Category Archives: Inventory Exclusion

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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W.L. Petrey Wholesale: Eleventh Circuit applies Inventory Shortages Exclusion in finding No Coverage under Crime Policy

By David S. Wilson and Chris McKibbin

In our March 24 post, we summarized the decision of the U.S. District Court for the Middle District of Alabama in W.L. Petrey Wholesale Co., Inc. v. Great American Insurance Company. In that decision, the Court applied the Great American policy’s Inventory Shortages exclusion in holding that no coverage was available to the insured, notwithstanding that the insured (“Petrey”) had been indemnified in respect of a (superficially) similar claim two years before.

The Eleventh Circuit Court of Appeals recently affirmed the District Court’s decision. The Eleventh Circuit held that, while evidence of an employee’s exclusive access to insured property may support an inference of employee involvement in a loss which is independently demonstrated by other evidence, evidence of exclusive access, coupled only with an inventory discrepancy, will not take a claim outside the Inventory Shortages exclusion.

The Facts

Petrey was a wholesaler of 5-Hour Energy drinks and employed salespeople to deliver the product along prescribed delivery routes in trucks provided by Petrey. Petrey also leased storage units to individual salespeople. The salespeople ordered the product based on customer demand, delivered it, and were supposed to account for the deliveries by entering the relevant data in Petrey’s computer system. Petrey would conduct a physical inventory of each salesperson’s truck and storage facility at least twice a year.

Petrey employed Justin Bree as a salesperson from 2007 until 2013, when Bree was dismissed because his primary customer requested that he no longer service its stores. After Bree’s dismissal, Petrey took possession of Bree’s delivery truck and its contents; his computer equipment; and the storage unit where Bree kept Petrey’s inventory.

A month after Bree’s termination, Petrey discovered that the inventory in the storage unit was short by 82,510 bottles. Petrey then audited Bree’s route inventory and took a physical count of the storage unit, confirming the discrepancy. Petrey also compared Bree’s orders for the products with his sales. This comparison revealed a pattern of Bree’s ordering more products than his sales would have required.

The Inventory Shortages Exclusion

Petrey submitted a claim to Great American alleging that Bree had stolen the product. Great American denied the claim on the basis of the policy’s Inventory Shortages exclusion, which provided that:

We will not pay for loss as specified below: …

 Loss, or that part of any loss, the proof of which as to its existence or amount is dependent upon:

 a.) an inventory computation; or

b.) a profit and loss computation.

The District Court held that the Inventory Shortages exclusion applied to exclude the claim in its entirety. Petrey could point to no independent evidence linking Bree to the discrepancy. The District Court rejected Petrey’s contention that “the proof of the existence of the loss is the missing items themselves”, noting that there was no basis for this assertion other than the inventory calculations. Consequently, there was no basis to conclude that there had been a loss due to employee dishonesty or, for that matter, that there had been any loss at all.

On appeal to the Eleventh Circuit, Petrey advanced two primary arguments. First, Petrey contended that its physical inventory count provided independent evidence of employee theft by demonstrating that Bree ordered the products, received them from Petrey, did not deliver them to his customers, and did not have them on hand in his storage locker. The Court rejected Petrey’s contention, observing that “this argument is circular, as Petrey has supported these assertions only with order and sales records – which boil down to inventory comparison computations.”

Second, Petrey argued that it provided independent evidence of an employee dishonesty loss by showing that only Petrey employees had access to Bree’s inventory (the “exclusive access” argument). The Court also rejected this argument, relying on the Second Circuit’s 1973 decision in Dunlop Tire & Rubber Corp.:

We agree with the Second Circuit that “circumstantial evidence that, if a loss in fact was sustained, [the insured’s] employees were the perpetrators” is not independent evidence of the existence of a loss. … Petrey’s assertion that only its employees could have stolen the 5-Hour Energy bottles “presupposes the factual existence of a loss” and “merely tends to foreclose the possibility of theft by persons other than employees,” rather than prove that employees stole anything from the company.

As such, Petrey was unable to identify any independent evidence linking Bree to the inventory discrepancy.

Conclusion

The Eleventh Circuit’s decision in W.L. Petrey Wholesale reaffirms the commercial crime policy’s requirement that there must be independent corroborating evidence of both a loss in fact, and employee dishonesty causing that loss, in order for an insured to rely on its inventory records or computations in support of a claim for indemnity. The Court reiterated an important distinction with respect to the “exclusive access” argument sometimes advanced by insureds in inventory loss claims: while “exclusive access” may provide circumstantial evidence supporting an inference of employee involvement, it does not, without more, demonstrate that a loss has occurred. Consequently, evidence of exclusive access, coupled only with a paper inventory shortage, should not take a claim outside of the inventory exclusion.

W.L. Petrey Wholesale Co., Inc. v. Great American Insurance Company, 2015 WL 4646599 (11th Cir.)

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W.L. Petrey Wholesale: U.S. District Court discusses Inventory Exclusion and Threshold for Corroborating Evidence of Employee Dishonesty

By David S. Wilson and Chris McKibbin

In W.L. Petrey Wholesale Co., Inc. v. Great American Insurance Company, the U.S. District Court for the Middle District of Alabama granted summary judgment dismissing a claim under Great American’s Employee Dishonesty coverage. The Court held that the Inventory Shortages exclusion applied to the loss, notwithstanding that the insured (“Petrey”) had been indemnified by the same insurer in respect of a (superficially) similar claim two years before. The decision provides a useful illustration of the types of claims which will, and will not, fall within inventory exclusions.

