In a ruling that turned on the interpretation of a technical financial term, a federal district court concluded that the Options Trading exclusion in an investment firm’s E&O policy precluded coverage for investor claims arising out of a financial transaction gone bad. In concluding that the exclusion precluded coverage, the court applied a standard financial industry definition to interpret the meaning of a specific policy term. The court’s opinion makes for interesting reading and provides food for thought about the policy placement process generally and about the process of policy interpretation. District of Utah Judge Dale Kimball’s March 1, 2019 opinion in the case can be found here.

Background

Allegis Investment Services is a broker-dealer investment company and its affiliate Allegis Investment Advisors is a registered investment advisor company (collectively, “Allegis”). In August 2015, Allegis, with full discretionary authority from its clients, executed a “put credit spread” based on the Russell 2000 index, pursuant to a “net credit spread” investment strategy. The trade was highly risky; it had a maximum potential profit of only $313,600, but a maximum potential loss of over $38 million. Allegis’s investor accounts suffered the maximum potential losses from the trade and many investors initiated arbitration against Allegis to recover their losses.

Allegis was insured under a Broker-Dealers and Investment Advisors Errors & Omissions Policy (the “E&O Policy.”) Allegis notified its E&O insurer of the investor claims and sought coverage for the claims under the policy. The insurer initially agreed to defend the claims under a reservation of rights but after further investigation denied coverage for the claims in reliance on the E&O Policy’s Options Trading exclusion. Allegis initiated a coverage lawsuit against the insurer, as well as against the insurance agency that had placed its policy. The parties filed cross-motions for summary judgment.

The Relevant Policy Language

The Options Trading policy exclusion on which the E&O insurer relied to deny coverage states in pertinent part: “This insurance does not apply to any Claim or Defense Expenses: … Arising out of the actual or alleged purchase, sale, attempted sale, solicitation or servicing of any of the following: … Commodities, any type of futures contracts, any type of options contract or derivative. However, this exclusion shall not apply to fully covered put or call options.”

The March 1, 2019 Decision

In a March 1, 2019 Memorandum Decision and Order,  Judge Kimball, applying Utah law, denied Allegis’s motion for summary judgment and granted the E&O insurer’s and the insurance agency’s motions for summary judgment.

In ruling that the Options Trading exclusion operated to preclude coverage, Judge Kimball first noted that courts give “an expansive meaning” to the term “arising out of” in insurance policy exclusions, and that the term is interpreted to be “very broad, general and comprehensive.” Thus, while the aggrieved investors had presented numerous and various claims against Allegis, the policy exclusion nevertheless applied to all of the investor claims; the exclusion, which Judge Kimball said was “plain, unambiguous, and broadly applies” to each of the investors’ claims,  “irrespective of the legal theory of recovery as long as it arises out of options trading.”

Allegis argued that the exclusion did not apply because of the exclusion’s carve-back preserving coverage for “fully covered put or call options.” Allegis argued that the options trades at issue should be considered “fully covered” because there was sufficient cash on hand to cover the trade. The policy itself does not define “fully covered put or call options.” Judge Kimball concluded that that the carve-back did not apply because the trades did not meet FINRA or CBOE definitions of “covered” options trading, which regulatory definitions Judge Kimball concluded applied to the coverage carve-back. Judge Kimball also concluded that Allegis was aware of this industry definition.

In reaching this conclusion, Judge Kimball said:

The exclusion, on its face, is written to preclude coverage for what are recognized as particularly high risk investments. The carve-back provision cannot reasonably be interpreted to permit coverage for a high-risk trade like the one that occurred in this case. The materials provided to the court demonstrate that covered puts or call options are well defined in the options industry. They do not result in the type of permanent losses Allegis’ investors suffered in the present case…. Based on the operative regulation, the court concludes that the August 2015 trade was clearly not a covered put option, let alone fully covered.  Although the Policy does not define a “fully covered” put option, the Policy is not ambiguous because Allegis did not present a reasonable alternative definition of “fully covered.” Accordingly, the court concludes that Allegis is not entitled to coverage under the Policy.

Judge Kimball also granted the insurance agency’s motion for summary judgment as well. His analysis of the agency’s obligations and contractual commitments makes for interesting reading. Anyone interested in insurance agent’s E&O issues will want to read the portion of Judge Kimball’s opinion dealing with the agency’s alleged liability, particularly the weight the Court gave to the disclaimer language in the documents the agency provided to its client.

Discussion

This coverage dispute involved a technical aspect of financial investment transactions and in the end the outcome was the result of the court’s interpretation of applicable financial industry regulations. To that extent, this case might be interpreted as application of highly technical regulatory definition to specific set of circumstances. There are a number of interesting points to consider here, as well.

One particular point to consider is the fact that the policy used but did not define a technical term – “fully covered put or call options.” In deciding the meaning of this term, the court read and interpreted FINRA and CBOE regulations and then applied its reading of the regulations, on summary judgment. In interpreting the policy language in this way, Judge Kimball concluded that the policy language was “unambiguous.” In effect, Judge Kimball concluded that the policy term had the “well defined” meaning used in the options industry.  Allegis was not able to overcome this conclusion because it could not provide the court with a convincing alternative meaning for the term. The interesting thing about this to me is that Judge Kimball relied on an external industry definition to find the meaning of a specific policy term; he didn’t say this as such, but in effect he concluded that the policy implicitly incorporated the options industry definition of a “covered” option contract.

Whether or not readers think it was fair of the court to deny coverage for Allegis based on a technical term that the policy did not define, there are some features of the factual background of this case that could further explain Judge Kimball’s conclusion.

The first is that the trade at issue was highly risky; it seemed important to Judge Kimball that Allegis had risked massive losses for what would have been at best a very slight gain. Judge Kimball effectively concluded that the trade was in fact the very kind of risky trade for which the exclusion was designed to preclude coverage.

The second is that in procuring the policy, Allegis, whom Judge Kimball observed is a sophisticated party, apparently made no affirmative efforts to determine that its trading strategy would be covered under the policy; to the contrary, the individual charged with procuring the insurance for Allegis testified that he had no knowledge of the net credit spread strategy, so he obviously could not have provided the insurance agency procuring the coverage with information about the strategy or the need for coverage. Judge Kimball in effect put the burden on Allegis to make sure that the policy provided the kind of protection that it was going to need.

In the end, Judge Kimball concluded that the coverage carve-back for “fully covered” put options did not apply because Allegis couldn’t come up with an alternative to the standard industry meaning for the term. If nothing else, this case underscores that insurance policies are highly technical agreements that encompass significant complexity and that reside within and must be understood within a larger context.

To be sure, it may never have been an available alternative here for Allegis to have a policy in place that would have covered this claim; Judge Kimball may be right that the trade at issue is the very type of transaction for which the exclusion was intended to preclude coverage. One possibility is that if the exclusion had been written on a “for” basis rather than on a “arising out of basis,” perhaps coverage could have been preserved for at least a portion of the investors’ claim. Of course, it is 20-20 hindsight to say that an alternative wording might have been preferable – and that is without even getting into the question of whether an alternative “for” wording would even have been available.

(Just as an aside, I feel like there is a larger essay that might be written on whether the “arising out of” language is ever appropriate, and whether all exclusions ought to be written on a “for” basis. Someday, perhaps, I will unburden myself with a essay addressed to this issue.)

In any event, for anyone involved in placing insurance transactions, there is a lot of food for thought here, both about the policy placement process and about the incorporation of technical terms into policy language.