by Christopher Graham and Joseph Kelly

The factoring business: You’re an industrial bank. Your business is buying accounts receivable. You buy them at a discount. You expect customers to collect them and turn over the full proceeds or make up the difference. You profit by being paid the full face amount of those discounted receivables. Customers benefit by receiving immediate cash. They also grant you a security interest in their assets to secure repayment. This way of financing business operations is “factoring.”

You have a factoring agreement with a trucking company. You agree to purchase all of company’s receivables. Your agreement is an Accounts Receivable Purchase and Security Agreement.

Purchases are on a rolling basis. Company reports sales periodically. You pay company, discounting the receivable amounts. Company guarantees payment, securing its guarantee with collateral including a large reserve account and all other assets. It grants you a security interest in those assets. And as required under the agreement, it provides electronic account statements on a rolling basis showing its obligation. Those statements naturally are sent electronically. Company hits send on its computer directing electronic transmission to your computer. You start your computer, and there it is! The wonders of the internet. No mail. No hard copy transmittal.

The factoring fraud: One day someone at company wants even more cash. But there’s a problem. Company is not generating enough sales to get the desired the cash. So someone electronically inflates receivables in the electronic account statements to whatever is needed to get that cash. It’s amazing what you can do with a few strategic key strokes and devilish ingenuity.

Company electronically transmits inflated electronic account statements; you provide the cash. Happy days are here again! This occurs repeatedly. And before you know it, we’re talking real money. When the scheme is discovered, there’s nowhere near enough receivables or other assets to repay you. Your loss is over $11.5 million!

The financial institution bond claim and suit: What to do? Didn’t we buy a financial institution bond? Sure did. Isn’t it different from the standard Form 24 Surety Association of America bond? Sure is. Isn’t it broader coverage for altered and forged, counterfeit, and lost and stolen documents of a type described in the bond’s insuring agreement E, Securities coverage? You think so. Let’s make a claim. And so you do. But insurer says pound sand. So you sue. And once again a court must decide a fascinating issue of insurance contract law.

Decision in a nutshell: Who wins? The insured bank, says the court in Transportation Alliance Bank, Inc. v. Bancinsure, Inc.*, Case No. 1:11CV148-DAK-EJF (D. Utah Feb. 21, 2014).

Why? Per this court, the undisputed material facts show bank suffered a loss within insuring agreement E, of this bond’s “broader”-than-Form-24 Securities coverage. This was a “Loss resulting directly from the Insured [bank] having, in good faith, for its own account or for the account of others,

(1) acquired, sold or delivered, given value, extended credit or assumed liability on the faith of any original . . .

(e) Evidence of Debt, . . . [and] (g) Security Agreement, . . . which (ii) is altered . . . .”

“Loss resulting directly”: How was this “Loss resulting directly” from those covered acts concerning an alteration of those covered documents? According to the court:

[Bank’s] loss from [trucking company’s] factoring fraud was the amount it over-advanced to [company] based on the fraudulent alteration of the amount of the various accounts receivable. [Bank’s] loss resulted directly from [its] having made the over-advances. [Bank] made the over-advances because and only because [company] fraudulently altered its accounts receivable. If [company] had not made the alterations, [bank] would not have over-advanced and would not have suffered the losses. This interpretation and explanation of the phrase “resulting directly from” is reasonable and follows from the ordinary meaning of the words, as the phrase is not a defined term in the Bond.

Original Evidence of Debt: But how were the over-advances extended “on the faith of any original . . . Evidence of Debt”? Per the court, the bank over-advanced on the faith of a combination of the A/R Purchase and Security Agreement and electronic account statements. That combination qualified as an “original” Evidence of Debt. Under the bond, “Evidence of Debt means an instrument . . . executed by a customer of the Insured [bank] and held by the Insured [bank] which in the regular course of business is treated as evidencing the customer’s debt to the Insured.” As the court explained, the electronic account statements are “instruments” “executed by a customer of the Insured,” namely, the trucking company customer; “held by [the] Insured” bank; and “in the regular course of business . . . treated as evidencing the customer’s debt to the Insured [bank].”

Instruments: If not hard copy, how did the account statements qualify as “instruments” as required for an Evidence of Debt? As the court explained: “The electronic account statements qualify as “instruments” for the same reasons they qualify as originals . . . .”

“Originals”: Regarding why they qualify as “originals” (and thus instruments):

[I]n the absence of a definition to the contrary [(there was no definition)], electronic transmissions are a way of life and are just as original as a printed, hard copy document that contains the same information. Indeed, by omitting Form 24 defined terms like “Original” and “Written,” [insurer] allowed for coverage based on electronic information, alterations, and transmissions. The electronic account statements [company] fraudulently altered and then transmitted to [bank] under the terms of the A/R Purchase and Security Agreement (itself a hard copy document) are reasonably considered to be originals for purposes of determining coverage under the Bond.

The court also cited a dictionary definition of original as its “plain meaning”: “Dictionaries define ‘original’ as ‘not secondary, derivative, or imitative,” or “being the first instance or source from which a copy, reproduction, or translation can be made.'” It also stated: “The ordinary meaning of the term ‘original’ includes electronic originals—particularly in today’s banking world where most people do most or all of their banking online, and electronic copies are widely considered originals.”

Regarding the definition of “Original” in Form 24, the court stated:

Form 24, unlike the Bond in this case, does define the term “Original” (with a capital O) in section 1(q) of the Conditions and Limitations of F&SA: “Original means the first rendering or archetype and does not include photocopies or electronic transmissions even if received and printed.” Had [insurer] included this definition of “Original” in the Bond, the electronic account statements that [bank] received would not be considered “originals.” The omission of the F&SA Form 24 definition of “original” in this Bond, which would have excluded electronic documents if applied, must be assumed to be deliberate. The Form 24 defined term and requirement that the documents be “Written” also was omitted from the Bond.

In concluding electronic statements were originals, the court also noted decisions “recognize[ing] that electronic documents cannot be distinguished from hard copies” and Utah’s Uniform Electronic Transactions Act (“UETA”), applicable to “‘transactions between parties each of which has agreed to conduct transactions by electronic means,’ with the parties’ intent to be determined by ‘the context and surrounding circumstances.'” Regarding the UETA, the court explained:

[Company] and [bank] intended to transact through electronic means when [company] gave [bank] access to its computer system. UETA therefore provides that “[a] record . . . may not be denied legal effect or enforceability solely because it is in electronic form.” . . . UETA also authoritatively states that an electronic document is equivalent to an original document for retention and presentation purposes. . . . Not only does UETA demonstrate that the banking world widely recognizes the reality and enforceability of electronic transmissions, but in the last decade several other federal acts have granted legal validity to electronic documents.