The Facts

There are two relevant losses, both involving tens of thousands of missing “5-Hour Energy” drinks. Petrey was a wholesaler of 5-Hour Energy drinks and employed salespeople to deliver the product along prescribed delivery routes in trucks provided by Petrey. Petrey also leased storage units to individual salespeople. The salespeople would order the product based on customer demand, deliver it, and then account for the deliveries by entering the relevant data in Petrey’s computer system. Petrey would conduct a physical inventory of each salesperson’s truck and storage facility at least twice a year.

First Claim: McKean

Petrey contracted McKean as a salesperson in 2010. On June 6, 2011, shortly before a scheduled physical inventory was to have taken place, McKean abandoned his truck and his job. When McKean’s supervisor was unable to track him down, the supervisor then inventoried McKean’s truck and storage unit, and noted an apparent shortage. This led to Petrey performing a complete reconstruction of all transactions, which confirmed the shortage. Petrey then wrote to McKean about the shortage. In response, McKean denied stealing the product, but did not provide any explanation as to what had happened to them.

Petrey submitted a claim to Great American alleging that McKean had stolen the product. Once Great American confirmed that (i) McKean was the only individual with access to the product at the relevant times; and, (ii) McKean had not provided any alternate explanation when directly accused, Great American agreed to indemnify Petrey. Great American based its quantum calculations on inventory records and sales calculations.

Second Claim: Bree

Petrey contracted Bree as a salesperson in 2007. On May 24, 2013, Bree was terminated by Petrey after one of Petrey’s customers requested that Bree no longer deliver to its store. At that time, Petrey recovered its delivery truck and contents from Bree, and changed the locks on the storage unit that it had leased to Bree. On June 26, 2013, a Petrey manager noted that the inventory numbers for Bree’s route seemed exceptionally high. The manager ordered an audit and physical inventory, and discovered an apparent shortage of 82,510 drinks. Petrey attempted to locate Bree, without success.

 The Inventory Shortages Exclusion

Petrey submitted a claim to Great American alleging that Bree had stolen the product. Great American denied the claim on the basis of the policy’s Inventory Shortages exclusion, which provided that:

We will not pay for loss as specified below: …

 

Loss, or that part of any loss, the proof of which as to its existence or amount is dependent upon:

 

a.) an inventory computation; or

 

b.) a profit and loss computation.

Petrey’s proof of loss with respect to Bree was based entirely on its audit and inventory records and calculations. Unlike with its claim in respect of McKean, Petrey did not provide evidence that Bree was the only individual with access to the product at the relevant times, or any other evidence that linked Bree to the inventory shortage.

In response to Great American’s summary judgment motion, Petrey provided affidavit evidence from its CFO, who asserted that “the proof of the existence of the loss is the missing items themselves.” The Court noted that there was no basis for this assertion, other than the inventory calculations. As such, there was no basis to conclude that there had been a loss due to employee dishonesty or, for that matter, that there had been any loss at all:

evidence suggesting that only [Petrey]’s employees could have been responsible for the disappearance of inventory in Bree’s care is not independent evidence of a loss due to dishonesty or theft. The existence of the loss is presupposed on the basis of inventory records alone, and the manner of the loss, if one existed, is a matter of speculation. Even if [Petrey]’s employees were the only ones who could have stolen Bree’s inventory, there is no evidence, apart from inventory calculations, that any inventory was in fact stolen by anybody. Moreover, there is no independent evidence that employee dishonesty was responsible for any loss of inventory, rather than, for example (among a number of possibilities), employee negligence in following company policies for securing the goods. [emphasis added]

The Court rejected Petrey’s argument that applying the Inventory Shortages exclusion in this manner rendered coverage illusory:

the purpose of the inventory shortage exclusion is widely recognized not (as Petrey Wholesale contends) to serve as a surreptitious and complete contradiction of the coverage provided in employee dishonesty policies, but to protect insurers from the dangers of negligence, bookkeeping errors, waste, inexactness [or] pilferage by nonemployees …

The Court noted that insureds could provide appropriate corroborating evidence in several ways:

  • security camera footage;
  • evidence that an employee destroyed records and abandoned his job when he became aware that a theft was about to be discovered;
  • eyewitness statements that an employee removed items from a warehouse;
  • confessions of dishonest employees;
  • evidence that a dishonest employee sold the items for personal gain; and,
  • records of deliveries of items that were never, in fact, delivered.

Conclusion

W.L. Petrey Wholesale provides guidance as to when the inventory exclusion will apply, and when it will not. The Court accepted that there must be some independent corroborating evidence of employee dishonesty in order for an insured to rely on its inventory records or computations as (partial) proof of a covered loss. The Court also endorsed Great American’s position with respect to the underlying purpose of its Inventory Shortages exclusion, affirming that the point of the exclusion is not to render coverage “illusory”, but rather to safeguard the fidelity insurer’s legitimate interest in not paying claims arising from theft by non-employees (which can be insured against under other forms of coverage) or from the insured’s own negligence or poor record-keeping.

W.L. Petrey Wholesale Co., Inc. v. Great American Insurance Company, 2015 WL 404523 (M.D. Ala.)

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