Introduction

Many forms covering employee dishonesty state that the insurer will cover dishonest acts “committed by an 'employee', whether identified or not, acting alone or in collusion with another person, except [the named insured] or a partner, with the manifest intent to cause [the named insured] to sustain loss, and also obtain financial benefit (other than employee benefits earned in the normal course of employment, including: salaries, commissions, fees, bonuses, promotions, awards, profit sharing or pensions) for: (a) the 'employee': or (b) any person or organization intended by the 'employee' to receive that benefit” (ISO employee dishonesty coverage form CR 00 01 10 90). The insuring agreement of ISO BP 00 03 01 06 businessowners coverage form, in the optional coverage for employee dishonesty, contains an extensive promise to pay: “We will pay for direct loss of or damage to Business Personal Property and 'money' and 'securities' resulting from dishonest acts committed by any of your employees acting alone or in collusion with other persons (except you or your partner) with the manifest intent to… (1) cause you to sustain loss or damage; and also (2) obtain financial benefit (other than salaries, commissions, fees, bonuses, promotions, awards, profit sharing, pensions or other employee benefits earned in the normal course of employment) for… (a) any employee; or (b) any other person or organization.”

The American Association of Insurance Services (AAIS) employee dishonesty coverage form AP-308 covers “risks of direct loss or damage, unless the loss is limited or caused by a peril that is excluded, resulting from 'dishonest acts' committed by any of [the named insured's] employees or leased employees, acting alone or in collusion with other persons, that occur within the policy period.” The coverage form defines “dishonest acts” as “dishonest or fraudulent acts committed with the apparent intent to cause [the named insured] to sustain loss or damage and to obtain financial benefit for the employee or for any other person or organization. The financial benefit does not include salaries, commissions, bonuses, fees, profit sharing or other employee benefits.”

Three elements, therefore, must generally be addressed in claiming coverage. First, there must be a direct loss. Second, the dishonest act must have been committed with a “manifest intent” to cause the employer to sustain a loss. Third, the employee must have had the intent to obtain financial benefit either for himself, or for another person or organization. Many seemingly dishonest acts can simply be ascribed to poor business sense and lack of judgment. For example, in the case of Municipal Securities v. Insurance Company of North America, 829 F.2d 7 (6th App. 1987) an over-eager securities trader exceeded the trading limit imposed upon her by her firm and attempted to recoup losses by making increasingly improper trades. Her actions cost the firm almost $1 million, but were not found to be dishonest.

We should note that ISO commercial crime forms CR 00 22 07 02 and CR 00 23 07 02 could be found much more restrictive in coverage, because they promises to 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” means “the unlawful taking of 'money', 'securities', or 'other property' to the deprivation of the Insured.” “Money” is defined as “currency, coins and bank notes in current use and having a face value; and travelers checks, register checks and money orders held for sale to the public.” In at least one of the cases discussed later in this article, that narrow definition would have meant an employee's dishonest act was not insured against (Auto Lenders Acceptance Corporation v. Gentilini Ford, Inc., 854 A.2d 378 [New Jersey 2004]).

Finally, in many of the cases discussed herein, the coverage form referred to is a fidelity bond; because the language in the bonds is similar to the employee dishonesty forms, and because the intent is to provide coverage for the insured, we include them.

This is not to say that a case involving a fidelity bond will necessarily be interpreted in the same manner as an employee dishonesty form in regards to a perceived ambiguity. In the case of Tri City National Bank v. Federal Insurance Company, 674 N.W.2d 617 ( Wis. App. 2003), the court noted that the “wording of fidelity bonds is not construed strictly against the drafter because the justification behind the rule—unequal bargaining power—has been eliminated.” This was because the bankers blanket bond was developed jointly by the banking industry and the insurers that provided surety coverage. Thus, neither party could be said to have unequal bargaining power.

Direct Loss v. Proximately Caused Loss

In assessing whether a dishonest act has been committed, the first thing to consider is whether or not the act directly resulted in loss or damage. Many courts appear to overlook this word in their attempt to focus on “manifest intent,” but nonetheless the word is there and must be considered.

