Employee Dishonesty 73

CHAPTER 1EMPLOYEE DISHONESTY:THE ESSENTIAL ELEMENTS OF COVERAGEUNDER INSURING AGREEMENT (A)

Michael Keeley[1], Strasburger & Price, LLP
Christopher A. Nelson, Travelers

I.Introduction

Financial Institution Bonds have been available to banks in one form or another for over 100 years.[2] As with all forms of insurance, such fidelity bonds create a risk sharing arrangement, with insurers assuming the risk of certain losses that are difficult for banks to protect against, and banks maintaining the risk of common business losses. For example, banks are in the business of making loans, and thus they are in the best position to avoid the risk of loss due to unpaid loans, whether due to a customer’s financial problems or fraud. Therefore, fidelity bonds specifically exclude coverage for loan losses except under very limited circumstances where the loss is caused by employee dishonesty. On the other hand, banks are not as equipped to avoid the risk of loss resulting directly from embezzlement, forged or counterfeit securities, or forged or altered negotiable instruments. As a result, the multi-peril Financial Institution Bond has been providing limited forms of insurance against such losses since 1916.[3]

From the very beginning, coverage for a bank’s loss due to employee dishonesty has been intended to be narrow, limited to embezzlement and embezzlement type acts.[4] For just as long, insured banks looking for relief from significant employee dishonesty losses have disagreed over the scope of coverage for such losses. As a result, over the years insurers, led by the Surety and Fidelity Association of American,[5] have continually modified the standard form bond to clarify the narrow scope of coverage. In 1976 the industry added the manifest intent requirement with the use of a rider,[6] and then by revision to the standard form Bankers Blanket Bond in 1980,[7] requiring proof that the employee acted with the manifest intent to cause the insured to sustain a loss. The 1980 standard form Bankers Blanket Bond also included a requirement that the employee act with the manifest intent to obtain a financial benefit for either herself or any other person or organization.[8] And, in 1986 the standard form Financial Institution Bond was revised again, this time to preclude coverage under Insuring Agreement (A) for a loss resulting directly from a loan unless the dishonest employee also acted in collusion with one or more parties to the transaction and received a financial benefit with a value of at least $2500.[9]

When this chapter was written for the second edition of this book in 1998, it was pointed out that the firestorm of controversy in employee dishonesty claims revolved around the meaning of the term “manifest intent.”[10] At that time, certain courts were applying a wholly objective standard in addressing the manifest intent issue, essentially equating manifest intent with recklessness, finding that an employee acted with the manifest intent to cause the bank to suffer a loss if the natural and probable consequences of the employee’s acts were a loss.[11] As the authors stated in that original chapter, those decisions were fundamentally unsound, either because they were based upon earlier bond forms that were no longer applicable, or because they were based upon inapplicable criminal or tort law cases. The authors maintained that the term manifest intent should instead be defined to mean specific intent; that is, acting with the conscious desire to achieve a particular result.

Ten years later, as we are in the middle of another financial crisis, the flames of controversy over the intended scope of coverage under Insuring Agreement A have waned, but there continues to be disagreement between policy holders, insurers, and brokers, and some confusion among the courts, as to the precise scope of coverage under Insuring Agreement A. It is safe to say that most, although not all, courts now recognize that losses caused by negligence or recklessness are not covered by the bond. But in recent years debate has centered upon whether an insured must establish that its employee acted with the “specific intent” or “purpose” to cause the insured to sustain a loss, or whether it is adequate to show that the employee knew that a loss was “substantially certain” to follow from his or her actions. A significant minority of courts have applied what the authors have referred to as the substantial certainty test.[12] Rather than requiring a showing of specific intent, these courts find that the manifest intent requirements is satisfied as long as the dishonest employee knew a loss to the employer was substantially certain to occur. The better reasoned decisions, however, apply what the lead author has characterized as the specific intent standard, requiring proof that the employee acted with the conscious purpose to cause his or her employer to suffer a loss.[13]

While most policies in use today include the manifest intent language of the bond, and thus the meaning of this term is as relevant today as it was ten years ago, many polices include a modified intent standard, using the word “intent” instead of “manifest intent.” At the same time, other insurers have begun using either the 2004 SFAA[14] or 2005 Insurance Services Office[15] versions of the standard form policies, replacing the term manifest intent with language that is hoped to leave no question about the limited scope of coverage.

