September 30, 2014 Articles

    Fidelity Coverage for Loss Arising from Financial Crises

    Looking beyond the four corners of the policy may provide avenues to another source of coverage

    by Matthew J. Schlesinger and Tara A. Brennan

    Businesses today rely on insurance coverage as a way to manage risks and guarantee their ability to survive sometimes catastrophic loss, such as some arising from the financial crisis. An often overlooked component of a business’s coverage program is its fidelity or crime bond—a specialized form of insurance designed to protect against loss from crime. Fidelity bonds can be further specialized by industry, such as with the Standard Form 24 Financial Institution Bond that combines various types of coverage to protect banks and other financial institutions.

    The typical fidelity bond consists of insuring agreements that define the scope of coverage as well as exclusions from coverage, definitions, and general conditions. Common insuring agreements target fidelity loss (loss from employee theft), on-premises loss (loss caused by a person present on the defined business premises of the insured), in-transit loss (loss while goods are being transported to or from the defined premises of the insured), forgery or alteration loss (loss caused by fraudulent signatures or documents), and similar risks inherent in the operation of a business. Recognizing the electronic nature of many businesses, more recent bonds also provide coverage for computer-related fraud and funds transfer fraud, as well. In the context of mortgage loans, there may also be coverage for the dishonest acts of a loan servicer or loans purchased by a financial institution that prove to be fraudulent because (possibly among other things) the documents contain a forgery, are counterfeit, or altered. Insurers use countervailing exclusions to limit the coverage that may otherwise be provided. For example, insurers often purport to exclude coverage for credit losses, trading losses, and similar risks that insurers deem unavoidable and thus uninsurable (at least in exchange for standard premiums).

    Because of the unanticipated factual circumstances and high stakes usually involved with fidelity bond losses, and because bonds are esoteric and less common in the broader range of insurance coverage, disputes frequently arise between policyholders and their insurance carriers as to the nature and scope of coverage. Several common areas of disagreement relevant to coverage for losses arising out of financial crises are outlined below.

    Characterization of the Loss

    How the loss is described and characterized during the initial stages of investigation may have wide-ranging implications at later stages of recovery. For example, the language used by opposing parties in correspondence or proofs of loss related to expectations of coverage or the cause of the loss is frequently marshaled by insurers and policyholders alike in an attempt to suggest waiver or concession of dispositive issues, and these apparent admissions ultimately can carry great weight with the factfinder, especially alongside claims for consequential damages based on allegations of bad faith.

    In this regard, it is helpful to understand the relevant roles of the insured and insurer in the claims process. The insured has the burden of proving its claim falls within the scope of coverage. If successful, the insurer has the burden of proving the application of any exclusions or limitations to coverage. In the claim process, then, it is the insured’s burden to produce evidence of its claim. The insurer’s basic role can be described as analyzing the evidence provided by the insured, which begins with the notice of loss, proof of loss, and continues through responses to subsequent requests for information and the insurer’s own investigation.

    Rules of Construction

    Fidelity bonds, as a specialized form of contract, are generally subject to standard rules of contract construction and interpretation. Because standard fidelity bonds are sometimes considered to be a product of negotiation between insured and insurers (or their representatives, such as the American Banker’s Association and the Surety Association), some courts have declined to apply a “contra-insurer” rule in which the insurer, as presumed drafter of the language, bears the risk of inadequate drafting; this rule usually requires any ambiguities in the policy to be construed against the insurer and in favor of coverage. See, e.g., Sharp v. Fed. Sav. & Loan Ins. Corp., 858 F.2d 1042, 1046 (5th Cir. 1988). But see Seaway Cmty. Bank v. Progressive Cas. Ins. Co., 531 F. App’x 648, 652 (6th Cir. 2013) (applying contra-insurer rule). Some language in financial institution bonds is not standard form, however, and thus, some courts recognize that even if the provision at issue is standard, the policyholder may not have been involved or represented in the so-called joint negotiations. Accordingly, even in jurisdictions where the contra-insurer rule has not been applied to fidelity bonds, the insureds still may be able to invoke the contra-insurer rule in disputes over the meaning of various clauses—particularly if they are able to demonstrate an ambiguity is present. See, e.g., First Nat'l Bank of Manitowoc v. Cincinnati Ins. Co., 485 F.3d 971, 977 (7th Cir. 2007).

    Causation

    Another overarching issue is the standard of causation under the bond—what must the insured show to demonstrate that the loss was actually caused by a covered event and not something else. This direct loss requirement has been used to deny coverage, for example, for losses related to forged documents where the underlying collateral or note would still have been valueless even had the signature been authentic. See, e.g., Flagstar Bank, F.S.B. v. Federal Ins. Co., 260 F. App’x 820 (6th Cir. 2008).

    The bond’s insuring agreements frequently refer to “loss resulting directly from” the covered event, but the meaning of “directly” has been a matter of much debate. Some courts construing the term apply the proximate cause or efficient proximate cause standard, which considers “the dominant cause,” as distinguished from causal factors that are “merely incidental.” Under this approach, a cause often will be considered direct if it plays a substantial role in the ultimate result. E.g., Retail Ventures, Inc. v. Nat'l Union Fire Ins. Co. of Pittsburgh, 691 F.3d 821 (6th Cir. 2012) (applying proximate cause test); Scirex Corp. v. Fed. Ins. Co., 313 F.3d 841, 850 (3d Cir. 2002). Other courts have held that “direct means direct,” and the insured’s loss must be the direct result of the covered event. E.g., Vons Cos., Inc. v. Fed. Ins. Co., 212 F.3d 489, 491-93 (9th Cir. 2000). Disputes commonly arise in this context, with the insured arguing the insurer is trying to pin the blame on “remote” uncovered causes when a covered cause is more recent in time in relation to the loss, thus rendering coverage illusory under the bond. Resolution of these disputes depends on fact-intensive analysis and detailed arguments before the court. Recently, some courts also have challenged whether applying a proximate cause standard or something more exacting is even a meaningful difference. E.g., First Defiance Fin. Corp. v. Progressive Cas. Ins. Co., 688 F.3d 265, 270 (6th Cir. 2012).