In the case of Hanson PLC v. National Union Fire Insurance Company of Pittsburgh, PA., 794 P.2d. 66 ( Wash. App. 1990), the court had to determine whether a loss “resulted directly” from an employee's fraudulent or dishonest act. James Laviola was the head of the rendering department of a large meat processor. The rendering department bought byproducts from a supplier, and turned these into tallow and meat meal. The supplier brought increasingly poor quality byproducts, but demanded he be paid as if the products were of good quality. He threatened to take his business elsewhere. According to his confession, Laviola was afraid his department would be shut down and he would be out of a job. He agreed to overpay the supplier to make it appear the department was making money. An inventory revealed that the department's actual inventory was about 1/20th of what it should have been. The meat processor presented a claim for employee dishonesty, and the insurer denied the claim on the basis the insured had failed to prove Laviola's dishonesty and intent. (The insuring agreement covered loss of money, securities and other property “which the Insured shall sustain… resulting directly from one or more fraudulent or dishonest acts committed by an Employee… with the manifest intent to cause the insured to sustain such loss; and to obtain financial benefit for the Employee…”) The trial court found for the insured, and the insurer appealed.

The insurer argued that the jury had been misinstructed regarding whether “resulting directly” was the same as “proximate cause.” The insurer claimed they were not; proximate cause was a technical legal term and the jury should have construed “resulting directly” in the same manner as the average person would. The court disagreed, noting that several cases in Washington had pursued a proximate cause analysis when construing the phrase “resulting directly” in an insurance policy. In other words, Laviola's fraudulent act was the one that set all other events in motion.

In a case before the New Jersey Supreme Court, a proximate cause analysis was also used to find for an insured employer (Auto Lenders Acceptance Corporation v. Gentilini Ford, Inc., 854 A.2d 378 [N. J. 2004].) In this somewhat complex situation, the employee of an auto dealership engaged in credit-application fraud over the course of a year, leading to the sale of twenty-seven autos to customers who did not qualify for credit. Gentilini Ford entered into a dealer agreement with a bank to provide installment sales to the dealer's customers. The bank entered into a separate agreement with Auto Lenders, in which Auto Lenders had the option to finance any contract the bank rejected. Each approved application resulting in a sales contract with the dealer thus meant the dealer was paid in full for the purchased auto, while the customers made payments either to the bank or Auto Lenders.

Randy Carpenter, the dealer's employee, falsified several credit applications that were submitted to Auto Lenders, including sending fictitious driver's licenses and pay stubs. Auto Lenders discovered this upon investigating several loans that went into default. Auto Lenders sued Gentilini for fraud and breach of contract; Gentilini in turn asserted claims against the bank, Randy Carpenter, the customers who had submitted false applications, and its insurer, who had declined to provide a defense against the Auto Lenders claim. Auto Lenders and Gentilini reached a settlement, and, with the exception of the claim against the insurer, all complaints were dismissed. At trial, the jury found for Gentilini and against the insurer.

The insurer (Ohio Casualty) appealed. On appeal, a divided court found the dealer had not sustained a direct loss because Randy Carpenter's fraudulent action had been directed against Auto Lenders, not against the dealer. But the dissenting judge argued that the result of Carpenter's conduct was a direct loss, since Gentilini had had to repurchase the outstanding installment contracts based on its agreement with Auto Lenders. The appeal, based on the dissention, went to the supreme court.

When the case came before the New Jersey Supreme Court, the court first addressed whether there was a direct loss. The Ohio Casualty policy provided coverage for “direct loss of or damage to Business Personal Property and 'money' and 'securities'.” The insurer argued that the losses were not direct and did not fall within the types of property specified in the insuring agreement. The insured, Gentilini, equated “direct loss resulting from” with “loss proximately caused by,” arguing that it forfeited valuable contractual rights when it conveyed the motor vehicles without receiving its anticipated consideration.

