Appeals has ruled that a financial institution's fidelity bond provides for coverage for losses beyond those of the bank, and includes losses of customer funds. In First Defiance Financial Corporation v. Progressive Casualty Insurance Company, three financial institutions sought to recover nearly $1-million (all figures U.S.) stolen by an employee from client brokerage accounts, thereby seemingly extending the reach of coverage under a fidelity bond beyond losses sustained by the financial institution itself.
The employee in question, Jeffrey Hunt, was a dual employee of First Defiance and a third-party broker-dealer. He managed discretionary brokerage accounts for First Defiance and traded securities on behalf of clients through the third-party brokerage. Eventually, it was discovered that Hunt stole about $860,000 from his clients' brokerage accounts. First Defiance reimbursed the stolen money and an additional $73,000 to cover lost interest and foregone gains in the client accounts.
First Defiance filed a proof of loss with Progressive Casualty Co., which issued a fidelity bond in favor of First Defiance and other related companies. Progressive denied the fidelity bond claim on the basis that Hunt did not directly cause the loss of First Defiance because he stole from the client accounts and not from First Defiance and its related entities.
In a 2-1 ruling, the appeal court affirmed the District Court's ruling that the fidelity bond provided coverage to First Defiance for money that the bank was forced to reimburse to customers whose money had been stolen by Hunt.
Much like the Supreme Court of Canada recently did in Progressive Homes v. Lombard Insurance Company, the First Defiance decision of last Aug. 1 took an exacting approach to the coverage analysis, paying strict attention to the wording of the policy. The coverage analysis implicated three requirements under the insurance policy: (1) whether the stolen money was "covered property"; (2) whether the employee's theft caused a "direct loss" to the bank; and (3) whether the employee committed his dishonest acts "with the manifest intent" to cause the loss.
The court determined that the loss of customer funds clearly fell within the definition of "covered property," which was "property... owned and held by someone else under circumstances which make the Insured responsible for the property prior to the occurrence of the loss." The dissent accepted the stolen funds were "covered property" which the insured was "responsible" for — however, they took issue with the majority's finding that the insured was responsible for the funds "prior to the occurrence of the loss," arguing "the insured's responsibility for the stolen property must arise prior the loss, not by virtue of vicarious liability."
The majority concluded that there was a prospective fiduciary duty to manage the assets for the client's benefit, which arose the moment the clients gave funds to the bank. Therefore, it followed that First Defiance became "responsible" for money in its customers' accounts when they opened their accounts and appointed a First Defiance adviser to exercise their discretion and manage the investment accounts. This responsibility was created "prior to" the loss of money in those accounts caused by the employee's theft.
The court then considered whether the loss was a "direct loss," and found that the unifying theme in the authorities considering the issue was that "losses contingent on things other than an employee's fraud are not 'direct' under most fidelity policies." Here, the court concluded that if the property was "covered property" and if a dishonest employee steals it, the employee directly caused the loss. In making the finding, the court drew no distinction between whether the interpretation of "direct loss" required a proximate cause standard or something more exacting. All that seems to have been required to meet the definition of "direct loss" is some direct relationship between the injury asserted and the wrongful conduct.
Finally, the court considered the question of whether the employee had the "manifest intent" to cause First Defiance a loss. The court held the phrase "manifest intent" established an objective test as to whether a particular result is substantially certain to follow from conduct. The Court confirmed that "[e]mbezzlement is a zero-sum game. For the employee to win, the employer must lose." Therefore, it follows that when an employee acts to gain through embezzlement, a loss to the employer is substantially certain to follow.
In this case, the court took a strict approach in determining coverage on the basis of the policy wording. In doing so, it rejected the historical trend that thirdparty losses are not covered by the terms of a fidelity bond.
This decision may have the effect of broadening the scope of coverage in fidelity bonds beyond what was thought to be covered. Underwriters both north and south of the 49th parallel are well advised to ensure that the policy wording limits their exposure to what the bond is intended to cover.
Originally published in The Lawyers Weekly, January 11, 2013
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