For all media inquiries,
please contact:
Ariel Rivera
Communications Specialist
973.530.2453
arivera@csglaw.com

Fraud in the Inducement as a Defense to Fidelity and Surety Claims

Fall 2006

Tort Trial & Insurance Practice Law Journal

I. INTRODUCTION


Under general principles of contract law, contractual obligations may be avoided by a party whose assent was given under circumstances which vitiate its validity. Contracts induced by intentional, or even under some circumstances innocent, misrepresentations may be abrogated, provided that the party relying on such misrepresentations acts promptly upon discovery thereof to void the contract. The equitable remedy of rescission has been applied to contracts of insurance and of suretyship to discharge, respectively, the fidelity insurer and the surety of their obligations on the basis of both affirmative misrepresentations or failure to disclose material facts which caused either to miscalculate the risk being assumed. When applicable, rescission results in a contract being voided in its entirety. The remedy, therefore, affords the fidelity insurer or the surety, as the case may be, a complete defense to the claim of an insured or obligee and is not limited to the extent of demonstrable prejudice.

In order to appreciate fully the application of common law principles of fraud in the inducement in the context of fidelity coverage or surety bonds, an understanding of those principles is helpful. Accordingly, a brief overview of them as set out in the Restatement (Second) of Contracts is presented in Part II of this article. Part III addresses issues raised by the fraud in the inducement defense to claims under fidelity policies, and Part IV does the same with respect to surety bonds. Part V explores the potential for waiver of the right to rescission by contractual disclaimer or by ratification from inaction.

II. BASIC PRINCIPLES OF RESCISSION FOR FRAUD


Under the Restatement (Second) of Contracts, a contract is voidable by a victim of misrepresentation under the following circumstances:

§164. When A Misrepresentation Makes A Contract Voidable

(1) If a party's manifestation of assent is induced by either a fraudulent or a material misrepresentation by the other party upon which the recipient is justified in relying, the contract is voidable by the recipient.

(2) If a party's manifestation of assent is induced by either a fraudulent or a material misrepresentation by one who is not a party to the transaction upon which the recipient is justified in relying, the contract is voidable by the recipient unless the other party to the transaction in good faith and without reason to know of the misrepresentation either gives value or relies materially on the transaction.1


A "misrepresentation" is "an assertion that is not in accord with the facts.”2 A misrepresentation is "fraudulent" if "the maker intends his assertion to induce a party to manifest his assent" and the maker (a) "knows or believes that the assertion is not in accord with the facts," (b) "does not have the confidence that be states at implies in the truth of the assertion," or (c) "does not have the basis that he states for the assertion."3 A misrepresentation is "material" if "it would be likely to induce a reasonable person to manifest his assent, or if the maker knows that it would be likely to induce the recipient to do so.4 Thus, although a contract is rendered voidable by a misrepresentation which is intended to deceive and is therefore fraudulent, an intent to deceive is not required as long as the misrepresentation is material. Conversely, although materiality is necessary if a misrepresentation is innocent, it is not necessary when there was an intention to mislead 5 In either case, the recipient must have been justified in relying on the misrepresentation to enter into the contract. Overall, under the common law as set out in the Restatement of Contracts, one seeking to void a contract must establish the following four elements: first, there must be a misrepresentation; second, the misrepresentation must be either fraudulent or material; third, the misrepresentation must have induced the recipient to make the contract; and fourth, the recipient must have been justified in relying on the misrepresentation. 6

III. FIDELITY BONDS


Despite use of the word "bond" in the shorthand term "fidelity bond," the phrase typically refers to "specialized insurance coverage" 7 by which financial institutions or commercial enterprises seek to protect themselves from the dishonest conduct of their employees.8 As a species of first-party insurance, fidelity coverage creates a contractual relationship between two parties: the purchasing insured which seeks protection and the insurer which issues and underwrites the coverage.

In this context, common law rules governing rescission for fraud can be applied straightforwardly. Rescission, however, is a strong remedy and when applied to insurance can raise policy concerns about denuding insureds of insurance protection. Many states have enacted statutes which specify the grounds upon which rescission of insurance policies will be permitted; and, as insurance, fidelity bonds are subject to those statutes. The statutes typically do not depart significantly from common law principles; instead, they seek to regulate the application of common law rules in the insurance context. Materiality, for example, is usually defined in terms of the underwriting factors which go into the insurer's decisions as to the issuance of coverage. One consequence of tying the definition of materiality so directly to underwriting decisions is that some courts conclude that reliance as a separate element is superfluous. The intent to deceive is also typically addressed in the statutes, though the majority allows rescission for innocent misrepresentations so long as the statutory materiality test is met and therefore are consistent with common law principles. In a minority of states, however, the opposite is the case. In states which have not enacted such statutes, there is decisional law which requires an intent to deceive for some kinds of misrepresentation thereby limiting the category of innocent misrepresentations which will support rescission.

