The Fidelity Law Journal... 234 Fidelity Law Journal, Vol. XX, November 2014 The doctrine of...

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The Fidelity

Law Journal

published by

The Fidelity Law Association

Volume XX, November 2014

Editor-in-Chief Michael Keeley

Associate Editors Carla C. Crapster

Adam P. Friedman Ann Gardiner

Timothy Markey Jeffrey S. Price Daniel J. Ryan

Cite as XX Fid. L.J. ___ (2014)

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THE FIDELITY LAW ASSOCIATION

President Timothy Markey, CNA

Vice President Vacant

Secretary Dolores Parr, Zurich

Treasurer Robert Olausen, Insurance Services Office, Inc.

Executive Committee Michael V. Branley, The Hartford

Tracey Santor, Travelers Mark Struthers, CUMIS

Advisors Michael Davisson, Sedgwick LLP

CharCretia V. Di Bartolo, Hinshaw & Culbertson LLP

Advisors Emeritus Samuel J. Arena, Jr., Stradley, Ronon, Stevens & Young, LLP

Bernard L. Balkin, Gilliland & Hayes, PC Robert Briganti, Belle Mead Claims Service, Inc.

Michael Keeley, Strasburger & Price, LLP Harvey C. Koch, Montgomery Barnett, LLP

Armen Shahinian, Wolff & Samson PC

The Fidelity Law Journal is published annually. Additional copies may be purchased by writing to: The Fidelity Law Association, c/o Wolff & Samson PC, One Boland Drive, West Orange, New Jersey 07052. The opinions and views expressed in the articles in this Journal are solely of the authors and do not necessarily reflect the views of the Fidelity Law Association or its members, nor of the authors’ firms or companies. Publication should not be deemed an endorsement by the Fidelity Law Association or its members, or the authors’ firms or companies, of any views or positions contained herein. The articles herein are for general informational purposes only. None of the information in the articles constitutes legal advice, nor is it intended to create any attorney-client relationship between the reader and any of the authors. The reader should not act or rely upon the information in this Journal concerning the meaning, interpretation, or effect of any particular contractual language or the resolution of any particular demand, claim, or suit without seeking the advice of your own attorney.

The information in this Journal does not amend, or otherwise affect, the terms, conditions or coverages of any insurance policy or bond issued by any of the authors’ companies or any other insurance company. The information in this Journal is not a representation that coverage does or does not exist for any particular claim or loss under any such policy or bond. Coverage depends upon the facts and circumstances involved in the claim or loss, all applicable policy or bond provisions, and any applicable law.

Copyright © 2014 Fidelity Law Association. All rights reserved. Printed in the USA. For additional information concerning the Fidelity Law Association or the Journal, please visit our website at http://www.fidelitylaw.org.

Information which is copyrighted by and proprietary to Insurance Services Office, Inc. (“ISO Material”) is included in this publication. Use of the ISO Material is limited to ISO Participating Insurers and their Authorized Representatives. Use by ISO Participating Insurers is limited to use in those jurisdictions for which the insurer has an appropriate participation with ISO. Use of the ISO Material by Authorized Representatives is limited to use solely on behalf of one or more ISO Participating Insurers.

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Patrick J. Collins is the Managing Attorney of Collins & Coldwell, LLC in Denver, Colorado. Mark J. Struthers is a Claims Consultant at CUMIS Insurance Society, Inc. in Madison, Wisconsin. Andrew L. Hunter, Patrice B. Collins and Shae E. Steven of Collins & Coldwell, LLC contributed to the content of this article. 231

PROTECTING THE INSURER’S SUBROGATION AND RECOVERY RIGHTS THROUGHOUT THE

CLAIM INVESTIGATION

Patrick J. Collins Mark J. Struthers

I. INTRODUCTION

The claims process is triggered upon receipt of a notice of loss alerting the insurer that an insured may potentially have a claim under the bond. When the claims professional first receives the notice of loss, subrogation and recovery may seem a world away. However, it is important that the claims professional identify potential obstacles to subrogation early in the claims process so that the insurer can be prepared when subrogation issues ultimately arise.

Throughout the claim investigation, the claims professional can identify and evaluate recovery prospects and communicate clearly with the insured to preserve the insurer’s right to subrogate. By identifying and working toward the resolution of potential subrogation issues, a claim professional can draft a settlement agreement that makes the insurer’s transition from the claim to subrogation more manageable and less costly. The purpose of this article is to demonstrate how careful planning by the fidelity claims professional can help protect the insurer’s subrogation and recovery rights. While this article is not intended to constitute an exhaustive list of potential subrogation and recovery issues, it is intended to provide the claims professional with a roadmap to protect the insurer’s post-claim interests. Accordingly, this article will discuss the following: (1) the doctrine of subrogation; (2) identification and evaluation of recovery and subrogation prospects throughout the

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232 Fidelity Law Journal, Vol. XX, November 2014

claim investigation; (3) negotiation of an amicable settlement agreement with the insured while preserving subrogation rights; (4) mitigation of potential conflicts with the insured arising from an insurer’s recovery and subrogation efforts; and (5) addressing the made whole doctrine as a limit to recovery.

II. THE DOCTRINE OF SUBROGATION

Subrogation is a legal mechanism defined as the substitution of another person in place of the creditor or claimant to whose rights he or she succeeds in relation to the debt or claim.1 By undertaking to indemnify or pay the principal debtor’s obligation to the creditor or claimant, the “subrogee” succeeds to all the rights, priorities, remedies, liens and securities of the “subrogor.”2

“In the case of insurance, subrogation takes the form of the insurer’s right to be put in the position of the insured in order to pursue recovery from third parties legally responsible to the insured for a loss that the insurer has both insured and paid.”3 After making payment, the subrogated insurer “stands in the shoes” of the insured to assert all claims which the insured himself could have asserted.4 The subrogee does not

1 BLACK’S LAW DICTIONARY 1467 (8th ed. 2004). 2 16 LEE R. RUSS & THOMAS F. SEGALIA, COUCH ON INSURANCE

§ 222:4 (3d ed. 1984). 3 Fireman’s Fund Ins. Co. v. Md. Cas. Co., 77 Cal. Rptr. 2d 296, 302

(Cal. Ct. App. 1998); see also Allstate Ins. Co. v. Loo, 54 Cal. Rptr. 2d 541, 543 (Cal. Ct. App. 1996); Liberty Mut. Fire Ins. Co. v. Auto Spring Supply Co., 131 Cal. Rptr. 211, 213-14 (Cal. Ct. App. 1976); Fireman’s Fund Indem. Co. v. State Comp. Ins. Fund, 209 P.2d 55, 57-58 (Cal. Ct. App. 1949); RUSS & SEGALIA, supra note 2, at § 222:5; 11 B. WITKIN, SUMMARY OF CALIFORNIA LAW, EQUITY

§ 169 (10th ed. 2005). 4 See Blue Cross & Blue Shield of Fla., Inc. v. Matthews, 498 So. 2d

421, 422 (Fla. 1986); Mayer v. Wylie, 494 S.E.2d 60, 63 (Ga. Ct. App. 1997) (Smith, J., concurring specially); Russ & Segalia, supra note 2, at § 222:5; see also Cont’l Ins. Co. v. Kennerson, 661 So. 2d 325, 327 (Fla. Dist. Ct. App. 1995); Grinnell Mut. Reinsurance Co. v. Recker, 561 N.W.2d 63, 69 (Iowa 1997).

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Protecting the Insurer’s Subrogation and Recovery Rights 233

obtain rights that the subrogor did not have.5 In the context of fidelity insurance, subrogation technically applies only to the insurer’s right to proceed against a third party responsible for a loss which the insurer has compensated pursuant to its contractual obligation under a policy, and which depends, inter alia, on the existence of the insured’s right to proceed against that entity.6

It has become a fundamental tenet of insurance law that opportunity for net gain to an insured through the receipt of insurance proceeds exceeding the insured’s loss is inimical to the public interest.7 Accordingly, subrogation effectuates an equitable adjustment between parties by preventing unjust enrichment to insureds and furthering the principal of indemnity.8 While assuring that the burden is placed on the party (or parties) responsible for causing the loss, subrogation is a mechanism that helps keep insurance premiums to a minimum while preventing a double windfall to the insured. Although the payment need not always be in a direct monetary transfer from insurer to insured,9 as a general rule, no right of subrogation arises until the claim has been paid.10 Because the insurer’s rights “flow from” the insured, “[i]n a subrogation suit, a tortfeasor may assert against the insurer any defense which the tortfeasor could have asserted against the insured.”11

5 United States v. Munsey Trust Co. of Wash., D.C., 332 U.S. 234, 242

(1947); Fireman’s Fund Ins. Co., 77 Cal. Rptr. 2d at 303; Cent. Nat’l Ins. Co. v. Ins. Co. of N. Am., 522 N.W.2d 39, 44 (Iowa 1994).

