Insurance Coverage Under E&O/D&O Policies for Fraud
“Fraud” Claims Can Trigger a Duty to Defend
In RSUI Indemnity Co. v. Murdock, a D&O policy was found to require the defense of a federal securities action.[1] The court affirmed the trial court’s determination that a Profit/Fraud Exclusion did not apply, because there was no adjudication of the underlying action, which was a requirement for the exclusion. The insured had breached its duty of loyalty through fraudulent acts that artificially drove down the stock of their company pre-merger.
The court rejected RSUI’s public policy argument against allowing fraud to trigger a duty to defend, noting its “respect of the right of sophisticated parties to enter into insurance contracts as they deem fit in the absence of clear indicia that a countervailing public policy exists.”[2]
Turning to the policy language, the court noted that “the Policy has an expansive definition of covered losses, which on its face does not exclude losses occasioned by fraud.”[3] It concluded that “[a]llegations of fraud fit comfortably within” the policy’s coverage of wrongful acts.[4]
Acknowledging that the policy did exclude “losses ‘based upon, arising out of or attributable to . . . any deliberately . . . fraudulent act,’” it pointed to the subsequent requirement that such an act must be “’established by a final and non-appealable adjudication,’ [implying] that fraud that does not fall within the exclusion because it has not been finally adjudicated will otherwise be covered.”[5]
SPACs and Other Business Entities May Find Fraud Defense Availability Especially Useful
Certain businesses are likely to have particular interest in the availability of fraud coverage in their insurance. For example, Special Purpose Acquisition Companies (“SPACs”) are increasingly prevalent.[6] SPACs are shell companies that exist to facilitate the raising of funds to acquire existing companies. Because SPACs have no commercial operations of their own, the initial public offerings through which they generate investment may not come with the substantive protections that apply to traditional IPOs. This could create heightened concerns of potential fraud claims. The Murdock decision therefore paves an encouraging path forward for SPACs and other businesses with similar concerns. Those companies could see strategic benefit in forming in Delaware merely for the precedential weight of the decision, and could avail themselves of the relevant E&O and D&O policies.
Triggering E&O Coverage
One subset of fraud litigation that may well implicate insurance coverage is claims by purchasers of questionable loans against loan amalgamators. In that context, the buyer need not be a seller’s “client” to trigger coverage under an E&O policy. In one case applying Colorado law, an insured claimed its insurer owed a duty to defend under a “professional liability policy . . . akin to an ‘error and omissions’ policy.”[7] The insured was a real estate investment trust (“REIT”) that delegated insurance acquisition functions to independent contractors.[8] Rather than legitimately procure insurance, the contractors allegedly set up Ponzi schemes through which they personally benefited.[9] Numerous suits were filed against the REIT and its insurer denied a defense to all of them.[10]
The insurer argued that it owed no duty to defend the REIT in any of the lawsuits because “none of them were brought by the recipients of professional services from [the REIT]; rather, they were all brought by [the REIT’s] creditors.”[11] The District of Colorado rejected this argument.[12]
Citing Fifth and Ninth Circuit cases[13] on the same point, the court held that the insurer’s “duty to defend [was] not discharged merely because the plaintiffs . . . in the underlying lawsuits were not [the REIT’s] clients.”[14] However, the court found the allegations in the underlying complaints fell outside the scope of coverage or within exclusions, so held the insurer had no duty to defend any of them.[15]
The Tenth Circuit reversed.
It held that each of the underlying complaints alleged conduct that created the potential for coverage, triggering the duty to defend.[16]
Next, it held that the REIT’s conduct in attempting to obtain insurance was not excluded as services provided as an “insurance broker” where that term was not defined in the policy but “professional services” was defined to include services “as a ‘property manager,’ ‘risk manager,’ and ‘insurance administrator,’ ” which, given “Colorado’s policy of construing coverage broadly, could include [the REIT’s] procurement of insurance for the properties it manages.”[17]
Finally, the Tenth Circuit held that a coverage exclusion for “claims ‘arising from the failure to effect or maintain any insurance’ ” did not apply.[18] “The underlying complaints allege wrongful acts resulting from [the REIT’s] efforts to provide professional services for others for a fee, not its failure to do so.”[19]
In holding that the insured owed a duty to defend, the Tenth Circuit necessarily embraced the district court’s conclusion that the duty to defend was not excused merely because the underlying plaintiffs were not the insured’s clients.[20] And the court’s narrow interpretation of policy exclusions demonstrates that a broker’s conduct is likely to constitute a “wrongful act” in the provision of “professional services” under the AIG E&O Basic Form Policy, not subject to any exclusion.
