So What Does Your Fidelity Policy Actually Cover?

In the insurance company's reality-denying view, a fidelity policy only covers a loss if the policyholder's employee steals money from the policyholder itself (i.e., embezzlement), while the act of repaying a customer renders the loss 'indirect.' Under this view, any payments that the policyholder is forced to make because of its employee's dishonesty do not count as a direct loss, even if the need to make the payment is directly caused by the theft or forgery. The argument relies on an unreasonably narrow interpretation of one word, 'direct,' which is never actually defined in the policies, and a false dichotomy between fidelity policies and commercial general liability ('CGL') policies that the fidelity policy never spells out. Insurance companies claim that because CGL policies insure against many of a policyholder's losses to third parties, fidelity policies cannot do the same thing in a different context.

Policyholders should be aware that the word 'direct' has been given a wide range of meanings by both courts and common usage, only one of which supports the coverage-restricting arguments of insurance companies. In many contexts, an action is seen as directly causing an event if it was a predominant reason for the event occurring, a proximate cause. Although some courts have taken the insurance companies' narrow view that the cause of a direct loss must immediately precede the loss with no intervening actions, no matter how foreseeable, insurance companies and these courts are at a loss to explain how this narrow meaning is made clear in the policy language.

Insurance companies frequently cite the case of Vons Co., Inc. v. Federal Insurance Co., 212 F.3d 489 (9th Cir. 2000), and several others like it, to support their position. In that case, the Ninth Circuit Court of Appeals affirmed the entry of summary judgment in favor of an insurance company that issued a fidelity policy. The Vons court held that the policy did not provide coverage for the policyholder's vicarious liability to investors defrauded by its employees, even though the policy expressly stated that it provides coverage for money 'for which the insured is legally liable.' The court relied on the meaningless tautology that 'direct means direct,' and stated that 'in the absence of a third party claims clause, [the policyholder's] policy did not provide indemnity for vicarious liability for tortious acts of its employee.' This was despite the clause in the policy stating that it covered money 'for which the insured is legally liable,' that is, money that does not belong to the policyholder but for which it is liable.

A Rational View

Fortunately for policyholders, several courts have taken a more rational view of fidelity policies, which comports with the reasonable expectations of businesses and their economic realities. The New Jersey Supreme Court, for example, has interpreted the words 'direct loss' in fidelity bonds and other employee dishonesty policies as implying a 'proximate cause' standard. See Auto Lenders Acceptance Corp. v. Gentilini Ford, Inc., 854 A.2d 378 (N.J. 2004). Contrary to insurance industry commentators' protestations, the Auto Lenders court concluded that the 'majority' position in the federal courts is that the words 'direct loss' in fidelity bonds and their equivalent call for application of the proximate causation standard, citing cases in the Second, Third, and Fifth Circuit Courts of Appeal. The New Jersey court understood that adoption of the conventional proximate cause test for interpretation of 'direct' loss 'comports with our general principles of insurance law, including our practice of interpreting coverage provisions broadly.' That is, the court refused to allow the insurance company's vague, undefined language to defeat coverage when a reasonable interpretation of the language supports coverage. See also Imperial Insurance, Inc. v. Employers' Liability Assur. Corp., 442 F.2d 1197, 1198-99 (D.C. Cir. 1970) ('The loss here was a pecuniary depletion of [the insured's] monetary assets … Moreover, the definition of [covered] money … does not clearly exclude liability to compensate for payments made from the insured's funds, if due to the misconduct described.').

Be on Guard

In this fidelity context, policyholders must be on guard both when they purchase their fidelity policies and when they make claims under them. While a letter officially denying coverage is typically a clear indication that the policyholder should consult with coverage counsel, claims correspondence that does not actually deny coverage must be viewed with equal suspicion. Beyond the direct loss issue, fidelity insurance policies contain numerous pitfalls for the unwary. In many cases, the insurance company will delay making any actual claims decision for years after a loss occurs. Instead, it will 'reserve its rights,' and send out countless letters requesting further information and reams of irrelevant documents. After lulling the policyholder into thinking that a decision would be forthcoming, the insurance company will then claim that it owes nothing, because the policyholder unreasonably delayed in filing a proof of loss or in bringing a lawsuit against the insurance company, contrary to time limitations in the policy. Surprisingly, this tactic actually works in several states, where courts take the view that time limitation clauses should be strictly enforced even if the insurance company itself occasioned the delays, and even if the insurance company was not prejudiced by the delay.

Conclusion

Policyholders that have paid for coverage for employee crime and dishonesty expect and should receive the benefit of their bargains. The policyholder who has fallen victim to an employee's 'inside job' is well advised to carefully study its various insurance policies that may provide some relief, and immediately place its broker or insurance companies on notice of the loss. Policyholders should be wary of the other types of pitfalls outlined above, and proceed with care toward obtaining the coverage they purchased.

John N. Ellison is a partner and Luke E. Debevec is an attorney at the Philadelphia office of Reed Smith LLP. They represent policyholders exclusively in insurance coverage disputes across the country.

Businesses purchase fidelity insurance to cover their losses from crime such as employee theft and forgery. This need is usually most pronounced for banks and other financial service firms, where employees have access to enormous amounts of money. For these policyholders, misplaced trust in a resourceful employee can result in millions of dollars disappearing from the policyholder or its clients with only a few keystrokes. When policyholders turn to their fidelity insurance for relief, these businesses then learn that they may have misplaced their trust in their insurance companies, too. All too often, policyholders have to fight for the coverage they reasonably expected.

