Proof—Roles of Adjusters and Lawyers in Fidelity Recovery

Christopher McKibbin and Arthur Goguen | September 14, 2009

“You only find out who is swimming naked when the tide goes out.”

• Announcing the CI Legal Expert Panel
• Another Twist to Consider—The Allstate Case
• Competition is Fierce—Restrictive Covenants in the Shafron Case
• Internet Use (To Catch Abuse)
• Facebook Litigation Grows
• Proof—Roles of Adjusters and Lawyers in Fidelity Recovery
• Best Practices for Successful Subrogation Recoveries
• State of Securities Class Actions
• Professional Liability and Securities-Related Claims Trends
• Misguided Critique of Covert Surveillance
• Employee Termination—A Risk You Can Manage
• Using Data Analytics to Maximize Company Performance
• Give It Up—Vehicle Fires & Frauds
• Overview of Detection & Investigation Techniques

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This famous aphorism by financial giant, Warren Buffett, applies as strongly in the current economic downturn as it did when he wrote it shortly after 9/11. As more policyholders tighten their belts and review internal operations, it is likely that more instances of employee fraud will come to light.

Previous recessions have seen increases in detection of losses due to employee dishonesty, and it is anticipated that this trend will continue through the current downturn. With more claims being made, the fidelity insurer’s pursuit of subrogated actions, both against defaulting employees and against others whose negligence has facilitated or enabled the fraudulent conduct, will become more prevalent.

Given the current economic climate, it is essential, then, for businesses to analyze their operations to adjust for a fidelity loss, while determining principles to guide the operations on partial or full recovery of subrogated claims.

The Starting Point—The Adjuster’s Investigation

Upon discovery of a fidelity loss, the fidelity insurer appoints an adjuster/claims examiner to handle the claim. In fidelity cases, adjusters are typically specialists.The adjuster’s role, similar to other types of insurance claims, is focused on ascertaining coverage and verifying the quantum of the loss. In a typical fidelity bond, the primary insuring agreement (Coverage A) requires the insured to demonstrate the following:

• A direct loss;
• Which results from dishonest or fraudulent acts by an employee, acting alone or in collusion with others; and
• Such dishonest or fraudulent acts being committed by the employee with the manifest intent to cause the insured to sustain the loss and to obtain a financial benefit for the employee or another person or entity. 

The meaning of each of these terms has been the subject of significant first-party litigation, both in Canada and in the United States. The practical implication of the courts’ approach to interpreting these terms is that the adjuster is required not only to ascertain the nature and quantum of the loss suffered by the insured, but also the intent of the alleged wrongdoer. The quality of the evidence developed by the adjuster on each of these points (nature of loss; quantum of loss; and, most importantly, the defaulter’s intent) can be critical to a later subrogated claim.

Setting up the Recovery Action—Potential Targets and Theories of Liability

Initially, the primary target of the subrogated claim is the defaulter himself. Defaulters are often spendthrifts, but in those cases where assets are still in the defaulter’s possession, it is possible to seek a Mareva injunction to freeze bank accounts, investment accounts and tangible property, provided that a strong prima facie case is made that (i) the defaulter is liable in fraud; and (ii) the stolen funds are traceable to the target accounts or property.

If, as more typically happens, the investigation determines that the defaulter has run through the money and is judgment-proof, counsel will have to assess other possible targets. Some of the common candidates include:

• Transferees of funds, who benefited from receipt of the funds from the defaulter;
• Auditors, who failed to detect ongoing fraud and/or failed to warn of weaknesses in internal controls; and
• Banks/financial institutions unwittingly enlisted by the defaulter into helping to affect the fraud. 

(1) Transferees
A defaulter will often arrange for funds to be transferred into the hands of relatives or associates, on the theory that, once the funds are out of the defaulter’s hands, they can no longer be pursued by the insured or by the fidelity insurer. An example of this situation is a secret-commissions case, in which a rogue employee arranges to make a secret profit or kickback on the transaction. The rogue employee may arrange for the transfer of funds or assets to his wife, other relatives or associates.

In such cases, a court may grant relief against the transferee for unjust enrichment and/or a remedy known as ‘constructive trusteeship,’ which is based on the beneficiary’s receipt of money in circumstances in which he or she knew, or ought to have known, that the funds were obtained through the defaulter’s wrongful conduct. Where a transferee receives funds in such a circumstance, and fails to make appropriate inquiries as to the source of the funds, the transferee may be found liable to the insured.