“Executed”: But then if not signed, how did those account statement “instruments” qualify as “executed” as also required for an Evidence of Debt? According to the court:

They were executed in the only way electronic data can be executed—electronic transmission at the command of the sender, [trucking company], which was a customer of [bank], the Insured. [Bank] treated the electronic account statements, and in particular the fraudulently altered amounts, as evidencing [company’s] debt to [bank].

Further:

[T]he Evidence of Debt definition requires that the instrument be “executed,” not that it be signed. “Execution” is a broader concept than “signed.” “As Black’s Law Dictionary indicates, there is more than one meaning for the term `execute.'” . . . Again, an electronic transmission is executed or done or performed when the sender transmits or “gives” the electronic document by hitting the send button and directing it to the intended recipient.

Alterations: But the A/R and Security Agreement wasn’t altered. So how was the Evidence of Debt, the combination of the A/R and Security Agreement and account statements “altered”? Well, as the court explained:

While the term “alter” is not defined by the Bond, the electronic change that [company] made reasonably constitutes an alteration under the ordinary meaning of the term. . . . The alteration occurred by simple key strokes in which [company] overwrote the correct account receivable data with false data, which it sent to [bank]. Indeed, electronically altering an amount such as $1,000 by placing a 2 in front of the 1 to make it $21,000 is no different substantively from taking a pen and writing in a 2 on a hard copy document. See, e.g., Metro Fed. Credit Union v. Fed. Ins. Co., 607 F. Supp. 2d 870, 881 (N. D. Ill. 2009). The alterations occurred in the only way an electronic alteration could occur — by using key strokes to overwrite or change the account data.

Original Security Agreement: How were over-advances extended “on the faith of any original . . . Security Agreement” that was “altered”? Per the court, the bank over-advanced on the faith of a combination of the A/R Purchase and Security Agreement and altered electronic account statements. The reasons why the court considered the statements “altered” and “original” are stated above. As for why the court considered the combination of the A/R Purchase and Security Agreement and altered statements a “Security Agreement” as defined under the bond:

Under the Bond, “Security Agreement means an agreement which creates an interest in personal property or fixtures and which secures payment or performance of an obligation.” . . . [Company’s] debt to [bank] was repayment of the full amount of the stated receivable either by collection, application of the reserve, or otherwise. The chief security for [company’s] repayment obligation was the reserve account, as set forth in the A/R Purchase and Security Agreement, but the Security Agreement also included [company’s] various other assets. Therefore, the A/R Purchase and Security Agreement created an interest for [bank] in that reserve account, which secured [company’s] payment or performance of an obligation. This satisfies the definition of Security Agreement.

“Actual physical possession”: But isn’t coverage under insuring agreement E also conditioned upon the insured bank or authorized representative having actual physical possession of an altered original Evidence of Debt or Security Agreement? Sure is. But this court found that “condition precedent” satisfied as well. It was undisputed that bank physically possessed the signed original security agreement. As for the electronic account statements, the court explained:

The court finds that [bank] had actual physical possession of both the Evidence of Debt and the Security Agreement in the form of electronic data. There is no difference between possessing a hard copy of an Evidence of Debt or Security Agreement and possessing the same data in its original electronic form on a secure server, to be viewed on a computer screen, and which was transmitted electronically instead of through the mail.

Tags: Financial Institution Bond, Insuring Agreement E, Securities, Evidence of Debt, Security Agreement, direct loss, causation, “Loss resulting directly from,” original, actual physical possession, electronic account statement, factoring, Form 24, Surety Association

by Christopher Graham and Joseph Kelly

Your company sells financial institution bonds and commercial crime policies. You sell standard industry forms or policies based on them. So your customers must commence legal proceedings against your company within two years of “discovery” of loss. Or your customers must sue your company within two years of a final judgment or settlement from certain legal proceedings brought to determine their liabilities for loss, claim, or damage which, if established, would constitute collectible loss under the bond or policy. You thereby shortened the limitations period for claims against your company. Or at least you have unless a statute or other controlling law prohibits you from doing so. Standard forms explicitly address contrary controlling law by automatically amending the contract to comply with that law.

Due to uncertainty about whether a South Dakota statute prohibits a bond’s standard-shortened contractual limitations period, a Federal District Court recently certified the following question to the South Dakota Supreme Court: “SCDL 53-9-6 prohibits parties from contractually limiting the statute of limitations except in the case of a ‘surety contract.’ Is the Policy a ‘surety contract?'” First Dakota National Bank v. Bancinsure, Inc., Case No. CIV 12-4061-KES (D. S.D. Dec. 31, 2013).

If the court concludes the bond isn’t a surety contract, the six-year South Dakota limitations period for breach of contract claims will apply to the insured’s suit and for all breach of contract suits against financial institution bond insurers in this state, notwithstanding a shorter limitations period in the bond. Similar issues may exist in other states. Stay tuned to this blog for the decision, especially if you do business in this state.

Tags: Financial institution bond, commercial crime policy. Notice/Proof–Legal proceedings against underwriter, contractual limitations period, surety

by Christopher Graham and Joseph Kelly

Remember 2003, 2004, 2005, and even part of 2006. Easy money from real estate investing. Prices always rise. It will never end. Use leverage. You’ll make a ton of money.

You gotta love it! And two brothers can’t get enough. So they scheme to use the same properties again and again to secure multiple bank loans. And they dupe their bankers.

One brother is a lawyer. How convenient! The brothers set up multiple companies to borrow. Brother lawyer issues title certificates showing properties with clean title. As far as the bankers know, no other bank has a lien. The properties look sufficient to secure the loans! For the brothers, there are no worries. Property values will rise. They’ll be worth more than enough to pay all loans. Money, money, money! Greed is good! The bankers never will know the difference.

But then the market collapses. The brothers present more “lien-free” properties to more banks for more loans. They need money to pay-off and keep current old loans. Round and round we go, where the Ponzi scheme stops nobody knows! But it does stop. And when it does, there’s over $80 million in loans from almost 50 banks to nearly 30 shell companies and over $20 million in losses. And the brothers wind up in a Federal pen. Yikes!

