On September 30, 2008, the United States Court of Appeals for the First Circuit held that, under Massachusetts law, an errors and omissions policy would not afford coverage for losses incurred after an employee of the insured mortgage broker falsified credit reports in mortgage applications to a lender. New Fed Mortgage Corp. v. Nat’l Union Fire Ins. Co. of Pittsburgh, PA, 543 F.3d 7 (1st Cir. Sept. 30, 2008).  

Background  

New Fed Mortgage Corporation (“New Fed”), a residential mortgage originator and broker, provided the lender, Decision One Mortgage Company, LLC (“Decision One”), with mortgage applications from prospective borrowers in exchange for a fee upon a loan’s approval. The potential borrowers’ applications submitted by New Fed to Decision One included credit reports prepared by independent credit bureaus, which Decision One relied on in determining value and terms of mortgages.  

New Fed warranted the truthfulness of all information it submitted and agreed to indemnify Decision One for any losses it incurred as a result of a breach of warranty on the part of New Fed. Decision One discovered discrepancies between the credit reports from New Fed and its own independently obtained reports and notified New Fed. New Fed’s investigation discovered that an employee, Kevin Dunn, falsified credit reports in fifteen mortgage applications to Decision One by assigning higher credit scores to prospective borrowers.  

Decision One sold four of the fifteen affected mortgages to a third-party investor who, upon learning of New Fed’s falsification of credit reports, demanded that Decision One repurchase each mortgage at its original price. Decision One then requested indemnification from New Fed for the losses it would incur in the repurchase and resale of these four loans. New Fed refused to indemnify  

Decision One. Decision One sold the four loans at auction, then requested New Fed to pay for the loss incurred in the sale. New Fed submitted a claim to its errors and omissions (“E&O”) insurer, National Union Fire Insurance Company of Pittsburgh, PA (“National Union”). National Union denied the claim on the ground that Decision One’s claim against New Fed resulted from employee dishonesty.  

New Fed sued National Union in federal district court in Massachusetts seeking to compel a defense and indemnification under the E&O policy. The district court granted summary judgment to National Union, relying sua sponte on a rationale not advanced by National Union. New Fed appealed to the United States Court of Appeals for the First Circuit. Reviewing the claim de novo, the First Circuit did not review the district court’s rationale for awarding summary judgment to National Union. Rather, the First Circuit affirmed the grant of summary judgment for National Union based on a finding that acts of employee dishonesty, such as those at issue here, come within the fraud and dishonestly exclusion of the E&O policy.  

Holding  

The First Circuit first explained that under Massachusetts law, the insured has the initial burden of proving a loss falls within the policy. Once that burden is met, the burden shifts to the insurer to show that an exclusion operates to bar coverage. The First Circuit defined an E&O policy as one that insures members of “designated callings against liability arising out of the mistakes inherent in the practice of that particular profession or business.” Massamont Ins. Agency, Inc. v. Utica Mut. Ins. Co., 489 F.3d 71, 74 (1st Cir. 2007). The court held that an employer is not covered under its E&O policy for losses caused by deceptive actions of its employees because such actions are not inherent in the employer’s business. Further, deceptive practices typically fall under the policy’s fraud and dishonesty exclusion.  

Duty to Indemnify  

According to the First Circuit, National Union met its burden of proving that New Fed’s claimed losses resulted from its employee’s falsification of credit reports, an excluded act. The E&O policy defined the insured as New Fed and any employee or independent contractor. Because Mr. Dunn was a mortgage broker working under contract for New Fed, he qualified as an insured under the policy. Dunn’s actions were not covered under the policy, however, because the policy expressly excluded coverage for “any Claim … alleging fraud, dishonesty, or criminal acts or omissions … on the part of the Insured.”  

Under Massachusetts law, coverage is determined by comparing the allegations in the underlying claim with the policy provisions. The court found that Decision One’s allegations that New Fed provided fraudulent information in four mortgage applications by altering the credit reports to reflect higher scores than those provided by the credit bureau fell within the fraud and dishonesty exclusion of the policy. The court, therefore, rejected New Fed’s argument that the fraud and dishonesty exclusion should not apply due to an absence of proof that New Fed intended to harm Decision One.  

Duty to Defend  

The First Circuit also determined that National Union had no duty to defend New Fed because Decision One’s allegations of employee misconduct were expressly excluded from coverage under the E&O policy. Under Massachusetts law, an insurer’s duty to defend is broader than its duty to indemnify, and is triggered by the allegations in the complaint. Nevertheless, an insurer is relieved of its broad duty to defend where the claims against the insured are squarely outside the policy coverage and its purpose. Such was the case here, where the court determined that the alleged alteration of credit reports to reflect higher scores than those provided by the credit bureau fell squarely within the scope of the fraud and dishonesty exclusion and, thus, outside the scope of available coverage.  

Implications  

The First Circuit concluded that an E&O policy excluding claims alleging fraud, dishonesty, or criminal acts or omissions does not cover losses incurred as the result of an employee’s falsification of documents. While the actions of Mr. Dunn in the scope of his employment for New Fed were expressly excluded from the E&O policy, this decision may open the door for coverage disputes based on employee misconduct in other manifestations. In the current economic climate with lenders closing their doors and consumers losing their homes, lenders may seek coverage for their losses under their E&O policies. The ensuing litigation will likely stem from improper acts of varying magnitudes, which could produce varying constructions of what constitutes fraud and dishonesty. Courts therefore may be conflicted between holding lenders and mortgage brokers accountable while at the same time striving to compensate the victims of their misconduct.