Source: http://www.agdglaw.com/?t=11&la=2410&format=xml&p=6358
Timestamp: 2019-04-24 01:52:21+00:00

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This is adaptation of an article originally published in the March 2014 issue of DRI’s publication, For the Defense.
Fidelity insurance has been defined as an agreement to indemnify an employer against a loss arising from lack of integrity or honesty of “an employee or of a person holding a position of trust, such as a loss from embezzlement.” As more companies become exposed to fraud and rocked by high profile corporate scandals, the more frequently victimized companies turn to their fidelity insurers to recover insurance proceeds for losses associated with employees’ misdeeds or theft. However, not all of the losses may be covered by the policies, such as losses resulting directly or indirectly from the trading of securities. Accordingly, it is important to examine closely the scope of the fidelity insurance available and the types of damages covered under the policies.
The trading loss exclusion was originally intended to bar coverage for losses related to the buying and selling of securities. The historical context surrounding the trading loss exclusion is critical because it established the foundation for how the trading exclusion is applied when companies victimized by corporate scandal seek coverage from their fidelity insurers. Moreover, the scope of the exclusion continues to challenge courts and practitioners.
Finding the early trading exclusion unambiguous, the court applied it to bar coverage for the market losses.
While the Harris court found that the trading loss exclusion precluded coverage for losses involving a dishonest employee, at least one early decision found that the exclusion was not intended to preclude coverage under those circumstances. See Paddleford v. Fid. & Cas. Co. of N.Y., 100 F.2d 606 (7th Cir. 1939). In fact, the court held that the exclusion was intended not to limit coverage for losses sustained through an employee’s dishonest acts, but to limit it for acts that were not dishonest, such as negligent conduct.
The Paddleford decision was soon rejected by the Third Circuit in Roth v. Maryland Cas. Co. when the court analyzed a fidelity bond that excluded coverage for “any loss resulting directly or indirectly from trading.” 209 F.2d 372, 373 (3d Cir. 1953). The court concluded that the trading loss exclusion precluded recovery of trading losses regardless of whether the trades were the result of dishonest acts otherwise covered by the bond. According to the Roth court, the Paddleford approach, which distinguished between honest and dishonest trading -- finding that losses suffered due to the latter were covered - did violence to the plain meaning of the insurance contract. The Seventh Circuit later overruled Paddleford in Continental Corp. v. Aetna Cas. & Sur. Co., 892 F.2d 540 (7th Cir. 1989).
The Harris, Paddleford and Roth decisions demonstrate that a clear tension existed even initially regarding the scope of the exclusion when an insured sustained losses as a result of employee dishonesty when trading also may have been involved.
By the 1970s, fidelity insurers were beginning to incorporate the trading loss exclusion in other fidelity policies, such as bankers blanket bonds. There was a need to include this exclusion into these bonds because financial institutions had started to engage in trading more frequently, which created higher risks compared to the banks’ usual business activities. Shearson/American Express, 579 F. Supp. at 1310 (citing Digest of Bank Insurance, 35 (3rd ed.1977)). Moreover, employee dishonesty related trading losses rose.
In 1976, the Surety Association of America increased bond premiums and decided to establish a separate charge for coverage for employee dishonesty trading losses, following the precedent established in connection with stockbroker blanket bonds. At this point in time, the trading loss exclusion was generally added with a rider, and the language paralleled the stockbroker wording. The Surety Association’s decision completely excluded all trading loss unless forgery was involved and unless a bond included a provision to buy back coverage for employee dishonesty trading losses.
In 1980, Fidelity insurers formally added the trading loss exclusion to the bankers blanket bond, now known as Standard Form No. 24, to “deal with the insurance problem caused by losses resulting from the buying and selling of securities.” The 1980 bankers bond form adopted the trading loss exclusion contained in stockbrokers’ blanket bonds and encompassed all loss resulting from trading except to the extent that such loss was covered under Insuring Agreements (D) (Forgery or Alteration) or (E) (Securities).
The U.S. District Court for the Western District of Missouri considered the bankers blanket bond exclusion for the first time in Shearson/American Express, Inc. 579 F. Supp. 1305 (W.D. Mo. 1984). The Shearson/American Express litigation involved a dishonest employee of the insured who engaged in securities speculation while falsely representing that he was doing so on behalf of the policyholder. The insured sought coverage from its fidelity insurer for losses that it suffered in connection with its employee’s unauthorized trading activity and for improper payments for securities. The court focused on the trading loss exclusion, which barred coverage for losses “resulting directly or indirectly from trading,” and found it applicable. In reaching this conclusion, the court held that the exclusion was not ambiguous. The court also concluded that the plain meaning of the exclusion was to deny coverage for losses resulting from the buying and selling of securities, regardless of whether the trades were legal.
While the trading loss exclusion continues to evolve, the exclusion’s purpose remains the same. Courts, however, will continue to analyze and reexamine the intent behind this exclusion when determining its applicability, especially as the frequency of large corporate scandals and Ponzi schemes increase. Accordingly, we anticipate that this exclusion will remain an important component of fidelity insurance.
