Wolff & Samson PC

Fraud in the Inducement as a Defense to Fidelity and Surety Claims

Fall 2006

By: Bodoga M. B. Clarke, James D. Ferrucci, and Armen Shahinian

Tort Trial & Insurance Practice Law Journal

Bodoga M. B. Clarke (bclarke@ific.com) is Senior Vice President/General Counsel at International Fidelity Insurance Co. in Newark, New Jersey. James D. Ferrucci (jferrucci@wolffsamson.com) and Armen Shahinian (ashahinian@wolffsamson.com) are members of the law firm Wolff & Samson PC, resident in the firm’s West Orange, New Jersey, Office. The authors also wish to acknowledge the assistance of Scott J. Goldstein, an associate with Wolff & Samson, in connection with the preparation of this article.

 


I. INTRODUCTION


Under general principles of contract law, contractual obligations may be avoided by a party whose assent was given under circumstances which vitiate its validity. Contracts induced by intentional, or even under some circumstances innocent, misrepresentations may be abrogated, provided that the party relying on such misrepresentations acts promptly upon discovery thereof to void the contract. The equitable remedy of rescission has been applied to contracts of insurance and of suretyship to discharge, respectively, the fidelity insurer and the surety of their obligations on the basis of both affirmative misrepresentations or failure to disclose material facts which caused either to miscalculate the risk being assumed. When applicable, rescission results in a contract being voided in its entirety. The remedy, therefore, affords the fidelity insurer or the surety, as the case may be, a complete defense to the claim of an insured or obligee and is not limited to the extent of demonstrable prejudice.

In order to appreciate fully the application of common law principles of fraud in the inducement in the context of fidelity coverage or surety bonds, an understanding of those principles is helpful. Accordingly, a brief overview of them as set out in the Restatement (Second) of Contracts is presented in Part II of this article. Part III addresses issues raised by the fraud in the inducement defense to claims under fidelity policies, and Part IV does the same with respect to surety bonds. Part V explores the potential for waiver of the right to rescission by contractual disclaimer or by ratification from inaction.

II. BASIC PRINCIPLES OF RESCISSION FOR FRAUD


Under the Restatement (Second) of Contracts, a contract is voidable by a victim of misrepresentation under the following circumstances:

§164. When A Misrepresentation Makes A Contract Voidable

(1) If a party's manifestation of assent is induced by either a fraudulent or a material misrepresentation by the other party upon which the recipient is justified in relying, the contract is voidable by the recipient.

(2) If a party's manifestation of assent is induced by either a fraudulent or a material misrepresentation by one who is not a party to the transaction upon which the recipient is justified in relying, the contract is voidable by the recipient unless the other party to the transaction in good faith and without reason to know of the misrepresentation either gives value or relies materially on the transaction.1


A "misrepresentation" is "an assertion that is not in accord with the facts.”2 A misrepresentation is "fraudulent" if "the maker intends his assertion to induce a party to manifest his assent" and the maker (a) "knows or believes that the assertion is not in accord with the facts," (b) "does not have the confidence that be states at implies in the truth of the assertion," or (c) "does not have the basis that he states for the assertion."3 A misrepresentation is "material" if "it would be likely to induce a reasonable person to manifest his assent, or if the maker knows that it would be likely to induce the recipient to do so.4 Thus, although a contract is rendered voidable by a misrepresentation which is intended to deceive and is therefore fraudulent, an intent to deceive is not required as long as the misrepresentation is material. Conversely, although materiality is necessary if a misrepresentation is innocent, it is not necessary when there was an intention to mislead 5 In either case, the recipient must have been justified in relying on the misrepresentation to enter into the contract. Overall, under the common law as set out in the Restatement of Contracts, one seeking to void a contract must establish the following four elements: first, there must be a misrepresentation; second, the misrepresentation must be either fraudulent or material; third, the misrepresentation must have induced the recipient to make the contract; and fourth, the recipient must have been justified in relying on the misrepresentation. 6

III. FIDELITY BONDS


Despite use of the word "bond" in the shorthand term "fidelity bond," the phrase typically refers to "specialized insurance coverage" 7 by which financial institutions or commercial enterprises seek to protect themselves from the dishonest conduct of their employees.8 As a species of first-party insurance, fidelity coverage creates a contractual relationship between two parties: the purchasing insured which seeks protection and the insurer which issues and underwrites the coverage.

