david_bergenfeld1

David Bergenfeld

laura_lang

Laura Lang

This past year was a very eventful one in the world of fidelity bond, commercial crime, and cybercrime coverages. In the following guest post, David Bergenfeld of the D’Amato & Lynch law firm’s Fidelity Bond Practice Group, and Laura Lang, Esq., take a look at the important developments during 2015 regarding these coverages. I would like to thank David and Laura for their willingness to publish their article as a guest post on this site. I welcome guest post submissions from responsible authors of topics of interest to this blog’s readers. Please contact me directly if you would like to submit a guest post. Here is David and Laura’s guest post.

 

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Throughout 2015, state and federal courts have confronted many issues, intricacies and anomalies of fidelity bond, commercial crime and cybercrime coverages, including direct loss, capacity, causation, insured property and a variety of exclusions.  While not intended to be an exhaustive review of all coverage decisions in 2015, the following highlights select emerging issues from across the country.

 

The Courts’ Interpretation of Direct Loss in Fidelity Bonds

 

In 2015 courts continued to grapple with “Direct Loss” and whether “Direct means Direct” or “Direct” is analogous to “Proximate Cause.”  The majority of states follow the “Direct means Direct” legal analysis.[1]  Proximate Cause is equivalent to the tort proximate cause concept.  “Direct means Direct” generally limits coverage to losses of assets that the insured held in an account for a customer or owned by the insured. [2]

 

In Cumberland & Erly, LLC v. Nationwide Mutual Insurance Company,[3] the Maryland district court held that when a law firm reimburses a customer trust account for which one of the law firm’s partners was the trustee, such loss would be considered a loss under both the “Direct means Direct” and “Proximate Cause” opinions.

 

A paralegal working at the insured law firm, Cumberland & Erly, LLC (“C&E”), embezzled $157,268.75 through forging checks.  C&E submitted its claim to the insurer who denied the claim based on the fact that the loss was not direct.  Specifically, by C&E reimbursing the trust account from which the funds were illegally obtained through forged checks, the loss was indirectly caused by the employee defalcation.  The court rejected the insurer’s argument regarding “Direct means Direct” and criticized such legal interpretation:  “[t]he ‘direct means direct’ approach suffers the flaw of attempting to define a term through the very language requiring definition. . . . The proximate cause theory, on the other hand, recognizes that restricting ‘direct loss’ to preclude recovery for any third-party obligations ‘would seem to conflict with the plain and ordinary meaning of a direct loss.”

 

It appears that the court  sought to reconcile its ruling in the case with the “Direct means Direct” legal structure when it noted that, “[e]ven under the ‘direct is direct’ approach . . . C&E’s loss is a ‘direct loss.’  In this case, no ‘intervening space, time’ or other event occurred as C&E immediately replaced the stolen funds.”  Necessarily, one could interpret the court’s application of the “Direct means Direct” approach to the facts before it, as an opening for a future insured to broaden the “Direct means Direct” legal structure and which may eventually mirror the “Proximate Cause” interpretation.

 

Utilizing a different rationale, the court in Avon State Bank v. Bancinsure, Inc., [4] reached a somewhat similar holding to Cumberland in that money that is held by an insured, even as a conduit or fleetingly, is still considered held by the insured and the resulting loss is considered a direct loss.

 

In Avon State Bank, David Gibson, a man who purported to be the son of a business associate of Ambrose Herdering, a customer of Avon State Bank, sought out the assistance of Herdering in moving the estate of Gibson’s deceased father from the Netherlands to the United States.  However, Gibson claimed he needed funds for the upfront payment of taxes and other fees.  Herdering sent certain funds to assist Gibson.  When Gibson needed more money, Herdering contacted Robert Carlson, an Assistant Vice President at Avon State Bank, who issued a loan to Herdering and invested $60,000 of his own money.  When an additional $750,000 was needed, Carlson expressed concern that Gibson was running a scam.  However, Carlson, on behalf of himself, recruited Donald Imdieke and Mike Froseth, non-bank customers, as investors, who provided $80,000 and $405,000 check that were made payable to Avon State Bank.  Carlson arranged for the deposit and a subsequent wire transfer to the Otua Auto Company account at the Taipei Fubon Bank in Hong Kong.  Carlson even made certain misrepresentations to Avon’s auditor to approve the wire transfer.  More than a year after the wire transfer, Imdieke and Froseth met with Avon’s President regarding their loss.  Carlson was suspended and ultimately terminated.  Froseth and Imdieke brought suit against Avon and were successful after a jury trial on their claims for Avon’s vicarious liability for fraudulent misrepresentation.  The parties to the underlying action settled during post trial appeals.

 

Bancinsure, Avon’s fidelity insurer, declined coverage for the bond claim because the loss was a third-party loss.  The court in reaching its holding stated that the “Bond provides coverage because Avon suffered the loss of third-party property in its possession when Carlson wired Froseth’s and Imdieke’s funds from Avon to an unverified Chinese bank account.  We therefore, conclude this loss falls within the coverage of the Bond, in accordance with Minnesota law.”  In particular, the court focused on the fact that “Avon held the funds, even if it did so fleetingly.”

 

Somewhat similar to Cumberland, where the court noted that the immediacy of the insured reimbursing its customer was a factor in finding coverage even under the “Direct means Direct” approach, the court in Avon State Bank found coverage under the “Direct means Direct” even though Imdieke and Froseth’s funds were immediately wire transferred out of the insured bank.