Fidelity insurance creates a two-party contract to which the parties are the insurer which issues the coverage and the business entity seeking the protection provided by it. A corporation, however, can only know that which is known to the persons who act on its behalf. When the person applying for fidelity coverage on behalf of a corporate entity is either himself engaged in dishonesty or has knowledge of the dishonesty of other employees, a third set of interests becomes involved in the process. The question then becomes whether, and to the extent to which, the knowledge of such a person should be imputed to the corporate applicant in determining whether the fidelity insurer may avoid liability because it was induced to issue coverage by the fraud of that person.

A. Materiality of the Misstatement

1. Statutory Definitions

Statutes governing rescission of insurance policies for fraud typically define materiality as a misrepresentation which, if the insurer had known the truth, would have caused the insurer to (i) not issue the coverage at all, (ii) not issue it at the same premium rate, (iii) not issue it in as large an amount; or (iv) not include coverage with respect to the particular hazard which ultimately resulted in the loss.9 Whether the misrepresentation is, in fact, material and would have led to a different underwriting decision is usually judged from the subjective standpoint of the insurer 10 as opposed to an external standard of some kind. For example, California law provides that “[m]ateriality is to be determined not by the event, but solely by the probable and reasonable influence of the facts upon the party to whom the communication is due, in forming his estimate of the disadvantages of the proposed contract, or in making his inquiries.” 11 New York's Court of Appeals stated that:

Any decision that a misrepresentation is not material must, of course, be based upon a holding, as question either of law or of fact, that the departure from the truth was not a factor which deprived a person of freedom of action and did not induce a choice which otherwise might not have been made. In no case which has been called to our attention has a court of this or other jurisdiction enforced a policy where information demanded by an insurance company "in order to decide whether it would issue a policy" and which might reasonably be considered a factor in arriving at a choice has been withheld. The question in such case is not whether the company might have issued the policy even if the information had been furnished; the question in each case is whether the company has been induced to accept an application which it might otherwise have refused. "Any misrepresentation which defeats or seriously interferes with the exercise of such a right cannot truly be said to be an immaterial one.”12


Similarly, the Utah Supreme Court has held that the "materiality of a fact misrepresented or withheld is determined by the probable and reasonable effect that a truthful disclosure would have had upon the insurer in determining the advantages of the proposed contract," basing this analysis on the concept of a "reasonable and prudent insurer." 13 Some states have utilized a mixed standard, requiring the information to be such that the insurer would deem it material and the insured would have reason to believe the information important to the insurer.14 In either case, the issue is generally a question of fact which revolves around the impact, actual and/or perceived, of the misrepresentation on decisions regarding issuance of the coverage.

Some misrepresentations, however, so obviously increase the risk to the fidelity insurer that they are, for all intents and purposes, material as a matter of law. In the fidelity context, failure to disclose knowledge of prior employee dishonesty in an application for fidelity bonding is accepted as one such misrepresentation. 15 The U.S. Court of Appeals for the Second Circuit examined a misrepresentation of this type in In re Payroll Express Corp.16 In that case, the insurers issued employee theft policies to Payroll Express Corp. ("PEC"). The president and CEO of PEC, in applying for the policies, was required to answer the following questions: (a) "[H]as the proposer suffered a loss during the past five years? If 'Yes' give brief details and amount involved," and (b) "Is there any other information which is or may become material to the proposed insurance and which is not already disclosed to the underwriters?" In response to the questions, the CEO admitted to a single burglary loss of $1,500,OOO and stated that there was no additional material information.17 In fact, there had been 18 losses during the previous five years, and the CEO and other employees had long been diverting funds for their own use.18 In analyzing the effect of the misrepresentations, the court determined that the misrepresentations were "reasonably related to the estimation of the risk or the assessment of the premium," so there could be "no doubt that [the CEO's] failure to inform [the insurer] in response to question 36 that certain employees were embezzling funds from PEC was material as a matter of law.”19

2. Reliance

Under the common law, reasonable reliance by the defrauded party is an essential element of fraud in the inducement. 20 In the insurance context, the statutes or decisional law in some states define materiality such that reliance is subsumed thereunder, with the result that reliance is eliminated as a separate element of a cause of action for fraud in the inducement. Some jurisdictions, however, follow the common law and retain the requirement that reliance on the misrepresentation must be established as part of the prima facie case for rescission.21