In this context, common law rules governing rescission for fraud can be applied straightforwardly. Rescission, however, is a strong remedy and when applied to insurance can raise policy concerns about denuding insureds of insurance protection. Many states have enacted statutes which specify the grounds upon which rescission of insurance policies will be permitted; and, as insurance, fidelity bonds are subject to those statutes. The statutes typically do not depart significantly from common law principles; instead, they seek to regulate the application of common law rules in the insurance context. Materiality, for example, is usually defined in terms of the underwriting factors which go into the insurer's decisions as to the issuance of coverage. One consequence of tying the definition of materiality so directly to underwriting decisions is that some courts conclude that reliance as a separate element is superfluous. The intent to deceive is also typically addressed in the statutes, though the majority allows rescission for innocent misrepresentations so long as the statutory materiality test is met and therefore are consistent with common law principles. In a minority of states, however, the opposite is the case. In states which have not enacted such statutes, there is decisional law which requires an intent to deceive for some kinds of misrepresentation thereby limiting the category of innocent misrepresentations which will support rescission.

Fidelity insurance creates a two-party contract to which the parties are the insurer which issues the coverage and the business entity seeking the protection provided by it. A corporation, however, can only know that which is known to the persons who act on its behalf. When the person applying for fidelity coverage on behalf of a corporate entity is either himself engaged in dishonesty or has knowledge of the dishonesty of other employees, a third set of interests becomes involved in the process. The question then becomes whether, and to the extent to which, the knowledge of such a person should be imputed to the corporate applicant in determining whether the fidelity insurer may avoid liability because it was induced to issue coverage by the fraud of that person.

A. Materiality of the Misstatement

1. Statutory Definitions

Statutes governing rescission of insurance policies for fraud typically define materiality as a misrepresentation which, if the insurer had known the truth, would have caused the insurer to (i) not issue the coverage at all, (ii) not issue it at the same premium rate, (iii) not issue it in as large an amount; or (iv) not include coverage with respect to the particular hazard which ultimately resulted in the loss.9 Whether the misrepresentation is, in fact, material and would have led to a different underwriting decision is usually judged from the subjective standpoint of the insurer 10 as opposed to an external standard of some kind. For example, California law provides that “[m]ateriality is to be determined not by the event, but solely by the probable and reasonable influence of the facts upon the party to whom the communication is due, in forming his estimate of the disadvantages of the proposed contract, or in making his inquiries.” 11 New York's Court of Appeals stated that:

Any decision that a misrepresentacion is not material must, of course, be based upon a holding, as question either of law or of fact, that the departure from the truth was not a factor which deprived a person of freedom of action and did not induce a choice which otherwise might not have been made. In no case which has been called to our attention has a court of this or other jurisdiction enforced a policy where information demanded by an insurance company "in order to decide whether it would issue a pclicy" and which might reasonably be considered a factor in arriving at a choice has been withheld. The question in such case is not whether the company might have issued the policy even if the information had been furnished; the question in each case is whether the company has been induced to accept an application which it might otherwise have refused. "Any misrepresention which defeats or seriously interferes with the exercise of such a right cannot truly be said to be an immaterial one.”12


Similarly, the Utah Supreme Court has held that the "materiality of a fact misrepresented or withheld is determined by the probable and reasonable effect that a truthful disclosure would have had upon the insurer in determining the advantages of the proposed contract," basing this analysis on the concept of a "reasonable and prudent insurer." 13 Some states have utilized a mixed standard, requiring the information to be such that the insurer would deem it material and the insured would have reason to believe the information important to the insurer.14 In either case, the issue is generally a question of fact which revolves around the impact, actual and/or perceived, of the misrepresentation on decisions regarding issuance of the coverage.

Some misrepresentations, however, so obviously increase the risk to the fidelity insurer that they are, for all intents and purposes, material as a matter of law. In the fidelity context, failure to disclose knowledge of prior employee dishonesty in an application for fidelity bonding is accepted as one such misrepresentation. 15 The U.S. Court of Appeals for the Second Circuit examined a misrepresentation of this type in In re Payroll Express Corp.16 In that case, the insurers issued employee theft policies to Payroll Express Corp. ("PEC"). The president and CEO of PEC, in applying for the policies, was required to answer the following questions: (a) "[H]as the proposer suffered a loss during the past five years? If 'Yes' give brief details and amount involved," and (b) "Is there any other information which is or may become material to the proposed insurance and which is not already disclosed to the underwriters?" In response to the questions, the CEO admitted to a single burglary loss of $1,500,OOO and stated that there was no additional material information.17 In fact, there had been 18 losses during the previous five years, and the CEO and other employees had long been diverting funds for their own use.18 In analyzing the effect of the misrepresentations, the court determined that the misrepresentations were "reasonably related to the estimation of the risk or the assessment of the premium," so there could be "no doubt that [the CEO's] failure to inform [the insurer] in response to question 36 that certain employees were embezzling funds from PEC was material as a matter of law.”19