 

In Hantz Financial Services, Inc. v. National Union Fire Insurance Company of Pittsburgh, PA,[5] the court held that in order for there to be coverage under a fidelity bond, the losses must follow immediately from the employee’s conduct.

 

Hantz[6] employee, Michael Laursen, received checks from customers and deposited such checks into his own personal account, which was as a separate commercial account that appeared to be set up by Laursen in the name of “Henry Firearms Service.”  Further, Laursen would request that the checks be made payable to “HFS.”  The customer checks were supposed to be deposited into a special Hantz broker-dealer (k)(2)(i) account, which according to Hantz’s Senior Vice President of Tax and Business, meant that the funds were not in Hantz’s possession.  Upon discovery of the Laursen’s theft, two of Laursen’s clients filed a FINRA arbitration action against Laursen, Hantz and Laursen’s supervisor.  Twenty-three clients were affected by Laursen’s diversion of funds.  Hantz sought coverage under its fidelity bond.  The insurer disclaimed coverage and argued that the losses at issue were not direct losses because Laursen stole money from Hantz’s clients and not from Hantz.  In other words, the claimed loss was indirect.

 

The court held that the losses were indirect and therefore not covered.  Specifically, the court noted that Hantz acknowledged that the stolen money belonged to Hantz’s clients and “Hantz’s own losses resulted from having to reimburse those clients for Laursen’s misappropriation, not from Laursen taking Hantz’s money.”

 

Unlike Cumberland and Avon, where the insured in some capacity held or controlled the stolen funds, albeit fleetingly in Avon, in Hantz, the client funds were diverted by Laursen to his own account or to an account for which the insured admitted it did not control or hold.  Therefore, it appears from these 2015 cases that having control or holding the stolen funds is critical to coverage under a fidelity bond in jurisdictions following the “Direct means Direct” approach.

 

Is Coverage Available for Brokers and/or Outside Investment Advisors Acting in a Dual Capacity?

 

Bernie Madoff may be gone, but he’s certainly not forgotten – especially in the financial institution bond arena.  In 2015, the New York State Supreme Court, Appellate Division – First Department, was faced with two matters, both of which addressed whether bonds issued to entities formed for the purposes of investing and trading in securities, covered losses the entities sustained by investing in Madoff’s Ponzi scheme.[7]  In 2009, Madoff pleaded guilty to 11 federal felonies and was sentenced to 150 years in prison, the maximum allowed.

 

The bonds in both the Jacobson and Nine Thirty FEF matters contain riders which provide that they will cover loss resulting directly from the dishonest acts of any Outside Investment Advisor named in the Schedule, solely for their acts as an Outside Investment Advisor for the Insured.  Thus, even though Madoff is named among the individuals and companies identified as an Outside Investment Advisor in both Schedules, coverage would only be available under the riders if Madoff was acting “solely” in his capacity as an Outside Investment Advisor.

 

Each of the bonds also contains a relevant exclusion (Exclusion x), which states that the bond does not cover “loss resulting directly or indirectly from any dishonest or fraudulent act or acts committed by any non-Employee who is a . . . broker” [emphasis added]).  The court in Jacobson highlighted the fact that in order to implicate Exclusion x, the wrongdoer need not have been acting in his/her capacity as a broker.  The mere fact that the wrongdoer is a broker is enough to exclude coverage under Exclusion x.

 

After analyzing coverage under both the riders and Exclusion x, the court denied coverage under the bonds for the following reasons:  (i)  Since Madoff was acting in a hybrid nature of both a securities broker and an investment advisor, and was not acting “solely” in his capacity as an Outside Investment Advisor, the entities’ claims were outside the coverage of the riders; and (ii) Madoff was a securities broker and a non-Employee, and thus his dishonest acts were excluded from coverage pursuant to Exclusion x.

 

In what appeared to be an attempt to preempt any reversal on the ground that the court’s interpretation of the bonds rendered them illusory, the court noted that “[t]he bonds could still provide coverage for losses resulting directly from the dishonest acts of Outside Investment Advisors who are not brokers.”  Therefore, the exclusion would not render the insuring coverage illusory.

 

Courts Deny Coverage for Losses Caused by the Alter Ego of the Corporation

 

Lee Farkas, the disgraced chairman of Taylor, Bean & Whitaker Mortgage Corp. (“TBW”) is the subject of another fidelity bond matter to come down the pipeline in 2015.  By way of background, Farkas and his six co-conspirators were responsible “for one of the biggest fraud schemes to emerge from the housing crisis and the sixth-largest bank failure in American history”, for which he was found guilty on 14 counts of securities, bank and wire fraud, and conspiracy to commit fraud and sentenced to 30 years in prison.[8]   In the ensuing coverage dispute between TBW and its fidelity bond insurer, the court noted that it was “faced with a very unusual situation where [Farkas], a majority shareholder, an alter ego of the corporation, initiates dishonest acts, directs his subordinate’s involvement, and the subordinate renders her assistance in the fraudulent scheme.” Certain Underwriters at Lloyd’s, London and London Market Insurance Companies, et al. v. Taylor, Bean & Whitaker Mortgage Corporation, et al.[9]  The court held that it would be against public policy to permit TBW to recover for losses caused by its alter ego’s fraudulent acts simply because Farkas used TBW employees to effectuate the improper withdrawals.

 

The insurers instituted this matter seeking to confirm their rescission of a fidelity bond issued to TBW in 2008 (the “Bond”)[10], or in the alternative, a declaration of no coverage.  In its counterclaim, TBW asserted that it is entitled to coverage under the Bond for the losses it sustained when Farkas directed others to withdraw funds totaling nearly $87 million from TBW’s operating accounts for his own personal use.