    In fidelity disputes, insurers may point to the errors, negligence, or lack of internal controls of the insured as attenuating factors in an attempt to avoid coverage, for the reasons discussed below. But no insurable losses ever would occur if a company’s internal controls were perfect, and such an implied exclusion would render a fidelity bond’s coverage illusory. Accordingly, the general rule with regard to fidelity bonds is that mere negligence by the insured will not absolve the insurer from liability under the bond; the loss will still be deemed direct. See Arlington Tr. Co. v. Hawkeye-Sec. Ins. Co., 301 F. Supp. 854, 858 (E.D. Va. 1969) (“Negligence on part of bank, if found to exist, would not defeat recovery under blanket bankers’ fidelity bond in question.”).

    Courts also consider causation in the context of whether there is coverage under the bond for the liability of an insured to a third person. If an employee steals money from an insured’s possession that is being held for a third-party and the third-party sues the insured for that money, there usually is coverage for that loss. See, e.g., First Defiance, 688 F.3d at 270-72. But the cause of the loss may be fatally attenuated if the insured’s employee commits a dishonest act against a third-party who then seeks to recover from the insured under a tort theory of vicarious employer liability. The bond must be examined closely to determine the extent of any such coverage.

    Manifest Intent

    The mental state of a defalcator may also be relevant to coverage under a fidelity bond. Insuring Agreement A in the standard fidelity bond (which covers loss from employee dishonesty)—as well as related policy riders that extend fidelity coverage to parties such as loan servicers—usually contain a requirement that the underlying wrongful acts be committed with the manifest intent to cause the insured to sustain such loss and to obtain an improper financial benefit for the defalcator or some other person. The purpose of this requirement, according to some courts, is to preclude coverage for mere violations of instructions or poor business judgment.

    Regardless of the inclusion of “manifest,” some debate remains as to the precise level of intent at issue: some courts require a purpose of causing a loss and obtaining a benefit, see Resolution Tr. Corp. v. Fid. & Deposit Co. of Md., 205 F.3d 615, 637-42 (3d Cir. 2000), while others just require knowledge that the result is substantially certain to follow, see FDIC v. United Pac. Ins. Co., 20 F.3d 1070, 1078 (10th Cir. 1994). Under either test, though, an embezzler for example would possess the necessary intent, as an embezzler “necessarily intends to cause the employer the loss since the employee’s gains are directly at the employer’s expense,” as one court has explained. First Nat. Bank of Louisville v. Lustig, 961 F.2d 1162, 1165 (5th Cir. 1992). This is one point that insurers and insureds tend to agree—embezzlement is the quintessential covered loss. See FDIC v. Nat’l Union Fire Ins. Co. of Pittsburgh, 205 F.3d 66, 74 (2d Cir. 2000) (“actions that amount to embezzlement or embezzlement-like conduct establish a fidelity bond’s manifest intent element as a matter of law”).

    The requirement of improper personal gain means that the loss cannot consist of employee benefits, salary, commissions, bonuses and similar gains occurring in the normal course of business. These “gains” may be written out of what is considered to be a “financial benefit” for purposes of triggering coverage. Thus, for example, a fidelity bond may be held not to cover a loss from an improper bonus where an employee inflates his or her sales statistics, but would usually be understood to cover a loss arising from an employee’s theft from the company’s cash drawer.

    Discovery
    Finally, fidelity disputes also frequently arise over when certain events or circumstances are discovered by the insured. The notice provisions of fidelity bonds generally require certain acts to be completed upon discovery of a loss or a situation reasonably likely to lead to a loss—at a minimum, timely notice must be given to insurers to allow them to promptly begin their investigation. Similarly, many bonds contain termination provisions that provide for automatic termination of coverage at the moment the insured discovers that an employee has been engaged in dishonest acts. For both of these bond conditions, the trigger is the point of discovery, often described as the point at which the insured first becomes aware of facts which would cause a reasonable person to assume that a loss of a type covered by the bond has been or will be incurred (even if the exact amount or details of the loss are not yet known) or that employee dishonesty has occurred. In this regard, mere suspicion is not enough; the knowledge required to trigger the provisions should be such that a “careful and prudent” person would be justified in charging another with fraud or dishonesty. See, e.g.,Midland Bank & Tr. Co. v. Fid. & Deposit Co. of Maryland, 442 F. Supp. 960 (D.N.J. 1977).

    These common areas of dispute with regard to fidelity bonds are just representative; due to the complexity of fidelity bonds themselves and the factual situations to which they apply, insurers often construe coverage narrowly. Thus, it is good practice to involve an experienced insurance attorney during the purchase of fidelity bonds and as soon as possible after a potential loss is discovered in order to better protect the rights guaranteed under the bond.

     

    Matthew J. Schlesinger and Tara A. Brennan are with Reed Smith LLP, Washington, DC.

    Keywords: insurance, coverage, litigation, fidelity bond, fidelity bonds, financial crisis

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