A financial institution’s employee ran a Ponzi scheme for 10 years. Without the institution’s knowledge or authorization, the employee issued false securities to investors through brokers in exchange for funds, which were transferred to an account controlled by the employee. While purportedly underwritten by the institution, and seeming so on face, the institution denies having anything to do with the securities and asserts that they were completely fraudulent, phony and unauthorized.
As part of the Ponzi scheme, the employee allegedly used subsequent institutional investors’ funds to pay interest to early investors. The employee also paid off the principal of any securities that the early investors sought to redeem. The employee also spent much of the revenue on personal luxuries. The employee’s last set of investors incurred losses when the scheme collapsed. The employee is now unable to repay those investors, and the financial institution refuses to do so. The employee intends to plead guilty to federal charges of fraud and money laundering. The total loss suffered by the institutional investors is said to exceed $12 million.
In this hypothetical scenario, the financial institution does not have a present, actual, out-of-pocket loss. On the contrary, it adamantly maintains that it has not incurred a loss. It denies that the funds at issue, which were stolen by its employee from third parties, were ever its own asset. It denies both issuing the securities and liability to the third parties. Is the financial institution, in fact, liable to the third-party investors for the fraud perpetrated by its employee, which targeted the third-party investors? If so, will the institution’s fidelity insurance bond cover the losses suffered by the third-party investors?
Named after flamboyant con man Charles Ponzi, a Ponzi scheme lures potential investors in with the promise of abnormally large returns, usually attributable to the investment manager’s savvy, skill or some magical potion. The returns are repaid with the investor’s principal, and the scheme is successful as long as new investors line up with fresh cash and old investors don’t try to withdraw too much of their money.
In December 1919, Charles Ponzi committed the original scheme. Ponzi wooed starry eyed investors into buying foreign postage coupons from him with the promise of 50 percent returns in 45 days. Ponzi claimed that by buying postage coupons cheaply overseas and redeeming them for much higher amounts in the Untied States, he could effectively double investors’ money within approximately three months.
The madness spread and millions of dollars of new money poured in each week. Old investors were reluctant to redeem their coupons in hopes of doubling their investment every few months. The consistent cash flow, together with investor greed, created the perfect cocktail to fuel Ponzi’s scheme. As with most pyramid schemes, however, Ponzi’s scheme did not last long. It was discovered and he was sent to prison, leaving investors holding the bag.
In our hypothetical, the dishonest employee’s alleged fraud, including investors to purchase fraudulent securities, may or may not eventually cause the insured institution to be liable to those third parties. However, according to case law, a fidelity bond would not cover any liability exposure that the financial institution faced. A fidelity bond is not liability insurance and does not cover an insured’s satisfaction or settlement of liability for loss to third parties as a result of fraud by an employee of the insured.
Such a loss is not a direct loss as the bond requires. At best it is an excluded, indirect loss. Property that an employee steals from a third party by purporting to deliver it to the insured, either as a gift or as an investment, is simply not an asset of the insured, so the loss of that stolen property could not effect coverage. A fidelity bond only covers the loss of property owned or held by the insured. A bond’s reference to property for which an insured is legally liable refers only to consciously and consensually held property, property that the insured holds before a theft, and property in which the insured has an insurable interest.
In fact, the insured would be merely returning money that belonged to the victim. An insured cannot have an employee rob or steal from someone else and then claim a loss on its fidelity bond when asked to return the money to the victim. In such a case, the insured has lost nothing. Moreover, it is arguable that an employee stealing from a third party does not have a “manifest intent” to cause loss to the employer, as employee-dishonesty coverage requires. It would be unreasonable to conclude that an employee manifestly intended to cause the insured to eventually incur a loss in the form of liability to a third party, after the employee is caught.
A fidelity bond really is intended only to cover actual, present, net loss directly resulting from employee dishonesty that reduces the insured’s available assets. An insured’s liability is not measured by its employee’s personal liability. If the fraudulent securities that our hypothetical, dishonest employee procured were not the insured’s assets, an insurer has a strong argument that bond coverage does not exist.