On January 30, 2009, litigation relating to Bernie Madoff’s alleged $50 billion Ponzi scheme made its way to Massachusetts via a class action complaint filed in the United States District Court by various investors in a so-called “feeder fund” that, allegedly unbeknownst to the plaintiffs, invested all or substantially all of the feeder fund’s assets in Madoff’s hedge fund.
The class action complaint does not name Madoff or any other purported Madoff insider, but names Rye Select Broad Market Fund, L.P. and the entities that controlled and managed that fund including MassMutual and its subsidiaries Tremont Partners, Inc., Tremont Group Holdings, Inc., Oppenheimer Acquisition Corp. and various executives of the Tremont entities. The plaintiffs’ allege the defendants solicited investments through various offering materials and these materials made numerous misrepresentations and omissions regarding the feeder fund’s investment strategy and its due diligence.
The Complaint asserts claims for Breach of Fiduciary Duty (Count I); Common Law Fraud (Count II); Breach of Contract (Count III); Negligent Misrepresentation (Count IV); Breach of Duty of Good Faith (Count V) and Unjust Enrichment (Count VI). This suit is almost certainly the first of many Madoff actions to be filed in Massachusetts, one of the hubs of the financial services industry.
The insurance industry’s professional liability lines, already facing significant exposure ($3.5 billion according to some sources) from the subprime crisis, now face potentially enormous exposures to Madoff’s fraud. On January 14, 2009, reinsurance intermediary Aon Benfield gave its current best estimate of the direct insured losses resulting from the alleged Madoff fraud at $1.8 billion.
The obvious sources of the industries’ exposure are E&O and D&O claims. Madoff suits that allege breach of professional duties and seek damages for the negligent rendering of professional services will likely result in claims against E&O policies. Likewise, a Madoff suit that names a company or a company’s directors and officers for wrongful acts committed by the officers or directors may likely result in a demand for coverage under D&O policies. Because there is a high degree of variability among E&O and D&O policies, coverage issues under such policies for Madoff claims will be numerous and complex.
Insurers may raise policy exclusions and seek declaratory judgments as to whether Madoff claims are covered. The most common exclusions in E&O and D&O policies that may bar coverage for such claims are exclusions for criminal, dishonest, or fraudulent acts; the insured gaining personal profit and known prior acts among others.
Although financial institutions facing Madoff claims will likely seek coverage under E&O and D&O policies, what is the possibility of Madoff claims triggering coverage, or at least a duty to defend, under CGL policies? Insureds may seek coverage under CGL policies because these policies may have significantly higher limits than E&O and D&O policies. The real drive, however, to trigger such coverage maybe defense costs.
Under typical E&O and D&O policies, defense costs erode policy limits because liability coverage includes defense costs inside limits. In contrast, defense costs under CGL policies are usually in excess of limits. Thus, an insured facing defense costs eating away indemnity limits of its E&O and D&O coverage will have an incentive to seek coverage under CGL policies and obtain a defense that does not erode limits.
If a Madoff claim, such as the recent suit filed in Massachusetts, which is similar to others filed in New York and Florida, alleges negligent misrepresentations and omissions in a feeder fund’s solicitation materials an insured may seek advertising injury coverage under part 1.B of its CGL policy. Such a claim will likely fail. However, a demand for such coverage will force an insurer to decide whether to disclaim coverage outright or defend under a reservation of rights while litigation a declaratory judgment action.
The standard CGL policy provides coverage for “those sums that the insured becomes legally obligated to pay as damages because of personal and advertising injury to which this insurance applies.” The policy imposes a duty on the insurer to defend “the insured against any suit seeking those damages.” Advertising injury is defined in the CGL policy as comprising only certain limited offenses: Specifically, the policy defines advertising injury as follows:
Personal and advertising injury means injury…arising out of one or more of the following offenses:
(d) Oral or written publication, in any manner, of material that slanders or libels a person or organization or disparages a person’s or organization’s goods, products or services;
(e) Oral or written publication, in any manner, of material that violates a person’s right of privacy;
(f) The use of another’s advertising idea in your “advertisement”; or
(g) Infringing upon another’s copyright, trade dress or slogan in your “advertisement”.
A Madoff claim against a fund or the fund’s managers premised at least in part on misrepresentations or omissions in solicitation materials does not fall into any of the definitions of advertising injury.
If a feeder fund incorporated (either directly or by reference) Madoff’s investment methodology or strategies in its promotional and solicitation materials, it is possible that an insured may seek advertising injury coverage arising from the “use of another’s advertising idea in your advertisement.” Such a claim appears destined to fail because coverage in the CGL policy for advertising injury does not remotely appear to be applicable in such circumstances.
While such an example may be extreme, the very real concern facing insurers is that attempts to trigger coverage under CGL policies for Madoff claims may only be constrained by the imagination of insured’s coverage counsel. Given the potentially enormous exposure for defense costs facing insureds and that defense costs erode limits in E&O and D&O policies, the pressure on insureds to try and trigger CGL coverage is likely to be immense. A claim against a Madoff feeder fund arising from misrepresentations and omissions in solicitation materials is a false advertising claim that does not trigger advertising injury coverage under a standard CGL policy. See, e.g., Superformance Int’l, Inc. v. Hartford Cas. Ins. Co., 203 F. Supp. 2d 587, 598 (E.D. Va. 2002)(a claim for false advertisement is not an “advertising injury” under the CGL Policy.
Even if such a claim could arguably be considered as coming within the definition of an advertising injury, such a claim would be excluded under the standard advertising injury exclusion that excludes coverage for an advertising injury “arising out of the failure of goods, products or services to conform with any statement of quality or performance made in [the insured’s] advertisement.” Skylink Techs., Inc. v. Assurance Co. of Am., 400 F.3d 982, 985 (7th Cir. Ill. 2005)(claim that advertised product failed to conform with the statement of performance on its package is excluded from coverage under advertising injury portion of CGL policy.); Am. W. Home Ins. Co. v. Lovedy, 2006 U.S. Dist. LEXIS 92118 (E.D. Tenn. Dec. 15, 2006)(insurer had no duty to defend or indemnify the insured regarding representations on website that do not fall within the definition of advertising injury and because the policy excludes advertising injury which arises “out of the failure of goods, products or services to conform with any statement of quality or performance.)
While the insureds’ efforts to obtain CGL coverage for Madoff claims will, most likely, be unsuccessful, any demand for such for coverage will cause insurers a difficult choice. Any such demand for coverage will force insurers to choose between denying coverage outright (and the risk of attorneys fees in a suit for defense, an estoppel argument in connection with indemnity and possibly other extra contractual liability if the insurer is found to have owed duty to defend) or providing a defense subject to a reservation of rights and paying substantial defense costs to the insured’s choice of counsel while pursing a declaratory judgment action. While this is a risk that insurers confront every day, the magnitude of defense costs and indemnity exposure in such cases significantly raises the stakes.