2. Reliance

Under the common law, reasonable reliance by the defrauded party is an essential element of fraud in the inducement. 20 In the insurance context, the statutes or decisional law in some states define materiality such that reliance is subsumed thereunder, with the result that reliance is eliminated as a separate element of a cause of action for fraud in the inducement. Some jurisdictions, however, follow the common law and retain the requirement that reliance on the misrepresentation must be established as part of the prima facie case for rescission.21


The decision in Shapiro v. American Home Assurance Co. 22 is an example of the approach which does not require separate proof of reliance. There, the court examined the issue of reliance upon misrepresentations in an application for directors and officers liability insurance under Massachusetts law. In opposing the insurer's motion for summary judgment, the insured argued that reliance must be shown separately in order to rescind the policy. 23 The Shapiro court flatly rejected that contention, holding tbat

[it] is likely that reliance is not treated as an independentrequiremem because the standard of materiality under Massachusetts common and starotory law is snch that any statement that is shown to be material is one so central to the risk being insured that the insurer would be expected to take it into consideration in making the underwriting decision. 24

 

The court noted that the long-standing Massachusetts definition of materiality in insurance contracts is facts "the knowledge or ignorance of which would naturally influence the judgment of the underwriter in making the contract at all, or in fixing the rate of the premium.”25 Under this standard, reliance is presumed once materiality is shown.

The decision in Zimmerman v. Continental Casualty Co.26 exemplifies the approach which does require a separate showing of reliance. In that case, the insurer sought to rescind an accident policy based upon the decedent insured's misrepresentations in the application for insurance. 27 The Nebraska Supreme Court, looking to the language of the applicable starute,28 held that


in order for misrepresentacions in an applicacion for insurance to conscimtc a defense to an action on the contract it is incumbent upon the insurance company to plead and prove, among other thiugs, that the statements or misrepresentations were made knowingly by the insured with the intent to deceive and that the insurance company relied and acted upon such statements or representations and was deceived by them to its injury. 29

 

The court noted that this result would have been attained under either the special accident insurance statute, Nebraska Revised Statutes §4-710.14, or the general insurance statute, Nebraska Revised Statutes §44-358. 30 The jury instructions, however, did not require the insurer to prove that it had relied to its detriment upon the misrepresentations, and in light of that omission, the Zimmerman conrt remanded the case for a new trial.31


B. Intent to Deceive

1. Statutory Requirements

a. Intent to Deceive Not Required - Most states wlrich have statutes governing rescission for fraud follow common law principles and permit rescission for an innocent misrepresentation which is material as well as for a misrepresentation made with the intent to deceive 32 The Arkansas statute is typical and provides as follows:

(a) All statements and descripcians in any applicacion for an insurance policy or annuity contract, or in negoticians therefor by, or in behalf of, the insured or annuitant shall be deemed to be representations and not warranties. Misrepresentations, omissions, concealment of facts and incorrect statements shall not prevent a recovery under the policy or contract unless either:

(1) Fraudulent;

(2) Material either to the acceptance of the risk or to the hazard assumed by the insurer; or

(3) The insurer in good faith would either not have issued the policy or contract, or would not have issued a policy or contract at the premium rate as applied for, or would not have issued a policy or contract in as large an amount or would not have provided coverage with respect to the hazard resulting in the loss if the true facts had been made known to the insurer required either by the application for the policy or contract or otherwise. 33


In such jurisdictions, an innocent misrepresentation which meets the applicable materiality test will suffice. 34 In New York, an innocent material misrepresentation renders an insurance contract void from the outset. 35 California provides by statute that " (c)oncealment, whether intentional or unintentional, entitles the injured parry to rescind insurance” 36 and that "[if] a representation is false in a material point, whether affirmative or promissory, the injured party is entitled to rescind the contract from the time the representation becomes false.”37 Though using different language, the Illinois statute is to the same effect; it provides that no "misrepresentation or false warranty shall defeat or avoid the policy unless it shall have been made with actual intent to deceive or materially affects either the acceptance of the risk or the hazard assumed by the company."" The effect, however, is the same, intent to deceive is not required.