One bank provides non-lawyer brother a line of credit, just over $100,000. It’s secured by a first lien on real estate, so the bank thought. Brother lawyer provides a title certificate saying so. But the property is security for two prior loans from two other banks. Borrowing brother defaults. He has no money. His brother doesn’t either. And after considering the two prior liens, the property is no repayment source.

So someone at the bank says, “Don’t we have insurance?” And someone thinks, “Oh, yeah. There’s this thing called a financial institution bond. The scheming lawyer, he gave us a title certificate; we relied on it to make the loan; it showed clean title when there really were two prior bank liens. Let’s ask them to pay.” And so they do. But the insurer has other ideas. So the bank sues.

Who wins? Insurer based on the undisputed facts and as a matter of law, says the court in Copiah Bank, N.A. v. Federal Ins. Co., et al Case No. 3:12-cv-27-FKB (S.D. Miss. Jan. 15, 2014).

Why?

Well says the court, the bond’s employee dishonesty coverage doesn’t apply, despite what bank says. Bank argued it had “Loss resulting directly from dishonest acts of any Employee, committed alone or in collusion with others, except with a director or trustee of the [bank] who is not an Employee, which arise totally or partially from: . . . (2) any Loan . . . .” It also argued “loss was directly caused by dishonest acts of [an] Employee which result[ed] in improper personal financial gain to such Employee and which were committed with the intent to cause [bank] to sustain such loss.” Bank argued brother lawyer qualified as an Employee because he supposedly was “an attorney retained by the [bank] . . . while . . . performing legal services for the [bank].”

That the undisputed material facts showed brother attorney wasn’t bank’s “Employee” was enough to grant insurer a summary judgment: “the only legal service provided by [brother attorney] in relation to the subject loan and the only source of ‘Dishonesty’ on which the Bank bases its claim is [brother attorney’s] April 2, 2009 title certificate, and the Bank has presented no evidence that it ever asked [brother attorney] to prepare that title certificate.”

Bank officer’s deposition testimony explaining how brother attorney was retained by bank while performing legal services for bank didn’t raise a fact issue requiring trial. As the court explained: “Although [bank officer] testified that, after he received the title certificate, he asked [brother attorney] to file the deed of trust and prepare another title certificate and that he considered this to constitute a ‘verbal agreement’ between [attorney] and the Bank, such an agreement would, at most, be an agreement that [attorney] provide those services.” “But, it is the April 2, 2009 title certificate, not the non-existent title certificate [bank officer] requested, that is the ‘dishonest act’ on which the Bank’s claim under the bond is based.”

Insurer relied on Moultrie National Bank v. Travelers Indemnity Co., 275 F.2d 903 (5th Cir. 1960), where the court held “as matter of law” that “a construction of the bond which would . . . bring [the attorney who issued the title certificate] within the definition of `an attorney retained by the bank’ is supported by neither reason nor authority. . .”

Bank relied on Federal Insurance Company v. United Community Banks, Inc., 2010 WL 3842359 (N.D. Ga. Sept. 27, 2010), where a court distinguished Moultrie and found an attorney was an “Employee” under a similar bond issued by the same insurer.

Moultrie was more like this case; the Georgia case didn’t apply. Unlike attorney in the Georgia case, brother attorney didn’t prepare or approve a settlement statement, serve as trustee on bank’s deed of trust, receive or disburse loan proceeds, or have closing documents for the loan. He also didn’t perform any closing for the loan. Bank in its notice to insurer, moreover, referred to him as “attorney” and/or “representative” for the other fraudster brother, not for bank.

The court also rejected bank’s argument that the bond’s “On Premises” coverage applied. Bank argued it had a “Loss of Property resulting directly from: . . . false pretenses, or common law or statutory larceny, committed by a natural person while on the premises of the [bank], while the Property is lodged or deposited at premises located anywhere.” But for this coverage, there was an exclusion for “loss resulting from the complete or partial non-payment of or default on any Loan whether such Loan was procured in good faith or through trick, artifice, fraud or false pretenses . . . .” Loan meant “all extensions of credit by [bank] and all transactions creating a creditor or lesser relationship in favor of [bank], including all purchase and repurchase agreements, and all transactions by which [bank] assumes an existing creditor or lessor relationship.” The line of credit thus was a “Loan,” notwithstanding bank’s contrary argument.

And the court rejected bank’s argument that the bond’s “Extended Forgery” coverage applied. Bank argued this was “Loss resulting directly from [bank] having, in good faith, for its own account or the account of others .. . extended credit . . . in reliance on . . . [a (3) “Certificate of Origin or Title”] which is a Counterfeit Original.” (bracketed material in original). But “Certificate of Origin or Title” meant a “document issued by a manufacturer of personal property or a governmental agency evidencing the ownership of the personal property and by which ownership is transferred.” Emphasis added). And “Counterfeit Original” meant “an imitation of an actual valid original which is intended to deceive and be taken as the original.” So “Certificate of Origin or Title” didn’t include real property. And bank failed to present evidence or argument showing the real property certificate of title was a “Counterfeit Original.”

Fidelity insurers decided years ago they didn’t wish to insure the risk of loss from loans involving borrower fraud. Financial institutions are in the business of underwriting loans and thus best positioned to manage their lending risks. Premiums for a broad loan loss insurance product would be prohibitive. The industry instead generally provides limited loan loss coverage. Standard form bonds include a loan loss exclusion, with exceptions for certain Employee Dishonesty, Forgery or Alteration, and Securities as detailed in insuring agreements A, D, and E. For the limited loan loss coverage under financial institution bonds, there have been numerous disputes about risks within the scope. And over the years the insurance and banking industry have modified the coverage periodically to further define the insured risk. We can expect suits and modifications to continue.

Tags: Mississippi, financial institution bond, employee dishonesty, on premises, extended forgery, loan loss exclusion, Employee

by Christopher Graham and Joseph Kelly

You’re the D&O, professional liability, or other insurer with a duty-to-defend policy. Your insured is sued in tort. You defend under a reservation of rights. But you don’t believe there’s coverage. And you don’t want to have to continue paying for a defense. So you sue for a declaration of no coverage.

