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Cooper Industries, Ltd. v. National Union Fire Insurance Co.

United States Court of Appeals, Fifth Circuit

November 20, 2017


         Appeals from the United States District Court for the Southern District of Texas

          Before STEWART, Chief Judge, and KING and JONES, Circuit Judges.

          KING, Circuit Judge:

         Cooper Industries, Ltd., invested its pension-plan assets in what turned out to be a Ponzi scheme. It submitted a claim under a commercial-crime insurance policy underwritten by National Union Fire Insurance Company. National Union denied the claim, and Cooper sued. Both parties eventually moved for summary judgment. The district court subsequently entered a take-nothing judgment against Cooper. The court held that Cooper could not recover under its policy with National Union because the claimed loss occurred only after Cooper loaned its funds to the fraudsters, at which point Cooper did not own either the earnings or the principal, as required under the policy. Cooper appealed, and National Union cross-appealed. We now AFFIRM the judgment of the district court.



         In the late 1970s, Paul Greenwood and Stephen Walsh decided to go into business together and formed an investment company. One of their company's investments was in Westridge Capital Management, Inc. ("WCM"), a Delaware corporation. One of Walsh's former clients convinced Greenwood and Walsh to lend him money to start WCM in 1983. The former client owned 49 percent of WCM, and Greenwood and Walsh owned the remainder. The former client ran WCM from Santa Barbara, California, and began operating as a registered investment advisor in 1996. Greenwood and Walsh served as directors of WCM from their New York offices until they resigned from the WCM board in January 2000.

         Greenwood and Walsh shuttered their first investment company in 1990 and formed WG Trading Company, L.P. ("WGTC"), a Delaware limited partnership. WGTC was a registered broker-dealer under the Securities Exchange Act of 1934 and a commodity pool under the Commodity Futures Trading Commission ("CFTC") regulations. Shortly after founding WGTC, Greenwood and Walsh established WG Trading Investors, L.P. ("WGTI"), [1]another Delaware limited partnership, as a conduit for investment in WGTC. WGTI was unregulated. Greenwood and Walsh intended to use these two entities to pursue equity index arbitrage, a strategy (as described in Greenwood's deposition[2]) we explain below.

         WCM and WGTC began a joint venture in 1995 to market an "enhanced equity index strategy." Greenwood and Walsh claimed that their strategy could offer higher returns than the indexes alone without a corresponding increase in risk. The strategy had an "alpha" portion and a "beta" portion. The beta portion was a small percentage of each investor's portfolio that WCM would invest in stock or bond index futures. WGTC then used the remaining funds for equity index arbitrage, which was the alpha portion of the investment strategy. WGTC would buy all of the stocks in an index (like the S&P 500) and sell futures against those stocks. This made sense as a trading opportunity when the price of the futures exceeded the price of the index.[3] The prices of the two assets must, by definition, converge at the expiration of the futures contract. By going short on (i.e., selling) the futures and long on (i.e., buying) the index, WGTC could (at least as Greenwood described the strategy) capture not only capital appreciation and dividends from the underlying stocks, but also the premium on the futures. WGTC used computers to monitor indexes for arbitrage opportunities. Greenwood called WGTC's strategy "a perfect hedge." Any increase in the price of the futures would theoretically be offset by a one-to-one increase in the value of the stocks. The strategy supposedly mimicked the rate of return on the index while providing extra income from the arbitrage.

         Investors could invest in the alpha portion in one of two ways. First, they could buy into WGTC's limited partnership, which would invest the partnership funds and distribute any profits back to the limited partners. Second, they could loan funds to WGTI (itself a limited partner in WGTC) in exchange for a promissory note. WGTI would invest the funds and use any profits to make payments on the notes. WGTI set the interest rate on the notes equal to the investment returns of WGTC. Whereas a limited partner in WGTC could potentially lose money if WGTC lost money, a holder of a promissory note from WGTI would simply receive no interest.


         Cooper Industries, Ltd. (together with Cooper US, Inc., "Cooper"), [4] was a publicly-traded electrical-equipment supplier.[5] Cooper provided its employees with a pension plan, which was managed by Cooper's Pension Investment Committee (the "Committee"). The Committee had divided the plan assets into two funds: a bond fund and an equity fund. In 2002, the Westridge Entities presented a pitch to the Committee. Two years later, the Committee contracted with WCM to invest some of the equity- and bond-fund assets.

         The contracts provided that WCM would be a fiduciary of the pension plans under the Employee Retirement Income Security Act of 1974 ("ERISA"). Pub. L. No. 93-406, 88 Stat. 829 (codified as amended in scattered sections of 26 and 29 U.S.C.). The Committee also entered into a side agreement with the Westridge Entities. WCM was to invest 15 percent of the equity-fund assets in S&P 500 futures through a JP Morgan trust account and the remaining 85 percent in a promissory note from WGTI. For the bond fund, WCM was to invest 5 percent of the assets in U.S. Treasury Bond futures through a different JP Morgan trust account and the remainder in another promissory note from WGTI.