6 See RUSS & SEGALIA, supra note 2, at § 222:2. 7 Johnny C. Parker, The Made Whole Doctrine: Unraveling the Enigma

Wrapped in the Mystery of Insurance Subrogation, 70 MO. L. REV. 721, 725 (2005).

8 Id. 9 See RUSS & SEGALIA, supra note 2, at § 223:10. 10 See Aetna Cas. & Sur. Co. v. Phoenix Nat’l Bank & Trust Co., 285

U.S. 209, 216 (1932); RUSS & SEGALIA, supra note 2, at § 223:17. 11 State Farm Fire & Cas. Co. v. Pac. Rent-All, Inc., 978 P.2d 753, 767

(Haw. 1999) (quoting 4 R. LONG, THE LAW OF LIABILITY INSURANCE § 23.03[2] (1998)); see also Seabright Ins. Co. v. Matson Terminals, Inc., 828 F. Supp. 2d 1177, 1191 (D. Haw. 2011).

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The doctrine of subrogation can be traced to Roman law12 and has its modern foundations in English common law courts. By the 1780s, English Courts of Chancery recognized the doctrine of subrogation as a type of suretyship, where one party (“A”) pledged to become legally liable for a debt of another party (“B”) in the event of the defaulting parties (“B’s”) failure to perform in a contract with another party (“C”).13 In that instance, English common law recognized that party “A” was automatically subrogated to the all the rights of party “C” as matter of equity.14

Today, subrogation arises in three contexts: (1) equitable subrogation; (2) statutory subrogation; and (3) contractual subrogation. Equitable subrogation is based upon principals of equity and objective fairness and is most commonly applied to preserve priority rights of a first lienholder. It arises as an operation of law and not by any contract, assignment or privity.15 Equitable subrogation is broad enough to include every instance in which one person, not acting voluntarily, has paid a debt for which another was primarily liable and which that other party should have been paid.16

The second type of subrogation is statutory subrogation, which arises from a legislative enactment that vests the right of subrogation in a person, entity or organization.17 In some instances, statutory subrogation can give an insurance carrier the right to recover from statutes governing issues including workers’ compensation, hospital liens and Medicare.18

12 See M.L. Marasighe, An Historical Introduction to the Doctrine of

Subrogation: The Early History of the Doctrine, 10 VAL. U. L. REV. 45, 45-54 (1975); Gary L. Wickert, The Societal Benefits of Subrogation, CLAIMS

JOURNAL, Dec. 6, 2012, http://www.claimsjournal.com/news/national/ 2012/12/ 06/218682.htm.

13 Marasighe, supra note 12, at 49. 14 Id. at 50. 15 St. Paul Fire & Marine Ins. Co. v. Murray Guard, Inc., 37 S.W.3d

180, 183 & n.1 (Ark. 2001); Century Indem. Co. v. London Underwriters, 16 Cal. Rptr. 2d 393, 397 (Cal. Ct. App. 1993).

16 St. Paul Fire & Marine Ins. Co., 37 S.W.3d at 183 (quoting 73 AM. JUR. 2D SUBROGATION § 14 (1974)).

17 PARKER, supra note 7, at 726. 18 Wickert, supra note 12.

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Contractual subrogation, the third type of subrogation, arises out of a contract between the parties, and can be manifested in many forms including insurance contracts, release agreements, assignments or trust agreements.19 In the fidelity law field, the contracting parties are the insured and the insurer and the contract governing subrogation can be found in the policy or bond.

For instance, the Surety and Fidelity Association of America’s Standard Form No. 24 Financial Institution Bond contains provisions regarding “ASSIGNMENT—SUBROGATION—RECOVERY.”20 Sec-tion 7 of the Financial Institution Bond states, in pertinent part:

(a) In the event of payment under this bond, the Insured shall deliver, if so requested by the Underwriter, an assignment of such of the Insured’s rights, title, and interest and causes of action as it has against any person or entity to the extent of the loss payment.

(b) In the event of payment under this bond, the Underwriter shall be subrogated to all of the Insured’s rights of recovery therefor against any person or entity to the extent of such payment.21

When the insured’s loss is fully paid, any other amount recovered would be viewed as double recovery and returned to the insurer up to the amount of its claim payment. Accordingly, after the claim has been paid, the insurer, by operation of law, inherits the rights of the insured to seek recovery from the bad actors who caused the loss sustained by the insured. Typically, after a claim payment is made and the parties sign a release, the insurer may pursue a claim directly against another party responsible for causing the loss to the financial institution based on the contractual subrogation clause expressly provided in the

19 Parker, supra note 7, at 726. 20 See Financial Institution Bond, Standard Form No. 24 (Revised to

May, 2011) [hereinafter Financial Institution Bond], reprinted in STANDARD

FORMS OF THE SURETY & FIDELITY ASSOCIATION OF AMERICA. 21 Id. Section 7 of the Financial Institution Bond also contains sections

(c) and (d) governing recoveries and the insured’s duty to cooperate, which will be reviewed infra Part V.

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insurance contract.22 The party responsible for causing the loss may be the claim principal and his or her associates, the financial institution customer, or a third party professional (to name a few options).

III. IDENTIFICATION AND EVALUATION OF RECOVERY AND SUBROGATION PROSPECTS THROUGHOUT THE CLAIM

INVESTIGATION

A. The Right of Recovery and Its Limitations

The insurer’s “right of recovery” is similar yet distinct from the right to subrogation. While subrogation allows the insurer to “step in the shoes” of the insured to file suit against the party who caused the loss, the right of recovery permits the insurer to reduce the amount of the insurer’s loss by recovering property or money that was covered by the claim payment. Like subrogation, the recovery provision in the insurance contract helps keep insurance provisions to a minimum and prevents the insured from recovering more than the amount of their loss.

The aforementioned Section 7 of the Financial Institution Bond contains a provision specifying the order of recovery and the insured’s duty to assist in recovery. Section 7 states, in pertinent part:

(c) Recoveries, whether effected by the Underwriter or by the Insured, shall be applied, net of the expense of such recovery, first to the satisfaction of the Insured’s loss which would otherwise have been paid but for the fact that it is in excess of either the Single or Aggregate Limit of Liability, secondly, to the Underwriter as reimbursement of amounts paid in settlement of the Insured’s claim, thirdly, to the Insured in satisfaction of any Deductible Amount, and fourthly, to the Insured for any loss not covered by this bond. Recovery on account of loss of securities as set forth in the third paragraph of Section 6, or recovery from reinsurance and/or

22 KPMG Peat Marwick v. Nat’l Union Fire Ins. Co., 765 So. 2d 36, 38

(Fla. 2000) (holding that insurer under fidelity bond may assert claim against its insured’s independent auditor for professional malpractice).

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indemnity of the Underwriter shall not be deemed a recovery as used herein.23

Accordingly, if the insurer has an excess loss that is not covered by the insurance contract, any recovery of property or money made by the insured or insurer will first go to cover that excess loss.24 After the excess loss has been collected by recovery of the insured, the insurer is next in line to be reimbursed up to the amount of its claim payment.25

During the claims process, it is prudent for the claims professional to identify all parties who hold priority for any recoveries, especially when there is an excess, unpaid portion of the loss. The claims professional can discuss with the insured the policy provisions addressing priority recovery rights from the beginning of the claim process to ensure there are no misunderstandings or surprises as the claim progresses or at the time of settlement. The claims professional can also provide in writing the relevant policy provisions relating to subrogation, recovery, and the insured’s duty of cooperation at the initial contact stage of the claim for the same reasons.

B. Identification of Potential Sources of Recovery

From the beginning of the claim, the claim investigator can identify and evaluate prospects for subrogation and recovery. This includes identifying responsible parties and their assets. Performing asset checks early in the claim investigation supports timely and effective mitigation and recovery efforts, which can benefit both the insurer and the insured. While this discussion of potential sources of recovery is by no means intended to be all encompassing, below is a list of common sources of recovery that a claims professional can be aware of and act to protect throughout the claims investigations process.

1. Restitution Orders

In employee dishonesty claims, the claim principal is often the most obvious source for a claims professional to begin researching the

23 Financial Institution Bond, supra note 20. 24 Id. 25 Id.

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possibility of recovery. However, the claims professional may also consider the possibility that associates of the claim principal benefitted from the claim principal’s malfeasance. In claims involving theft, embezzlement or fraud on the part of the claim principal or a third party, one form of recovery to consider is the possibility of obtaining a restitution order naming the insured as the victim of a crime.

a. The Benefits of a Federal Restitution Order

Upon receipt of a dishonesty claim, the claims professional can immediately determine whether a criminal investigation has been initiated against the bad actor(s). If the insured has not yet contacted law enforcement authorities regarding possible criminal behavior, the claim investigator may consider contacting the authorities, or advise its insured to report the theft to authorities. It can be beneficial to contact federal authorities if there has been a potential violation of federal law. Federal prosecution may be based on embezzlement from a federally-insured financial institution26, or intent to defraud a federally-insured financial institution.27

Upon payment of the claim, the insurer can complete a Victim Impact Statement and deliver it to either the Federal Bureau of Investigation or the United States Attorney’s Office with jurisdiction, depending on the status of the criminal case against the claim principal.

