Category Archives: Employee Theft

Teva: Supreme Court of Canada rejects Fictitious or Non-Existing Payee Defence in finding Collecting Banks Liable for Employee Cheque Fraud

By David S. Wilson and Chris McKibbin

On October 27, 2017 the Supreme Court of Canada released its long-awaited decision in Teva Canada Ltd. v. TD Canada Trust. In a 5:4 decision, the Supreme Court held that two banks that accepted fraudulent cheques procured by a dishonest employee were strictly liable in conversion to the employer, and could not establish the “fictitious or non-existing payee” defence afforded by subsection 20(5) of the Bills of Exchange Act.

The decision is a welcome development for Canadian fidelity insurers who seek to subrogate against banks in respect of certain types of employee cheque frauds. The Supreme Court reversed the decision of the Court of Appeal for Ontario, which had found that the payees were either fictitious or non-existing. The Supreme Court’s decision places fidelity insurers in an excellent position to look to banks as subrogation targets in appropriate circumstances.

The Facts

Teva Canada Limited (“Teva”) is a pharmaceutical company. McConachie was Teva’s Finance Manager. McConachie implemented a fraudulent scheme whereby he prepared false cheque requisition forms for business entities with names that were similar or identical to those of Teva’s real customers. Based on McConachie’s fraudulent forms, Teva’s accounts payable department issued the cheques and mechanically applied the requisite signatures.

The fraudulent cheques were made payable to payees with six different names. Two of those names, PCE Pharmacare and Pharma Team System, resembled the names of existing entities to whom no debt was owed: PCE Management Inc. and Pharma Systems. The four other names (Pharmachoice, London Drugs, Pharma Ed Advantage Inc. and Medical Pharmacies Group) were legitimate entities to whom no debt was owed.

McConachie registered the business names as sole proprietorships and opened bank accounts at several banks, including the Bank of Nova Scotia and TD Canada Trust (the “collecting banks”). He then deposited 63 fraudulent cheques totalling $5,483,249 into these accounts and eventually removed the funds.

After discovering McConachie’s fraud and terminating him, Teva sued the collecting banks in conversion.

The Tort of Conversion and the Bills of Exchange Act

A collecting bank is prima facie liable in conversion where it transfers funds to an improper recipient, unless a statutory defence succeeds. As conversion is a strict liability tort, the bank’s negligence, or lack thereof, is irrelevant; any alleged contributory negligence on the part of the drawer is also irrelevant.

Here, Teva was the drawer of the cheques. The cheques were improperly obtained by McConachie and deposited to accounts held by him with the collecting banks. The collecting banks thereby dealt with the cheques under the direction of one not authorized, and made the proceeds available to someone other than the person rightfully entitled to possession. The collecting banks were therefore strictly liable to Teva in conversion, and would have to compensate Teva unless they could establish a statutory defence.

Before the Supreme Court, the collecting banks relied on the “fictitious payee” defence afforded by subsection 20(5) of the Bills of Exchange Act, which provides that:

Where the payee is a fictitious or non-existing person, the bill may be treated as payable to bearer.

This statutory defence renders a cheque payable to bearer, such that mere delivery, without endorsement, effects negotiation (the cheque would otherwise be payable to order, and would require an endorsement for negotiation).

The issue then became whether the payees were fictitious or non-existing. This analysis involves a two-step framework. The first step, which the majority characterized as the subjective fictitious payee inquiry, asks whether the drawer intended to pay the payee. If the collecting bank demonstrates that the drawer lacked such intent, then the payee is fictitious, the analysis ends and the bank’s defence succeeds. It is crucial to note, however, that “drawer intent” does not mean a specific intention to pay a payee in respect of any particular cheque; rather, the drawer’s intent to pay is presumed, unless the bank demonstrates otherwise.

If the bank does not prove that the drawer lacked such intent, then the payee is not fictitious, and the analysis proceeds to step two. This second step, which the majority characterized as the objective non-existing payee inquiry, asks whether the payee is either (1) a legitimate payee of the drawer; or (2) a payee who could reasonably be mistaken for a legitimate payee of the drawer. If neither of these is satisfied, then the payee does not exist, and the bank’s defence succeeds. If either is satisfied, then the payee exists, and the bank is liable.

