United States: District Courts Buck Trend On Fidelity Coverage For Social Engineering And Business Email Compromise Schemes

Last Updated: August 9 2017
Article by John C. Pitblado

The FBI continues to warn that losses are on the rise from business email compromise (BEC) or "social engineering" schemes, which the Bureau describes as:

Carried out by transnational criminal organizations that employ lawyers, linguists, hackers, and social engineers, BEC can take a variety of forms. But in just about every case, the scammers target employees with access to company finances and trick them into making wire transfers to bank accounts thought to belong to trusted partners—except the money ends up in accounts controlled by the criminals.

Just when it appeared that the circuit courts restored order to the question of coverage for losses arising from these schemes under fidelity policies, a couple of recent trial court decisions could result in a circuit-by-circuit patchwork of coverage law, depending on the outcome of appeals from those decisions.

As we previously reported, both the Fifth and Ninth Circuit Courts of Appeal ruled last year that BEC schemes were not covered under the "computer fraud" provisions in fidelity policies. In Apache Corp. v. Great Am. Ins. Co., 662 F. App'x 252 (5th Cir. 2016), the court reversed a trial court decision in favor of coverage in a $2.4 million scheme that was perpetrated as follows: A caller (purporting to be a representative of the insured's vendor) requested that the insured change bank-account information for payments to the vendor. The insured's employee stated that change could only be processed through a formal request on the vendor's letterhead, which the insured then received via email from a "petrofacltd.com" domain with an attached letter requesting the change. However, the vendor's authentic email domain was "petrofac.com." The insured's employee called the number on the letterhead to verify the request (which was fraudulently "verified"), and then another employee approved and implemented the change. The Fifth Circuit held that the loss was not "directly" caused by the use of a computer but was, rather, incidental and therefore not covered.

Similarly, In Pestmaster Servs., Inc. v. Travelers Cas. & Sur. Co. of Am., No. 14-56294 (9th Cir. July 9, 2016), the court held there was no coverage under either the computer crime or funds transfer fraud provisions of a fidelity policy, where the insured sustained a loss because its vendor had access to the insured's bank account and would transfer funds from that account to the vendor's account in order to pay for the insured's payroll expenses. But the vendor did not pay payroll taxes from the transferred funds, causing the insured various direct and indirect losses.

Citing Pestmaster, the Ninth Circuit more recently held in Taylor & Lieberman v. Federal Ins. Co., 681 Fed. Appx. 627 (9th Cir. 2017) that there was no coverage for a more traditional BEC scheme, where a fraudster used the email address of the insured's client to request changed wire instructions from an employee of the insured. The insured's employee requested the transfer and sent a confirmation email to the client. A second transfer was completed in the same manner. The court held there was no coverage under the forgery, computer fraud, or funds transfer fraud provisions of the insured's fidelity policy.

And recently, a Michigan federal court concluded the same in American Tooling Center, Inc. v. Travelers Cas, & Surety Co. of Am., Case No. 16-12108 (E.D. Mich., Aug. 1, 2017), holding there was no coverage under the computer fraud provision of a fidelity policy for a scheme where the insured's VP received instructions to change the wiring of payment for legitimate invoices to a new bank account. The email address reflected the domain name as "yifeng-rnould," but the correct domain name for the vendor's email was "yifeng-mould." As of this writing, no notice of appeal to the Sixth Circuit has been filed, though the appeal period remains open.

Bucking the Trend

Despite what appeared to be a developing consensus, a couple of other recent district court opinions have gone the other way. One is already on appeal at the Eleventh Circuit. The other is likely to be appealed in the Second Circuit (though no notice has been filed to date).

In Principle Solutions Goup, LLC v. Ironshore Indem., Inc., No. 1:15-CV-4130-RWS (N.D. Ga. March 29, 2017), the court addressed coverage for a scheme where the insured's controller received an email from someone purporting to be one of the insured's managing directors and appeared to be sent from his corporate email address. The email referenced a company acquisition and instructed the controller to work with an attorney to wire money. The controller later received an email from someone purporting to be the attorney. The attorney emailed the wire instructions. The attorney called the controller and said he had approval from the insured's director to complete the wire transfer. The controller instructed another employee to create the wire and then approved it, resulting in a $1.717 million loss. The court found coverage under the insured's commercial crime policy, citing the "Computer and Funds Transfer Fraud" provisions, distinguishing Apache and Pestmaster, both of which the insurer cited. The insurer appealed, and the case is pending in the Eleventh Circuit.

Correspondingly, in the much-anticipated decision Medidata Solutions, Inc. v. Federal Ins. Co., No. 15-CV-00907 (S.D.N.Y. July 21, 2017), a New York federal court found coverage for a similarly sustained $4.7 million loss: an employee of the insured received an email purportedly from the insured's president stating that they were close to finalizing an acquisition and that an attorney would contact the employee to discuss. The employee received a call from someone purporting to be the attorney. The attorney directed a wire transfer, and the employee told the attorney she needed an email from the insured's president requesting a wire transfer and approval from the insured's VP and director of revenue. The employee, VP, and director of revenue thereafter received an email purportedly from the insured's president requesting that they sign off on the transfer — the email showed the president's email address and his picture. The employee submitted the wire for approval, and the VP and director of revenue signed off.

The court took a very hard look at the question of whether this fit the definition of a computer violation, which was defined as the "fraudulent: (a) entry of Data into ... a Computer System; [and] (b) change to Data elements or program logic of a Computer System, which is kept in machine readable format ... directed against an Organization." After summary judgment was completed, the court ordered further briefing with expert reports regarding the precise mechanics of the scheme, which allowed the mock email to appear as though it were internal, particularly given that it included the president's picture, and whether this required change to data elements in the insured's computer system. The court held that it did, finding coverage. No notice of appeal has been filed yet, though the appeal period remains open as of this writing.

So, the focus now shifts to the Eleventh Circuit, which appears poised to be the next circuit court to address the issue. The Sixth and Second Circuits may soon address it as well. These recent decisions finding coverage certainly sow uncertainty, where it previously appeared a consensus was forming.

But the issue may otherwise become academic as insurers respond to the uncertainty with different forms and new coverages. For example, in Principle Solutions, the insurer attempted to introduce evidence on insuring intent by pointing out that it offered for sale an entirely separate rider designed to address schemes precisely like those at issue, called "Cyber Deception" coverage, and which differed in material ways from the relevant "computer systems" fraud coverage. Other insurers are similarly addressing BEC and social engineering schemes with specialized coverage. Still, under typical current policy forms, the field of play is very much in flux, and coverage practitioners on both sides of the issue should familiarize themselves with the relevant decisions in their forum.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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