Recent Developments in Fidelity Insurance
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This article tracks the most significant fidelity insurance decisions rendered in the past year. The twelve decisions discussed herein cover thirteen different aspects of fidelity insurance, including: discovery of loss; adverse domination; rescission; alter ego doctrine; definition of "employee"; definition of "evidence of debt"; definition of "forgery"; definition of "counterfeit"; burden of proof to show dishonesty; direct loss; manifest intent to cause a loss; manifest intent to obtain a financial benefit; and the inventory computation exclusion.A. Discovery Of Loss
Fidelity policies generally cover only those losses which are discovered for the first time during the effective period of the current policy. Losses which are discovered before the inception date or after the expiration date of the policy are not covered. In the past year, two important decisions were rendered on this topic, both of which rejected the traditional notion that the giving of notice may be deferred after the insured has discovered fraudulent conduct until such time as the insured is actually able to prove that the loss had occurred.
1. The City Savings Case
In Resolution Trust Corp. v. Fidelity & Deposit Co. of Md., 205 F.3d 615 (3d Cir. 2000) (applying New Jersey law), the United States Court of Appeals for the Third Circuit reversed the judgment of the United States District Court for the District of New Jersey, which had granted summary judgment to the fidelity insurer on a $7,000,000 claim on the ground that the loss had been discovered after the policy’s expiration date.3 In so holding, the Third Circuit concluded that there were issues of fact which precluded summary judgment as to the "precise date" on which the insured had discovered the loss. Determining the "precise date" of the discovery of the loss became important in the case because: (a) the insured’s receiver contended that the loss was discovered just before the expiration date (in which case the loss might be covered under the policy); and (b) the insurer contended that the loss had been discovered just after the expiration date (in which case the loss would not be covered). The case was then remanded to the District Court for further proceedings.
Although the Third Circuit reversed the District Court’s judgment, it evinced an analysis of the "discovery" issue which should prove to be favorable to the fidelity insurance industry in the future:
We understand this discovery standard as comprised of a subjective and objective component: the trier of fact must identify what facts and information the insured actually knew during the relevant time period, and it must determine, based on those facts, the conclusions that a reasonable person could draw from them.
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The facts must be viewed as they would have been by a reasonable person at the time discovery is asserted, and not as they later appeared in the light of subsequently acquired knowledge.
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[The] discovery definition does not require that the bank have enough information to charge its employee with fraud or dishonesty[.] All that is required is that it have enough information to assume that the employee has acted fraudulently or dishonestly. Moreover, we understand the objective, "reasonable person" component as permitting the trier of fact to analyze the full range of information the insured knew so as to determine whether a reasonable person would assume, based on all of the circumstances, that a covered loss had or would be incurred.
Inevitably, a court must assess each case on its own facts, keeping in mind the general principle that the "discovery threshold is low ..."
Indeed, by adhering to that general principle, we remain true to the plain language of the bond. All that it requires is that the insured possess sufficient information to lead to a reasonable assumption of a covered loss; it states specifically that the insured need not know "the exact amount or details" of the loss to be charged with discovery ...
Id. at 630-31 [citations and quotation marks omitted].
2. The Gulf USA Case
Similar reasoning was applied by the court in Gulf USA Corp. v. Federal Ins. Co., No. CV98-440-N-EJL (D. Idaho, Aug. 6, 1999). In the Gulf USA case, the United States District Court for the District of Idaho granted summary judgment in favor of the fidelity insurer on the ground that the insured had discovered the $17,000,000 loss approximately six months prior to the April 22, 1992 inception date of the subject policy.4 The commercial crime policy covered "direct losses of Money, Securities and other property caused by Theft ... by any identifiable Employees ..." Id. at 7. Section 4.5 of the crime policy stated:
Upon knowledge or discovery by a proprietor, partner or officer of any Insured of loss or of an occurrence which may become a loss, written notice shall be given at the earliest practicable moment, and in no event later than sixty days after such discovery. Within four months after such discovery the Insured shall furnish the Company affirmative proof of loss with full particulars.
Id. at 7. The policy also provided that it only covered those losses discovered for the first time during the policy period (which was April 22, 1992 to April 22, 1993). Id. at 7.
The subject loss involved a series of purported thefts of the insured’s funds by its former president, David Rowland, who left the insured in July 1991 when his 34 percent stake in the insured was purchased by a new owner. In the immediate wake of this transaction, the new owner began investigating a series of suspicious real estate transactions Rowland had engineered over the prior two years and found evidence that Rowland had personally skimmed several million dollars from the transactions. The investigation culminated in an October 1991 agreement (executed six months before the policy’s inception date) wherein the insured agreed to release Rowland from all liability in exchange for Rowland’s promise to pay the insured a sum of money plus certain securities.
In holding that there was no genuine issue of triable fact that the insured had discovered the loss no later than the date of the October 1991 release (i.e., six months before the policy’s inception date), the District Court stated that:
At issue, then, is what constitutes a "discovery." The answer to this question necessarily involves an examination of what must be discovered, that is the "loss or ... occurrence which may become a loss." Because the Crime Policy does not further define this language, the Court looks to case law.
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In this regard, the Court finds particularly instructive the analysis of identical "discovery" language set forth in Ellenberg v. Underwriters at Lloyd’s (In re Prime Commercial Corp.), 187 B.R. 785 (Bankr. N.D. Ga. 1995) (hereinafter Prime Commercial). In that case, the court correctly observed that "the Policy requires not just notice upon discovery of a loss but upon discovery of ‘an occurrence which may become a loss.’" Id. at 801. Since a crime policy is concerned only with a loss occasioned by a theft, the Prime Commercial court reasoned that "if the Policy had required notice only upon the discovery of theft, it would have been sufficient to stop after the words, ‘[u]pon knowledge or discovery by a proprietor, partner or officer of any Insured of loss,’ ... because knowledge of a loss is knowledge of a theft for purposes of the Policy." Id. Based on this reasoning, the court concluded:
"It followed that the added words, ‘occurrence which may become a loss,’ cannot be read as requiring notice where the insured knows of a theft .... Therefore, the added words, ‘occurrence which may become a loss,’ must refer to knowledge of some event or events short of actual knowledge of a theft that nonetheless requires notice to the insurer because that event may involve a loss by theft."
Id. (emphasis added).
This Court agrees with the Prime Commercial court’s analysis, and adopts that court’s interpretation of the "discovery" language as its own. Applying that language to the issues here, and viewing the evidence in a light most favorable to [the insured], the Court finds there are no genuine, disputed issues of material fact that by October of 1991, [the new owner] had actual knowledge of events sufficient to trigger Gulf’s obligation under the Crime Policy to notify Federal that the [tainted real estate transactions] may have involved a loss by theft.
Id. at 12-13.
The conclusions reached by the courts in the aforementioned cases were essentially the same: fidelity policies do not require discovery of all details of a fraud before the insured may be charged with "discovery" of a loss.
B. Adverse Domination Doctrine/Rescission
1. Origins Of The Doctrine
"Adverse domination" is an equitable doctrine which operates to toll the statute of limitations for a corporation’s claims against its officers of directors when the persons in charge of the corporation cannot be expected to pursue claims adverse to their own interests. Republic of Philippines v. Westinghouse Elec. Corp., 714 F. Supp. 1362, 1371 n.3 (3d Cir. 1989). In recent years, the doctrine gained prominence in failed bank and thrift litigation. See, e.g., M. Dore, Statutes of Limitation and Corporate Fiduciary Claims: A Search for Middle Ground on the Rules/Standards Continuum, 63 Brooklyn L. Rev. 695, 713-14 (1997).