The Sale of Defectively Originated Loans Should Trigger E&O Coverage
In AIMCO v. Nutmeg, alleged misconduct, errors or omissions in the procurement of insurance were potentially covered “wrongful acts” in the provision of “professional services.” Likewise, AMN’s origination and sale of defective and fraudulent loans should trigger standard mortgage broker/banker errors and omissions coverage. That is, the origination and sale of mortgage loans are enumerated “professional services.” And the sale of defective or fraudulent loans constitutes a “breach of duty, neglect, error, misstatement, misleading statement or omission” in the conduct of those services.
That the sale of defectively or wrongfully originated loans would be covered professional services under a standard E&O policy is further supported by the Merriam-Webster’s Dictionary of Law defines “originate”: “to issue (a mortgage loan) usually for subsequent sale in a pool of mortgage loans to a secondary market.”[21]
A Claim for Negligent Loan Origination Will Clearly Invoke E&O Coverage
Even when the only asserted cause of action is a breach of contract, allegations of negligence within a claim should trigger coverage. Courts “look to [the] essence of a claim regardless of how it is denominated” and “the precise legal theory asserted . . . is not controlling, so long as the complaint gives sufficient notice of the transaction sued upon.”[22]
However, a cause of action independent of contract issues and explicitly asserting damages based on defective loan origination will make an insurer more likely to admit coverage. It is, therefore, helpful for the plaintiff to add an additional negligence cause of action in order to plainly trigger E&O coverage for services not directly provided by the insured.
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[1] RSUI Indem. Co. v. Murdock, 248 A.3d 887, 902 (Del. Mar. 3, 2021).
[2] Id. (internal citation omitted).
[3] Id.
[4] Id.
[5] Id. at 902-03.
[6] See Tom Zanki, SPACs Power Another Record-Breaking Month for IPOs, Law360 (Mar. 1, 2021), https://www.law360.com/articles/1360026/spacs-power-another-record-breaking-month-for-ipos.
[7]Apartment Inv. & Mgmt. Co. (AIMCO) v. Nutmeg Ins. Co., 2008 WL 901547, *12 (D. Colo. 2008).
[8]Id. at *1, *9.
[9]Id. at *9.
[10]Id. at *1-2.
[11]Id. at *13.
[12]Id.
[13]Administaff, Inc. v. Am. Int'l Specialty Lines Ins. Co., 75 Fed. Appx. 239 (5th Cir. 2003); Bank of Calif., N.A. v. Opie, 663 F.2d 977 (9th Cir. 1981).
[14]Id.
[15]Id. at *16-20.
[16]Apartment Inv. & Mgmt. Co. (AIMCO) v. Nutmeg Ins. Co., 593 F.3d 1188, 1192-93 (duty to defend standard), 1196-97 (standard satisfied) (10th Cir. 2010).
[17]Id. at 1197-98.
[18]Id. at 1198.
[19]Id.
[20]The Tenth Circuit also noted that the Colorado Supreme Court has not addressed whether an insurer can disregard known facts outside an individual complaint but contained in related complaints. Id. at 1193.
[21]Merriam-Webster’s Dictionary of Law (1996) (emphasis added), at http://dictionary.reference.com/browse/ originate.
[22]Bainbridge, Inc. v. Travelers Cas. Co. of Conn., 159 P.3d 748, 755-56 (Colo. Ct. App. 2006) (allegations of conditions existing prior to underlying plaintiff’s purchase of home triggered coverage for claims the previous owners of home could have asserted), citing Yoder v. Hopper, 695 P.2d 1182, 1185 (Colo. Ct. App. 1984), Fire Ins. Exch. v. Bentley, 953 P.2d 1297, 1302 (Colo. Ct. App. 1998) and numerous other Colorado cases. See also Gerrity Co., Inc. v. CIGNA Property & Cas. Ins. Co., 860 P.2d 606, 607 (Colo. Ct. App. 1993) (“factual allegations in the complaint, and not the legal claims, []determine an insurer's duty”); Hecla Min. Co. v. New Hampshire Ins. Co., 811 P.2d 1083, 1089-90 (Colo. 1991) (frequently cited in assessing whether insurer must defend).