• "Salary And Benefits" Exclusion In Fidelity Bonds Applies To Unearned As Well As To Earned Compensation
  • December 9, 2003 | Author: Richard S. Feldman
  • Law Firm: Rivkin Radler LLP - Uniondale Office
  • A fidelity bond does not afford coverage to employers for all losses resulting directly from fraudulent and dishonest employee conduct. Rather, the fidelity provision sets forth a subclass or type of dishonest or fraudulent conduct that may be covered under the bond. Typically, it promises to indemnify the insured for:

    "(A) Loss resulting directly from dishonest or fraudulent acts of an employee committed alone or in collusion with others. Dishonest or fraudulent acts as used in this Insuring Agreement shall mean only dishonest or fraudulent acts committed by such Employee with the manifest intent:

    "(a) to cause the Insured to sustain such loss, and

    "(b) to obtain financial benefit for the Employee or for any other person or organization intended by the employee to receive such benefit, other than salaries, commissions, fees, bonuses, promotions, awards, profit sharing, pensions or other employee benefits earned in the normal course of employment."

    Broken down into its components, this provision requires that the following elements be present in order for a loss to constitute a covered event:

    1. the insured must incur a loss;

    2. the loss must have resulted directly from dishonest or fraudulent acts of an employee or employees;

    3. the employee must have committed the acts with the manifest intent to cause the insured to suffer the loss sustained;

    4. the employee must have committed the acts with the manifest intent to obtain a financial benefit for the employee or a third party, and

    5. the financial benefit obtained must not be of the type covered by the "salary and benefits" exclusionary clause.

    Salary And Benefits Exclusion

    The salary and benefits exclusion has been standard in fidelity bonds since 1980. Prior to that time, similar language was frequently added to policies by rider. The rationale for the standard exclusion is two-fold. The exclusion avoids the involvement of insurers in employer-employee disputes about entitlement to salary, commissions, or benefits, for in all such cases the conduct of the employee is within the internal control of the insured employer. The exclusion also was a response to some court decisions that expanded coverage beyond the limit intended by insurers.1

    Since the introduction of the standard salary and benefits exclusion, most courts that have considered the issue have taken a restrictive view of the type of employee dishonesty that is covered by the fidelity bond. The recent decision by a Maryland appellate court in ABC Imaging of Washington, Inc. v. The Travelers Indemnity Co. of America2 illustrates that predominant view.

    The ABC Imaging Case

    The Maryland case involved ABC Imaging of Washington, Inc., a District of Columbia business engaged in printing, blueprinting, and graphics in the Washington, D.C., area. The Travelers Indemnity Company of America provided a business insurance policy to ABC Imaging, the coverage of which included a fidelity bond insuring against loss resulting from employee dishonesty.

    ABC Imaging alleged that it hired Darrell Miller as an assistant department manager at its main office in Washington, D.C., on November 17, 2000, at an annual salary of $29,000, or $558 per week. As a result of a data entry error, a clerk at ABC Imaging entered Miller's weekly pay rate rather than his hourly pay rate in records that were used by an outside source to generate paychecks for ABC Imaging employees. Thus, between November 20, 2000, and January 7, 2001, the six week period in which he was employed by ABC Imaging, Miller received and cashed paychecks totaling $54,832.32, or $52,432.32 more than he was entitled to receive.

    When ABC Imaging discovered the error on January 7, 2001, its management confronted Miller about the matter, whereupon Miller allegedly ran from the premises, never to return. The next day ABC Imaging's attorney sent correspondence to Miller demanding return of the overpaid funds. Miller neither responded nor returned the money.

    Several weeks later, ABC Imaging submitted a proof of claim to Travelers as required by its insurance policy. Travelers denied the claim, asserting that the manner by which the funds came into Miller's possession fell within the "salary" exclusion of the policy.3 ABC Imaging filed suit against Travelers, alleging breach of contract, unfair claim practices violations, and misrepresentation. ABC Imaging and Travelers filed cross-motions for summary judgment. After a hearing, the court entered summary judgment in favor of Travelers on each of ABC Imaging's claims, and ABC Imaging appealed.

    In its decision, the Maryland appellate court observed that there are two prongs to the proof required for ABC Imaging to recover for employee dishonesty under the policy written by Travelers. First, there had to be proof of Miller's "manifest intent" to cause loss to ABC Imaging. Second, there had to be proof that Miller, by his dishonest actions, obtained a benefit for himself "other than salaries, etc." The appeals court focused on the second prong -- whether the benefits obtained by Miller were, or were not, salary, as defined by the policy language.