The advantages of reporting a potential crime to federal authorities lie in the application of the Mandatory Victims Restitution Act of 1996.28 The MVRA amended Title 18 section 3563 of the United States Code to make paying restitution a condition of probation and also a mandatory part of many federal sentences.29 The MVRA prioritizes private victim restitution orders by specifying “[r]estitution to all victims.”30 Under the language of the MVRA, the term “victim”

26 18 U.S.C. § 657 (2012). 27 18 U.S.C. § 1006 (2012). 28 18 U.S.C. § 3663A (2011) [hereinafter MVRA]. 29 Mandatory Victims Restitution Act of 1996, Pub. L. No. 104-132,

110 Stat. 1227 (1996). 30 § 207(c)(2), 110 Stat. at 1238 (codified at 18 U.S.C. § 3612(c)

(2013)).

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includes persons “other than the victim of the offense” where a court has ordered restitution to such a person under 18 U.S.C. § 3663(a)(3).31 Accordingly, when the claim principal or a third party is being criminally prosecuted, it is of the utmost importance to alert the United States Attorney’s Office that the insurer has paid a claim and become the victim of the loss.

Significantly, the MVRA declared that where both the United States Government and a private victim are owed restitution, “the court shall ensure that all other victims receive full restitution before the United States receives any restitution.”32 The MVRA also makes the United States responsible for the collection of restitution, stating “[t]he Attorney General shall be responsible for collection of an unpaid fine or restitution . . . .”33 This collection provision is extremely advantageous to the insurer who has attained the status of victim after paying the claim, because seeking recovery against a dishonest claim principal or third party can often be a long and expensive exercise.

b. Enforcement of Restitution Orders Under the MVRA

The MVRA specifically repealed prior statutory law which authorized the United States Government to enforce restitution orders “in the same manner as a judgment in a civil action.”34 In so doing, the MVRA stated that restitution may be enforced in any manner provided under 18 U.S.C. §§ 3611‒3615.35 Accordingly, the MVRA amended 18 U.S.C. § 3613, a fine enforcement mechanism, to include enforcement of a restitution order.36 After making this inclusion, the MVRA specifically states that the United States may enforce a judgment imposing restitution

31 § 204(a), 110 Stat. at 1228 (codified at 18 U.S.C. § 3663A(a)(3)). 32 § 206(a), 110 Stat. at 1235 (codified at 18 U.S.C. § 3664(i) (2013)). 33 § 207(c)(2), 110 Stat. at 1237-1238 (codified at 18 U.S.C. § 3612(c)). 34 § 205(a)(2), 110 Stat. at 1230 (striking 18 U.S.C. § 3663(c)-(i)). 35 18 U.S.C. § 3664(m)(1)(A)(i) (2011). 36 18 U.S.C. § 3664 (2011).

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“in accordance with the practices and procedures for the enforcement of a civil judgment under Federal law or State law.”37

As procedures for the enforcement of a civil action under federal law include the enforcement procedures available under the Fair Debt Collection Practices Act,38 this change effectively removes restitution enforcement mechanisms from state procedural laws and places it under the purview of the FDCPA. Further, section 3001(a)(1) of the FDCPA states that it “provides the exclusive civil procedures for the United States—(1) to recover a judgment on a debt; or (2) to obtain, before judgment on a claim for a debt, a remedy in connection with such claim.”39 The FDCPA is therefore the exclusive federal procedure for garnishment of a restitution order issued under the MVRA.

The United States Court of Appeals for the First Circuit analyzed the MVRA’s restitution enforcement provision in United States v. Witham and specifically ruled that the federal government may use the FDCPA’s garnishment procedure to enforce an order of restitution to a private party victim of a federal crime.40 The case involved a debate over the narrow question of whether the federal government could collect restitution for a private victim of a federal crime or only debts owed to the government.41 The Court ultimately held that the MVRA gave the federal government authority to use the FDCPA to enforce restitution orders for the benefit of private victims.42

Federal enforcement of private victim restitution orders, especially through the use of garnishment, provides an insurer with a strong possibility of recovering some of its loss without expending large amounts of resources. Due to the explicit preservation of victim’s rights laid out in the MVRA, the United States Attorney’s Office is often more responsive to the queries of the insurer regarding restitution enforcement

37 Mandatory Victims Restitution Act of 1996 § 207(c)(3), 110 Stat. at

1238 (codified at 18 U.S.C. § 3613(a)) (emphasis added). 38 28 U.S.C. §§ 3001‒3308 (2012) [hereinafter FDCPA]. 39 28 U.S.C. § 3001(a)(1). 40 648 F.3d 40, 47-49 (1st Cir. 2011). 41 Id. at 41. 42 Id. at 41, 47‒49.

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than may otherwise be the case if the restitution were ordered by the State.

2. Objecting to the Dischargeability of a Debt Owed to the Insured

Exceptions to discharge of a debt in bankruptcy are governed by 11 U.S.C. § 523 and include false pretenses, false misrepresentation, actual fraud, defalcation while acting in a fiduciary capacity, embezzlement, larceny and willful and malicious injury.43 At the outset of the claim investigation, the claim investigator can determine if any of the above-listed actions may have been committed by the claim principal or a third party, such as a customer of the financial institution. The claims professional can then note that there are allegations of dishonest behavior by either the claim principal or third parties.

If a claim principal or other bad actor, including a dishonest borrower, files for bankruptcy protection during the claim investigation, the claims professional can determine whether the claim merits a partial payment to the insured in order to preserve the right to object to the dischargeability of the bad actor’s debt owed to the insured. In the alternative, the claims professional may also consider whether to require the insured to object to dischargeability in order preserve any right to recover from the bad actor. Deciding to take action is very important in cases where the claim principal and/or other associates own assets of value, such as a home, or maintain steady employment.

Making this decision timely is important, as objections to bankruptcy petitions must be made within the timeframe allotted on the notice of bankruptcy. If the insurer chooses not to timely object, it will lose the possibility of recovering from the bad actors as long as the debt was reported on the bankruptcy petition and the insured was given notice of the bankruptcy filing.44

43 See 11 U.S.C. § 523(a) (2012). 44 See 11 U.S.C. § 362 (2012).

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C. Identification of Potential Sources of Subrogation

1. Actions Against Third Party Professionals

Third party professionals are often responsible for part of the loss sustained by a financial institution. In cases in which a third party professional acted negligently or intentionally against the financial institution’s interest, the claims professional can list all involved third parties so that, upon payment of the claim, the insurer can accurately assess the risks and benefits of subrogation actions against potential bad actors.

a. Real Estate Appraisers

Many fidelity bond claims involve mortgage loans made on properties that were overvalued at the time the loan was made. In these cases the insured is unable to mitigate the loss due to the lack of equity in the property. When these types of bond claims arise, the claims professional can review the original appraisal of the property against a subsequent appraisal in order to assess the possibility of a subrogation action against the appraiser of real property.

The Financial Institutions Reform, Recovery and Enforcement Act of 1989,45 Title XI,46 controls the conduct of a licensed real estate appraisers. The purpose of FIRREA is to ensure that real estate appraisals are conducted in accordance with uniform standards.47 These standards require that “all appraisals be performed in writing by individuals whose competency has been established and whose conduct will be supervised effectively.”48 FIRREA established an Appraisal Standards Board to provide these guidelines, which were then promulgated as the Uniform Standards of Professional Appraisal Practice.49

45 Hereinafter FIRREA. 46 12 U.S.C. § 3331‒3355 (2012). 47 12 U.S.C. § 3331. 48 Id. 49 12 U.S.C. § 3332.

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The Uniform Standards of Professional Appraisal Practice (“USPAP”) guidelines are published annually.50 The guidelines are divided into Definitions, Preamble, Rules, Standards and Standards Rules (which include comments), and the Statements on Appraisal Standards.

