The First Circuit Court of Appeals recently held that the fraud and dishonesty exclusion in an errors and omissions policy issued to a mortgage originator and broker excluded coverage for the fraudulent acts of one of its employees in the loan origination process. New Federal Mortgage v. National Union Fire Insurance Company of Pittsburgh, PA, No. 07-2762 (Sept. 28, 2008). This case could foreshadow how other courts will deal with coverage claims spawned by the subprime crisis against mortgage brokers and originators by purchasers of those mortgage loans.

The Insured was a residential mortgage originator and broker. According to the Complaint filed in the matter, Kevin Dunn worked under contract to the Insured as a mortgage broker and allegedly submitted false mortgage applications to a lender. The Insured previously signed a warranty statement regarding the accuracy and truthfulness of its loan applications and agreed to indemnify the lender for any losses that may arise from the breach of that warranty.

The loan applications and credit reports that had been allegedly falsified by Dunn later came to light. The lender sent a letter to the Insured, claiming that it had suffered substantial losses "as a result of the fraudulent information included in the loan packages submitted by" the Insured. That Claim was noticed to the Insurer, which denied coverage on the basis of the policy’s fraudulent and dishonest acts exclusion, which excluded coverage for “any Claim . . . alleging fraud, dishonesty, or criminal acts or omissions . . . on the part of the Insured." The Insured then brought suit seeking to compel the insurer to provide defense and indemnity.

The trial court granted summary judgment, and the First Circuit affirmed. The First Circuit noted that the only allegations made against the Insured in the demand letter were of fraudulent or criminal acts. Therefore, the court confirmed that coverage was excluded under the Policy’s fraudulent and dishonest acts exclusion:

Here the E&O policy excludes from coverage “any Claim . . . alleging fraud, dishonesty, or criminal acts or omissions . . . on the part of the Insured.” . . . . Whether the policy provides coverage is determined by comparing the allegations in the underlying claim . . . with the policy provisions . . . . [The] demand letter alleges that [the Insured] submitted "fraudulent information" in four mortgage applications. The letter stated: '[T]he credit reports for the [prospective borrowers], which were obtained by [the Insured] and submitted to [the lender] in support of the loan applications, were altered to reflect higher credit scores than those scores actually provided to [the Insured] by the credit bureau.' [The lender’s] allegations place [the Insured’s] conduct squarely within the E&O Policy's fraud and dishonesty exclusion, and [the Insured] is not entitled to indemnification."

The First Circuit further denied the Insured’s claim that it was entitled to a defense, finding that the alleged activity was “plainly excluded from coverage.”

For a copy of the decision, please click here.