The court examined the rulings in several courts that had addressed similar issues involving the “proximate cause” test. (Proximate causation is the theory often used to determine coverage when one event sets in motion a sequence of events that result in damage.) According to Couch on Insurance Third Edition (§ 101:44): “The concept of proximate cause is as ubiquitous in insurance as it is in tort law. There has never been a single, clear, satisfactory definition of proximate cause. In plain English, the concept has always meant something like the 'main' or 'moving' cause, even if that cause was accompanied by, or followed by, other causes of a relatively minor nature.”

So, in Auto Lenders, the court had to consider whether proximate causation could be applied to the terms of the employee dishonesty policy, since it was most commonly used in determining property coverage. The court noted that in New Jersey, the proximate cause test had been used to determine coverage when the policy covered damages “arising from” as well as “direct loss… caused by.”

The insurer argued that the appeal presented a very different question from whether or not the proximate cause theory applied; the issue was whether the damage that appeared to be outside the provision of coverage could be afforded coverage through use of the theory. The court replied that the proximate cause theory had not been previously used to evaluate an employee dishonesty policy, but the majority of federal courts that had addressed “direct loss” within this context had applied the theory. The court said, “[T]urning to the present dispute, we conclude that Gentilini sustained a direct loss of Business Personal Property as the result of Carpenter's conduct when it was induced by his fraudulent acts to hand over automobiles in exchange for installment sales contracts signed by non-creditworthy customers… any loss to Gentilini resulting from the default of the purchasers on the sale of the automobiles was proximately, and therefore directly, the result of Carpenter's actions.”

Not all jurisdictions follow the “proximate cause” theory with regard to employee dishonesty. The case of Tri City National Bank v. Federal Insurance Company, 674 N.W.2d 617 (Wis. App. 2003) involved a situation very similar to that in Gentilini, but the court refused to apply a proximate cause test. In Tri City , two bank employees participated in a fraudulent scheme to obtain mortgage loans for insufficiently funded borrowers. A colluding outsider would recruit a “buyer” for a property the outsider owned, and have the buyer apply for a mortgage with one of two companies. The bank employees would then send a false verification to the mortgage company that indicated the borrower had an account at Tri City and issue a cashiers check for the closing. The outsider would then take the loan proceeds, and pay for the cashiers check, and pay off the employees. At least seventy-four loans were processed in this manner; the scheme came to light when the borrowers predictably defaulted on the loans. The mortgage companies sued Tri City to recover their losses, and Tri City notified Federal Insurance and requested confirmation that it would cover the bank for either judgments or settlements. Federal denied coverage on the basis that the losses were not the direct result of the employees' dishonest acts.

As noted earlier, Tri City involved a bankers bond, the language of which led the court to state the usual rule of construing any ambiguity strictly against the policy drafter did not apply. Tri City held that: (1) the language of the bond—”losses resulting directly from”—was ambiguous, and therefore a reasonable banker would expect coverage; (2) “direct” had been defined as “proximate cause,” and the employee acts were the proximate cause of the losses. The court dismissed the first argument by explaining the origin of the bankers bond, and then turned to the second. The court disagreed with equating “direct” with “proximate cause,” agreeing with the insurer that in each of the cases Tri City cited to support its position “the decisions focused on causation, but only in a direct loss (that is, losses of the insured's own property, or property for which it was legally responsible)… In each case the insured sustained a direct loss of its property or property for which it was legally responsible, and the proximate cause issue was whether some intervening event broke the causal connection between the dishonest conduct of an employee and the insured's loss.”

The difference between this case and Auto Lenders, although at first blush involving similar circumstances, is that in Tri City the bank was not directly out-of-pocket except with regard to making good on its employees' actions. It was the lenders who directly sustained the loss; the bank initially lost nothing through its employees' dishonest acts. It was only after inappropriate borrowers defaulted on the loans that the mortgage companies sued the bank and the loss to the bank resulted. However, the Tri City court noted the decision in Auto Lenders had reached the same conclusion as its own, in that the employer is covered only for direct losses caused to it by its employee's dishonest acts, not for vicarious liability to losses sustained by others arising out of the employee's conduct.