Most states have adopted a version of the Real Estate Appraisers Act, which governs the administrative regulation of all appraisers licensed in accordance with FIRREA.51 While USPAP does not require that a real estate appraisal be perfect, it does establish a standard that requires an appraiser to use diligence and due care in formulating a market valuation and not render services in a careless or negligent manner.52

Importantly, numerous courts have upheld negligent misrepresentation and professional malpractice claims against real estate appraisers in connection with defective appraisals. For example: in Superior Bank, F.S.B. v. Tandem National Mortgage, Inc., the Court found the defendant appraiser liable to a third party for negligent misrepresentation.53 In First Federal Savings & Loan Association of Rochester v. Charter Appraisal Co., the court held that the economic-loss doctrine did not bar a repurchaser’s negligent misrepresentation claim against the appraiser where a contract was entered into between the appraiser and the plaintiff.54 Rather, the Connecticut Supreme Court affirmed the district court’s finding for the plaintiff when the appraiser overvalued real property and the bank relied on appraisal values in good faith.55 In First State Savings Bank v. Albright & Associates of Ocala, Inc., the Florida Court of Appeals held that a real estate appraiser may be

50 See UNIFORM STANDARDS OF PROFESSIONAL APPRAISAL PRACTICE,

2014-2015 Uniform Standards of Professional Appraisal Practice (Appraisal Standards Bd. 2014) [hereinafter USPAP].

51 See, e.g., ME. REV. STAT. ANN. tit. 9-A, § 3-316 (2011). 52 See Private Mortg. Inv. Servs., Inc. v. Hotel & Club Assocs., Inc.,

296 F.3d 308, 315 (4th Cir. 2002) (holding that it is a failure to exercise due care that allows for civil claims against real estate appraiser).

53 197 F. Supp. 2d 298, 312 (D. Md. 2000). 54 724 A.2d 497, 501‒04 (Conn. 1999). 55 Id.

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liable to third parties for negligent misrepresentation.56 Finally, in Costa v. Neimon, the Wisconsin Court of Appeals found that a real estate appraiser may be held liable to third parties not in privity of contract with the appraiser for negligent misrepresentation of an appraisal on which the third party reasonably relied.57

b. Outside Auditors

Pursuant to federal law, American depository institutions must obtain some form of independent outside audit every year.58 Certified public accountants who conduct audits of financial institutions have duties imposed on them by federal law as well as by the American Institute of Certified Professional Accountants,59 including the AICPA Professional Code of Conduct.60 Auditing standards are also imposed under the Generally Accepted Auditing Standards,61 the Generally Accepted Accounting Practices,62 and the terms of the contractual engagement entered into between the outside auditors and the financial institutions. Determining whether these standards were violated can become very complex depending on what type of audit was performed. For example in an audit of financial statements, the outside auditor will determine whether the financial statements represented, in all material respects, the true financial condition of the financial institution and were prepared in conformity with GAAP. On the other hand, in an Agreed Upon Procedure63 engagement, the auditor’s scope will be limited to the terms of the contract, the AICPA standards governing AUP engagement, and the AICPA Professional Code of Conduct.

56 561 So. 2d 1326, 1329 (Fla. Dist. Ct. App. 1990), overruled on other

grounds by Garden v. Frier, 602 So. 2d 1273 (Fla. 1992). 57 366 N.W.2d 896, 898 (Wis. Ct. App. 1985). 58 12 C.F.R. § 363 (2012). 59 Hereinafter AICPA. 60 12 C.F.R. § 363.3; AICPA CODE OF PROFESSIONAL CONDUCT (Am.

Inst. of Certified Pub. Accountants 2014). 61 CODIFICATION OF ACCOUNTING STANDARDS AND PROCEDURES,

Statement on Auditing Standards No. 95, § 150 (Am. Inst. of Certified Pub. Accountants 2013); hereinafter GAAS.

62 RESEARCH AND DEV. ARRANGEMENTS, Statement of Fin. Accounting Standards No. 1, § 420 (Fin. Accounting Standards Bd. 2013); hereinafter GAAP.

63 Hereinafter AUP.

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A claims professional does not need to be intimately familiar with auditing standards in order to alert the insurer’s recovery department that there may be subrogation potential regarding work (or lack of work) performed by the financial institution’s outside auditors. In this regard, a claims professional can make note of situations in which the malfeasance of the claim principal escaped the eyes of the outside auditors. Ultimately, upon payment of the claim, the insurer and its counsel must determine whether a potential subrogation action against an outside auditor has merit and whether it is worth pursuing complex litigation as a form of potential recovery. The insurer will be unable to make this determination however, if the claims professional fails to alert other departments to the possibility of subrogation against the outside auditors.

IV. NEGOTIATING AN AMICABLE SETTLEMENT AGREEMENT WITH THE INSURED WHILE PRESERVING SUBROGATION

RIGHTS

After it has been determined that a claim is to be paid by the insurer, it is critical that the claims professional carefully draft an all-encompassing settlement agreement which explains the terms of the settlement and protects the insurer’s right to subrogate and recover for claim payments made. A settlement agreement can include release terms which, at their most basic level, delineate what the insured is releasing in exchange for a claim payment. The release terms contained in a settlement agreement may vary drastically from claim to claim to address the unique circumstances involved in each claim.

A. Scope of Release

The “scope” of a release is an area of negotiation which can have significant implications for both the insured and the insurer at a future date. The more broadly a release is worded, the more protective it is to the insurer with regard to potential exposure to future claims filed. Conversely, the more narrowly a release is worded, the more protective it is to the insured with regard to opportunities to file future claims for losses later realized or discovered.

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This concept will be best illustrated through the following hypothetical claim scenario, with release language options ranging from narrow to broad:

Claim Scenario: John Doe, a former loan officer of Insured, allegedly approved 20 vehicle loans in conscious disregard of Insured’s lending policy, as all 20 loans had loan-to-value ratios in excess of established policy limits. All 20 loans have been charged-off, and the direct cause of Insured’s resulting loss has been shown to be Mr. Doe’s conscious disregard of his employer’s lending policy. Coverage is being afforded by Insurer for the 20 loans, and a release is being negotiated between Insured and Insurer.

The release contains the following language:

For and in consideration of the payment provided herein, Insured hereby releases and forever discharges Insurer of and from any and all existing claims, demands, obligations, liabilities, costs, expenses, attorneys’ fees, rights of action and causes of action of any kind, resulting from or arising out of [insert i., ii., or iii.]:

i. Narrow: the lack of faithful performance of John Doe with respect to the 20 loans named herein.

ii. Moderate: the lack of faithful performance of John Doe with respect to all loans he approved, underwrote or otherwise handled during his employment as a loan officer at Insured.

iii. Broad: any and all unfaithful, dishonest or improper acts of John Doe whether known or unknown at this time, which could have been claimed under any insurance policy underwritten by Insurer which may have provided coverage to Insured.

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If an insurer prefers the use Option iii, it will likely be better received if the insured is made aware early in the claim investigation process that a future release and settlement of its claim will be broadly-scoped. In that case, the insured can choose to conduct internal audits necessary within the allotted timeframes to uncover all suspected wrongdoings committed by the named claim principal, instead of submitting claims piecemeal. Oftentimes, with such a forewarning and opportunity to review its records for potential additional items of claim, the insured is much more receptive to Option-iii-type release language.

Generally speaking, where proposed release terms are reviewed by the insured’s attorney, negotiations focused on narrowing the scope of the release language may be required to reach an amicable settlement of the claim.

B. Release of Performing Loans

Perhaps in anticipation of releasing “any and all future claims” against a particular employee, an insured may submit a claim for “loan losses” which includes performing loans (i.e., current or delinquent, but not yet charged-off), in addition to its charged-off loans. This type of claim may arise after a financial institution has conducted a loan audit which reveals an improper lending practice by a former loan officer that affected the approvals of both performing and charged-off loans. To be conservative, an insured may submit every loan wherein the improper conduct has been identified, regardless of the loan’s status.

Despite the fact that the performing loans may never cause a loss to the insured, the insurer has been called upon to make a coverage assessment on these loans. This type of claim submission, while certain to complicate the release, may be encouraged by insurance companies who may ultimately save time and resources by adjusting one comprehensive claim instead of several piecemeal claims which arise with each additional set of loan charge-offs.

When settling a claim that involves both charged-off and performing loans, it is important that the release addresses how the performing loans will be handled moving forward. In drafting a settlement agreement for this type of claim, the professional has several options.

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Depending on timing and the feasibility of keeping a portion of the claim open, the insured has the option to enter into a “partial” release and settlement agreement with its insured.64 Suppose the claim investigation has been completed, and coverage is determined to exist for twenty loans; however, only ten of those loans have been charged-off and the remainder are performing. A partial release may afford payment for the charged-off loans and may set parameters for monitoring the performing loans while delineating payment terms and coverage agreements in the event that the performing loans default. This type of agreement would require the insured and insurer to schedule periodic updates wherein the insured will report on the loans’ statuses.