(2) Auditors
The insured’s auditor may be liable to the insured on the basis of breach of contract and auditor’s negligence.

Most companies, beyond a certain size, obtain audited financial statements, and statutory audits are mandated for some financial institutions, such as credit unions. Here, counsel must keep in mind the limited scope of an auditor’s obligation, usually as defined by its contract with the insured.

The law of auditor’s negligence is still developing, but the courts have recognized two primary duties on the part of the auditor: To probe any fraud or suspected fraud which the auditor either identified or reasonably ought to have identified, and to warn the company of significant weaknesses in internal controls. Essentially, the more glaring the missed evidence of fraud or the failure to warn of weaknesses in internal controls, the more likely a court will conclude that the auditor failed to comply with its standard of care. 

(3) Banks and other Financial Institutions
Where the defaulter has utilized a bank or other financial institution to further his fraud, the bank may be liable on any of several grounds, depending on the manner in which the bank allowed itself to be used:

• Negligence – One example is a bank’s negligence in permitting a mortgage fraud, which causes a loss to a third party. Another example is a bank’s negligence in the opening and operation of its customer’s accounts. The courts have recognized that banks may owe a duty of care to innocent third parties to ensure that the bank account is not used as an instrument of fraud. This is particularly important in fraudulent-invoice schemes, where the defaulter generates cheques and opens an account in the name of a fictitious entity in order to get the cheques cashed—a bank which fails to perform appropriate due diligence on the entity opening the account may be found liable to innocent third parties victimized by the defaulter’s fraud. 
• Bills of Exchange Act – The Bills of Exchange Act and the common law relating to bills of exchange have myriad implications on fidelity recovery work involving cheques, drafts and money orders. The most common application of bills of exchange law in the fidelity context occurs where the insured’s bank pays out the insured’s funds on cheques with forged drawer signatures (typically created by a rogue bookkeeper). In such circumstances, the bank is strictly liable in conversion to the insured, as the bank can take no rights in the cheque through a forged signature. 
• Constructive Trusteeship – This remedy may be granted in circumstances where the transferee of funds takes “knowing receipt” of funds, i.e., receipt where he knew, or ought to have known, that the funds were tainted. However, courts may also impose a constructive trust in circumstances where an entity such as a bank provides “knowing assistance” to the defaulter, i.e., the bank enables the defaulter to remove the funds of others in circumstances in which the bank knew, or ought to have known, that the defaulter was not entitled to the funds. 

Definition of Judgment Proof

Judgment proof refers to a debtor who has little or no assets for a creditor to seek payment of a judgment from. In some cases, a person threatened with or subject to potential litigation may make his or herself judgment proof by diverting his/her assets into holdings that can't be reached by local courts, such as investing their money offshore through offshore trusts and International Business Corporations (IBCs). This becomes a factor when considering whether or not to prosecute for the recovery of funds.

Prosecuting the Recovery Action – Some Practical Considerations

Once the decision has been made to prosecute a recovery action, there are a number of practical considerations, some of which include:

• Deciding whether to sue the defaulter: Even if a defaulter is judgment-proof, it is usually desirable to include him as a defendant in an action against others such as auditors and banks. Either the defaulter will fail to defend, in which case default judgment may be obtained, or he will defend, in which case he is required to submit to documentary and oral discovery. We have seen several instances where defaulters, knowing they are judgment-proof and that they have nothing left to lose, “come clean” during the discovery phase. However, one downside is that a defaulter who defends the action may then hinder its effective prosecution by causing delays and by failing to comply with his procedural obligations, especially when the defaulter is not represented by counsel. 
• Getting information from third parties: In fraud cases, the police, if involved, can be a useful source of information, as can other government agencies. Some government agencies may, however, require a court order compelling them to divulge information gleaned in the course of their investigations. 

Employee dishonesty claims require quick and efficient action by both the adjuster and counsel—with one (trained) eye always on recovery potential—if the fidelity insurer expects to maximize net recoveries.

Christopher McKibbin is a lawyer with Halfnight & McKinlay Professional Corporation, a Toronto insurance litigation boutique. Arthur Goguen is an adjuster with Baker, Bertrand, Chassé & Goguen Claim Services Limited, a nationwide specialty claims adjustment firm.