Category Archives: Employee Theft

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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Frazier Industrial: U.S. District Court analyzes Scope of Commercial Crime Policy’s Employee Theft Coverage in Bid-Rigging Scheme

By David S. Wilson, John Tomaine and Chris McKibbin

The recent decision of the U.S. District Court for the District of New Jersey in Frazier Industrial Company v. Navigators Insurance Company provides a useful example of judicial analysis of the Employee Theft coverage in the context of a bid-rigging scheme between an insured’s employee and an outside contractor.  The Court analyzed the plain wording of the Commercial Crime Policy in issue to find that, although kickbacks paid to the employee by the contractor represented a covered Employee Theft loss, the portion of the excess payments retained by the contractor was not covered.

The Facts

Frazier Industrial (“Frazier”) was a manufacturer of structural steel storage systems.  Frazier’s sales to its customers included installation services, which Frazier typically contracted out to independent contractors.  The independent contractor’s price was included in Frazier’s quote to its customer, and the customer paid Frazier for both sales and installation.  CTC was one independent contractor utilized by Frazier.

In March 2011, Frazier learned that its Vice President – Operations, identified as “JMG”, had engaged in a bid-rigging scheme with CTC whereby:

(i)         JMG identified projects with considerable profit margins;

(ii)        if CTC’s bid for the project was substantially below Frazier’s internal budget, JMG would inform CTC that it could increase its bid (and by how much), while still winning the contract; and,

(iii)       JMG approved the inflated bid and CTC would split the padded amount with JMG, after it was paid by Frazier.

Frazier alleged that the padded sums amounted to at least $1,938,000 and that, of this, JMG received over $960,000 from CTC.

The Employee Theft Coverage

Frazier maintained a Commercial Crime Policy with Navigators which contained the following Employee Theft insuring agreement:

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.

“Theft” was in turn defined as “the unlawful taking of property to the deprivation of the Insured.”

Frazier contended that the entire amount of its loss was covered by the Policy, insofar as JMG had colluded with CTC in the bid-rigging scheme and Frazier had incurred a loss as a result.  Navigators’ position was that the portion of the funds retained by CTC did not constitute an unlawful taking by JMG and that, consequently, that portion of the loss did not come within coverage.

The Court held that it was necessary to first assess coverage in respect of the excess amounts paid by Frazier to CTC and then, secondly, the portion paid by CTC to JMG.  With respect to the amount paid by Frazier to CTC, the Court reviewed the case law on payments to third parties induced by dishonest employees (including Tesoro Refining, which we discussed in our April 14 post), and observed that:

Courts have generally found that payments to third-parties do not qualify as a “loss” under commercial crime policies.  This is the case even where the employer’s loss was as a result of the employee colluding with the third party.  In finding so, courts rely on the understanding that such payments are not an “unlawful taking” by the employee and are, therefore, outside the scope of the policies.  In cases where courts have found a loss under the policy, the entire transaction was a fraudulent setup by the employee and the insured never received the good or service from the third-party, thus negating the employer’s authorization.  [citations omitted]

In the Court’s view, the bid-rigging scheme, which involved the provision of actual services albeit at inflated prices, was not a fraudulent setup from the outset, and Frazier had received some benefit.  The fact that JMG exercised control over the bidding process did not change this conclusion.  Thus, the Court concluded that the excess payments to CTC did not constitute an Employee Theft loss:

Frazier bought insurance from Navigators to protect it from employee theft, not against a less favorable deal from a deceitful contractor. … Frazier does not assert that the underlying transaction was fraudulent and that the independent contractor did not perform its work. … In addition, Frazier has not argued nor demonstrated that CTC’s bids were either unreasonably priced or not the lowest for a particular job — the latter likely to be the case otherwise JMG’s choice of CTC would have raised suspicions.  Rather, Frazier set an internal budget and expected that any independent contractor it chose would make a profit on their service. As such, Frazier was not “unknowingly deprived of money.”  Consequently, the “loss” that Frazier claims here is — at its core — an inability to obtain the lowest price, and that is not a basis to raise a claim under the Crime Policy.  [citations omitted]

The Court reached a different conclusion with respect to CTC’s payments to JMG, holding that the payments to JMG were not payments to a third party and that Frazier had not consented to such payments.  The Court concluded that:

