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A federal court recently ruled that a carrier must defend its policyholder against a claim involving the treasurer’s erroneous payment to a scammer. The ruling shows that a “wrongful act” under a D&O policy need not be an egregious act of wrongdoing, that coverage may hinge on whether extrinsic evidence can establish coverage, and that breach of contract claims are not always uninsurable as a matter of law.

In Bridlewood Estates Property Owners Association v. State Farm General Insurance Co., a California federal district court evaluated whether an insured association may be entitled to coverage for a breach of contract claim under an endorsement to its package liability policy providing directors and officers (D&O) coverage. Because the claims arose from an email spoofing scheme resulting in the association’s treasurer mistakenly issuing payment to a fraudster instead of the contracting party, the court determined that contract claims were based on a “wrongful act” by an officer potentially covered by the policy and that, as a result, the lawsuit triggered the insurer’s defense obligations. The decision shows the potential for D&O coverage for contract claims, as well as highlights the difficulty insurers face to exclude contractual liability on public policy grounds, which vary greatly between states and can be swayed by policy provisions applying one particular state’s laws over another.

Background

In September 2022, Aztec Paving, Inc. issued a six-figure invoice for repairs it conducted at a property owned by Bridlewood Estates Property Owners Association. After Aztec emailed the invoice, a scammer sent payment wiring instructions to Bridlewood using a spoofed Aztec email address. Based on the malicious wire instruction email, Bridlewood’s treasurer ultimately sent payment to the fraudster’s bank account, rather than to Aztec. When Aztec’s invoice wasn’t paid, Aztec filed a mechanic’s lien against the property and initiated litigation against Bridlewood alleging breach of contract.

Bridlewood tendered Aztec’s lien and complaint to State Farm, seeking coverage under a Directors and Officers Liability Endorsement included as part of the association’s residential community association policy. The D&O endorsement provided that the insurer would pay any sums that the policyholder becomes obligated to pay as a result of a “wrongful act,” which was defined in the endorsement as “any actual or alleged error, misstatement, misleading statement, act, omission, neglect, or breach of duty committed, attempted or allegedly committed or attempted by an insured.” The insurer denied coverage for the claim, arguing that lien was based on Bridlewood’s failure to pay a contractual obligation, not for any “wrongful act” by an insured. The insurer failed to respond to the association’s notice of the complaint.

Bridlewood sued State Farm in federal court, alleging that the insurer breached the policy and wrongfully denied coverage by ignoring facts about the claim that would potentially trigger coverage. The insurer moved to dismiss, arguing that Bridlewood could not meet its burden to identify any “wrongful acts,” which was necessary to trigger coverage under the policy’s D&O endorsement.

The Court’s Order

The California federal district court denied State Farm’s motion to dismiss. The court first found that the breach of contract claim was not necessarily outside the scope of the policy’s coverage. For starters, the D&O endorsement did not include a contract exclusion. Despite containing 19 different exclusions, the court noted, none applied to contractual liabilities.

The court also recognized that Bridlewood had pointed to extrinsic evidence known to the insurer suggesting a potential claim for coverage based on the treasurer’s “wrongful act,” namely, the officer’s error, negligence, or breach of duty in misdirecting payment. Specifically, the court found that the insurer was aware of facts showing that the payment was misdirected due to hacking of the contractor’s email system, as well as email communications showing the “deception” that led to the treasurer’s payment error. That extrinsic evidence suggested a potential for coverage because it supported a finding that the treasurer committed a “wrongful act” in transmitting payment to the wrong bank account. But for that mistake, the court reasoned, Aztec would have received payment and no basis to sue.

Without a contract exclusion, the insurer next argued that California law was settled in holding that the failure to pay amounts due under a contract cannot qualify as a “wrongful act.” The court disagreed and distinguished that precedent because Bridlewood’s claim was not simply about the association’s refusal to pay amounts owed under a contract. Rather, the alleged non-payment was because the treasurer was deceived, made an error, and misdirected the payment to a hacker instead of to Aztec.

The court also highlighted Ninth Circuit precedent holding that liabilities arising from an alleged breach of contract are not necessarily uninsurable under California law. Accordingly, the court found that Bridlewood had established that its claim may fall within the scope of coverage under the D&O endorsement, which is all that is required to trigger a defense obligation, because its potential liability stemmed from the treasurer’s “wrongful acts.” Because State Farm failed to establish that any exclusion or other limitation to coverage barred Aztec’s contract claims, the court denied the motion to dismiss.

Takeaways

The Bridlewood opinion highlights several factors for policyholders to consider when procuring insurance, submitting a claim, or challenging a carrier’s claim denial.

First, don’t assume that every insurance policy automatically excludes coverage for any claim or lawsuit alleging breach of contract. Although many policies do contain contract exclusions, as Bridlewood’s D&O endorsement showed, it is not a certainty. The D&O endorsement at issue contained nineteen specific exclusions, but did not contain a contractual liability exclusion. As with all insurance claims, the devil is in the details, and closely comparing the allegations against the actual policy language is important to identify any unexpected sources of recovery.

Second, even when policies do not contain contractual liability exclusions, insurers may argue that any claim involving contractual liabilities is uncovered because those exposures are uninsurable as a matter of public policy. When an insurer attempts to limit coverage in that manner, however, it bears the burden of establishing that the policy clearly and unambiguously bars coverage for the claim at issue. To prevail on this public policy argument, the insurer should be required to clearly articulate public policy in the relevant jurisdiction stating that contractual liabilities are uninsurable. That coverage defense should not prevail based on public policy pronouncements in other states, especially when the dispute is before a federal court sitting in diversity that is required to adhere to the governing state law.

Whether contractual liabilities are insurable ultimately will depend on applicable state law. But as the court noted in Bridlewood, claims involving breach of contract allegations against policyholders are not necessarily barred from coverage as a matter of California law or public policy. In the absence of a contractual liability exclusion and without governing public policy against insuring contract claims, the insurer could not disclaim coverage simply because the policyholder’s liability arose from a contract.

Third, insurers owe a duty to defend policyholders based on the potentiality of coverage for the policyholder’s claim, which is a very low bar that can be met unless the loss cannot possibly fall within the scope of coverage under the policy. The Bridlewood opinion is a good example of a court properly enforcing this broad defense obligation.

Similarly, where a policy is triggered by a claim for a “wrongful act,” policyholders should confirm that the insurer’s interpretation adheres to the actual definition of wrongful act and does not adopt a narrower view than what the policy says. For example, many times, as was the case in Bridlewood, the D&O endorsement of “wrongful act” only required an alleged “act” or “omission” to trigger coverage, even if the act was not negligent or fraudulent.

Finally, coverage for a loss, like the insurability question for contract claims, may turn on what state’s law applies. Policyholders are well served by assessing that question, including whether the policy dictates a particular state or forum, during the procurement and renewal process. Evaluating these issues before a claim arises can help avoid uncertainty during the claims adjustment process and help maximize recovery in the event of a claim.