The depreciating investment vs the “hopeless” investment: Which one is covered?

The inclusion of the “Depreciation” clause in a professional liability policy for brokers and financial advisors has become all but standard, which clause essentially stipulates that an insurer is not liable to indemnify the insured for any loss arising from the depreciation in value of any investments made on the advice of the insured broker or advisor.

THE DEPRECIATING INVESTMENT VS THE “HOPELESS” INVESTMENT: WHICH ONE IS COVERED?

 

The inclusion of the “Depreciation” clause in a professional liability policy for brokers and financial advisors has become all but standard, which clause essentially stipulates that an insurer is not liable to indemnify the insured for any loss arising from the depreciation in value of any investments made on the advice of the insured broker or advisor. Although there is still come uncertainty as to what the correct interpretation of this clause is, the Bloemfontein High Court, in the case of Oosthuizen v Castro (2017) 4 All SA 876 (FB), has given us some clues.

The Oosthuizen v Castro case is about a widow (Oosthuizen) who sustained a loss after investing a large sum of money on the advice of a financial advisor (Castro). The investment turned out to be a lamentably bad investment, and the financial advisor was sued for the widow’s losses. The financial advisor, in turn, had a professional indemnity policy in place with Centriq Insurance Company. His claim for indemnity was repudiated on, inter alia, the basis that the loss fell within the scope of the deprecation exclusion clause, which provided as follows :

“The Insurers shall not indemnify the Insured in respect of…any third party claim arising from or contributed by depreciation (or failure to appreciate) in value of any investment.”

Judge Daffue of the Bloemfontein High Court found the financial advisor to have breached his professional duties owed to the widow. The advisor informed the widow, prior to making the investment, that it was “extremely safe” in circumstances where it was plainly not, and it turned out that he had not done proper research in respect of the investment and in fact did not fully understand it. The Court found the advisor to have been negligent and dishonest, and stated that he “failed to exercise the degree of skill, care and diligence which one is entitled to expect from a FSP.”

Centriq was joined to the litigation as a Third Party by the financial advisor, who took the view that he was entitled to an indemnity from the insurer in respect of the claim made against him by the widow. The Court was called upon to interpret the meaning of the depreciation clause quoted above, and in particular, whether the losses sustained by the widow following the investment made arose out of a “depreciation in value” of the investment.

The Court, in making a finding that the exclusion does not apply, stated the following in paragraph 75 of the Judgment :

“In my view the exclusion clause must be interpreted restrictively so that it makes business sense, i.e. in the eyes of both insurer and insured.  It cannot be applicable where the insured advised a client to invest in a scheme that was a hopeless “investment” from the onset, contrary to legislation and probably a fraudulent and unlawful Ponzi scheme.  The purpose of the first leg of the exclusion is to prevent an insured from claiming indemnification if his client has filed a claim because his/her investment had not grown by, for example 20% over a three year period as expected, but only by 15%, or remained static, or worse, depreciated by 5 or 10%.  We all know that financial markets are volatile, that several unforeseen market forces may affect investments and therefore, it would be “businesslike” for the insurer to exclude indemnification in such events."

When referring to this particular investment, the Court concluded the following :

"It is not a case of depreciation of an investment as the “investment” was worthless from beginning to end.”

It is important to note that, from the various methods of interpretation, the Court in this case elected to apply the “business sense” interpretation insofar as the clause is concerned, as opposed to applying the method of considering the ordinary grammatical meaning of the words.  Although the investment was a bad one, it was an investment nonetheless, which became worthless after depreciating swiftly. Accordingly, all the elements required for the exclusion clause to operate were, on the face of it, present.  Judge Daffue, however, chose to interpret the clause from a business sense, and held that the clause does not apply to “hopeless” or “worthless” investments.

The Judgment creates uncertainty over what exactly constitutes a “hopeless” or “worthless” investment. This would probably depend on the facts of each case, but it is clear that the door for this argument to be raised by insured parties going forward has been left wide open.

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