Purchasers of crime insurance should consider the coverage afforded by their policies in light of recent Madoff-related coverage disputes.

Bernard Madoff orchestrated the largest, longest and most widespread Ponzi scheme in history. In March 2009, Madoff plead guilty to money laundering, securities fraud, mail fraud, wire fraud, investor adviser fraud, filing false statements with the U.S. Securities and Exchange Commission, making false statements, perjury and theft from an employee benefit plan; he was sentenced to 150 years in prison. Prosecutors estimated at the sentencing hearing that losses in Madoff’s accounts since 1996 approach $13 billion.

Victims have sought reimbursement from their insurance carriers, and coverage disputes have arisen. Two cases filed recently place the spotlight on crime insurance policies, and the issues raised in those suits offer an opportunity for all purchasers of crime insurance—not just Madoff’s victims—to consider the coverage afforded by their policies.

The Recent Litigation

On July 14, 2009, a pharmaceutical company sued its crime insurer arising out of Madoff-related loss. According to its complaint, the pharmaceutical company invested its own assets directly with Madoff. The company avers that its crime carrier disclaimed coverage for its loss.

The next day, a real estate firm sued its crime insurer seeking to recover assets its affiliate invested with Madoff. According to the complaint, the carrier issued a crime policy to the real estate firm covering “the unlawful taking of money or securities by a third party, by means including . . . computer fraud and electronic funds transfer fraud.” The crime insurer allegedly disclaimed coverage, and in its complaint the real estate firm seeks a declaratory judgment of coverage and damages for breach of contract.

Scope of Crime Insurance Coverage

In assessing the policyholders’ allegations in these suits, as well as the insurers’ likely defenses, the scope of coverage afforded generally by crime policies provides a useful starting point. Such policies typically contain separate insuring agreements covering loss caused by financial fraud, theft, forgery, embezzlement and other criminal conduct by rogue officers, employees and others within the policyholder’s organization. The policies also often cover loss of and physical damage to the policyholder’s property resulting from outsiders’ criminal acts, such as robbery or burglary, occurring on the policyholder’s premises, as well as loss due to theft or an unexplained disappearance of money or other property in transit. Whether crime policies will respond to a policyholder’s Madoff-related loss, however, is less straightforward, as the alleged disclaimers of coverage described above illustrate. As explained below, coverage turns upon application of specific insuring agreements and exclusions to the circumstances of a policyholder’s interaction with Madoff giving rise to the loss.

Madoff-Related Coverage Issues

Losses must fall within one or more of a crime policy’s insuring agreements for the policy to respond, subject to other policy exclusions and conditions. The two recent complaints referenced above allege coverage for Madoff-related loss under crime policies’ insuring agreements for Computer Fraud and Funds Transfer Fraud.

A typical Computer Fraud insuring agreement covers “direct loss of, or . . . direct loss from damage to, Money, Securities and Other Property directly caused by Computer Fraud.” In its complaint, the pharmaceutical company averred that its carrier’s crime policy “broadly defined ‘Computer Fraud’ to mean ‘the use of any computer to fraudulently cause a transfer of [money] from [the pharmaceutical company’s or its bank’s] premises to a person outside [its] bank or its premises.” Attempting to track the policy’s requirements, the pharmaceutical company further averred (i) that Madoff’s Ponzi scheme was facilitated by a series of computer-generated monthly statements depicting numerous false purchases and sales of securities at actual market prices; (ii) that Madoff could not have generated the security- and date-specific pricing data needed to prepare those manipulated statements without using computers; and (iii) because the company audited certain of Madoff’s fraudulent, computer-generated statements and found them to match market results, it continued to transfer funds to Madoff, causing loss of money due to Computer Fraud. Similarly, the real estate firm averred that Madoff “employed electronic funds transfers and computers to accomplish his frauds.”

Although some policy forms require that the fraudulent entry of data be made into a computer system operated by the policyholder, thereby exhibiting drafting intent to cover losses due to “hacking” of the policyholder’s or its financial institution’s IT system, other policy forms are drafted more broadly. Beyond this issue, the courts adjudicating the two recent suits must determine whether Madoff’s use of computers to generate false trading slips and account statements “directly caused” the investors to transfer funds to Madoff, or whether electronic transfers of the policyholders’ funds out of Madoff’s accounts for improper purposes fall within the Computer Fraud insuring agreement.

In addition, crime policies often insure loss “resulting from Funds Transfer Fraud committed by a Third Party.” “Funds Transfer Fraud” typically means fraudulent written instructions to a financial institution directing transfer of money out of a policyholder’s account without the policyholder’s knowledge or consent. For its part, the real estate firm alleges that Madoff committed Funds Transfer Fraud, but does not allege with specificity who issued the fraudulent instructions, or to which financial institution. Absent further factual development, establishing Funds Transfer Fraud coverage for Madoff-related loss may be difficult.

Crime policies also typically cover loss caused directly by forgery or alteration of a financial instrument, and Madoff plead guilty to forgery, among numerous other crimes. Coverage for Madoff-related losses under this insuring agreement appears unlikely, however, as the standard crime insurance policy defines “forgery” in pertinent part as “the signing of another natural person’s name with the intent to deceive, but does not mean a signature that includes one’s own name, with or without authority.” Courts typically find no forgery where the fraud involved deception about extrinsic facts rather than the identity of the signer. Moreover, a “financial instrument” typically is defined to mean a check or other written promise to pay money drawn by or upon the policyholder. If no evidence exists that Madoff or any of his employees signed another person’s name to a “financial instrument” in carrying out the fraud, insurers likely would dispute coverage on this basis.

In addition to disputes over whether Madoff-related or similar losses fall within these or other insuring agreements, exclusions from coverage may come into play. For example, most crime policies exclude loss resulting from “trading” of currency, securities or other property. A typical trading exclusion will apply to loss “resulting directly or indirectly from trading whether or not in the name of the Insured and whether or not in a genuine or fictitious account.” Such exclusions also may apply both to “authorized and unauthorized” trades. Their applicability in the context of Madoff-related losses is unclear, however, because unbeknownst to his victims, Madoff apparently did not trade securities using the funds entrusted to him.

Crime policies also often exclude loss of income. Although the wording of these exclusions varies, they generally exclude “loss of income, whether or not earned or accrued, or potential income, including interest and dividends, not realized by [the policyholder] as the result of any loss covered” by the policy. Such exclusions may bar recovery of lost investment income and dividends that supposedly were accruing in accounts managed by Madoff.

Conclusion

As illustrated by these recent Madoff-related insurance coverage disputes, crime insurance policies are not “all risk” policies, but instead insure against loss sustained by reason of specific perils, with coverage narrowed by exclusions and conditions. At the time of purchase, policyholders can choose those insuring agreements that best fit their needs, and other policy terms and conditions may be subject to negotiation with insurers. Although prudent review of these alternatives by the policyholder’s insurance professionals may not prevent every potential coverage dispute, it will increase the chance that insurance protection will respond should the policyholder fall victim to financial crimes. And should a dispute arise, careful application of the facts to the specific policy language is required in assessing whether a loss is covered.