Ninth Circuit Holds That Alleged Misappropriation of Client Funds Triggers E&O Coverage, But No Bad Faith Where Insurer’s Denial Was Reasonable

The U.S. Court of Appeals for the Ninth Circuit, applying California law, affirmed a district court’s ruling that an insurer did not act in bad faith by failing to defend its insureds and settle a claim where there was a “genuine issue” as to the insurer’s liability.  Sharp v. Evanston Ins. Co., 2020 WL 2569694 (9th Cir. May 21, 2020).  However, the court concluded that the insurer’s denial of coverage was incorrect because various policy exclusions requiring malice and California Insurance Code Section 533 did not apply to bar coverage for the insureds’ alleged negligent mishandling of fiduciary funds.

The insured company’s officers were sued by the company’s bankruptcy trustee for allegedly mishandling client funds.  The company’s professional liability insurer declined to defend the trustee’s claims and did not participate in the settlement between the parties.  The trustee then filed suit against the insurer to cover the unpaid balance of the settlement amount; he also alleged bad faith.

First, the appellate court affirmed the district court’s summary judgment ruling in favor of the insurer on the bad faith claim.  The court held that California’s “genuine issue” doctrine permits summary judgment for an insurer on a claim for bad faith where there is a genuine issue as to the insurer’s liability and thus the insurer’s denial was reasonable.  Further, the court held that the insurer was given little advance notice of the mediation date and was not presented with a formal settlement offer until months after the settlement had already taken place.

Second, the appeals court affirmed the district court’s ruling that the insurer was obligated to indemnify the insured for the settlement because the officers’ underlying conduct—mishandling of fiduciary funds—was negligent, rather than wilful and malicious, and thus triggered the policy’s “professional services” insuring agreement.  Based on this conclusion, the appeals court further affirmed that certain exclusions cited by the insurer—including a fraud and dishonesty exclusion and an exclusion for failure or refusal to collect, pay, or return a policy premium, commission, tax or policy fee—as well as California Insurance Code Section 533 (all of which required a finding of intentional or willful conduct), did not apply.