We ve Been Robbed! Why did we pay for the coverage if it does not cover the claim? By George E. Nowack, Jr. Fidelity Insurance

Transcription

1 We ve Been Robbed! By George E. Nowack, Jr. We ve been robbed! Those are words that are being said with increasing frequency by Boards of Directors and members of community associations. Unfortunately, theft of community association funds by Board members, managers, staff and others with access to association funds is but another consequence of the difficult economic times being experienced by many Americans, and the reported incidents increase every day. These incidences are abetted by sophisticated software that can produce credible but fake documents and by the increasing use of credit cards and online transactions. While risk management can help prevent or minimize some theft, it is critical that the board understand the key insurance that might be available for theft fidelity insurance. The practical effect of the theft of an association s funds depends on the overall financial condition of the association. However, because the theft of funds may be committed by neighbors and trusted agents via keystrokes and pen strokes, the emotional impact on members of community associations is more traumatic than if done by a stranger at the end of gun barrel. The initial shock expressed by members usually turns to anger as the extent of the theft is uncovered. Many associations channel that anger into efforts to recover the money. Hopes for recovery of funds usually focus on the association s insurance coverage, rather than the thief s assets. Spirits run high when copies of insurance policies show that Directors & Officers coverage and insurance for employee dishonesty were in effect at the time the theft was committed. However, the elation instantly reverts to anger if the claim is denied by the insurer. While most comments made about insurers when a fidelity claim is denied cannot be published, a common one that is acceptable is Why did we pay for the coverage if it does not cover the claim? It is a legitimate question that can usually be answered simply by showing the members of a Board the definition of the insured and/or the list of exclusions of coverage in the policies. This leads to the next logical question, Is there a way that we can avoid the absence of coverage in the future? The answer to that question is yes. A Board can avoid the shock and frustration caused by an uninsured theft of an association s Why did we pay for the coverage if it does not cover the claim? funds. It requires each Board to do two things: (a) understand the terms, conditions, and exclusions of a policy; and (b) have the policy reviewed to determine the persons it covers and take steps to prevent an uninsured person from having access to an association s funds. Fidelity Insurance Fidelity Insurance is the generic reference to insurance that reimburses an insured for a theft of its money or property. Most people initially refer to insurance coverage for theft of funds as a fidelity bond, not fidelity insurance. The two provide different forms of coverage. A bond is a three-party contract where the bonding company guarantees the honesty of one party to a second party. If there is a breach of honesty, the bonding company reimburses the second party for the amount of the loss caused by the insured party. The bonding company will usually then pursue the dishonest party for recovery of the amount it paid to the second party. Inasmuch as a fidelity bond is a guarantee of payment, they are expensive and require an investigation of each of the bonded persons. Bonds depend on the character, capacity and credit of the person seeking to be bonded. Bonds are in effect until cancelled. Unlike a bond, a policy of insurance is a two-party contract involving an insurer and the insured. An association, as the insured, is known as the first party. The claim to recover a loss belongs to the first party. The insurer is the second party that agrees to reimburse the insured, not a third party, for a loss covered by the policy. Payment is not guaranteed, but depends on the terms of the policy. Fidelity insurance is in effect during a specific policy period. Unlike in a bond, if the fidelity insurer pays for a loss, the insurer does not have a right of recovery against the insured (i.e. the community association). Directors & Officers Insurance Is Not Fidelity Insurance Most directors of community associations and the members mistakenly believe that when a Board member commits a theft of an association s funds that a Directors & Officers ( D&O )

