In the recent decision of Cadaret, Grant & Co. v. Great American Insurance Co., the U.S. District Court for the Eastern District of New York applied the “direct loss” requirement of coverage, the ownership condition and the legal liability exclusion to find no coverage under a Financial Institution Bond in respect of a registered representative’s selling away Ponzi Scheme. The decision applies important foundational concepts relating to each of these provisions and is instructive for claims professionals dealing with claims under fidelity, crime and Financial Institution Bond coverages arising from third-party losses.
The Facts
Cadaret, Grant & Co. (“Cadaret”) is a securities broker-dealer. Steven Pagartanis worked as a registered representative licensed to sell securities through Cadaret between September 2012 and March 2017.
In February 2017, Abramovich, an individual who had invested with Pagartanis, filed with FINRA a statement of claim and demand for arbitration against, inter alia, Cadaret and Pagartanis. Abramovich alleged that Pagartanis transferred funds from her Cadaret brokerage account to her personal chequing account and requested that she write cheques payable to Sonesta Holdings (“Sonesta”) and Kinnico Land Trust (“Kinnico”). Pagartanis did not provide written evidence of the existence of either entity. Pagartanis eventually deposited funds into her accounts but refused to provide any accounting of the performance of her investments.
Cadaret answered Abramovich’s statement of claim in May 2017, stating that the investments in Sonesta and Kinnico “were intentionally concealed from [Cadaret] by Pagartanis.” Cadaret also stated that Pagartanis “intentionally evaded [Cadaret’s] detection of his involvement in these investments through deceitful and surreptitious means“; that the transactions “were intentionally done off [Cadaret’s] books and records by Mr. Pagartanis“; and that “Mr. Pagartanis blatantly lied to [Cadaret] about his activities in an effort to conceal his involvement with Kinnico and Sonesta.”
The SEC filed a civil complaint against Pagartanis on May 30, 2018 alleging that Pagartanis “defrauded at least nine retail investors of approximately $8,000,000 by soliciting and selling them securities using false and misleading statements from 2013 to at least February 2018” in a Ponzi scheme involving a shell company called Genesis. On December 10, 2018 Pagartanis pleaded guilty to conspiracy to commit mail and wire fraud.
According to Cadaret’s characterization of the Genesis scheme, Pagartanis convinced clients to: (i) liquidate funds in their Cadaret brokerage accounts; (ii) wire funds from their Cadaret brokerage accounts to their personal bank accounts; and, (iii) write cheques from their personal accounts to sham companies controlled by Pagartanis.
Nine Cadaret clients filed claims against Cadaret through the FINRA arbitration program and by written complaints seeking to hold Cadaret responsible for losses sustained in the Genesis scheme. Cadaret settled all nine claims at mediation and sought indemnity under its Bond in respect of the settlements.
The Insuring Agreement and the Legal Liability Exclusion
Insuring Agreement (A) of Cadaret’s Bond indemnified for:
Loss resulting directly from dishonest or fraudulent acts committed by an employee . . . with the manifest intent: (1) to cause the Insured to sustain such loss; and (2) to obtain an improper financial benefit for the Employee or another person entity.
A Rider to the Bond expressly defined “Employee” to include registered representatives.
Exclusion 2(t) of Cadaret’s Bond excluded:
… damages of any type for which the Insured is legally liable, unless the Insured establishes that the act or acts which gave rise to the damages involved conduct which would have caused a covered loss to the Insured in a similar amount in the absence of such damages.
The Decision
The District Court found that no coverage was available in respect of the settlements because they were third-party losses:
Cadaret’s third-party losses are not a “direct loss” covered by the Bond. … The New York Court of Appeals differentiated a policy indemnifying against liability that “obligate[s] the insurer to discharge an obligation owed by the insured to another arising from some act of the insured,” and employee dishonesty coverage in a fidelity bond where “the insurance is against the loss of property, owned by or belonging to the insured or others, through employee dishonesty.” 175 E. 74th Corp. v. Hartford Acc. & Indem. Co. … Under employee dishonesty coverage of a fidelity bond, “the policy insures only against loss to the insured sustained through the dishonesty of its employees. It does not contemplate … the assertion of a third-party claim.” The Bond at issue here indemnifies Plaintiff for “[l]oss resulting directly from dishonest or fraudulent acts committed by an employee” and falls into the latter policy contemplated by 175 E. 74th Corp. “[D]irect loss” language in fidelity bonds precludes coverage for losses resulting from liability for third-party settlements. [emphasis added; most citations omitted]
Consequently, the “direct loss” requirement of the insuring agreement was not met in respect of the settlements.
The Court also rejected Cadaret’s contention that clients’ personal funds met the ownership condition because Cadaret owed a fiduciary duty in respect of the funds. The Court carefully distinguished the fiduciary duty owed by Cadaret to clients from any purported duty in respect of funds held outside Cadaret:
First, the client funds were held in clients’ personal bank accounts at the time of the theft, not in any entity connected to Cadaret or accessible by Cadaret’s advisors, including Pagartanis. Second, although Plaintiff owed a fiduciary duty to clients with assets in Cadaret accounts, Plaintiff was not responsible for the funds once they were withdrawn from Cadaret’s accounts. In fact, in Plaintiff’s own undisputed words, “[i]t could not have been more clear to [the claimants] that Cadaret had nothing to do with” the clients’ investments in Pagartanis’ scheme. [emphasis added]
The Court also held that the legal liability exclusion applied to exclude the loss, and that the exception to the exclusion did not apply:
… the express language of exclusion section 2(t) excludes coverage for “damages of any type for which the Insured is legally liable, unless the Insured establishes that the act or acts which gave rise to the damages involved conduct which would have caused a covered loss to the Insured in a similar amount in the absence of such damages.” This language reinforces the intention of the Bond that only Plaintiff’s direct losses would be covered by expressly excluding coverage for indirect losses due to legal liability similar to the one at issue here, payment of settlements to third parties in anticipation of potential legal liability. [emphasis added]
Cadaret contended that exclusion 2(t) did not apply because it would have sustained the same loss had it reimbursed clients absent the settlements. The Court rejected this argument, correctly holding that the only type of “legal liability” that fits within the exception is legal liability in respect of circumstances that would already constitute a qualifying first-party loss to the insured, irrespective of the possibility of third-party liability:
Cadaret’s argument that section 2(t)’s exclusion does not bar its claim because it would have sustained the same loss had it reimbursed clients absent the settlements misinterprets the Bond language. The exception to the exclusion concerns conduct that would have caused a covered loss absent legal liability, not whether Cadaret would have paid the same cost if it had reimbursed the clients involved in the scheme absent the threat of legal liability. Plaintiff would need to establish that Pagartanis’ theft of personal client funds constitutes a covered loss under the Bond absent the settlement payment, something it cannot do … As Defendant aptly argues, “[i]n the absence of [third-party] liability . . . [Plaintiff] would not have any loss whatsoever.” [emphasis added]
Conclusion
It is axiomatic that fidelity and crime insurance coverage is first-party in nature and does not respond in respect of an insured’s liability to third parties. The “architecture” of fidelity bonds includes several provisions and elements of coverage which are intended to buttress that principle, including the direct loss requirement; the ownership condition; the legal liability exclusion; the indirect loss exclusion; and others. Cadaret is a good example of a court applying relevant Bond provisions to arrive at the correct result.
Cadaret, Grant & Co. v. Great Am. Ins. Co., 2025 WL 2711405 (E.D.N.Y.)