Coverage for "Intentional" Securities Fraud

June 10, 2002

Northern California ABTL REPORT, Summer 2002
by Mary McCutcheon

An initial review of California Amplifier, Inc. v. RLI Insurance Company, 94 Cal. App. 4th 102 (2001) (rev. den. 2/13/02) ("Cal Amp") sends a chill down the spine of anyone with an interest in obtaining insurance funds for securities class actions. Fortunately, a second read shows that the case does not eliminate coverage for securities class action claims, as long as they are brought under federal law. And, in view of the enactment of the Securities Litigation Uniform Standards Act of 1998 (SLUSA), which preempts most securities class actions filed in state court, the decision may have limited impact on securities coverage matters. Nevertheless, it remains relevant to a variety of other insurance coverage disputes.

In Cal Amp, the insured sought coverage for the settlement of a class action alleging violations of California Corporations Code Section 25400(d), which proscribes the making of "false or misleading" statements which the seller knew or "had reasonable ground to believe" was false or misleading, for the purpose of inducing the sale or purchase of a security. The insurer, RLI, claimed that coverage was precluded by California Insurance Code Section 533, which provides that an insurance company cannot provide coverage for a "willful act", i.e., an act which is "inherently harmful" or committed with an "intent to harm". J.C. Penney Casualty Ins. Co. v. M. K. 52 Cal. 3d 1009, 1020 (1991). Section 533 does not, however, forbid coverage for negligence, gross negligence or even recklessness. Id.

The Cal Amp court construed Section 25400(d) as imposing liability only when a defendant "knowingly and intentionally" made a false or misleading statement. Therefore, according to the court, coverage for California securities law is precluded by Insurance Section 533 as a matter of law. Id. at 107.

The Cal Amp court acknowledged that the required level of culpability for violation of one element of Section 25400(d), whether the defendant knew or "had reasonable ground to believe" that the statement was false or misleading, is "recklessness." The court described "recklessness" as a "'conscious choice of a course of action … with knowledge of the serious danger to others involved in it.'" Id. at 109-110 (citing Delaney v. Baker 20 Cal. 4th 23, 31-32 (1999)). The court also found, however, that liability can only be imposed where the statement is made "for the purpose of inducing the purchase or sale" of a security. So, the court found, while recklessness satisfies one element of the statute, deliberate intent is required to satisfy the second element. Id. at 110.

In reaching this decision, the court relied on the language of Section 25500, which imposes liability on "any person who willfully participates in any act or transaction in violation of Section 25400." The court decided that this limitation was meant to emphasize the "high level of scienter" required for a violation, i.e., "more than recklessness." Id.

Cal Amp stated that the intent to manipulate the market is an "inherently harmful act", in effect adding another category of conduct categorically uninsured by Section 533. Id. While this is potentially a troubling statement, the opinion does not expand the scope of conduct proscribed by Insurance Code Section 533, so much as define the level of intent required for violations of state securities laws. Indeed, the court acknowledged that securities actions brought under federal law (e.g., Rule 10b-5) are not necessarily precluded from coverage by 533. Id. at 117.

The class action underlying Cal Amp was brought at a time when plaintiffs evaded the strict pleading requirements of the PSLRA by bringing actions in state court. Because SLUSA preempts most state law securities class actions, the principal holding of Cal Amp applies only to those cases that are the exceptions to SLUSA. Nevertheless, for those cases, the results are draconian - there is no coverage.

Cal Amp does, however, address issues of relevance to other insurance disputes. As discussed above, it reaffirmed the fact that reckless conduct is insurable under Section 533. Id. at 117. It also addressed the issue of judicial estoppel in the context of insurance coverage. The underlying action had settled, so there was no determination as to the actual state of mind of the insureds. In a summary judgment motion in that action, the insureds unsuccessfully argued that liability under state securities laws requires a knowingly false statement. When they asserted the contrary position in the coverage action, the insurer cried judicial estoppel. The trial court declined to apply the doctrine because the inconsistent position "involved a legal rather than factual issue", and because the initial position taken in the class action was unsuccessful. The Court of Appeal affirmed, describing the contradictory arguments as "a reasonable litigation tactic." Id. at 118. Thus, an insured may aggressively defend the underlying liability action without fear that a legal position taken to minimize liability will result in a finding of no coverage.

While the Cal Amp decision may be a footnote to the history of the PSLRA and SLUSA, it provides guidance to insureds seeking to preserve coverage in all types of insurance disputes.