Repayment of Improperly Received Funds May Constitute Covered Loss; Coverage is Not Precluded on Public Policy Grounds

A Pennsylvania federal court, applying Pennsylvania law, has held that the relief sought in connection with the repayment of funds paid to a charter school may constitute covered “loss” under the E&O policy issued to a charter school and did not constitute “tuition expenses,” which were carved out of the definition of “loss.”  Peerless Insurance Co. v. Pennsylvania Cyber Charter School, 2014 WL 1917486 (W.D. Penn. May 13, 2014).  The court also concluded that coverage for such loss was not excluded on public policy grounds because there was no indication that the insured acted negligently, intentionally, or otherwise unlawfully, and there would be no windfall to the insured from the insurer’s reimbursement of the funds.

The insured charter school received payments from school districts for its kindergarten program, which admitted students one year younger than those admitted in the school districts’ respective kindergarten programs.  The Pennsylvania Supreme Court determined that, under the state’s charter school statute, the insured was not entitled to such payments.  Based on that decision, certain school districts filed suit against the charter school seeking repayment of those funds, along with interest.  After the charter school sought coverage under the policy, the insurer agreed to defend the insured and filed a declaratory judgment action to determine its obligations.  The insurer argued that the amounts sought by the school districts did not constitute “loss” under the policy because the repayment of funds was equitable relief in the form of restitution; that the amounts sought were excluded pursuant to the “tuition expense” carveout; and that the amounts were uninsurable under Pennsylvania public policy.

The court disagreed with the insurer, concluding that a covered “loss” may include a claim for restitutionary relief in certain circumstances.  According to the court, if ordered to repay the funds, the insured would have expended its own resources to educate certain kindergarteners without any compensation in return.  Thus, there would be no windfall for the insured if the amount repaid were recoverable under the policy.  The court also determined that, even if the return of the payments did not fall within the policy’s definition of “loss,” the “damages” and interest sought pursuant to the school districts’ prayers for relief would constitute “loss” under the policy.

The court further concluded that the payments at issue were a legislatively-mandated funding transfer and did not constitute “tuition expenses,” which the policy expressly carved out of the definition of “loss.” The court also determined that the “loss” claimed by the insured was not uninsurable on public policy grounds.  The court explained that the insured was collecting funds that it believed it was entitled to and was using those funds to educate children, and there was no indication that the insured’s actions were negligent, intentional, or otherwise unlawful.  In rejecting the public policy argument, the court also relied on the fact that the insured would not receive a windfall if insurance were to reimburse the insured for its repayment obligations because the insured had to expend its resources in the first instance in educating the children.

Finally, the court determined that the policy’s illegal profit exclusion did not apply to bar coverage because the underlying complaints did not allege that the insured knew it was violating the law or doing something improper when it requested the funds from the school districts, which funds were given without protest.  Rather, at the time, the parties thought the payments were required by law.