You’re the insured. You’ve been sued by a party claiming injury. Now your insurer sues you. So you have two suits to address and you’re not too happy. You’re also concerned your insurer’s suit will prejudice your defense in the tort suit. You believe insurer’s suit will address issues material to your liability in the tort suit. So you argue it should be stayed. You also claim it would be bad faith for insurer to pursue a coverage suit prejudicial to your tort suit defense.

Insurer argues its suit won’t prejudice your tort suit defense and that delaying resolution of coverage would require funding a defense that isn’t covered. What’s a court to do?

Well, one court, in Federal Ins. Co. v. Holmes Weddle & Barcott P.C., et al, Case No. C13-0926JLR (W.D. Wa. Nov. 14, 2013), deferred deciding on a stay until a legal malpractice insurer and insured law firm briefed three coverage issues. As explained: “It may be that all that is needed to decide this coverage action is to apply settled contract and insurance law to a set of admitted and undisputed facts.” This court wasn’t convinced law firm’s malpractice defense would be prejudiced by addressing those three issues.

Insurer already had moved for a summary judgment. And so “the court [could] simply examine that motion to determine whether it is possible to resolve this case without causing prejudice to [the firm].” Insurer’s motion “raise[d] several arguments that could potentially resolve the question of coverage without requiring the court to find facts of consequence to the malpractice action.”

The malpractice case was about how the firm handled a pre-policy period tort suit. Insurer argued the malpractice claim during the policy period and a motion for discovery sanctions in the tort suit were “Related Claims.” In discovery for the tort suit, firm produced an incomplete claim file. After client lost at trial, the court sanctioned firm and client, finding each “‘recklessly certified’ that the claim file was complete when in fact it was not.” Client’s claim against firm in part alleged malpractice by failing to produce the entire claim file. Resolving the “Related Claims” issue wouldn’t prejudice firm’s defense in the malpractice case because it “would require the court to examine only the proximity of the relationship between the post-trial [pre-policy period] sanctions motion and [client’s policy period] legal malpractice claim.” And “[t]his inquiry does not implicate questions of causation [in the malpractice suit], it only requires the court to compare two claims to determine whether they are ‘related’ as a matter of contract and insurance law.”

Insurer also relied on prior knowledge and application exclusions. Insurer’s argument “would require the court to examine only whether [firm] knew about facts prior to January 2012 that ‘might reasonably be expected to give rise to a claim.'” Relying on Carolina Casualty Ins. Co. v. Ott, No. C09-5540 RJB (W.D. Wa. Mar. 26, 2010), the court in a similar vein concluded “[t]his limited inquiry would not prejudice [firm] in the legal malpractice action.”

So it would allow insurer’s summary judgment motion to proceed on those issues and on whether the firm must reimburse insurer for defense fees. But the court left the door open for firm to object again.

If the firm believed insurer’s arguments may prejudice its defense, it would need “to point out in a very specific manner if and where it believes resolution of these issues will require findings that would cause prejudice to its defense in the malpractice action”

“[Firm] may file a cross motion for summary judgment if it wishes, but the court will expect [it] to safeguard its own interests by raising only issues and arguments that will not cause prejudice in the malpractice action.”

The court will resolve the case by summary judgment only if it wouldn’t prejudice firm’s defense. Otherwise it would stay the case. Insurer meanwhile would continue to defend firm under a reservation of rights. Firm also agreed to indemnify insurer for defense expenses, if there was no coverage.

The court appears to have struck a fair balance between insurer and firm’s interests. Stay tuned because we may see more from this court about issues important to D&O and professional liability insurers.

Tags: Washington, professional liability, legal malpractice, management liability, D&O, duty to defend, declaratory action, stay, related claims, prior knowledge, application exclusion, prejudice

by Christopher Graham and Joseph Kelly

The 2008 financial crises continues to generate lawsuits affecting professionals, directors, and officers and their insurers. The Fourth Circuit recently addressed an insurer’s duty to defend and indemnify a real estate closing service sued for conspiring to strip equity from homeowners in foreclosure. See Cornerstone Title & Escrow, Inc. v. Evanston Ins. Co., Case No. 13-1318 (4th Cir. Feb. 19, 2014). The opinion is “unpublished” and thus non-binding in the Fourth Circuit, but parties still may cite it in arguing their positions. For D&O and professional liability insurers and their customers, the analysis of the personal profit exclusion thus potentially has broader application. This court says the exclusion won’t apply where the insured allegedly is liable and makes restitution for co-conspirators’ improper gains, but isn’t alleged to have received gains itself.

The scheme

Remember 2008. Real-estate values collapse. Home equity vanishes. Mortgages exceed collapsing market values. Or equity is substantially diminished. Jobs are lost. Mortgage payments are missed. Foreclosures ramp up.

And schemers scheme.

A foreclosure “consulting” business is born. Consultant joins forces with mortgage broker and real-estate closing service. Consultant’s market? Homeowners facing foreclosure. Its product? Sale-leaseback transactions: we’ll buy your home; you get cash for your home equity; you avoid foreclosure; we’ll lease the home to you; you stay in it; and you re-purchase it later.

And what does consultant get? A consulting fee, it says.

What does consultant really get? The fee. Plus cash homeowner was to get for her home equity. Plus monthly rent much higher than the mortgage payment.

How does consultant get homeowners’ cash for equity? Consultant tells them unspecified closing fees and charges consumed the equity and convinces them to sign over their checks.

How is closing service involved? It supposedly provides closing services for the sale-leaseback, fails to deliver checks to homeowners for their equity, and delivers them instead to consultant.

What else happens? High rent drives homeowners/now-renters from their homes. There’s never a buy-back for homeowners.

The suit

And . . . the Maryland Attorney General in 2008 sues consultant, mortgage broker, closing company and related parties. AG alleges closing service and all other defendants violated Maryland’s Protection of Homeowners in Foreclosure Act and Consumer Protection Act, by scheming to “take title to homeowners’ residences and strip the equity that the homeowners ha[d] built up in their homes.” AG also alleges closing service, by failing to disclose it provided homeowners’ equity checks to consultant, violated the Consumer Protection Act; and, in acting as settlement agent, “participated in and provided substantial assistance to [consultant’s equity-stripping] scheme.” AG identifies 13 transactions and asks for a variety of relief, including restitution.