 

Insuring Clause 1 of the Bond provides coverage for any direct financial loss sustained by it that was directly caused by “dishonest acts by any Employee of [TBW], whether committed alone or in collusion with others, which dishonest acts . . . resulted in the receipt of improper Personal Financial Gain for said Employee, or for the person(s) acting in collusion with said employee . . .”  The insurers assert that since the Bond definition of Employee specifically excludes any Major Shareholder of TBW, Farkas is not an Employee, and thus his actions are not covered by the Bond. TBW argues that despite the fact that Farkas was not an Employee, the Bond effectively provides coverage for acts of any partner or Major Shareholder of TBW who is acting in the capacity of an Employee.[11] TBW reasons that since Farkas was directly involved in the day-to-day business of TBW and received a W-2, he was therefore acting in his capacity as an Employee when he committed the dishonest acts in question.  The insurers claimed that Farkas could not be considered to be acting in the capacity of an employee because TBW had no right to “govern and direct” him, as required by the Bond. The Court agreed.  In fact, the Court went so far as to conclude that Farkas “dominated and controlled the corporation” to such an extent to become the alter ego of the corporation.  The court ultimately held that Farkas was not TBW’s employee nor did he act in an employee capacity when he stole from the corporation and any losses caused by his dishonest acts are not covered by the Bond.

 

In a last ditch effort to obtain coverage under the Bond, TBW argued that its losses were caused by the dishonest acts of its employees, Desiree Brown and Delton DeArmas, who colluded with Farkas, and effectuated the improper transfers of funds at his direction.  The court refused to adopt TBW’s position and stated that by allowing TBW to recover losses caused by its alter ego’s dishonest conduct “only because its alter ego used his corporation’s employee as an instrumentality in the fraudulent scheme” would still essentially allow TBW to recover for its own fraudulent or dishonest acts, and would thus violate public policy.  As the court so eloquently articulated “[a]n undertaking insuring a person against his own dishonesty would be, to say the least, a novel and unusual contract.”  Therefore, the court ruled that coverage was not available.

 

Courts’ Interpretation of Counterfeit and Computer Systems Fraud Insuring Agreements

 

Among the other issues, courts have decided whether coverage under the fidelity bond and appended riders covers the veracity of the factual content or the ancillary issue of the source of the information (whether original or authorized).  Specifically, in (i) Universal American Corp. v. National Union Fire Insurance Company of Pittsburgh, PA.,[12] the court held that the applicable computer systems rider did not cover false data that was entered into a computer system by authorized users; (ii) Bank of Brewton v. Travelers Companies, Inc.,[13] the court held that a fidelity bond did not cover losses from duly authorized stock certificates that were rendered valueless because it was obtained under false pretenses; (iii) Apache Corporation v. Great American Insurance Company,[14] the court held that loss resulted directly from an email even though the insured’s employee made intervening phone call to verify the existence of the fraudster.

 

In Universal American, the insured, a health insurance company, permitted health care providers the access to submit claims directly into the insured’s computer systems.  A majority of the claims submitted through the insured’s computer system were processed, approved and paid automatically, without manual review.  The insured suffered a loss of $18 million when authorized health care providers submitted claims into the computer systems for services they never performed.  The insured submitted its claim for coverage under the computer systems fraud rider, which provided coverage for “[l]oss resulting directly from a fraudulent . . . entry of Electronic Data . . . into . . . the Insured’s proprietary Computer System . . . .”  The insurer denied coverage for the claim on the ground that the rider did not cover such fraud.

 

Both the insured and the insurer filed motions for summary judgment in the trial court.  The Supreme Court denied the insured’s motion and granted the insurer’s motion for summary judgment, holding that the computer systems fraud rider “does not extend to fraudulent claims entered into [the insured’s] system by authorized users.”  The Appellate Division affirmed the Supreme Court’s holding.  The Court of Appeals affirmed the Appellate Division’s ruling.  In reaching its ruling, the Court of Appeals noted that the computer systems fraud rider “unambiguously applies to losses incurred from unauthorized access to [the insured’s] computer system, and not to losses resulting from fraudulent content submitted to the computer system by authorized users.  The Court of Appeals noted that the “intentional word placement of ‘fraudulent’ before ‘entry’. . . manifests the parties’ intent to provide coverage for a violation of the integrity of the computer system through deceitful and dishonest access.”  In other words, the “rider applies to losses resulting directly from fraudulent access, not to losses from the content submitted by authorized users.”

 

In Bank of Brewton, the insured made a number of loans to a favored borrower, who pledged 360 shares of The Securance Group to the insured in the form of two certificates, Certificate No. 2 and Certificate No. 7.  About four years later, an employee of the insured noticed that Certificate No. 2 “was actually a color copy of the original Certificate No. 2.”  After the insured inquired with the borrower, he advised that he lost the original Certificate No. 2 and “asserted that he had not pledged or encumbered Certificate No. 2 other than with the [insured], and requested a replacement certificate [from The Securance Group, which issued Certificate No. 11].  Subsequently, the borrower delivered Certificate No. 11 to the insured.  About six months later, the insured consolidated all of the borrowers’ loans into one loan and increased the balance to $1.5 million, which included the various loan fees.  Five months later, the president of The Securance Group, who was also a member of the insured’s board, discovered that three years earlier the borrower pledged Certificate No. 2 to another bank, which received the original Certificate No. 2.  The Securance Group notified the insured of its discovery and that as a result “Certificate No. 11 was void and of no effect.”  The borrower did not replace now Certificate No. 11 with new collateral, defaulted on the loan and filed for bankruptcy protection.

