An investment advisor whose failed real-estate fund lost $5 million in union-pension money, and who later defaulted when the pension trustees sued over the fund’s mismanagement, was entitled to coverage under its business-liability insurance policy, a Massachusetts federal judge has ruled. And because the insurer was wrong in concluding that the pension suit was not covered, the insurer presumably must pay its full $3 million policy limits to the pension trustees, and face bad-faith claims as well.

The court’s decision, in Scottsdale Insurance Co. v. Byrne, highlights the risks an insurer faces when relying on policy exclusions to refuse a defense—particularly in circumstances where the policyholder has little or no incentive to defend itself, and where the applicability of the exclusions cannot be determined with certainty.

The pension trustees in Scottsdale v. Byrne sued the investment advisor in late 2014. They claimed that the pension fund had given the advisor $5 million to invest, and the advisor had put the money into various real-estate ventures, including a resort managed by the advisor itself. The advisor then engaged in various forms of mismanagement and self-dealing, including taking excess fees and failing to make mortgage and tax payments, resulting in failure of the ventures.

The trustees’ complaint announced in its first sentence that “this is an action under” the federal ERISA statute, which establishes standards for pension plans. And in one of the two counts of the complaint, the pension trustees claimed that the investment advisor’s self-dealing in taking excess management fees violated fiduciary duties imposed by ERISA because the conduct involved and affected “plan assets” within the meaning of the statute. In the other count, the trustees claimed that the investment advisor “breached the standard of care owed in the investment industry” and was negligent.

Scottsdale insured the investment advisor under a “business and management indemnity policy.” When the investment advisor tendered the matter to the insurer, Scottsdale focused on the complaint’s prominent references to ERISA, and pointed to an exclusion in its policy barring coverage for claims involving “actual or alleged violation of the responsibilities… imposed by [ERISA], or any rules or regulations promulgated thereunder, or similar provisions of any federal, state or local statutory or common law.”

The insurer also cited an exclusion added to the policy by special endorsement, which precluded coverage for claims involving certain “professional services”—that is, “services as a real-estate broker or agent, multiple-listing agent, real-estate appraiser, title agent, title abstractor or searcher, escrow agent, real-estate developer, real-estate consultant, property manager, real-estate inspector, or construction manager,” and went on to list services including “the purchase, sale, rental leasing or valuation of real property; the arrangement of financing on real property; or any advice proffered by an Insured in connection with any of the foregoing.”

Based principally on these exclusions, the insurer declined to defend the investment advisor in the pension trustees’ suit. A receiver who was separately appointed to oversee the wind-up of the failed real-estate ventures decided not to defend the trustees’ case, and instead consented to a default judgment, and assigned to the pension trustees any rights of the investment advisor under its insurance policy.

The insurer brought a declaratory-judgment action, and moved for summary judgment. In addition to the ERISA and professional-services exclusions, the insurer argued that because at least some of the advisor’s misconduct had allegedly been deliberate, the default judgment represented a “final judgment against [the] Insured” for “dishonest, deliberately fraudulent or criminal act[s],” and/or for “the gaining of any profit, remuneration or financial advantage to which [the Insured was] not legally entitled,” triggering a third set of coverage exclusions.

The federal judge presiding in the coverage case rejected all three of the insurer’s coverage arguments. The ERISA exclusion did indeed bar coverage, the court agreed, for one of the two counts of the pension trustees’ complaint, because that count expressly referenced the federal ERISA statute. But the other count was for negligence, and thus the insurer was obligated to defend. (Curiously, the court failed to address the insurer’s principal argument as to that count: that it likewise involved duties imposed by “provisions of… state… common law” that were, in this context and within the meaning of the policy exclusion, “similar to” the supposedly applicable duties imposed by ERISA.)

Nor did the court accept that the pension trustees’ claims necessarily fell within the categories of real-estate “professional services” excluded by the policy endorsement. The alleged mismanagement of the resort’s finances, the court said, “appear[s] to go well beyond” the policy’s conception of professional “property management, as that term is commonly understood.”

Finally, the insurer’s reliance on the intentional-acts exclusion, the court held, was misplaced given that the refusal to defend occurred a time before any “final judgment” had been against the Insured, a pre-condition to the operation of that exclusion.

Since none of the three exclusions gave the insurer a sufficient basis for declining to defend the investment advisor, the court held, the refusal to defend was, as a matter of law, a breach of the insurer’s obligations under the policy. The pension trustees, as assignees of the investment advisor’s policyholder rights, were entitled to summary judgment on their claim for breach of contract—and “presumably,” the court added, would be entitled to judgment for the entire $3 million per-claim policy limit, under the Massachusetts rule imposing such liability on a non-defending insurer unless the judgment against the policyholder “can be allocated [between] covered and uncovered claims.”

The court gave the parties 14 days from its decision to file motions concerning the form of judgment to be entered. (While the court did not mention it in the conclusion of its ruling, also yet to be addressed was the trustees’ counterclaim against the insurer for violation of the Massachusetts unfair-practices statute Chapter 93A, which would expose the insurer to possible multiple damages and attorneys’ fees.)

As noted, the Scottsdale v. Byrne decision provides a useful illustration, first, of the risks faced by an insurer in declining to defend a policyholder, particularly on the basis of exclusions that may not cleanly apply to the entirety of the underlying dispute. In this case, moreover, it appears that by refusing to defend, the insurer may have lost not only an opportunity to have an appointed defense lawyer explore defenses on the merits that might be available to the policyholder, but also a chance at establishing a fuller record for assessment of the coverage issues—for example, for assessing whether the advisor’s losses were fundamentally the result of deliberate self-dealing or mere negligence, or whether the ERISA or real-estate “professional services” exclusions might indeed apply on the facts. Such strategic considerations are often the subject of discussion between an insurer and its coverage counsel at the time a decision is made whether to defend a claim notwithstanding potential coverage issues.

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William L. Boesch

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