Meanwhile, the FDIC argued with some limited success that the doctrine tolled compliance with the timing-related conditions (i.e., notice; proof of loss; suit) contained in fidelity bonds issued to troubled financial institutions. See, e.g., FDIC v. Oldenburg, 34 F.3d 1529, 1544 (10th Cir. 1994); California Union Ins. Co. v. American Diversified Savings Bank, 948 F.2d 556, 565 (9th Cir. 1991). In the fidelity bond context, the doctrine has been applied to toll the time in which an insured has to notify its insurer of dishonesty committed by a dominant corporate actor based on the recognition that since the malefactor cannot be expected to protect the interests of the insured corporation, knowledge of the malefactor’s fraud should not be inputted to the insured corporation until after the malefactor has been deposed from power.
2. The Lloyd’s Securities Case
In perhaps the worst-reasoned fidelity insurance decision in the last 25 years, the court in Shields v. National Union Fire Ins. Co. of Pittsburgh PA (In re Lloyd’s Securities), 153 B.R. 677 (E.D. Pa. 1993), inexplicably broadened the scope of the "adverse domination doctrine" to vitiate not only the fidelity insurer’s timing-related defenses, but also to dismiss valid rescission and alter ego defenses as well.5 In the wake of this disastrous decision, receivers and bankruptcy trustees boldly pursued fidelity claims on behalf of small or medium-sized insureds who had become insolvent despite the fact that the dominant corporate actor/thief had: (a) owned the insured company; and/or (b) deceived the fidelity insurer in applying for the policy.
3. The Payroll Express Case
However, in In re Payroll Express Corporation, 186 F.3d 196 (2d Cir. 1999) (applying New Jersey law),6 the United States Court of Appeals for the Second Circuit refused to vitiate the insurers’ rescission defense based on an invocation of the "adverse domination" doctrine. In that case, certain of the fidelity insurers (i.e., the London Excess Insurers) successfully obtained summary judgment rescinding their policies based on misrepresentations made by the insured about its prior loss history. In re Payroll Express Corp., 216 B.R. 344 (S.D.N.Y. 1997), reconsideration denied, 216 B.R. 713 (S.D.N.Y. 1997).
On appeal, the insured’s bankruptcy trustee argued that the "adverse domination" doctrine vitiated the insurers rescission defense because the dominant corporate actor who caused the insolvency-creating loss had also filled out the insurance application form which contained the rescission-worthy misrepresentations. In so arguing, the trustee relied very heavily on the Lloyd’s Securities decision. Affirming the District Court’s grant of summary judgment to the London Excess Insurers, the Second Circuit held that the adverse domination doctrine should not be applied to vitiate a rescission defense:
For several reasons we disagree with the Trustee’s contention that the district court erred by declining to apply the adverse domination doctrine in the present case. We first note that New Jersey has not adopted the adverse domination theory.
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The Trustee appears to argue that the [doctrine] should apply to misrepresentations made on an insurance application by a defalcating employee. The difficulty with the Trustee’s attempt to apply the adverse domination theory to the [London] policies is that no otherwise applicable time period, and therefore no tolling is implicated by the district court’s decision. The district court held that the [London] policies were void ab initio because [the dominant corporate actor] made material misrepresentations on the application. That holding has nothing to do with the timing of the corporation’s discovery of the wrongdoings for notice purposes.
To the extent that the court in Lloyd Securities based its determination that the material misrepresentations on the fidelity bond application should not be imputed to the debtor corporation on the adverse domination doctrine, the decision was, at best, an extension of the doctrine well beyond its equitable tolling roots. Whereas the equitable tolling of statutes of limitations and other time periods only exposes an insurer to losses of a sort the insurer has already agreed to absorb, extending this doctrine to the concealment of fraud in a policy application exposes the insurer to risks the insurer otherwise would not have assumed. We decline to extend the doctrine in such a manner, particularly in the absence of any indication that the New Jersey Supreme Court would recognize even a traditional version of the theory.
In re Payroll Express Corp., 186 F.3d 196, 206-07 (2d Cir. 1999).
4. The "Adverse Interest Exception"
In Payroll Express, supra, the insured’s trustee also attempted to argue that the dominant corporate actor’s misrepresentations on the fidelity insurance application should not be imputed to the insured because the malefactor had been perpetrating a fraudulent scheme to loot the insured, and was thereby acting adversely to his principal’s interests. In rejecting this argument, the Second Circuit held that the insured was bound by the misrepresentations made by its "agent" on the application form:
The Trustee also invokes the adverse interest exception to general agency principles to justify why the debtor corporation should not be barred from enforcing the terms of the [London] policies despite the [dominant corporate actor’s] misrepresentations. The general rule is that a representation made by an authorized agent of the principal is binding upon the principal. There is an exception to this rule when the agent is acting completely adversely to the interests of the principal.
The New Jersey Supreme Court has yet to ascertain the operation and scope of the adverse interest doctrine, but we think it is clear that under New Jersey law, principles of agency operate to hold [the insured] responsible for the consequences of [the malefactor’s] misrepresentations. A corporation, possessing an identity only in a legal sense, necessarily speaks through its agents. In an action for contract rescission, an agent’s misrepresentations bind the principal if the agent was authorized to represent the principal in obtaining the contract.
Id. at 207 [citations omitted].
C. Alter Ego Doctrine/Definition of "Employee"
In the past year, three cases have been decided under New Jersey law in which fidelity insurance claims were dismissed based on the insurers’ argument that: (a) reimbursement was barred by the "alter ego" doctrine; and (b) the dominant corporate actor who had caused the loss did not constitute an "Employee" within the definition of the policy.
In the fidelity insurance context, the "alter ego" doctrine is an equitable defense which posits that if a small or medium sized corporate insured is controlled by a dominant officer/owner who misuses his power at the expense of the insured, the resulting loss is not covered under the policy because: (a) the malefactor is considered to be the "alter ego" of the corporate insured; and (b) a corporate insured cannot recover on a fidelity bond for loss sustained due to its own wrongdoing. J. McCullough, Alter Ego-Type Defenses In The Fidelity Insurance Contract, International Ins. L. Rev., 295, 299 (1994). See Premium Finance Co. v. Employers Reinsurance Corp., 979 F.2d 1091, 1093-94 (5th Cir. 1992); Red Lake County State Bank v. Employers Ins. of Wausau, 874 F.2d 546, 550 (8th Cir. 1989).
Fidelity losses are not covered unless caused by "employee" dishonesty. A key element in determining whether a person qualifies as an "employee" is whether that person possesses the characteristics set forth in the bond’s definition of "employee" the most frequently litigated of which is the characteristic of being subject to the corporate insured’s "governance and control." If the employer does not have the right to "govern and direct" a person’s actions, any loss caused by that person is not covered under the fidelity insuring clause of the bond. McCullough, supra at 296. See Bird v. Centennial Ins. Co., 11 F.3d 228 (1st Cir. 1993); In re World Hospitality, Ltd., 983 F.2d 650 (5th Cir. 1993); California Union Ins. Co. v. American Diversified Sav. Bank, 948 F.2d 556 (9th Cir. 1991); Kerr v. Aetna Casualty & Surety Co., 350 F.2d 146 (4th Cir. 1965); Three Garden Village, L.P. v. U.S. Fidelity & Guar. Co., 318 Md. 98, 567 A.2d 85 (Md. 1989); Employers Admin. Services, Inc. v. Hartford Acc. & Indem. Co., 147 Ariz. 202, 709 P.3d 559 (Ariz. Ct.App. 1985).