The above-described partial release method may not be feasible if the claim involves a larger number of loans. Suppose a claim identifies 200 loans, half of which have been charged-off and half of which are performing. Perhaps it is imprudent for the insurer to allot the time or financial resources to investigate and provide coverage determinations on the 100 performing loans in the chance that they default in the future. Therefore, an insurer may choose to perform its claim evaluation on only the charged-off loans. A resulting partial release may afford a coverage payment on certain charged-off loans while concurrently carving out a promise by the insurer to evaluate the performing loans for coverage—waiving policy time limits—in the event that the insured reports them as charged-off.

Any form of a “partial” release, by definition, will leave the claim in an “open” status, which may be undesirable or impracticable for the insured for a number of reasons. Therefore, settlement negotiations between the insurer and insured could yield a “full and final” release of the claim, despite the fact that it involves a number of performing loans.

Understandably, it may be challenging for the insurer to persuade the insured to release its claim on loans which—despite their

64 A partial release may be entered into for a variety of reasons

unrelated to performing loans, including where an insured has proven the merits of a portion of its claim earlier than other portions requiring further claim production or investigative steps, or where partial claim payment is necessary to keep the credit union afloat or is a requisite to the initiation of time-sensitive subrogation actions.

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present “performing” status—exhibit the same underwriting issues reflected in the charged-off loans. An agreement by the insured to accept an estimated settlement payment in exchange for the release of its claim on the performing loans is, simply put, a gamble for the insured. That is, if all performing loans in a claim are ultimately paid in full by the borrowers, the insured will “doubly” recover on those loans after accounting for the settlement payment plus the payoffs by the borrowers. Conversely, a negotiated settlement in exchange for the release of performing loans could ultimately equate to far less than the total future charge-offs on those loans.

To compute an accurate settlement estimate for the performing loans, an insurer can utilize the data it has gathered throughout its claim investigation, including loan performance trends and the incidence of afforded coverage. To accomplish the goal of a full and final settlement, the professional may present an estimate to the insured by calculating the statistical charge-off rate of the loans in the claim, and then computing the percentage of covered losses among the total charge-offs. With those figures, the insurer may: 1) estimate future charge-offs among the presently-performing loans, and 2) estimate the percentage of coverage that would be afforded to those future charge-offs based on the coverage found on the present charge-offs.

By utilizing claim statistics in this way to present a full and final settlement offer on the claim’s performing loans, it is more likely that an insured would feel comfortable releasing its claim on performing loans.

C. Waiver of Recovery Rights

Subrogation rights should be addressed and delineated in any release and settlement of a claim. By virtue of making a claim payment, the insurance company becomes legally subrogated to the rights of the insured to pursue recovery against any party who may be deemed responsible for causing the loss paid by the settlement.65 As subrogee, the insurer “stands in the shoes” of the insured in pursuing its rights of recovery against responsible parties.66 Notably, the release and

65 See RUSS & SEGALIA, supra note 2, at 222:4. 66 See Blue Cross & Blue Shield of Fla., Inc. v. Matthews, 498 So. 2d

421, 422 (Fla. 1986).

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settlement executed between the insurer and insured should include a provision whereby, in exchange for the claim payment, the insured agrees to assist the insurer in pursuing rights of subrogation by providing documentation or witnesses as may be necessary to provide testimony or authenticate records at trial.

A subrogation action may be brought against any responsible party including: a former employee of the financial institution, a car dealership or property appraiser thought to be in collusion with a former employee, or an auditor who negligently performed independent audits for the financial institution. But the most basic form of recovery is against the defaulted borrower on the loan underlying the claim payment. Most likely, recovery against the defaulted borrower has already been pursued by the insured’s collection department, including the repossession and disposition of collateral and the obtaining of a judgment against the borrower for the deficiency balance.

It often takes years for financial institutions to recover any significant amount from its collection efforts. Collections may produce nominal or sporadic payments from the borrower, when the borrower is gainfully employed. Once in a while, collection efforts may produce more significant garnishment payments or even a full recovery if the individual receives an inheritance. With this in mind, the insurer may consider the amount of time and financial resources that it will take to recover from the defaulted borrowers and decide whether it is in the insurer’s best interest to retain recovery rights against defaulted borrowers or to waive the recovery rights in order to negotiate a settlement with the insured.

An insurer’s decision to release recovery rights is most conservative when the collateral securing the loans being paid has already been recovered, disposed of, and applied toward the loan balance, and the insured is merely collecting payments to apply toward the deficiency balances.

Allowing the insured to retain collection rights against defaulted borrowers does not impair the insurer’s ability to initiate subrogation lawsuits against third parties and claim principals responsible for causing the loss. Rather, it is simply a method by which the insured and insurer can come to a negotiated settlement without having to monitor the

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insured’s collection efforts and demand the remittance of payments each time the insured collects.

V. MITIGATING POTENTIAL RECOVERY CONFLICTS

BETWEEN THE INSURER AND THE INSURED

Cooperative efforts by the insurer and insured in addressing mitigation and recovery issues during the claim investigation can pave the way for a successful resolution to the claim. As settlement approaches, the parties to the claim will have already made progress relating to issues surrounding subrogation, recovery, and cooperation, allowing them to focus on other issues necessary to resolve the claim.

Importantly, the matters of who will bear the cost of recovery and who will bear the cost of subrogation against the parties who caused the loss need to be addressed and resolved as soon as possible during the claim process. Identifying the insurer’s and the insured’s rights and responsibilities relating to mitigation, subrogation, and recovery rights based on policy provisions and law need to be understood by both parties from the start of the claim in order to support necessary cooperation in their efforts during and after the claim. Identifying the rights and responsibilities also helps both parties understand who should bear the cost of these efforts.

The claim investigator also needs to ensure that the insured understands its duty to secure and protect, and not impair, subrogation and recovery rights for the benefit of the insurer. Understanding by the insured of this duty early in the claim process also helps the insured protect its rights to the ultimate claim settlement as it has incentive to undertake reasonable mitigation attempts that can minimize its loss prior to settlement. This supports cooperative efforts between the parties and sets the stage for a successful claim resolution.

A. The Insured’s Duty to Cooperate

As touched on briefly above, apart from paying the premium when it is due, the primary obligation that the insured owes the insurer is

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the duty to cooperate.67 In the context of fidelity claims investigation, the duty to cooperate commits the insured to providing evidence for its claim and participating in the claims investigation process. In the context in which a claim payment has been made to the insured, the duty of cooperation extends to enforcement subrogation and recovery rights and participating in litigation. Importantly, the duty of cooperation also forbids the insurer from taking any action to harm the insured’s claim.

In the Financial Institution Bond, the duty to cooperate is split into two provisions, Section 7(d) and Section 8. Section 7(d) is purposefully placed in the section covering assignment, subrogation and recovery to specifically enforce the insured’s cooperation in those areas. Section 7(d) states:

(d) The Insured shall execute all papers and render assistance to secure to the Underwriter the rights and causes of action provided for herein. The Insured shall do nothing after discovery of loss to prejudice such rights or causes of action.68

Section 8 of the Financial Institution Bond is titled “COOPERATION.” That section states:

Upon the Underwriter’s request and at reasonable times and places designated by the Underwriter, the Insured shall:

(a) submit to examination by the Underwriter and subscribe to the same under oath; and

(b) produce for the Underwriter’s examination all pertinent records; and

67 ROBERT H. JERRY II, UNDERSTANDING INSURANCE LAW 845 (3d ed.

1987). 68 Financial Institution Bond, supra note 20.

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(c) cooperate with the Underwriter in all matters pertaining to any claim or loss.69

The cooperation clause serves the dual purpose of protecting the insurer’s interests and to prevent collusion between the insured and the injured party. 70 Even if the insured’s duty to cooperate was not expressly stated in the insurance contract, the duty is implied under general contract law principles,71 including the duty of good faith and fair dealing. The Illinois Supreme Court explained the importance of the insured’s duty to cooperate when it stated:

Typically the insurer has little or no knowledge of the facts surrounding a claimed loss, while the insured has exclusive knowledge of such facts. The insurer is, therefore, dependent on its insured for fair and complete disclosure; hence, the duty to cooperate. When the insured has no obligation to assist the insurer in any effort to defeat recovery of a proper claim, the cooperation clause does obligate the insured to disclose all of the facts within his knowledge and otherwise to aid the insurer in its determination of coverage under the policy.72

Because the duty to cooperate is implied in every contract in which cooperation is necessary for performance,73 the duty extends to cover the insurer’s right to protect its subrogation and recovery rights. The duty to cooperate is one of the foremost tools in aiding a maximum recovery during the claims investigation process.

