Sixth Circuit Enforces 24-Month Contractual Limitations Period In Bond; Employee's Knowledge Bars Coverage for Company Under E&O Policy

The United States Court of Appeals for the Sixth Circuit, applying Michigan law, has held that an insured securities broker-dealer’s failure to bring legal proceedings within the 24-month period specified by its financial institution fidelity bond precluded coverage for losses resulting from an employee’s embezzlement scheme.  Hantz Fin. Servs., Inc. v. Am. Int’l Specialty Lines Ins. Co., 2016 WL 6609544 (6th Cir. Nov. 9, 2016).  The court also held that the insured’s errors and omissions policy did not respond because the wrongful acts by the employee were “committed with knowledge that [they were wrongful acts].”

The employee’s embezzlement came to light in March 2008.  By May 2008, the company determined that the employee had embezzled more than $2.6 million from twenty-two clients.  Although the company ended up settling nearly all of the claims asserted against it by the affected clients, one couple’s claim proceeded to a FINRA arbitration, with an award entered in their favor in June 2010.  The state circuit court entered judgment confirming the award on December 17, 2010, and the court of appeals affirmed the judgment on January 24, 2012.

While working to settle and litigate the affected clients’ claims, the broker-dealer sought coverage under both its bond and its E&O policy.  To this end, the insured provided the bond insurer with a sworn proof of loss in May 2008.  Over the following two and a half years, the insurer and broker-dealer traded communications, with the insurer requesting information for its investigation and the insured responding to those requests and updating the insurer on the status of the claim.  The insurer ultimately denied coverage under the bond in March 2011, and the broker-dealer brought suit against the insurer on March 18, 2013.  The broker-dealer also brought suit against its E&O insurer, which had likewise denied coverage.

With respect to the bond, the Sixth Circuit affirmed the entry of judgment in favor of the insurer on the grounds that the bond prohibits the insured from bringing a legal proceeding against the insurer to recover its losses “after the expiration of 24 months from the date of … final judgment or settlement.”  In reaching this conclusion, the court rejected the insured’s argument that the time for filing suit did not begin to run until the underlying judgment was affirmed on January 24, 2012.  According to the court, under Michigan law, a “final judgment” refers to a trial court’s order ending the litigation at that level, and not when all appeals are exhausted.  The court also rejected the insured’s contention that the insurer had waived the limitations period by conducting a lengthy investigation of coverage and by raising certain potential grounds for denial, while at the same time failing to advise the insured that it would enforce the limitations period.  The court found that “the insurer’s failure to specify which defenses it would assert does not constitute a waiver of those defenses by any stretch.”

As to the E&O policy, the court concluded that coverage was barred by the policy’s “Wrongful Acts Exclusion,” which precluded coverage for losses in connection with “any actual or alleged Wrongful Act committed with knowledge that it was a Wrongful Act.”  The parties conceded that the broker knowingly stole client funds, but the broker-dealer argued that it nonetheless was entitled to coverage because only the employee, and not the company, had knowledge of the wrongdoing.  The court, however, found the insured’s reading of the provision “strained” and held that the employee’s knowledge precluded coverage for both the company and the employee, who were both insureds under the policy.

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