1. The Hartford Case
In Hartford Fire Ins. Co. v. Conestoga Title Ins. Co., 328 N.J. Super 456, 746 A.2d 460 (App.Div. 2000), the insured abstract company ("Merit") purchased a fidelity bond from Hartford. Merit was a small company run by its president, William Attardi, and was owned by Attardi’s wife, who was not active in the business. Merit was authorized to issue title insurance commitments on behalf of Conestoga. Through Merit, Attardi stole approximately $1,200,000 in trust funds. Conestoga then obtained a $1,200,000 judgment against Merit and Attardi. Hartford commenced a declaratory judgment action against Conestoga. In so doing, Hartford contended that the loss fell outside the purview of the bond’s coverage because: (a) Attardi was Merit’s alter ego; and (b) Attardi did not constitute an "Employee" under the bond’s definition of that term. The trial court granted summary judgment to Hartford. On appeal, the New Jersey Appellate Division affirmed the trial court and concluded that:
The Hartford bond insured Merit against dishonest acts of its employees; and, in relevant part, it defined the term "employee" as:
Any natural person: (1) [w]hile in your service ...; and (2) [w]hom you compensate by salary ...; (3) [w]hom you have the right to direct and control while performing service for you.
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The question is whether Attardi was an employee as that term is defined in the bond ... In Conestoga Title Insurance Co. v. Premier Title Agency, Inc., 328 N.J.Super 460, 746 A.2d 462 (App.Div.2000), decided today, we agreed with the majority of courts that this common definition of employee in corporate fidelity bonds -- persons whom you have the right to direct and control while performing services for you -- is unambiguous and means that thefts by corporate alter egos are not covered.
The only difference between this case and Conestoga is that here the corporate alter ego, Attardi, had installed his wife as director and had designated her as the owner of all the corporate stock. Had her position or stock ownership been grounded in reality, Merit, and therefore Conestoga, might have had a case worth pursuing. But, in fact she knew nothing of the corporation’s business and was completely uninvolved. Instead, the corporation was entirely dominated by Attardi.
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At best it could be said that Attardi’s wife had a theoretical right to govern Merit and thereby control her husband. In Conestoga, supra, however, we endorsed the commonly held view that under the standard fidelity bond’s definition of covered and excluded employees, "the ‘right’ to govern and direct ... must be more than an ephemeral right inhering in the corporate form; rather it must have some grounding in reality." Bird v. Centennial Ins. Co., 11 F.3d 228, 233 (1st Cir. 1993)
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If we were to permit recovery on the bond in these circumstances, the reality is that a thief who utterly dominated a corporation could wrongfully obtain the benefits of a fidelity bond by placing formal ownership of the company in a spouse or confederate. That is patently inconsistent with the settled policy of not permitting insurance for intentional wrongdoing.
Hartford, 328 N.J.Super. at 458, 746 A.2d at 461-62 [some citations omitted].
2. The Conestoga Title Case
In Conestoga Title Ins. Co. v. Premier Title Agency, 328 N.J.Super. 460, 746 A.2d 462 (App.Div. 2000), another of Conestoga’s abstractors (i.e., Robert Wurster, the sole shareholder and president of Premier) was also implicated in a theft of trust funds (i.e., $385,470.59). Premier was insured under a fidelity bond issued by Old Republic Insurance Company. After Conestoga obtained a judgment against Premier/Wurster, Conestoga took an assignment from Premier of Premier’s right to seek reimbursement for the loss under Premier’s fidelity bond. Old Republic denied coverage for the loss on the grounds that: (a) Wurster was Premier’s "alter ego"; and (b) Wurster did not constitute an "Employee" under the bond because Premier did not have the power to govern and direct Wurster’s employment-related activities. Following a bench trial, the trial court entered judgment for Old Republic. On appeal, the New Jersey Appellate Division affirmed the trial court and concluded that:
The fidelity bond insured Premier against dishonest acts of its employees; and, in relevant part, it defined the term "employee" as "Any natural person ... in your service ... [w]hom you compensate directly by salary ...; and [w]hom you have the right to direct and control while performing services for you [.]"
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An assignee’s rights are limited to the rights of the assignor and are subject to all the equities and defenses that could have been asserted against the assignor before assignment. Therefore, we turn our attention to Premier’s alleged rights under the fidelity bond.
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The courts of this state have not yet addressed the basic issue, but numerous cases have held that this common definition of employee in corporate fidelity bonds -- persons whom you have the right to direct and control while performing services for you -- is unambiguous and means that thefts by corporate alter egos are not covered.
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Although Conestoga continues to rely, in part, on Premier’s theoretical right to control Wurster, the trial judge properly rejected that argument, as do we.
Our conclusion finds strong support in considerations of policy:
A corporation can only act through its officers and directors. When one person owns a controlling interest in the corporation and dominates the corporation’s actions, his acts are the corporation’s acts. Allowing the corporation to recover for the owner’s fraudulent or dishonest conduct would essentially allow the corporation to recover for its own fraudulent or dishonest acts. The [fidelity] bonds, however, were clearly designed to insure the corporations against their employee’s dishonest acts and not their own dishonest acts.
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And the policy of not permitting insurance for intentional wrongdoing has been expressed as our own in other settings involving insurance claims.
Conestoga, 328 N.J.Super. at 463-66, 746 A.2d at 464-65 [citations omitted].
3. The Payroll Express Case
In Payroll Express, supra, the insured was a check-cashing service owned by Robert Felzenberg and his wife, Barbara Felzenberg. The insured collapsed in 1992 in the wake of a series of thefts committed by Robert Felzenberg. According to the insured’s bankruptcy trustee, Barbara Felzenberg was also implicated in the thefts. The evidence showed that the Felzenbergs exercised unfettered dominance over the insured’s affairs. The fidelity insurers argued that the trustee should not obtain reimbursement under the bonds for the loss because: (a) the Felzenbergs were the "alter egos" of the insured; and (b) the Felzenbergs did not constitute "Employees" under the bonds.
In a somewhat confusing opinion, the United States District Court for the Southern District of New York held that Robert Felzenberg was not the insured’s "alter ego" under New Jersey law. Payroll Express, 216 B.R. at 344 (S.D.N.Y. 1997), aff’d, 186 F.3d at 196 (2d Cir. 1999). In so holding, the court cited a New Jersey case which dealt with "piercing the corporate veil" in a non-fidelity insurance context. Payroll Express, 216 B.R. at 361 (citing Coppa v. Taxation Div. Dir., 8 N.J. Tax 236, 245 (1986)). The test evinced in Coppa made it difficult to find that the owners of a family-owned company were its "alter egos." Coppa, 8 N.J. Tax at 245. In relying on Coppa, the District Court disregarded the large number of fidelity insurance cases decided outside New Jersey which had adopted the "alter ego doctrine" to defeat coverage for losses caused by dominant corporate actors. On appeal, the Second Circuit affirmed the District Court’s judgment on this point.