In this updated chapter, the authors further examine the history of employee dishonesty coverage and the intent requirements of the bond, and analyze the meaning of these terms in light of the plain language of the bond and the meaning of intent in other areas of the law. It is suggested that the plain meaning of the bond, as well as the history and purpose of the manifest intent provision, require the application of a specific intent standard, requiring a showing that the employee acted with the obvious, conscious desire or purpose to cause the insured to sustain a loss. Regardless of how manifest intent is defined, a jury attempting to discern an employee’s manifest intent must be instructed to discern the employee’s subjective state of mind, based upon the full range of relevant evidentiary circumstances, rather than utilizing an objective standard that allows an inference of manifest intent based only upon the fact of a loss, or based upon what a reasonable person would have intended under the circumstances. Such an objective standard would inappropriately turn the bond into errors and omissions insurance, rather than fidelity coverage, by providing coverage for an employee’s negligent or reckless acts. With respect to the 2004 version of the standard form policies, the authors suggest that there should be no disagreement at all about the limited scope of coverage under the bond.

This chapter also addresses the less controversial, although no less important, issues of collusion and financial benefit. These elements often assume paramount importance in analyzing loan loss claims. Under Insuring Agreement (A) an insured must establish that an employee not only had the manifest intent to cause the insured to sustain a loss, but that she acted in collusion with one or more parties to the loan transactions, and actually received a financial benefit with a value of at least $2500. Issues often arise concerning the meaning of collusion, and the character, value, and timing of the financial benefit required to be received by the employee. These and similar issues also are addressed in this chapter.

II.History

A.  Origins of Modern Employee Dishonesty Coverage

Modern fidelity coverage had its origins in the latter part of the nineteenth century.[16] These early fidelity bonds indemnified against loss “through” the fraud or dishonesty of either an employee identified by name or by a specific job designation. The first “blanket bond” was underwritten by Lloyd’s of London in 1908.[17] The word “blanket” was used to signify that a uniform dollar amount of coverage applied to each insuring agreement, rather than to mean that blanket coverage was being provided.

B.  Beginnings of Standard Form Policies

In 1916, Standard Form No. 1 was created by SFAA, the Bond and Surety Underwriters Trade Association and the American Bankers Association.[18] By 1941 Standard Form No. 1 had evolved into what is known today as Standard Form No. 24, with further revisions being made in 1946, 1951, 1969, 1980, 1986, and most recently, 2004. Standard Form No. 1 continued to indemnify the insured against loss “through any dishonest act of any of the Employees wherever committed, and whether committed directly or by collusion with others.”[19]

In subsequent years the words “fraudulent” and “criminal” were added to the fidelity insuring agreement. In fact, the first version of the present Insuring Agreement (A) appeared in 1936 in Standard Form No.8 as an insuring clause providing coverage for: “Any loss through any dishonest, fraudulent, or criminal act of any of the Employees, including loss of property, through any such act of any of the Employees, wherever any such act may be committed and whether committed directly or by collusion with others.”[20] In the 1986 standard form bond, the “loss through” language was changed to “loss resulting directly from,” and the term “dishonest and fraudulent acts” was expressly limited to those dishonest and fraudulent acts specifically committed with the manifest intent to cause the bank a loss and to obtain a financial benefit.[21]

C.  Adverse Decisions Lead to Sky Rocketing Loss Ratios

From early on courts seemed predisposed to construe fidelity bonds in favor of coverage, leading to a broad construction of the term “dishonesty.” Insurers were held liable for losses caused by an employee’s actions that “evinced a want of integrity and an intentional breach of trust... whether for the benefit of [the employee] or of another”;[22] that were “reckless, willful, and wanton... [or] manifestly unfair to the employer”;[23] and that were “done in breach of the officer’s duty to the bank and [were] willful omissions.”[24] Remarkably, one court concluded:

