Why AIG is not obliged to defend a Ponzi scheme class action

Ontario’s Court of Appeal has confirmed AIG Canada doesn’t have to pay legal costs to defend a class action lawsuit related to an alleged Ponzi scheme involving real estate funds.

That’s because of a material misrepresentation by the insured, the court ruled.

A lower court determined AIG had to pay for the insured’s legal defence because there was no material misrepresentation of the facts. The motions judge came to this conclusion based on an AIG underwriter’s response to a broker’s email, which the court found to be vague and imprecise.

But the insured’s email was not the only indication of a material misrepresentation, regardless of how the underwriter responded to it, the appellate court ruled.

In a 3-0 decision, a panel of Appeal Court judges found the insurer’s retroactive denial of coverage was justified, because the insured never did provide the information AIG required to write the risk. The court awarded AIG the more than $1 million it had already paid out in legal defence costs.

In Davies v. AIG Insurance Company of Canada, released last week, AIG issued D&O policies to the Davies real estate companies. John Davies is the principal.

Davies and his spouse, Judith Davies, “are named defendants in two lawsuits alleging that Mr. Davies and his associates used the Davies Companies (and other corporate vehicles) to operate a Ponzi scheme,” as the Appeal Court decision describes the issue.

“The claims further allege that the Davies Companies’ purported real estate developments were funded by millions of dollars in syndicated mortgages advanced by individual investors and that the Davies (and others) misappropriated those monies.”

These claims have not been proven in court. The Davies deny the allegations.

Initially, AIG paid out defence costs for the class action lawsuit based on the D&O policies they issued to the Davies companies.

Later, they abandoned this coverage position, claiming the insured’s applications for coverage contained a material misrepresentation. Specifically, AIG argued, the insured failed to disclose that syndicated mortgages were the source of financing for the Davies Companies.

At issue was how to interpret a broker’s email, in which the client responded to the underwriter’s questions about financing.

Back in 2015, leading up to issuance of the D&O policies, the Davies companies’ insurance broker sent an email to AIG’s underwriting group. The broker attached the 2013-14 financial statements of the Davies companies.

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AIG’s underwriter observed the financial statements contained companies unfamiliar to the insurer. Plus, they “reflected a significant amount of inter-company loans and almost $40 million in long-term debt to external lenders,” as the Appeal Court noted. “However, the financial statements did not disclose the identity of the external lenders.”

AIG sent a note to the client through the broker with the following queries:

Regarding the inter-company loans, [AIG] were hoping to get an understanding as to who the loan facility is that is providing to the current [Davies] companies.
Please provide the terms of the loans from outside sources.

On May 28, 2015, the broker replied he had spoken with the client the previous day. He summarized the clients’ responses as follows:

Question: “Regarding the inter-company loans, [AIG] were hoping to get an understanding as to who the loan facility is that is providing to the current companies”.

Answer: “Balfor will go shoulder to shoulder for covenants, the remaining loans provided by mezzanine and construction financing. Memorandum of understanding and term sheet from a lender on board. Kingset (sp?) Capital in Toronto. John Love’s company. $500MM funds. All schedule A banks in funds.”

A motions judge described the email as lacking “detail or precision.” He also noted a “complete absence of any mention of syndicated mortgages as the method of financing being used by John Davies in his real estate developments.”

Nevertheless, the motions judge found, although “the absence of syndicated mortgages is troubling,” its wording was “insufficient to conclude a misrepresentation had occurred.”

Furthermore, since the AIG underwriter did not seek clarity around the questions, AIG could not then claim that any misrepresentation was ‘material,’ the motions judge found. AIG “cannot merely rely on its interpretation of what was not clear,” he ruled.

AIG appealed, and the Court for Appeal of Ontario overturned the motion judge’s decision.

“The applications judge’s materiality determination was fatally flawed because he failed to consider the misrepresentation when making that determination,” the Appeal Court ruled. “Instead, he focused on the email and [the AIG underwriter’s] response to it.”

But considered on the whole, AIG’s basic position was consistent throughout, the Appeal Court found. The insurer needed further information about the companies’ financial backing. It could not provide a quote without the information. And the insurer would not have agreed to coverage if it knew the true source of the Davies companies’ financial backing.