Misdirection Leaves COR Clearing Without Insurance Reimbursement

December 9, 2020

A recent bout of federal litigation largely turned on the meaning and interpretation of the word "direct." At stake was a brokerage firm's demand for reimbursement by its insurance company of $2.3 million in settlements paid to customers victimized by a stockbroker's fraud. It's the stuff of lawsuits, settlements, and legal fees. In the end, we get a fascinating glimpse into the machinations of legal analysis and the dissection of contracts. 

The Cervino Fiasco

This tale of legal woes begins in 2013, when COR Clearing, LLC (which was subsequently acquire by Axos Clearing LLC) hired Christopher Cervino as a registered representative. By the summer of 2014, Cor begin investigating customer complaints against Cervino, who was fired in October 2014. Apparently, Cervino had become involved with what looked like a conspiracy to defraud investors via a pump-and-dump scheme involving the pennystock VGTel. Federal Insurance Company, Plaintiff/Appellee, v. Axos Clearing LLC, Defendant/Appellant (Opinion, United States Court of Appeals for the Eighth Circuit ("8Cir"), No. 18-2653 / December 7, 2020) (the "8Cir Opinion") http://brokeandbroker.com/PDF/AxosOp8Cir201207.pdf As asserted in pertinent part in the 8Cir Opinion [Ed: footnote omitted]:

[T]he VGTel investors filed arbitration complaints with the Financial Industry Regulatory Authority ("FINRA") in late 2014 and April 2015. The larger group alleged that, when COR hired Cervino from an independent broker dealer, he was already engaged in the fraudulent VGTel pump-and-dump scheme with a group of conspirators that included securities fraudster Edward Durante and a crooked financial advisor, Sheik Khan. The conspirators transferred investor accounts to COR where Cervino executed unauthorized VGTel trades. In January 2016, COR submitted a Preliminary Proof of Loss to Federal requesting coverage under the Bond for the VGTel settlements. Also in January 2016, the Securities and Exchange Commission filed an amended criminal complaint against Durante, Cervino, Khan, and others; they were convicted of securities and wire fraud after a sixteen-day jury trial in March 2017. 

at Page 3 of the 8Cir Opinion

Side Bar: " Securities and Exchange Commission filed an amended criminal complaint against Durante, Cervino, Khan, and others . . . " ummm, what? The SEC is filing criminal complaints? And that's from an Opinion of a federal circuit court? Wow! 

In any event, a likely more accurate take on things is found in "Investment Adviser And Broker Sentenced For Securities Fraud Scheme" (DOJ Release / January 19, 2018) 
https://www.justice.gov/usao-sdny/pr/investment-adviser-and-broker-sentenced-securities-fraud-scheme The DOJ Release notes the imposition of the following sentences by the United States District Court for the Southern District of New York ("SDNY"):
  • Cervino one year and one day in prison plus three years of supervised release and ordered to forfeit $35,000; and
  • Khan 53 months in prison plus three years of supervised release and ordered to forfeit $290,787
As asserted in part in the DOJ Release:

The securities fraud scheme was conceived and led by Edward Durante, a recidivist securities fraud defendant, who pled guilty in August 2016 to various crimes related to the scheme, including conspiracy, securities fraud, money laundering, and perjury.  As part of the scheme, Durante, CERVINO, KHAN, and others conspired to control and manipulate the public stock of VGTL in order to artificially inflate the stock price and trading volume so as to profit from sales of VGTL stock and to further induce investments in private shares of VGTL.  

Durante, through entities he controlled, held a majority of the publicly traded stock of VGTL.  Durante recruited CERVINO, a broker, to open brokerage accounts associated with Durante-controlled entities and investors who were clients of KHAN, an investment adviser.  Many of KHAN's clients had no idea that KHAN and Durante had opened accounts on their behalf with CERVINO.  KHAN, along with Durante, then induced her clients to purchase VGTL stock through CERVINO - sometimes without the clients' knowledge or permission - while Durante and CERVINO ensured that many of these purchases were matched with sales of VGTL stock by Durante-controlled accounts.  The reality of these transactions was that Durante and his co-conspirators were effectively taking both sides of a single transaction in VGTL stock in order to artificially control VGTL's stock price.  The defendants' efforts to artificially inflate the market for VGTL increased the stock price from approximately $.25 per share to as much as $1.90 during the course of the scheme, and dramatically inflated the trading volume, which increased the defendants' abilities to raise private investments in VGTL and to unload Durante-controlled shares at artificially high prices at the expense of victim investors.  To compensate CERVINO for his efforts to control and manipulate the market in VGTL, Durante made at least two cash payments to CERVINO totaling $35,000, in addition to the substantial commissions CERVINO received for executing trades in VGTL.  For her part, KHAN received more than $400,000 from Durante, including more than $100,000 in payments for liquidating her clients' investments in safe annuities so that the money could then be invested into VGTL.  In total, CERVINO purchased more than $3.5 million of VGTL shares in client accounts controlled by KHAN and/or Durante.  The VGTL shares were ultimately worthless and clients lost the entirety of their investments.

