On August 1, 2011, in a 2-1 decision characterized by a testy but interesting exchange between the majority and the dissent, the Sixth Circuit held that a fidelity policy provided coverage for nearly one million dollars a bank employee stole from client brokerage accounts. For those who (like me) are not regularly involved in fidelity claims, the two opinions provide an interesting opportunity to consider the purpose and operation of fidelity coverage and how it relates to general liability policies. The Sixth Circuit’s decision can be found here.
First Defiance Financial Corporation is a bank holding company. Jeffrey Hunt was a “dual employee” for First Defiance, providing investment advisory services to First Defiance customers and also trading securities for Online Brokerage Services. The clients’ assets were held in individual accounts at a third institution, National Financial Services. These client accounts were accessible only by First Defiance’s investment advisors, which acted as the “exclusive agent” on the clients’ behalf.
In April 2007, First Defiance learned that Hunt had transferred a total of about $859,000 from nineteen client accounts to his own bank account. First Defiance ultimately repaid the clients for their losses, including lost interest and unrealized client income. The total amount of First Defiance paid to the customers was about $930,000.
First Defiance provided a proof of loss to its fidelity insurer for the amount of its payment to the clients. The fidelity policy provides insurance against “[l]oss resulting directly from dishonest or fraudulent acts committed by an Employee, acting alone or in collusions with others.” In its Covered Property provision, the policy specifies that the policy covers “loss of Property (1) owned by the Insured, (2) held by the Insured in any capacity, or (3) owned and held by someone else under circumstances which make the Insured responsible for the Property prior to the occurrence of the loss.”
The fidelity insurer denied First Defiance’s claim for the loss, and First Defiance initiated a coverage lawsuit against the fidelity insurer. The district court entered summary judgment for First Defiance, holding that First Defiance’s loss was covered under the policy. The fidelity insurer appealed the coverage ruling. The parties also cross-appealed the district court’s calculation of the amount that the fidelity insurer owed. I do not discuss in this post the issues relating to the calculation of the insurer’s obligations.
The August 1 Opinions
In a majority opinion written by Judge Jeffrey Sutton for a divided Court, the Sixth Circuit affirmed the district court, holding that the fidelity policy covers First Defiance’s losses. Judge Deborah Cook dissented, writing a separate opinion that is well worth reading.
The crux of the majority’s opinion is its conclusion that the money in the client brokerage accounts represented Covered Property within the meaning of the fidelity policy. In reaching this conclusion, the majority determined that money in the brokerage accounts was “held under circumstances that made the insured responsible for the property” and that that responsibility arose “prior to the occurrence of the loss.”
The fidelity insurer had argued that First Defiance’s responsibility did not arise prior to the loss, and that First Defiance could have incurred liability only after Hunt stole the money, giving rise at most to a potential tort claim against the bank.
The majority rejected this argument, concluding that the definition refers to “responsibility” before the loss, not to liability, and that “the fiduciary relationship” between First Defiance and its clients “pre-dates the theft” making First Defiance “responsible for transactions undertaken with a client’s money from the moment the fiduciary relationship was formed.” The majority added that the bank’s responsibility “need not be established by a tort verdict, which necessarily cannot happen before the theft; it can be established by the terms of the account between the bank and the client and the fiduciary duties that spring from them.”
In her dissenting opinion that relies on policy drafting history and the purposes of the relevant language in the fidelity policy, Judge Cook characterizes the majority opinion’s policy interpretation as “simplistic.” Judge Cook asserts that “neither the policy language nor the history of fidelity coverage supports the majority’s view that the customer accounts constituted First Defiance’s ‘Covered Property.’”
Judge Cook focused specifically on the language in the definition of Covered Property requiring that the employer’s responsibility must vest “prior to the occurrence of the loss.” Judge Cook reviewed how this language had been added to the policy form to clarify that “a fidelity bond, unlike a general liability policy, provides no coverage for an employer’s vicarious liability for employee torts.” The provision, Judge Cook said, adds a “temporal element” requiring that “the insured’s responsibility for the stolen property must arise prior to the loss, not by virtue of vicarious liability.” First Defiance could have but did not assume responsibility for the risk of theft prior to loss “by placing [a] guarantee in its investment agreements with its customers.”
In an irritable response to the dissent, the majority opinion reiterates that First Defiance was “responsible” for money in the customer accounts at the time the accounts were opened, “long before –prior to—the loss of some money in those accounts cause by Hunt’s theft.” The majority opinion emphasizes that the policy does not require that the insured entity’s contract expressly state that insured entity undertakes responsibility for theft from customer accounts, but instead the policy requires only that “the ‘circumstances’ of the relationship must make the insured ‘responsible for the money before the theft.” In a dismissive characterization of the dissent’s position on this issue, the majority opinion adds the concluding comment that this question has been “Asked and answered.”