The decision in Shapiro v. American Home Assurance Co. 22 is an example of the approach which does not require separate proof of reliance. There, the court examined the issue of reliance upon misrepresentations in an application for directors and officers liability insurance under Massachusetts law. In opposing the insurer's motion for summary judgment, the insured argued that reliance must be shown separately in order to rescind the policy. 23 The Shapiro court flatly rejected that contention, holding that

[it] is likely that reliance is not treated as an independent requirement because the standard of materiality under Massachusetts common and statutory law is such that any statement that is shown to be material is one so central to the risk being insured that the insurer would be expected to take it into consideration in making the underwriting decision. 24

 

The court noted that the long-standing Massachusetts definition of materiality in insurance contracts is facts "the knowledge or ignorance of which would naturally influence the judgment of the underwriter in making the contract at all, or in fixing the rate of the premium.”25 Under this standard, reliance is presumed once materiality is shown.

The decision in Zimmerman v. Continental Casualty Co.26 exemplifies the approach which does require a separate showing of reliance. In that case, the insurer sought to rescind an accident policy based upon the decedent insured's misrepresentations in the application for insurance. 27 The Nebraska Supreme Court, looking to the language of the applicable statute,28 held that


in order for misrepresentations in an application for insurance to conscimtc a defense to an action on the contract it is incumbent upon the insurance company to plead and prove, among other things, that the statements or misrepresentations were made knowingly by the insured with the intent to deceive and that the insurance company relied and acted upon such statements or representations and was deceived by them to its injury. 29

 

The court noted that this result would have been attained under either the special accident insurance statute, Nebraska Revised Statutes §4-710.14, or the general insurance statute, Nebraska Revised Statutes §44-358. 30 The jury instructions, however, did not require the insurer to prove that it had relied to its detriment upon the misrepresentations, and in light of that omission, the Zimmerman court remanded the case for a new trial.31


B. Intent to Deceive

1. Statutory Requirements

a. Intent to Deceive Not Required - Most states which have statutes governing rescission for fraud follow common law principles and permit rescission for an innocent misrepresentation which is material as well as for a misrepresentation made with the intent to deceive 32 The Arkansas statute is typical and provides as follows:

(a) All statements and descriptions in any application for an insurance policy or annuity contract, or in negotiations therefor by, or in behalf of, the insured or annuitant shall be deemed to be representations and not warranties. Misrepresentations, omissions, concealment of facts and incorrect statements shall not prevent a recovery under the policy or contract unless either:

(1) Fraudulent;

(2) Material either to the acceptance of the risk or to the hazard assumed by the insurer; or

(3) The insurer in good faith would either not have issued the policy or contract, or would not have issued a policy or contract at the premium rate as applied for, or would not have issued a policy or contract in as large an amount or would not have provided coverage with respect to the hazard resulting in the loss if the true facts had been made known to the insurer required either by the application for the policy or contract or otherwise. 33


In such jurisdictions, an innocent misrepresentation which meets the applicable materiality test will suffice. 34 In New York, an innocent material misrepresentation renders an insurance contract void from the outset. 35 California provides by statute that " (c)oncealment, whether intentional or unintentional, entitles the injured parry to rescind insurance” 36 and that "[if] a representation is false in a material point, whether affirmative or promissory, the injured party is entitled to rescind the contract from the time the representation becomes false.”37 Though using different language, the Illinois statute is to the same effect; it provides that no "misrepresentation or false warranty shall defeat or avoid the policy unless it shall have been made with actual intent to deceive or materially affects either the acceptance of the risk or the hazard assumed by the company."" The effect, however, is the same, intent to deceive is not required.

b. Intent to Deceive Required - The strictest states, which appear to be in the minority, require that in all cases there be some proof of intent to deceive in order for an insurer to rescind a fidelity bond or other insurance contract. The Louisiana statute, for instance, provides that "no oral or written misrepresentation or warranty made in the negotiation of an insurance contract, by the insured or in his behalf, shall be deemed material or defeat or void the contract or prevent it attaching, unless the misrepresentation or warranty is made with the intent to deceive.” 39 The courts in Missouri, which does not have a statute governing rescission of insurance policies, apply a doctrine of "false swearing," which requires proof that the insured made the representation with an intent to deceive the insurer.40