AG not only seeks to hold closing service responsible for its alleged non-disclosure, but also for co-defendants’ acts. AG alleges the service’s “concerted action [made] the enterprise possible”; so it’s “jointly and severally liable” for each co-defendant’s acts, including failing to provide written agreements; requiring membership fees before providing consulting services; obtaining interests in homes while offering consulting; representing services were to avoid foreclosure; failing to disclose the nature of services, material terms of sale-leaseback agreements, rental agreements, and of any subsequent repurchase; failing to provide statutorily required forms and notices; failing to determine whether homeowners have reasonable ability to make lease payments and repurchase homes; misleading consumers about entitlement to closing proceeds and about placing them in escrow; taking consumers’ settlement checks; and recording deeds and encumbering properties before rescission periods expire.

Closing service denies AG’s allegations.

The policy and coverage litigation

Closing service looks for defense under a “Service and Technical Professional Liability Insurance” policy. Subject to the policy’s terms, Evanston Insurance Company agreed to pay “the amount of Damage and Claims Expenses because of any (a) act, error or omission in Professional Services rendered or (b) Personal Injury committed by [closing service].”

But insurer refuses to defend. It cites exclusions for claims arising out of (a) improper personal gain, (b) dishonesty, (c) conversion, theft, and the like, and (d) the Real Estate Settlement Procedures Act.

Closing service settles with AG by agreeing to pay over $100,000 in restitution. And it sues insurer for breach of a duty to defend and indemnify.

Insurer wins a summary judgment. AG’s claims are excluded as arising out of improper personal gain and conversion, theft, and the like. Dishonesty and RESPA exclusions aren’t addressed.

But the appeals court decides the improper personal gain and conversion exclusions are no grounds for avoiding coverage and returns the case to the district court to consider the dishonesty and RESPA exclusions.

So why the result? The duty to defend is broader than the duty to indemnify. If some claims in AG’s complaint are potentially within coverage, insurer must defend all claims, even if others are excluded. This appeals court reasoned that at least some of AG’s claims were outside the scope of the improper personal gain and conversion exclusions. So the district court was wrong in finding no duty to defend, at least based on the two exclusions it cited. Since its decision on defense was in error, and its decision on indemnity was for the same reasons, its indemnity decision was wrong too.

Personal Profit Exclusion:

How did the improper personal gain exclusion apply? It applied to claims “based upon or arising out of [closing service’s] gaining any profit or advantage to which [closing service] is not legally entitled.”

What was the appeals court explanation for why AG claims were outside its scope? The AG’s “complaint did not allege that any particular ‘profit’ or ‘advantage’ inured to [closing service’s] benefit, as [the improper personal gain] exclusion . . . requires. To the contrary, the complaint alleged that all the relevant benefits and funds went to [consultant and related parties] and, perhaps, [mortgage broker]. It was [consultant and related parties], after all, who “stripped” the equity from homeowners’ homes by contriving false fees and other reasons to obtain the homeowners’ settlement proceeds.”

“There is no allegation that [closing service] should not have collected the settlement proceeds because, as a settlement agent, the company was required to do so. [citation omitted] While the homeowners’ equity and money might be an illegal profit or advantage that went to someone after settlement, those assets went to parties other than ‘the Insured’ under the terms of [its] policy with Evanston.”

The improper personal gain exclusion also “would not apply because the underlying complaint did not allege illegal profiteering by [closing service]. Instead, the complaint alleged illegal conduct that produced incidental gains. Put another way: the Attorney General could have succeeded on its claims against [closing service] without showing that [it] received a single dollar or any other advantage, legal or illegal. In fact, many of the claims for which [closing service] was allegedly jointly and severally liable did not involve money at all, but instead alleged wrongful disclosures and misrepresentations. [citation omitted] The underlying nondisclosure claims, at a minimum, do not ‘arise out of’ the illegal profit or advantage itself, so those allegations of the complaint do not fall within the exclusion.”

“[I]t makes no difference that [closing service] received fees for the settlement services that it provided at closing when the houses were conveyed to [consultant]. The complaint does not allege that [closing service] overcharged or that it failed to provide bona fide settlement services. . . . [Closing service’s] receipt of legally justified funds does not defeat policy coverage. [citation omitted] More importantly, . . . , [AG’s] complaint did not seek damages for the ‘consideration or expenses paid to [closing service] for services or goods.’ [citation omitted] Because [AG’s] claims did not touch upon [closing service’s] settlement fees, those fees could hardly have been a ‘profit’ or ‘advantage’ that spurred the underlying claim.”

It also didn’t matter that AG sought “restitution” from closing service. “[I]n a case that involves ‘concerted action’ . . . the restitution award doesn’t necessarily aim to disgorge benefits from particular defendants. Instead, the award serves to disgorge the benefits going to the scheme as a whole. A conspiring Consumer Protection Act defendant will therefore face potential restitution anytime any of his co-conspirators enjoyed some benefit. [citation omitted] A defendant who enjoyed no personal gain could still be ordered to pay restitution if he were part of a broader concerted action that produced benefits to a fellow co-defendant.”

In deciding this point, the court relied on J.P. Morgan Secs. Inc. v. Vigilant Ins. Co., 992 N.E.2d 1076, 1082-83 (N.Y. 2013). That court found the exclusion inapplicable where the insured’s disgorgement payment “did not actually represent the disgorgement of [insured’s] own profits,'” but instead “‘represented the improper profits acquired by third-part[ies].'”

Conversion Exclusion:

How did the conversion exclusion apply? It applied to claims “based upon or arising out of the actual or alleged theft, conversion, misappropriation, disappearance, or any actual or alleged insufficiency in the amount of, any escrow funds, monies, monetary proceeds, or any other assets, securities, negotiable instruments, irrespective of which individual, party, or entity actually or allegedly committed or caused in whole or part the [excluded act].”

What was the appeals court explanation for why AG’s claims were outside its scope? Well:

In Maryland, the payee of a check (here, the homeowner) must receive the check before he or she can bring a conversion action based on a misuse or improper delivery of it. [citation omitted] Where the payee has not received the check, the payee retains a cause of action against the drawer (in this case, [closing service]) for the liability reflected in the check, but, at least at that point in time, cannot bring a conversion action. [citation omitted] In this case, [closing service] allegedly misdirected the settlement checks before they ever reached the hands of the homeowners. Thus, the necessary element of delivery for a Maryland conversion action to the payee was absent at the time of the allegedly wrongful transfer by [closing service].

