Broadly-worded Customer Funds Exclusion bars coverage for “innocent insureds” under title agent’s professional liability policy

by Christopher Graham and Joseph Kelly


Bethel, et al v. Darwin Select Insurance Company, Case No. 12-3528 (8th Cir. Nov. 18, 2013)(MN law)

This case involves professional liability insurance for title agents and a broadly-worded exclusion for claims against the title agent and it’s employees involving misappropriation of customer funds held in escrow or otherwise. The broad wording that is the first part of the exclusion is common in many professional liability and D&O policy exclusions. Here, as in other cases where plain language is problematic, the insureds try to avoid that language by arguing coverage is “illusory” if coverage is denied and denying coverage is contrary to the insureds’ “reasonable expectation” and impermissible because these insureds are “innocent.” But those creative arguments have limited application; a broadly worded exclusion can be and in this instance was applied.

Zen Title, as agent of United General Title Insurance Company, recorded mortgages, deeds, and mortgage satisfactions and paid related fees; and paid off mortgage loans for United General’s customers in refinancing transactions. For that work, United entrusted Zen with millions of dollars, albeit to be held in segregated escrow accounts.

United Title sued Charles Bethel and Jennifer Frantz — Zen investors and, in Frantz’s case, a Zen bookkeeper and title agent as well — Zen, and others under various liability theories for a “wide-ranging fraudulent scheme to misappropriate the funds entrusted to Zen Title by [United].”

Darwin Select issued a professional liability policy to Zen Title including Bethel and Frantz as Insureds.

Under that policy, Darwin was obligated to defend and indemnify Insureds against any claim for any “[n]egligent act, error, omission, misstatement, misleading statement, neglect or breach of duty … by an Insured, in the performance of or failure to perform Professional Services.”

But the policy’s “Customer Funds Exclusion” 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.”

Bethel and Frantz tendered defense of United’s suit to Darwin. Darwin denied coverage based on the Customer Funds Exclusion.

Bethel and Frantz sued Darwin for breach of its duty to defend and bad faith.

The District Court granted Darwin’s summary judgment motion. Bethel and Frantz appealed.

Customer Funds Exclusion

Bethel and Frantz argued that United’s allegations regarding failure to record mortgage instruments were outside the scope of the Customer Funds Exclusion; so Darwin should defend.

Darwin argued that United’s claims “arise out of”, result from, or in some way involve the loss of, or improper use of customer funds; so the Customer Funds Exclusion applies.

The Eighth Circuit noted that “the Minnesota Supreme Court has defined ‘arising out of’ broadly as ‘originating from,’ ‘growing out of,’ or ‘flowing from'”; and “‘but for’ causation, a cause and result relationship, is enough to satisfy the [“arising out of”] provisions of the policy.”

Applying that Minnesota law, the Eighth Circuit sided with Darwin: “all of [United’s] claims flow from, grow out of, or originate in the loss or improper use of [United’s] funds” and United’s ‘complaint explicitly links its allegations regarding the failure to record mortgage instruments to the scheme to misappropriate [United’s] escrowed funds.”

Illusory Coverage

Bethel and Frantz argued that applying the Customer Funds Exclusion to bar coverage would in essence mean coverage was “illusory.” The Eighth Circuit disagreed: “even reading the Customer Fund Exclusion broadly, the Policy covers a wide range of Zen Title’s professional activities.”

Reasonable Expectations Doctrine

Bethel and Frantz argued that under the reasonable expectations doctrine Darwin must defend them even if United’s allegations are within the Customer Funds Exclusion. The Eighth Circuit once again disagreed: the reasonable expectations doctrine applies only to resolve policy wording ambiguities; there were none here. And the customer funds exclusion wasn’t hidden within the policy; it was clearly set forth in the exclusions section of the policy.

Innocent Insured Doctrine

Bethel and Frantz argued that they were “innocent insureds” and shouldn’t lose coverage because of wrongdoing by Zen Title and others. But the Eighth Circuit again disagreed: “application of the Customer Funds Exclusion does not depend on who caused the loss or misuse of customer funds. Instead, it focuses on what gave rise to the claim.” “[T]he plain language of the exclusion makes clear that it applies regardless of whose conduct caused the loss or improper use of customer funds.”

Category: Professional Liability Insurance Digest Comment »

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