In each case, Frazier authorized a payment intended only for CTC, as compensation for the respective installation.  JMG’s scheme resulted in him receiving a portion of these payments, fraudulently profiting from compensation that Frazier did not intend for him.  Thus, the employee’s actions are no different than if he inflated the bids himself and skimmed a portion off-the-top, before forwarding the payments on to the unsuspecting contractor. … Put another way, the payment to CTC was merely a pretext for JMG to receive his share.  Consequently, the fact that JMG had the money pass through an intermediary prior to reaching his pocket does not change the fundamental nature of the employee’s actions — an “unlawful taking” — nor its effect — to the “deprivation of the insured.”  [citations omitted]

The Court briefly considered, and rejected, the application of the indirect loss exclusion to the CTC loss, holding that, on the wording of the exclusion there in issue, there was no “inability to realize income that [Frazier] would have realized had there been no loss of or damage to ‘money.’”  The exclusion might have applied, had Frazier been seeking income it could have realized from the profits taken by the employee (such as interest).  However, no such claim was advanced.

Conclusion

Frazier Industrial provides an example of the distinction that may be drawn between employee benefits and third-party benefits in bid-rigging and similar schemes, and demonstrates the importance of careful factual analysis of the flow of funds in a dishonest scheme involving benefit to both an employee and a third party.  The decision is also instructive in distinguishing between schemes which involve a real transaction through which the insured receives some actual benefit, and schemes which are wholly fraudulent and fictitious from the outset.

[Editors’ Note: Our guest co-author, John Tomaine, is the owner of John J. Tomaine LLC, a fidelity insurance and civil mediation consultancy in New Jersey.  After over thirty-one years with the Chubb Group of Insurance Companies, he retired as a Vice President in 2009.  He is an attorney admitted in Connecticut and New Jersey, and holds a Master’s Degree in Diplomacy and International Relations.  He is available to serve as an expert witness in fidelity claim litigation and to consult on fidelity claim and underwriting matters.]

Frazier Industrial Company v. Navigators Insurance Company, 2015 WL 8134055 (D.N.J.)

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Taylor, Bean & Whitaker: U.S. District Court applies Alter Ego doctrine to deny coverage in respect of both Majority Shareholder and Colluding Subordinate Employees

By David S. Wilson and Chris McKibbin

A recent decision of the U.S. District Court for the Middle District of Florida, In Re Taylor, Bean & Whitaker Mortgage Corporation, provides a helpful illustration of how to assess coverage where an insured’s alter ego allegedly colludes with subordinate employees who are not, themselves, directing minds of the insured.

The Facts

The insured, Taylor, Bean & Whitaker Mortgage Corporation (“TBW”), had been a leading wholesale mortgage lending firm, but collapsed in 2009 due to massive fraud directed by its majority shareholder, Lee Farkas. Farkas removed over $87 million from TBW, primarily by siphoning money out of TBW into various entities owned by Farkas and others. TBW alleged that at least two of its employees had assisted Farkas. According to TBW, its treasurer, Desiree Brown, had effected electronic transfers of funds from TBW’s operating accounts to the recipient entities.  TBW also alleged that its CFO, Delton De Armas, had set up a “Due From” account, which was used to track the amounts Farkas and Brown had taken from TBW’s operating accounts, and to give the defalcations an air of legitimacy with TBW’s bookkeepers.

The Lloyds Coverage

TBW maintained fidelity coverage with certain Lloyds Underwriters. TBW’s bankruptcy trustee submitted a proof of loss for $87 million, asserting that Farkas, Brown and De Armas had committed acts of employee dishonesty.

The Underwriters sought, inter alia, a declaration of no coverage arising from the acts of Farkas, Brown and De Armas.  As Farkas was the majority shareholder of TBW, the Underwriters determined that he fell within an exception to the definition of “Employee”, which provided that:

 It is understood, however, that the term Employee does not include any Major Shareholder of [TBW], nor, except as provided above, any director of [TBW].

A Major Shareholder was in turn defined as “a natural person who has or had directly, indirectly or beneficially 25% or more of the outstanding voting shares of [TBW].”

Can an Alter Ego also be an Employee?