b. Intent to Deceive Required - The strictest states, which appear to be in the minority, require that in all cases there be some proof of intent to deceive in order for an insurer to rescind a fidelity bond or other insurance contract. The Louisiana statute, for instance, provides that "no oral or written misrepresentation or warranty made in the negotiation of an insurance contract, by the insured or in his behalf, shall be deemed material or defeat or void the contract or prevent it attaching, unless the misrepresentation or warranty is made with the intent to deceive.” 39 The courts in Missouri, which does not have a statute governing rescission of insurance policies, apply a doctrine of "false swearing," which requires proof that the insured made the representation with an intent to deceive the insurer.40


2. Equitable Fraud

Some states that do not have statutory provisions governing the rescission of insurance contracts, such as New Jersey,41 apply a doctrine of equitable fraud, under which the evaluation of misrepresentations on insurance applications entails an analysis as to whether the questions were "objective" or "subjective." In FDIC v. Moskowitz 42 the court noted that under New Jersey law, the "'insurer need not show that the insured actually intended to deceive.' . . . Rather '[e]ven an innocent misrepresentation can constitute equitable fraud justifying rescission.”43 Only the answers to "objective questions" will constitute equitable fraud, which supports rescission for an innocent misrepresentation. The court explained:


Equitable fraud, however, distinguishes between subjective and objective questions on the application. Objective questions seek information within the applicant's knowledge, such as whether the applicant has been examined or treated by a physician. Subjective questions seek to probe the applicant's state of mind and are concerned with more ambiguous issues, such as what is the state of the applicant's health or whether the applicant has or has had a specified disease or illness. Answers to subjective questions do not constitute equitable fraud if the question is directed toward probing the knowledge of the applicant and determining the state of his mind and . . . the answer is a correct statement of the applicant's knowledge and belief.44


In the Moskowitz case, a bank applied for a financial institution bond. The application contained a question asking whether there was "'any criticism of your operations in the last State or Federal examination.”45 The bank answered in the negative even though a joint report of state and federal regulators contained many negative observations, some of which the bank had acknowledged.46 Although finding that the question was subjective in that one person's definition could differ from that of another, the report detailed extensive comments and was "rife with criticism" such that "only one reasonable conclusion may be drawn from a fair reading of the 1988 Report - the regulators criticized [the bank].”47 Thus, the court concluded that under such circumstances, the response was "objectively false," 48 and, therefore, even though, the question may have been "subjective," rescission was nevertheless required.

The court in Liebling v. Garden State Indemnity Co.49 also addressed the distinction between subjective and objective questions on an application for a claims made attorney malpractice insurance policy. In that case, the insurer sought to rescind the policy because the attorney-applicant answered "No" to a question as to whether the firm was "'aware of any circumstances, or any allegations or contentions as to any incident which may result in a claim being made against the firm." 50 At the time that the question was answered, the applicant represented the plaintiff in a personal injury action and had been advised by the judge's chambers that a motion to dismiss the case for failure to prosecute had been granted. He justified his negative response to the question on the ground that the court's written order dismissing the matter had not yet been entered and might bave been based on the negligence of the attorney who preceded him as attorney for the plaintiff. The Liebling court found that the question was subjective and that therefore "equitable fraud is present only if the answer was knowingly false."51 The court affirmed summary judgment granting rescission because the attorney "did not honestly believe that he was secure [from a possible malpractice claim]. . and [t]herefore, his answer in the application was knowingly false.”52
The Restatement (Third) of Suretyship & Guaranty provides:

§4. Fidelity Coverage

 

Unless the contract creating the secondary obligation or the circumstances indicate to the contrary, when (i) the principal obligor is an employee of the obligee and (ii) the underlying obligation is the faithful performance of the principal obligor's duties to the obligee, the obligee is treated for purposes of §12 (When Secondary Obligation Is Voidable Due to Misrepresentation) as having induced the secondary obligor's assent to the secondary obligation by representing to the secondary obligor that the obligee was unaware of any previous acts by the principal obligor that would have breached the underlying obligation.53
The Restatement of Suretyship includes a provision addressing contracts that provide fidelity coverage because "they can fall, at least in part, within the §1 concept of secondary obligations"54 and the Restatement of Suretyship rules governing rescission of surety bonds for fraud in the inducement apply "with particular focus in the context of fidelity coverage. 55 The commentary notes that in providing coverage, the fidelity insurer "is relying largely on the fact that it is the obligee [insured] that has selected the principal obligor as an employee in which trust and confidence are placed."56 When the insured retains an employee whom it knows to be dishonest, the insurer's reliance is misplaced with the result that the insurer underwrites a risk which is different than that which it intended. For that reason, the Restatement of Suretyship regards the insured's silence as a representation that it is unaware of previous dishonesty by the employees to be covered, and if that statement is untrue, the misrepresentation is to be treated as material and therefore justifying rescission. The illustration to the commentary reflects a classic case for rescission of a fidelity bond:


