In its recent decision in Bethel v. Darwin Select Ins. Co., 2013 U.S. App. LEXIS 23183 (8th Cir. Nov. 18, 2013), the United States Court of Appeals for the Eighth Circuit, applying Minnesota law, had occasion to consider the application of a customer funds exclusion in a professional liability policy.

Darwin insured Zen Title, a title insurance agency, under a claims made and reported professional liability policy.  One of Zen Title’s clients was United General Title Insurance Company ("UGT"), for whom Zen Title had responsibility for recording mortgages, deeds, and mortgage satisfactions and for paying fees associated with those recordings.  Zen Title’s responsibilities also including paying off mortgages on behalf of UGT and its customers in connection with mortgage refinancing transactions.  During the policy period, UGT terminated its relationship with Zen Title and brought suit against the company and its three principals. The court described the underlying complaint as alleging:

… a wide-ranging fraudulent scheme to misappropriate the funds entrusted to Zen Title by UGT. UGT alleged that "Zen, and the other Defendants associated with Zen and acting for same, deliberately chose to delay the recording [of mortgage instruments] so as to benefit from the pool of cash escrowed for the purpose of paying recording fees." In addition, Zen Title allegedly failed to use escrowed funds to pay off existing mortgages in mortgage refinancing transactions. The gravamen of UGT's allegations was that the defendants delayed recording mortgage instruments in order to retain and use funds that had been escrowed to pay fees associated with those recordings.

The complaint alleged several causes of action, including one for negligent failure to file various mortgage instruments in breach of Zen Title’s duties owed to UGT.

Zen Title tendered the suit to Darwin, and Darwin denied coverage on the basis of its policy’s customer funds exclusion, which barred coverage for “any Claim . . . based upon, arising out of, directly or indirectly resulting from, in consequence of, or in any  way involving . . . any actual or alleged . . . loss, disappearance, pilferage or shortage of, or commingling or improper use of, or failure to segregate or safeguard, any client or customer funds, monies, or securities.”  In the ensuing coverage litigation, the United States District Court for the District of Minnesota granted summary judgment in favor of Darwin, concluding that the allegations in underlying complaint fell entirely within the exclusion.

On appeal, Zen Title argued that the cause of action for negligence potentially fell outside of the customer funds exclusion, such that Darwin at least had a duty to defend.  Darwin countered that when read in the context of the complaint, the cause of action for negligence was related to Zen Title’s alleged scheme of misappropriating escrow funds, and thus arose out of the excluded conduct.  The court agreed with Zen Title, observing that:

As described in UGT's complaint, the insureds failed to record mortgage instruments precisely so that they could divert the funds that would have had to be paid as filing fees at the time of recording. Thus, as alleged, the insureds failed to record mortgage instruments only because it constituted a necessary component of the broader scheme to misappropriate funds escrowed for filing fees. As such, there is a direct cause-and-effect relationship between all actionable conduct alleged in UGT's complaint and the loss or improper use of customer funds.

In reaching its holding, the Eighth Circuit rejected the insured’s attempt to divorce the cause of action for negligence from its context within the rest of the complaint.  While the court agreed that plaintiff could have filed a cause of action for negligence that had nothing to do with the alleged fraudulent scheme, the court could not ignore the actual allegations in the complaint.  As the court explained, “Minnesota's notice pleading rules did not require UGT to identify the specific circumstances under which each failure to record occurred, and so UGT's claims could possibly be premised on unspecified failures to record that are unrelated to the fraudulent scheme. This argument underestimates the significance of what UGT actually included in its complaint. UGT did specifically allege that the defendants failed to record mortgage instruments in order to facilitate the misappropriation of customer funds. UGT did not specifically allege any other failures to record.” 

The Eighth Circuit also rejected the insured’s argument that the customer funds exclusion rendered the policy’s coverage illusory, noting that the exclusion would not bar coverage for simple acts of negligence, such as failing to file a mortgage instrument or erring in doing so, since in such scenarios, the underlying actions would not involve the misappropriation of customer funds.  The court also rejected the argument by two of Zen Title’s principals that the wrongful acts of a third principal should not be attributed to them. The court held that the application of the exclusion did not depend on who committed the wrongful act, but instead on what gives rise to the underlying claim.  As the court explained:

The plain language of the exclusion makes clear that it applies regardless of whose conduct caused the loss or improper use of customer funds. … the Customer Funds Exclusion applies to any claim that arises out of any loss or improper use of client funds caused by anyone, be they a "guilty" insured, an "innocent" insured, or even a non-insured. It is irrelevant whether [the individual principals] participated in the wrongful conduct that triggered the Customer Funds Exclusion, so long as UGT's claims arose from some loss or misuse of customer funds.