[The bond guarantees] openness and fair dealing on the part of the bank’s officers. It is intended to, it does, underwrite that the bank’s officers shall act with common honesty and an eye single to its interests. It guarantees that the bank shall at all times have the benefit of the unbiased, critical, and disinterested judgment of the president in regard to the loans it makes.[25]

As one commentator noted:

The cases seemed to look for a way to find dishonesty or to give the jury instructions on the definition of dishonesty which minimized the element of intent to commit the wrongful act. A snowballing effect resulted, with more claims resulting from the publicity given to the cases unfavorable to the surety industry and those claims bringing about more unfavorable results.[26]

In other words, contrary to the intent of the industry, courts were turning the bond into credit insurance.

By the mid 1970s adverse court decisions had taken their toll on insurers. The industry’s loss ratio for the eleven year period from 1967 through 1977 ranged from 61.4 percent to 125 percent, with ratios exceeding 100 percent in 1969, 1974, 1976, and 1977.[27] Not surprisingly, a number of insurers were forced to reduce the volume of their business, while others stopped offering fidelity bonds entirely.[28] By the late 1970s a mere dozen or so companies wrote a significant amount of fidelity bond business, while only fifteen years earlier there had been many times more.[29] Such losses and the resulting tightening of the bond market eventually caused the SFAA to react with a series of modifications to the bond.

D.  SFAA’s Revisions to Counteract Decisions, Including Rider 6019, and 1980 and 1986 Revisions

Beginning in 1976, the SFAA made available a rider that limited coverage for dishonest acts to those acts committed by the employee with the “manifest intent” to cause the insured to sustain a loss and to obtain a financial benefit for himself or another person or organization.[30] The rider also replaced the “loss through” language of Insuring Agreement (A) with the narrower phrase, “resulting directly from.”[31] The changes became permanent when the bond was formally revised in 1980.[32]

Although loss ratios decreased after addition of the manifest intent requirement, by the mid 1980s they again were out of hand. At the same time, the country was in the midst of what then was the largest financial institution crisis in history. With the number of claims again increasing and loss ratios of 83.6, 105.4, 140.0, and 69.9 for the years 1982 through 1985,[33] the SFAA again acted to modify the terms of the standard form bond. In 1986 the SFAA added some real teeth to the financial benefit requirement, requiring proof that the employee actually receive a financial benefit of at least $2,500 in connection with a loan, and requiring proof and that the employee acted in collusion with one or more parties to the loan transaction. The title of the bond was changed from Bankers Blanket Bond to Financial Institution Bond in order to counteract those decisions that had relied upon the term “blanket” in holding that coverage under the bond was intended to be very broad.[34]

E.  Overview of Decisions Construing “Manifest Intent” Provision

While courts readily accepted the fact that the SFAA added the manifest intent language to the bond in order to limit coverage for dishonesty claims to embezzlement-type acts, there was a great divergence of opinion in the courts as to the precise meaning of the term manifest intent. Early on, some courts concluded that a purely objective standard should be followed in defining the term “manifest intent,” such that an employee could be found to have the manifest intent to cause the insured a loss if the natural consequences of the employee’s actions was a loss.[35] Few recent cases have adopted this standard. Rather, in recent years, debate has centered upon whether an insured must establish that its employee acted with the “specific intent” or “purpose” to cause the insured to sustain a loss, or whether it is adequate to show that the employee knew that a loss was “substantially certain” to follow from the employee’s actions.[36] While the first standard—the specific intent test—is purely a subjective one, the latter standard—the substantial certainty test—employs a fiction to allow a finding of manifest intent regardless of the employee’s actual subjective intent or purpose. To date, the Second, Third, Fourth, and Fifth Circuits have adopted the specific intent test. The Sixth, Seventh, and Tenth Circuits appear to have adopted the substantial certainty test.