Compassion Sometimes Backfires

By Bob Devetski

Your company prides itself on being a good place to work, taking care of its employees and being a good corporate citizen. It provides generous employee benefits. It has a wellness program. It matches 401k contributions. It values its employees and lets them know this in these and other ways.

So, when 10-year employee Mrs. A in accounting goes to human resources, says she is an alcoholic and needs help, and confesses to having stolen $5,000 from a dormant bank account to pay for her sick husband’s medical bills, your company responds with compassion. Mrs. A is told that she must get treatment for her alcoholism and make restitution of the stolen money in installment payments deducted from her paycheck. She is removed from her supervisor position, her security clearance is taken away, and she is assigned to input data with no access to the general ledger. Mrs. A submits a written apology, which is placed in her employee file. She is told that any future violation of company rules will result in termination.

Fast forward to 20 years later. Mrs. A is a model employee, much loved by her colleagues. She has been promoted in accounting back to a position of responsibility. Her assistant begins training to replace her when she retires at the end of the year. As the assistant learns Mrs. A’s job, she notices a recurring payment to a vendor she does not recognize: $7,500 a month for services the nature of which is unclear. The assistant calls the person listed as president of the company on its monthly invoice and speaks with a person who says that his company provides data security. The assistant goes to the IT department, which knows nothing about this vendor. Internal auditors get involved and discover that the vendor is a shell that provides no services to your company, and that the president is Mrs. A’s husband. When confronted, Mrs. A admits to having paid the straw man vendor $7,500 per month over a 15-year period, thereby embezzling a total of $1.35 million. She is immediately fired and the authorities are notified. Mrs. A and her husband go to prison. None of the money is recovered.

For many years, your company has purchased commercial crime insurance covering losses resulting from embezzlement by an employee. Your risk manager submits a claim for the $1.35 million loss less the $10,000 deductible. The carrier denies the claim on the ground that coverage automatically terminated as to Mrs. A 20 years ago when her $5,000 theft was discovered, citing the following provision of the policy:

This insurance terminates as to any Employee as soon as the Insured’s Chief Executive Officer, Chief Financial Officer, Treasurer, Controller, Risk Manager, General Counsel or any person serving in a functionally equivalent position not in collusion with a perpetrator of a loss becomes aware of any criminal or dishonest act by such Employee while employed by or in the service of the Insured.

Your company is aghast that by not firing Mrs. A 20 years ago, it appears to have lost its insurance for any loss caused by her at any time since then. According to the insurer, once your company learned of her prior dishonesty, crime coverage applicable to her subsequent conduct terminated automatically even though her prior misconduct was committed long ago. Is the insurer right about this?

As is always the case with insurance questions, the answer depends on the specific wording in the insurance policy. The policy language quoted above is the same as in a Wisconsin case with nearly identical facts. In Waupaca Northwoods LLC v. Travelers Casualty & Surety Co. of America, 2011 BL 109466 (E.D. Wisc. Apr. 25, 2011), the court held that Travelers owed coverage to its policyholder fora dishonest employee’s theft, even though the company had known of a prior act of dishonesty by that employee before the Travelers policy was purchased.

The court pointed out that Travelers’ policy language focused on the present tense, rather than looking back to any time before the policy was issued. The policy says the insurance “terminates” “as soon as” the company “becomes aware of any dishonest” act. The court reasoned that this use of present tense language suggests an awareness that is future-looking from the time of the policy’s purchase – and that if the company became aware of a dishonest act before the policy was issued, this termination clause would not be triggered. The court also said that because the policy speaks of coverage that “terminates” rather than “excludes,” the policy must only be forward-looking since a policy could not “terminate” upon its very inception.

Finally, the court held that had Travelers wanted to exclude coverage for this situation, it could have easily used wording that clearly eliminates coverage for known dishonest employees. The court pointed to a different case involving a Hartford policy that precluded coverage if the company “has knowledge” that the dishonest employee committed any dishonest act, “whether such act be committed before or after the date of the employment” by the company. The court stated that such policy language would clarify that the termination or exclusion of coverage relates back to any known employee who previously engaged in dishonest conduct, not just to conduct that arose after the policy became effective.

Travelers cited the many other cases decided in favor of the insurance company on similar facts and similar policy language, all based on the premise that as between the employer and the insurance company, the employer should bear the risk of employing a person with a known prior record of dishonesty.

