The Federal Insurance Company ("Federal") issued a financial institution bond ("the Bond") to COR Clearing LLC ("COR"), a settlement and clearing company that allows independent broker-dealers to access public stock markets and shopping for their customers. The bond was issued in April 2014 and April 2015. In 2016, COR paid $ 2,080,000 to settle claims from investors that a former COR-registered representative, Christopher Cervino ("Cervino"), had conspired with others to defraud investors by implement a "pump" -and-dump "scheme in a risky penny stock called VGTel. COR filed a claim with its liability insurance company, a subsidiary of XL Specialty Insurance Company, for VGTel and other settlement payments, which it later paid for $ 3,625,000 over the insurance deduction. COR also filed a claim under the Federal Bond to recover its losses for the VGTel settlements.
In Federal Insurance Company v. Axos Clearing LLC, No. 18-2653, United States Court of Appeals For the Eighth Circuit (December 7, 2020) Federal denied coverage and sued COR's claim is covered not by the Bond's insurance clauses. The district court issued a summary judgment and declared that COR's claim for compensation under the bond was not covered and rejected COR's counterclaim with prejudice. COR appealed.
COR hired Cervino in 2013 to serve as a registered representative at COR's Equity Desk in Edison, New Jersey. His responsibilities were limited to conducting business according to the client's instructions. COR began investigating customer complaints regarding accounts that Cervino monitored in the summer of 2014 and terminated Cervino in October 2014.
The victims of Cervino's actions claimed that when COR hired Cervino from an independent broker, he was already involved in fraudulent VGTel pump-and-dump system with a group of conspirators who included securities fraudster Edward Durante and a crooked financial adviser, Sheik Khan. The conspirators transferred investor accounts to COR, where Cervino carried out unauthorized trading with VGTel.
In January 2016, COR submitted preliminary evidence of loss to the Federal and requested coverage under the bond for the VGTel settlements. Also in January 2016, the Securities and Exchange Commission filed an amended criminal case against Durante, Cervino, Khan and others. they were convicted of securities and wire fraud after a sixteen-day jury trial in March 2017.
Regarding the appeal of the disputed insurance clauses in the appeal, the court found that insurance clause 1.B does not apply to the leading New Jersey case with Auto Lenders Acceptance Corp. v Gentilini Ford, Inc., 854 A.2d 378 (NJ 2004), COR's loss "was not directly due to Cervino's actions." It also concluded that the insurance of clause 1.D does not apply as there is no evidence that Cervino committed covered fraudulent acts.
Insurance clause 1.B. Section 1 of the Bond's insurance clauses contains four "dishonesty" coverages. Clause 1.B provides coverage for: “Loss arising directly from dishonest acts of any employee committed alone or in cooperation with others except with a director or trustee of the INSURED who is not a employee deriving in whole or in part from: (1) any trade or (2) any loan provided, however, that the INSURED must first establish that the loss was caused directly by dishonest acts by someone employee which results in incorrect personal financial gain for such a employee and what actions have been taken in order to get the INSURED to maintain such a loss.
The district court concluded that clause 1.B does not cover VGTel's settlement payments because: The only loss suffered by COR was payments made to settle third party claims for their losses. COR did not suffer any risk of losing its own assets directly as a result of Cervino's actions.
Traditionally, financial institutional bonds and similar employee dishonesty coverage were tort contracts that covered the insured's direct losses from employee dishonesty. (and other risks such as counterfeiting), not the insured's liability to third parties for harmful acts of employees that are intended to harm or deceive third parties. The insurance covers the insurance's liability towards third parties, in contrast to fidelity bonds that cover loss of property owned by the insured or held by the insured, as a result of the employees' dishonesty.
The direct loss provisions in credibility bonds do not describe indirect and consequential damages to the employer as a result of legal settlements with third parties which were the actual objectives of the employee's actions.
In most jurisdictions, this type of employee dishonesty provision covers the insured's loss if its employee's embezzled customer funds in the insured's possession or control. However, if the employee embezzled a customer's personal funds that are not in the employer's possession or control, it is not a covered direct loss even if the employer later replaced the customer in a legal judgment or settlement.
Since state law governs the interpretation of Federal & # 39 ;s Bond in this diversity action, the district court followed the controlling decision of the Supreme Court of New Jersey.
While New Jersey adopted the immediate causal test to determine whether an employee's dishonest acts caused the insured's direct loss, the Eighth District agreed with the district court that the direct loss incurred by COR was due to the New Jersey Supreme Court applying the principle of direct loss. covered by employees' dishonesty in bonds of financial institutions does not include indirect and consequential damages to the employer as a result of legal settlements parties who were the real targets of the employee's actions.
Under New Jersey According to the law, COR's payments to settle claims based on an employee's dishonest acts against third parties were not a direct loss under Insurance Section 1B of the bond.
The district court issued a summary judgment because there was "No evidence that Cervino (1) requested property, (2) instructed customers to withdraw property from their accounts with COR, or (3) instructed or recommended customers to liquidate or terminate anything." The Eighth Circuit concluded that the allegations made by the COR may well accuse Cervino of "dishonest acts", they do not provide evidence that Cervino, while employed by the COR, committed the dishonest acts which trigger coverage under clause 1.D – " property from a customer who was not in a COR account, instructed or advised a customer to withdraw property from the customer's COR account, or instructed or advised a customer to liquidate an investment. ”
The eighth circuit concluded that the district court did not err in rejecting COR's paragraph 1.D counterclaim because COR did not show that permissible evidence would be available at trial to prove that Cervino personally committed a covered dishonesty.  A credibility bond, issued by an insurance company, is not a type of insurance that will reimburse an insured against a third party claim due to an employee's oeti and criminal acts. Rather, the bond only covers the damages of an ethical or criminal act by an employee that harms the employer, the holder of the bond. Because the crooked employee did not double or otherwise take money from COR, there was no coverage for the losses it paid to liquidate fraudulent third parties.
© 2020 – Barry Zalma. He also acts as an arbitrator or mediator for insurance-related disputes. He practiced law in California for more than 44 years as an insurance coverage and claims lawyer and more than 52 years in the insurance industry. He is available at http://www.zalma.com and firstname.lastname@example.org.
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