4. Analysis Of The New Jersey Alter Ego Cases
In the future, courts applying New Jersey law in fidelity bond cases where the "alter ego" doctrine has been invoked will likely follow Hartford and Conestoga Title, not Payroll Express. Had the Hartford and Conestoga Title cases been decided before Payroll Express (which preceded those two cases), it is likely that Payroll Express would have been decided differently (i.e., it would have followed the reasoning of Hartford and Conestoga Title). However, because no "alter ego" case in the fidelity bond context had yet been decided in New Jersey before Payroll Express, the courts in Payroll Express felt constrained to apply New Jersey’s law involving "piercing the corporate veil," rather than fidelity decisions from other jurisdictions.
5. The Southern New England Case
Another recent definition of "employee" case grappled with the issue of whether an outside counsel constituted an "employee" of the insured. In Southern New England Conf. Assn. of Seventh Day Adventists v. Federal Ins. Co., 1998 WL 1184201 (Mass. Super.Ct. Dec. 22, 1998), the insured charitable organization (i.e., "SNECA") was victimized by an attorney (i.e., "Clark") who stole $582,000. SNECA then sought reimbursement under its fidelity bond for the theft loss. Clark had stolen: (a) the proceeds of a $242,453.94 collection action which the attorney had commenced against a third party on SNECA’s behalf; (b) funds earmarked to purchase real estate for SNECA; (c) funds intended to pay construction-related subcontractors to whom SNECA owed money; and (d) moneys supposed to be paid to the government to pay taxes owed by SNECA. Clark was a partner employed in an outside law firm which the insured’s board of trustees retained to perform legal work at a fixed annual rate on the insured’s behalf. The fidelity insurer denied coverage for the loss on the ground that the attorney did not fall within the bond’s definition of "employee," which stated as follows:
One or more persons while in the regular service of any Insured in the ordinary course of the Insured’s business during the term of this coverage section and whom any Insured compensated by salary, wages, and/or commissions and has the right to govern and direct in the performance of such service; and shall also mean ... any director or trustee of any Insured while performing acts within the scope of the usual duties of an Employee ...
Id. at *4. Agreeing with the fidelity insurer, the trial court concluded that there was no coverage for the loss because Clark was not an "employee."
SNECA contends that Clark was an employee for purposes of the Policy because, in addition to paying Clark a "salary," it retained, at all times, the right to govern and direct Clark in the performance of his duties regarding SNECA’s funds in his possession. SNECA concedes that Clark was an independent contractor so far as he was exercising his professional judgment in representing SNECA; however, SNECA contends that with regard to the administration of funds entrusted to him, Clark acted as SNECA’s employee and thus his theft is covered under the Policy. SNECA contends that Clark, with regard to SNECA funds in his possession, was no different than SNECA’s treasurer and held the funds subject to SNECA’s right of direction.
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The distinction, argued by SNECA, that Clark was an employee with regard to holding SNECA’s funds, and an independent contractor with regard to all other activities is not persuasive. "The test used ... to determine whether an individual is, on the one hand, a servant or employee ... or, on the other hand, an independent contractor, ... is the control which may be exercised over the individual in the performance of his work. If in the performance of his work an individual is at all times bound to obedience and subject to direction and supervision as to details, he is employee; but if he is only responsible for the accomplishment of an agreed result in an agreed manner, he is an independent contractor. The essence of the distinction is the right to control."
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It is clear that Clark was not an employee under this test because Clark was not "at all times bound to obedience and subject to direction and supervision as to details" in his relationship with SNECA.
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SNECA contends that the term "employee" as defined in the Policy is broader than its ordinary meaning. That is, SNECA contends that the term, as defined, is not dependent upon withholding taxes, fringe benefits, tenure or the like; but, instead, requires merely that the employee be paid a "salary" and act with regard to the loss subject to SNECA’s right to govern and direct in the performance of its regular service. It is evident to this court, however, that what SNECA paid to Clark was not a "salary" or "wage" but a retainer for legal services for each calendar year, and that Clark was not "at all times bound to obedience and subject to direction and supervision as to details" by SNECA. Hence, Clark was an independent contractor of SNECA and not its employee.
Id. at *4-5 [citations and footnotes omitted].
6. The Vons Case
Another recent definition of "employee" case dealt with a loss arising out of the "outsourcing" context. In Vons Companies, Inc. v. Federal Ins. Co., 57 F. Supp.2d 933 (C.D. Cal. 1998), aff’d, 2000 WL 557971 (9th Cir. May 9, 2000) (applying California law), the insured grocery store chain (i.e., "Vons") contracted with a trading company (i.e., "Stanford") to provide it with a broker (i.e., "Shirley") to assist the grocery chain in a legitimate practice known as "diverting," wherein grocers buy and sell goods on a secondary market which seeks to exploit regional differences in the prices of food and beauty products. Shirley worked on Vons’s premises for approximately four years. Vons later ordered Shirley off its premises after it learned that Shirley had taken kickbacks from a Vons trading partner (i.e., "Premium Sales").
Several years later, Vons was sued by investors who were victimized by a massive Ponzi scheme which was principally orchestrated by Premium Sales. In the suit, the investors claimed that Vons was vicariously liable because Shirley had, from Vons’s premises, falsely documented a large number of bogus transactions between Vons and Premium Sales. Vons later settled the suit for $10,000,000 and sought reimbursement under its commercial crime policy. In concluding that Vons’s fidelity claim was not covered under the policy, the District Court stated that Shirley did not constitute an "employee" within the policy’s meaning. In so stating, the District Court reasoned that:
Insuring Clause 1 provides "[t]he Company shall be liable for direct losses of Money, Securities or other property caused by Theft or Forgery by any Employee of any Insured acting alone or in collusion with others." In the ... Policies, "employee" is defined:
either in the singular or plural, means one or more persons while in the regular service of any Insured in the ordinary course of the Insured’s business during the term of this coverage section and whom any Insured compensates by salary, wages and/or commissions and has the right to govern and direct in the performance of such service; and shall also mean:
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(D) any individual or individuals assigned to perform Employee duties for any Insured, within the Insured’s Premises, by any agency furnishing temporary personnel on a contingent or part-time basis.
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Prior to 1986, Vons had occasionally engaged in transactions on the secondary market using its own buyers, who were full-time employees. It did not have a formal diverting program. Vons contends that in 1986, a company called [Stanford] agreed to supply personnel to work exclusively on Vons’ premises to assist Vons in buying and selling products.
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[Stanford] placed two clerical workers and two secondary market buyers on Vons’ premises, including [Shirley]. Shirley worked exclusively for Vons to implement the contract between Stanford and Vons, on Vons’ premises, from December 1987 to November 1991. Shirley had full access to Vons’ proprietary computer program showing Vons’ purchasing needs and pricing information. He did not review proposed transactions with [Stanford] or obtain their approval before completing a buy or sell for Vons. His job was to secure the best possible prices for Vons.
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First, Shirley was not a Vons employee. He worked for Stanford. Vons’ own General Counsel submitted an affidavit in the [investors’] litigation detailing myriad reasons why Shirley was not Vons’ employee.
Furthermore, in the very proof of loss that, when denied, prompted this lawsuit, Vons again stated that Shirley was not its employee. In that document ... Plaintiff declared that [Shirley] was "an employee of Stanford Trading, Inc., which company provided services to Vons as an independent contractor." Vons alleged that Shirley was Stanford’s employee in paragraph 18 of the Complaint itself ....