         Cooper ultimately invested more than $140 million of its equity-fund assets and $35 million of its bond-fund assets through the Westridge Entities. Cooper redeemed its equity-fund investments in May 2008. It recovered its roughly $140 million in principal, as well as about $42 million in gains. Of those gains, about $20.3 million came from the beta portion of the portfolio- i.e., the S&P 500 futures purchased with funds from the trust account. The remaining $21.8 million came from the alpha portion-i.e., WGTC's equity index arbitrage. Cooper did not redeem its $35-million bond-fund investment.


         The stellar returns were illusory: Greenwood and Walsh were running a Ponzi scheme. The National Futures Association ("NFA") discovered the fraud during a February 2009 audit and suspended their membership. Later that month, the CFTC and the Securities and Exchange Commission ("SEC") filed an enforcement action in the U.S. District Court for the Southern District of New York. The court appointed a receiver to collect and liquidate any assets, and to determine how to distribute the assets among the victims.

         The receiver found that WGTC and WGTI operated as a single entity with elements of a classic Ponzi scheme. The entities commingled funds and used fraudulent accounting practices to conceal their true financial condition from investors and regulators. They were financially inseparable; neither entity could have survived without financial support from the other. At the same time, WGTC and WGTI had generated substantial legitimate earnings through equity index arbitrage. From 1996 to 2008, WGTC and WGTI generated about $330.6 million of actual net earnings. But Greenwood and Walsh had promised investors much more. They had reported earnings of about $981.7 million-$651 million more than they had actually earned.[6]

         According to the receiver's report, in addition to reporting fictitious returns, Greenwood and Walsh also stole over $130 million from WGTI. They used that money to fund extravagant lifestyles. Greenwood, for instance, spent over $3 million on a collection of 1, 348 teddy bears[7] and $32 million on a hunter pony[8] farm. The thefts only exacerbated the discrepancy between actual and reported returns by reducing the amount of money available for arbitrage. Greenwood and Walsh's fraud depended on a steady inflow of new money. If an investor wanted to withdraw funds, they would have to use other investors' principal and earnings in order to cover the shortfalls they created through misrepresentations and theft. In order to maintain a steady inflow of investors, Greenwood and Walsh lied to prospective investors, including Cooper, about WGTC's returns. Greenwood and Walsh ultimately pleaded guilty to securities fraud, commodities fraud, wire fraud, money laundering, and conspiracy.

         After completing his investigation, the receiver submitted an initial distribution plan to the court. He proposed returning about 85 percent of each investor's net investment (i.e., contributions minus withdrawals) for a total first-round distribution of $815 million. These distributions excluded earnings and interest. In fact, the plan proposed clawing back any earnings that Greenwood and Walsh had paid to investors. The district court approved that plan on March 21, 2011.[9]

         By that point, Cooper had already received $140.1 million in principal from its equity-fund investment, as well $20.3 million in earnings from the beta portion of its portfolio (the index futures) and $21.8 million from the alpha portion of its portfolio (the arbitrage). As for the bond-fund investment, the court determined that Cooper's first pro rata distribution would be $29.9 million. However, the court allowed the receiver to withhold $21.8 million- the purported earnings Cooper actually received from the alpha portion of its equity-fund investment-and directed him to file a claw-back action for that amount. The receiver did so, and he eventually settled with Cooper, returning $9.8 million of what he withheld. Cooper has since received an additional $4.2 million in distributions. Although Cooper has revised its claim of loss several times, it now claims to have lost about $17.2 million, with $8.7 million of that loss attributable to the bond fund and $8.5 million attributable to the equity fund.[10] To date, Cooper has recovered all of the equity-fund principal and all but about $1.1 million of the bond-fund principal. In National Union's view, however, Cooper is a net winner because it still received more than it invested in the Westridge Entities.


         Cooper bought annual commercial-crime insurance policies (also known as fidelity bonds) from National Union Fire Insurance Company of Pittsburgh ("National Union") that provided coverage from October 1, 2003, until October 1, 2012. The policy relevant to this dispute began on October 1, 2008 (the "Policy"). As relevant here, it covered Cooper's employee-benefit plans (as additional insureds) against various types of employee misconduct, including theft and fraud:

We will pay for loss of or damage to "funds"[11] and "other property"[12] resulting directly from fraudulent or dishonest acts committed by an "employee", whether identified or not, acting alone or in collusion with other persons.

         The Policy's definition of "employee" was broadened in two separate endorsements to ultimately include "[a]ll U.S., U.K. and Canadian Fiduciaries, " as well as "[a] trustee, administrator, employee or manager, including any outside administrator or manager who is an independent contractor, of any Employee Welfare or Pension Benefit ...

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