The Act does not define the terms fictitious or non-existing, and it has been left to the courts to provide guidance. Canadian courts have generally followed the analytical framework provided by Falconbridge, which the majority quoted in full:

In the case of a bill drawn by [the drawer] upon [the drawee] payable to [the payee], the payee may or may not be fictitious or non-existing according to the circumstances:

 (1) If [the payee] is not the name of any real person known to [the drawer], but is merely that of a creature of the imagination, the payee is non-existing and is probably also fictitious.

 (2) If [the drawer] for some purpose of his own inserts as payee the name of [the payee], a real person who was known to him but whom he knows to be dead, the payee is non-existing, but is not fictitious.

 (3) If [the payee] is the name of a real person known to [the drawer], but [the drawer] names him as payee by way of pretence, not intending that he should receive payment, the payee is fictitious, but is not non-existing.

 (4) If [the payee] is the name of a real person, intended by [the drawer] to receive payment, the payee is neither fictitious nor non-existing, notwithstanding that [the drawer] has been induced to draw the bill by the fraud of some other person who has falsely represented to [the drawer] that there is a transaction in respect of which [the payee] is entitled to the sum mentioned in the bill. [emphasis added]

The Supreme Court’s 1996 Boma decision modified the approach to non-existing payees slightly by finding that the payee was not non-existing in cases where the drawer could reasonably have mistaken a payee for a payee with an established relationship with the drawer. This involves an objective assessment. As a result, according to Boma, a payee will be non-existing when the payee lacks an established relationship with the drawer, unless the drawer could reasonably have mistaken the payee to be one with such a relationship.

Boma’s narrowing of the ambit of non-existing payees becomes extremely significant where the fraudster has, as part of the fraud, caused his employer to issue cheques payable to an entity which has a name similar to, but not the same as, an existing creditor of the employer. It is not uncommon for a fraudster to set up a similarly-named entity to receive cheques, as the similar name deceives the employer and helps to conceal the fraud.

Where there is evidence that objectively establishes such a similarity, the bank’s reliance on the defence can be defeated and the bank will be liable. In Boma, for example, cheques payable to “J. Lam” and “J.R. Lam” were found to be sufficiently similar to the name of a legitimate subcontractor, Van Sang Lam, to allow the Court to conclude that an intention to pay should be attributed. Thus, although “J. Lam” and “J.R. Lam” did not exist in reality, they were nevertheless not “non-existing” for the purposes of subsection 20(5), and the bank was liable.

Here, McConachie used the names of four actual entities that had dealings with Teva, and two entities that did not technically exist, but whose names were similar to entities with which Teva had legitimate dealings.

Applying the principles to the case at bar, the majority held that:

Though only four of the names used were those of existing customers, the other two names used were very similar to names of Teva’s real customers. The motions judge found that there was “a rational basis for concluding that cheques were apparently made payable to existing clients”, and that “the payees could plausibly be understood to be real entities and customers of the plaintiffs”. As a result, the payees were not fictitious or non-existing.

Consequently, the collecting banks were liable to Teva.

Conclusion

Teva is a very significant decision for fidelity subrogation professionals, as fidelity insurers are now better-positioned to look to banks as subrogation targets in certain types of cheque losses. Where a dishonest employee has defrauded his employer through a cheque scam, it is imperative that the fidelity subrogation professional consider potential bank liability. This requires careful analysis, particularly with respect to whether the payee name is “sufficiently similar” to an existing entity with which the insured had legitimate prior dealings. Where the analysis demonstrates that a bank’s reliance on subsection 20(5) of the Act is unfounded, a subrogating fidelity insurer may be able to obtain a significant recovery.

Teva Canada Ltd. v. TD Canada Trust, 2017 SCC 51

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Fidelity Law Association / ABA Fidelity & Surety Law Committee Conference – Boston, November 8-10, 2017

Blaneys partners David Wilson and Chris McKibbin will attend the joint FLA/ABA FSLC Conference. The FLA Conference on November 8 will focus on contemporary fidelity insurance issues, including social engineering fraud claims, knowledge of prior dishonesty, rescission, forensic investigations and communications with claimants and witnesses. The curriculum is designed for fidelity claims professionals, underwriters and lawyers. Chris will moderate the panel entitled The Future Ain’t What It Used To Be: Challenges Facing Fidelity and Commercial Crime Insurers in the 2020s. This panel addresses developing fidelity risks and exposures such as social engineering fraud, ransomware and Bitcoin and other cryptocurrencies.

