Why it matters: The policyholder was unable to obtain a defense because the allegations of the complaint did not track the scope of services provided by the insured and as defined by the policy. Here, the policyholder was a mortgage broker, but, as alleged, the losses resulted from misuse of funds. Even though the duty to defend is broadly applied and the allegations of the complaint are liberally construed, this case shows that a defense cannot be taken for granted. The coverage provided by the policy still must align with the nature of the dispute.

Detailed Discussion

A Texas federal court judge determined that a lawsuit by investors is not entitled to coverage because the acts undertaken by the policyholder were not listed in the “Insured Services” provision of the policy.

A group of individuals invested almost $5 million with Halo Companies. Halo employees touted an investment scheme where the money would be used to purchase nonperforming residential mortgages, restructure their terms, and reconstitute the mortgages into performing loans.

But according to the investors, Halo never purchased the proposed assets and never returned the investment funds. In a lawsuit seeking the return of the almost $5 million, the investors alleged that Halo failed to ensure the purchase of the mortgage, neglected to inform the investors that their funds were not being used for the intended purchase, and made false assurances regarding the intent to use the funds or manage the mortgages.

Halo turned to Axis Surplus Insurance Co. for defense and indemnification against the claims. Axis declined and filed a declaratory judgment in Texas federal court, arguing that the allegations in the underlying complaint did not fall under the “Insured Services” defined in the policy.

“Insured Services” are defined by the policy as “Mortgage broker services consisting of counseling, taking of applications, obtaining verifications and appraisals, loan processing and origination services in accordance with lender and investor guidelines and communicating with the borrower and lender. Debt settlement and credit services including arbitration and negotiations; real estate sales and brokerage services."

The description of mortgage broker services in the policy provides the exhaustive definition of covered activity, Axis argued. Alternatively, Halo told the court the phrases were merely an incomplete list of examples.

Relying on the eight corners of the policy and the underlying complaint, U.S. District Court Judge A. Joe Fish sided with the insurer.

“The allegations in the underlying action are fundamentally based on the Halo defendant’s misuse of the [investors’] funds, not in mortgage broker services,” he wrote. “Taking the allegations in the petition as true, none of the funds even went to purchase mortgages. The fact that the proposed investment scheme was supposed to involve mortgages does not overshadow the fact that the allegations ultimately stem from fraud and misappropriation of funds.”

Halo tried to hang its hat on the “real estate sales” language in the definition, to no avail. “The court cannot conclude that the parties truly intended for ‘real estate sales and brokerage services’ to apply to mortgage investment schemes; the provision unambiguously refers to the purchase and sale of real property,” Judge Fish wrote.

The court denied summary judgment on the issue of whether Axis had a duty to indemnify, however, holding that under Texas law that issue cannot be decided until liability is settled.

To read the opinion in Axis Surplus Ins. Co. v. Halo Asset Management, click here.