    With respect to this issue, ABC Imaging asserted that, unless the payments were made to Miller in the honest belief that they were for salary, the exclusion should not apply. Therefore, it argued, because the payments to Miller could not have been made in the honest belief that the inflated amounts were due, the sums paid were not salary. As the keystone of its argument, ABC Imaging, cited various provisions of the Maryland Code and asked the appellate court to define "salary" as "compensation due," or "contracted and agreed upon by the employer and employee," definitions that could not include funds "accidentally or erroneously paid to an employee."4

    In essence, ABC Imaging argued that because Miller expressly contracted for an annual salary of $29,000, any amount erroneously delivered to him had no relationship to the amount of contracted salary. It posited that the overpayment could not reasonably be considered to be salary and, therefore, was not excluded from coverage. ABC Imaging emphasized that there was no doubt that it did not "knowingly" make the overpayment to Miller. Thus, it contended, Miller's dishonesty was not in the creation of the overpayments, but rather in his retention of the funds with the knowledge that he was not entitled to the excess payments.

    The appellate court was not persuaded by ABC Imaging's arguments. It found the policy language to be unambiguous and concluded that it excluded coverage even when the only financial benefit gained by the dishonest employee was additional salary or commissions to which the employee was not entitled. In reaching that conclusion, the Maryland appellate court pointed to the decision in Resolution Trust Corp. v. Fidelity & Deposit Co. of Md.5

    In the Resolution Trust Corp. case, employees of a lending institution earned a salary bonus based upon the closing of a substantial loan transaction that thereafter was discovered to have been fraudulent. In discussing a fidelity bond exclusion that was virtually the same in wording as the exclusion in the ABC Imaging policy, the Third Circuit Court of Appeals noted:

    "Attempts to limit the exclusion to financial benefits [such as salaries and commissions] earned in the normal course of employment have been rejected. The words 'earned in the normal course of employment' do not modify the enumerated exclusions that precede them, but are intended to include in the list of excluded benefits other benefits typically earned by employees."6

    The Third Circuit concluded that recovery of the fraudulently obtained bonuses was precluded by the exclusion, noting that "the 'earned in the course of employment' language is descriptive of the character of the payment . . . rather than the frequency with which the payment is received or the timing of its receipt."7

    With this ruling to rely upon, the ABC Imaging court held that a fidelity bond containing the standard industry exclusion, as in the ABC Imaging policy, "clearly and unambiguously excludes from coverage" the acts of an employee who fraudulently or dishonestly obtains salary or commissions. Accordingly, it affirmed the lower court's judgment.

    Other Decisions

    Other courts have reached the same conclusion as to the effect of the "salary" component of the exclusion. For example, Hartford Acc. & Indem. Ins. Co. v. Washington Nat'l. Ins. Co.8 involved a claim against a fidelity bond containing the standard exclusion language. The claim arose when it was determined that two employees of the insured had conceived and implemented a scheme whereby inflated sales of life insurance policies resulted in payment to them of excessive commissions. In denying coverage based upon the exclusion, the district court observed that:

    "all types of commissions and salaries are excluded from indemnity coverage, even commissions and salaries which have not been earned in the normal course of employment. More precisely, all courts to speak on the matter have found the industry-wide definition of 'dishonest and fraudulent acts' to be unambiguous; that definition excludes recovery for losses resulting from an employee's intent to obtain a financial benefit for himself from commissions. . . . Any sort of commission benefit is exempt from fidelity coverage, even unearned commissions."9

    Another case, Berger v. Fireman's American Loss Control Co.,10 involved an automobile leasing business. One of the salesmen, Thomas Miller, fraudulently led the owner to believe that he had obtained lease agreements for over 150 cars. For these agreements, Miller was paid commissions. In explaining why it was rejecting the company's claim that the insurance policy covered the losses it sustained as a result of the fraud, the court said that the insured:

    "would have us read the language of subsection (b) as follows: 'to obtain financial benefit for the Employee, . . . other than salaries, [or] commissions . . . earned in the normal course of employment.' Appellant asseverates that the phrase 'earned in the normal course of employment' indicates an intent to limit the scope of the exclusion. Since the financial benefits which Miller obtained were not earned at all, they obviously could not be earned in the normal course of employment. Therefore, they are not excluded from coverage."

    The court said that it had an "entirely different" view. It observed that the phrase "other employee benefits" preceded the phrase "earned in the normal course of employment." Because there was no comma between these two phrases, the court continued, it was "clear" that they were to be read together as one phrase. "Such a reading makes substantive sense in that prior to this phrase, the exclusionary clause names specific examples of the general category of employee benefits earned in the normal course of employment. A proper reading of the pertinent language is: 'to obtain financial benefit for the Employee, . . . other than salaries, [or] commissions,'" the court declared. Put simply, it ruled, the policy "clearly and unambiguously" excluded from coverage the acts of an employee who fraudulently or dishonestly obtained salary or commissions.