  • To register, or for more information, click here.
  • A copy of the conference brochure may be accessed here.

The ABA FSLC Fall Meeting on November 9-10 is entitled “Managing and Litigating the Complex Fidelity Claim.” The program is designed as a workshop that will help fidelity claims professionals and lawyers gather useful practical tips to employ in claims handling. The program will feature a number of panel discussions on topics such as effective communications with insureds, discoverability of insurance company documents, ethics considerations, confidentiality agreements and litigation strategies. Chris will participate in the panel entitled Criminal Prosecution of the Accused, which considers how the fidelity claim investigation is affected by parallel criminal investigation and prosecution.

  • To register, or for more information, click here.
  • A copy of the conference brochure may be accessed here.

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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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Commercial Ventures: U.S. District Court holds that Insured’s Co-Owner and President is not an “Employee” under Crime Policy

By David S. Wilson and Chris McKibbin

Several recent decisions, such as Telamon Corporation v. Charter Oak Fire Insurance Company (see our March 13, 2017 post), have highlighted the importance of assessing the precise legal status of an alleged defaulter’s work relationship vis-à-vis the insured as part of a proper coverage analysis. The decision of the U.S. District Court for the Central District of California in Commercial Ventures, Inc. v. Scottsdale Insurance Company provides another example of the courts considering this challenging issue. In Commercial Ventures, the Court dealt with an alleged defaulter who was both a minority owner and the President of the insured, and specifically addressed whether contingent ownership distributions constituted “salary, wages or commissions” within the crime coverage’s definition of “Employee”.

The Facts

Commercial Ventures had two affiliated companies, Noblita, LLC (“Noblita”), which operated an apparel business, and Daylight Investors, LLC (“Daylight”), which owned 49 per cent of Noblita. Rik Guido personally owned another 49 per cent of Noblita, and was also its President. As an owner of Noblita, Guido was entitled to receive $27,500 per month, but only under certain conditions.

Noblita’s Limited Liability Company Operating Agreement (the “Operating Agreement”) defined Guido’s compensation as follows:

Mr. Guido will not be paid for such services [as President], but so long as (1) he is President of the Company and rendering his full time services to the Company (and in compliance with the terms of this Agreement) and (2) the company has adequate monies, Mr. Guido will receive a Distribution of twenty–seven thousand five hundred dollars ($27,500) per month.

The Operating Agreement defined “Distribution” as “the transfer of money or property by [Noblita] to one or more Members without separate consideration.”

In November 2013, Daylight sued Guido in state court, alleging that Guido participated in a fraudulent scheme whereby he transferred money and inventory from Noblita to a Florida-based company in which he had an ownership interest.

Commercial Ventures maintained a Business Management Indemnity Policy with Scottsdale, under which both Noblita and Daylight were additional insureds. The policy’s crime coverage included coverage for employee theft. Daylight notified Scottsdale of a potential employee theft loss arising from Guido’s alleged actions.

Scottsdale inquired as to the nature of Guido’s role with Noblita. Noblita’s controller advised that Guido was not entitled to take any distribution from Noblita unless the company had adequate monies or was profitable. The controller added that, during the majority of the months in which Guido worked for Noblita, it had negative operations and Guido was therefore not entitled to any distribution.

In Scottsdale’s view, Guido was a non-salaried member of Noblita, and was therefore not an “Employee” within the meaning of the crime coverage.

The Employee Theft Coverage

Scottsdale moved for summary judgment before the District Court on this issue. The crime coverage defined “Employee” as:

Any natural person while in the services of the Insured, including sixty (60) days after termination of service; provided the Insured:

i. compensates such person directly by salary, wages or commissions; and

 ii. has the right to direct and control such person while performing services for the Insured.

 The parties’ dispute centred on whether Guido’s contingent compensation constituted “salary, wages or commissions”. Commercial Ventures asserted that, because the crime coverage did not define the terms “salary, wages or commissions”, the terms were ambiguous. The Court considered dictionary definitions of those terms:

Salary

  • fixed compensation paid regularly for services.”
  • [a]n agreed compensation for services—esp. professional or semiprofessional services usu. Paid at regular intervals on a yearly basis, as distinguished from an hourly basis.”

