A recent decision of the U.S. District Court for the Middle District of Florida, In Re Taylor, Bean & Whitaker Mortgage Corporation, provides a helpful illustration of how to assess coverage where an insured’s alter ego allegedly colludes with subordinate employees who are not, themselves, directing minds of the insured.
The insured, Taylor, Bean & Whitaker Mortgage Corporation (“TBW”), had been a leading wholesale mortgage lending firm, but collapsed in 2009 due to massive fraud directed by its majority shareholder, Lee Farkas. Farkas removed over $87 million from TBW, primarily by siphoning money out of TBW into various entities owned by Farkas and others. TBW alleged that at least two of its employees had assisted Farkas. According to TBW, its treasurer, Desiree Brown, had effected electronic transfers of funds from TBW’s operating accounts to the recipient entities. TBW also alleged that its CFO, Delton De Armas, had set up a “Due From” account, which was used to track the amounts Farkas and Brown had taken from TBW’s operating accounts, and to give the defalcations an air of legitimacy with TBW’s bookkeepers.
The Lloyds Coverage
TBW maintained fidelity coverage with certain Lloyds Underwriters. TBW’s bankruptcy trustee submitted a proof of loss for $87 million, asserting that Farkas, Brown and De Armas had committed acts of employee dishonesty.
The Underwriters sought, inter alia, a declaration of no coverage arising from the acts of Farkas, Brown and De Armas. As Farkas was the majority shareholder of TBW, the Underwriters determined that he fell within an exception to the definition of “Employee”, which provided that:
It is understood, however, that the term Employee does not include any Major Shareholder of [TBW], nor, except as provided above, any director of [TBW].
A Major Shareholder was in turn defined as “a natural person who has or had directly, indirectly or beneficially 25% or more of the outstanding voting shares of [TBW].”
Can an Alter Ego also be an Employee?
TBW acknowledged that Farkas, as majority shareholder of TBW, came within this exception. However, TBW pointed to an exclusion in one of the polices, which excluded coverage for:
any loss involving any act of any partner or Major Shareholder of [TBW], except when acting in the capacity of an Employee.
Based on this, TBW contended that a Majority Shareholder could still be considered an Employee for coverage purposes, so long as the individual was “acting in the capacity of an Employee” at the time that the dishonest act was committed.
The Court rejected this argument. After considering the case law on the alter ego doctrine, the Court concluded that:
… [the] Underwriters established that Farkas dominated and controlled the corporation to such an extent that the corporation’s independent existence was in fact nonexistent; Farkas became an alter ego of the corporation. … For this reason, Farkas was not TBW’s employee nor did he act in an employee capacity when he looted TBW’s property. Accordingly, any losses caused by his dishonest acts are not covered by the bonds in question.
Collusion of Subordinate Employees with Alter Ego
TBW had a clever argument in reserve. While Farkas may not have been an “Employee”, Brown and De Armas certainly were Employees at the time that they had assisted Farkas with his defalcations. As such, TBW reasoned, its losses were due to their dishonest acts. The Court rejected TBW’s argument, accepting the Underwriters’ position that allowing indemnity in such circumstances would effectively nullify the alter ego doctrine, and was also contrary to public policy:
The Court is faced with a very unusual situation where a majority shareholder, an alter ego of the corporation, initiates dishonest acts, directs his subordinate’s involvement, and the subordinate renders her assistance in the fraudulent scheme. TBW claims that Farkas directed all of the transfers that caused its losses. Over time, the embezzlement on Farkas’ behalf became part of Brown’s duties. The Court believes that allowing coverage under these circumstances is not proper. … allowing TBW to recover for losses caused by its alter ego’s fraudulent or dishonest conduct only because its alter ego used his corporation’s employee as an instrumentality in the fraudulent scheme would still essentially allow TBW to recover for its own fraudulent or dishonest acts.
In addition, it would be inconsistent with public policy against allowing one to insure against one’s own thefts, dishonest acts or intentionally inflicted damage. See Cal. Union… (“[T]here is a public policy against permitting a corporation to collect insurance for the defalcations of its alter ego.”). …
Thus, TBW could not recover for any losses caused by the dishonest acts of the employees committed at Farkas’ direction.
Taylor, Bean & Whitaker is useful to fidelity insurers in reinforcing the intended parameters of the alter ego doctrine. The Court’s reasoning and conclusions with respect to Farkas’ falling outside the definition of “Employee” are fairly straightforward. However, the Court’s application of the alter ego doctrine (and public policy considerations) in respect of Brown and De Armas demonstrates a willingness to critically assess the substantive claim advanced by the insured, and to ascertain whether it simply involves an attempt to draw an artificial distinction between the acts of an alter ego and the acts of colluding subordinate employees. It is not uncommon for an alter ego to have some form of “assistance” in effecting a fraud; Taylor, Bean & Whitaker indicates that such assistance should not enable an insured to nullify the alter ego doctrine where it would otherwise apply.
In Re Taylor, Bean & Whitaker Mortgage Corporation, 2015 WL 728493 (M.D.Fla.)