TBW acknowledged that Farkas, as majority shareholder of TBW, came within this exception. However, TBW pointed to an exclusion in one of the polices, which excluded coverage for:

 any loss involving any act of any partner or Major Shareholder of [TBW], except when acting in the capacity of an Employee.

Based on this, TBW contended that a Majority Shareholder could still be considered an Employee for coverage purposes, so long as the individual was “acting in the capacity of an Employee” at the time that the dishonest act was committed.

The Court rejected this argument. After considering the case law on the alter ego doctrine, the Court concluded that:

 … [the] Underwriters established that Farkas dominated and controlled the corporation to such an extent that the corporation’s independent existence was in fact nonexistent; Farkas became an alter ego of the corporation. … For this reason, Farkas was not TBW’s employee nor did he act in an employee capacity when he looted TBW’s property. Accordingly, any losses caused by his dishonest acts are not covered by the bonds in question.

Collusion of Subordinate Employees with Alter Ego

TBW had a clever argument in reserve. While Farkas may not have been an “Employee”, Brown and De Armas certainly were Employees at the time that they had assisted Farkas with his defalcations. As such, TBW reasoned, its losses were due to their dishonest acts. The Court rejected TBW’s argument, accepting the Underwriters’ position that allowing indemnity in such circumstances would effectively nullify the alter ego doctrine, and was also contrary to public policy:

 The Court is faced with a very unusual situation where a majority shareholder, an alter ego of the corporation, initiates dishonest acts, directs his subordinate’s involvement, and the subordinate renders her assistance in the fraudulent scheme. TBW claims that Farkas directed all of the transfers that caused its losses. Over time, the embezzlement on Farkas’ behalf became part of Brown’s duties. The Court believes that allowing coverage under these circumstances is not proper. … allowing TBW to recover for losses caused by its alter ego’s fraudulent or dishonest conduct only because its alter ego used his corporation’s employee as an instrumentality in the fraudulent scheme would still essentially allow TBW to recover for its own fraudulent or dishonest acts.

 In addition, it would be inconsistent with public policy against allowing one to insure against one’s own thefts, dishonest acts or intentionally inflicted damage. See Cal. Union… (“[T]here is a public policy against permitting a corporation to collect insurance for the defalcations of its alter ego.”). …

Thus, TBW could not recover for any losses caused by the dishonest acts of the employees committed at Farkas’ direction.

Conclusion

Taylor, Bean & Whitaker is useful to fidelity insurers in reinforcing the intended parameters of the alter ego doctrine. The Court’s reasoning and conclusions with respect to Farkas’ falling outside the definition of “Employee” are fairly straightforward. However, the Court’s application of the alter ego doctrine (and public policy considerations) in respect of Brown and De Armas demonstrates a willingness to critically assess the substantive claim advanced by the insured, and to ascertain whether it simply involves an attempt to draw an artificial distinction between the acts of an alter ego and the acts of colluding subordinate employees. It is not uncommon for an alter ego to have some form of “assistance” in effecting a fraud; Taylor, Bean & Whitaker indicates that such assistance should not enable an insured to nullify the alter ego doctrine where it would otherwise apply.

In Re Taylor, Bean & Whitaker Mortgage Corporation, 2015 WL 728493 (M.D.Fla.)

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Tesoro Refining: U.S. District Court analyzes scope of “Unlawful Taking” and “Forgery” under Employee Theft Coverage in Commercial Crime Policy

By David S. Wilson and Chris McKibbin

On April 7, 2015, the U.S. District Court for the Western District of Texas released its decision in Tesoro Refining & Marketing Company LLC v. National Union Fire Insurance Company of Pittsburgh, Pennsylvania. The decision analyzes what constitutes “unlawful taking” for the purposes of the Employee Theft coverage, and also provides guidance with respect to the forgery clause now found in some forms of that coverage.

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 alleged defaulter, Leavell, was the manager of Tesoro’s Credit Department and managed Enmex’s account. The District Court found that:

  • 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, and were provided to the auditors as evidence of Enmex’s creditworthiness.
  • By September 2008, the Enmex balance reached almost $89 million. In October, a document purporting to be a new $24 million LOC was created on Leavell’s drive. A PDF version of this document, with the addition of a Bank of America logo, was created a few days later 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 alleged that Leavell had forged the LOCs and the security agreement.