The critical issue here is the question of when First Defiance became responsible for the theft. Was it responsible for the theft from the moment the client accounts were created, or was it responsible only after the theft had taken place, on the basis of vicarious liability?
The question matters, because the answer to the question determines whether or not this loss properly belongs under a first-party policy like the fidelity policy at issue here, or more properly belongs under a third-party liability policy like a general liability policy.
Without presuming to suggest the right answer to this question, I will say that I found the dissenting opinion’s review of the history of the relevant language in the fidelity policy to be instructive. At least based on the sources referenced in the dissenting opinion, it seems that the language at issue here was added to the policy in order to clarify that the fidelity policy, unlike a general liability policy, provides no coverage for an employer’s vicarious liability for employee torts.
However, that observation does not alone answer the question of when the bank became responsible for the employee theft. On the one hand, I tend to agree that to agree with the majority’s common sense reasoning that the customer would certainly assume that the bank would be responsible for an employee theft from the customer’s account, and I also agree with the majority that as a practical matter its highly unlikely that there would be a written expression of this assumption in the bank’s agreement with the customer.
On the other hand, I tend to agree with the dissent that the expectation that the bank would be responsible for the employee’s theft simply reflects a general assumption that an employer is responsible for employee misconduct. If, for example, First Defiance had not voluntarily reimbursed the customers for their loss as a result of the theft and the customers had been forced to sue the bank, the customers would have, one way or the other, based their claims against the bank on some version of vicarious liability.
Framing the question in terms of that hypothetical lawsuit also seems to suggest that – even though the bank voluntarily made the customers whole – the payment to the customers was as a result of a third party liability claim.
All of that said, I would have a hard time subscribing to the dissent’s view of this case if the end result was that there was no insurance at all for this loss. I would be more comfortable altogether with the dissent’s position if I were sure that if the loss were not covered under the fidelity policy, it would be picked up under another policy. I would not be comfortable at all with the dissent’s position if it would result in the loss falling into a crease between policies. In particular, I would want to know whether or not the typical general liability policy would have in fact picked up this loss. Of particular concern is the possibility that a liability policy might preclude this loss because it was the result of an intentional act.
It would seem that, in a world in which there is little certainty, the safe thing for an insured organization to do in a situation like this is to submit a claim under both the fidelity and liability policies.
I am very interested to know the thoughts and reactions of readers who work more frequently with fidelity policies. I would like to know what others think of the majority’s position on these issues and also the dissenting opinion as well. I am also curious to know about what readers may think about the possibility that the possible coverage for this claim under a general liability policy. I encourage readers to post their comments to this post using the comment feature in the right hand column.
For those readers interested in a good quick introduction to fidelity coverage I recommend the Much Shelist law firm’s November 1, 2011 memo entitled “The ABCs of Fidelity Bonds: What Policyholders Need to Know” (here).
SEC, The Jury Has a Message for You: Many readers many be aware that on July 31, 2012, a civil jury in federal court in Manhattan acquitted Citigroup employee Brian Stoker on allegations that he had misled investors in connection with $1 billion of collateralized debt obligations. In a highly unorthodox accompaniment to the verdict form, the jury included a message to the SEC that “"This verdict should not deter the SEC from continuing to investigate the financial industry, to review current regulations, and modify existing regulations as necessary."
In his August 3, 2012 New York Times article entitled “Jury Gets Encouragement from Jury That Ruled Against It” (here), Peter Lattman reports, based on his interview of one of the jurors, how the note came about. As Lattman points out, the note seems to reflect common discontent that persons in the financial industry who were responsible for the excesses that contributed to the credit crisis have not been brought to account. As Alison Frankel notes in an August 2, 2012 post on her On the Case blog (here), for the SEC, the jury’s note “has to read like one more reminder that the public is still waiting for corporate accountability.”
In her August 1, 2012 Summary Judgment column on the Am Law Litigation Daily (here), Susan Beck has an interview with the foreman of the jury that heard Stoker’s case. From the foreman’s comments, it seems clear that the jury thought that while there was wrongdoing it was more in the form of collective wrongdoing of the company itself rather than that of one lower level individual. Beck quotes the foreman as saying that "He did not act in some kind of vacuum where his behavior was not tolerated or encouraged by his bosses. . .To try to hang all this on Stoker didn’t work."
