Fidelity bonds were designed to provide coverage for first-party property loss. Despite the nature of first-party coverage, some U.S. courts have applied tort and liability concepts, rather than the contract terms, to allow coverage for third-party losses. As two recent decisions highlight, fidelity coverage should be limited to direct losses sustained by the insured, except in the limited situation where the insured possessed and controlled a third party’s property at the time it was lost.

Coverage is typically provided for direct financial loss “resulting directly from” or as “a direct result of” covered conduct. The first-party nature of fidelity coverage is confirmed by exclusions for indirect or consequential loss or damages for which the insured is legally liable to third parties. Therefore, coverage is usually not available for payment to resolve the insured’s liability for loss sustained by a third party.

So-called “ownership provisions” provide a limited exception to the direct loss requirement. U.S. courts have narrowly interpreted such provisions to be consistent with first-party coverage, and limited their application to the loss of a third party’s property only while in the possession and control of the insured at the time of the loss, such as when the insured is acting as a bailee or trustee of the property.

The majority of U.S. courts apply the contracted for terms and follow a narrow “direct means direct” approach to causation under fidelity bonds. Under this test, an insured must show that it sustained a depletion of funds as a direct and immediate result of covered conduct, and that the time between the conduct and the loss was not too remote.

Some courts, however, have found direct loss to be “nebulous and largely indeterminate”, and therefore looked to proximate causation concepts drawn from tort law and liability insurance to determine coverage . Under this standard, an insured must show that the insured conduct was a substantial contributing factor to the loss, rather than the sole or immediate cause.

Two recent cases, one involving a fraudulent payment request and the other an advance money scam, which are increasingly common fraudulent schemes, address whether fidelity coverage is available for an insured’s liability for a third party’s loss. In both cases, coverage turned on whether the insured had possession and control over the third party’s funds at the time they were stolen.

In Taylor & Lieberman v. Federal Ins. Co. (2015 WL 3824130 al. June 18, 2015), a federal district court in California analyzed whether a loss incurred by the insured’s client relating to a fraudulent payment request was covered under a policy providing forgery, computer fraud and funds transfer coverage. The insured accounting firm managed its client’s accounts and had power of attorney over the client’s funds held in an account at City National Bank. A perpetrator obtained access to the client’s e-mail account and directed the insured’s employee to  wire funds to accounts in Malaysia and Singapore.

The insuring agreements at issue in Taylor provided coverage for “direct loss” “resulting from” a covered occurrence. The insurer asserted that the insured was attempting to recover for a third-party loss, rather than a direct loss, because the false e-mails requesting a wire transfer from the client’s account did not immediately and without intervening cause result in a loss. Rather, the loss only occurred after the bank was unable to recover the lost funds and the client demanded payment from the insured. 

The court noted the different approaches to determining whether a loss is direct, and that the policy at issue included liability coverage sections expressly separate from the indemnity coverage provided under the relevant insuring agreements.

Although it did not reference an ownership provision, the insured argued that the loss should be considered a direct loss because it was a bailee or trustee of the stolen funds. The insurer pointed out, however, that the funds were held in a separate account at another entity at the time they were stolen.

The court agreed with the insurer that the loss was  not direct. While coverage might have applied if the hacker had entered the insured’s computer system and withdrawn funds from an account “owned or attributed” to the insured, here, the loss “resulted from a series of far more remote circumstances.” The court found significant the fact that before the insured incurred any loss: (i) the client gave the insured power of attorney over money held in the client’s own account; (ii) the hacker motivated the insured to transfer funds out of the client’s account; (iii) the insured discovered the fraud and attempted to recover the funds; and (iv) the client requested that the insured repay the funds. In view of this long causation chain, the court held that the loss did not follow immediately and without intervening causes and was not direct.

In Avon State Bank v. BancInsure, Inc. (787 F.3d 952 (8th Cir. 2015), however, an appellate court found that a third party’s loss was direct for purposes of fidelity coverage because the funds were possessed and controlled by insured at the time of the loss. The Court of Appeals for the Eighth Circuit examined coverage for the insured bank’s payment to resolve claims by two individuals who were induced by the insured’s employee to invest in an advance money scam. A long-time customer of  the bank was duped into believing that the estate of a former associate would transfer money to the bank if the customer made up-front payments of taxes and other fees. The customer promised huge returns to the bank’s assistant vice president, Robert Carlson, in exchange for his help. Carlson obtained a loan from the bank and also paid USD 60,000 of his own money to the customer for costs relating to the estate transfer.

When the fraudster requested an additional sizeable payment to cover purported taxes on the estate, Carlson recruited two individuals, Donald Imdieke and Mike Froseth, to invest almost USD 500,000. Carlson deposited their checks into an account at the bank, and then wired the funds to an account in Hong Kong. This payment violated bank policy and Carlson had concerns that the estate was a scam. Not surprisingly, the funds were never repaid, and Imdieke and Froseth sued the bank for its vicarious liability for Carlson’s conduct.

The district court held that the bond covered the bank’s settlement with the two individuals. On appeal, the insurer argued that the loss to the insured bank was not direct because it was sustained by a third party, and the bank itself did not suffer a depletion of its own funds through covered conduct.

The Eighth Circuit disagreed with the insurer, finding  that the bond’s “loosely worded language” did not include specific limitations on third party losses. The court found that the bond applied to loss “resulting directly from dishonest or fraudulent acts committed by an Employee,” and this “precisely describe[d] the loss” the bank suffered through its employee’s fraudulent conduct. The court  also found that applicable Minnesota law allows fidelity coverage for loss of a third party’s property while in the insured’s possession and control. Here, the loss occurred while in the insured’s possession as the funds were held in the insured bank’s own account.

Although the court did not refer to an ownership clause, the bond provided coverage for property “held by the Insured in any capacity” or “for which the Insured is legally liable.” Significantly, the insured bank “held” the funds because its employee obtained checks made payable to the bank, deposited the funds into the bank’s own account,  and wired the money out of the bank’s account. This was sufficient to show that the bank “held” the funds, even if the funds were not in the insured’s account for an extended period of time.