The last few months of 2005 witnessed the issuance of several decisions in which courts construed the scope of coverage for dishonest acts by employees.  This spate of activity reflects a general trend in this area, and a corresponding rise in the severity of such claims. 

Single v. Multiple Occurrences:  In Acid Piping Technology, Inc. v. Great Northern Insurance Co., 4:04 CV 1667 CDP, 2005 WL 3008512 (E.D. Mo. Nov. 9, 2005), the court addressed the common issue of whether multiple instances of employee wrongdoing constituted a single occurrence under the policy.  There, the employee created 92 purchase order invoices with inflated product costs, and double billed the insured-employer for freight charges on 6 additional occasions.  Against this factual background, the court refused to find a single occurrence under the policy, which would have limited recovery to a single $5,000 limit after a $1000 deductible.  Instead, the court found that the language "any loss caused by an employee … either resulting from a single act or any number of acts" was ambiguous.  Liberally construing the language in favor of the insured, the court held that each of the 98 separate instances was a separate, dishonest event, and that the insured was entitled to a separate limit for each such event.  In so doing, the court declared that it was giving effect to the "reasonable intention" of the insured when it purchased the employee dishonest protection, since "[a]n insurance policy with a $5,000 limitation for any number of overcharged or double billed invoices, provides little to no protection for an insured whose employees handle up to $50,000 in a single transaction."

Prior Coverage:  In Travelers Indemnity Co. v. Vas-Nes, P.C., 03-5120-SW-ODS, 2005 WL 3107697 (W.D. Mo. Nov. 18, 2005), the court found that a policy's "prior coverage" clause did not apply where the policyholder was not named as an insured under the previous policy.  In Vas-Nes, Dr. Douglas Nespory incorporated his medical practice under the name Vas-Nes, P.C., but obtained an insurance policy covering employee dishonesty naming him personally as the insured.  When the subsequent year's policy was issued, the professional corporation was named as the insured, but not Dr. Nespory.  Under these facts, the court found that Vas-Nes was precluded from invoking the policy's prior coverage clause.

Alter Egos and Dominate Shareholders:  At the risk of belaboring the obvious, employee dishonesty insurance covers only those losses perpetrated (at least in part) by an "employee" of an insured.  Historically and through the present, fidelity bonds and crime policies have incorporated the notion that, to be an "employee," a person must be subject to the "control," "direction," or "supervision" of the insured.  In Lutz v. St. Paul Fire and Marine Insurance Co., No. 1:03-CV-750, 2005 WL 2372871 (S.D. Ohio Sept. 26, 2005), the court examined language commonly found in commercial crime policies, which defines an "employee" in pertinent part as someone "whom you have the right to direct and control while performing services for you."  St. Paul moved for summary judgment under Ohio law, arguing that the perpetrator in that case was a "dominate shareholder" – and therefore not under the insured's direction or control – because he was: (1) the insured's only shareholder; (2) the insured's president; and (3) the only director for a period of time.  Additionally, the only other director in the company's existence testified that he had no decision-making authority, no control over the perpetrator or the direction of the company, and could not even recall how he became a director.  On these facts, the court granted St. Paul's motion for summary judgment, declaring that the "dominate shareholder" principle is the "majority rule" in the United States. 

Suit Limitation Clauses:  Employee dishonesty coverages commonly include a condition dictating that: "Any lawsuit to recover on a property claim must begin within two years after the date on which the direct physical loss or damage occurred."  Courts generally uphold the application of suit limitation clauses, subject to the nuances of each state's law.  For instance, in Systems America, Inc. v. St. Paul Travelers Co., No. C 05-02499-JF, 2005 WL 2333755 (N.D. Cal. Sept. 22, 2005), the court clarified that, under California law, courts will implicitly incorporate a "delayed discovery rule" into a suit limitation clause.  Pursuant to this rule, a limitation period will not begin to run until the insured knew or reasonably should have known that its notification duty under the policy had arisen.  Thus, the court in Systems America denied St. Paul's motion to dismiss where the insured's complaint alleged that thefts had occurred between 1998 and March 2002, but were not discovered until March 2004.

A "delayed discovery" rule was specifically rejected by an Illinois federal court in a case litigated by Bates & Carey LLP.  Click here for more details!

Forgery or Alteration:  In First National Bank in Manitowoc v. Cincinnati Insurance Co., No. 03-C-241, 2005 WL. 2460719 (E.D. Wis. Oct. 5, 2005), the insured-bank filed a claim under the "forgery or alteration" insuring agreement of its fidelity bond.  The bank sustained a loss of nearly $2.2 million after its customer, a used car dealer, forged leases on non-existent or overstated vehicles, and obtained a loan from the bank to purchase those vehicles.  Cincinnati denied coverage, arguing that the bank's lending practices were "sloppy" and therefore were neither "in the usual course of business" nor in "good faith," as required by the terms of the bond.  Furthermore, Cincinnati claimed that the bank did not have actual physical possession of the leases – a pre-condition for coverage – because the bank had only carbon copies, as opposed to originals, of the lease documents.

