In our January 6, 2015 post, we analyzed the decision of the U.S. District Court for the Central District of California in Pestmaster Services, Inc. v. Travelers Casualty and Surety Company of America and its implications for the interpretation of the Computer Fraud and Funds Transfer Fraud coverages. On July 29, 2016, the Ninth Circuit Court of Appeals released a brief opinion affirming the District Court’s interpretations of these coverages.

The Facts

Pestmaster, a pest control business, was insured under a Travelers Wrap+ policy. In 2009, Pestmaster hired a payroll company, Priority 1, to handle its payroll and payroll tax obligations. Pestmaster executed an ACH authorization which authorized Priority 1 to obtain payment of Priority 1’s approved invoices by initiating ACH transfers of funds from Pestmaster’s bank account to Priority 1’s bank account. These amounts included both payroll and payroll taxes, the latter of which Priority 1 was supposed to remit to the IRS.

In 2011, Pestmaster discovered that Priority 1 had failed to remit $373,000 in payroll taxes, and had instead diverted these funds to its own uses. Pestmaster sought indemnity from Travelers under both its Funds Transfer Fraud and Computer Fraud coverages.

Funds Transfer Fraud

The Funds Transfer Fraud coverage indemnified Pestmaster for direct loss of money or securities contained in its transfer account on deposit at a financial institution, directly caused by Funds Transfer Fraud. Funds Transfer Fraud was defined as:

an electronic, telegraphic, cable, teletype or telephone instruction fraudulently transmitted to a Financial Institution directing such institution to debit your Transfer Account and to transfer, pay or deliver Money or Securities from your Transfer Account which instruction purports to have been transmitted by you, but was in fact fraudulently transmitted by someone other than you without your knowledge or consent …

The Ninth Circuit affirmed the District Court’s holding that the Funds Transfer Fraud insuring agreement does not cover transactions that are authorized by the insured:

… Pestmaster argues that the transfer of funds from its bank account to Priority 1’s bank account is covered by the Funds Transfer Fraud provision. The district court found that this provision “does not cover authorized or valid electronic transactions … even though they are, or may be, associated with a fraudulent scheme.” We agree that there is no coverage under this clause when the transfers were expressly authorized.

Computer Fraud

The Computer Fraud coverage indemnified Pestmaster for direct loss of money, securities or other property directly caused by Computer Fraud, i.e., the use of a computer to cause a transfer of money, securities or other property from inside the insured’s premises or the insured’s bank’s premises. The Ninth Circuit interpreted Travelers’ wording as requiring an unauthorized transfer, which is consistent with the Computer Fraud jurisprudence requiring an element of unauthorized access or a “hacking” incident. The Ninth Circuit continued:

When Priority 1 transferred funds pursuant to authorization from Pestmaster, the transfer was not fraudulently caused. Because computers are used in almost every business transaction, reading this provision to cover all transfers that involve both a computer and fraud at some point in the transaction would convert this Crime Policy into a “General Fraud” Policy. While Travelers could have drafted this language more narrowly, we believe protection against all fraud is not what was intended by this provision, and not what Pestmaster could reasonably have expected this provision to cover. [emphasis added]

As such, coverage was not available in respect of the authorized transfers.

The Court remanded to the District Court the narrow issue of whether two individual transactions, made shortly before the discovery of the fraud and totalling $11,991, were unauthorized transfers.

Conclusion

The Ninth Circuit’s decision in Pestmaster provides an endorsement of fidelity insurers’ intentions as to the proper scope of the Computer Fraud and Funds Transfer Fraud coverages. The Court’s observation with respect to the Computer Fraud coverage is of particular significance, insofar as it represents one of the clearest articulations as to how the merely-incidental involvement of a computer at some stage in a fraudulent transaction is insufficient to trigger indemnity. Insureds often point to such merely-incidental involvement of a computer in attempting to bring a loss within the Computer Fraud coverage, even though this is not the intended scope of the coverage, and notwithstanding that there are other products (such as Social Engineering Fraud coverage) which may respond to certain types of losses involving authorized computer transfers.

Pestmaster Services, Inc. v. Travelers Casualty and Surety Company of America, 2016 WL 4056068 (9th Cir.)