Misappropriation of Funds Exclusion Bars Coverage for a Negligent Background Check that Led to Hiring of Embezzler

The United States District Court for the Eastern District of California, applying California law, has held that a misappropriation of funds exclusion barred coverage under an E&O policy for a claim against a company that provided an allegedly negligent pre-employment background check, resulting in the hiring of an employee with a criminal background who subsequently embezzled funds from his employer. Human Resource Advantage, LLC v. The Hanover Ins. Co., 2025 WL 2731859 (E.D. Cal. Sept. 25, 2025).

At a client’s request, the insured company conducted a pre-employment background screening of a job candidate that failed to detect both a criminal history and the use of a fraudulent social security number, leading the client to hire the candidate. Two years later, a subsequent background check on the candidate—then, an employee—revealed a criminal record, including prior acts of embezzlement, grand theft, and forgery, as well as the use of a fraudulent social security number. The client later discovered that the candidate had embezzled more than one million dollars from it.

The client issued a letter to the insured alleging negligence and breach of contract, which the policyholder tendered to its professional liability insurer. The insurer denied coverage, citing an exclusion that barred coverage for claims “[a]rising out of or resulting, directly or indirectly, from any actual or alleged commingling, misappropriation or improper use of funds or monies.”

The client ultimately obtained a default judgment of $3,771,957 against the insured, and the insured initiated this coverage action. The insured argued that (a) the misappropriation of funds exclusion was ambiguous; (b) the underlying litigation arose from a failure to conduct a proper pre-employment background screening, not from the misappropriation of funds; and (c) the concurrent proximate cause doctrine required the insurer to provide a defense. The court rejected all three arguments, holding that, while broad, the language of the relevant exclusion was unambiguous and that the underlying claim “arose out of” the misappropriation of funds, given “the low bar California courts assign to the phrase ‘arising out of’” and the fact that the client “would not have a suit without [the employee]’s embezzlement as there would be no injury” to the client. The court further held that the concurrent proximate cause doctrine applies to multiple causes that operate totally independent of one another, and thus did not apply here because the embezzlement and negligent background screening were “dependently intertwined and exist as links in a causal chain.” Moreover, because the court concluded that no coverage was available, it granted the insurer summary judgment on the insured’s claim for breach of the implied covenant of good faith and fair dealing.