    Thus, the court concluded, all types of commissions and salaries were excluded from indemnity coverage, even commissions and salaries that had not been earned in the normal course of employment.11

    Minority View

    It should be noted that there have been isolated decisions to the contrary. For example, in Klyn v. Travelers Indem. Co.,12 an insured's comptroller allegedly embezzled funds from a payroll account over which he had sole control by secretly and fraudulently paying himself unauthorized and excessive salary, commissions, and bonuses. In rejecting the insurance carrier's argument that recovery was barred under the policy provision excluding "salaries, commissions, fees, bonuses, . . . or other benefits earned in the normal course of employment," based upon the plaintiff's allegations that it did not knowingly make the payments to the comptroller as compensation for his employment, the court held:

    "Where the employer does not knowingly pay funds to its employee under the belief that the funds have been honestly earned, but is instead unaware of the employee's receipt of the funds or pays the lost funds for some purpose other than the employee's compensation, the employee has committed pure embezzlement which is recoverable under the [policy]."13

    The same result was reached in Cincinnati Ins. Co. v. Tuscaloosa County Parking & Transit Auth.,14 a case involving employee embezzlement. In that case, when the dishonesty was discovered, the insured made a claim under a fidelity bond containing the standard exclusion. After determining that the language of the exclusion was not ambiguous, the Supreme Court of Alabama resorted to standard dictionary definitions of "salary" and "earned," and held that because the embezzled funds were not earned, the loss was covered.15 The Alabama court opted for what is clearly the minority view of the exclusion and stated: "The parties cite cases that are not binding on this Court. Some are consistent with our holding; some are not relevant."16


    As the majority of courts that have considered the issue have concluded, the salary and benefits exclusion in a fidelity bond bars coverage for an employer's claims stemming from an employee's actions that inflate salary or other compensation paid to the employee. This view seems quite correct, and as a practical matter means that insurance companies will not have to become involved in employer-employee disputes about an employee's entitlement to such compensation.

    1 See Jane Landes Foster, Jeffrey A. Lutsky and Daniel T. Fitch, Does a Criminal Conviction Equal Dishonesty? Criminal Intent Versus Manifest Intent, 24 Torts & Ins. L.J. 785, 800-02 (1989).

    2 820 A.2d 628 (Md. App. 2003).

    3 The fidelity bond provisions of the policy written by Travelers and issued to ABC Imaging contained the following exclusion:

    "G. Property Definitions

    "1. a. 'Employee(s)' means:

    "(1) Any natural person:

    "(a) While in your service (and for 30 days after termination of service); and

    "(b) Whom you compensate directly by salary, wages or commissions; and

    "(c) Whom you have the right to direct and control while performing service for you....

    * * *

    "2. 'Employee Dishonesty' means only dishonest acts, including 'forgery' or extortion, committed by an 'employee,' whether identified or not, acting alone or in collusion with other persons, except you or a partner, with the manifest intent to:

    "a. Cause you to sustain loss; and also

    "b. 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:

    "(1) The 'employee'; or

    "(2) Any person or organization intended by the 'employee' to receive that benefit."

    4 See Md. Code Ann., Lab. & Empl. §§ 3-401(e), 3-501, 10-101(g) (1999 Repl. Vol. & 2002 Supp.) (all defining "wage"); see also former Md. Ann. Code art. 100, § 94 (Repl. Vol. 1985) (repealed by Acts 1991, ch. 8, § 1, effective Oct. 1, 1991 and replaced with Md. Ann. Code, Lab. & Empl. Article).

    5 205 F.3d 615 (3d Cir. 2000).

    6 Id. at 647 (quoting Foster, et al., supra, 24 Torts & Ins. L.J. at 789).

    7 Id. at 648.

    8 638 F. Supp. 78 (N.D. Ill. 1986).

    9 Id. at 83.

    10]Slip op. Court of Appeals, M.D. No. 508 (Dec. 16, 1982).

    11 Slip op. at 3-4; see, also, Resolution Trust Corp. v. FDIC, supra, 205 F.3d at 649 (3rd Cir. 2000) (stating that the "'earned in the course of employment' language is descriptive of the character of the payment at issue"); Municipal Sec., Inc. v. Insurance Co. of N. Am., 829 F.2d 7 (6th Cir. 1987) (per curiam) (affirming summary judgment in favor of the defendant insurance company because the employee sought only to enhance her regular commissions); Auburn Ford Lincoln Mercury, Inc. v. Universal Underwriters Ins. Co., 967 F. Supp. 475 (M.D. Ala.) (rejecting the insured plaintiff's argument that the dishonest employee would not have received the additional commissions "in the normal course of his employment"), aff'd, 130 F.3d 444 (11th Cir. 1997); Benchmark Crafters, Inc. v. Northwestern Nat'l Ins. Co., 363 N.W.2d 89, 91 (Minn. App. 1985) (reversing verdict in favor of insured where it was "uncontroverted that [the dishonest employee] did not gain anything except his regular salary).

    12 709 N.Y.S.2d 780 (N.Y. App. Div. 4th Dep't 2000).

    13 Id. (quoting Federal Deposit Ins. Corp. v. St. Paul Fire & Mar. Ins. Co., 738 F. Supp. 1146, 1160 (M.D. Tenn. 1990), mod. on other grounds, 942 F.2d 1032 (6th Cir. 1991).

    14 827 So. 2d 765 (Ala. 2002).

    15 Id. at 768.

    16 Id. (internal footnotes omitted).