 

The insured filed a claim with its insurer, who tentatively took the position the claim was not covered but continued to investigate.  The insured filed suit in the Circuit Court of Montgomery County alleging breach of contract.  The insurer removed the action to the United States District Court for the Middle District of Alabama and then moved to transfer venue to the United States District Court for the Southern District of Alabama, which was granted.

 

On the summary judgment motion filed by the insurer, the court held that the insured could not have relied upon Certificate No. 2 because the insured issued a subsequent loan after it discovered that Certificate No. 2 was a copy.  With respect to Certificate No. 11, the court stated, “that Certificate No. 11 was not a counterfeit under the terms of the Bond because it was not an imitation purporting to be an authentic document; rather Certificate No. 11 was an authentic document that happened to be null and void when issued.”

 

On appeal, the 11th Circuit affirmed the lower court’s ruling that coverage is not provided by the fidelity bond.  In rendering its decision, the court noted that “Certificate No. 11 was issued by [The Securance Group] and numbered, dated, and signed by the appropriate officer just like every other stock certificate it issues; the problem, simply, was that because it was obtained under false pretenses, it had no value.”  More generally, “[a]n attempt to deceive by means of a document that imitates the appearance of an authentic original is not the same as an attempt to deceive by means of false factual representations implicit in the authentic document.”  Therefore, no coverage is provided for documents that contain false representations as opposed to counterfeit documents that imitate an original.

 

In Apache, the insured’s employee, Steph Fraser received a phone call purportedly from an employee at Petrofac Facilities Management (“Petrofac”) seeking to change Petrofac’s account information where the insured made payments to Petrofac.  The insured’s employee advised that such information must be provided by Petrofac on its letterhead.  Subsequently, an email was received with an attachment containing the change on Petrofac letterhead.  The bank account change was routed to another employee of the insured’s who called the number on such Petrofac letterhead to verify the information.  Upon telephone verification, the information was entered into the insured’s computer system and then approved by another employee of the insured.  Payment began to be sent to the new bank account.

 

After several months, the insured was contacted by Petrofac regarding delinquent invoices and the fraud was discovered.  The insured’s loss totaled $2.4 million.

 

The insured filed a claim with its insurer who denied the claim.  The Crime Protection Policy issued by the insurer to the insured contained an insuring agreement which provided:

 

Computer Fraud

 

We will pay for loss of . . . money . . . resulting directly from the use of any computer to fraudulently cause a transfer for that property from inside the premises or banking premises:

a) to a person . . . outside those premises; or

b) to a place outside those premises.

 

In the summary judgment motion in the subsequent coverage action between the insured and the insurer, the insured argued that “the fraudulent email sent by the fraudsters . . . was computer fraud and directly caused the fraudulent transfer of funds . . . despite the phone call and supervisor clearance that took place after receiving the email.”  In other words, the insured argued that the fraudulent email was the “substantial factor in bringing about the injury.”  The insurer argued that the phone call and supervisor clearance were intervening factors that remove the loss from coverage because the insuring agreement requires that the loss result directly from the computer usage.

 

The court agreed with the insured and reasoned that the scope of the insuring agreement would be reduced to the point of non-existence “if anytime some employee interaction took place between the fraud and the loss, or anytime fraud was perpetrated anyway other than a direct ‘hacking.’”  The court clarified that its holding should be limited to instances where the intervening human actions “do not rise to the level of negating the email as being a ‘substantial factor.’”

 

In reaching its holding, the court relied upon the following cases:  (i) First National Bank of Louisville v. Lustig[15] and (ii) Citibank Texas, N.A. v. Progressive Casualty Ins. Co.[16]  The Lustig case dealt with a loan officer who misrepresented the loans he submitted for approval.  However, such loan officer did not receive any improper financial benefits.  Considering Apache deals with improper payments caused by a fraudulent email, it does not appear that the Apache court’s reliance upon Lustig is on point.  In Citibank Texas, the facts dealt with tellers processing the improperly deposited checks.  Considering that the employees’ actions in Apache case were more substantial in confirming by telephone the change in Petrofac’s bank account and approving such change, the Apache court’s reliance upon Citibank Texas may not be on point.

 

The Fidelity Bond Terminates Upon the FDIC Takeover of the Insured

 

In FDIC v. Kansas Bankers Surety Company, the court upheld the application of the language of the bond that terminated the bond upon the takeover by the Federal Deposit Insurance Corporation (“FDIC”) even in the face of numerous prior attempts by the insured to file a proof of loss which were rejected by the insurer.[17]

 

Beginning in 2003, Greg Bell, a loan officer for New Frontier Bank of Greeley, Colorado, for which the FDIC eventually became the receiver, agreed with a large bank borrower, Johnson Dairy, to arrange for loans to Bell’s friends and relatives, who would then lease cattle to Johnson Dairy.  This arrangement was set up to avoid certain bank loan limits which Johnson Dairy had reached.  Johnson Dairy expanded through this financing structure and in 2007, 9,000 of the 10,000 cattle that Johnson Dairy had were leased.  In the fall of 2008, milk prices fell sharply.  In January 2009, Johnson Dairy filed for bankruptcy protection.  Johnson Dairy sent a threatening letter to New Frontier Bank accusing the bank of wrongful conduct.