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Vons’ contention that Shirley was a "temporary employee" as defined by the policy is also unpersuasive. Shirley was on Vons’ premises for nearly four years. In addition, Stanford was not an employment agency or its equivalent. Rather, Vons contracted with Stanford to operate Vons’ diverting efforts. Vons did not contract with Stanford to provide Vons with personnel per se.
Vons, 57 F. Supp. at 936-38, 945-46.
D. Forgery Claims Under Insuring Agreements (D) And (E)
Two recent "forgery" claims which were resolved in the fidelity insurers’ favor highlight the importance of the bond definitions of the terms "forgery" and "evidence of debt."
1. The First Union Case
In First Union Corp. v. U.S. Fidelity & Guar. Co., 126 Md.App. 499, 730 A.2d 278 (Md. Ct. Spec App. 1999), the Court of Special Appeals of Maryland affirmed summary judgment in the fidelity insurer’s favor in connection with a $35,000,000 loan loss case. The insured bank (i.e., Signet, First Union’s predecessor) made $300,000,000 in loans to a purported off-shore subsidiary of Philip Morris Company for the ostensible purpose of purchasing computer equipment related to allegedly top-secret cigarette research. The perpetrator who defrauded the insured bank was Ed Reiners, an alleged officer of Philip Morris. Through sloppy loan underwriting practices, the insured bank did no due diligence investigation of Reiners or of Philip Morris to determine whether the loans were authorized. After the loans were disbursed and the insured bank was trying to syndicate the loans to other banks, the insured bank discovered that the entire scheme was a hoax. Although the insured bank recovered much of the loan proceeds, it still sustained a $35,000,000 loss from the scheme.
a. Evidence Of Debt
The insured bank sought reimbursement under insuring agreement (E) of its financial institution bond (standard form no. 24). In so doing, the insured bank claimed that its loss was caused by fraudulently-executed "incumbency certificates" which Reiners submitted to the insured bank in order to establish his authority to act on Philip Morris’s behalf. According to the insured bank, the "incumbency certificates" constituted an "evidence of debt," one of the insured documents recited in insuring agreement (E).
However, the court disagreed. The court noted that when the banking and surety industries amended the standard forms in 1980, insuring agreement (E) was significantly revised. Whereas the 1969 forms simply covered losses caused by reliance on forged documents, the 1980 forms narrowed the coverage "by enumerating and defining the specific documents [which came] within its purview." First Union, 126 Md.App. at 506, 730 A.2d at 281-82. In reviewing the post-1980 claims which had involved losses purportedly caused by a forged "evidence of debt," the court concluded that the term referred only to "primary indicia of debt, such as promissory notes or other investments that reflect a customer’s debt to the bank." First Union, 126 Md.App. at 507, 730 A.2d at 282.7
Turning to the facts of the case, the court concluded that the incumbency certificates did not evidence the purported debt owed by Philip Morris to the insured bank. Id. The court concluded that the certificates "simply represent that Edward Reiners is a high-ranking official of Philip Morris authorized to act on behalf of the company, and are not primary indicia of debt." Id.
b. Written Instructions
The insured bank also alleged that the loss was covered under insuring agreement (D) as forged "written instructions." However, the court rejected this contention and concluded that the coverage afforded under insuring agreement (D) referred principally to commercial paper, such as checks or drafts, and the subject incumbency certificates did not constitute commercial paper. First Union, 126 Md.App. at 509, 730 A.2d at 283 (citing KW Bancshares, Inc. v. Syndicates of Underwriters of Lloyd’s, 965 F. Supp. 1047, 1052 (W.D. Tenn. 1997)).
During the discovery phase of the coverage litigation, the insured bank’s senior vice president testified that the loan committee approved the loss-causing loans before receiving the incumbency certificates from Reiners. The court concluded that this admission was fatal to the bank’s claim because both insuring clause (D)(2) and (E)(1)(e) required the insured to act "on the faith of" (or in reliance upon) the tainted document. First Union, 126 Md.App. at 510, 730 A.2d at 283-84. Thus, the bank could not show that it had relied on the certificates because the bank never saw the certificates before approving the loans. Id.
2. The Vons Case
In Vons, supra, the insured grocery chain store contended that the $10,000,000 settlement from the underlying investors’ suit involving Shirley’s fraud constituted a covered "forgery" under insuring clause (4), entitled "depositor’s forgery." Vons, 57 F. Supp.2d at 943. The insured contended that the claim constituted a covered forgery loss because Shirley and Premium Finance created a large amount of false documentation which purported to show that real transactions had taken place. Id. at 944. However, the court pointed out that the documents represented fictitious transactions, so that the documents were merely false, not forged. Id. at 944-45. Moreover, the court pointed out that the false documents (i.e., purchase orders, invoices, wiring instructions, etc.) which allegedly gave rise to the loss were not the type of documents which were covered under the "depositor’s forgery" insuring clause. Id. at 945.
E. Coverage For "Counterfeit" Documents
Losses caused by certain "counterfeit" documents are covered under insuring clause (E). The definition of the term "counterfeit" first appeared in the standard forms in 1969. It states that the document must be "an imitation which is intended to deceive and to be taken as an original."8
1. How Close Must The "Imitation" Be?
A key inquiry in a counterfeit document claim under insuring agreement (E) is how closely the fake document imitates the genuine original. This inquiry should include three questions:
(1) What are the facially apparent physical characteristics of the fake vis-a-vis the genuine original?
(2) What are the objective facts relating to the creation of the fake vis-a-vis the genuine original?
(3) What was the subjective intent of the creator of the fake vis-a-vis the creator of the genuine original?9
Many of the cases have held that the fake document should exactly replicate the genuine original.10 The minority view is that the fake document need not constitute an exact imitation of the genuine original.11
2. The State Bank Of The Lakes Case
The minority view was adopted in State Bank of the Lakes v. Kansas Bankers Surety Co., 1999 WL 674739 (N.D. Ill. Aug. 23, 1999). In that case, the insured sustained a loan loss on a line of credit to a borrower who pledged as security to the insured documents entitled "manufacturer’s statements of origin" ("MSOs") on certain boats. The MSOs turned out to be bogus. The insurer contended that the loss was not covered because the fake MSOs were not "exact imitations" of the "genuine originals." The key difference which the insurer focused on was the fact that the fakes were unsigned. In denying the insurer’s summary judgment motion, the court concluded that even though the genuine originals were signed and the fakes were not, the fakes still constituted covered imitations because they closely resembled the originals and referred to actual prior boat transactions. Id. at *3.
F. "Direct" Loss
1. Recent Case Law Trend
In 1997-98, three appellate courts issued influential opinions which concluded that some third-party losses did not constitute the type of "direct loss" which was covered under the fidelity insuring agreement. See Aetna Casualty & Surety Co. v. Kidder Peabody & Co., 246 A.D.2d 202, 676 N.Y.S.2d 559 (1st Dep’t 1998), appeal denied, 93 N.Y.2d 805, 689 N.Y.S.2d 429, 711 N.E.2d 643 (1999); Lynch Properties, Inc. v. Potomac Ins. Co, 962 F. Supp. 956 (N.D. Tex. 1996), aff’d, 140 F.3d 622 (5th Cir. 1998) (applying Texas law); Peoples Bank & Trust Co. v. Aetna Casualty & Surety Co., 113 F.3d 629 (6th Cir. 1997) (applying Kentucky law). The thread of principle which runs through these cases was perhaps stated best in Peoples Bank, in which the United States Court of Appeals for the Sixth Circuit stated that:
As a practical matter....losses resulting from frauds on third parties will rarely be covered by Standard Form 24. These policies will cover a loss suffered by a third party only where the dishonest employees intended to cause the third-party loss, and knew or expected that the loss would migrate to the bank. The migratory route would need to be short, certain, and obvious to support an inference (in the absence of direct evidence) that dishonest employees harbored such knowledge or expectation.