The Financial Institution Bond

Starting in April 2014 and again in April 2015, the Federal Insurance Company issued a Financial Institution Bond to COR. In response to the above VGTel lawsuits, COR paid $80,000 in settlement with one investor and another $2 million in settlement with another 22 investors. As you might imagine, COR got in touch with Federal and asked the insurer to cover the $2.8 million in settlement payments under the Bond, as provided under Clause 1.B of the Bond, which provides coverage for:

Loss resulting directly from dishonest acts of any Employee, committed alone or in collusion with others except with a director or trustee of the ASSURED who is not an Employee, which arises totally or partially from: 
(1) any Trade, or 
(2) any Loan
provided, however, the ASSURED shall first establish that the loss was directly caused by dishonest acts of any Employee which result in improper personal financial gain to such Employee and which acts were committed with the intent to cause the ASSURED to sustain such loss.

DNeb Grants Summary Judgment

In light of the fact that we're discussing a lawsuit between Federal and COR, I'm sure that you sort of figured out at this point that Federal declined to deem that coverage under the Bond attached to the settlement payments at issue. As such, the parties wound up before the United States District Court for the District of Nebraska ("DNeb"), which found in reference to Clause 1.B of the Bond that:

The only loss COR suffered was payments made to settle claims brought by third parties for their losses. COR did not suffer any risk that its own assets would be directly lost as a result of Cervino's actions. 

at Page 5 of the 8Cir Opinion

Accordingly, DNeb granted Summary Judgment to Federal after finding that the Bond did not cover COR's sought reimbursement and dismissed with prejudice COR's counterclaim. In September 2020, COR appealed to the 8Cir, which affirmed.

Gentilini Ford: What's a Direct Loss?

A key issue in dispute before DNeb was whether New Jersey (as argued by COR) or Nebraska law  (as argued by Federal) applied. DNEB found that New Jersey law governed the diversity case under Nebraska's choice-of-law provisions. Guided by New Jersey law, DNeb then guided its deliberations by the seminal New Jersey case of Auto Lenders Acceptance Corp. v. Gentilini Ford,
Inc., 854 A.2d 378 (N.J. 2004)
https://www.courtlistener.com/opinion/2326496/auto-lenders-v-gentilini-ford/ The 8Cir viewed Gentilini Ford as having established the following:

In Gentilini Ford, an automobile dealership allowed its higher risk customers to purchase vehicles on installment contracts, paying a cash deposit and executing a note. Gentilini Ford then assigned its rights in the financed vehicles to a financing company, Auto Lenders, in exchange for a cash payment equivalent to the purchasers' notes. 854 A.2d at 381-82. After a number of customers defaulted on their loans, Auto Lenders discovered that a Gentilini Ford employee had submitted fraudulent credit applications based on falsified pay stubs to overstate the borrowers' creditworthiness. Gentilini Ford settled Auto Lenders' fraud and breach of contract claims for $215,000 and filed a complaint to recover the settlement payment from its insurer under the commercial insurance policy provision covering a direct loss caused by an employee's dishonest acts. Id. at 383. Reversing an appellate decision in favor of the insurer, the Supreme Court of New Jersey adopted "the conventional proximate cause test" for direct losses and ruled that "Gentilini suffered a direct loss of or damage to twenty-seven automobiles when it exchanged those vehicles for installment contracts of an otherwise unacceptable risk." But the Court held that the $215,000 settlement payment was not "an accurate measure of direct loss under the terms" of the policy and remanded, directing that "Gentilini will have the burden of proving its loss on each contract through further proceedings." Id. at 398-99. 

