October 1, 2013
While passage of the Dodd-Frank financial reform legislation 2010 was supposed curb the opportunities for rogue traders to engage in the type of risky behavior that led to MF Global’s collapse, evidence suggests that high risk trading remains pervasive. A March 2013 Senate Report detailing pervasive managerial failures and regulatory shortcomings surrounding JP Morgan Chase’s $6.2 billion “London Whale” trading loss raises serious questions about whether “Strategically Important Financial Institutions” (SIFIs) are too complex to manage. And Attorney General Eric Holder’s startling admission in testimony before the Senate Judiciary Committee on March 6, 2013 that SIFIs are too big to discipline due to the destabilizing effect criminal prosecutions would have on financial system suggests that the 2010 financial reform legislation has done little to deter the risk taking that led to a world-wide financial crisis in 2008.
Is There A Sufficient Causal between Trading Losses and Employee Dishonesty to Trigger Fidelity Bond Coverage?
A question that has received little attention in the courts is whether banks may have coverage for trading losses under their fidelity bonds. Fidelity bonds protect insureds against “direct financial loss” arising out of the fraudulent or dishonest acts of the insured’s employees. The scope of coverage available under the bond can vary dramatically depending on the meaning ascribed to the term “direct.” Insurers maintain that “direct” losses are limited to those that result immediately from the employee’s conduct, such as embezzlement or theft. They bolster their narrow view of the “direct” requirement by pointing to policy language excluding coverage for “indirect or consequential losses.” Policyholders, by contrast, argue that the term “direct” requires only that an employee’s misconduct proximately causes a loss. Under the broad proximate cause understanding of the term, a policyholder’s vicarious liability to third parties may qualify as a covered loss under a fidelity bond.
The MF Global Debacle
The New York Appellate Division’s recent decision in New Hampshire Insurance Company v. MF Global, Inc., 108 A.D.3d 463, 970 N.Y.S.2d 16 (N.Y.A.D. 2013), clarifies the circumstances under which a fidelity bond covers the insured’s liability to third parties for trading losses. The losses at issue arose when Evan Dooley, a MF Global trader, entered into a large number of unauthorized “sell contracts” on wheat futures that exceeded his available margin credit. These “sell contracts” created an aggregate open position that would be liquidated when corresponding “buy contracts” were executed. If the price of wheat decreased, the trades would be profitable, but if the price increased, a loss would ensue. When the price of wheat rose quickly, Dooley was forced to liquidate his “sell” positions, resulting in a $141 million loss.
As a “Clearing Member” of Chicago Mercantile Exchange (CME), MF Global assumed direct liability for all losses on trades cleared through MF Global accounts. MF Global therefore transferred $141 million to the CME Clearing House to cover the loss, and sought coverage under its fidelity bond for the loss. The insurer denied coverage, and filed an action for declaratory relief to establish that MF Global did not suffer a “direct financial loss” under the terms of bonds.
The Appellate Division affirmed the trial court’s ruling that MF Global sustained a “direct” financial loss as a matter of law. The court explained that a “direct” loss need only be the “proximate” result of an employee’s covered misconduct. In finding no triable issues of fact regarding whether MF Global’s loss was the “direct and proximate result” of the trader’s unauthorized trades, the court noted that the trader’s “trading activity resulted in a near instantaneous shortfall for which MF Global, as a Clearing Member, was automatically and directly responsible.”
Implications of MF Global
The MF Global decision, while a significant victory for policyholders in fidelity bond disputes, does not undermine the insurance industry’s position that fidelity bonds liability to third parties for losses generated by rogue traders. The MF Global court was careful to distinguish Aetna Cas. & Sur. Co. v. Kidder, Peabody & Co., 246 A.D.2d 202, 676 N.Y.S.2d 559 (1998), where the court had addressed whether the fidelity bonds at issue covered litigation settlement payments made by Kidder Peabody to third-party investors who sustained losses as a result of insider trading schemes conducted by a Kidder Peabody employee. In finding no direct relationship between the employee’s trades and the settlement payments, the Kidder, Peabody court emphasized that the payments did not follow immediately after the trades. “Instead, the losses stemmed from the employee’s misconduct, which caused pricing irregularities in the stock, which led to losses to the investors, which led to litigation, which concluded in a settlement years after the employee’s misconduct.” In MF Global, by contrast, “the effect of Dooley’s actions was immediate and direct—MF Global bore the responsibility for the losses occurring on its trading system, and made good on those losses within hours of the misconduct.”