The financial services industry is uniquely exposed to the risk of employee dishonesty. There may be practical limits to employee dishonesty losses in other sectors; only so much merchandise can be smuggled from a stockroom. But banks, brokers, and other financial service firms deal in digits, not widgets, and sheer ingenuity may be the only limit to what determined employees can steal.
Given this unique exposure, prudent financial institutions seek not only to limit their risk of employee dishonesty, through careful hiring and controls, but also to transfer it, through fidelity insurance. Like all insurance, though, fidelity insurance may be undermined by an insurance company’s skewed interpretation of policy wording when claims a represented. Thus, prudence also dictates careful analysis and forceful advocacy on fidelity claims.
One of the most commonly asserted insurance defenses is that the policyholder’s loss was not a “direct loss” within policy coverage. Policyholders should be encouraged by recent decisions which confirm the limited application of this defense.
“Direct Loss” Defense
Policyholders prevailed against “direct loss” defenses in two recent noteworthy decisions. In Scirex Corp. v. Federal Ins. Co., 313 F.3d 841 (3d Cir. 2002), the policyholder was a testing laboratory which ran trials for drug companies and had to replicate several studies, at no charge, when it found that its nurses had routinely submitted false observations reports. Instead of observing patients for the full required time during drug tests, the nurses released patients early and “pre-recorded” their “observations,” making the initial studies unreliable and unsuitable for the clients’ purposes. The insurance company denied coverage, arguing that the cost of re-doing the studies was an ordinary operating expense, not a “direct loss” from employee dishonesty. The Third Circuit rejected that argument, reasoning that the employees’ false reporting of clinical observations was the proximate cause of the funds lost in replicating the drug tests.
Likewise, in Building One Service Solutions, Inc. v. National Union, No. 02-311-A (U.S.D.C. E.D. Va. 11/26/2002), a federal district court reached a similar result on “direct loss,” also applying a proximate cause analysis. The court in Building One agreed with the policyholder that employee dishonesty insurance covered not just the amounts directly embezzled by an employee, but also the policyholder’s losses on contracts fraudulently entered by the employee as part of the embezzlement scheme. The dishonest employee in Building One purposely underbid on contracts awarded to the policyholder, in order to create additional accounts which he used to cover up the embezzlement. The insurance company sought to pay only the directly embezzled amounts, not the losses on the resulting contracts, claiming that business judgments and market were conditions also contributed to the loss. The trial court found disputes of fact as to causation and therefore denied the defense motion for summary judgment, after which the insurance company, facing the threat of trial, settled the claim.
The proximate cause analysis in Scirex and Building One is consistent with many other decisions. Losses resulting from employee dishonesty need not result immediately or be isolated from all other causes to be covered under fidelity insurance. The losses which can result “directly” from employee dishonesty are as varied as employee dishonesty itself, and can include not only contract fulfillment, as in Scirex and Building One, but also loan losses and even judgments or settlements in favor of third parties.
The risks transferred by modern fidelity insurance policies maybe much broader than insurance companies admit when claims arise. Policy language varies, but the cases show that fidelity insurers often assert defenses which have no support in the policy language or rely on ambiguous language that, if challenged, will be construed in favor of coverage. Prudent financial institutions should vigorously dispute those defenses. If legitimate fidelity claims are not accepted and paid, then policyholders have transferred only premium, not risk.