Material misrepresentations in an insurance application can serve as the basis for rescission of the resulting policy. A recent federal district court decision examined the question of whether or not an insurer could rescind a fidelity bond on the grounds that the credit union manager who signed the credit union’s insurance application failed to disclose that she was embezzling funds from the credit union. In a March 17, 2017 opinion (here), District of Minnesota Judge Donovan Frank, applying Minnesota law, held that because the manager was acting entirely for her own benefit when she failed to disclose her theft, the misrepresentation could not be imputed to the credit union, and therefore the insurer was not entitled to rescind the bond.
A March 23, 2017 post on the Hunton & Williams law firm’s Insurance Recovery Blog about the Minnesota court ruling can be found here.
St. Francis Campus Credit Union is a credit union in Little Falls, Minnesota. In January 2014, the credit union discovered that its manager, Marguerite Cofell, had embezzled more than $3 million from the credit union. In February 2014, the National Credit Union Administration was appointed as receiver of the credit union. A receiver was appointed because of the loss to the credit union caused by the theft.
The credit union notified its fidelity bond insurer of the loss. In June 2015, the insurer sent a letter to the credit union’s outside counsel in which the insurer sought to rescind the fidelity bond. Included with the rescission letter was a check for the premium the insurer had paid for the bond. The credit union’s lawyer sent the letter and check to the NCUA. At the NCUA, the check and the letter were separated, and the check was cashed “pursuant to the procedures in place because there was a receivership.”
The credit union filed a lawsuit against insurer seeking a judicial declaration that the insurer owed coverage under the bond. The insurer filed a motion for summary judgment.
Minn. Stat. Section 60A.08, which provides in pertinent part that
No oral or written misrepresentation made by the assured, or in the assured’s behalf, in the negotiation of insurance, shall be deemed material, or defeat or avoid the policy, or prevent its attaching, unless made with intent to deceive and defraud, or unless the matter misrepresented increases the risk of loss.
In completing the credit union’s application for the fidelity bond, Cofell answered “no” to the following application questions:
Does any director, officer, board committee member, or employee have knowledge of or information regarding any act, error, or omission which might give rise to a claim against them or the credit union, […] which would be covered under … the Bond or any of its endorsements?
Does any director, officer, board committee member, or employee have knowledge of or information regarding any claims, demands or lawsuits currently pending or threatened that may be or have already been brought against them or the credit union?
The March 17, 2017 Order
In his March 17, 2017 order, Judge Frank denied the insurer’s motion for summary judgment, holding that because Cofell was acting entirely for her own benefit when she made misrepresentations in the fidelity bond application, the misrepresentations could not be attributed to the credit union, and therefore the insurer was not entitled to rescind the bond.
In reviewing the issue of whether or not the application misrepresentation could be attributed to the credit union, Judge Frank considered general principles of the law of agency under Minnesota law, noting the general rule that a principal is bound by its agent’s authorized actions. This general rule is subject to an exception which holds that a principal is not imputed with the knowledge of an authorized agent who is acting adversely to the interest of the principal. This exception is “necessarily narrow and requires that the employee be working solely for her own benefit” – for example, the exception would not apply with an agent commits fraud that benefits the company at the expense of others.
In this case, Judge Frank found, Cofell’s and the credit union’s interests were “directly adverse.” The only reason Cofell did not dislose the existence of her theft “was for her own benefit and to the detriment of the company.” Thus, Judge Frank concluded, “the adverse interest exception applies to Cofell’s misrepresentation on the insurance application.” Because the misrepresentation cannot be imputed to the credit union, the insurer cannot rescind the contract under the provisions of the Minnesota statute.
Judge Frank also rejected the insurer’s argument made in reliance on principles in the Restatement (Second) of Agency to the effect that the NCUA (as the credit union’s receiver) could not retain the benefits of Cofell’s misrepresentation (the bond) while simultaneously disavowing the misrepresentation. Judge Frank noted the Restatement contains a specific provision covering this case’s precise facts. The Restatement provides that when an embezzler signs for the company’s fidelity insurance, which includes a provision representing that the signer has no knowledge of any prior wrongdoing, then the knowledge of the agent’s embezzlement is not imputed to the company as a basis for the insurer to rescind coverage.
Judge Frank emphasized the narrowness of his ruling, noting that it is “only when an employee who acting adversely to her employer by embezzling from the company misrepresents her knowledge of that embezzlement on an application for fidelity insurance that the employee’s knowledge will not be imputed to the company to allow the insurer to rescind the fidelity insurance.”
Finally, Judge Frank rejected the insurer’s argument that NCUA (as the credit union’s receiver) had agreed to allow the rescission, based on the fact that the NCUA had cashed the returned premium check. He noted that under Minnesota law, merely cashing the check is not enough to demonstrate rescission; rather the party cashing the check must have the requisite knowledge of the insurer’s basis for rescission. Given that the check was cashed as part of the NCUA’s receivership procedures, Judge Frank concluded that the insurer “had not demonstrated that either cashing the check or retaining the funds constituted an unequivocal acceptance of the offer to rescind.