2. Equitable Fraud

Some states that do not have statutory provisions governing the rescission of insurance contracts, such as New Jersey,41 apply a doctrine of equitable fraud, under which the evaluation of misrepresentations on insurance applications entails an analysis as to whether the questions were "objective" or "subjective." In FDIC v. Moskowitz 42 the court noted that under New Jersey law, the "'insurer need not show that the insured actually intended to deceive.' . . . Rather '[e]ven an innocent misrepresentation can constitute equitable fraud justifying rescission.”43 Only the answers to "objective questions" will constitute equitable fraud, which supports rescission for an innocent misrepresentation. The court explained:


Equitable fraud, however, distinguishes between subjective and objective questions on the application. Objective questions seek information within the applicant's knowledge, such as whether the applicant has been examined or treated by a physician. Subjective questions seek to probe the applicant's state of mind and are concerned with more ambiguous issues, such as what is the state of the applicant's health or whether the applicant has or has had a specified disease or illness. Answers to subjective questions do not constitute equitable fraud if the question is directed toward probing the knowledge of the applicant and determining the state of his mind and . . . the answer is a correct statement of the applicant's knowledge and belief.44


In the Moskowitz case, a bank applied for a financial institution bond. The application contained a question asking whether there was "'any criticism of your operations in the last State or Federal examination.”45 The bank answered in the negative even though a joint report of state and federal regulators contained many negative observations, some of which the bank had acknowledged.46 Although finding that the question was subjective in that one person's definition could differ from that of another, the report detailed extensive comments and was "rife with criticism" such that "only one reasonable conclusion may be drawn from a fair reading of the 1988 Report - the regulators criticized [the bank].”47 Thus, the court concluded that under such circumstances, the response was "objectively false," 48 and, therefore, even though, the question may have been "subjective," rescission was nevertheless required.

The court in Liebling v. Garden State Indemnity Co.49 also addressed the distinction between subjective and objective questions on an application for a claims made attorney malpractice insurance policy. In that case, the insurer sought to rescind the policy because the attorney-applicant answered "No" to a question as to whether the firm was "'aware of any circumstances, or any allegations or contentions as to any incident which may result in a claim being made against the firm." 50 At the time that the question was answered, the applicant represented the plaintiff in a personal injury action and had been advised by the judge's chambers that a motion to dismiss the case for failure to prosecute had been granted. He justified his negative response to the question on the ground that the court's written order dismissing the matter had not yet been entered and might have been based on the negligence of the attorney who preceded him as attorney for the plaintiff. The Liebling court found that the question was subjective and that therefore "equitable fraud is present only if the answer was knowingly false."51 The court affirmed summary judgment granting rescission because the attorney "did not honestly believe that he was secure [from a possible malpractice claim]. . and [t]herefore, his answer in the application was knowingly false.”52
The Restatement (Third) of Suretyship & Guaranty provides:

§4. Fidelity Coverage

 

Unless the contract creating the secondary obligation or the circumstances indicate to the contrary, when (i) the principal obligor is an employee of the obligee and (ii) the underlying obligation is the faithful performance of the principal obligor's duties to the obligee, the obligee is treated for purposes of §12 (When Secondary Obligation Is Voidable Due to Misrepresentation) as having induced the secondary obligor's assent to the secondary obligation by representing to the secondary obligor that the obligee was unaware of any previous acts by the principal obligor that would have breached the underlying obligation.53
The Restatement of Suretyship includes a provision addressing contracts that provide fidelity coverage because "they can fall, at least in part, within the §1 concept of secondary obligations"54 and the Restatement of Suretyship rules governing rescission of surety bonds for fraud in the inducement apply "with particular focus in the context of fidelity coverage. 55 The commentary notes that in providing coverage, the fidelity insurer "is relying largely on the fact that it is the obligee [insured] that has selected the principal obligor as an employee in which trust and confidence are placed."56 When the insured retains an employee whom it knows to be dishonest, the insurer's reliance is misplaced with the result that the insurer underwrites a risk which is different than that which it intended. For that reason, the Restatement of Suretyship regards the insured's silence as a representation that it is unaware of previous dishonesty by the employees to be covered, and if that statement is untrue, the misrepresentation is to be treated as material and therefore justifying rescission. The illustration to the commentary reflects a classic case for rescission of a fidelity bond:


On April 6, 1996, O obtained a fidelity bond from S, pursuant to which S agrees to satisfy any losses to O resulting from P's failure faithfully to execute the duties inherent in P's position as O’s treasurer. At that time, O knew that P had previously embezzled funds from O on at least three occasions. S was unaware of these previous acts of P. Because O is treated as having represented that it was unaware of any previous acts of P that would trigger S's liability under the bond, O has made a material misrepresentation to S. Under §12(1), the fidelity bond is voidable by S. 57

