Misappropriation of funds: covered by liability policy?

Smart v AAI Ltd; JRK Realty Pty Ltd v AAI Ltd [2015] NSWSC 392.

fraud money.jpg

The plaintiffs each agreed to transfer funds to Q1, a finance broker that promised to lend these funds out to clients. This turned out to be a fraudulent enterprise, and the clients Q1 had referred to in fact never existed. Despite having received what each understood to be “interest” payments on the loans, neither plaintiff’s funds were returned to them. Q1 was wound up and deregistered, and the plaintiffs brought a claim against Q1’s insurer on the basis that Q1 was liable to each of them immediately before its deregistration, and that this liability was covered under the Policy.

The insuring clause in the policy provided:

“The Insurer will indemnify the Insured against civil liability for compensation and claimant’s costs and expenses in respect of any Claim or Claims first made against the Insured and notified to the Insurer during the Period of Insurance resulting from the conduct of the Professional Services…”

Each of the emboldened phrases above were considered by the New South Wales Supreme Court. While the case itself was factually complicated, with much of the evidence disputed between the parties, the Court’s interpretation of the insuring clause is illustrative of common issues to liability insurance. Craig Langstone, partner at Fee Langstone, says that the decision is a useful one, because while these issues are common to the insurance industry, it is rare to find case law that directly deals with these questions.

“Civil Liability for Compensation”

There was no dispute that Q1 was liable to the plaintiffs. However, the Insurer argued that the plaintiffs were not, per the Policy wording, seeking “civil liability for compensation,” but rather a claim for repayment of a debt. In other words, the plaintiffs’ claims were restitutionary, not compensatory as the Policy required.

The “critical question,” the Court said, is how to “characterise the nature of the liability that has been established.” In answering this question, the Court made it clear that the facts that give rise to the liability are the key consideration, rather than the form of the liability.

The Court summed up the facts giving rise to Q1’s liability as follows:

1. Q1 promised that the plaintiffs’ funds would be lent to third party clients of Q1;

2. Q1 broke this promise as it did not lend the plaintiffs’ funds to third party clients;

3. Q1 misappropriated the funds advanced to it by the plaintiffs, and thus failed to repay the plaintiffs’ funds.

On these facts, the Court felt that Q1’s liability was best characterised as a breach of a duty or obligation to use the plaintiffs’ funds to effect the lending transactions. Thus, despite the fact that the plaintiffs’ claims took the form of restitutionary claims for debt, on the Court’s analysis of the facts the claims were in substance claims for compensation. Thus, the Court was satisfied that the plaintiffs had established a “liability for compensation” within the meaning of the insurance clause.

“Resulting from the conduct of the Professional Services”

The Insurer also argued that Q1 had never really acted as a broker, as in reality there had never been any borrowers. It argued that the Policy did not provide cover for “pretended” professional services, even when the plaintiffs believed them to be real services.

The Policy defined “Professional Services” as the “professional business described in the schedule,” that being “Mortgage Broker/Finance Broker/Mortgage Originator, Mortgage Management/Debt reduction.”

Under this wording, the Court did not agree with the Insurer that the Policy required the Services to actually be provided in respect of the particular transaction that gave rise to the claim. Rather, the claims simply had to “result from” the conduct of the Professional Services. It was important that the Policy defined this as the “business” of loan broking, as this was broader in scope than the individual transactions themselves. This meant that, even though the clients were fictional and the relevant transactions did not in fact involve loan broking, the fact remained that the plaintiffs entered into them on the basis that Q1 was in the “business” of loan broking. Thus, the Court held that the plaintiffs’ claims did result from the conduct of the Professional Services per the Policy wording.

“Any claim or claims first made against the Insured and notified to the Insurer during the Period of Insurance.”

The Policy defined “Claim” as being “any demand by a third party upon the Insured for compensation.” Upon this wording, and on reviewing the relevant authorities the Court was satisfied that this required “some form of assertion” that a duty or obligation had been breached, rather than a mere demand for the return of funds.

The plaintiffs put forth a number of documents in which they had made demands on Q1 during the period of insurance. In none of these, however, was there evidence of an assertion of a breach of a duty or obligation. The closest the plaintiffs came to such an assertion was a by a reference to “Q1 somehow [making] good.” On examination of the relevant witness, however, it was found that “making good” was a reference to the plaintiffs’ desire for assistance in figuring out “whether their funds had gone and how they could get them returned,” and did not necessarily imply a breach of duties or obligations on the part of Q1.

Thus, while the Court had concluded that the plaintiffs’ claims were compensatory in nature, and not restitutionary, they were nonetheless outside the policy cover as no “claim” per the meaning of the Policy was brought within the period of insurance.

Assumption of Liability/Dishonesty Exception

As a separate issue, the insurer argued that Q1’s liability was not covered by the Policy due to the operation of a standard assumption of liability exclusion. Per this exclusion, the Insurer had excluded cover for contractual breaches unless the relevant breach amounted to a tort as well. The plaintiffs’ claim, the Court found, was purely for contractual liability – namely, a liability for misrepresentation – and thus the exclusion applied.

The clause further provided that the insurer would not be liable for any liability assumed by Q1 “outside the normal course of the Professional Services,” as that term was defined in the Policy. On the facts, the Court found that Q1’s agents had assumed liability outside the normal course of the Professional Services. While the transactions in question began as broking transactions, which would have been within the scope of the Professional Business, in reality these developed into Q1 assuming the role of a lender (albeit fraudulently). This, the Court found, involved a far greater degree of attendant risk than the simple broking transactions the Policy contemplated, and thus meant that Q1 had assumed a liability that the Policy did not cover.

The insurer also argued that Q1’s liability was not covered, having arisen from a “dishonest, fraudulent, criminal or malicious act or omission by the Insured.” This was subject to a write back in the relevant clause that provided that such fraudulent activities would be covered if they were committed “by an employee occurring or committed in connection with the Professional Services.” It followed from the judge’s earlier finding that the relevant acts were outside the scope of the Professional Services that the write back did not apply.

Read the full judgment here