Insurance Coverage for Ponzi Scheme Losses?

Posted by Kathy Bazoian Phelps

   It sounds like a good idea: Insure against losses from investing in a Ponzi scheme. Insurance policies, including homeowner’s policies, can provide coverage from losses from fraud, embezzlement or forgery. But does it work to provide compensation for losses in a Ponzi scheme?

   Last year, the Second Circuit affirmed a district court’s dismissal of a Madoff customer’s complaint against a homeowners policy, but not for the reasons you might expect. Horowitz v. American International Group, Inc., 498 Fed. App’x 51 (2d Cir. 2012).

   Horowitz purchased a homeowner’s insurance policy from AIG with a Fraud Safeguard endorsement providing for up to $30,000 in coverage for losses resulting from fraud, embezzlement or forgery. Horowitz had invested a total of $4,327,230.55 with Madoff and had withdrawn $4,553,000, leaving a balance that Horowitz believed to be more than $8.5 million of expected profits.

   AIG denied coverage, finding that Horowitz had not suffered a loss under the policy terms. After Horowitz sued AIG, the district court dismissed the complaint, finding that the Madoff Ponzi scheme was not a peril covered by the policy and that a Ponzi scheme is not a predictable peril. The Second Circuit disagreed, finding that "a Ponzi scheme is likely just the sort of fraud anticipated by the policy drafters." Id. at 53.

   That should mean a win and $30,000 of insurance benefits for Horowitz, right? Not in that case. Even though Ponzi scheme losses were covered, the Second Circuit found that, "in our view the dispute in this case turns not on whether the peril, i.e., the Madoff fraud, is a covered event, but on the Horowitzes' remaining arguments concerning which losses flowing from that fraud are directly attributable to the covered conduct and thus recoverable under the policy." Id.

   The Second Circuit rejected Horowitz’ interpretation of "loss" and found that "the covered loss is limited only to the ‘something’ of value’ that the Horowitzes were induced to part with as a result of the fraud." In other words, their expected profits of over $8.5 million were not "something of value" and therefore not a covered loss.

   The decision is in line with decisions on other issues in Ponzi scheme cases ranging from fraudulent transfer claims to claims distribution that draw a distinction between an investor’s capital investment and expected profits. The Second Circuit expressly rejected Horowitz’s alternative methodologies of loss calculations:
   (1) the full account balance as reflected in their final BLMIS statement;
   (2) earnings reasonably expected on their capital investment based on a growth assumption or implied interest rate;
   (3) net loss in constant dollars;
   (4) non-recoverable tax payments; or
   (5) legitimate growth on investments during the pre-Ponzi period.

   The lesson here is that while an investor can obtain insurance in the hope of recouping some of the losses in a Ponzi scheme, to recover, the investor must prove an actual loss of value and not merely a loss of expected profits.

   For other decisions relating to Madoff investors’ claims against their insurance policies, see Lissauer v. Fireman’s Fund Insurance Companies, 459 Fed. App’x 67 (2d Cir. 2012); Chaitman v. Chubb Insurance Co. of New Jersey, 2012 N.J. Super. Unpub. LEXIS 2738 (Sup. Ct., App. Div. Dec. 14, 2012).