69 Id. 70 Martin v. Travelers Indem. Co., 450 F.2d 542, 533 (5th Cir. 1971);

Arton v. Liberty Mut. Ins. Co., 302 A.2d 284, 288 (Conn. 1972); M.F.A. Mut. Ins. Co. v. Cheek, 363 N.E.2d 809, 811 (Ill. 1977); M.F.A. Ins. Co. v. Sailors, 141 N.W.2d 846, 849 (Neb. 1966); see also 8 JOHN A. APPLEMAN & JEAN

APPLEMAN, INSURANCE LAW AND PRACTICE § 4771 (1981). 71 Jerry, supra note 67, at 845. 72 Waste Mgmt., Inc. v. Int’l Surplus Lines Ins. Co., 579 N.E.2d 322,

333 (Ill. 1991). 73 See, e.g., Birmingham Fire Ins. Co. v. Am. Nat’l Fire Ins. Co., 947

S.W.2d 592, 596 (Tex. Ct. App. 1997).

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B. Inclusion of an Express Duty to Cooperate in the Settlement Agreement

As discussed above, most, if not all, courts recognize an implied duty imposed on the insured to cooperate with its insurer throughout a bond claim. Moreover, any well drafted fidelity insurance contract will contain a duty to cooperate imposed on the insured as a premise for claim payment. But the duty to cooperate does not cease at the execution of a settlement agreement between insurer and insured. Rather, it can be argued that the insured’s duty to cooperate throughout the insurer’s recovery efforts is equally as important as its duty to cooperate with the claim investigation conducted by the insurer. Accordingly, it is very important that the duty to cooperate is also enshrined in the release and settlement agreement entered into between the insurer and the insured, though it may already exist in the fidelity bond.

A duty to cooperate clause in a release and settlement agreement serves to alert the insured that it will be bound to continuing duties as the insurer seeks recovery from actors responsible for the loss. Notably, the affirmative contractual recognition of the duty to cooperate at the close of the fidelity bond claim can serve to limit an insured’s unfavorable reaction to the insurer’s filing of a subrogation lawsuit which will demand cooperation on the part of the insured. This is especially true in cases involving professional negligence claims made against third parties that are either wholly or partly responsible for the loss sustained by the insured. In such cases, some level of burden will be placed on the insured. For example, an insured will often be asked to produce an extensive amount of documentation to respond to the opposing side’s discovery requests. These requests usually encompass production of general ledger accounts, board minutes and policies and procedures from years past. The insured will then be asked to allow its employees to sit for depositions regarding what is often a bit of a painful memory. Many times a defendant in a professional negligence suit will assert the defense of comparative negligence. Accordingly, depositions of an insured’s employees can often focus on tasks that the employee could have done to prevent the loss from occurring. If a case is going to trial, the insured will be asked to allow its employees to testify in open court. Being deposed in an accusatory setting or providing trial testimony can be a stressful experience. Crafting a specific duty to cooperate clause in the

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settlement agreement alerts the insured to its continuing duty owed to the insurer and removes the possibility of acrimony between an insurer and an insured should subrogation litigation commence.

VI. THE MADE WHOLE DOCTRINE AS A LIMIT TO RECOVERY

In the event that part of the insured’s loss goes unpaid, the insured and insurer are competing for the same pool of funds to recover for the loss. Because of the subrogation and right of recovery provisions expressly contained in Section 7 of the Financial Institution Bond, fidelity insurers may believe that the insurance contract protects the insurer’s right to first recovery after the insurer has paid the claim and received an assignment or acknowledgement of contractual subrogation from the insured. However, some states have denied the insurer’s right to recover by applying equitable principals to express contract subrogation provisions, as is done when subrogation arises by an operation of law and not by an agreed upon contract.74

A. The “Anti-Subrogation Rule”

As the name implies, the Made Whole Doctrine, or “Anti-subrogation Rule,” is an equitable principal that places the burden of an unpaid loss on the insurer. The doctrine is defined as follows:

It is widely held that in the absence of contrary statutory law or valid contractual obligation to the contrary, the general rule under the doctrine of equitable subrogation is that whether an insured is entitled to recovery for the same loss from more than one source, e.g., the insurer and the tortfeasor, it is only after the insured has been fully compensated for all the loss that the insurer acquires a right to subrogation.75

Couch also states that “where the right of an insurer to subrogation is expressly provided for in the policy, its rights must be

74 See Garrity v. Rural Mut. Ins. Co., 253 N.W.2d 512, 515 (Wis.

1977). 75 RUSS & SEGALIA, supra note 2, at § 233:12.

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measured by, and depend solely on, the terms of such a provision.”76 Typically, the Made Whole Doctrine “operates as a default rule” and as such, most courts have determined that “the parties can contract out of [it]” provided they do so with “sufficient clarity”.77

Under the Made Whole Doctrine, the insured maintains the priority of rights to collect from the responsible third party until it is fully compensated for all of its damages.78 The fundamental tenet of the Made Whole Doctrine can be summarized as: “[Where] either the insurer or the insured must to some extent go unpaid, the loss should be borne by the insurer for that is a risk the insured has paid it to assume.”79 Fidelity bonds provide express assignment and subrogation clauses as described in the above-cited Section 7, in an effort to ensure that the insurer’s right to subrogate is judicially recognized.

While recognition of the Made Whole Doctrine is generally accepted, its application varies from state to state.80 Some states have used the Made Whole Doctrine to limit the insurer’s right to recover until an insured is fully compensated for its loss, even when the insurance contract explicitly states the insurer’s right to first recovery after payment. For the purposes of this article, we classify states’ application of the Made Whole Doctrine into three categories:

(1) States that observe the contractual subrogation provisions explicitly described in an insurance contract as a limit to the Made Whole Doctrine;

76 Id. 77 Dist. No. 1-Pac. Coast Dist. v. Travelers Cas. & Sur Co., 782 A.2d

269, 276 (D.C. 2001); see also, e.g., Cagle v. Bruner, 112 F.3d 1510, 1521 (11th Cir. 1997); Culver v. Ins. Co. of N. Am., 559 A.2d 400, 402‒04 (N.J. 1989).

78 Parker, supra note 7, at 737. 79 St. Paul Fire & Marine Ins. Co. v. WP Rose Supply Co., 198 S.E.2d

482, 484 (N.C. Ct. App. 1973); Garrity, 253 N.W.2d at 514. 80 Massachusetts does not adhere to the Made Whole Doctrine. In

Frost v. Porter Leasing Corp., 436 N.E.2d 387 (Mass. 1982), the Massachusetts Supreme Court stated: “A health insurer should not be obliged to forego asserting subrogation rights in order to assist in making a claimant whole on some other aspect of his damages, such as lost wages and pain and suffering, for which the insured has not purchased coverage from the health insurer.”

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(2) States that only limit contractual subrogation when the terms of the contract would violate or interfere with mandated coverage under state statute; and

(3) States that do not allow the contractual modification of the Made Whole Doctrine.

Before we review states’ application of the Made Whole Doctrine, we examine how the doctrine is applicable under a fidelity bond.

B. Application of the Made Whole Doctrine to Fidelity Coverage

The Made Whole Doctrine applies to fidelity bond coverage when the insured suffers an excess loss not covered under the bond.81 That application is demonstrated in District No.1-Pacific Coast District v. Travelers Casualty and Surety Company.82 In that case, Aetna issued a fidelity bond to two labor unions (collectively the “MEBA”) to insure against any lack of faithful performance on behalf of the unions’ employees.83 The bond limited the coverage to $100,000 per employee, but excess coverage was provided for certain employees.84

Four MEBA employees covered by the excess coverage stole nearly $2 million from the union by making bogus payments to themselves during the merger with another union.85 The MEBA made a claim under its fidelity bond to recover the funds embezzled by its employees.86 MEBA also made a claim for the salaries paid to the four employees, which was denied by the insurer because it was not covered under the bond.87

81 Samuel J. Arena, Jr. & Marianne Johnston, Determining the Amount

of Loan Loss and the Potential Income Exclusion, in LOAN LOSS COVERAGE

UNDER FINANCIAL INSTITUTION BONDS 153, 216 (Gilbert J. Schroeder & John J. Tomaine eds., 2007).

82 782 A.2d at 275-76. 83 Id. at 270‒71. 84 Id. at 271. 85 Id. 86 Id. at 271‒72. 87 Id. at 272.