 

On February 4, 2009, the bank’s attorney sent a letter to its insurer notifying it of a potential claim, which included the letter from Johnson Dairy.  The insurer responded asking the bank to advise if the bank, its directors, officers or employees have any reason to believe that wrongful acts or wrongful lending acts were committed.  In February 2009, Johnson Dairy filed an Adversary Proceeding Complaint against the bank alleging that the bank’s loans and the Bell cow leasing structure were coercive and meant to enrich the bank.  The bank’s general counsel forwarded a copy of the complaint to the insurer.

 

In March 2009, the bank’s general counsel forwarded another of the complaint to the insurer with a letter noting that the complaint alleges that Bell committed dishonest and fraudulent acts and received improper financial benefits.  As noted in the letter, the bank believes that should Johnson Dairy succeed in its action, such loss to the bank would be a collectible loss under the bond and therefore, the bank requested that the insurer provide a defense for the bank.  At the end of March 2009, the insurer responded that it was not electing to provide a defense for the bank.  Therefore, the insurer advised that the bank should file a proof of loss within six months after the entry of judgment or the occurrence of a settlement.

 

At the beginning of April 2009, the bank submitted another letter describing in summary form the adversary proceeding.  Additionally, two boxes of credit files were submitted to the insurer.  In his deposition, the bank’s general counsel noted that at the beginning of April 2009, the bank had not suffered a loss and that he did not know whether Bell caused any loss to the bank.  Further, the bank’s general counsel could not verify as to the truth or falsity of the allegations in the complaint.  Less than a week after receiving the bank’s letter, the insurer responded that the April 2009 letter was not a proof of loss because it only restates the allegations in the complaint and lacks any first-hand knowledge of such allegations.  The insurer indicated that the allegations against Bell raised certain suspicions and encouraged the bank to investigate further.  Lastly, the insurer “pointed out that it is imperative that the bank file [a] proof of loss prior to any taking over of the bank by a receiver or other liquidator or state or federal official.”  The insurer quoted condition 14 of the bond, which provided that no federal official acting in the capacity of a receiver could exercise any right to a claim unless a proof of loss was received prior to such takeover.

 

A further letter was sent by the bank to its insurer claiming in summary form that it discovered at Bell’s deposition that Bell received an improper financial benefit, but the bank failed to enclose such deposition transcript.  The insurer responded that such letter was not a proof of loss and again quoted condition 14 relating to termination of the bond upon the FDIC takeover of the bank.  Therefore, the insurer again encouraged the bank to file a proof of loss.  The insurer sent a further letter to the bank indicating that the materials received only provided support for the argument that the bank took actions which harmed Johnson Dairy for the benefit of the bank.

 

After the above-referenced correspondence exchange between the bank and the insurer, the FDIC took over the bank on April 10, 2009.  The FDIC settled the adversary proceeding for some amount less than the amount due under the Johnson Dairy loans.  The FDIC submitted a claim for the difference between the settlement amount and the loan amount due.

 

In the coverage action between the FDIC and the insurer, the FDIC argued that (i) the proof of loss requirement was excused because the bank discovered and provided notice of the loss; (ii) the bond provided a six month time period, which did not run until after the settlement of the adversary proceeding, in which the bank could file the proof of loss; and (iii) the termination clause upon the takeover by the FDIC was against public policy.

 

The court held that (i) the bond required more than discovery and notice – the filing of a proof of loss with full particulars; (ii) the termination clause trumps the six month time limit subsequent to settlement clause; and (iii) that public policy at the state and federal level both recognize such termination clauses as valid.

 

In reaching its holding with the respect to the supremacy of the termination clause over the six month time period to file a proof of loss, the court noted that estoppel may prevent an insurer from invoking the termination clause where the insurer “lulls [an insured] into thinking that it can delay its investigation of a potential claim.”

 

Inventory Shortage Exclusion Does Not Render Employee Dishonesty Coverage Illusory

 

Early in 2015, the U.S. District Court for the Middle District of Alabama in the matter of W.L. Petrey Wholesale Co., Inc. v. Great American Insurance Company[18] applied an inventory shortage exclusion contained in a business insurance and crime protection policy to preclude coverage for theft by a Petrey (the “insured”) employee.  The court also concluded that the application of the inventory shortage exclusion did not render coverage illusory.  Finally, the court held that the insurer did not waive its right to deny coverage under the exclusion after providing coverage for a similar claim in 2011.

 

The insured is a wholesale distributor of goods and supplies which employs sales persons to deliver its products to various convenience stores.  As described by the court, the sales person places an order on behalf of its customer, Petrey delivers the goods to a storage unit and then the sales person delivers the goods to its customer.  All relevant data is entered into a computer system, and at least twice a year, a physical inventory is conducted for each sales person’s truck and storage facility.

 

After one of Petrey’s salespersons was terminated on account of a customer complaint, his inventory reports were reviewed and the applicable inventory did not reconcile.  A physical inventory was performed, which revealed an inventory shortage of over 82,000 bottles of 5-Hour Energy drinks valued at $111,415.35.  Petrey submitted a claim to its insurer, Great American, who in turn, denied the claim, relying in part on the inventory shortage exclusion.

 

The policy states in relevant part that the insurer will pay for “loss . . . resulting directly from dishonest acts committed by an employee . . . with the manifest intent to: (a) cause you to sustain loss; and also (b) obtain financial benefit . . . for:  (1) the employee; or (2) any person or organization intended by the employee to receive that benefit.”  This section contains an exclusion, which states that the insurer will not pay for loss for “inventory shortages”:  Loss, or that part of any loss, the proof of which as to its existence or amount is dependent upon: (a) an inventory computation; or (b) a profit and loss computation.