Financial Benefit

Employee dishonesty coverage requires that the employee committing the dishonest act intend to cause a loss to the employer, and, by so doing, gain some financial benefit. Therefore, not all dishonest acts give rise to coverage.

For example, in the case of General Analytics Corporation v. CNA Insurance Companies, 86 F.3d 51 (4th Cir. 1996), presumably an employee, unhappy with her employer, altered purchase orders received from the IRS. General Analytics then ordered the requested items from Pioneer Research Corporation, and shipped them to the IRS. The IRS rejected the orders and returned them to General Analytics. Pioneer refused return of the items, leaving General Analytics with a loss of over $90,000. The court ruled that an issue of fact existed as to whether the employee's action was accompanied by a “manifest intent” (discussed later in this article) to benefit the employee, Pioneer, or some other unknown person. Accordingly, the case was remanded for more proceedings.

In Mortgage Associates, Inc. v. Fidelity and Deposit Company of Maryland, 105 Cal. App. 4th 28 (2002) the court found for the insurer since the insured was unable to establish two suspected employees had received financial benefit of at least $2,500, a requirement of the policy. A real estate investment company set up a scheme whereby fictitious buyers' loan applications for property at inflated values were processed; suspicion fell on two Mortgage Associates employees as participants in the scheme. However, Mortgage Associates was unable to prove the employees, who quit their jobs shortly after investigation began, had benefited by at least $2,500. The court enforced the policy language and found for the insurer.

In another case, action was brought by a bank against its insurer under a standard bankers blanket bond. The bank president, Massey, not only made loans with little documentation, but often with no documentation. He loaned money to friends on favorable terms, often misrepresented the value of collateral, and released collateral on outstanding loans. The bank lost about $2 million. The bank claimed coverage for the loss under its bond, but in the litigation failed to prove that Massey had received the requisite financial benefit of at least $2,500. In fact, other bank employees stated he was careless, not dishonest. In finding for the insurer, the court noted “The bank's approach, 'We must have been cheated because we lost a lot of money,” is unfortunately all too common in this era of freedom from accountability. The magnitude of Massey's errors equals the board's in hiring him. Because the bank has not shown that the banker intended to cause the bank a loss or that he benefited financially from his omissions and ineptness, it will not recover on the bond. Fidelity and competence are different. First Bank will take nothing from Progressive Insurance Company.” This case is Progressive Casualty Insurance Company v. First Bank, 828 F.Supp. 473 (S.D. Tex. 1993).

And, as noted earlier, some employee dishonesty forms state that the employee can commit a dishonest act with the intent to benefit some third party and coverage will be triggered. Thus, in the case of Hanson, discussed earlier, Laviola's action in overpaying for the by-products was held to benefit the supplier, even though Laviola's stated intent was to keep his department operating.

Manifest Intent

One of the most vexing things to determine with regard to employee dishonesty is whether the action was carried out with the manifest intent of causing a loss and reaping financial benefit. As noted in the Introduction, Webster's Collegiate Dictionary (Tenth Edition) defines manifest as “1: readily perceived by the senses and esp. by the sight 2: easily understood or recognized by the mind; obvious.” But how is an intention—something in someone's mind—to be readily perceived by sight? Are all intentions “easily understood”?

Quoting the court in Auto Lenders, “[a]lthough the use of 'manifest intent' in fidelity bonds was intended to bring clarity to policies and, more specifically, to make clear those acts covered or excluded by the policy, the term quickly became a major battleground in employee-dishonesty coverage disputes.” As the various jurisdictions wrestled with the concept, three main criteria evolved to determine whether or not an employee acted with the intent necessary to trigger coverage. (The court in Auto Lenders gives an enlightening discussion of the three criteria.)