Insurer attempts to rescind coverage are almost always hotly contested. However, the usual issues in a rescission fight are whether there was a misrepresentation or whether the misrepresentation was material. Neither of those issues were present here. The ongoing embezzlement was not disclosed and the withheld fact was clearly material to the risk.
Another issue that frequently comes up in rescission is whether the knowledge of the misrepresented fact can be imputed to the applicant. However, the usual circumstance where this kind of issue comes up involves a situation where the person with factual knowledge is a different person than the one that signed the application. Here, the person with the knowledge was the person that signed the application. You can certainly see how the insurer believed that it has a basis on which to rescind the fidelity bond. The policy was procured based on a knowing, material misrepresentation.
The legal principle on which Judge Frank concluded that Cofell’s misrepresentation could not be attributed to the credit union – that is, the adverse interest exception – comes up not in frequently in cases involving fidelity bond insurance applications, where the application signatory was actively involved in misconduct that was undisclosed in the application.
For example, in an August 2016 decision, Western District of Louisiana Judge Elizabeth Foote, applying Louisiana law, held that an insurer was not entitled to rescind a fidelity bond where one of the two signatories to the application was actively engaged in an undisclosed embezzlement scheme.
Similarly in a November 2011 decision (here), Judge David Bunning, applying Kentucky law, held that a bank’s insurer was not entitled to rescind the bank’s fidelity bond where the CEO who signed the bond application was engaged in an undisclosed embezzlement scheme.
In each of these prior cases, the courts held that the application signatories had been acting solely in their own interests when they failed to disclose their respective schemes in the insurance application, and therefore the adverse interest exception to the usual rules of agency law applied.
The applicability of the adverse interest exception arises in a variety of contexts involving alleged fraud by agents. The question of whether or not the adverse interest exception applies usually turns on the question of whether or not the agent is acting solely for his or her own benefit or whether the agent’s principal benefited from the agent’s actions.
An example of a case in which the adverse interest exception was held not to apply is the Petrobras securities class action. In that case, Petrobras had tried to argue, in reliance on the adverse interest exception, that its officials’ actions and knowledge could not be attributed to the company for purposed of determining whether or not the company itself had acted with scienter. In an August 2015 ruling (discussed here), Southern District of New York Judge Jed Rakoff rejected this argument, ruling that the company as well as the individuals had benefited from the officials’ actions and misrepresentations.
Insurers disturbed by this ruling’s suggestion that an insurer would have to insure a claim known at the time the insurance was procured – even where the insurance was procured by a knowing misrepresentation – will want to consider the pains Judge Frank took to emphasize the narrowness of his holding. His reiteration of the narrowness of his ruling underscored the fact that it was only going to be a very limited set of circumstances in which an insurance application signer’s knowledge will not be imputed to his or her employer.
There is one part of Judge Frank’s decision that is worth further consideration. In addressing the insurer’s argument that the NCUA (as the credit union’s receiver) could not retain the benefits of the misrepresentation (that is, the bond) while simultaneously disavowing the misrepresentation, Judge Frank noted that the courts were split on this question. The way the courts dealt with the issue, he said, turned on which party the court decides is best able to bear the risk of loss. Some courts, he noted, have concluded that the employer is best equipped to identify and put forward trustworthy employees, which other courts have concluded that the insurer, who has at least facially agreed to insure against that very risk, is better equipped to bear the risk and spread it across the market.
Judge Frank did not expressly say which side of this court split he favored but he did go ahead and rule that the insurer was not entitled to rescind the policy in this circumstance, which at least inferentially suggest that he favored the school of thought that the insurer, which had facially agreed to insured the very kind of risk at issue, is better equipped to bear the risk and spread it across the market. While Judge Frank did not expressly endorse this principle, it is a helpful concept that could and arguably should be taken into account in many insurance-coverage related disputes.
I do kind of wonder whether it made a difference that the plaintiff in this case was the NCUA acting in its capacity as receiver, rather than the credit union itself. The sympathies in the case might have been different if the credit union had been representing its own interest; the NCUA perhaps could distance itself from any suggestion that the theft could have or should have been prevented or caught sooner. The presence of the NCUA as receiver – rather than the credit union itself – subtly suggests a slightly different feel to the “who should bear the loss” question that Judge Frank considered.
One final note. I have no idea why the court (and apparently the parties) were referring to and citing the Restatement (Second) of Agency. The American Law Institute promulgated and published the Restatement (Third) of Agency some years ago; according to the ALI’s website, the Restatement (Second) of Agency is out of print and has been “completely superseded” by the Restatement (Third) of Agency.