FIDELITY BOND GETS NARROW READING

August 13, 2004

Steven P. Garmisa
Hoey & Farina Attorney
garmisa@hoeyfarina.com
1-888-425-1212

Answering a question of first impression in Illinois, the Appellate Court followed the "resoundingly uniform" rule that the phrase "direct loss" gets a narrow interpretation in a fidelity bond.

The court also declared -- in what is arguably dicta -- that a sophisticated insured is "undeserving" of benefiting from the traditional rules for strictly construing insurance policies against the insurer. RBC Mortgage Co. v. National Union Fire Insurance Co., 2004 WL 1469417 (Ill.App. 1st Dist.) (June 30).

The case involved Brandon Earl, employee of a mortgage banking firm, RBC, who forged documents to get a $450,000 loan. RBC, which was owned by First City, sold the loan to a third party, EMMC. So, RBC didn't suffer an immediate financial loss from the fraud.
When the fraud was uncovered, EMMC filed a lawsuit against RBC/First City. After setting this lawsuit, RBC claimed coverage under a Fidelity Bond issued by National Union.

The Cook County Circuit Court granted the insurance company's motion to dismiss, and RBC/First City appealed.

Here are some highlights of Justice Allen Hartman's opinion (with various omissions not noted in the quoted text):

"The insuring agreement between First City and National Union was in the form of a financial institution bond or fidelity bond, in effect from March 1, 1999, to March 1, 2002. Under Insuring Agreement A entitled "Fidelity," National Union promised to indemnify RBC for:
" '(A) Loss resulting directly from dishonest or fraudulent acts committed by an employee acting alone or in collusion with others. Such dishonest conduct or fraudulent acts must be committed by the employee with the manifest intent:

" '(a) to cause the insured to sustain such loss; and
" '(b) to obtain financial benefit for the Employee or another person or entity.'

"The policy does not provide a definition for 'loss resulting directly from,' and excludes from coverage generally 'indirect or consequential loss of any nature.' The agreement permitted National Union to 'elect' whether to provide a defense for RBC in the event of a claim against it."

Moving to dismiss, National Union argued that the loss to RBC/First City -- in having to pay the settlement agreement with EMMC -- isn't the kind of "direct loss" covered by the fidelity bond.

Agreeing with National Union, the trial judge, the late Lester D. Foreman, commented that "courts throughout the land take, surprisingly, a very, very narrow approach to fidelity bonds with regard to this issue of direct loss. [T]o suffer a direct loss[,] it's got to be a situation where the employee puts his hand in the employer's pocket. And if it turns out that the loss occurred as a consequence of the involvement of a third party[,] that's not what fidelity bonds insure against."

Affirming Foreman's ruling, Hartman recounted, "RBC maintains that National Union denied coverage for the very risk it contemplated in purchasing the bond. RBC contends: (A) the Circuit Court erred in finding 'direct loss' to be unambiguous, and the language must be construed strictly against National Union as drafter of the policy; and (B) the question of whether the loss is direct or not should be examined under the 'proximate cause' standard, which would give rise necessarily to unresolved questions of fact. RBC requests that the matter be remanded for further proceedings.

"RBC argues that it incurred 'direct' losses from the dishonest and fraudulent conduct of its employee, Earl. These losses, it urges, emanate from the settlement agreement with EMMC, and manifest themselves in the form of a reduced market value of the fraudulent loans it re-purchased from EMMC, and the compensatory payments made to EMMC for losses already incurred.

"RBC construes these losses as 'flow[ing] "directly" from the dishonesty of [its] employee.' RBC insists that as the insured, the bond's language should be construed broadly in its favor, and strictly against National Union.

"National Union counters that RBC is 'attempting to manipulate a first-party fidelity bond to deflect third-party liability to their insurer.' It argues RBC suffered no losses where EMMC, not First City, actually funded the loans, and that RBC could not have lost the loans' market value since EMMC never paid market value to RBC; instead, it paid only a brokerage fee.

"Even if Earl's fraud caused RBC to lose money, National Union maintains, the 'losses are entirely derivative, based solely on [RBC's] contractual liability to a third party,' EMMC. For losses to be 'direct,' they must be immediate, definite, and ascertainable, such as in cases of theft or embezzlement.

"National Union points out that RBC did not file its proof of loss upon discovery of the fraud in December of 1999, or when it was sued by EMMC in March of 2000, but waited instead until June of 2001, once the settlement was reached.

"Fidelity insurance is a form of insurance in which the insurer undertakes to guaranty the fidelity of an officer, agent, or employee of the insured, or to indemnify the latter for losses caused by dishonesty or a want of fidelity on the part of such a person. Although there is no Illinois case addressing 'direct loss' in the context of fidelity insurance, the law, as extrapolated from other jurisdictions, is resoundingly uniform on this issue.

"Language in a fidelity bond, to the effect that the insured is covered for 'losses directly resulting from,' signifies a 'direct loss' or the actual depletion of bank funds caused by the employee's dishonest acts.

