The recent decision in National Credit Union Administration Board, as Liquidating Agent of St. Paul Croatian Federal Credit Union v. CUMIS Insurance Society, Inc., from the U.S. District Court for the Northern District of Ohio, is yet another case illustrating how important the precise terms of a policy can be in determining the coverage. As we’ve previously discussed on this blog (here and here), a D&O insurance policy is reliable protection for the indemnification rights of the officers and directors in times of financial distress. Many policies also offer coverage to the entity for injuries caused by misdeeds of its employees. The St. Paul case illustrates what can happen when the employee charged with procuring the insurance policy on behalf of the entity is also the party engaging in fraudulent conduct.
St. Paul Croatian Federal Credit Union (“St. Paul”) was established in 1943 to serve members of St. Paul Croatian parish in Cleveland, Ohio. For more than 53 years it operated from a single branch with about 3 employees. In 1996, a manager retired and one of the tellers, Anthony Raguz, was promoted to fill his position. The credit union grew tremendously over the next fifteen years, and by March 31, 2010, St. Paul had total assets of $250 Million and a loan portfolio of $240 Million.
However, according to the district court’s decision, not all was well behind the scenes. The district court recited the following facts. In 2000, without the board of directors’ knowledge, Mr. Raguz began accepting bribes in exchange for loan approvals starting in 2000. To conceal his fraudulent activity, Mr. Raguz had several operational techniques. For example, if a fraudulent loan was in jeopardy of default, Mr. Raguz created another, completely fictional, loan and used the proceeds from that transaction to make payments on fraudulent loan. Mr. Raguz also concealed his fraud by “resetting” loans which were about to become delinquent by creating transactions which resembled refinance of the loans. Mr. Raguz would roll the accrued interest and penalties into the outstanding principal and issue a new loan for that amount. The proceeds of the new loan would be applied to pay off the older loan.
These techniques allowed Mr. Raguz to avoid reporting the loan as delinquent. In fact, St. Paul reported no loan delinquencies at all during the period Mr. Raguz was manager. Mr. Raguz’s fraudulent conduct continued unabated for about 10 years until St. Paul collapsed and was taken over by regulators.
The liquidator appointed to administer St. Paul’s assets made a claim for losses caused by Mr. Raguz under a bond policy CUMIS had issued in favor of St. Paul. (Bond policies insure a policyholder against losses caused by the dishonest acts of its employees.) CUMIS notified the liquidator that it was rescinding the bond policy on the basis that Mr. Raguz had made material misrepresentations on the applications he submitted to obtain and renew the bond policy. The Liquidator then sued CUMIS to enforce the bond policy. At that point, the District Court for the Northern District of Ohio was faced with the question of whether CUMIS could rescind the policy, when the undisputed record showed that Mr. Raguz lied on all of the applications and renewal for the bond policy.
Relying on prior Ohio case law, the Liquidator claimed that the policy could not be rescinded because (1) the applications were not expressly incorporated into the policies and (2) the policies did not include a statement providing clear notice that that material misstatements in the applications would render the policies void ab initio (from the beginning, as if the policies never existed). To resolve the Liquidator’s claims, the court examined whether the statements in the application qualified as a representation, or whether they were a warranty. “In the law of insurance,” said the court, “a representation is a statement made prior to the issuance of a policy which tends to cause the insurer to assume the risk. A warranty is a statement, description or undertaking by the insured of a material fact either appearing on the face of the policy or in another instrument specifically incorporated in the policy.” Thus, if the statement is incorporated into the policy, it qualifies as a warranty; if it is not, then it is merely a representation.
Under the court’s opinion, this distinction is critical. If a statement of fact is a warranty, then any misstatement of the fact allows the issuer to declare the policy void ab initio. In contrast, if the statement at issue is a representation, a misstatement will only render the policy voidable. If the policy is void ab initio, then the insurer is free to rescind the policy and avoid responsibility for losses at any time. In contrast, if the policy is merely voidable or subject to cancellation at the time the true facts become known to the insurer. The insurer cannot, however, avoid liability under the policy if it discovers the fraud after a loss was incurred.
Applying these principles to the St. Paul policy, the court found that neither the statements of Mr. Raguz nor the applications themselves had been incorporated into the policy. Although the applications submitted by St. Paul contained material misrepresentations and the policy referenced the application, the court held that the application was not incorporated into the policy. The court found that in order for the applications to have been incorporated into the policy, the incorporation must have appeared “in unequivocal language on the face of the policy.” Although the policy referenced the applications, when the court compared the language to other cases in which the application had been successfully incorporated into the policy (including a D&O case, The Unencumbered Assets, Trust v. Great American Insurance Co., 817 F. Supp. 2d 1014 (S.D. Ohio 2011)), it found that the specific language of incorporation was not present in the St. Paul policy.
In addition, the court found that the policy did not contain any express condition that a misstatement in the application would render the policy void ab initio. CUMIS relied on language that alerted St. Paul to the possible consequences of misstatements, but that language appeared only in the application. Since the court had already determined that the application was not incorporated into the policy, the fact that the warning also appeared in the application prevented it from being effective.
St. Paul teaches a number of lessons to insurers and insureds. In the first instance, employers must be diligent in their applications for D&O insurance. Misstatements, mistakes and false statements can be the basis for your insurer to avoid coverage when you need it most. Of course, when the person who has created and concealed the fraud is also responsible for the procurement of insurance, the entity is at great risk. While courts may do what they can in such a circumstance to avoid loss of coverage, the company should not count on it. Strong internal controls and audit procedures, including double-checking insurance applications so that they are not left in the hands of a single person, can help companies avoid corporate fraud and misstatements to insurers.
In any event, insureds should review their policies carefully to determine whether the statements in the application have been incorporated into the policy and on what bases the insurer may cancel the policy. Otherwise, the insured may find that the policy is unavailable when it is needed most. Meanwhile, insurers who want to be protected from having to provide coverage when the insured has misrepresented critical facts on an application should check the language of their policy documents to see if they track the incorporation requirement set forth in St. Paul. If both insurers and insureds are focused on this issue, this may be a point for further negotiation.
The fact that the court found that the policy was not void ab initio was not the end of the matter for St. Paul. In our next post, we will discuss the other arguments CUMIS made in support of its efforts to terminate the bond policy without covering St. Paul’s claims.