In analyzing coverage or the likelihood of success in litigation, it is helpful to consider the courts’ historical interpretation of the meaning of the word “trading” as applied in the context of the trading loss exclusion. The most basic definition of “trading” in fidelity cases in which the term is not expressly defined is the “buying and selling of securities.” E.g., Shearson/American Express, 579 F. Supp. 1305 (W.D.Mo. 1984); Sutro v. Indem. Ins. Co., 264 F. Supp. 273, 289 (S.D.N.Y. 1967). Through the years, courts have expanded this definition to encompass specific trading conduct.
In Bass v. American Ins. Co., the Ninth Circuit found that the sale of municipal bonds, the servicing of the customers, and the underwriting of the municipal bonds were activities within the meaning of the term “trading.” 493 F.2d 590, 592 (9th Cir. 1974). Later, the Ninth Circuit found that“[t]rading losses are generally understood to be market losses sustained by firms as a result of ill-advised, unauthorized or simply unlucky trading decisions made in the purchasing, selling or trading of securities. Ins. Co. of N. Am. v. Gibralco, 847 F.2d 530, 533 (9thCir. 1988). In First Federal v. Fidelity, the Sixth Circuit found that trading loss is loss which results “from fluctuations in market value of the securities purchased.” 895 F.2d 254, 260 (6th Cir. 1990). Relying on this definition, the court rejected the notion that trading includes non-market losses such as loss resulting from missing securities underlying repurchase agreements.
Trading may also encompass trades made by a policyholder on behalf of its customers. Harris, 155N.E. at 10. In addition to trades made by an insured on behalf of a customer, trading loss may also be excluded by the trading loss exclusion when the trades were conducted on behalf of the insured. Lincoln Grain, Inc. v. Aetna Cas. & Sur. Co., 756F.2d 75 (8th Cir. 1985).
Courts have also found that “trading” does not need to be authorized or legal trading to fall within the trading loss exclusion. In Shearson/American Express, the court found that the trading loss exclusion precludes coverage regardless of whether the losses resulted from legal or illegal trading. In Roth, 209 F.2d at 373, the court rejected the argument that the office manager of the insured broker did not engage in “trading” through his unauthorized purchasing and selling securities for customers. Similarly, in Straz v. Kansas Bankers Sur. Co., No. 97-4245,1998 U.S. App. Lexis 20537, at *9 (7th Cir. Aug. 18, 1998), the court found that the trading loss exclusion applied despite the fact that the insured engaged in risky securities trading that was not authorized by its customer.
In 2010, the Massachusetts Mutual court addressed the trading loss exclusion in the context of the infamous Madoff Ponzi scheme. Mass. Mut. Life Ins. Co., No. 4791-VCL, 2010 Del. Ch. Lexis 156, at *14 (D. Del. June 22, 2010). In doing so, the court highlighted that this exclusion may not bar coverage when the losses involve fictitious trading. The court held that Madoff was a thief and did not lose money through reckless, improvident or even dishonest trading. Because he engaged in embezzlement or embezzlement-like acts, the exclusion did not apply.
Recently, however, one court found that fictitious trading did not fall within the ambit of the trading loss exclusion.
For nearly a decade, courts throughout the nation have struggled in deciding whether an insured’s losses involving both employee dishonesty and trading acts are excluded from coverage under the trading exclusion. The conflict will arise because fidelity bonds typically include an insuring agreement covering loss arising from the dishonest acts of an insured’s employee.
Policyholders argue that employee dishonesty coverage is eviscerated if the trading loss exclusion applies to these losses because a single act of trading could preclude coverage for an employee’s clearly dishonest acts. On the other hand, insurers argue that the courts must apply the unambiguous language of the trading loss exclusion to preclude any losses arising directly or indirectly from trading irrespective of whether a loss involves employee dishonesty.
When a practitioner assesses coverage on the basis of the trading loss exclusion in a case that also involves employee dishonesty, it is crucial to consider the possibility that a court may deem trading activity to be ancillary to an employee’s dishonest conduct. Courts have continued to apply the trading loss exclusion broadly to preclude coverage when a loss results from trading. In several cases, however, courts have analyzed the principal cause of the loss and concluded that the loss arose principally from employee dishonesty and not from trading loss. An insurance coverage practitioner should closely analyze the facts of the particular case to assess whether a court could potentially deem the insured’s loss to be solely the result of the employee’s dishonest conduct.
As mentioned, Paddleford was one of the earliest cases that addressed the struggle between employee dishonesty coverage and the trading loss exclusion. In that case, the insured brokerage business engaged in the buying and selling of stocks, bonds and grains for customers. An employee of the insured ordered that unauthorized trades were made on behalf of customers, when the trades were “fictitious and fraudulent.” The insurer issued a bond containing an insuring agreement covering employee dishonesty, but excluding loss “resulting directly or indirectly from trading.” The court concluded that the trading loss exclusion was not intended to exclude loss incurred through a “dishonest act,” but the exclusion only excluded coverage for trading loss resulting from negligence or an error of the employee. In reaching this holding the court stated that “it borders on preposterous to say that it was the intention of the parties to indemnify plaintiffs against the loss occasioned by a dishonest employee and at the same time make this indemnity unavailing if the loss was occasioned while engaged in trading.” Accordingly, the court concluded that the trading loss exclusion was not intended to preclude coverage for a loss that resulted from an employee’s dishonesty.