 

The court noted that although neither party cited a case defining the term “inventory computation”, Petrey appeared to concede that its proof of loss is dependent upon inventory calculations within the meaning of the exclusion.  However, Petrey argued that “dependent upon,” as set forth in the inventory shortage exclusion, applies only when proof of loss is “wholly” dependent, rather than partially dependent upon inventory calculations.  While the court did not disagree with this contention set forth by the Alabama Supreme Court in American Fire & Casualty Co. v. Burchfield[19], the court distinguished Burchfield from the matter at hand noting that in that case, in addition to using the inventory calculations to show the amount of loss, the insured also offered independent evidence of the employees’ theft, including a confession by the employees to support its proof of loss.  The court rejected Petrey’s contention that since it also provided an affidavit from its chief financial officer, its proof of loss was only partially dependent upon the inventory calculations.  The court concluded that since the CFO’s affidavit relied on nothing other than inventory calculations, and did not provide any independent corroboration of the existence of a loss apart from the inventory calculations, Petrey’s loss is not insured under the terms of the policy.

 

Petrey then argued that the inventory shortage exclusion renders coverage for employee dishonesty illusory since “inventory calculations are the only available means to prove the existence of a loss of inventory due to employee dishonesty” (citing American Fire and Casualty Company, v. Burchfield).[20]  The court disagreed with Petrey’s interpretation of Burchfield and noted that under Alabama law, an exclusion renders coverage illusory and is unenforceable as against public policy, only when it “completely contradict[s] the insuring provision.”   The court added that the inventory shortage exclusion is a “standard clause that appears in virtually every employee dishonesty policy” and has been construed by a number of courts in matters where coverage was found to exist.[21]  As the court noted, the Burchfield decision articulated that the purpose of the inventory exclusion is not to serve as a “surreptitious and complete contradiction of the coverage provided in employee dishonesty policies, but to protect insurers from the dangers of negligence, bookkeeping errors, waste, inexactness, pilferage by nonemployees, or dishonesty inherent in a claim built upon self-created inventory records.”  Lastly, the court pointed out that evidence other than business records could easily be used to prove a loss due to employee dishonesty, including eyewitness statements, evidence that an employee sold the items for personal gain, and records of deliveries of items that were never delivered.  The court ultimately held that because the inventory shortage exclusion does not “completely contradict” the insurance coverage provided by the employee dishonesty policy, the exclusion did not render the coverage illusory.

 

In a final attempt to obtain coverage under the policy, Petrey argued that by paying for a claim under similar circumstances in 2011, for which Petrey provided a proof of loss involving inventory computations, the insurer waived its right to rely on the inventory shortage exclusion to deny coverage for this claim.  The court disagreed that the payment made in 2011 operates as a waiver of the inventory shortage exclusion in this case, and noted that under Alabama law, the doctrine of waiver is not available to “bring within the coverage of a policy risks not covered by its terms or risks expressly excluded therefrom.”

 

Blanket Crime Policies Do Not Cover Expected Limited Partnership Distributions

 

In 3M Company v. National Union Fire Insurance Company of Pittsburgh, PA[22] the court held that an insured (3M Companies and its related entities, collectively, “3M”) may not recover under a blanket crime policy for nondistributed earnings relating to a limited partnership interest that were lost due to a fraud perpetrated by the investment advisors.

 

In 3M Company, the insured invested in limited partnership interests in WG Trading Company LP (“WG Trading”).  WG Trading was managed by investment advisors who also managed related entities.  All of these entities turned out to be a sizeable Ponzi scheme, whereby earlier investors were paid using later investments.  After the discovery of the Ponzi and liquidation of WG Trading and related entities, the insured recovered all of its investments.  3M submitted a claim to its insurers claiming that certain of its investments in WG Trading were invested in legitimate investment vehicles and produced legitimate earnings, which were never paid to the insured.  3M claimed that through its forensic accountant it could untangle the large Ponzi scheme to quantify such lost earnings.  While the regulators, including the SEC, the CFTC and the United States District Court for the Southern District of New York, believed that such endeavor was impossible to accomplish, the court assumed for the purposes of the action between 3M and its insurers that the insured could achieve the impossible.

 

In the ensuing coverage action, the insurers argued that coverage was not available because the earnings for which 3M sought coverage are not insured property under the policy.  Specifically, the insurers argued that even if the insured can quantify the legitimate earnings, the lost earnings were (i) not owned by the insured; (ii) held by the insured in any capacity; or (iii) property for which the insured was legally liable.  3M argued that the insured property clause defined insured property and the insuring agreement did not use such term.  Therefore, the insured property clause was irrelevant to the claim.

 

The court reviewed the insured property clause and the insuring agreement and reached the conclusion that the insured property clause does not define the term “insured property” because the policy uses explicit definitions in a definition section, which is not used in the insured property clause.  Further, the court reasoned that the insured property clause actually limits coverage under the policy.

 

With respect to the lost earnings claimed by 3M, the court reasoned that 3M owned “a limited partnership interest in WG Trading.  Up until the point at which earnings were distributed to the partners, the earnings of WG Trading were owned by WG Trading, and not by [the insured] or any of the other limited partners.”[23]  The court went on to analyze the rights to the claimed lost earnings under Delaware partnership law because WG Trading was organized under the laws of Delaware.  In its conclusion, the court stated that 3M “did not own any specific earnings or any other ‘specific limited partnership property.’”  In other words, until the limited partnership declared the distributions, 3M did not own these lost earnings.  Therefore, they would not be covered under the bond.