What else did the appeals court say about the exclusion? The AG’s complaint included “other allegations” outside of its scope so insurer would have a duty to defend even if closing service’s alleged misdirection of homeowner checks qualified as a claim “based upon or arising out of . . . conversion . . . .”

Tag: Maryland, professional liability, improper personal gain, personal profit exclusion, conversion exclusion, duty to defend

by Christopher Graham and Joseph Kelly

So your client or customer threatens a suit. And the time for suit is about to expire. You can avoid the suit. But you have to agree to extend time to sue. Sounds good. Otherwise you’ll be defending a lawsuit. Maybe you’ll have adverse publicity too. Maybe you can work things out with no suit. Maybe they’ll just drop it. So you agree. A year passes; no suit. More time passes; still no suit. Looks like the problem is over. You say, Hallelujah!

But then the sheriff shows up with that pesky summons and complaint. The suit is by the United States for the Coast Guard. It would be too late for it to sue. But you signed a tolling agreement giving it more time. Your company was sub-contracted work to convert old cutters into new and improved cutters. One of the cutters had a structural failure. The US government alleges you “knowingly misled the Coast Guard to enter into a contract for the lengthening of Coast Guard cutters by falsifying data relating to the structural strength of the converted vessels.” It alleges you violated the False Claims Act and alleges common law fraud, negligent misrepresentations and unjust enrichment.

You have claims-made private company D&O or management liability insurance. The claim involves wrongful acts. So you notify the insurer.

But wait a minute, says the insurer. Our policy covers a Claim first made during the policy period. We defined Claim as including “a written demand for monetary or non-monetary relief.” This Claim was first made well before then, back when you signed a tolling agreement.

Your tolling agreement acknowledges you were informed by the government that it believed it “may have certain civil causes of action and administrative claims against [you] under the False Claims Act, [citation omitted], other statutes and regulations including the Program Fraud Civil Remedies Act, [citation omitted], equity, or the common law, arising from [your] performance of conversion work on the U.S. Coast Guard Deepwater Program’s 110 Foot Island Class vessels.” And your agreement also states that, “as consideration for the United States not filing, or initiating claims against [you] under the False Claims Act, [citation omitted]or the Program Fraud Civil Remedies Act,” a certain period would be excluded to determine the timeliness of “any civil or administrative claims.”

You argue the Claim at least for negligent misrepresentation and unjust enrichment was first made when the government sued you. Those two claims aren’t explicitly mentioned in the tolling agreement. And they were in a suit filed during the insurer’s claims-made policy period. Insurer says pound sand! You say see you in court!

So what does the court decide? Insurer wins, as explained in XL Specialty Ins. Co. v. Bollinger Shipyards, et al, Case No. 12-2071, (E.D. La. Jan 3, 2014). As the court explained:

The tolling agreement between [subcontractor] and the United States stated that the government believed that it had claims against [subcontractor] arising from its performance of the conversion work for [general contractor], and memorialized [subcontractor’s] agreement to toll the statute of limitations so that the parties could discuss settlement of those claims before engaging in litigation. Clearly, then, under the language of the D&O Policy, the United States’ “claim” against [subcontractor] was first made in 2008, over two years before the policy period began.

So, as an insured, what should you do when asked to agree to toll the time for suit? Well, you better consider whether you have professional liability, D&O, or other insurance? And if you have insurance, you better notify your insurer. It appears this insured may not have had a management liability policy when asked to sign the tolling agreement. We say that because the insured didn’t sue under any policy in effect then.

But if it did have a policy then, it should have notified its insurer promptly after the government threatened suit and before signing any agreement. For an insured, the wisest course is to give prompt notice of anything that might be a Claim or turn into one.

Tags: Louisiana, D&O, tolling agreement, management liability policy, private company D&O policy, claim, policy period

by Christopher Graham and Joseph Kelly

You have a contract. You’re obligated to pay a third party. And naturally, being a capitalist, you’d prefer not to take the hit. You’re creative. And you’re savvy about insurance. And you think, gee, maybe my D&O or professional liability insurer can pay instead of me. So you ask. But they refuse. They say: “That’s your contract, not our policy obligation.” So off to court you go. And the wearers of black robes decide who wins and loses! And so it was in Entitle Ins. Co. v. Darwin Select Ins. Co., Case No. 13-3269 (6th Cir. Jan. 29, 2014.

This time the insured was a title insurer. Its contracts were with mortgage lenders and real-estate sellers and buyer-borrower. The contracts were closing protection letters. And under those contracts, title insurer agreed to indemnify lender, seller, or buyer for certain misconduct by title insurer’s closing agent. The misconduct was agent’s theft. And the theft was of a whopping $3.9 million in escrowed funds.

Yikes, says title insurer. That’s a lot of dough! And, yes, we issued closing protection letters. And so yes, we have to make those who have them whole. But gee wiz, we really would prefer not to take a big hit. Title agent has no money; so out of luck there. But how about Darwin’s professional liability policy? What does that policy provide? Does it fit the claim and cover the loss?

Under the insuring agreement, Darwin agreed that it “will indemnify the Insured for Loss, including Defense Expenses, from any Claim or Extra-Contractual Claim first made against them during the Policy Period or any applicable Extended Reporting Period … for Professional Liability Wrongful Acts committed on or after the date of incorporation or formation of the Named Insured and prior to the end of the Policy Period.”

“Professional Liability Wrongful Act,” in the definitions, means “any actual or alleged act, error, omission, misstatement or misleading statement, in the performance of or failure to perform Professional Services … by any Insured, or by an individual or entity for whom the Company is legally responsible.”

Okay, that’s great–so it can be an actual or alleged act “by an individual or entity for whom the Company [(title insurer)] is legally responsible”? Wouldn’t that include the thieving title agent who stole the $3.9 million, you ask? And as title insurer, isn’t it “legally responsible” for what title agent did? And so shouldn’t Darwin as professional liability insurer pay?

No, says the court. Under the contract between title insurer and agent, the scope of the agency was limited to issuing title policies. It included nothing else; and, thus, none of the closing and escrow services title agent offered.

Title insurer’s liability for agent’s acts was limited to acts within the scope of agent’s very limited agency. And when agent stole the $3.9 million it was acting for itself rather than within the scope of the agency. “To the extent that [title agent] performed closing and escrow-related services for the clients, [it] did so on its own behalf”–so said the appeals court.