2 insurance policy will cover the loss. D&O policies cover the wrongful acts of directors and officers. Wrongful acts are defined in virtually every D&O policy as any act, error, or omission, neglect or breach of duty committed or attempted to be committed by the association or by one or more of the Board members. Based on that definition, there is a common misunderstanding that D&O coverage applies to the act of theft by an insured or a claim that a Board was negligent if it allowed a fellow Board member or manager to steal an association s funds. The reason D&O policies do not cover fidelity claims is because of three exclusions that apply to the coverage. 1. D&O policies exclude coverage for any loss brought about or contributed to by any deliberate fraudulent or dishonest act or omission or any purposeful violation of a law by an insured. The theft of an association s funds by a Board member is a deliberately fraudulent and dishonest act that results in the claim being excluded from coverage. 2. The second exclusion is known as an insured v. insured exclusion. It applies to a claim brought by the Association, an insured, against the Board member(s), also an insured, that committed the theft or allowed the theft to occur. The insured v. insured exclusion also applies to claims by an association against a management company that is included as an insured under an association s fidelity insurance. An insured v. insured exclusion is analogous to the insurance maxim that an insured cannot sue himself or herself. 3. On occasion, an individual member of an association or a group of owners will sue the members of the Board that allowed the theft to happen. That claim is also usually denied from D&O coverage based on the exclusion for any claim based on any Board member obtaining a profit or remuneration the person was not legally entitled to receive. These three exclusions also apply when a management company is included as an insured under an association s D&O policy. If a management company or manager steals an association s funds, the theft would be an intentional dishonest act by an insured, a suit by the association against the management company/manager to recover the funds would be an insured vs. insured claim, and the claim would be based on the person obtaining an illegal profit or remuneration. Employee Dishonesty Insurance With few exceptions, community associations are non-profit corporations under state statutes. Insurance that covers theft of a corporation s funds is known as employee dishonesty insurance. It is a form of property insurance that indemnifies an insured for the loss of its property, money, securities, or any property that is the result of acts of fraud, dishonesty, forgery, theft, larceny, embezzlement, misappropriation, or any criminal act on the part of an employee of the insured. The coverage is included in some property insurance policies or coverage is provided by a separate insurance policy commonly known as a crime or commercial crime policy. Employees are commonly defined in employee dishonesty policies as: Any natural person (1) While in your service (and 30-days after termination of services); and (2) Whom you compensate directly by salary, wages, or commissions; and (3) Whom you have the right to direct and control while performing services for you; or Any natural person employed by an employment contractor while that person is subject to your direction and control; Any natural person who is leased to the insured But, employee does not mean any: Agent, broker, factor, commission merchant, co-signee, independent contractor or representative of the same general character; or Director or trustee except while performing acts coming within the scope of the usual duties of an employee If your association is like most associations, it does not have any employees. The corporation is operated by a Board of Directors whose members have access to an association s funds. Since Board members rarely fit the definition of an employee, standard employee dishonesty insurance will not cover the theft of an association s funds by Board members. A self-managed community association recently learned firsthand the importance of properly identifying an employee for employee dishonesty insurance. The association s property policy included $10,000 of employee dishonesty insurance. The association s treasurer embezzled over $120,000 and when a If your association is like most associations, it does not have any employees. The corporation is operated by a Board of Directors whose members have access to an association s funds. Board members rarely fit the definition of an employee.

3 claim was filed, the insurer denied coverage because the policy only covered employees of the corporation. The policy did not cover a member of the Board. Insurers that specialize in community association insurance recognize a standard employee dishonesty policy does not cover the dishonest acts of directors. As a result, their forms broaden the definition of an employee to expressly include directors and officers. For example, one insurer s policy defines an employee as a natural person who is a duly elected or appointed director, trustee, officer, committee volunteer, or member, whether salaried or not. Another company s policy includes an endorsement that defines an employee as any natural person while serving as an elected or appointed member of a board of directors or board of trustees. Yet another fidelity insurer s policy provides coverage for non-compensated directors, officers and committee members. Employee dishonesty insurance only covers the theft of an association s funds. It does not cover a loss of funds that is the result of a decision of the a board of directors, i.e. investing reserve funds in high risk investment tools or overpaying on a contract because using change orders in a construction contract are too burdensome. While those are examples of a loss of an association s funds, the losses were not caused as the result of a theft. A theft is generally defined as an intentional unlawful taking of money, securities, etc. to the deprivation of an insured. The requirement that the act must be intentional is known as manifest intent, meaning the employee knew his or her action was unlawful and would result in the taking of an insured s property. Poor or careless business decisions made by a board of directors that result in a loss of an association s funds, while not covered by fidelity insurance, may be considered a wrongful act under a D&O insurance policy. Coverage for the claim, however, will depend on the definition of a loss and overcoming the standard insured versus insured exclusion. Coverage for Dishonest Acts of Community Association Managers Many community associations delegate the day-to-day operations to a management company. Depending on the contract, the management company and its employees are given access to an association s funds. While most management contracts do not give managers access to an association s reserve funds, recent headlines report thefts of six- and seven-figure amounts from association s operating accounts that are committed over a period of years. Since a management company and its employees are not employees of an association, and since most employee dishonesty policies exclude the dishonest acts of an agent or independent contractor of an association, standard employee dishonesty policies written in the name of an association will not reimburse an association for such thefts. The Federal Housing Administration (FHA) issued its Condominium Project Approval Guide (Guide) on June 30, Section dictates the required fidelity insurance coverage of associations and management companies as follows: Fidelity Bond/Fidelity Insurance may also be known as Employee Dishonesty or Crime Policy (project approval): For all new and established projects with more than 20 units, the homeowners association is required to obtain and maintain this insurance; The homeowners association must maintain this insurance for all officers, directors, and employees of the association and all other persons handling or responsible for funds administered by the association; The coverage must be no less than a sum equal to three months aggregate assessments on all units plus reserve funds unless State law mandates a maximum dollar amount of required coverage. If the homeowners association engages the services of a management company, the homeowners association must require the management company to maintain this insurance coverage for its officers, employees and agents handling or responsible for funds of, or administered on behalf of, the owners association. The required coverage must meet the following requirements: Must name the owners association as an obligee; Must be in an amount not less than the estimated maximum of funds, including reserve funds, in the custody of the owners association or management agent at any given time during the term of each bond; In no event may the aggregate amount of such bonds be less than a sum equal to 3 months aggregate assessments on all units plus reserve funds unless State law requires a maximum amount of required coverage. Employee dishonesty insurance only covers the theft of an association s funds. It does not cover a loss of funds that is the result of a decision of the a board of directors...