In perhaps the most widely repeated example, an insurance company will offer a business a fidelity policy for 'direct loss' of money due to theft or forgery. When an employee of the business steals a client's money or goods, or enriches herself through a forged document, and the business pays for its client's loss, most reasonable policyholders would think that the fidelity policy would provide relief. There was a dishonest act by an employee that directly resulted in the need to repay a client. Indeed, many businesses view this situation as the prototypical example of what they intended to insure against when purchasing a fidelity policy. Business reality is that under the doctrine of respondeat superior, employers are almost always strictly liable for losses caused by their employees' and agents' actions. When an employee steals from a client, the employer's responsibility to pay the loss follows like night follows day. However, insurance companies usually take the surprising position that the policyholder's loss was not 'direct,' and therefore is not covered at all.

A Reality-Denying View

In the insurance company's reality-denying view, a fidelity policy only covers a loss if the policyholder's employee steals money from the policyholder itself (i.e., embezzlement), while the act of repaying a customer renders the loss 'indirect.' Under this view, any payments that the policyholder is forced to make because of its employee's dishonesty do not count as a direct loss, even if the need to make the payment is directly caused by the theft or forgery. The argument relies on an unreasonably narrow interpretation of one word, 'direct,' which is never actually defined in the policies, and a false dichotomy between fidelity policies and commercial general liability ('CGL') policies that the fidelity policy never spells out. Insurance companies claim that because CGL policies insure against many of a policyholder's losses to third parties, fidelity policies cannot do the same thing in a different context.

Policyholders should be aware that the word 'direct' has been given a wide range of meanings by both courts and common usage, only one of which supports the coverage-restricting arguments of insurance companies. In many contexts, an action is seen as directly causing an event if it was a predominant reason for the event occurring, a proximate cause. Although some courts have taken the insurance companies' narrow view that the cause of a direct loss must immediately precede the loss with no intervening actions, no matter how foreseeable, insurance companies and these courts are at a loss to explain how this narrow meaning is made clear in the policy language.

Insurance companies frequently cite the case of Vons Co., Inc. v. Federal Insurance Co., 212 F.3d 489 (9th Cir. 2000), and several others like it, to support their position. In that case, the Ninth Circuit Court of Appeals affirmed the entry of summary judgment in favor of an insurance company that issued a fidelity policy. The Vons court held that the policy did not provide coverage for the policyholder's vicarious liability to investors defrauded by its employees, even though the policy expressly stated that it provides coverage for money 'for which the insured is legally liable.' The court relied on the meaningless tautology that 'direct means direct,' and stated that 'in the absence of a third party claims clause, [the policyholder's] policy did not provide indemnity for vicarious liability for tortious acts of its employee.' This was despite the clause in the policy stating that it covered money 'for which the insured is legally liable,' that is, money that does not belong to the policyholder but for which it is liable.

A Rational View

Fortunately for policyholders, several courts have taken a more rational view of fidelity policies, which comports with the reasonable expectations of businesses and their economic realities. The New Jersey Supreme Court, for example, has interpreted the words 'direct loss' in fidelity bonds and other employee dishonesty policies as implying a 'proximate cause' standard. See Auto Lenders Acceptance Corp. v. Gentilini Ford, Inc., 854 A.2d 378 (N.J. 2004). Contrary to insurance industry commentators' protestations, the Auto Lenders court concluded that the 'majority' position in the federal courts is that the words 'direct loss' in fidelity bonds and their equivalent call for application of the proximate causation standard, citing cases in the Second, Third, and Fifth Circuit Courts of Appeal. The New Jersey court understood that adoption of the conventional proximate cause test for interpretation of 'direct' loss 'comports with our general principles of insurance law, including our practice of interpreting coverage provisions broadly.' That is, the court refused to allow the insurance company's vague, undefined language to defeat coverage when a reasonable interpretation of the language supports coverage. See also Imperial Insurance, Inc. v. Employers' Liability Assur. Corp., 442 F.2d 1197, 1198-99 (D.C. Cir. 1970) ('The loss here was a pecuniary depletion of [the insured's] monetary assets … Moreover, the definition of [covered] money … does not clearly exclude liability to compensate for payments made from the insured's funds, if due to the misconduct described.').

Be on Guard

In this fidelity context, policyholders must be on guard both when they purchase their fidelity policies and when they make claims under them. While a letter officially denying coverage is typically a clear indication that the policyholder should consult with coverage counsel, claims correspondence that does not actually deny coverage must be viewed with equal suspicion. Beyond the direct loss issue, fidelity insurance policies contain numerous pitfalls for the unwary. In many cases, the insurance company will delay making any actual claims decision for years after a loss occurs. Instead, it will 'reserve its rights,' and send out countless letters requesting further information and reams of irrelevant documents. After lulling the policyholder into thinking that a decision would be forthcoming, the insurance company will then claim that it owes nothing, because the policyholder unreasonably delayed in filing a proof of loss or in bringing a lawsuit against the insurance company, contrary to time limitations in the policy. Surprisingly, this tactic actually works in several states, where courts take the view that time limitation clauses should be strictly enforced even if the insurance company itself occasioned the delays, and even if the insurance company was not prejudiced by the delay.

Conclusion

Policyholders that have paid for coverage for employee crime and dishonesty expect and should receive the benefit of their bargains. The policyholder who has fallen victim to an employee's 'inside job' is well advised to carefully study its various insurance policies that may provide some relief, and immediately place its broker or insurance companies on notice of the loss. Policyholders should be wary of the other types of pitfalls outlined above, and proceed with care toward obtaining the coverage they purchased.

John N. Ellison is a partner and Luke E. Debevec is an attorney at the Philadelphia office of Reed Smith LLP. They represent policyholders exclusively in insurance coverage disputes across the country.