Although title agent had many victims, title insurer made whole only the victims having closing protection letter contracts. All victims purchased title insurance from title insurer via the rouge agent. But only some victims paid extra for a closing protection letter. Title insurer paid victims only because of it’s legal liability under closing protection letter contracts, not because it was “legally responsible” for the rouge agent’s acts.

As the court explained:

[Title insurer] asks that we interpret its insurance policy to allow [title insurer] to secure business by making contractual guarantees to its clients regarding the performance of third-party business partners that are not its agents and then force its insurer to foot the bill when that third-party fails to perform according to [title insurer’s] guarantee, despite [title insurer’s] disavowal of all non-contractual responsibility, legal or otherwise. Because this interpretation directly contravenes the language of its professional liability insurance policy, we must decline E[title insurer’s] request.

The district court also had held the claimed amounts weren’t “Loss” because the Loss definition carved-out “amounts due pursuant to an express contract or agreement . . . .” And it held that title insurer’s liability fell within an exclusion “for actual or alleged liability under any express contract or agreement.” As the district court explained, the closing protection letters were “a debt [the title insurer] voluntarily accepted, not a loss resulting from a wrongful act within the meaning of the Policy.” To hold otherwise would mean a party could “enter into a contract safe in the assumption that if he later decides to engage in an act which might be considered a breach, the insurance company will step forward to cover the consequences of his act if he was wrong; and if he was right, he still walks away with no consequence to himself. Such a practice is inimical to the entire concept of insurance.”

The appeals court didn’t address these issues because it didn’t have to. But they are additional arguments insurers will make when faced with insurance claims such as in this case. This type of litigation is seen with some frequency. And you should expect to see more of it, especially when there’s big money at stake making litigation cost easier to swallow.

Tags: Ohio, professional liability, title insurance, loss, contractual liability, contract exclusion, wrongful act

by Christopher Graham and Joseph Kelly

May a liability insurer use an exclusion to avoid an indemnity obligation if it breaches a duty to defend?

As we discussed here, New York’s highest court last year initially said no. But when asked to reconsider, a majority of the court said yes. See K2 Investment Group, LLC, et al v. American Guarantee & Liability Ins. Co., 2014 NY Slip Op 01102 (Feb. 18, 2014).

There has been much commentary about K2 in the blogosphere. There is after all a lot of New York insurance business. The original decision also adopted a minority position. And it departed from long-standing New York precedent.

And it was that long-standing precedent, Servidone Construction Corp. v. Security Ins. Co. of Hartford, 64 N.Y.2d 419 (1985), which lead the majority to change its decision. As it explained:

Plaintiffs have not presented any indication that the Servidone rule has proved unworkable, or caused significant injustice or hardship, since it was adopted in 1985. When our Court decides a question of insurance law, insurers and insureds alike should ordinarily be entitled to assume that the decision will remain unchanged unless or until the Legislature decides otherwise. In other words, the rule of stare decisis, while it is not inexorable, is strong enough to govern this case.

The majority also noted cases from Hawaii and Massachusetts following Servidone and that a “federal district judge, writing in 1999, said that ‘the majority of jurisdictions which have considered the question’ follow the Servidone rule.” *See Flannery v Allstate Ins. Co*., 49 F. Supp. 2d 1223, 1227 (D. Col. 1999); *compare Employers Ins. of Wausau v Ehlco Liquidating Trust*, 186 Ill. 2d 127, 150-154 (1999) and Missionaries of Co. of Mary, Inc. v Aetna Cas. and Sur. Co., 155 Conn. 104, 112-114 (1967)(noted as minority view cases).

That Servidone involved a settlement rather than a judgment was deemed a distinction without a difference. And contrary to what the dissent argued, the original K2 decision couldn’t be reconciled with Servidone because both cases addressed whether an insurer could raise an exclusion despite breaching a defense duty.

The dissent argued that under Servidone, an insurer in breach of a duty to defend may avoid an indemnity obligation based on “non-coverage,” but not an exclusion. It explained:

Noncoverage involves the situation where an insurance policy does not contemplate coverage at its inception. For example, a homeowner’s policy would not provide malpractice liability coverage. Exclusions, in contrast, involve claims that fall within the ambit of the policy’s coverage parameters but are excepted by a particular contractual exclusion provision. Hence, a homeowner’s policy might contain an exclusion for certain types of water damage to the house.

The dissent argued “‘[u]nder those circumstances [(namely, non-coverage)], the insurance policy does not contemplate coverage in the first instance, and requiring payment of a claim upon failure to timely disclaim would create coverage where it never existed.'” [citations omitted]. An exclusion differs because it’s a way to avoid coverage that otherwise exists, so says the dissent.

The dissent also argued that Illinois, Massachusetts, and Colorado decisions cited by the majority applied the rule that an insurer breaching a duty to defend may raise a defense of non-coverage, but not an exclusion. *See also Alabama Hosp. Assn. Trust v Mutual Assur. Socy. of Alabama*, 538 So 2d 1209, 1216 (Ala. 1989)(cited by the dissent for the same rule).

None of this persuaded the majority.

Although not cited as a basis for the majority decision, plaintiffs were lenders who sued an entity and its owners to collect on a $2.85 million debt. But then also alleged one of the owner borrowers was their lawyer for the loan and committed malpractice by failing to record a mortgage securing the debt. After his insurer refused to defend, the lawyer allowed a default judgment against him exceeding the $2 million policy limit, though plaintiffs had demanded only $450,000 to settle. Then following the default, the lawyer assigned his rights against the insurer to the plaintiff lenders, who sued the insurer to collect. The lawyer apparently wouldn’t have to pay. And the default was only on the malpractice claim, not on the claim against the lawyer/owner/borrower to collect the $2.85 million debt.

With the majority decision, the insurer will be permitted to prove at trial that the judgment was really about lawyer’s as borrower/business owner, rather than as plaintiff lenders’ supposed lawyer. The insurer may now rely on: (1) a “status exclusion” for a “Claim based upon or arising out of, in whole or in part . . . D. the Insured’s capacity or status as: 1. an officer, director, partner, trustee, shareholder, manager or employee of a business enterprise . . . ;” and a “business pursuits” exclusion for a “Claim based upon or arising out of, in whole or in part . . . E. the alleged acts or omissions by any Insured . . . for any business enterprise . . . in which any Insured has a Controlling Interest.”

