In an era of ever–increasing globalisation, it seems that London looks set to retain its popularity as a place in which to resolve international disputes. Recently, this was reinforced by the Lord Chancellor (the head of the UK's court system) when he engaged consultant Cap Gemini Ernst & Young to produce a report into the business case for a new commercial court, with the objective of strengthening and improving London's position as the leading world centre for dispute resolution.
Facultative reinsurers will already be familiar with the commercial court, as it is the most likely forum for determining disputes concerning facultative risks placed in London. In addition, some treaty disputes are heard there, though in general they tend to be dealt with privately in arbitration centres in London, Paris, New York or Bermuda.
Very often, therefore, foreign cedants of facultative risks find themselves pursuing their reinsurance recoveries in their reinsurers' home courts. The cedants could be forgiven for feeling at a procedural and cultural disadvantage as a result, though they should not be unduly concerned; England's commercial court judges are as impartial and technically competent as ever. An example of this was the recent commercial court case of La Positiva & Ors v RJ Jessel, in which the authors acted for the successful cedants.
Financial institutions and their insurers should take particular note of this case. Traditionally, banks have been somewhat reluctant to acknowledge internal fraud in order to preserve their credibility. However, with the increasing prevalence of fraud and increasing regulatory pressure on banks to be more transparent, claims under these policies will increase, and it is therefore vital for insureds and insurers to understand how the covers work.
La Positiva & Ors v RJ Jessel concerned a claim by three Peruvian insurers which had insured Banco del Sur del Peru (now part of Banco Santander) against the infidelity of its employees. Various employees of the bank, acting together, made two large, unauthorised withdrawals prior to the inception of the bank's fidelity renewal policy. The bank became aware of the smaller withdrawal before the renewal and immediately started investigating. The withdrawal was made by various employees, organised by a senior, respected and long-standing employee with an unblemished service record. He claimed to have made the withdrawal without authority as part of an ordinary commercial transaction, a loan to Banco Centro de Credito Co-Operativo del Peru (BCCC), and produced evidence to support this.
The bank's internal auditor accepted this explanation, albeit with misgivings, and was content to await repayment of the loan, due after the inception date of the renewal policy. Indeed, during the negotiations to renew the insurance the bank made a request for increased limits on the renewal policy and this was accepted.
Repayment of the withdrawal did not occur on the due date owing to the collapse of BCCC. Banco del Sur del Peru still believed in the senior employee's honesty, but became concerned so it decided to advise insurers of a potential loss and notified a claim under the renewal policy. The insurers and reinsurers jointly instructed loss adjusters to begin the investigation of the claim, during which the bank discovered a cleverly concealed larger withdrawal. It later transpired that the employees' scheme was to make loans to third parties using the sums withdrawn in return for kick-backs.
The insurance and reinsurance were both written on a DHP84 wording, similar to many of the banker's blanket bond fidelity wordings currently used in the London market. As in most fidelity policies, cover is triggered neither by an event nor a third party claim but by the ‘discovery' of an insured loss by the insured, and the subjective state of mind of the insured is an important factor. The DHP84 insuring agreement states:
“...the insurers hereby undertake to pay and make good to the insured all such losses as they may during the period of this insurance ... sustain or discover that they have sustained...”
However, the exclusions section in the policy excludes claims:
(a) for losses not discovered during the period of this insurance;
(b) arising out of any circumstance or occurrence which has been notified to insurers on any other policy of insurance effected prior to the inception of this insurance; and
(c) arising out of any circumstance or occurrence known to the insured prior to the inception hereof and not disclosed to insurers at inception.
The infidelity covered by DHP84 is “any dishonest or fraudulent act of any of the insured's employees committed with the intention of making improper personal gain for themselves, whether committed directly or in collusion with others”.
Surprisingly, the meaning of ‘discovery' in the context of a fidelity policy seems never to have been considered by the English courts prior to the La Positiva trial. Neither had it been considered by the Peruvian courts.
The loss adjusters' investigation was inconclusive. They found some evidence that the bank had discovered the loss (or at least an act suggesting dishonesty) before inception but they accepted that there was important evidence pointing in the other direction, in particular the loan documents, including a letter of credit from BCCC, which were put forward as an explanation for the smaller withdrawal.
By contrast, the reinsurers' approach was quite different. They took the view that the loss had certainly been discovered before inception but that even if it had not been discovered, the fact of the withdrawal should have been disclosed to the insurers and to themselves before the risk was bound. However, rather than direct the insurers to defend the bank's claim on these grounds, they chose instead to avoid the reinsurance on the grounds of the insurers' alleged non-disclosure of the first withdrawal.
Unsurprisingly, with uncertainty surrounding their reinsurance cover, with equivocal findings by the loss adjusters on coverage and under the pressure of the bank's arbitration claim in Peru, the insurers eventually agreed a settlement with the bank for about 50% of both withdrawals and subsequently commenced commercial court proceedings against reinsurers in England. For the claimants, with no prior experience of English proceedings, this was a trip into the unknown.
Trigger of cover
One of the principal issues before the court was the trigger of cover: had the insured ‘discovered' an insured loss before or during the policy period? Was it enough that the insured suspected the withdrawal was a dishonest act of an employee done with the intention of making improper personal gain? Or must the insured have known that the withdrawal was the result of the dishonest act of an employee with the intention of making improper personal gain? This was an important issue as the bank's internal auditor agreed that he had had suspicions about the smaller withdrawal before inception.
But he also said he always had suspicions – indeed, it was his job to have them. Importantly, however, his evidence was that the senior management of the bank harboured no suspicions and that its decision to notify the claim was merely a precaution, made more necessary by the fact that by that time BCCC had failed to pay under the letter of credit.
The judge decided that ‘discover' meant know rather than suspect. He relied on the ordinary dictionary definition, which was “to become aware of for the first time”, regarded as the same as acquiring knowledge. As the judge commented, the distinction between suspicion and knowledge is well established and, in law, time-honoured. He considered that knowledge was needed to establish a claim – mere suspicions were not enough.
Question of knowledge?
This led to the more difficult issue of whether knowledge is objective or subjective. The reinsurers argued that it was objective; the loss was deemed to be discovered when the insured had discovered facts from which a reasonable insured would have deduced that the employee in question had acted dishonestly with the intention of making an improper personal gain. One could call this constructive knowledge – knowledge that a party is deemed by law to have or should have, but in reality did
Again, the court agreed with the insurers, taking the view that if the knowledge was to be tested objectively (which would have excluded cover), the policy should say so. The judge stated that there would be no difficulty in formulating such a provision and cited a US case in which just such a provision was used (Home Savings & Loan v Aetna Casualty & Surety Company 817 P.2d 341 (Utah
Financial institutions and their insurers should review their fidelity policy wordings to ensure that the ambiguities highlighted in this case are removed. Insurers may wish to consider whether cover should be triggered by actual knowledge of dishonesty or by constructive knowledge.
Underwriters will also want to consider how the insuring clause fits with the policy's exclusions, which was also a significant issue in this case.
Perhaps most importantly, the case demonstrates that foreign insurers can bring their disputes to England in complete confidence that they will be dealt with strictly on their merits.
John Leadley (right) is a partner in the Dispute Resolution Department London office of Baker & McKenzie. He is a member of the firm's Global Risk Solutions Group. Philip Young is an associate in the Dispute Resolution Department London office of Baker & McKenzie and a member of the firm's Global Risk Solutions Group.