The Insurance Benefits From Early Discovery Of Employee-Caused Losses

Earlier this month, we posted about the U.S. District Court for the Northern District of Ohio’s decision that a credit union’s insurance policy was not invalid from the start because of its employee’s misrepresentations on the application.  The decision, National Credit Union Administration Board, as Liquidating Agent of St. Paul Croatian Federal Credit Union v. CUMIS Insurance Society, Inc., also illustrates other arguments that insurers may make in denying coverage for claims under D&O policies or reserving their rights to litigate later.  In this post, we explore how the court determined whether St. Paul “discovered” the loss more than two years before it filed suit against its insured, in which case its lawsuit would have been barred by a suit limitations period.

To briefly recap the facts of the case, St. Paul Croatian Federal Credit Union (“St. Paul”) and its insurer, CUMIS, agreed that a St. Paul bank manager, Mr. Raguz, had engaged in fraud by creating fake loans and accepting bribes.  St. Paul eventually collapsed and was taken over by regulators. The liquidator appointed to administer St. Paul’s assets made a claim for its losses against CUMIS under a bond policy it had issued in favor of St. Paul.  CUMIS responded not only by claiming that the bond policy was invalid from its inception because Mr. Raguz made material misrepresentations in obtaining and renewing it, but also because the policy stated that “legal proceedings” to recover loss from CUMIS had to be “brought within two years of Discovery of Loss.”  Under the policy, “Discovery occur[ed] when [St. Paul] first become aware of facts which would cause a reasonable person to assume that a loss of a type covered under this Bond has been or will be incurred, regardless of when the act or acts causing or contributing to such loss occurred.”

To support its contention that St. Paul was aware of the loss long before it brought suit, CUMIS argued that the St. Paul board of directors were aware of two “critical facts” about the fraud, which would have led a reasonable person to assume a loss.  First, CUMIS claimed that the delinquency rate of zero for the loan portfolio was unreasonable given its size, and that the directors should have known this fact more than two years before the lawsuit.  In addition, CUMIS claimed that the directors should have known of the fraud more than two years in advance because the loan portfolio included $131.2 million of loans that were purportedly secured by deposits, even though in fact there were only $122.5 million of deposits securing the loans.    

The directors of St. Paul responded that they were unaware of the fraud because they relied upon reports and opinions from auditors and official regulators as to the soundness of the loan portfolio.  Moreover, during this period of growth for the loan portfolio, the type of loans St. Paul was making changed.  For most of St. Paul’s history, its loans were secured by real estate.  However, under Mr. Raguz’s management, most of the loans were supposedly secured by deposits with St. Paul.  Because the directors assumed that these loans could be paid from the collateral if there was any default, they did not think the loans would ever become delinquent.   Therefore, the directors reasonably did not believe that a loss had occurred or would occur.

The District Court found that this set of facts presented a fact question that had to be determined at trial, and not on summary judgment as requested by CUMIS.  Therefore, CUMIS will still have the opportunity to convince a finder of fact that the St. Paul board of directors reasonably should have known of the loss and that St. Paul’s suit was therefore untimely, but it cannot avoid a jury trial on that issue.

Despite the favorable outcome – for now – in favor of the insured, this case still provides a warning to organizations with a single strong leader, like Mr. Raguz at St. Paul.  Because a small organization, such as St. Paul, may not have the staffing resources to implement substantial internal controls and checks, routine outside audits may be the best line of defense against fraud – and against later claims by insurers that the company had reason to know of covered losses but didn’t act in time to notice a claim or bring suit.  While intrusive audits may initially appear unseemly and distrustful to employees, in the end, the audits can benefit employees because they afford additional protection against the destruction of their company by an avaricious leader, and can also allow the company to act quickly when it discovers a loss.

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