Wage

  • a payment usually of money for labor or services usually according to contract and on an hourly, daily, or piecework basis.”
  • [p]ayment for labor or services, usu. Based on time worked or quantity produced; specif., compensation of an employee based on time worked or output of production.”

Commission

  • a fee paid to an agent or employee for transacting a piece of business or performing a service.”
  • [a] fee paid to an agent or employee for a particular transaction, usu. as a percentage of the money received from the transaction.”

The Court noted that the parties were in agreement that “salary, wages or commissions” constituted compensation for a person’s services, and held that:

… the Court finds that the definition of “employee” is unambiguous as it is clearly defined in the policy. In addition, “salary, wages or commissions” — words used to define “employee” — are not ambiguous as they are only subject to one interpretation in this case as well. Therefore, the issue becomes solely whether there is a triable issue of fact as to whether Plaintiff paid Mr. Guido for his services, in turn, meaning whether he was paid “salary, wages, or commissions.” [citations omitted]

The Court then considered whether Guido’s contingent compensation under the Operating Agreement could be considered “salary, wages or commissions”. The Court observed that accepting the insured’s arguments on this issue would entail that the definition of “Distribution”, which specifically indicated that distributions were made “without separate consideration”, would be meaningless, as would the provision stipulating that “Mr. Guido will not be paid for” his services as President. In accepting Scottsdale’s view, by contrast:

… the Court may give these provisions their plain meaning and may still read the Operating Agreement as a cohesive whole. In other words, in the Court’s view, it appears that the parties, as reflected in the Operating Agreement, intended to appoint Mr. Guido as President of Noblita and to provide him with ownership distributions. The Operating Agreement did not intend, however, to compensate Mr. Guido for his services as President; rather, it compensates him in his role as an owner through distributions only. Though the Operating Agreement indicates that Mr. Guido is entitled to his owner distributions only so long as he served as President, this does not mean that his owner distributions are intended to compensate him for his services. [emphasis added]

Consequently, Guido was not an “Employee” and no indemnity was available.

Conclusion

Although the decision is based on the interpretation of the specific contract between Noblita and Guido, Commercial Ventures provides general guidance as to the proper interpretation of the definition of “Employee” found in many crime coverages, as well as the meaning of the specific terms “salary, wages or commissions”. The Court rejected the insured’s contention that these terms were ambiguous, and found that ownership distributions did not fall within their ambit. The interpretive approach adopted in Commercial Ventures will be of assistance to fidelity claims professionals in assessing whether individuals who maintain both ownership and other roles within an insured come within the definition of “Employee”.

Commercial Ventures, Inc. v. Scottsdale Insurance Company, 2017 WL 1196462 (C.D. Cal.)

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Telamon: Seventh Circuit finds Insured’s Vice-President to be Independent Contractor falling outside Crime Policy’s Employee Theft Coverage

By David S. Wilson and Chris McKibbin

On March 9, 2017, the Seventh Circuit Court of Appeals released its decision in Telamon Corporation v. Charter Oak Fire Insurance Company. The decision affirms the ruling of the U.S. District Court for the Southern District of Indiana, which had held that the insured’s Vice-President of Major Accounts was not an “employee” within the meaning of a crime policy, as her services were provided to the insured by an outside entity pursuant to a series of consulting services agreements (see our April 25, 2016 post for more detail).

The Facts

Juanita Berry worked for Telamon from 2005 to 2011. Her work was governed by a series of Consulting Services Agreements (the “Agreements”) between Telamon and J. Starr Communications, Berry’s one-woman company through which she provided her services. The terms of the Agreements remained largely unchanged during Berry’s six-year association with Telamon. Her role did not. Berry’s responsibilities expanded well beyond those described in the Agreements, and she eventually became Telamon’s Vice-President of Major Accounts, making her the company’s senior manager in the New York and New Jersey region.

In that capacity, Berry oversaw Telamon’s AT&T Asset Recovery Program, which was supposed to remove old telecommunications equipment from AT&T sites and sell it to salvagers. Berry removed the equipment and sold it, but she pocketed the profits. By the time that Telamon discovered this conduct in 2011, it had incurred $5.2 million in losses. Telamon fired Berry and she was later convicted of wire fraud and tax evasion.