Cooper Sportswear Mfg. Co. v. Hartford Cas. Ins. Co., 818 F. Supp. 721 (D.N.J. 1993); Douglas Wilson & Co. v. Insurance Co. of N. America, Philadelphia, Pa., 590 F.2d 1275 (4th Cir. 1979).

For example, in a more recent New York case, Capital Bank & Trust Co. v. Gulf Ins. Co., 91 A.D.3d 1251 (N.Y. App. Div. 2012), a bank loan officer forged the name of the bank president on loan documents in 2004 that led to the loss of $1.7 million. The bank timely submitted a claim to its insurer, Gulf, which denied the claim because the bank president had knowledge of prior forgeries by the same employee three years before the bank reported the 2004 forgery. The bank had not fired the loan officer or submitted a claim to its insurance company because he was the top performing officer and the forgeries did not cause any loss to the bank. Gulf, however, denied the bank’s claim based on its policy provision stating that:

Coverage terminates as to any employee as soon as the bank, or any director or officer not in collusion with such employee learns of any dishonest or fraudulent act committed by any such employee while employed by the bank.

Despite the present tense wording of this policy, the New York court enforced this provision and denied coverage to the bank, even though the bank president had learned of the employee’s dishonesty before the inception of the policy. Contrary to the Wisconsin court in Waupaca, the New York court in Capital Bank held that dishonest acts committed by the employee, of which the bank was aware before the policy began, terminated coverage as to that employee immediately upon the policy’s inception.

While it may be hard to reconcile these two cases, the New York court was not asked to consider the present tense of the policy language or what effect this had on its interpretation, because the bank did not make this argument. Instead, the bank argued only that the employee’s act in 2001 did not rise to the level of a “dishonest or fraudulent act” because the insured had suffered no loss. The court held that sustaining a loss was not a required part of the termination provision – it applied upon prior discovery of dishonesty, regardless of whether the dishonesty led to a loss.

The New York court was also swayed by the policy’s prior knowledge exclusion, which eliminated coverage for a loss arising out of or in connection with any circumstances or occurrences known to the bank prior to the inception of the policy. In this provision, there is a clear reference to acts which occur before the inception of the policy. Thus, the court was not required to address any present tense confusion created by the termination provision – the insured’s prior knowledge of the employee’s dishonesty was enough to rule out coverage.

The two cases Travelers cited in Waupaca in its effort to persuade the Wisconsin court to uphold its automatic termination provision were about policies with key differences in language. In Cooper Sportswear, supra, the Hartford policy excluded coverage for employees who committed a prior dishonest act “whether such act be committed before or after the date of employment by the Insured.” Likewise, in Douglas Wilson & Co., supra, another Hartford policy excluded coverage for dishonest acts by employees who had committed a prior dishonest act “in the service of the Insured or otherwise.” Both cases involve policy language that focused not just on acts of which the company becomes aware in the future, but on acts committed prior to the inception of the policy as well. As such, the policy provisions at issue in the cases cited by Travelers contain language broader in scope than the present tense language Travelers wrote into its policy.

In cases where the policy language clearly excluded orterminated coverage for dishonest employees whosepast dishonesty was known to the company, coveragewas denied and the denial was upheld in court. Butwhere the policy language spoke in the present tenseand did not clearly say that knowledge of prior dishonestacts that predated the policy would exclude coverage,the insurance company could not deny coverage forsubsequent dishonest acts. Since insurance companieswrite their own policies, they are free to write themin a manner that leaves no doubt about what theycover and do not cover. As the Wisconsin court ruledin Waupaca, they must use language that makes theirintent to terminate coverage upon pre-policy discoveryof employee dishonesty clear to the policyholder, or riskrejection of this coverage defense.

The unfortunate reality exposed by this situation, andthe uncertainty it creates about whether your companyhas crime coverage for its $1.35 million loss in the aboveexample, is that showing compassion for a dishonestemployee – no matter how justified or consistent with yourcorporate culture – puts your company at considerablerisk. Long experience with crime claims teaches thatdishonest employees, when discovered and forgiven,often strike again. Crime insurers know this too; hence theautomatic termination provision cutting off coverage for adishonest employee once any bad act is discovered, nomatter how long ago.

The only way to eliminate this risk is to fire any employee discovered to have committed any dishonest act, even one resulting in only a small loss, or even no loss at all. If a company does not do this, the risk of a subsequent embezzlement by the same employee, and the likelihood of a fight with its crime carrier over coverage for the new loss, rise exponentially.

BOB DEVEETSKI is a partner in Barnes & Thornburg's South Bend, Indiana, office. 574-237-1147 or robert.devetski@btlaw.com.