 

Commercial Crime Policies Protect Against Defalcating Employees But Not Against Deceitful Vendors.

 

In Frazier Industrial Company v. Navigators Insurance Company,[24] an employee of the insured engaged in a scheme whereby the employee would share with a vendor the insured’s internal budget for a project.  Pursuant to the employee’s guidance, the vendor would increase its bid up to an amount such that the vendor’s bid was still the lowest.  The vendor’s bid was then included with the insured’s sales price of the product to a customer as an all-inclusive price.  The vendor would share a portion of the increased bid with the insured’s employee.   Upon discovery of the scheme, the insured fired the employee, JMG.  In total, the amount of the increase in the vendor’s bids totaled about $2 million and JMG received about $1 million.  Subsequent to discovery of the scheme, JMG agreed to reimburse the insured $2 million minus amounts the insured recovered under its insurance policy.

 

The applicable commercial crime policies provided:

 

We will pay for loss of . . . “money” . . . resulting directly from “theft” committed by an “employee”, . . . acting alone or in collusion with other persons.

The crime policies contained exclusions that limited coverage to only theft.  The policies further excluded losses from failing to realize income.

 

On summary judgment in the coverage action between the insured and the insurer, the court ruled that amounts the employee gained were losses within coverage of the policy.  However, the amounts of the increased bids by the vendor were not covered.  In reaching its holding, the court reasoned that the employee’s share of the padded bids was analogous to the situation where an employee fraudulently profits from inflating the bids himself and “skimming a portion [of the inflated amount], before forwarding the payments on to the unsuspecting contractor.”  With respect to the padded amount not shared with the employee, the court held that the insured did not argue or demonstrate that the inflated bids were “either unreasonably priced or not the lowest for a particular job.”  In other words, the court reasoned that the crime policy did not protect the insured “against a less favorable deal from a deceitful contractor.”

 

Conclusion – Looking to 2016

 

2015 was noteworthy for fidelity bond, commercial crime and cybercrime coverage cases because many courts around the country appeared to be narrowing down numerous issues in order to apply the plain language and clear meaning of the bond.  However, one case, Apache, in a cybercrime context, the court broadened the meaning of direct loss to almost mean proximate cause due to the unique facts presented in that case.  Even with the contrast between Apache and the other cases, the courts appear likely to expand coverage in the new areas of cybercrime coverage to reflect the exigencies of business in today’s technology driven era.

 

__________________

David Bergenfeld, Esq., is a Senior Associate in D’Amato & Lynch, LLP’s Fidelity Bond Practice Group.  Laura Lang, Esq. is in private practice with a focus on insurance coverage.  We are deeply grateful to our colleagues who provided significant contributions toward this article.

 

 

 

[1] A majority of states follow “Direct means Direct”:  Vons Cos., Inc. v. Fed. Ins. Co., 212 F.3d 489 (9th Cir. 2000) (California); Abady v. Certain Underwriters at Lloyd’s London Subscribing to Mortgage Bankers Bond No. MBB-06-0009, 317 P.3d 1248 (Colo. Ct. App. 2012) (Colorado); Finkel v. St. Paul Fire and Marine Ins. Co., No. 3:00CV1194 (AHN), 2002 WL 1359672 (D. Conn. June 6, 2002) (Connecticut); Beach Community Bank v. St. Paul Mercury Insurance Company, 635 F.3d 1190, 1195 (11th Cir. 2011) (Florida); Georgia Bank & Trust v. Cincinnati Insurance Company, 538 S.E.2d 764, 766 (Ga. Ct. App. 2000) (Georgia); RBC Mortgage Company v. Nat’l Union Fire Ins. Co., 812 N.E.2d 728 (Ill. App. Ct.2004) (Illinois); City of Burlington v. Western Surety Company, 599 N.W.2d 469, 472 (Iowa Sup. Ct. 1999) (Iowa); Citizens Bank, N.A. v. Kansas Bankers Surety Co., 149 P.3d 25 (Kan. Ct. App. 2007) (Kansas); Forcht Bank, N.A., v, Bancinsure, Inc., 514 Fed. Appx. 586 (6th Cir. 2013) (Kentucky); Methodist Health System Foundation, Inc. v. Hartford Fire Insurance Company, 834 F.Supp.2d 493 (E.D. La. 2011) (Louisiana); Fireman’s Fund Ins. Co. v. Special Olympics Int’l, Inc., 346 F.3d 259 (1st Cir.2003) (Massachusetts); Hantz Financial Services v. National Union Fire Ins. Co., Case No. 13-CV-11197, 2015 WL 5460632 (E.D. Mich. Sept. 17, 2015 (Michigan); Bancinsure, Inc. v. Highland Bank,  779 F.3d 565 (8th Cir. 2015) (Minnesota); In re Ben Kennedy and Assoc., Inc. v. St. Paul Ins. Co., 40 F.3d 318 (10th Cir. 1994) (Oklahoma); Aetna Cas. & Sur. Co. v. Kidder, Peabody & Co., 246 A.D.2d 202, 676 N.Y.S.2d 559 (N.Y.App.Div.1998) (New York); Armbrust Int’l Ltd. v. Travelers Cas. And Sur. Co., No. C.A. 04–212 ML, 2006 WL 1207659 (D.R.I. May 1, 2006) (Rhode Island); Lynch Props., Inc. v. Potomac Ins. Co., 140 F.3d 622, 629 (5th Cir. 1998) (Texas); Direct Mortgage Corp. v. Nat’l Union Fire Ins. Co., 625 F.Supp.2d 1171 (D. Utah 2008) (Utah); Patrick v. St. Paul Fire and Marine Ins. Co., No. Civ. 1:99CV314, 2001 WL 828251 (D. Vt. Feb. 15, 2001) (Vermont); Tri City National Bank v. Federal Insurance Company, 674 N.W.2d 617, 626 (Wis. Ct. App. 2003) (Wisconsin).