The Employee Theft Coverage

Telamon submitted a claim under its Travelers Wrap+ crime policy and, separately, to its property insurer, Charter Oak. Travelers concluded that there was no coverage available under the crime policy in respect of Berry’s conduct because Berry was not an employee within the meaning of the policy. The relevant portions of the definition provided that:

Employee means …

 any natural person . . . who is leased to the Insured under a written agreement between the Insured and a labor leasing firm, while that person is subject to the Insured’s direction and control and performing services for the Insured. …

 Employee does not mean

 any … independent contractor or representative or other person of the same general character not specified in paragraphs 1. through 5., above.

Travelers reasoned that the Agreements made it clear that Berry worked as an independent contractor, and that J. Starr could not reasonably be considered to be a labour leasing firm. Telamon disputed Travelers’ position, contending that J. Starr was a labour leasing firm because it had provided Berry’s consulting services to Telamon in exchange for payments; as Berry was a “leased employee”, the exception for independent contractors could not apply. The District Court accepted Travelers’ position and granted summary judgment dismissing the claim. Telamon appealed.

Before the Seventh Circuit, Telamon asserted that the plain meaning of a “labor leasing firm” is a company “in the business of placing its employees at client companies for varying lengths of time in exchange for a fee”; in Telamon’s view, all that it needed to demonstrate was that J. Starr was a business concern that sold another person’s work for a specified time and for a specified fee.

The Seventh Circuit held that, even accepting that definition, J. Starr could not reasonably come within it:

We will accept that definition for purposes of this opinion. Yet even so, we cannot conclude that J. Starr meets it. It is true that the Agreements were contracts between Telamon and J. Starr under which the former obtained the right to Berry’s labor. But J. Starr was not a firm in the business of leasing labor; it was just Berry’s vehicle for providing her own services. To classify her corporate alter ego as a “labor leasing firm” would be to elevate form over substance.

 The cases Telamon cites to support its position underscore our point. The “labor leasing firm” in Pacific Employers had multiple branches and specialized “in providing industrial clients with daily workers.” … Similarly, the firm in Torres “hire[d] individuals and place[d] them with client companies for varying lengths of time,” including at least six with the company litigating its insurance coverage. … There is no way to squeeze J. Starr into the same box. Berry’s company was a legal convenience, and nothing more. Because it was not a “labor leasing firm,” she was not an “Employee” for purposes of the Travelers policy. [citations omitted]

Consequently, no coverage was available under the Travelers policy.

Conclusion

Telamon provides useful appellate guidance on the employee-independent contractor distinction found in most crime policies. The Seventh Circuit’s decision reinforces the importance of assessing whether an alleged defaulter comes within the definition of “Employee” in a theft claim. In this case, Berry was held out by Telamon as a Vice-President and exercised considerable power over Telamon’s operations and personnel, but performed these duties as an independent contractor. With more work relationships moving away from the traditional employee-employer model, fidelity claims professionals must ensure that the precise legal status of the alleged defaulter’s work relationship vis-à-vis the insured is established as part of the coverage analysis.

Telamon also provides specific guidance with respect to the meaning of “labor leasing firm” and, arguably, similar terms used in other fidelity coverages. Although J. Starr did, in the narrowest and most technical sense, supply its (only) worker to another company for payment, the Court rejected Telamon’s attempts to characterize J. Starr as a labour leasing firm, even accepting Telamon’s proposed definition of the term for the purposes of the analysis. This finding is of assistance to fidelity claims professionals who must address creative arguments which attempt to bring similarly-situated workers within the definition of “Employee”.

Telamon Corporation v. Charter Oak Fire Insurance Company, 2017 WL 942656 (7th Cir.)

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Tesoro Refining: Fifth Circuit analyzes scope of “Unlawful Taking” and “Forgery” in Commercial Crime Policy’s Employee Theft Coverage

By David S. Wilson, Chris McKibbin and Stuart M. Woody

In our April 14, 2015 post, we analyzed the decision of the U.S. District Court for the Western District of Texas in Tesoro Refining & Marketing Company LLC v. National Union Fire Insurance Company of Pittsburgh, Pennsylvania and its implications for what constitutes “unlawful taking” for the purposes of the Employee Theft coverage.  The Fifth Circuit Court of Appeals recently affirmed the District Court’s grant of summary judgment in favour of National Union.