The first of these is often referred to as the objective approach. This approach, which is the least used of the three, focuses on the consequences of the employee's action, but not necessarily on his or her state of mind. The problem with this approach is that many actions are reckless or simply stupid (the bank president's actions in Progressive Casualty, discussed earlier, come to mind). And, using recklessness as a standard for determining coverage would appear to grant coverage where none had ever been intended. Most courts hold that recklessness in and of itself, although perhaps an indication of intent, does not satisfy the language requirement of manifest intent. Such was the ruling in Federal Deposit Insurance Corporation v. St. Paul Fire and Marine Insurance Company, 942 F.2d 1032 (6th App. 1991). In this case, a bank president approved several questionable loans—to friends, to persons seeking to buy shares in a company in which he had a financial interest, and to a condominium project in which he also had a financial interest. The loans were not paid off, resulting in substantial losses to the bank. When the FDIC gained control of the bank, it presented a claim to the insurer. The claim was denied, and the FDIC brought suit. The district court found in favor of St. Paul , and the FDIC appealed. The court said, in upholding the verdict, “Intent, as used in ordinary language, is thought to refer to a subjective phenomenon that takes place inside people's heads. In fact, however, the word 'intent' is really shorthand for a complicated series of inferences all of which are rooted in tangible manifestations of behavior. For us, the external behavior ordinarily thought to manifest internal mental states is all that matters. We need not concern ourselves with the question of whether mental states actually exist, as an ontological matter.” The court upheld the insurer, finding that had the loans been repaid the bank president would have also benefited.

The next criterion regularly used (at least, in the federal courts), is substantial-certainty. Applying this test means that the act is substantially certain to result in a loss. It is akin to the objective approach, but places more emphasis on the “loss” aspect. In other words, the employee might or might not have the intention of causing his or her employer to sustain a loss, but the employee should know that the actions will, for the most, result in a loss. The problem here, of course, is that the criterion overlooks the employee's mental state and makes the guilty employee less culpable. So, for example, Andrew Fastow (CFO of Enron) might have been substantially certain that his accounting practices would one day result in Enron's collapse, but his stated intent was to benefit the company. Thus, the substantially certain result of an action can be poles apart from the intent that triggered the action.

Many federal courts, however, use this approach in determining coverage. The case of Federal Deposit Insurance Corporation v. United Pacific Insurance Company, 20 F.3d 1070 (10th App. 1994) involved a bank president who engaged in several complicated loan transactions. The first of these was disapproved by the State of Utah Commissioner of Financial Institutions. The loan agreement was not finalized; however, soon thereafter the bank president entered into another loan transaction nearly identical in nature to the first. (Both loans had to do with setting up tax shelters comprised of oil and gas drilling limited partnerships. Both loans were secured with certificates of deposit and promissory notes of questionable credibility.) This time, however, he did not seek approval from the Commissioner.

One of the principals of the tax shelter pleaded guilty to securities and tax fraud, and the tax shelter investors sued the bank, demanding their promissory notes and certificates of deposit. The State moved in, closed the bank, demanded the president's resignation, and appointed the FDIC as receiver. The FDIC presented a claim to the insurer, which was denied. At trial, the jury found for the FDIC, and an appeal ensued. The insurer claimed that the FDIC had failed to prove that the loan transaction had come within the coverage agreement—that is, that a loss resulting directly from a dishonest or fraudulent act had been committed by the employee with the manifest intent to cause the insured to sustain a loss, and to obtain personal financial benefit.

The insurer held that manifest intent meant that there was a requirement of “purposeful deleterious conduct” and that the jury had not been instructed as to this. The court, however, held a different view. The court reviewed the jury instructions regarding manifest intent, the first of which was “[t]he concept of 'manifest intent' does not require that the employee wish for or desire a particular result, but it does require that the result be substantially certain to happen.” The second instruction was “'Manifest intent' means apparent or obvious intent. 'Manifest intent' does not necessarily require that the employee actively wish[es] for or desire[s] a particular result…” A later instruction to the jury is to consider that “[I]ntent and motive should not be confused. Motive is what prompts a person to act, or fail to act. Intent refers only to the state of mind with which the act is done or omitted. Good motive is never a defense where the act done or omitted is dishonest or fraudulent. So, the motive of Starley [the bank president] is immaterial except insofar as evidence of motive may aid in the determination of intent. There was an intent to cause the bank to sustain a loss if the natural result of Starley's conduct would be to injure the Bank even though it may not have been his motive.”