 

A Minority of states analogize “Direct” to “Proximate cause”:  Pine Bluff National Bank v. St. Paul Mercury Insurance Co., 346 F. Supp. 2d 1020 (E.D. Ark. 2004) (Arkansas); Omnisource Corp. v. CAN/Transcontinental Insurance Co., 949 F. Supp. 681 (N.D. Ind. 1996) (Indiana); (Louisiana); Graybar Electric Co. v. Fed. Ins. Co., No. 4:06 CV 1275 DDN, 2007 WL 1365327 (E.D. Mo. May 9, 22007) (Missouri); Auto Lenders Acceptance Corporation v. Gentilini Ford, Inc., 854 A.2d 378 (N.J. Sup. Ct. 2004) (New Jersey); Retail Ventures, Inc. v. Nat’l Union Fire Ins. Co., 691 F.3d 821 (6th Cir. 2012) (Ohio); Jefferson Bank v. Progressive Cas. Ins. Co., 965 F.2d 1274 (3rd Cir. 1992) (Pennsylvania); Hanson v. Nat’l Union Fire Ins. Co., 794 P2d 66 (Wash Ct. App. 1990) (Wash Ct. App. 1990) (Washington).

 

For the following states it is unclear whether they adhere to the “Direct means Direct” or analogize direct loss to proximate cause:  Towne Management Corp., v, Hartford Accident and Indemnity Co., 627 F. Supp. 170 (D. Md. 1985) (direct loss); Cumberland & Erly, LLC v. Nationwide Mutual Ins. Co., Civ. Act. No. RDB-14-2399, 2015 WL 5173069 (D. Md. Sept. 3, 2015) (Proximate Cause and Direct Loss) (Maryland); Bank of Bozeman v. Bancinsure, Inc., 404 Fed. Appx. 117 (9th Cir. 2010) (Direct Loss); Frontline Processing Corp. v. American Economy Insurance Co., 149 P.3d 906 (Mont. Sup. Ct. 2006) (Proximate Cause) (Montana).

 

[2] Vons Cos., Inc. v. Fed. Ins. Co., 212 F.3d 489 (9th Cir.2000).

 

[3] Civ. Act. No. RDB-14-2399, 2015 WL 5173069 (D. Md. Sept. 3, 2015).

 

[4] 787 F.3d 952 (8th Cir. 2015).

 

[5] Case No. 13-cv-11197, 2015 WL 5460632 (E.D. Mich. Sept. 17, 2015).

 

[6] Hantz Financial Services, Inc., is a FINRA registered broker-dealer.

 

[7] Jacobson Family Investments, Inc., et al. v. National Union Fire Ins. Co. of Pittsburgh, Pa., 129 A.D.3d 556 (1st Dep’t, June 18, 2015) and United States Fire Ins. Co. v. Nine Thirty FEF Investments, LLC, 132 A.D.3d 413 (1st Dep’t, Oct. 6, 2015).

 

[8] Macias, Amanda, The Only CEO Prosecuted for the Mortgage Crisis Is Someone You’ve Never Heard of, and He Feels Like a Zombie in Prison, The Business Insider (March 20, 2014).

 

[9] 2015 WL 728493 (U.S. Dist. Ct., M.D. Florida, February 19, 2015).

 

[10] The insurers actually issued both a primary and an excess fidelity bond to TBW in 2008, but for purposes of the court’s analysis, we are only concerned with the primary bond.

 

[11] Exclusion 1(e).

 

[12] 25 N.Y.3d 675 (2015).

 

[13] 777 F.3d 1339 (11th Cir. 2015).

 

[14] Civ. Act. No. 4:14–CV–237, 2015 WL 7709584 (S.D. Tex. Aug. 7, 2015).

 

[15] 961 F.2d 1162 (5th Cir. 1992).

 

[16] No. 3:06-cv-0395-H, 2006 WL 3751301

[17] 105 F. Supp. 3d 1234 (D. Colo. 2015).

 

[18] 2015 WL 404523 (U.S. District Court, M.D. Alabama, Northern Div., January 29, 2015).

 

[19] 285 Ala. 358, 232 So.2d 606 (Ala. 1970).

 

[20] 232 So.2d 606 (Ala. Sup. Ct. 1970)

 

[21] Id. At 609.

 

[22] Case No. 14-CV-1058 (PJS/JSM), 2015 WL 5687879 (D. Minn. Sept. 28, 2015).

 

[23] The court concluded that the term “owned by the insured” should be interpreted under state law using “plain meaning” as compared to ERISA (the insured included an ERISA plan) because “the plain and ordinary meaning of ‘owned’ does not resemble ERISA’s expansive concept of ‘plan assets’, which has nothing to do with defining ownership or property rights and which departs dramatically from the usual meaning of the word.”  Id. at *8.

 

[24] 2:13-cv-01647-WJM-MF, 2015 WL 7783549 (D.N.J. Dec. 3, 2015)