Applying New Jersey law, a federal district court has held that a law firm’s professional liability policy does not provide coverage for an employee’s misappropriation of client funds. Cadre v. ProAssurance Cas. Co., 2016 WL 3844208 (D.N.J. July 14, 2016).

A law firm discovered that an employee had embezzled funds from the firm’s client trust account. The law firm sought coverage for the losses under its professional liability policy, which provides coverage for sums “the Insured shall become legally obligated to pay as damages because of any claim or claims . . . involving any act, error or omission in rendering or failing to render professional services.” The policy defined “claim” as “a demand or suit for damages received by the Insured.” It also defined “Damages” to mean “monetary judgments, award or settlements,” but further provided that the term “does not include the return or restitution of legal fees, costs and expenses charged by the Insured, or any allegedly misappropriated client funds or interest thereon.” The insurer denied coverage under the policy for the embezzlement losses.

In the subsequent coverage litigation, the court held that the policy does not afford coverage for the employee’s embezzlement. As an initial matter, the court held that no “claim” had been made against the law firm because no demand or suit for damages had been asserted against the firm. In so holding, the court rejected the firm’s argument that the discovery of facts that might lead to a potential suit also constitutes a claim.

Additionally, the court rejected the firm’s argument that it reasonably expected its policy to cover losses from an employee’s embezzlement of client funds. The insured argued that a New Jersey rule of court that requires limited liability companies such as the insured firm to purchase professional liability insurance binds not just law firms but also insurance companies, and therefore a compliant policy must cover all claims arising out of the performance of professional services. The court disagreed, finding that the rule governs attorneys only and says nothing of how the business of insurance is to be run. Moreover, the court held that, because the policy’s definition of damages expressly excludes “misappropriated client funds,” the insured reasonably should have concluded that the policy would not cover every claim arising out of the provision of legal services.