The dissent also was troubled that if the insurer defended the insured lawyer it could have addressed the status issues in the underling malpractice suit. It explained:

If, as the majority asserts, [lawyer’s] liability for professional negligence may have partially arisen from his actions as both an attorney and a manager of [a business] — and was therefore precluded under the “insured’s status” or “business enterprise” exclusion clauses — [insurer] should have fully participated in the underlying action and attempted to establish the basis for the exclusion. I believe that these issues should have been resolved in the original action rather than being delayed for years. The majority’s decision to authorize additional litigation and fact finding will prolong final resolution of this matter even further.

But this argument didn’t sway the majority either, particularly given Servidone.

Although now resolved in New York courts, we may see legislative attempts to change the rule and expect the debate isn’t over elsewhere. See our blog discussion here about Columbia Casualty Company v. Hiar Holdings, LLC, No. SC93026 (Mo. Aug. 13, 2013)(failure to defend foreclosed insurer’s coverage defense and opened up limits).

Tags: New York, duty to defend

by Christopher Graham and Joseph Kelly

Claims-made insurers limit risk by insuring only those claims alleging wrongful acts after a certain date. Their means for limiting risk often is a prior acts exclusion. The date often is before, rather than at policy inception and thus is known as a retroactive date.

But what if a Claim alleges wrongful acts before and after the retroactive date? Insurers also typically limit their risk to claims alleging wrongful acts unrelated to wrongful acts before the retroactive date. They typically wish to avoid insuring a Claim having anything to do with the pre-existing wrongful acts, even if it also alleges new wrongful acts.

But when are pre- and post-retro date wrongful acts related? Insurers address the issue through varying policy wording. But regardless of the wording, it’s a frequently litigated issue.

And so it was in American Guarantee & Liability Ins. Co. v. The Abram Law Group, et al, Case No. 13-13134 (11th Cir. Feb. 14, 2014). In that case, developer and bank sued lawyers alleging in count one malpractice in a January 26, 2006 closing for acquiring vacant land, with bank financing. That January date was before the May 1, 2006 retroactive date in the lawyers’ professional liability policy.

But developer and bank in a second count in the same suit alleged lawyers and title company committed fraud and conspiracy in an April 23, 2007 closing for a loan for developing the vacant land into a subdivision. The second closing thus was after the May 1, 2006 retroactive date.

In the first closing, the lawyers allegedly failed to identify exceptions to “good title.” So developer acquired land with unexpected title exceptions; and bank’s mortgage was subject to those exceptions. After the first closing, developer identified the exceptions. But the lawyers through the April 2007 closing allegedly covered up their earlier malpractice and made it appear that the exceptions weren’t an issue. They did so to avoid liability to developer and so title insurer wouldn’t have to cover the title exceptions. The lawyers also were title insurer’s agents and faced liability to title insurer for any mistakes. Developer and bank’s fraud and conspiracy allegations thus were based on the lawyers’ alleged post-retro date cover up of their pre-retro date mistakes.

The defendant title insurer meanwhile cross-claimed against the lawyers to indemnify it for any judgment for developer and bank involving the January 2006 loan and for negligence in failing to identity title exceptions. So the cross-claim only alleged wrongful acts before the May 1, 2006 retroactive date.

As is typical, this insurer used a prior acts exclusion to limit risk for claims alleging wrongful acts before the May 1, 2006 retroactive date. It also limited risk for claims alleging wrongful acts after the retroactive date, where the Claims nevertheless were based on wrongful acts before the retroactive date.

This is the wording insurer used: “This policy specifically excludes coverage for Damages and Claim Expenses because of Claims brought against any Insured based on any act or omission or any Related Act or Omission that occurred or is alleged to have occurred prior to 5/01/06.”

The insurer defined “Related Act or Omission” as “an act or omission that forms the basis for two or more claims, where a series of continuous, repeated, interrelated or causally connected acts or omissions give rise to one or more claims….”

In the prior acts exclusion, the phrase “that occurred or is alleged to have occurred prior to 5/01/06” modified the phrase “Claim brought against any Insured based on any act or omission or any Related Act or Omission.” It would have made more sense for the exclusion to read: “This policy specifically excludes coverage for Damages and Claim Expenses because of Claims brought against any Insured based on any act or omission that occurred or is alleged to have occurred prior to 5/01/06 or any Related Act or Omission that occurred or is alleged to have occurred on or after 5/01/06.” (Emphasis added).

But the Appeals Court didn’t address that issue and it made no difference in the result at least because the evidence was that the Claims, even those involving post-retro date wrongful acts, otherwise were based on an act or omission that occurred or was alleged to have occurred before the May 1, 2006 retro-date.

According to the Appeals Court: “Though [lawyers] contend Count Two alleging fraud in the underlying lawsuit relates only to the April 23, 2007, Development Loan closing and thus is covered under the policy, the acts and omissions giving rise to the malpractice claim from the January 26, 2006, Acquisition Loan closing also undergird the fraud claim regarding the Development Loan.”

“The alleged negligence involved in the Acquisition Loan closing is the necessary predicate to the fraudulent scheme to extinguish the 2006 lender’s title insurance policy and fraudulent insertion of additional exceptions to the 2007 title insurance policy. Further, the [other] claims . . . all flow from [lawyers’] alleged failure to disclose the restrictions and easements in the January 26, 2006, closing.”

So: “The district court did not err in determining the acts and omissions surrounding the Acquisition Loan closing form the basis of the claims regarding the fraud alleged during the Development Loan closing . . . .”

The Appeals Court also stated that the district court did not err “in finding the other acts or omissions surrounding the [post-retro date] Development Loan closing were interrelated to or causally connected to the acts or omissions at the [pre-retro date] Acquisition closing. Cf. Cont’l Cas. Co. v. Wendt, 205 F.3d 1258, 1262-63 (11th Cir. 2000) (applying plain meaning of the term “related” to a dispute over insurance coverage).” But with the way the prior acts exclusion was worded it’s hard to understand why that would make a difference. The act and omission and “Related Act or Omission” addressed by the prior acts exclusion were all described as before the retro-date. The exclusion thus didn’t explicitly address the relationship of pre- and post-retro date wrongful acts. That made no difference here. But it might in another case. So an insurer with a prior acts exclusion like this would be well-advised to revise it.

Tags: Georgia, professional liability, prior acts exclusion, interrelated or related wrongful acts