The Employee Theft Coverage

Tesoro had initially sought to advance a claim under the Forgery coverage of its commercial crime policy with National Union, but loss resulting from forgery by employees was excluded unless the loss resulted from forgery of commercial paper “made or drawn by or drawn upon” the insured. Thus, Tesoro tried to fit the loss within the Employee Theft coverage instead, asserting that Leavell’s alleged conduct represented a “theft” which had caused a loss to Tesoro (i.e., its inability to recover funds on the LOCs). 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 in turn defined as “the unlawful taking of property to the deprivation of the insured.” Notably, National Union’s insuring agreement includes forgery, unlike some other forms of the theft coverage.

On cross-motions for summary judgment, Tesoro advanced two arguments in support of coverage. First, Leavell’s alleged conduct represented an “unlawful taking” of either Tesoro’s money or its property (fuel sold to Enmex on credit). Second, Leavell’s alleged conduct represented a “forgery” and was, on National Union’s wording, covered employee theft. The Court rejected both arguments.

1. There was no “unlawful taking” by Leavell

Tesoro asserted that Leavell’s alleged misconduct had induced it to continue to sell fuel to Enmex, on the mistaken belief that the account was adequately collateralized. National Union pointed out that no money or fuel had been taken by Leavell, and that the fuel had all gone to Enmex. Tesoro countered that, as “unlawful taking” was not defined in the policy, it was broad enough to encompass Leavell’s alleged misconduct. The Court rejected this contention, holding that, at a minimum, “unlawful taking” requires that an employee seize or otherwise exercise control over an article, such that possession or control of the article is transferred without the owner’s authorization or consent.

While Leavell’s misrepresentations may have led Plaintiff to continue selling the fuel to Enmex on credit despite its outstanding debt, his misrepresentations did not exert control over the fuel such that possession or control of the fuel was transferred by virtue of the misrepresentations themselves. Stated differently, Leavell’s alleged forgeries did not transfer possession or control of the fuel — the fuel was transferred only upon its subsequent sale by Plaintiff to Enmex. …

 

Interpreting “theft” under the policy to be satisfied by any dishonesty that results in deprivation to the insured would read the language defining “theft” as an “unlawful taking” out of the policy, which the Court may not do. [emphasis in original]

As such, the “unlawful taking” requirement was not made out.

2. The “forgery” clause is not a stand-alone coverage, and a loss must meet the other requirements of the Employee Theft wording

Tesoro also contended that its loss resulted from “forgery” within the scope of the Employee Theft coverage, and that loss resulting from forgery was covered irrespective of whether it met the other requirements of the provision (including, of course, the “unlawful taking” requirement). National Union reasoned that the use of the term “include” meant that the alleged forgery loss had to meet the other requirements of the insuring agreement, i.e., the forgery must constitute an unlawful taking, committed by an employee, to the deprivation of the insured.

The Court accepted National Union’s argument, holding that the provision covers losses resulting from unlawful takings by employees by means of forgery, not simply any loss resulting from an employee’s forgery:

It would be incongruous to interpret the sentence’s use of “include” to place forgery in the same class or category as an unlawful taking, as urged by Plaintiff, such that an act requiring no taking would suffice to show the unlawful taking required for coverage. Plaintiff’s interpretation—that “a forgery always constitutes a theft” under the policy—suggests that language explaining the scope of a covered “unlawful taking” creates a basis for coverage separate and independent from an unlawful taking. The Court finds this interpretation unreasonable.

Conclusions

Tesoro Refining provides valuable guidance as to the scope of “unlawful taking” in Employee Theft wordings, and reinforces fidelity insurers’ intention that the “taking” must be by the employee, rather than any “taking”, by anyone, that is consequent upon an employee’s dishonesty. The Court also endorsed National Union’s position that the inclusion of forgery in the Employee Theft coverage does not create a “stand-alone” forgery coverage, and that the other requirements of the coverage must be established to trigger indemnity.

Tesoro Refining & Marketing Company LLC v. National Union Fire Insurance Company of Pittsburgh, Pennsylvania, 2015 WL 1529247 (W.D.Tex.)

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