Theft of Client Funds and the Interplay Between Bad Actors and Innocent Insured Coverage

Theft of Client Funds and the Interplay Between Bad Actors and Innocent Insured Coverage

A question that occasionally comes up concerns insurance coverage for the loss of client funds. This is a particularly troublesome concern due to the nature of the problem. After all, having someone steal your own money is one thing. Having a member of your firm steal someone else’s money while your firm is responsible for overseeing those funds is something else entirely.

The ramifications of discovering such a loss are nightmarish. Not only can the necessity of having to replace the missing funds in order to prevent harm to any client be more than your firm may be financially able to cover; but your firm’s reputation may take a hit and the bar will be contacting you shortly.

The question asked of me often comes after a lawyer has heard about a theft at another firm and learned that there was minimal to no coverage in place for that loss. All these callers want is to have me provide an assurance that their malpractice policy would cover such a loss if something similar were to happen to them. Unfortunately, I can’t because most legal malpractice insurance policies don’t cover theft of client funds.

Think about it. Theft of funds is an intentional and illegal act, and the stolen funds are a loss of property. Malpractice polices don’t cover intentional and illegal acts nor do they provide property coverage. In addition, many malpractice policies specifically exclude coverage for this type of risk just to make sure it’s clear. The proper way to cover this type of risk is to purchase a crime policy or to add a crime endorsement to your business owner’s policy.

Sometimes the caller will then say, “But wait! Our malpractice policy has innocent insured coverage. Wouldn’t this mean that those of us who were not involved in the theft have coverage?” Here again, remember that policy language can specifically exclude coverage for this type of loss. However, let’s assume your policy language doesn’t.

Here’s the first of two problems. Malpractice policies have a prior knowledge clause in them, and this clause can lead to the stripping away of innocent insured coverage. The vast majority of lawyers certainly know that failing to disclose knowledge of a potential claim on an application for insurance is a bad idea. Coverage can be denied, and policies rescinded if and when such misrepresentations come to light. Unfortunately for any lawyers hoping an innocent insured clause will protect them after a misappropriation, the lawyer stealing funds from clients knew about a potential claim when committing the bad act. Since wrongdoers tend not to disclose their misdeeds and theft often occurs over time, misrepresentations on insurance applications do occur. If this failure to disclose a misappropriation results in the insurer declaring the policy void and the policy is rescinded, there may be no coverage for anyone.

Here’s the second problem. After a misappropriation, a question that may be asked is this. Were the “innocent insureds” truly innocent? Oft times the answer to this question will turn out to be no.

The rules of professional conduct mandate that lawyers properly train and supervise all staff who will handle client property. These rules also require that lawyers accept accountability for all client property that is in their possession. A firm must implement practices and procedures that are designed to minimize the possibility of anyone, including all lawyers at a firm, from misappropriating funds.

By design, these rules require the continuous and meaningful oversight of other people’s property. A lawyer cannot simply turn over the books and all responsibility for client funds to a non-attorney and say, “Thanks for helping me with this; I really dislike these administrative back-office tasks.” By the same token, a firm cannot turn a blind eye to the warning signs of any lawyer or staff member who may be going rogue. Failure to take these ethical requirements to heart and affirmatively act to prevent a misappropriation is not the same as being innocent should the worst happen.

The failure to anticipate and to follow through with the creation and implementation of appropriate practices and procedures intended to prevent theft of client property does passively create the circumstances that can allow a misappropriation to occur. In other words, a blind eye is not the same as being truly innocent and there’s the rub.  If there are few to no preventative measures in play at your firm, the time to rethink that decision is now because should the worst ever happen, when it comes to coverage for any loss, you may find that you aren’t as innocent as you might think. If you need help with what to do, here’s one place to start

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Since 1998, Mark Bassingthwaighte, Esq. has been a Risk Manager with ALPS, an attorney’s professional liability insurance carrier. In his tenure with the company, Mr. Bassingthwaighte has conducted over 1200 law firm risk management assessment visits, presented over 550 continuing legal education seminars throughout the United States, and written extensively on risk management, ethics, and technology. Mr. Bassingthwaighte is a member of the State Bar of Montana as well as the American Bar Association where he currently sits on the ABA Center for Professional Responsibility’s Conference Planning Committee. He received his J.D. from Drake University Law School.