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The recovery provision in the bond allowed MEBA to recover “any loss covered by this bond which exceeds the amount of indemnity provided by this bond.”88 MEBA and Aetna reached an agreement where the insurer paid over $1 million of the embezzlement losses while in return MEBA agreed to “assig[n] all rights, title and interest” to Aetna, with limited exceptions enumerated in paragraph 4 of the Agreement.89 Paragraph 4 provided that the parties would share any additional recoveries in accordance with the following:

a. Subject to the excess loss provisions set forth in the Bond, AETNA and the Insured will share in the recovery of any monies not exceeding the amount of the aforesaid payment received either through the Court, from the United States Government, or directly from Messrs. C.E. DeFries, Clyde Dodson and Claude Daulley, with AETNA receiving 75% and the Insured receiving 25% of any monies so recovered until AETNA has received 75% of the aforesaid payment to the Insured.

b. It is expressly understood that the preceding sharing agreement does not apply to the first $409,662.37 of any recovery of monies from C.E. DeFries. Such amount will be the sole property of the Insured. If additional monies beyond the $409,662.37 are recovered from C.E. DeFries[,] . . . the sharing agreement specified in the preceding paragraph . . . will be applicable to such additional recovery.90

Subsequently, MEBA filed a civil restitution action to recover the embezzled money from its employees, ultimately reaching a settlement in which it recovered over $900,000.91 Following settlement, MEBA advised Aetna of its recovery and claimed that under Paragraph 4 of the Agreement it was entitled to keep all of the recovered funds. Aetna maintained that it was owed 75% of the funds under the

88 Id. 89 Id. 90 Id. 91 Id.

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Agreement.92 Travelers (Aetna’s successor in interest) filed suit for the union’s breach of the Agreement.93

MEBA argued that to be “made whole,” it was entitled to recover all losses from the employees, including salaries and severances paid.94 Travelers argued that per the Agreement, it was entitled to 75% of the monies received from wrongdoers (other than DeFries).95 Travelers also insisted that the fidelity bond did not cover wrongly procured salaries, and in any case, MEBA had waived any claim that they were covered by agreeing to settle the claim.96

The trial court reasoned that the settlement between MEBA and Aetna was unambiguous as to the parties understanding that the bond only covered embezzlement losses, not salary and severance losses.97 Because Aetna only insured MEBA for losses stemming from embezzlement, the insurer did not have to wait until the insured was made whole before sharing in its recovery.98 The Court of Appeals for the District of Colombia affirmed Travelers’ right to reimbursement by rejecting MEBA’s argument that the “made whole” doctrine requires a different result than what the Agreement already expressly provided.99

The Court’s holding in District No. 1 implicitly recognized the parties’ right to freely contract, which is the prevailing determination in regard to insurance contracts in most jurisdictions. However, as we will see, some jurisdictions are unwilling to uphold subrogation provisions present in insurance contracts without fusing the contract terms with principals of equity.

92 Id. 93 Id. 94 Id. at 273. 95 Id. 96 Id. 97 Id. 98 Id. 99 Id. at 275-76.

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C. Contracting Out of the Made Whole Doctrine

1. States Permitting Contractual Modification of the Made Whole Doctrine

A majority of the states apply the Made Whole Doctrine only when there is no assignment, subrogation or priority agreement provided in the insurance contract. Within that class, a few states require only broad subrogation language to be present in the policy to modify the equitable principals of the Made Whole Doctrine.100 Even though contractual modification of the Made Whole Doctrine is permitted in the majority of states, many of the states allowing contractual modification require clear and unambiguous contract language explicitly stating the insurer is entitled to priority in recovery. If the contract contains specific language regarding the insurer’s priority of rights, courts in many states will generally permit the contractual language to take priority over any equitable principals..101 A few of those states are detailed below:

100 Auto. Ins. Co. of Hartford v. Conlon, 216 A.2d 828, 829 (Conn.

1966); Cary v. Phoenix Ins. Co., 78 A. 426, 430 (Conn. 1910); Eddy v. Sybert, 783 N.E.2d 106, 109‒10 (Ill. App. Ct. 2003) (holding that contract terms need not be specific, but must be enforceable).

101 Ex parte State Farm Fire & Cas. Co., 764 So. 2d 543, 546 (Ala. 2000); Wolfe v. Alfa Mut. Ins. Co., 880 So.2d 1163 (Ala. Civ. App. 2003); Samura v. Kaiser Found. Health Plan, 22 Cal. Rptr. 2d 20, 24‒27 (Cal. Ct. App. 2003); Auto. Ins. Co. of Hartford, 216 A.2d at 829; Dist. No. 1-Pac. Coast Dist., 782 A.2d at 276; Blue Cross & Blue Shield of Fla., Inc., 498 So. 2d at 422; Fla. Farm Bureau Ins. Co. v. Martin, 377 So. 2d 827, 830 (Fla. Dist. Ct. App. 1979); Duncan v. Integon Gen. Ins. Co., 482 S.E.2d 325, 326 (Ga. 1997); Erie Ins. Co. v. George, 681 N.E.2d 183, 188 (Ind. 1997); Ludwig v. Farm Bureau Mut. Ins. Co., 393 N.W.2d 143, 146-47 (Iowa 1986); Unified School Dist. No. 259 v. Sloan, 871 P.2d 861, 865 (Kan. 1994); Wine v. Globe Am. Cas. Co., 917 S.W.2d 558, 564 (Ky. 1996); Stancil v. Erie Ins. Co., 740 A.2d 46, 49‒50 (Md. Ct. Spec. App. 1999); Morin v. Mass. Blue Cross, Inc., 311 N.E.2d 914, 916 (Mass. 1974); Medica, Inc. v. Atl. Mut. Ins. Co., 566 N.W.2d 74, 77 (Minn. 1997); Westendorf v. Stasson, 330 N.W.2d 699, 703 (Minn. 1983); Ploen v. Union Ins. Co., 573 N.W.2d 436, 443 (Neb. 1998); Providence Washington Ins. Co. v. Hogges, 171 A.2d 120, 124 (N.J. 1961); Williams & Miller Gin Co. v. Baker Cotton Oil Co., 235 P. 185, 187 (Okla. 1925); Julson v. Federated Mut. Ins. Co., 562 N.W.2d 117, 121 (S.D. 1997); Hill v. State Farm Mut. Auto. Ins. Co., 765 P.2d 864, 866 (Utah 1988); Collins v. Blue Cross & Blue Shield of Va.,

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California—The Made Whole Doctrine only applies when there is no agreement to the contrary.102 California courts require specific contractual subrogation language that grants insurers “all right of recovery against any party for loss to the extent that payment is therefore made by this company.”103 Any contract provision should also provide language that the insurer recovery rights are “first dollar” or “first in priority” rights.104

Indiana—The Made Whole Doctrine applies, but can be overridden by contract terms that are “clear, unequivocal and so certain as to admit no doubt on the question.”105 Standard subrogation language will not modify the Made Whole Doctrine.106

Kentucky—Courts consider all agreements and communications, including but not limited to settlement agreements, policy and plan language, releases and trusts agreements, to determine the parties’ intent in waiving the Made Whole Doctrine.107 However, language

193 S.E.2d 782, 784‒85 (Va. 1973); Thiringer v. Am. Motorist Co., 588 P.2d 191, 194 (Wash. 1978); Kanawha Valley Radiologists, Inc. v. One Valley Bank, 557 S.E.2d 277, 281-82 (W. Va. 2001).

102 See Barnes v. Indep. Auto. Dealers of Cal. Health & Welfare Benefit Plan, 64 F.3d 1389, 1395 (9th Cir. 1995).

103 See Travelers Indem. Co. v. Ingebretsen, 113 Cal. Rptr. 679, 684-85 (Cal. Ct. App. 1974); see also Shifrin v. McGuire & Hester Constr. Co., 48 Cal. Rptr. 799, 802-03 (Cal. Ct. App. 1966).

104 Barnes, 64 F.3d at 1395. 105 Capps v. Klegs, 382 N.E.2d 947, 950 (Ind. Ct. App. 1978). 106 Id.; see also Willard v. Auto. Underwriters, Inc., 407 N.E.2d 1192,

1193 (Ind. Ct. App. 1980). 107 Wine v. Globe Am. Cas. Co., 917 S.W.2d 558, 563‒65 (Ky. 1996).

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must clearly and explicitly provide insurer with right of subrogation.108

Texas—If a contract provides for subrogation regardless of whether the insured is first made whole, the contract’s specific language controls and the equitable defense of the Made Whole Doctrine must be overridden.109 Also, when the insurer relies upon a subrogation provision found in a settlement agreement (executed after the payment of benefits giving rise to the subrogation claim), the Made Whole Doctrine is not considered.110

Washington—Made Whole Doctrine may be overridden by specific plan or policy language to the contrary, and the provisions must be “clear and unambiguous”.111

2. States Allowing Contractual Modification of the Made Whole Doctrine Barring Any Conflict With Competing State Statutes

A few states have limited the parties’ ability to contractually modify around the Made Whole Doctrine when the contract terms violate or interfere with mandated coverage under state statutes.112 Such state

108 Id. 109 See Osborne v. Jauregui, Inc., 252 S.W.3d 70, 80 (Tex. Ct. App.

2008); see also Matthiesen, Wickert & Lehrer, S.C., The Made Whole Doctrine in all 50 States, 41‒44 (Sept. 27, 2013), http://www.mwl-law.com/wp-content/uploads/2013/03/made-whole-doctrine-in-all-50-states.pdf.

