While employers, especially small business owners, like to think that their employees are loyal and would not steal from the organization, the statistics show otherwise. The U.S. Chamber of Commerce estimates that employers lose $20 to $40 billion per year due to employee theft. More shocking still, 30% of all business failures are caused by employee theft.
Even with these staggering figures, the specific statistics are even more eye-opening. According to the Association of Certified Fraud Examiners, U.S. organizations lose 6% of their annual revenues to employee fraud. The median loss to employers is $140,000. The median loss for small businesses was $98,000 higher than the median loss suffered by larger companies. The vast majority of employee fraudsters are not life-long criminals; only 12% had a previous conviction for fraud-related offenses. It is estimated that less than 10% of employee theft is discovered and less than 10% of these are reported. Even upon discovery, recovery from the employee is very low. The median recovery to the employer (from the employee) is 20% of the original loss, and approximately 40% of employers report recovering nothing.
Beginning in 2008 – the height of the Great Recession – employee dishonesty crimes spiked, with an initial jump of 20% from the first to second half of 2008. Despite an improvement in global economics, the 2012 statistics show the trend of employee theft only increasing. Given this bleak picture, employers need to protect against internal losses. The primary tool for employer protection is a specialized insurance policy referred to as Employee Dishonesty Coverage. These policies are designed to indemnify the employer in cases of fraud and embezzlement by a member of the organization as well as provide third-party coverage. Given the special nature of this coverage, it is critical that the employer understand both the pre-requisites and a nuanced exclusion from this type of coverage.
A. Pre-requisites to Employee Dishonesty Coverage
While Employee Dishonesty Coverage seems straightforward – i.e., an employee steals from the company and the policy indemnifies – it is not nearly this simple. The first step is understanding the triggers to coverage. While policies may vary slightly, there are typically three pre-requisites to trigger coverage:
1. The action must be intentional, fraudulent and dishonest. Accidental or negligent loss to the company is not sufficient;
2. The employee must intend to obtain a financial benefit for himself or another person; and
3. The financial benefit must be other than salaries, commissions, fees, bonuses, promotions, awards, profit sharing or pensions or other employee benefits earned in the normal course of business.
B. The Critical Nuances of the “Prior Knowledge” Exclusion
Assuming that the employee’s actions satisfy the above pre-requisites, Employee Dishonesty Coverage has a specialized exclusion that employers must understand: “Prior Knowledge.” While seemingly self-explanatory, the Prior Knowledge exclusion has multiple twists that frequently result in the denial of coverage.
The first nuance to the Prior Knowledge Exclusion is an employer that discovers employee theft/dishonesty will be forever barred from any subsequent dishonest act committed by that employee. If, for example, management finds that a valued employee has been stealing but agrees to retain the employee (even upon the agreement that the employee reimburse the company for the theft), and that employee later steals again, the subsequent theft will not be covered based on prior knowledge.
The second – and most important – nuance goes to what person has this prior knowledge. Generally, this exclusion prohibits recovery if anyone employed by the company has knowledge of the fraudulent activity. It is axiomatic, however, that if an employee is intentionally, fraudulently and dishonestly stealing money from the company, that someone employed by the company has prior knowledge of the dishonest acts – namely the employee who is stealing. Accordingly, policy holders must be very diligent in reviewing the exclusionary language, and potentially negotiating a revision to include less restricting language. A generally accepted (but negotiated) alternative is that the CEO, CFO and/or General Counsel have no prior knowledge of the unlawful behavior.
The final important aspect of the Prior Knowledge exclusion relates to the definition of “knowledge.” While the exclusion, on its face, only purports to exclude known behavior, a Kansas Court has extended this breadth. In American Special Risk Mgmt. v. Cahow, the Court of Appeals of Kansas held that an insurer’s investigation into potentially unlawful behavior was sufficient to trigger the prior knowledge exclusion because, by instituting the investigation, the insurer had a reasonable expectation that dishonest acts had occurred.
Given the specificity of both the pre-requisites of Employee Dishonesty Coverage and the highly nuanced Prior Knowledge Exclusion, employers must be ultra-diligent with respect to this type of coverage. Considering that the Prior Knowledge Exclusion can, without an experienced broker or attorney’s review, become the rule, it is highly recommended that the employer engage a professional for a pre-policy review (or audit in the event a policy is already issued). If, however, the employer takes these steps on the front-end, Employee Dishonesty Coverage can literally save a company from closing its doors for good.
Frank Cragle is a trial lawyer and a member of Hirschler Fleischer’s Insurance Recovery Team. He handles a variety of commercial business disputes, including insurance recovery and policyholder claims. Frank also devotes a substantial portion of his time to business tort litigation claims. For more information, contact Frank at 804.771.9515 or firstname.lastname@example.org.
Kristen M. Chatterton