(Article from Insurance Law Alert, April 2024)
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Holding
A California district court denied an insurer’s motion to dismiss, finding that a policyholder sufficiently alleged breach of contract and breach of the implied duty of good faith and fair dealing based on the insurer’s refusal to defend an underlying suit arising out of a fraudulent email hacking scheme. Bridlewood Estates Prop. Owners Assoc. v. State Farm General Ins. Co., 2024 U.S. Dist. LEXIS 47593 (S.D. Cal. Mar. 18, 2024).
Background
The dispute arose when a homeowners association fell victim to an email hacking scheme. As a result of the scheme, the Treasurer of the association issued a wire transfer to an entity that he believed was a paving company that had performed work for the association, but in fact was a hacker’s bank account. After the fraud was discovered, the paving company demanded payment and filed a mechanic’s lien on the subject property.
The association tendered the demand and lien to State Farm, which had issued a Residential Community Association Policy. The policy included a Directors and Officers Liability Endorsement (“DO Endorsement”) that provided coverage for the wrongful acts of the association’s directors and officers. State Farm denied coverage, arguing that the underlying claims were outside the scope of coverage because they failed to allege any wrongful acts. The association sued and State Farm moved to dismiss. The court denied State Farm’s motion.
Decision
The court ruled that the association sufficiently alleged claims for breach of contract, breach of the implied covenant of good faith and fair dealing, and declaratory relief so as to withstand a motion to dismiss. The court reasoned that the underlying claims against the association alleged a “wrongful act,” defined in the endorsement as “any actual or alleged error, misstatement, misleading statement, act, omission, neglect, or breach of duty . . . arising solely out [ ] of his or her capacity as director, officer ‘manager’ or trustee . . . .” In particular, the court explained that extrinsic facts known to State Farm suggested a potential claim based on the Treasurer’s error, negligence, or breach of duty, including his failure to notice a difference in email addresses or to contact the paving company to confirm the wiring instructions prior to issuing payment.
The court noted that to the extent that the underlying claim against the association is a breach of contract claim, it is not necessarily excluded from coverage under the DO Endorsement. The court stated: “The DO Endorsement does not expressly exclude contractual liabilities from coverage. Indeed, it delineates nineteen different exclusions; none are for contractual violations.”
Importantly, the court did not rule that the underlying claims were covered under the DO Endorsement. Rather, denying State Farm’s motion to dismiss, the court found only that the underlying facts did not conclusively negate coverage. In so ruling, the court relied not only on the allegations in the underlying complaint, but also on extrinsic facts known to State Farm in reaching its decision—including the contents of an email chain between the fraudster and the Treasurer, which was attached to the policyholder’s tender letter and various “discovery exchanges in the underlying action” related to the cause of the Treasurer’s mistaken payment.
Comments
The decision is noteworthy in several respects. First, most decisions in the emerging body of insurance coverage law arising out of email schemes and fraudulently induced wire transfers involve coverage under “computer fraud” provisions. As discussed in previous Alerts, those decisions often turn on whether the losses at issue arose “directly” from computer fraud or, conversely, were caused by intervening acts of negligence by innocent parties. This case presents the question of whether losses arising from a fraudulent email scheme arise from an executive’s “wrongful act” for purposes of D&O coverage.
Second, the decision does not alter the principle that, under California law, an insured’s failure to pay amounts due under a contract does not qualify as a “wrongful act” for policy coverage purposes. Rather, the court deemed this case distinguishable from scenarios in which “an insured simply refused to pay amounts due under a contract” and then looked to its insurer for a “bailout.” As the court explained, the association’s failure to pay arose out of the potential negligence and/or breach of duty on the part of the Treasurer—which the court found may constitute a “wrongful act” under the DO Endorsement.
Finally, the decision serves as an important reminder that in some jurisdictions, such as California, an insurer’s duty to defend is determined not only by the allegations in the underlying complaint, but also by “extrinsic facts known to the insurer.”