The court rejected Cincinnati's defenses, and instead granted summary judgment on the issue of liability in the bank's favor.  The court refused to infer a "wet ink" originality requirement into the bond.  Additionally, even if the bank had a penchant for "general sloppiness and risk-taking," the evidence showed that the bank remained "ignorant" of the nature of the fraud and that no "red flags had gone off that would tip the bank off that the loans were either forged or counterfeit."  Stressing that any negligent conduct by the bank had not risen to the level of "gross negligence or knowing indifference," the court determined that the bank had acted in good faith and in the "usual course of business" when it acted upon the leases presented to it by the car dealer.  On November 28, 2005, the court denied Cincinnati's motion for reconsideration, and entered judgment in the stipulated amount of nearly $1.75 million, plus prejudgment interest.

Excess and Drop-Down Issues:  In Times-Picayune Publishing Corp. v. Zurich American Insurance Co., 421 F.3d 328 (5th Cir. 2005), the court addressed the issue of whether Zurich was responsible under its excess employee dishonesty policy for all of the embezzlement losses that were not covered by an underlying policy, or only for that part actually embezzled during the three-year term of the excess policy.  The insured, Times-Picayune, was insured under a series of six $1 million primary policies covering acts of employee dishonesty from January 1, 1995 through July 1, 2001.  Beginning on the second policy year, Times-Picayune began to purchase excess insurance that would cover acts of employee dishonesty and, commencing July 1, 1998, Zurich issued a 3-year policy with limits of $1.5 million. 

Unbeknownst to Times-Picayune, one of its employees embarked upon a six-year embezzlement scheme in January 1995.  He stole a total of over $2.2 million until his actions were discovered in December 2000.  Times-Picayune ascertained how much money was embezzled during each policy period, and made a claim under its sixth primary policy for both the losses incurred during that policy period as well as the preceding primary policy periods.  The primary insurer settled with Times-Picayune for the full policy limit of $1 million.  Times-Picayune turned to Zurich for the remaining $1.2 million. 

In the ensuing lawsuit, Zurich contended that, under the "prior loss" clause in the underlying policy, it was not responsible for any losses in those policy years in which the employee did not embezzle more than the $1 million limit of the primary policy.  Instead, Zurich maintained that it was only bound to cover losses exceeding $1 million incurred during the three-year life of its own excess policy.  Because the amount embezzled during that three-year period was $1,165,873.00, Zurich took the position that its exposure was only $165,873.00 after applying the $1 million underlying limit.  The district court granted summary judgment in Zurich's favor. 

Applying Louisiana law, the appellate court reversed, holding that the district court had failed to give "proper effect to the excess policy's insuring and drop-down clauses."  Pursuant to the "most straight-forward construction" of the insuring clause, the court indicated that Zurich must pay for covered losses that the primary policy would not cover because it had been exhausted by the payment of benefits.  The court further held that its construction of the insuring clause was reinforced by the language of the drop-down clause, which obligated Zurich "in the event of exhaustion, [to] continue in force as primary insurance excess of the retention applicable in the Primary Policy."  Accordingly, in the view of the appellate court, Zurich's duty to pay was triggered by a single condition: the exhaustion of the underlying primary policy by actual payment of benefits.  Because there was nothing in the plain language of the excess policy stating that Zurich was only bound to pay for losses exceeding $1 million which were incurred during the period of its policy, Zurich was liable "as primary insurer" for the entire $1.6 million in unreimbursed losses. 

Termination of Coverage:  Citing an undeveloped factual record, the court in Akins Food, Inc. v. American and Foreign Insurance Co., No. C04-2195JLR, 2005 WL 2090678 (W.D. Wash. Aug. 30, 2005), refused to grant summary judgment in the insurer's favor, even though the insured's bookkeeper received an employment application disclosing an employee's prior conviction for grand theft auto prior to a theft-related loss.  Discussing whether the insured had "discovered" the existence of this prior dishonest act prior to the loss, the court found that the term "discovery" was ambiguous since it was susceptible to two different – albeit reasonable – interpretations: (1) "discovery" requires actual knowledge by the insured; or (2) "discovery" requires only constructive knowledge by the insured. 

Construing the term against the insurer, the Akins court held that, to exclude coverage, "at least one of the specified … officials in the insurance agreement (i.e., partner, member, manager) must have had actual knowledge of [the] prior theft or dishonest act."  Id. at *3.  Placing the burden of proof upon the insurer, the court rejected the argument that the bookkeeper's alleged knowledge was sufficient to charge the insured with actual knowledge.  The bookkeeper (ironically named "Heist") appeared to have performed "more of a ministerial role in accepting applications," and the record was "devoid of information relating to Heist's responsibilities regarding the processing of employment applications, regarding the processing of employment applications, her actual knowledge of [the] prior conviction, or any delegation of authority." 

Thus, despite the fact that the "discovery" language discussed in Akins is often contained in the "conditions" section of the policy (and therefore would be an issue upon which the insured traditionally bears the burden of proof), an insurer wishing to prevail upon this issue would be well advised to: (1) proceed as if it bears the burden of proof, even though it likely will not concede this point; and (2) discover sufficient evidence establishing that a person with an appropriate level of authority (or a person who was explicitly delegated such authority) actually acquired knowledge regarding the prior act in question.

For further information regarding any of these decisions or the firm's fidelity practice generally, please contact Fred Stein at (312) 762-3128, or at fstein@batescarey.com.