Frankel’s column has an interesting analysis of how the acquittal in the SEC’s case against Stoker may affect the long running saga of the SEC’s settlement of its enforcement action against Citigroup in connection with the CDO transaction. As noted here, Judge Jed Rakoff has rejected the settlement and refused to stay the case. More recently, the Second Circuit stayed the case pending an appeal of Rakoff’s rejection of the settlement, in an opinion that strongly suggested that Rakoff was wrong on the merits. Frankel suggests, among other things, that in the upcoming appellate arguments, the SEC may rely on the acquittal to show that the agency was wise to settle its case with Citigroup rather than test evidence that might not have withstood muster. On the other hand, the special counsel representing Judge Rakoff in the appeal may be able to argue (perhaps in reliance on the jurors’ comments in press reports) that the jury verdict actually reflected the jurors’ belief that there was misconduct among higher ups at Citigroup, and so Rakoff was right to reject the settlement.
There definitely is something about this case where every single thing that happens is interesting and worthy of commentary. It will in any event be interesting to see how the appeal regarding the erstwhile settlement unfolds. The appellate case is due to be argued in late September.
The Unintended Consequences of the JOBS Act: When Congress passed the Jumpstart our Businesses Startups (JOBS) Act earlier this year (about which refer here), it was hoped that the legislation would encourage “Emerging Growth Companies” and facilitate job creation. However, as discussed in Jason Zweig’s August 4, 2012 Wall Street Journal article entitled “When Laws Twist Markets” (here), things are playing out a little different than expected. As Zweig puts it “No matter how Congress monkeys with the laws, one always remains in force: the law of unintended consequences.”
By way of illustration, Zweig cites as an example of one company trying to take advantage of the JOBS Act’s streamlined IPO procedures and reduced reporting requirements the 132 year-old British football club, Manchester United, which hopes to launch its $300 million IPO next week. Zweig also refers to “blind pools” and “blank check” investment funds that are angling to take advantage of the JOBS Act’s provisions. Neither type of company is likely to contribute to job creation in the United States. Zweig also reports that at least seven Chinese companies are converting to JOBS Act reporting provisions, in order to be able to reduce the disclosures they are required to file; as Zweig points out, this is “no trivial matter since several other Chinese-based companies have recently been accused by U.S. regulators of filing misleading financial statements.”
As I have previously noted (here), a company’s status as an “Emerging Growth Company” arguably is for some companies itself a risk factor of which the company’s investors should be warned, particularly those companies taking advantage of the JOBS Act’s relaxed reporting requirements.
It should be noted that none of the comments above about the JOBS Act have anything to do with what may be the Act’s most distinctive feature, its allowance for online “Crowdfunding.” As I discussed here, the Act’s crowdfunding provisions were intended to facilitate fundraising for start-ups, but for many reasons, “crowdfunding is unlikely to be an attractive alternative for start-up companies.”
So far at least, it would seem the JOBS Act has produced only unintended consequences.
My New All-Time Favorite Headline: The headline for the lead article in the August 4, 2012 Detroit Free Press, regarding legal controversy surrounding Michigan’s emergency management law for financially troubled municipalities, reads simply “CHAOS” in four-inch high letters. (An online version of the article, sans the headline under which the story appeared in the print edition, can be found here.)
Given the financial condition of many of Michigan’s municipalities, and indeed given the ongoing developments around the world, the Free Press might well consider using that same headline every day. And newspapers everywhere else, too.
And Finally: I am an enthusiastic (if intermittent) fan of European football, particularly English Premier League football. Owing to this interest, I downloaded onto my iPad the Fan Chants app, which has recordings and lyrics of soccer fan chants from around the world. Some of the chants are rude and even profane, but overall the chants are highly entertaining. They can also be highly addictive; for example, since writing the paragraph above referring to Manchester United, I have been sitting here silently chanting to myself “Oh Man-ches-ter (Oh Man-ches-ter) is won-der-ful (is won-der-ful)…”
In contemplation of all of this, it somehow seemed appropriate to share this video clip of Sheffield United fans singing the “Greasy Chip Butty Song.” (A Chip Butty apparently is a sandwich consisting of French fries on buttered bread.) Here are the lyrics for those who can’t make out the words in the video:
You Fill Up My Senses,
Like A Gallon Of Magnet,
Like A Packet Of Woodbines,
Like A Good Pinch Of Snuff,
Like A Night Out In Sheffield,
Like A Greasy Chip Butty,
Like Sheffield United,
Come Fill Me Again,
Na Na Na Na Na…OOOOHH!