The Facts

The insured (“Tesoro”) was a refiner and marketer of petroleum products.  In 2003, Tesoro began selling fuel to Enmex, a petroleum distributor, on credit.  The manager of Tesoro’s Credit Department, Leavell, managed Enmex’s account.

By late 2007, Enmex’s credit balance had grown to $45 million, and Leavell (and Tesoro’s auditors) became concerned about Enmex’s ability to pay down the outstanding debt.  In discussions with Tesoro’s auditors in December 2007, Leavell represented that the Enmex account was secured by a $12 million letter of credit (LOC).

Between December 2007 and March 2008, a series of documents purporting to be LOCs (and, in one case, a security agreement) were created in Leavell’s password-protected drive on Tesoro’s server.  Leavell provided these to the auditors as evidence of Enmex’s creditworthiness.

By September 2008, the Enmex balance had reached almost $89 million.  In October 2008, a document purporting to be a new $24 million LOC was created on Leavell’s drive.  A PDF version of this document, with a Bank of America logo added, was created a few days later and saved in the Credit Department’s shared folder.

In December 2008, Tesoro presented the $24 million LOC to Bank of America, which confirmed that the LOC was not valid.  Tesoro ceased selling fuel to Enmex, and was not paid for some of the fuel it had already sold.  Tesoro submitted a crime claim to National Union, alleging that Leavell had forged the LOCs and the security agreement, resulting in Tesoro’s loss.

The Employee Theft Coverage

The insuring agreement provided that:

We will pay for loss of or damage to “money”, “securities” and “other property” resulting directly from “theft” committed by an “employee”, whether identified or not, acting alone or in collusion with other persons.

For the purposes of this Insuring Agreement, “theft” shall also include forgery.

“Theft” was defined as “the unlawful taking of property to the deprivation of the insured.”  Unlike some other forms of the theft coverage, National Union’s insuring agreement defined “theft” to include forgery.

Interpreting the Insuring Agreement

Tesoro contended that the District Court erred in holding that an “unlawful taking”, whether by forgery or by other means, was required to create coverage under this insuring agreement.  In Tesoro’s view, the sentence in the insuring agreement addressing forgery created coverage for losses from any employee forgery, irrespective of whether there was any unlawful taking by the employee.

National Union contended that the employee theft insuring agreement always required proof that an “unlawful taking” had occurred, irrespective of the form of that taking.  National Union took the position that the term “include”, as used in the sentence addressing forgery, meant that a forgery that is within the category of “theft” is covered, but the insuring agreement does not create coverage for acts of forgery wholly distinct from “theft”.

The Court accepted National Union’s interpretation, holding that:

Tesoro’s interpretation isolates the sentence addressing forgery from its context.  Context is key and can in part be provided by a document’s title… This insuring agreement is titled “Employee Theft”… When an “Employee Theft” insuring agreement contains a sentence explaining that “theft”, a defined term, shall also include forgery, that sentence is making clear that a forgery that leads to “theft” is covered.

The Court also noted that Tesoro’s proposed interpretation would nullify the “Acts of Employees” exclusion when applied to the Forgery or Alteration insuring agreement.  Such an interpretation would result in the policy excluding all employee forgery involving commercial paper from the Forgery or Alteration insuring agreement, while covering all forms of employee forgery under the Employee Theft insuring agreement.

There was no “Unlawful Taking” by Leavell

Tesoro further contended that, even if it was required to prove an “unlawful taking” under the Employee Theft coverage, it could still do so, insofar as Leavell’s conduct met the requirements of the Texas criminal offence of theft (in particular, theft by deception).  The Court did not endorse Tesoro’s equating of the policy’s “unlawful taking” requirement with any act constituting a theft under state criminal law, but accepted it arguendo for the limited purpose of determining whether summary judgment could be properly granted in favour of National Union.