The commentary also observes:

Of course, if the previous acts of the principal obligor are disclosed to the secondary obligor there is no longer the same reliance by the secondary obligor on the obligee's placement of trust and confidence. Thus, the principle of §12(3) would not apply.58


C. Attribution of Knowledge to the Insured Corporation

Fidelity insurance is issued to protect the insured against the perfidy of its employees. An issue arises, however, when the person who signs the application on behalf of the insured has either committed some covered defalcation or has actual knowledge of other employees who did. A corporation only has such knowledge as is in the possession of its officers, employees and directors; and as a general principle of agency, an officer's knowledge is imputed to the corporation.59 An exception may arise, however, when the officer acts adversely to the interest of the corporation.


1. Adverse Domination

The Restatement (Second) of Agency provides:


§280. Agent's Knowledge of His Own Unauthorized Acts

If an agent has done an unauthorized act or intends to do one, the principal is not affected by the agent's knowledge that he has done or intends to do the act.60

Comment c to section 280 makes it clear that

[i]f, in order to protect himself against the embezzlement or other wrongdoing of an agent, the principal obtains a contract of indemnity which states that the signer has no knowledge of any prior wrongdoing by the agent, the knowledge of his own embezzlement by the agent who signs the contract is not imputed to the principal. The risk of embezzlement by dishonest agents is the risk insured against and it would defeat the purpose of the contract to bind the principal by the knowledge of such agents.61


Section 282 of the Restatement, however, seems to present a conflicting approach, at least in part. That section provides as follows:

§282 Agent Acting Adversely to Principal

(1) A principal is not affected by the knowledge of an agent in a transaction in which the agent secretly is acting adversely to the principal and entirely for his own or another's purposes, except as stated in Subsection (2).

(2) The principal is affected by the knowledge of an agent who acts adversely to the principal:

(a) if the failure of the agent to act upon or to reveal the information results in a violation of a contractual or relational duty of the principal to a person harmed thereby;

(b) if the agent enters into negotiations within the scope of his powers and the person with whom he deals reasonably believes him to be authorized to conduct the transaction; or

(c) if, before he has changed his position, the principal knowingly retains a benefit through the act of the agent which otherwise he would not have received.62
Section 282(1) is completely consistent with section 280. Section 282(2), however, expressly contemplates that even when the agent is acting adversely to the interests of the principal, the knowledge of the former will be attributed to the latter in certain circumstances. One of those situations arises when "the agent enters into negotiations within the scope of his powers and the person with whom he deals reasonably believes him to be authorized to conduct the transaction.”63 On its face, section 282(2)(b) appears to include an employee or officer knowingly misrepresenting the honesty of persons to be covered by fidelity insurance as part of the process of negotiating the policy with the insurer. Thus, section 282(2)(b) would permit attribution of the employee's knowledge to the insured, while section 280 clearly prohibits any such attribution. Because commentary to section 280 specifically addresses that situation and the commentary to section 282(2) does not, it may be that the drafters of the Restatement simply did not regard the rule of section 282(2) as applying to misrepresentations by a dishonest employee on an insurance application, while affording some protection to parties which negotiate contracts in other contexts.

In any event, the majority of courts endorse the position taken by section 280.64 In Puget Sound Nat'l Bank v. St. Paul Fire & Marine Insurance Co.65 for example, the Washington Court of Appeals held that a director's knowledge was not, in fact, imputed to the principal, a bank. In Puget Sound Nat'l Bank, one of the bank's directors owned an insurance brokerage and arranged for his clients to finance their premiums through the bank. He was the sole contact between the customers and the bank. Later review of these loans showed that many were fraudulent, with the customers either having financed far less than their promissory notes indicated or being completely unaware that the loans existed all.66 The director who defrauded the bank was also the individual who, as the procuring agent for the bank, filled out the application for fidelity insurance. Following the discovery of the director's defalcations, the bank sued the insurer for recovery under the policies. The insurer claimed that the director's knowledge of his own fraudulent scheme was imputed to the bank, rendering the fidelity policies void ab initio. The insurer argued, among other things, that the director was acting in the bank's interests in obtaining the policies, and thus his knowledge would be imputed to the bank. 67 Rejecting the insurer's position, the court found that both the director's defalcations and his concealment thereof on the policy applications were not in the bank's interest and also found that the bonds were obtained at the request of the bank's board of directors and the applications were signed by another officer of