A recent federal court decision in “a property loss insurance case” involving the unauthorized growing of marijuana could have a negative impact on the enforceability of insurance policies sold to legitimate marijuana-related businesses. How much of an effect remains to be seen, but there is reason to think it should be minimal.

At issue in K.V.G. Properties, Inc. v. Westfield Insurance Company, No. 16-11561 (E.D. Mich. Nov. 8, 2017), was an insurer’s denial of a commercial property owner’s claim for coverage under a “commercial insurance policy.”  Certain of the property owned by the policyholder, which was intended to be “used for general office or light industrial business,” was damaged when the tenants to whom the property was rented used the property to grow marijuana.  As the court explained, growing marijuana was “an activity not authorized” by the policyholder.  In fact, the property owner was unaware that its tenants were using its property for that purpose until learning that “DEA agents executed a search warrant on the” property.

Nonetheless, the insurance company denied the property owner coverage for the damage to the property caused by that unauthorized activity.

In relevant part, the insurer relied on the “illegal/dishonest acts” exclusion in its policy, which precludes coverage for damage caused by a “[d]ishonest or criminal act by … anyone to whom you entrust the property for any purpose.”

The U.S. District Court for the Eastern District of Michigan found that this exclusion barred coverage here. It began: “Putting aside whether the tenants’ marijuana operations were legal under Michigan law (of which there is no evidence), it is clear that the operations violated federal law.”  The court then stated:  “Beyond criminal activity, the exclusion also applies to dishonest conduct.  [The property owner] says the tenants were supposed to be conducting general office and/or light industrial business and [it] did not give the tenants permission to grow marijuana on the property.”  That fact, and the fact that “the alterations” to the property “were done surreptitiously,” suggested to the court “that the loss falls under the dishonest/illegal acts exclusion.”

The court’s reference to federal law in determining that the “illegal/dishonest acts” exclusion applied is concerning. In K.V.G., the policyholder was not a marijuana-related business; indeed, it did not even know that its tenants were growing marijuana on its property.  Nonetheless, applied in the context of a dispute between a marijuana-related business and its insurer, similar reliance on federal law could be used to find an insurance policy unenforceable on the grounds of a similar exclusion or, more generally, public-policy considerations.  Indeed, one federal district court has already reached that very conclusion, finding that an insurer could deny coverage for a marijuana-related loss because marijuana is illegal under federal law.

That said, there is reason to think that K.V.G. will not have such a far-reaching effect.  While the Eastern District of Michigan did refer to federal law, it focused much more on the tenants’ dishonesty.  It found that the property owner “entrusted” the property to the tenants, “trusting that the tenants would abide by the obligations in the leases.”  The tenants, however, abused that trust.  Concluding that “[t]he tenants’ use of the [property] to grow marijuana was illegal or at the very least dishonest,” the court found that the insurance company “is entitled to summary judgment on the grounds that the damage to the [property] is excluded under the illegal or dishonest acts exclusion.”

Arguably, the lynchpin of the court’s decision was that the tenants acted dishonestly vis-à-vis the policyholder, not that they had violated federal law. As such, a fair reading of this decision would be a narrow one limited to circumstances where damage to property is caused by a dishonest act unknown to the policyholder, such as the use of leased property for an unintended and/or concealed purpose.

However, when a policyholder advises its insurer that property will be used for a marijuana-related purpose, and then that property is used for its intended purpose in a jurisdiction where medical or recreational marijuana is legal, there is no such dishonest act. To the contrary, when the insurer knows that the property will be used for a marijuana-related purpose and the property is in fact used for that purpose in a jurisdiction where marijuana is legal under state law, the insurer should have to honor its contractual obligations when a marijuana-related loss occurs. K.V.G. should not be read to change that outcome.