The Court noted that proving theft by deception would require Tesoro to show that the forged security documents were a substantial or material factor in inducing it to continue selling fuel to Enmex.  The Court held that the available evidence did not support that conclusion.  Indeed, Tesoro had continued selling fuel to Enmex during periods in which it knew that the receivable was not secured.  Thus, Tesoro could not demonstrate that it was induced to do anything differently as a result of the alleged deception.  On that basis, the Court held that summary judgment had been properly granted to National Union.

Conclusion

For those Employee Theft coverages that include forgery within the meaning of theft, the Fifth Circuit’s decision in Tesoro Refining provides guidance as to how to interpret and apply the provision, including ascertaining whether the alleged forgery actually induced the insured to do anything it would not have done in the absence of the forgery.  The Court’s finding on causation is significant, notwithstanding that it came in the context of analyzing the Texas criminal offence of theft by deception.

As a general observation, we suggest that caution be exercised in relying on criminal law provisions and concepts as an interpretive guide to fidelity policies.  In Tesoro Refining, the Court made it clear that it was analyzing the Texas provision solely because Tesoro had advanced the argument as a basis for denying summary judgment to National Union.  Other courts in the United States and Canada have cautioned against too easily equating fidelity coverage concepts and criminal law concepts.  In Iroquois Falls Community Credit Union Limited v. Co-operators General Insurance Company, for example, the Court of Appeal for Ontario overturned the motions court’s grant of summary judgment to an insured credit union, specifically rejecting the holding that the credit union had to have notice of criminal conduct before it was obligated to put its insurer on notice. 

More broadly, the Court’s overall interpretive approach (reading and interpreting the policy as a whole, including the headings and related insuring agreements and exclusions) is of assistance to fidelity insurers in rebutting arguments which seek to create ambiguity by interpreting a particular sentence (or even a subset of words within a sentence) without regard to the intended scope of coverage as evidenced by the headings and related insuring agreements and exclusions in the policy.

Tesoro Refining & Marketing Company LLC v. National Union Fire Insurance Company of Pittsburgh, Pennsylvania, 2016 U.S. App. LEXIS 13838 (5th Cir.)

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Telamon: U.S. District Court finds Insured’s Vice-President to be Independent Contractor falling outside Crime Policy’s Employee Theft Coverage

By David S. Wilson and Chris McKibbin

In Telamon Corp. v. Charter Oak Fire Ins. Co., the U.S. District Court for the Southern District of Indiana held that a Vice-President of Major Accounts who provided management and marketing services to a telecommunications company was not an “Employee” within the meaning of the employee theft coverage afforded by its Travelers Wrap+ policy, but rather an independent contractor.

The Facts

The insured, Telamon Corporation (“Telamon”), is a telecommunications company headquartered in Indiana.  Telamon installed telecommunications equipment for customers such as AT&T.  The alleged defaulter, Juanita Berry, operated a one-person telecommunications consulting company, J. Starr Communications, Inc. (“J. Starr”).

Pursuant to a Consulting Services Agreement dated June 1, 2005 between Telamon, Berry and J. Starr, and subsequent renewals thereof (the “CSAs”), J. Starr agreed to provide Berry’s services to Telamon.  The CSAs specifically provided that Berry provided these services as an independent contractor.  Berry initially worked with Telamon as a senior sales consultant, primarily due to her existing relationship with AT&T.  In 2007, Berry transitioned into an account management role, and oversaw sales and installation projects for AT&T and other accounts.

In 2009, Berry assumed the title of Vice-President of Major Accounts and, in that capacity, was the most senior representative of Telamon’s Dayton, New Jersey facility.  Consistent with her title, she had “operational oversight” with respect to that facility, including engineering, installation, warehouse inventory management and other responsibilities.  Telamon allowed Berry to hold meetings with clients, hire and fire Telamon personnel, set employee salaries and approve expenses.  She also had access to Telamon’s project accounting software, which permitted her to review and manage projects for which she was responsible.

Meanwhile, commencing in 2007, Berry spearheaded Telamon’s “AT&T Asset Recovery Program”, through which Telamon removed old telecommunications equipment from AT&T sites and returned it to Telamon facilities.  Unbeknownst to Telamon executives, Berry also allegedly directed Telamon employees to package and ship the equipment to a Florida company known as WestWorld Telecom (“WestWorld”).

