside investment advisor named in the attached schedule but also sought to exclude coverage for losses arising out of dishonest acts of investment brokers. Madoff wore both hats, which the court found created an ambiguity in the application of the exclusion. Significantly, the court did not rule that in the face of such ambiguity, the policyholder automatically prevailed. Nevertheless, the court placed the burden on the insurer to prove through extrinsic evidence that its interpretation was the only reasonable interpretation; otherwise, the ambiguity would be interpreted against the insurer. Here, the insurer’s letter denying coverage conflicted with the testimony of its claims’ personnel. The court ruled that the insurer’s testimony was not credible and could not be reconciled with the record. Policyholders should similarly scrutinize the carrier’s pleadings, reservation of rights letters, and denial letters to evaluate inconsistencies at trial or on summary judgment that clearly undermine self-serving testimony or after-the-fact argument by insurer counsel. The heavy burden placed on insurance companies can be made impenetrable through careful consideration of all available evidence.

Detailed Discussion

Jacobson Family Investments and related entities Nine Thirty FEF Investments, LLC, and Nine Thirty VC Investments, LLC, had the misfortunate of investing sizable sums of money with Bernard Madoff and his firm, Bernard L. Madoff Investment Securities LLC. The investments seemingly performed well over the years until the details of Madoff’s Ponzi scheme were revealed in 2008. The investment funds had balances of roughly $14.7 million when Madoff’s fraud was uncovered.

Seeking to recover its losses, JFI turned to United States Fire Insurance Company based on a Financial Institution Bond in effect during the relevant period. The bond included Exclusion (x), which prohibited coverage for “loss resulting directly or indirectly from any dishonest or fraudulent act or acts committed by any non-Employee who is a securities, commodities, money, mortgage, real estate, loan, insurance, property management, investment banking broker, agent, or other representatives of the same general character.”

In contrast was Rider 9, an endorsement, which provided coverage for losses arising from dishonest acts of Outside Investment Advisors, including named party Bernard L. Madoff Investment Securities.

U.S. Fire denied coverage for JFI’s Madoff-related losses. Critically, US Fire relied on Exclusion (x), because Madoff was acting as a broker. However, US Fire later claimed in its complaint and on summary judgment that a mere showing that Madoff and Madoff Securities were registered securities brokers during the relevant period was sufficient to trigger the exclusion.

JFI contended that Madoff was acting in the capacity as an investment advisor, thus Rider 9 explicitly provided coverage and Exclusion (x) was inapplicable.

After a bench trial, Judge Jeffrey K. Oing ruled for the policyholders. Looking to the insurer’s letter disclaiming coverage, he noted that U.S. Fire wrote that Madoff “was acting as a broker” – not that he was simply registered as a securities broker. That inconsistency created an ambiguity with respect to the exclusion, especially when juxtaposed with Rider 9. The court held that in light of the ambiguity, U.S. Fire could only defeat coverage if it could prove that its interpretation was the only reasonable one.

“U.S. Fire failed to establish by credible testimonial or documentary evidence that its construction and interpretation of Exclusion (x) is the only proper meaning for that provision,” Judge Oing wrote. “As such, failing to resolve the ambiguity in its favor, I am compelled, as a matter of law, to hold that Exclusion (x) excludes coverage under Rider 9 if Madoff and Madoff Securities were ‘acting’ as securities brokers.”

Judge Oing then concluded that neither Madoff nor his firm was acting as securities brokers.

Despite Madoff holding himself out as a broker, creating and sending to JFI fake trade confirmations and bogus monthly brokerage accounts, it was all part of a fictitious world. “Madoff and Madoff Securities were not rogue brokers churning brokerage accounts to generate exorbitant fees; he was doing nothing more than running an elaborate confidence game – he was a con man,” the court said. U.S. Fire tried to avoid the “imposter defense,” but the court found that JFI had not assumed the risk of loss. Madoff and Madoff Securities had complete and total discretion without any supervision or oversight from the insureds. “Because the insureds did not reserve for themselves any duty to review and approve what Madoff and Madoff Securities did with their investment accounts, whether the insureds should have to bear the loss depends not on Madoff and Madoff Securities’ status as securities brokers...but on whether they were acting as securities brokers,” the judge wrote.

The true relationship between the insureds, Madoff, and Madoff Securities was more akin to investors and outside investment advisors, given the fact that “the entire brokerage relationship was phony and a figment of the insureds’ imagination.” Madoff himself, in his guilty plea allocution on March 12, 2009, said he “never invested these funds in the securities as I promised.”

“The totality of such evidence compels me to conclude that Madoff and Madoff Securities were not acting as securities brokers within the meaning of Exclusion (x) so as to trigger its exclusionary language, and that Madoff and Madoff Securities were acting solely as Outside Investment Advisors,” Judge Oing concluded, with coverage available under Rider 9.

To read the decision in U.S. Fire Insurance Co. v. Nine Thirty FEF Investments, LLC, click here.