In New Federal Mortgage v. National Union Fire Insurance Company of Pittsburgh, PA, No. 07-2762 (Sept. 28, 2008) the First Circuit Court of Appeals recently ruled on a case that is likely emblematic of an emerging wave of coverage litigation – claims against subprime mortgage originators by the purchasers of subprime loans. The case is also noteworthy for its interpretation and application of an often used fraudulent-conduct exclusion that has thus far eluded scrutiny of a court in a reported decision.

The insured, New Fed Mortgage Corporation, was a mortgage broker whose employee had allegedly engaged in the now well-publicized practice of falsifying credit reports in mortgage applications in order to obtain lender approval. The lender in this case, Decision One Mortgage Company LLC, eventually discovered the alleged alterations and demanded indemnification for the resulting loss in value from New Fed pursuant to their contract. New Fed noticed the Decision One claim to its Errors & Omissions insurer, National Union Fire Insurance Company of Pittsburgh, PA, by sending a copy of Decision One’s demand letter. That letter alleged loss as a result of the fraudulent acts of New Fed’s employee. National Union denied coverage, citing a clause excluding coverage for “any Claim ... alleging fraud, dishonesty, or criminal acts or omissions ... on the part of the Insured.”

The formulation of this exclusion is unique for its use of the term “alleging” rather than, for example, “arising from.” The First Circuit provided guidance in its interpretation of the exclusion, instructing that under Massachusetts law the applicability of the exclusion is determined by “comparing the allegations of the underlying claim ... with the policy provisions.” The court noted that Decision One’s demand letter to New Fed exclusively alleged that New Fed submitted “fraudulent information” in four mortgage applications. The court then found that these allegations “place New Fed’s conduct squarely within” the fraud exclusion and therefore National Union had no duty to indemnify New Fed. The conduct fit so squarely, in fact, that the court found it not even “reasonably susceptible” of an interpretation that it is covered and thus also found no duty to defend.