In 2010, Telamon accounting personnel discovered unusual updates in Telamon’s project accounting system, including purchases being charged to jobs for which the material charged was not compatible.  These entries were traced back to Berry.  A subsequent physical inventory of the Dayton warehouse revealed that a significant amount of telecommunications equipment was missing.  Subsequent investigation revealed Berry’s alleged diversion of this equipment to WestWorld, and payments by WestWorld to J. Starr, rather than to Telamon.

The Employee Theft Coverage

Telamon terminated Berry and submitted claims to its crime insurer, Travelers, and its property insurer, Charter Oak Fire, for over $5 million.  Travelers declined coverage on the basis that Berry was not an “Employee” within the meaning of the crime coverage.  The relevant portions of the definition provided that:

Employee means …

 any natural person . . . who is leased to the Insured under a written agreement between the Insured and a labor leasing firm, while that person is subject to the Insured’s direction and control and performing services for the Insured. …

 Employee does not mean

 any … independent contractor or representative or other person of the same general character not specified in paragraphs 1. through 5., above.

Travelers reasoned that the CSAs made it clear that Berry worked as an independent contractor, and that J. Starr could not reasonably be considered to be a labour leasing firm.  Telamon disputed Travelers’ position, contending that J. Starr was a labour leasing firm because it had provided Berry’s consulting services to Telamon in exchange for payments; as Berry was a “leased employee”, the exception for independent contractors could not apply.

On Travelers’ and Telamon’s cross-motions for summary judgment, the District Court rejected Telamon’s contentions.  The Court examined non-fidelity authority on the interpretation of the term “labor leasing firm”, finding that it meant a company that is in the business of placing its employees at client companies for varying lengths of time in exchange for a fee.  The Court concluded that J. Starr was not such a company:

There is nothing in the CSAs to support Telamon’s interpretation of J. Starr as a labor leasing firm.  The CSAs that governed Berry’s employment identify J. Starr and Berry as the “Consultant” and “independent contractor,” and expressly state that “[t]he personnel performing services under this Agreement [i.e., Berry] shall… not be employees of [Telamon].”

 Moreover, the evidence establishes that J. Starr was a one-person consulting company in the business of selling telecommunications equipment to, inter alia, WestWorld Telecom.  Indeed, Telamon’s Chief Operating Officer, Stanley Chen, testified that J. Starr and Berry sold telecommunications equipment before, during, and after Berry’s involvement with Telamon.  Berry provided sales consulting services primarily aimed at Telamon’s major client, AT&T.  Thus, J. Starr was not in the business of providing employees to client companies in exchange for a fee and was not, therefore, a “labor leasing firm” within the meaning of the Travelers Crime Policy.  Instead, Berry was an independent contractor pursuant to the terms of her employment with Telamon.  Telamon even admits this fact.  Therefore, Berry falls outside the coverage grant for theft by “Employees” under the Crime Policy.  [citations omitted]

As a result, the Travelers policy did not afford coverage in respect of Berry’s alleged acts.

Conclusion

Telamon provides a good illustration of the employee-independent contractor distinction found in most crime policies.  The decision demonstrates the importance of assessing whether an alleged defaulter comes within the definition of “Employee” in a theft claim; here, Berry was held out by Telamon as a Vice President, and exercised considerable power over Telamon’s operations and personnel, but performed these duties as an independent contractor.  With more work relationships moving away from the traditional employment contract model, it is essential that fidelity claims professionals ensure that the precise legal status of the alleged defaulter’s work relationship with the insured is established as part of the coverage analysis.

Telamon also provides specific guidance with respect to the meaning of “labor leasing firm” and, arguably, similar terms used in other fidelity coverages.  Although J. Starr did, in the narrowest and most technical sense, supply its (only) worker to another company for payment, the Court rejected Telamon’s attempts to characterize J. Starr as a labour leasing firm, instead focusing on the clear provisions of the CSAs to the effect that Berry served as an independent contractor, rather than as an employee.  This finding is of assistance to fidelity claims professionals who are confronted with creative arguments which attempt to bring similarly-situated workers within the definition of “Employee”.

Telamon Corp. v. Charter Oak Fire Ins. Co. and Travelers Cas. and Surety Co. of Am., 1:13-cv-382-RLY-DML (S.D. Ind. December 10, 2015) [Note: this decision recently came to our attention and does not appear to be accessible online; please contact us if you would like a copy.]

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