Peoples Bank, 113 F.3d at 634.
2. The Vons Case
The trend evinced in Kidder Peabody, Lynch Properties, and Peoples Bank was recently continued in The Vons Companies v. Federal Ins. Co., 2000 WL 557971 (9th Cir. May 4, 2000). In Vons, the insured grocery store chain sought reimbursement under its commercial crime policy for a $10,000,000 settlement payment which it paid to plaintiff investors who had claimed that the insured and its purported agent, Shirley, had defrauded them in a Ponzi scheme. In holding that the $10,000,000 settlement payment did not constitute a type of "direct loss" which was covered by the policy, the United States Court of Appeals for the Ninth Circuit concluded that:
Vons’s principal contention is that the district court erred in rejecting its interpretation of the policy as providing liability coverage. Vons’s argument rests on section 11 of the policy which provides in relevant part that coverage "shall apply only to Money, Securities or other property owned by the Insured or for which the Insured is legally liable, or held by the Insured ... whether or not the Insured is liable." By its plain language, Vons argues, the policy covers "money for which the insured is legally liable." According to Vons, it became legally liable for the $10 million attributable to Shirley’s actions when it entered into the settlement agreement with the plaintiffs in the [investors’] litigation.
The problem with the argument is that it is founded on the interest clause of the policy ("ownership"), not the insuring clauses. Under the insuring clauses, Vons is covered only for direct losses to Vons caused by its employee’s dishonesty, not for vicarious liability for losses suffered by others arising from its employee’s tortious conduct. A direct loss to Vons may, of course, be caused by its employee’s theft of property for which it is legally liable, the typical case being where the insured is a bailee or trustee of property. Vons’s reliance on these cases is inapposite because the claim against it does not arise from the theft of property for which it is legally liable. Instead, the loss Vons suffered resulted from the threat of vicarious liability for Shirley’s tort which caused damage to third parties.
* * *
Under its policy, Federal provided Vons with coverage for "direct losses" that were "caused by" employee theft or forgery. Vons’s policy did not provide coverage for third party claims. We hold that "direct" means "direct" and that in the absence of a third party claims clause, Vons’s policy did not provide indemnity for vicarious liability for tortious acts of its employee. Our disposition of the coverage issue makes it unnecessary to reach other issues.
Id. at *2, 4 [citations and emphasis omitted].
G. Employee Dishonesty Claims
1. Burden Of Proof
The insured generally has the "burden of proof" to demonstrate a covered loss under the "insuring agreements," Sutro Bros. & Co. v. Indem. Ins. Co. of No. America, 264 F. Supp. 273, 290 (S.D.N.Y. 1967), aff’d, 386 F.2d 798, 801 (2d Cir. 1967), while the insurer generally has the burden of proof to show that the loss is precluded from coverage by an "exclusion." Kimmins Indus. Service v. Reliance Ins. Co., 19 F.3d 78, 81 (2d Cir. 1994).
2. The Provincial Hotels Case
The insured’s burden of proof to demonstrate a covered loss under the employee dishonesty insuring agreement was recently examined in Provincial Hotels, Inc. v. Mascair, 734 So.2d 136 (La. App. 1999). In that case, the insured hotel employed Mascair as its manager. On January 28, 1992, Mascair was terminated and allegedly admitted to the hotel’s three owners that he had embezzled approximately $110,000 from the hotel, which subsequently sought reimbursement of the loss under its commercial crime policy. During the ensuing coverage litigation, Mascair invoked his fifth amendment privilege against self-incrimination during his deposition. At trial, the insured introduced this fact and the testimony of the three owners who were present when Mascair purportedly "confessed" to his embezzlement. However, the insured introduced no statements or records showing the amounts taken or the times when the dishonest acts occurred. Moreover, the hotel’s books were never audited. Meanwhile, the fidelity insurer introduced evidence that the hotel’s financial records were in general "disarray" and in an "unreliable" state. In affirming the trial court’s dismissal of the insured’s fidelity claim, the Louisiana Court of Appeals concluded that:
To recover from Zurich, Provincial had the burden of proving not only that dishonest acts were perpetrated by an employee during the policy period, but also the amount of the loss directly caused by these dishonest acts. After reviewing the evidence, we agree with the trial judge that Provincial failed to meet its burden.
There was absolutely no proof that the alleged dishonest acts occurred during the policy period or the exact amount of the loss attributable to employee dishonesty during that period.
Id. at 139.
3. "Manifest Intent" To Cause A Loss
In early-2000, major opinions were issued by the United States Court of Appeals for the Second and Third Circuits. These are important decisions because the appellate panel in each case evinced an extravagant exegesis on the "manifest intent to cause a loss" element of the "employee dishonesty" insuring agreement. Moreover, the cases were decided under the laws of New York and New Jersey, two of the most significant commercial jurisdictions in the country.
a. The City Savings Case
In Resolution Trust Corp. v. Fidelity & Deposit Co. of Md., 205 F.3d 615 (3d Cir. 2000) (applying New Jersey law), the United States Court of Appeals for the Third Circuit affirmed the determination of the United States District Court for the District of New Jersey that genuine issues of fact precluded summary judgment for the fidelity insurer on the question of whether the accused employees had acted with the requisite "manifest intent to cause the insured to sustain a loss."
In reaching this conclusion, the Third Circuit conducted a lengthy survey of the fidelity case law and literature which have addressed the "manifest intent to cause a loss" issue since the adoption of the "definition of dishonesty" by the surety industry in the late-1970s. Id. at 637-44.12 From this survey, the Third Circuit devised a "test" for determining whether an employee acted with the "manifest intent" to cause loss:
[T]he term "manifest intent" as it is used in the fidelity provision requires the insured to prove that the employee engaged in dishonest or fraudulent acts with the specific purpose, object or desire both to cause a loss and obtain a financial benefit. Inasmuch as we equate the "substantially certain to result" standard with the mental state "knowingly," we are of the view that "purposefully" rather than "knowingly" better captures the meaning of "intent" as it used [sic] in the fidelity provision, given the history that prompted its inclusion in the dishonesty definition and its stated purpose. Indeed, we believe that our construction strikes an appropriate balance because it comports with the drafters’ obvious intent to limit the types of employee misconduct covered by this provision but ensures that proof of the employee’s recklessness and the substantial likelihood of loss factor into the ultimate inquiry into the employee’s subjective state of mind.
* * *
We emphasize, however, that by recognizing that the term "manifest intent" requires proof of the employee’s purpose in engaging in the dishonest or fraudulent acts, we are cognizant that the employee’s actual subjective state of mind virtually is impossible to prove absent resort to circumstances evidence -- objective indicia of intent.
* * *
And inasmuch as proof of recklessness and/or the employee’s knowledge of the likelihood that a loss was to result both serve as manifestations of the employee’s specific purpose or design, we hold that a jury may consider those factors, along with any other objective indicia of intent, in ascertaining the employee’s state of mind in engaging in the wrongful conduct.