While Gentilini Ford adopted the proximate cause test to determine whether an employee's dishonest acts caused the insured's direct loss, we agree with the district court that the direct loss the Court found in Gentilini Ford was the transfer of automobiles for riskier-than-anticipated notes, not the $215,000 settlement payment the insured sued to recover. Therefore, the Court held, "[t]he losses it incurred . . . depend on whether Gentilini still has an interest in those contracts, the amount outstanding on those contracts that have entered default, and Gentilini's ability to mitigate its losses through repossession." Id. at 399. This reasoning demonstrates that the Supreme Court of New Jersey applied the principle that direct losses covered by employee dishonesty provisions in financial institution bonds do not include "indirect and consequential injuries to the employer resulting from legal settlements with third parties who were the actual targets of the employee's acts." Kidder, Peabody, 676 N.Y.S.2d at 564. Indeed, in remanding, the Court noted that "Gentilini is not entitled to an award of attorneys' fees incurred in prosecuting its action against [the insurer]" because New Jersey law "does not authorize an award of attorneys' fees to enforce first-party coverage," and "the policy under which Gentilini seeks coverage . . . does not concern liability to third parties." Id. at 399-400 (emphasis added).

On appeal to the 8Cir, COR argued the DNeb:

misapplied Gentilini Ford in concluding that COR is not seeking indemnity for direct losses, as Clause 1.B requires. In appealing the grant of summary judgment dismissing its Clause 1.D counterclaim, COR argues the district court incorrectly held that there was no evidence Cervino's dishonest acts triggered coverage under Clause 1.D. Federal raises three additional issues: (i) the court should have held that Nebraska rather than New Jersey law governs COR's Bond claims; (ii) COR presented insufficient evidence Cervino intended to cause COR to incur losses, as Clauses 1.B and 1.D require; and (iii) COR cannot prove it suffered a loss in excess of the Bond's deductible. The district court concluded the latter two issues presented material fact disputes not appropriate for summary judgment. . . .

at Page 4 of the 8Cir Opinion

Clause 1.D

Largely a sideshow issue for 8Cir, was COR's argument that DNeb improperly granted summary judgment dismissing COR's counterclaim for coverage of the VGTel settlement payments under Clause 1.D:

B. Insuring Clause 1.D. A separate insuring clause in the Bond's Section 1 Dishonesty provisions, Insuring Clause 1.D, provides coverage for: 

Loss of Customer's Property resulting directly from the dishonest acts of a Registered Representative, committed alone or in collusion with others and which arises totally or partially from the Registered Representative

(1) soliciting such Property from the Customer when the Property has not been in an account with the ASSURED; 
(2) instructing or advising the Customer to withdraw such Property from the Customer's account with the ASSURED; or 
(3) instructing or advising the Customer to liquidate an investment, or terminate an insurance, annuity, futures or other contract, 

provided, however, the ASSURED shall first establish that the loss was directly caused by dishonest acts of the Registered Representative which result in improper personal financial gain to such Registered Representative or other natural person acting in collusion with such Registered Representative and which acts were committed with the intent to cause the Customer to sustain such loss. 

DNeb declined to find that Clause 1.D required coverage given the facts at issue because there was no evidence that Cervino:
(1) solicited property, 
(2) instructed customers to withdraw property from their accounts with COR, or 
(3) instructed or advised customers to liquidate or terminate anything. 

8Cir: A Matter of Misdirection (at Third Parties)

In rejecting COR's argument and affirming DNeb, 8Cir noted that most jurisdictions view Clause 1.B as an employee dishonesty provision, which covers the insured's loss if its employee embezzled customer funds in the insured's possession or control; however, such loss would not be covered if the employee embezzled a customer's personal funds not in the employer's possession or control. In tackling the question as to whether the settlement payments were covered under Clause 1.B, 8Cir concluded that "under New Jersey law, COR's payments to settle third-party liability claims based on an employee's dishonest acts directed at the third parties were not a direct loss under Insuring Clause 1.B of the Bond." at Page 8 of the 8Cir Opinion

Bill Singer's Comment

Overall, the 8Cir Opinion is succinct and presents a well reasoned rationale. For industry veterans who chafe at the constraints of various restrictions on outside business activities or private securities transactions, this case offers a resounding explanation as to why such practices are often discouraged. On the other hand, this case also serves as a sober warning to brokerage firms about entering into settlements that they believe will fall under their insurance coverage.