This argument was cast off as contrary to “the plain meaning of the insurance contract” because “the words employed leave no doubt” that losses resulting from trading are excluded irrespective of whether the trading resulted from employee dishonesty. The court rejected the decision in Paddleford and found that the plain meaning of the exclusion did not require the loss to result from negligent or mistaken trading but could also encompass dishonest trading.
Later, in Continental Corp, the Seventh Circuit overruled Paddleford to conclude that employee dishonesty claims may fall within the purview of the trading loss exclusion. In Continental, the insured’s employee engaged in a real estate scheme during which he intentionally omitted encumbrances on various properties when issuing title insurance.
While the bond in Continental did not exclude loss arising from trading, the district court likened the trading loss exclusion to an exclusion in the bond for losses “resulting from (a) liability of the insured under contracts of insurance… or (b) liability of the insured because of an inspection, title search, survey or report….” The district court relied on Paddleford to conclude that the exclusion did not apply because the employee’s conduct was dishonest. The Seventh Circuit reversed the holding of the district court. The court found that after “fifty years of evolution of the fidelity insurance business” the reasoning in Paddleford was “fundamentally flawed,” and overruled Paddleford.
After Paddleford, courts often applied the trading loss exclusion broadly to find that the exclusion precluded recovery of trading losses despite the existence of employee dishonesty. In several notable cases, loss involved an employee’s alleged improper conduct. One example of an early case finding that coverage existed for conduct that can be construed as dishonest is Bass, 493 F.2d at 590.
In Bass, a company that engaged in the purchase and sale of municipal bonds was insured under a fidelity bond that covered “loss through any dishonest, fraudulent or criminal act of any [employee]” but excluded “loss resulting directly or indirectly from trading with or without the knowledge of the insured.” The company filed for bankruptcy, and the trustee sought recovery under the bond related to the alleged conduct of the company’s president in purchasing delinquent bond coupons, among other reasons.
The bond coupons were purchased by another company in which the president and the principal shareholder of the company held personal interests. The Ninth Circuit affirmed the trial court’s finding that the coupon purchase was a “trading loss” that was excluded from coverage despite the arguably dishonest acts of the company’s president in purchasing the coupons.
Research Equity Fund v. Ins. Co. of N.A., 602 F.2d 200 (9th Cir. 1979), also involved conduct that could fall within the policy’s employee dishonesty insurance clause. The insured investment firm sustained losses after its portfolio manager was bribed to make unprofitable trading recommendations. The firm engaged in the recommended securities trades, suffered losses as a result, and then sought coverage under its fidelity bonds. While the portfolio manager’s conduct could be construed as dishonest, the court found that the bond’s trading loss exclusion, which precluded coverage for “loss resulting directly or indirectly from trading,” clearly excluded coverage for the loss.
Despite the potential implication of the bond’s employee dishonesty insuring clause, these courts appear to have interpreted the meaning of the language “resulting directly or indirectly from trading” to preclude coverage for any loss resulting from trading irrespective of whether the claim involved an employee’s dishonest conduct. Through the years, however, several other courts examined whether it is the trading activity or the employee’s dishonest conduct that actually caused the loss in assessing the trading loss exclusion’s applicability.
Loss Resulting From Employee Dishonesty?
In the post-Paddleford world, courts continued to grapple with the applicability of the trading loss exclusion to loss arising from employee dishonesty. While Roth and Continental established that dishonest acts committed by an employee may be excluded under the trading loss exclusion, courts later confronted cases in which, based on the facts, they determined that a loss arose solely from an employee’s dishonest conduct. In those cases, courts have found that the trading loss exclusion does not apply despite the existence of ancillary “trading” activity.
Gibralco is a prime example. The insured municipal bond brokerage firm obtained a broker’s blanket bond covering loss resulting from employee dishonesty and excluding coverage for “loss resulting directly or indirectly from trading.” The insured’s employee maintained two unauthorized trading accounts and engaged in unauthorized trading of bonds in accounts in the name of real and fictitious customers. The employee kept some of the bonds. The employee also sold some of the bonds and used the proceeds for his personal benefit.
The insured argued that the trading loss exclusion did not apply because the insured did no more than lend money to customers who, in turn, invested in securities. The court relied upon the “sound approach” to the trading exclusion in Gibralco and concluded that the employee’s dishonest conduct in processing the loans, rather than the purchaser’s securities purchases, was the ultimate cause of the loss. The court concluded that the employee’s conduct included no representation that he was “engaging in securities trading in a manner that the trading exclusion is intended to discourage” and the fidelity bond coverage “should not be defeated by an expansive interpretation of the trading loss exclusion.

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