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The Circular Illogic of the “Authorized Fraud” Argument

David A Gauntlett


  • Policyholders are often better served by securing distinct and robust “crime” coverage in addition to cyber coverage.
The Circular Illogic of the “Authorized Fraud” Argument

A decision earlier this year by the Ninth Circuit Court of Appeals highlights the continuing insurance coverage challenges that policyholders face for losses arising from social engineering fraud and demonstrates that policyholders are often better served by securing distinct and robust “crime” coverage in addition to cyber coverage to address “social engineering fraud.”

 In Ernst & Haas Management Co. v. Hiscox, Inc., Case No. 20-56212, 2022 U.S. App. LEXIS 2372 (9th Cir. (Cal.) Jan. 26, 2022), the policyholder submitted a claim under its crime coverage policy to recover $200,000 loss under the policy’s “computer fraud and funds transfer fraud” coverage provisions. An accounts payable clerk for Ernst had received an email purporting to be from her superior directing her to make a payment via wire transfer for a $50,000 invoice, which the clerk regularly did pursuant to her job duties. The clerk received a second request for $150,000, which she completed, and a third for $470,000, at which point her suspicions were raised and the fraud was discovered.

The computer fraud provision covered loss “resulting directly from” the use of a computer to fraudulently cause a transfer from Ernst to a person or location outside of Ernst. Id. at *13. The district court, however, granted Hiscox’s motion to dismiss on the grounds that Ernst’s loss did not “directly result from” computer fraud or funds transfer fraud because Ernst’s employee had “authorized” the wire transfers when she initiated the wire transfer requests to Ernst’s bank. Ernst at *15.

The Ninth Circuit found that the district court’s analysis that Ernst’s loss did not result directly from the computer fraud because Ernst authorized its bank to initiate the wire transfers was in error. Id. at *15-16. The court highlighted the illogical result that would derive from such an application, which is that the insured could essentially cure a prior fraud by authorizing a payment based on fraudulent instruction. “That reasoning—that this fraud became ‘authorized’ precisely when it succeeded – cannot be the correct reading of the contract.” Id. at *15.

The court further found that Ernst immediately suffered a direct loss when the funds were transferred as directed by the fraudulent email. “There was no intervening event—[the clerk] acting pursuant to the fraudulent instruction ‘directly’ caused the loss of the funds. Thus, taking the pleaded facts as true, Ernst suffered a loss resulting ‘directly’ from the fraud.” Id. at *16-17.

With its decision in Ernst, the Ninth Circuit has joined other jurisdictions that have more soundly held that an insured’s loss was directly caused by computer fraud even though the insured’s employees initiated the wire transfers based on the “authorization” they had received from a computer fraudster including the Sixth Circuit (American Tooling Ctr., Inc. v. Travelers Cas. & Sur. Co. of Am., 895 F.3d 455, 461-63 (6th Cir. 2018); the Second Circuit (Medidata Sols., Inc. v. Fed. Ins. Co., 268 F. Supp. 3d 471, 476-478 (S.D.N.Y. 2017), aff’d, Medidata Sols., Inc. v. Fed. Ins. Co., 729 Fed. Appx. 117, 119 (2d Cir. July 6, 2018), the Eleventh Circuit (Principle Solutions Group, LLC v. Ironshore Indemnity, Inc. 944 F.3d 886, 891-893 (11th Cir. 2019)), the District of Alaska (City of Unalaska v. Nat’l Union Fire Ins. Co., 2022 U.S. Dist. LEXIS 51387, *18-19 (D. Ala. March 18, 2022)), and the Eastern District of Virginia (Cincinnati Insurance Company v. Norfolk Truck Center, Inc. 430 F.Supp.3d 116, 130 (E.D.Va. 2019).