One of the recurring coverage issues that arises in connection with Errors and Omissions (E&O) Insurance is the question of whether or not the activities that are the basis of the underlying claim involve Insured Services (or Professional Services) as that term is defined in the policy. In a September 27, 2013 decision (here), Northern District of Texas Judge A. Joe Fish, applying Texas law, found that an E&O insurer did not have to defend its insured because the failed investment that was the basis of the underling claim was not undertaken in connection with the mortgage broker services specified in the policy’s definition of Insured Services.
Halo Companies, Inc. and various related entities were sued in a state court action in Texas in which the claimants alleged that Halo defendants had negligently allowed James Temme and Stewarrdship GP to misuse funds meant for investments. Temme and Stewardship had proposed to buy nonperforming mortgages, restructure their terms and reconstitute the mortgages into performing loans. Halo was to service the mortgages as part of an alliance with Temme and Stewardship. The claimants allege that in reliance on the representations of Halo and others, the claimants invested $5 million in the proposed mortgage plan.
The claimants further allege that the proposed assets were never purchased and their funds were never returned. The claimants allege that the Halo defendants failed to perform sufficient due diligence, failed to ensure that Temme was purchasing the mortgages, and failed to inform the claimants that he invested funds were not being used to purchase the intended assets.
Halo submitted the claimants’ lawsuit as a claim under its professional liability policy. The carrier denied coverage for the claim and initiated an action seeking a judicial declaration that the underlying claim was not covered under its policy. The insurer moved for summary judgment.
In disputing coverage, the insurer argued that the actions alleged in the underlying claim did not fall within the policy’s definition of Insured Services which provides as follows:
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. Content and services via [four websites identified by their URLs].
The September 27, 2013 Opinion
In his September 27 opinion, Judge Fish granted the carrier’s motion for summary judgment with respect to the issue of whether or not the insurer had a duty to defend its insureds in the underlying action. However, he denied the insurer’s summary judgment motion as to the insurer’s indemnification obligations, on the grounds that under Texas law the duty to indemnify could not be determined until liability has been decided.
In arguing that activities involved in the underlying claim did not constitute Insured Services, the carrier contended that the underlying action “arises from an investment scenario gone wrong” and does not involve the performance of the kinds of mortgage broker services specified in the definition. Halo, by contrast, argued that the term “mortgage broker services” is not defined in the policy and that the phrases in the definition of Insured Services following the words “consisting of …” are “merely an incomplete list of examples of mortgage broker services.”
After reviewing various alternative proposed definitions of the term “mortgage broker services,” Judge Fish noted that “the allegations in the underlying action are fundamentally based on the Halo defendant’s misuse of the [claimants’] invested funds, not in mortgage broker services.” He added the observation that “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.”
Judge Fish concluded that the underlying actions fall outside the policy’s definition of Insured Services and granted summary judgment in the insurer’s favor with respect to the duty to defend. However, in reliance on Texas law, which provides among other things that an insurer may have a duty to indemnify even if the duty to defend never arises.” The Texas courts have reasoned that the duty to defend is based on the mere allegations in the complaint, whereas the duty to indemnify is determined by the actual facts establishing liability in the underlying action. Judge Fish said that “Since liability has not been established in the underlying action, the court must deny the plaintiff’s motion for summary judgment on the duty to indemnify.”
This case underscores the critical importance of the definition of Insured Services (or, as it is sometimes phrased, Professional Services) to the determination of liability under policies of E&O insurance. This case is somewhat unusual in that the policy definition at issue was unusually detailed. It is far more common for the definition to consist of a narrower descriptive term – for example, some policies might have said, with respect to this company, that the covered services consisted of “mortgage broker services.” Just the same, even though the definition of Insured Services here was broader and more detailed, the underlying claim was nevertheless found not to be covered.
The problem with these kinds of disputes involving the question whether a particular set of activities fall within the services defined in the policy is that an enterprise of even modest complexity likely is involved in a wide variety of activities.
Another issue that can contribute to the problem is that an insured company can be accused of having engaged in activities that it denies ever having been involved in. This concern is another way of saying that the coverage can wind up depending on how the claimant characterizes the alleged activities that are the basis of the claim.
I understand why insurers require and rely on narrow definitions. They will argue that in accepting the risk, they intend only to cover activities that are identified as within the operations of the enterprise that they have chosen to insure. They would not want to insure other activities – for example, here, the insurer might well say that it chose to insure Halo’s mortgage broking activities, but it did not chose to and did not intend to insure other activities such as Halo’s participation in an investment opportunity.
For policyholders, this line of analysis is highly unsatisfying, They believe they purchased their policy to provide insurance for claims made against them in connection with their delivery of services for a fee. Policyholders take it very badly when insurers contend that – well, we certainly didn’t insure you for that.
These issues can sometimes be addressed by the wording of the definition of Insured Services. To the extent the definition more completely and comprehensively describes the range of services and activities, the less likely these kinds of disputes are to arise. However, as this case shows, even a broader definition may not be sufficient to encompass all of the insured company’s activities.
When I have run across these kinds of disputes in the past, I have often wondered why the industry can’t come up with a more comprehensive definition of Insured Services, one that takes into account that in this day and age even small enterprises are diverse and complex and therefore that it is hard to describe all of its activities in a single paragraph. Insurers could protect themselves, if they feel they must, through exclusions. While it might be argued that this approach might not result in any greater coverage, at least the categories of activities the insurer are unwilling to cover would be express. In addition, policy exclusions are narrowly construed against the insurer.
I freely concede that there are many others in the industry that have much more experience with these issues than I do. There may be readers who disagree with my analysis. I strongly encourage readers who disagree with me or who find flaws with my approach to add their thoughts to this blog post using the blog’s comment feature.