Insurance Policies Likely To Cover Payroll Service Providers For Customer Indemnification Demands

Insurance coverage should not be overlooked

Payroll service providers regularly face demands from their customers to defend and indemnify lawsuits filed against their customers by employees alleging various Labor Code violations.  For many payroll service providers, the cost of defending and indemnifying their customers is viewed as a cost of doing business, but that should not be the case.  

As detailed below, payroll service providers should turn to their professional liability or errors and omissions (“E&O”) insurer for insurance coverage for these types of customer demands. When they do, their insurer may try to rely on various common exclusions to avoid its coverage obligations.  
 

However, in most cases, those exclusions do not apply. Accordingly, payroll service providers should carefully consider the insurance coverage that is potentially available, but often overlooked or incorrectly denied by insurers, for these types of demands.  

A Typical Scenario

A common scenario is that a customer is sued by one of its employees alleging that the customer’s wage statements did not include certain information or included incorrect information.  Because the payroll service provider completed the wage statements, the customer turns to their payroll service provider and demands defense and indemnification for the lawsuit.  The customer’s demand is typically based on a payroll services agreement that requires indemnification if a lawsuit arises out of certain alleged actions by the payroll service provider.  When that demand is made, the payroll service provider should tender the claim to its professional liability or E&O insurer.

The Insurance Coverage

Professional liability policies typically provide coverage for all “Loss” that the payroll service provider is legally obligated to pay resulting from a “Claim” alleging a “Wrongful Act.”  Most professional liability policies broadly define a “Claim” to include not only lawsuits, but also any “written demand for monetary or non-monetary relief.”  Additionally, the phrase “Wrongful Act” is typically defined as “any act, error or omission, misstatement or misleading statement” in the payroll service providers' performance of “Professional Services.”  

Accordingly, a written indemnification demand from a customer pursuant to a payroll services agreement triggers coverage under a professional liability policy because (1) it seeks monetary relief and (2) by invoking the payroll services agreement, it necessarily alleges an error or omission on the part of the payroll service provider.  After all, if the customer was not claiming an error on the part of the payroll service provider, it would not be entitled to a defense or indemnification under the terms of most payroll services agreements.  

The Insurer’s Response

In response to such a claim, insurers typically rely on certain exclusions that are common to professional liability policies to deny coverage.  However, the insurers’ reliance on these exclusions is often misplaced.  

For example, an insurer may say that an exclusion for claims arising out of the payroll service provider’s employment of an individual or its “employment practices” precludes coverage.  This position ignores the nature of the customer’s claim.  The lawsuit against the customer arises out of the employment of the individual by the customer, not the payroll service provider.  

Furthermore, the claim from the customer arises out of the payroll service providers’ performance of payroll services for the customer, not the payroll service provider’s employment of any individual or its employment practices.  Stated differently, the claim that is being submitted for coverage is not the lawsuit, it is the demand to defend and indemnify the lawsuit from the customer. Indeed, the payroll service provider is often not even named in the lawsuit against the customer.  Accordingly, an exclusion for “employment practices” does not apply.

Insurers also commonly assert that an exclusion for claims arising out of any obligation a payroll service provider “has under contract” or “assumes under contract” precludes coverage.  The insurers argue that the customer is premising its demand on a payroll services agreement and, therefore, the claim arises out of obligations the payroll service provider has under contract and is not covered.  

However, most professional liability policies include exceptions to this type of exclusion for (1) the obligation to perform “Professional Services” and (2) any liability the payroll service provider would still have in the absence of the contract.  Both exceptions apply in the scenario discussed above.  Clearly, a payroll services agreement involves the payroll service provider’s obligation to perform its professional service.  

Additionally, the payroll service provider faces liability even in the absence of the payroll services agreement.  The payroll service provider provided services that allegedly exposed their customer to potential liability.  Accordingly, the customer has potential claims against the payroll service provider for its failure to conform its professional services to the requirements of the Labor Code.  That is precisely the type of claim a professional liability policy is designed to cover.       

Another exclusion that is often raised by insurers precludes coverage for claims alleging unfair competition or unfair or deceptive business practices.  This exclusion is usually invoked because the lawsuit against the customer includes such allegations.  As discussed above, though, the claim that is being submitted for coverage is not the lawsuit.  Because the customer usually does not allege that the payroll service provider engaged in unfair competition or unfair or deceptive practices, the exclusion is not implicated.

Furthermore, a professional liability policy for a payroll service provider should include an exception to this exclusion for any claim alleging that the payroll service provider’s “Wrongful Act” caused its customer to violate a consumer protection law.  If such an exception is included, then the exclusion would not apply for this additional reason.  

In addition to certain exclusions, insurers may also point to common exceptions to the definition of “Loss” to avoid or limit coverage. For example, many definitions of “Loss” preclude coverage for “fines or penalties.” Because the lawsuit against the customer usually seeks certain statutory penalties for Labor Code violations, insurers try to argue that the statutory penalties do not fall within the definition of “Loss.” Once again, the insurer's argument fails. The customer is not seeking fines or penalties imposed against the payroll service provider. What the employee plaintiff is seeking from the customer is simply a measure of the damages that the customer is demanding from the payroll service provider. Thus, the customer is seeking damages that are covered by most professional liability policies. 

Insurance Coverage Should Not Be Overlooked

As the above makes clear, payroll service providers should carefully consider the coverage provided by their professional liability policies when faced with indemnification demands from customers for lawsuits alleging Labor Code violations.  If an insurer has denied coverage for such a claim, payroll service providers should evaluate the insurers’ position in light of the law, the facts, and the pertinent policy provisions because the coverage defenses raised by insurers are often without merit. 

Michael S. Gehrt is an Insurance Recovery Partner in Pasich LLP.  He represents policyholders in complex insurance coverage matters.  Visit https://pasichllp.com/  Connect Michael Gehrt