Insurer Held Not Liable for Losses Arising from the Insureds’ Alleged Ponzi Scheme Because Coverage Was Precluded By California Insurance Code Section 533

Insurer Held Not Liable for Losses Arising from the Insureds’ Alleged Ponzi Scheme Because Coverage Was Precluded By California Insurance Code Section 533

Dillon v. Continental Casualty Co., 2014 U.S. Dist. LEXIS 41709 (N.D. Cal. Mar. 26, 2014), [enhanced enhanced version available to lexis.com subscribers].

In Dillon, the district court held that Insurance Code Section 533 (“Section 533”) [enhanced version available to lexis.com subscribers] precluded insurance coverage for the insured’s alleged operation of a “Ponzi Scheme” relating to the exchange of real estate.

This insurance coverage dispute arose out of the collapse of an Internal Revenue Code Section 1031 [enhanced version available to lexis.com subscribers] exchange company (“Vesta”), which held funds to shield clients transacting in real estate from capital gain tax liability. Vesta was unable to repay clients due to fraudulent transfers made by the company’s manager and CEO. The CEO and other Vesta-related individuals subsequently pled guilty to wire fraud, money laundering, and conspiracy in connection with the transfers. Thereafter, Dillon, the court appointed receiver for those that had deposited funds in the 1031 exchange, sought coverage as a court-appointed receiver of the insured under four employee dishonesty policies issued by the insurer.

The insurer denied Dillon’s claim and Dillon initiated coverage litigation. The parties thereafter filed cross-motions for summary judgment. The insurer argued that summary judgment should be granted in its favor because Dillon could not recover under the Vesta Policy without violating the public policy against insuring the willful wrongdoing of the insured. The insurer further argued that because the corporate individuals who pled guilty to intentional criminal conduct were Vesta’s sole owners, their fraudulent conduct must be imputed to Vesta.

The Dillon court agreed with the insurer and granted summary judgment in its favor. In so ruling, the district court held that, given the overwhelming evidence that the corporate individuals knowingly operated a Ponzi scheme and engaged in fraudulent behavior, the relevant conduct must be considered willful and therefore uninsurable under Section 533. The court further held that the corporate individuals’ conduct could be imputed to Vesta because they were plainly “acting within the course of their employment and moreover were using the corporation to perpetuate their fraudulent scheme.”

The Dillon court also rejected Dillon’s argument that regardless of whether the conduct of the corporate individuals was attributable to Vesta, Section 533 permitted recovery in this case because the insurance proceeds would be used entirely to compensate the client exchangers – the victims of the wrongdoing – for their losses. While the court agreed with Dillon that the basic purpose of Section 533 is to ensure that insureds do not take advantage of their own wrongful conduct, it explained that Section 533 has been held to apply even where the recovery from the insurance company would be primarily for the benefit of the victim rather than the insured. The Dillon court observed that if it were to permit Dillon to recover from the insurer, it would essentially be permitting corrupt corporate officers to take out criminal liability insurance, willfully violate the law, and then, in the event the wrongdoing is discovered, cover any losses to the victims with the insurance proceeds. The district court found that Section 533 does not permit such a result.

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