The court agreed with these instructions and found for the FDIC and against the insurer. The court added that the statement in the instructions that the concept of manifest intent did not require that “the employee actively wish for or desire a particular result” was an accurate description of the applicable legal standard.

As noted above, finding simply on the basis of outcome, rather than on the intention behind the outcome, would appear to ignore the word intent—which is the employee's thought process—and focus on the word manifest—how the thought process has been made apparent in the physical reality. However, that is the approach many courts have taken.

The third approach taken by many courts is to look at the specific intent of the employee causing the loss. Thus, the court in the case of Federal Deposit Insurance Corporation v. National Union Fire Insurance Company of Pittsburgh, PA., 205 F.3d 66 (2nd Cir. 2000), applied New York law and found that the “manifest intent required to trigger coverage under fidelity bond does not require that insured's employee actively wish for or desire a particular result, but can exist when a particular result is substantially certain to follow from the employee's conduct.” Though this might appear to be the substantially certain test, the court added that “whether a fidelity bond's manifest intent requirement has been satisfied is discerned by considering the relationship between the employee and the employer-insured, the employee's knowledge that his conduct may cause the insured a loss, and all other surrounding circumstances bearing upon the employee's purpose.” In this case, a bank trustee served on the mortgage and real estate committee. Unbeknownst to the bank, he was also a partner with a construction manager hired to oversee development of condominium units at a country club. The bank and the construction manager owned the project, which was financed by the bank. Several of the manager's employees told the bank trustee that the construction manager was stealing from the project—taking kickbacks, over-billing, and using the bank's loan to finance personal expenses. The bank trustee did nothing, and at trial said he could not recall being told this. Other witnesses testified that the trustee took steps to protect his interest in the projects he shared with the construction manager, but did nothing to protect the bank's interest. Ultimately, the condo project failed when the units either were not built or were not sold. The bank was left with some $8 million in unpaid debt. The FDIC stepped in and issued a “cease and desist” from unsafe banking practices order to the bank. The bank learned of the trustee's involvement, and he was forced to resign. The bank was closed to the public and the FDIC appointed receiver.

The FDIC filed a proof of loss with National Union, and National Union denied the claim. At trial, FDIC filed a motion for summary judgment, which was granted. National Union appealed, and this action followed. The court first looked at whether a dishonest act had been committed, and ruled that the trustee's failure to disclose the manager's fraudulent conduct fulfilled this fidelity bond requirement.

Next, the court examined whether the trustee's act had been committed with the manifest intent to cause a loss. The court noted that the New York Court of Appeals had not yet addressed the issue, and so it looked at the lower New York courts and also other circuits. The court looked at two of its earlier decisions, and said that, taken together, they were “properly interpreted as defining manifest intent to require that the insured establish that the employee acted with the specific purpose or object to harm the insured…. Having determined that a court should examine objective indicia of intent and that recovery under a fidelity bond requires that the employee acted with the purpose or desire of causing his or her employer a loss, we now examine the related issue of what evidence circumstantially demonstrates that the employee acted with the specific purpose to cause the insured harm.”

Many courts use some combination of the substantial certainty and the specific intent criteria. Thus, the court in National Union Fire Insurance Company of Pittsburgh, PA also noted with approval the decision in Resolution Trust Corporation v. Fidelity and Deposit Company of Maryland, 205 F.3d 615 (3rd App. 2000), which said that coverage required that the insured prove that the employee engaged in the dishonest or fraudulent acts with specific purpose, object or desire both to cause loss and obtain financial benefit; although “purposefully” rather than “knowingly” better captured the sense in which intent was used, the employee's knowledge that loss was substantially certain to result could be considered, along with other factors, as objective indicia of intent