Khazai Rug: Court of Appeals of Kentucky applies Crime Policy’s Inventory Exclusion to Alleged Employee Theft Loss

By David S. Wilson and Chris McKibbin

The inventory exclusion precludes an insured from proving an employee theft loss solely by reliance on inventory calculations, independent of other proof of actual employee theft. A recent decision of the Court of Appeals of Kentucky, Khazai Rug Gallery, LLC v. State Auto Property & Casualty Insurance Company, provides a good example of the application of the inventory exclusion, and makes important findings with respect to whether it is appropriate to infer a connection between a demonstrated instance of employee theft and another similar instance for which there is insufficient independent evidence.

The Facts

Khazai Rug Gallery (“Khazai”) was a rug vendor. It incurred two demonstrated employee theft losses and two other alleged losses. The first demonstrated loss involved missing rugs. Two rugs were found to be missing from storage. The president of Khazai confronted the suspect employee. The employee admitted stealing five rugs and then returned them. Khazai then performed an inventory count and concluded that 79 rugs were missing. No employee admitted to stealing the 79 rugs, and no surveillance footage existed to prove that the rugs were stolen. The only evidence of a loss was the inventory computation.

The second demonstrated loss involved cash. The president discovered that $800 in cash was missing from a sales desk. Surveillance footage showed that an employee had stolen the money from a drawer. The president then recalled that he had previously placed $16,800 in cash in his office and that, when he went to check on it, he found that it was missing. The employee only admitted to stealing the $800, and paid it back as restitution. No proof of the $16,800 loss existed, other than the president’s statement.

The Inventory Exclusion

Khazai submitted claims under its employee dishonesty coverage for the 79 rugs and the $16,800 in cash. The insurer concluded that the inventory exclusion applied. This exclusion, and its exception, were paraphrased by the Court as follows:

Both contracts contained the same exclusion for employee theft: State Auto would not pay claims when the proof of the loss was solely dependent on an “inventory computation” or “a profit and loss computation[.]” Only “where you establish wholly apart from such computations that you have sustained a loss, then you may offer your inventory records and actual physical count of inventory in support of the amount of loss claimed.”

The Court explained the rationale for the inventory exclusion:

Similar and identical inventory exclusion clauses have been in use by the insurance industry for more than half a century. They were created to address the problem of insurance claims where employers believed their employees had stolen items from their stores, but the losses could only be explained by bookkeeping that could simply be an accounting error or a product of negligence or wastage or pilferage unconnected to employee theft. [citations omitted]

Khazai Rug attempted to demonstrate that there was independent evidence of employee thefts of both rugs and cash, as the theft of the five rugs and the $800 in cash had been proven by admissions and surveillance evidence. Thus, Khazai Rug contended, the 79-rug loss and the missing $16,800 were simply computations of total losses resulting from prior demonstrated acts of employee thefts of rugs and cash.

The Court rejected this contention, observing that:

Khazai’s allegations of employee theft are equally infirm. Both the [five] stolen rugs and the stolen [$800 in] cash were singular, proven incidents where Khazai was made whole and suffered no loss. … Khazai did not perform additional investigative measures to discover a pattern of loss, nor did it establish any independent evidence that more than five rugs and $800 in cash were stolen. … Khazai’s sole proof that 79 rugs and $16,800 were stolen was its inventory computation. As was the case in Teviro Casuals, an isolated theft cannot form the prima facie evidence of other thefts absent some evidentiary basis other than an inventory computation.

In the absence of any such evidence, the Court declined to infer any connection between the demonstrated losses and the alleged losses. As a result, no independent evidence of employee dishonesty existed, and the exclusion applied:

… a business with an employee theft insurance contract containing the computation exclusion must present substantive evidence demonstrating a prima facie loss and employee theft before it may utilize its inventory or profit-and-loss computations as additional evidence of the fact that there was a loss, or as proof of the loss’s value. …

Khazai’s evidence that rugs had been stolen only proves that five rugs were stolen and then returned. Khazai discovered that two rugs were missing, and upon investigation, the employee who had stolen the rugs was identified and confronted. The employee admitted to stealing five rugs, and he returned all five rugs. The employee denied taking any additional rugs, and he signed a confession admitting he took only five rugs. He later entered a guilty plea to the theft. Khazai performed an inventory almost two months later and discovered that 79 rugs were missing.

Regarding the allegedly stolen cash, Khazai’s evidence is similar. Khazai’s office manager discovered that $800 was missing, and after reviewing surveillance footage, discovered that an employee had taken the money from a drawer. The employee later pled guilty to stealing the $800 and paid restitution to Khazai. Khazai’s president then recalled he had allegedly placed $16,800 in his office desk drawer, and when he went to check on it, found it was missing. No surveillance footage was available to show it had been stolen. No employee admitted to stealing the money. And, assuming the cash was stolen, someone other than an employee could have taken it.

 Thus, aside from the inventory, the evidence only establishes that five rugs were stolen and returned. And similarly, aside from Khazai’s president’s statement that $16,800 cash was stolen from his desk, the evidence only establishes that $800 was stolen and later paid back through restitution. These facts, even viewed in a light most favorable to Khazai, are insufficient to make a prima facie employee theft case.

Conclusion

Insureds confronted with suspected losses may jump to conclusions regarding the cause of such losses, especially in an environment where there have already been similar events or where controls are poor. However, those conclusions may not always be supportable. As the Court observed, commercial crime insurers have maintained forms of the inventory exclusion for over 50 years, precisely to ensure that employee theft insurance covers demonstrated acts of employee theft only, rather than record-keeping errors, negligence, wastage or theft by non-employees.

Khazai Rug is notable for two reasons. First, much like the Eleventh Circuit’s decision in W.L. Petrey (see our September 8, 2015 post), it reinforces the requirement of independent prima facie evidence of employee dishonesty beyond inventory computations. Second, and more importantly, it provides an illustration of a court declining to infer a connection between a demonstrated instance of employee theft and another similar instance for which there is insufficient independent evidence of employee involvement.

Khazai Rug Gallery, LLC v. State Auto Property & Casualty Insurance Company, 2017 WL 945116 (Ky. Ct. App.)

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