Applying California law, the United States Court of Appeals for the Ninth Circuit has upheld the district court’s rescission of a tower of crime policies based on the insured’s material misrepresentation in the application for the policies.  Kurtz v. Liberty Mutual Ins. Co., 2016 WL 4547366 (9th Cir. Sept. 1, 2016).

The insured, a purported qualified intermediary for tax-advantaged real estate transactions, sought to purchase primary and excess crime policies that provided coverage for employee theft and theft of clients’ property.  The application for the primary policy asked: “Are proceeds from [Internal Revenue Code Section] 1031 transactions held in bank accounts segregated from those of your operating funds?”  In an application dated July 2, 2007, the insured company answered “no.”  The primary insurer responded to the company’s broker that the company was ineligible for coverage as a result of this answer.  The broker advised the insured to “correct” the application and it would resubmit the application to the primary insurer.  In an application dated August 13, 2007, the company answered the question “yes.”  Thereafter, the primary insurer and three excess insurers issued policies to the company.

A Chapter 7 bankruptcy trustee later brought suit against the insurers to recover under the policies for the misappropriation of client funds by the intermediary’s principal.  It came to light that the company did not segregate 1031 transaction funds from its operating funds.  The insurers denied coverage based on the company’s misrepresentation in the application regarding the segregation of client funds.  The district court held that the insurers were entitled to rescind the policies based on the misrepresentation.

On appeal, the Ninth Circuit affirmed, holding that the application question was unambiguous because the only reasonable interpretation of the question is whether the intermediary holds proceeds from 1031 transactions in separate bank accounts from its operating funds.  Additionally, the appellate court upheld the district court’s conclusion that the insurers had not waived their misrepresentation defense due to a failure to investigate the intermediary’s changed answer on the second application.  According to the appellate court, the intermediary’s misrepresentation was not an “obvious red flag.”