Id. at 642-43 [citations omitted].
b. The Union Savings Case
In FDIC v. National Union Fire Ins. Co. of Pittsburgh, PA, 205 F.3d 66 (2d Cir. 2000) (applying New York law), the United States Court of Appeals for the Second Circuit affirmed summary judgment in favor of the FDIC against the fidelity insurer on a $3,000,000 loan loss case. In so doing, the Second Circuit (much like the Third Circuit in Resolution Trust Corp., supra) devised a test for determining whether an employee acted with the "manifest intent" to cause a loss:
Having determined that a court should examine objective indicia of intent and that recovery under a fidelity bond requires that the employee acted with the purpose or desire of causing his or her employer a loss, we now examine the related issue of what evidence circumstantially demonstrates that the employee acted with the specific purpose to cause the insured harm. Under [Glusband v. Fittin, Cunningham & Lauzon, Inc., 892 F.2d 208, 210 (2d Cir. 1989) (applying New York law)], evidence of an employee’s reckless behavior standing on its own does not satisfy the language of the fidelity bond. Courts from other circuits have permitted consideration of the recklessness of the employee’s conduct and agree that although recklessness itself is not sufficient to support an inference of intent under a fidelity bond, recklessness in addition to other evidence of intent can support a finding of intent under a fidelity bond.
* * *
Accordingly, ... "proof of an employee’s recklessness, or an employee’s knowledge that a result was substantially certain to occur from the conduct, are objective indicia -- manifestations -- of the employee’s specific purpose or intent." Resolution Trust Corp., [205 F.3d 615]. Therefore, whether a fidelity bond’s manifest intent requirement has been satisfied is discerned by considering the relationship between the employee and his or her employer, the employee’s knowledge that his conduct may cause the insured a loss, and all other surrounding circumstances bearing upon the employee’s purpose. Under Glusband and the New York cases, actions that amount to embezzlement or embezzlement-like conduct establish a fidelity bond’s manifest intent element as a matter of law. Actions that will possibly result in the benefit of the employer do not, as a matter of law, establish manifest intent. Furthermore, evidence that the employee acted recklessly can be a manifestation of the employee’s intent to cause the insured a loss. Finally, manifest intent does not require that the employee actively wish for or desire a particular result, but can exist when a particular result is substantially certain to follow from the employee’s conduct.
Id. at 73-74 [some citations omitted].
The recent opinions by the Second and Third Circuits present a mixed bag for fidelity insurers. Although the recent opinions guarantee that the courts in New York and New Jersey will consider evidence of the accused employee’s "subjective intent" in engaging in the loss-causing transactions,13 the courts also left the door open to a wide range of so-called "objective indicia" of the employee’s intent in determining whether the employee acted with the requisite "manifest intent." This is important because "objective indicia" often produce "hindsight re-examinations" which ignore the business judgment that the employee exercised at the time in which the transactions at issue occurred. If a court indulges too heavily in hindsight re-examinations, it will likely give short shrift to evidence of the employee’s "subjective intent," the precise issue which is so vital in determining whether coverage exists.
4. "Manifest Intent" To Obtain A Financial Benefit
a. The City Savings Case
In Resolution Trust Corp., supra, the Third Circuit also closely scrutinized the "earned in the normal course of employment" aspect of the "manifest intent to obtain a financial benefit" element of the employee dishonesty insuring agreement. The court’s analysis exhaustively outlined the parameters of the "financial benefit" element of the coverage (referred to by the court as "exclusion (b)"), and in material part stated:
[U]nder the plain language of the bond, the phrase "earned in the normal course of employment" cannot be viewed as a limitation on the exclusion. Rather, it is reasonable to conclude that the drafters included the phrase to provide a broader exclusion, thereby shrinking the bounds of coverage under the fidelity provision.
* * *
Extrapolating from the cases we have found on point, we understand the exclusion found in subsection (b) to eliminate coverage where the insured’s theory is that the employee’s purpose in engaging in the misconduct that caused the loss was to receive some type of financial benefit that, generally speaking, the insured provides knowingly to its employees as part of its compensation scheme and as a result of the employment relationship.
Following this approach, courts have explained that payments qualifying as "payoffs" or "kickbacks" fall outside the exclusionary clause, as well as financial benefits obtained as a result of the employee’s interest in an entity that benefits from the improper transaction, because the payments in those instances clearly are not "salaries, commissions, fees, bonuses, promotions, awards, profit sharing, pensions or other employee benefits earned in the normal course of employment."
* * *
Moreover, courts have rejected the argument that the exclusion precludes coverage only for losses caused by an employee’s desire to obtain, for example, honestly earned commissions, finding that the term "earned" encompasses financial benefits both fraudulently obtained and honestly earned from the employer.
* * *
Thus, contrary to the district court’s construction of the exclusion found in subsection (b), courts addressing its scope have held that the "earned in the course of employment" language is descriptive of the character of the payment at issue rather than the frequency with which the payment is received or the timing of its receipt. Indeed, this construction makes sense in a view of the fact that each of the eight nouns proceeding the last phrase "other employee benefits ..." share the singular characteristic that they are all financial benefits provided knowingly by an insured, in its capacity as an employer, to its employees as a form of compensation and as a result of the employment relationship.
* * *
Thus, we cannot agree with the district court’s reasoning that the last phrase "earned in the normal course" indicates that the excluded benefits are limited to those forms of compensation that are given by the employer to the employee of a "regular basis." Rather, we hold that the exclusion covers payments knowingly made by the insured to the employee as a consequence of their employment relationship and in recognition of the employee’s performance of job-related duties.
Resolution Trust Corp., 205 F.3d at 647-49 [citations and footnotes omitted].
b. The First Philson Case
A similar ruling was issued in a recent Pennsylvania case entitled First Philson Bank, N.A. v. Hartford Fire Ins. Co., 727 A.2d 584 (Pa. Super. Ct. 1999), appeal denied, 747 A.2d 901 (Pa. 1999). In that case, the insured bank sustained a $4,000,000 loan loss arising out of an automobile floor plan financing system in which the dealer-customer financed fictitious vehicles and engaged in a check-kiting scheme. The insured bank sought reimbursement under its fidelity bond for the loss, which it contended had been caused by a dishonest bank officer who purportedly aided and abetted the scheme. In affirming summary judgment for the fidelity insurer, the court concluded that the insured had not carried its burden to show that the bank officer had obtained an improper financial benefit from the scheme. Id. at 589-90. In so concluding, the court observed that the bank officer’s receipt of shares of the insured’s stock through an ESOP, along with various salary increases and bonuses from the insured, constituted a receipt of benefits "earned in the normal course of employment." Id. at 590.
H. Inventory Computation Exclusion
The fidelity industry’s claims history has shown that if an insured has an inventory shortage and discovers a minor incident of theft, the insured may, through the use of inventory computations, be tempted to pin its entire shortage on the employee who perpetrated the minor theft. Fidelity insurers seek to preclude such claims absent other evidence which verifies that the subject employee caused the larger loss.
In Reedy Industries, Inc. v. Hartford Ins. Co., 306 Ill.App.3d 989, 715 N.E.2d 728 (1999), the insured discovered a purported shortage of 439 canisters of freon valued at $83,484 from its business premises. The missing number of canisters was calculated by reviewing the insured’s purchase orders, vendor invoices, and stock requisition forms. The "cage area" where the canisters of freon were stored had not been kept secure and experienced heavy foot traffic from both employees and non-employees. The insured contended that the claim was due to "employee theft," but could not identify "who" perpetrated the thefts. Moreover, the insured’s policy contained a deductible of $10,000 per occurrence. In concluding that the claim did not constitute a reimbursable loss under the policy, the court stated that:
The only evidence that Reedy sustained a loss is the [inventory] analysis performed by Ward, which Hartford argues falls within the inventory shortages exclusion. This type of exclusion has been a part of many fidelity policies for over four decades.