110 Rosa’s Café, Inc. v. Wilkerson, 183 S.W.3d 483, 488 (Tex. Ct. App. 2005); Matthiesen, Wickert & Lehrer, S.C., supra note 109, at 42.

111 See Thiringer v. Am. Motors Ins. Co., 588 P.2d 191, 194‒95 (Wash. 1978) (en banc); see also Fisher v. Aldi Tire, Inc., 902 P.2d 166, 168‒69 (Wash. Ct. App. 1995).

112 Gary L. Wickert & Loren R. Smith, Contracting Away Made Whole: Does the Made Whole Doctrine Apply if Your Policy/Plan Says it Doesn’t?, NASP SUBROGATOR 94, 97 (Fall 2006), available at http://www.mwl-

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statutes typically mandate coverage and include uninsured motorist coverage, no-fault coverage and personal injury protection coverage.113

3. States That Do Not Allow Contractual Modification of the Made Whole Doctrine

A small but significant minority of states do not recognize insurers’ and insureds’ ability to contractually modify the Made Whole Doctrine.114 These states have “blurred” the distinction of equitable and contractual subrogation to allow the Made Whole Doctrine as an equitable defense to contractual subrogation.

Wisconsin’s case law has done more to influence the expansion of the Made Whole Doctrine than that of any other state such that the state has been referred to as “the mother of all made whole states.”115 Wisconsin courts have held that “[s]ubrogation is recognized or denied upon equitable principles, without differentiation between ‘legal subrogation,’ arising by application of equity, or ‘conventional subrogation,’ arising from contracts or acts of the parties.”116 By blurring the distinction and reasoning behind equitable and contractual subrogation, Wisconsin courts have determined that “the conventionally subrogated or contractual insurer has no share in the recovery from the

law.com/wp-content/uploads/2013/03/CONTRACTING-AWAY-MADE-WHOLE-NASP-FALL-06.pdf.

113 See Colo. Rev. Stat. § 10-4-713(1) (2000); Colo. Rev. Stat. § 10-4-717 (2000); Me. Rev. Stat. Ann. tit. 24-A, § 2902 (2005); R.I. Gen. Laws § 27-7-2.1 (1993), R.I. Gen. Laws § 31-31-7 (1993); see also Marquez v. Prudential Prop. Cas. Ins. Co., 620 P.2d 29, 32 (Colo. 1980); Wescott v. Allstate Ins. Co., 397 A.2d 156, 164‒65 (Me. 1979); Lombardi v. Merchs. Mut. Ins. Co., 429 A.2d 1290, 1293 (R.I. 1981).

114 Franklin v. Healthsource of Ark., 942 S.W.2d 837, 839-40 (Ark. 1997); Hare v. State, 733 So. 2d 277, 284 (Miss. 1999); Swanson v. Hartford Ins. Co., 46 P.3d 584, 589‒90 (Mont. 2002); York v. Sevier Cnty. Ambulance Auth., 8 S.W.3d 616, 621 (Tenn. 1999).

115 Matthiesen, Wickert & Lehrer, S.C., supra note 109, at 106. 116 Am. Ins. Co. v. City of Milwaukee, 187 N.W.2d 142, 145 (Wis.

1971).

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tort-feasor if the total amount recovered by the insured from the insurer does not cover his loss.”117

In Rimes v. State Farm Mutual Automobile Insurance Co., the Wisconsin Supreme Court refused to recognize a subrogation clause present in an insurance contract under which the insurer made payment pursuant to the medical-pay provisions of its policy.118 The insurance contract contained a subrogation agreement allowing the insurer to subrogate to the extent of its payments.119 Further, upon payment under the medical-pay provisions, the insured signed a subrogation receipt covering the payments made by State Farm.120 The provisions of the subrogation receipts provided a cooperation clause as well as a first right of recovery clause to State Farm.121

After the insured recovered additional funds from the tortfeasors, the trial court refused to recognize State Farm’s contractual provisions regarding its right to recover the funds attributable to its claim payment until a finding had been made that the insured had been “made whole.”122 The trial court then held a two-day mini trial to determine the insured’s madewholeness.123 After determining that the insured had not been “made whole,” the court refused to recognize the insurer’s right to subrogation as provided in the insurance contract and subrogation receipt.124 On appeal, the Wisconsin Supreme Court held that the trial court properly denied the insurer’s subrogation rights because the insured’s damages exceeded the amount that she had recovered from both the insurer and the tortfeasor.125

Over the next thirty years, Wisconsin continued to uphold the rule that the Made Whole Doctrine can trump express policy or plan

117 Garrity, 253 N.W.2d at 515. 118 316 N.W.2d 348, 353-56 (Wis. 1982). 119 Id. at 350. 120 Id. at 350‒51. 121 Id. 122 Id. at 353. 123 Id. at 351‒52. 124 Id. at 352. 125 Id. at 356.

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provisions to the contrary.126 However, recently, the court has determined that express subrogation clauses in ERISA benefit plans trump the Made Whole Doctrine. In Steffens v. BlueCross BlueShield of Illinois, BlueCross paid nearly $68,000 to the insured under BlueCross’s ERISA benefits plan.127

BlueCross’s plan contained a subrogation clause as well as a first right of recovery clause that explicitly rejected the Made Whole Doctrine.128 BlueCross’s first right of recovery clause stated:

The Plan’s right to reduction, reimbursement and subrogation will not be reduced even if the recovery does not fully compensate you or your dependents, or you or your dependents were not made whole, for all losses sustained or alleged, or the recovery is not described as being related to medical costs. The amount the Plan is entitled to will also not be reduced by legal fees or court costs incurred in seeking the recovery. Any so-called “make-whole” or “full-compensation” rule or doctrine is hereby explicitly rejected and disavowed.129

The Wisconsin Supreme Court held that subrogation clauses in ERISA benefit plans trump the Wisconsin Made Whole Doctrine because in the context of ERISA contracts, it was a “principle of contract law that parties are entitled to the benefits of their bargain.”130 The court determined that because the plan’s first right of recovery clause expressly disclaimed the Made Whole Doctrine, the insurer was able to fully recover the funds that it had paid out pursuant to the policy, regardless of

126 See Drinkwater v. Am. Family Mut. Ins., 714 N.W.2d 568, 573

(Wis. 2006) (“[A]n insured must be made whole before an insurer may exercise subrogation rights against its insured, even when unambiguous language in an insurance contract states otherwise.”); Ruckel v. Gassner, 646 N.W.2d 11, 19 (Wis. 2002).

127 804 N.W.2d 196, 200‒01 (Wis. 2011). 128 Id. at 200. 129 Id. 130 Id. at 209 (citing Cutting v. Jerome Foods, Inc., 993 F.2d 1293,

1298‒99 (7th Cir. 1993) (“[Under ERISA] the make-whole rule is just a principle of interpretation, it can be overridden by clear language in the plan.”)).

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whether the injured party was “made whole” through settlement.131 In so doing, the Steffens court followed the well-established rule that ERISA preempts the existing state rules that enforce the Made Whole Doctrine.132

Wisconsin has yet to extend the holding in Steffens to subrogation clauses outside of ERISA benefit plans. If it were to do so, it would almost certainly be on the basis of an express recovery clause that fully disclaimed the Made Whole Doctrine. Accordingly, BlueCross’s plan language is a model for drafting policy language and settlement agreements alike.

VII. CONCLUSION

Understanding how decisions made during the claim investigation affect recovery and subrogation rights of the insurer is an important aspect of adjusting a fidelity bond claim. This includes considering the possibility of recovery and subrogation throughout the claim investigation and conducting negotiations with the insured with this in mind. To preserve the insurer’s recovery rights, a claim professional can include clear and unequivocal language in a settlement agreement with the insured, expressly stating the insurer’s right to recuperate recovered property and monies. Further, a settlement agreement can include a clause describing the insured’s duty to cooperate with subrogation litigation in order to proactively mitigate any potential conflicts that may arise between the insurer and the insured during recovery efforts.

131 Id. at 209‒13. 132 See Wal-Mart Stores, Inc. Assocs.’ Health & Welfare Plan v. Scott,

27 F. Supp. 2d 1166, 1170‒71 (W.D. Ark. 1998); Marshall v. Emp’rs Health Ins. Co., 927 F. Supp. 1068, 1072‒73 (M.D. Tenn. 1996); Ramsey Cnty. Med. Ctr., Inc. v. Breault, 525 N.W.2d 321, 324‒25 (Wis. Ct. App. 1994); see also RUSS & SEGALIA, supra note 2, at § 223:139.

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