4 The fidelity insurance the Guide requires an association to maintain is employee dishonesty insurance and is a fidelity bond for management companies. The employee dishonesty insurance requires the definition of an employee to include directors, officers, and employees. It also requires an expanded definition of an employee to cover all other persons handling or responsible for funds administered by the association, but not including a management company. I f a n a s s o c i a t i o n i s m a n a g e d b y a management company, the Guide requires a management company to obtain fidelity insurance which names each of its association clients as an obligee. Since an obligee is the third party that requires and receives the protection of a bond, the Guide is requiring a management company to obtain a fidelity bond for every one of its clients. Since a bond is a guarantee of payment to the third party association, compliance with the Guide will guarantee that community associations will control a claim and recover any stolen funds. Requiring a management company be bonded, rather than requiring a management company to maintain an employee dishonesty policy also avoids an uninsured loss where an owner/principal/partner of a management company is the thief. Each bond must be in an amount of no less that the estimated total funds, including reserves, held by an association or the management agent, but in no event less than a sum equal to 3 months aggregate assessments on all units plus reserve funds. This coverage is not normally covered by current bond products. Specifically, the Guide requires a management company s bond to cover the total funds in the custody of the owners association. (It has to be assumed the management agent has access to the funds under an association s control. Otherwise, the bond would have to cover funds that are only accessible by an association to be covered by a management companies bond.) Generally, a bond requires the money, securities, etc. be under the custody and control of the bonded parties. Requiring a management company s bond to cover funds under the control of an Requiring a management company be bonded, rather than requiring a management company to maintain an employee dishonesty policy also avoids an uninsured loss where an owner/principal/ partner of a management company is the thief. association will likely cause specialized bond products to be created. Aside from the coverage issues, management companies and their community association clients will have to address the cost of bonds that comply with the requirements of the Guide. The cost of each bond cannot be absorbed by a management company under existing per door rates and the increase in the per door rate to cover the bond will likely be more than most associations can afford. The apparent goals of the Guide to place an association in a position of controlling a claim and assuring a recovery of its funds is better achieved by existing employee dishonesty insurance policies written in the name of an association that add a management company as an insured. The endorsement is commonly known as a designated agent endorsement. It expands the definition of an employee to include a management company and its employees, just like Board members are considered employees under an expanded definition of an employee. If a management company employee steals an association s funds, a designated agent endorsement enables an association to file a first party claim to recover it s funds. Covering a management company and its employees under an association s employee dishonesty policy also avoids an uninsured loss where the theft is committed by a principal/partner/owner of the management company. The exclusion of coverage for the dishonest acts of owners, partners, principals of an insured does not apply when a management company is an insured under an association s employee dishonesty policy. That exclusion does not apply because the principal, partner, owners of a management company are not a principal, partner, or owner of the insured, the community association. Naming the management company as a designated employee of an association allows an association to recover its funds in the same amount of time it can recover its funds under a bond. In both cases, an association controls the claim and can file a direct claim with the fidelity insurer.

5 Covering a management company and its employees under an association s employee dishonesty policy also avoids an uninsured loss where the theft is committed by a principal/ partner/owner of the management company. The exclusion of coverage for the dishonest acts of owners, partners, principals of an insured does not apply when a management company is an insured under an association s employee dishonesty policy. That exclusion does not apply because the principal, partner, owners of a management company are not principal, partner, or owners of the insured, the community association. Naming the management company as a designated employee of an association speeds up the time it takes for an association to recover its funds. If an association depends solely on its management company s fidelity insurance, an association must await the management company filing a claim, receiving the recovery of the funds and returning the funds to the association. On the other hand, if a management company is named on an association s fidelity insurance, then the association can file a direct claim with its fidelity insurer. Once the association s fidelity insurer pays the claim, then that insurer can go after the company for reimbursement.. The insurance industry does not have a standard employee dishonesty policy for community associations. The policy provisions discussed in this article are not included in any policy and may not be offered by every insurer. Board members are reminded of their duty to exercise sound business judgment in operating an association. That duty certainly includes their obligation to obtain fidelity insurance that covers all persons that have access to an association s funds. Board members can discharge that duty only by obtaining a written confirmation of coverage. And any person that is not covered by a policy should be prevented from having access to any of an association s funds. If the discharge of a board member s duty is not sufficient motivation to prevent an uninsured theft of funds, perhaps the motivation should be avoiding the disappointment and criticism that will be expressed by a board member s neighbors and the self-criticism and disappointment the board members will feel for allowing that to happen. For more information, contact George Nowack via at georgenowack@wncwlaw.com or by telephone at