* * *
The exclusion was designed to curb abuses by employers insured against employee dishonesty where covered losses were claimed on the basis of mere estimates, but where the losses might actually be the result of bookkeeping errors, waste, or negligence.
* * *
Under the express terms of the policy, coverage is limited to a loss in excess of $10,000 per occurrence. Even if we assume that Ward’s computations do not fall within the inventory shortages exclusion and that the missing freon was due to employee dishonesty, Reedy failed to present any evidence as to the number of occurrences and which occurrences, if any, are in excess of the deductible.
Reedy, 306 Ill.App.3d at 994-95, 715 N.E.2d at 732 [citations omitted
1 Jeffrey M. Winn is a partner in the New York office of Sedgwick. His practice is devoted to representing insurers in coverage disputes and claims investigations.
2 Susan E. Burke is an associate in the New York office of Sedgwick. Her practice is devoted to representing insurers in coverage disputes and defending health plan administrators, fiduciaries and insurers in ERISA actions.
3 The subject policy contained a standard form "discovery" clause.
4 The fidelity insurer was represented by Joseph K. Powers of Sedgwick-NY. The insured has since appealed the District Court’s dismissal to the United States Court of Appeals for the Ninth Circuit, where the fidelity insurer is represented by Mr. Powers and Maria Orecchio of Sedgwick-NY.
5 The reasoning of the case was particularly unfortunate because the court admittedly refused to apply Pennsylvania law as evinced by the Supreme Court of Pennsylvania.
6 The London Excess Insurers who successfully rescinded the policy and defeated application of the "adverse domination doctrine" beyond its "equitable tollings roots" were represented by James M. McCullough, III of Sedgwick-NY.
7 On this point, the court cited the following cases: Portland Fed. Employee’s Credit Union v. Cumis Ins. Society,
894 F.2d 1101 (9th Cir. 1990); Suburban Nat’l. Bank v. Transamerica Ins. Co.,
438 N.W.2d 119 (Minn.App. 1989); Merchant’s Nat. Bank v. Transamerica Ins. Co.,
408 N.W.2d 651 (Minn.App. 1987); O’Brien’s Irish Pub, Inc. v. Gerlew Holdings, Inc.,
175 Ga.App. 162, 332 S.E.2d 920 (1985).
8 Prior to 1969, the absence of a definition of "counterfeit" gave rise to two interpretations. The "pro-insured" interpretation reasoned that the subject document simply needed to contain a misstatement of fact (e.g.,
overstatement of amount or creation of fictitious transactions) in order to be a "counterfeit." See Snyder National Bank v. Westchester Fire Ins. Co.,
294 F. Supp. 500 (N.D. Tex. 1968), aff’d
, 425 F.2d 849 (5th Cir. 1970); Fidelity Trust Co. v. American Surety Co.,
175 F. Supp. 630 (W.D. Pa. 1959), aff’d
, 268 F.2d 805 (3d Cir. 1959); Prudential Capital Corp. v. Royal Indem. Co.,
21 A.D.2d 664, 249 N.Y.S.2d 728 (1st Dep’t 1964). The "pro-insurer" interpretation contended that a document was "counterfeit" only when it purported to constitute another existing document and that other document was genuine. See Capital Bank v. Fidelity & Casualty Co.,
414 F.2d 986 (7th Cir. 1969); Exchange National Bank of Olean v. Ins. Company of North America,
341 F.2d 673 (2d Cir. 1965), cert. denied
, 382 U.S. 816 (1965); First National Bank & Trust Co. v. Aetna Casualty & Surety Co.,
309 F.2d 702 (6th Cir. 1962); State Bank v. Maryland Casualty Co.,
289 F.2d 544 (8th Cir. 1961); State Bank of Kenmore v. Hanover Ins. Co.,
49 Misc.2d 341, 267 N.Y.S.2d 672 (Sup. Ct., Erie County 1965), aff’d
, 25 A.D.2d 618, 269 N.Y.S.2d 388 (4th Dep’t 1966). After the definition of "counterfeit" was adopted, virtually every court has followed the "pro-insurer" interpretation. See Reliance Ins. Co v. Capital Bancshares, Inc.,
685 F. Supp. 148 (N.D. Tex. 1988), aff’d
, 912 F.2d 756 (5th Cir. 1990); Liberty National Bank v. Aetna Life & Casualty Co.,
568 F. Supp. 860 (D.N.J. 1983); Gateway State Bank v. North River Ins. Co.,
387 N.W.2d 344 (Iowa 1986); William Iselin & Co., Inc. v. Fireman’s Fund Ins. Co.,
69 N.Y.2d 908, 516 N.Y.S.2d 198, 508 N.E.2d 932 (1987), modified for reasons stated in dissenting opinion of Sandler J.,
117 A.D.2d 86, 501 N.Y.S.2d 846 (1st Dep’t 1986).
9 See Reliance Ins. Co. v. Capital Bancshares, Inc.,
912 F.2d 756, 757 (5th Cir. 1990).
912 F.2d at 757; Bank of the Southwest v. National Surety Corp.,
477 F.2d 73, 77 (5th Cir. 1973); FDIC v. Fidelity & Deposit Co. Of Md.,
827 F. Supp. 385, 393-94 (M.D. La. 1993).
11 One American Corp. v. Fidelity & Deposit Co. Of Md.
, 658 So.2d 23 (La. App. 1995), writ denied
, 662 So.2d 470 (La. 1995).
12 This included the two prior cases which had addressed the issue under New Jersey law. See Oritani Savings & Loan Assn. v. Fidelity & Deposit Co. of Md.,
821 F. Supp. 286 (D.N.J. 1991); North Jersey Savings & Loan Assn. v. Fidelity & Deposit Co. of Md.
, 283 N.J.Super. 56, 660 A.2d 1287 (Law Div. 1993).
13 In New York, most of the "manifest intent" cases have concluded that consideration of such "subjective intent" evidence is proper. See Glusband v. Fittin, Cunningham & Lauzon, Inc.,
892 F.2d 208 (2d Cir. 1989); Leucadia, Inc. v. Reliance Ins. Co.,
864 F.2d 964 (2d Cir. 1988); In re J.T. Moran Financial Corp.
, 147 B.R. 335 (Bankr., S.D.N.Y. 1992); Aetna Casualty & Surety Co. v. Kidder Peabody & Co., Inc.,
246 A.D.2d 202, 676 N.Y.S.2d 559 (1st Dep’t 1998); Continental Bank, N.A. v. Aetna Casualty & Surety Co.,
164 Misc.2d 885, 626 N.Y.S.2d 385 (Sup. Ct., New York County 1995); Drexel Burnham Lambert v. Vigilant Ins. Co.,
157 Misc.2d 198, 595 N.Y.S.2d 999 (Sup. Ct., New York County 1993). However, in National Bank of Pakistan v. Basham,
142 A.D.2d 532, 531 N.Y.S.2d 250 (1st Dep’t 1988), aff’d
, 73 N.Y.2d 1000, 541 N.Y.S.2d 345, 539 N.E.2d 101 (1989), the court ignored such evidence.