"If an employee's dishonesty causes losses to a third party, which then leads to litigation concluding in a judgment or settlement, the insured has not incurred a 'direct loss' under a fidelity bond; the insured's loss is 'indirect' and the third party's loss is 'direct.'
"To find coverage in these circumstances would convert a direct loss policy into a third-party indemnity policy or liability policy, under which the liability insurer indemnifies its insured for the insured's 'indirect' loss, but payment, in practical effect, runs directly to the third-party claimant.

"In the absence of a third-party-claims clause, an insured's fidelity bond, unlike a liability policy, does not provide indemnity for vicarious liability for losses suffered by others arising from its employee's tortious conduct.

"In Tri City National Bank v. Federal Insurance Co., 674 N.W.2d 617 (2003), a case strikingly similar to the instant case, the Court of Appeals of Wisconsin addressed the precise question presented in the case at bar.

"On appeal, Tri City initially argued, as does RBC here, that the bond's language was ambiguous and should be construed in favor of Federal as drafter of the policy. The Court of Appeals of Wisconsin stated, 'should there be any ambiguity, the wording of fidelity bonds is not construed strictly against the drafter because the justification behind the rule -- unequal bargaining power -- has been eliminated.'
"The court also determined the operative language to be unambiguous, stating that 'the bond clearly restricts indemnification to those losses that occur as a direct result of an employee's dishonest acts. This language is not susceptible to more than one meaning.'

"The court noted that it was only after the mortgage defaults occurred, about three years after the fraudulent conduct, that Tri City's liability to the mortgage companies came into being.
"In the case sub judice," Hartman continued, "it must be noted initially that the phrase 'resulting directly from' is clear and unambiguous, and must be afforded its plain and ordinary meaning.
"Despite RBC's insistence that the 'policy language may be construed in more than one way,' an ambiguity is not created simply because the parties disagree about the meaning of the policy language. Courts will not strain to find ambiguity in a policy where none exists and, here, the language of the bond makes clear that indemnification is restricted to only those losses occurring as a 'direct' result of the employee's fraudulent acts.

"Although RBC observes correctly that the phrase is not defined in the policy, as are other terms, the mere absence of a definition does not itself render a policy term ambiguous.

"Because the phrase is unambiguous, the rules of construction need not be applied in interpreting the subject language of the fidelity bond. Nevertheless, First City is engaged in the business of mortgage brokering, and RBC, its parent company, is a corporate entity responsible for both mortgage brokering loans, as well as mortgage banking. In this capacity, RBC's bargaining power is not disparate from that of National Union, and is undeserving of the usual rules of construction.

"The history of Standard Form No. 24, the form at issue here, further compels this conclusion. Therefore, despite RBC's protestations that it had a reasonable expectation of coverage for this type of loss, and that it would not have 'purchased such useless protection' had it been aware that National Union 'intended to limit coverage it afforded RBC to the "paradigmatic cases of theft and embezzlement," ' the policy will be applied as written. Courts will generally avoid interpretations that render contract terms surplusage, and must strive to give each term in the policy meaning unless to do so would render the clause or policy inconsistent or inherently contradictory.

"Under this framework, RBC's losses were derived, not directly from the conduct of Earl, but from RBC's breach of the warranty contained in the brokerage agreement with EMMC. Had there been no contractual liability on the part of RBC for the fraudulent loan packages, RBC would not have incurred monetary losses.
"EMMC, however, in electing to sue and, ultimately seek a settlement from RBC, provided a distinct intervening cause displacing Earl's fraud as the direct cause of the losses. Earl's actions merely set into motion the chain of events that would later result in RBC's liability to EMMC.

"Further, as in Tri City, RBC suffered no losses at the time of the fraud. Its losses did not come into being until after the settlement agreement, one and one-half years after the fraudulent conduct. 'This fact, in itself, illustrates the "conditional nature" of the loss, taking it out of the policy.' The Vons Cos. v. Federal Insurance Co., 57 F.Supp.2d 933, 944 (C.D.Cal.1998), aff'd, 212 F.3d 489 (9th Cir.2000).

"Since RBC is unable to plead facts that would entitle it to relief under the law, the Circuit Court's dismissal of its complaint was proper under section 2-615."

"RBC maintains that proximate cause is the proper standard to apply in determining whether a loss is direct or indirect.

"In Tri City, the insured similarly argued that the 'proximate cause' standard should govern the analysis of direct loss. The court, however, found the standard to be inapplicable in the context of employee dishonesty policies. The court noted that in the fidelity bond cases applying the proximate cause standard, causation was at issue only in the context of losses of the insured's own property, or that for which it was legally responsible, and the question to be resolved was whether some intervening event broke the causal connection between the dishonest conduct of an employee and the insured's loss.

"In the present case, adopting the reasoning from the majority of other jurisdictions, the proximate cause analysis simply is too broad to capture accurately the intent behind the phrase 'loss resulting directly from.'

"A 'direct loss' must be afforded its plain and ordinary meaning; 'direct' means 'direct.' To equate 'loss resulting directly from' with 'loss proximately caused by' requires a strained reading of 'direct loss,' which is a much narrower concept than 'proximately caused loss.' This is because a proximate cause need not be the sole cause nor the last or nearest cause. It is sufficient if it concurs with some other cause acting at the same time, which, in combination with it, causes the injury.

"Accordingly, the proximate cause analysis will not be applied to the case at bar."

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