On April 6, 1996, O obtained a fidelity bond from S, pursuant to which S agrees to satisfy any losses to O resulting from P's failure faithfully to execute the duties inherent in P's position as O’s treasurer. At that time, O knew that P had previously embezzled funds from O on at least three occasions. S was unaware of these previous acts of P. Because O is treated as having represented that it was unaware of any previous acts of P that would trigger S's liability under the bond, O has made a material misrepresentation to S. Under §12(1), the fidelity bond is voidable by S. 57

The commentary also observes:

Of course, if the previous acts of the principal obligor are disclosed to the secondary obligor there is no longer the same reliance by the secondary obligor on the obligee's placement of trust and confidence. Thus, the principle of §12(3) would not apply.58


C. Attribution of Knowledge to the Insured Corporation

Fidelity insurance is issued to protect the insured against the perfidy of its employees. An issue arises, however, when the person who signs the application on behalf of the insured has either committed some covered defalcation or has actual knowledge of other employees who did. A corporation only has such knowledge as is in the possession of its officers, employees and directors; and as a general principle of agency, an officer's knowledge is imputed to the corporation.59 An exception may arise, however, when the officer acts adversely to the interest of the corporation.


1. Adverse Domination

The Restatement (Second) of Agency provides:


§280. Agent's Knowledge of His Own Unauthorized Acts

If an agent has done an unauthorized act or intends to do one, the principal is not affected by the agent's knowledge that he has done or intends to do the act.60

Comment c to section 280 makes it clear that

[i]f, in order to protect himself against the embezzlement or other wrongdoing of an agent, the principal obtains a contract of indemnity which states that the signer has no knowledge of any prior wrongdoing by the agent, the knowledge of his own embezzlement by the agent who signs the contract is not imputed to the principal. The risk of embezzlement by dishonest agents is the risk insured against and it would defeat the purpose of the contract to bind the principal by the knowledge of such agents.61


Section 282 of the Restatement, however, seems to present a conflicting approach, at least in part. That section provides as follows:

§282 Agent Acting Adversely to Principal

(1) A principal is not affected by the knowledge of an agent in a transaction in which the agent secretly is acting adversely to the principal and entirely for his own or another's purposes, except as stated in Subsection (2).

(2) The principal is affected by the knowledge of an agent who acts adversely to the principal:

(a) if the failure of the agent to act upon or to reveal the information results in a violation of a contractual or relational duty of the principal to a person harmed thereby;

(b) if the agent enters into negotiations within the scope of his powers and the person with whom he deals reasonably believes him to be authorized to conduct the transaction; or

(c) if, before he has changed his position, the principal knowingly retains a benefit through the act of the agent which otherwise he would not have received.62
Section 282(1) is completely consistent with section 280. Section 282(2), however, expressly contemplates that even when the agent is acting adversely to the interests of the principal, the knowledge of the former will be attributed to the latter in certain circumstances. One of those situations arises when "the agent enters into negotiations within the scope of his powers and the person with whom he deals reasonably believes him to be authorized to conduct the transaction.”63 On its face, section 282(2)(b) appears to include an employee or officer knowingly misrepresenting the honesty of persons to be covered by fidelity insurance as part of the process of negotiating the policy with the insurer. Thus, section 282(2)(b) would permit attribution of the employee's knowledge to the insured, while section 280 clearly prohibits any such attribution. Because commentary to section 280 specifically addresses that situation and the commentary to section 282(2) does not, it may be that the drafters of the Restatement simply did not regard the rule of section 282(2) as applying to misrepresentations by a dishonest employee on an insurance application, while affording some protection to parties which negotiate contracts in other contexts.

In any event, the majority of courts endorse the position taken by section 280.64 In Puget Sound Nat'l Bank v. St. Paul Fire & Marine Insurance Co.65 for example, the Washington Court of Appeals held that a director's knowledge was not,in fact, imputed to the principal, a bank. In Puget Sound Nat'l Bank, one of the bank's directors owned an insurance brokerage and arranged for his clients to finance their premiums through the bank. He was the sole contact between the customers and the bank. Later review of these loans showed that many were fraudulent, with the customers either having financed far less than their promissory notes indicated or being completely unaware that the loans existed all.66 The director who defrauded the bank was also the individual who, as the procuring agent for the bank, filled out the application for fidelity insurance. Following the discovery of the director's defalcations, the bank sued the insurer for recovery under the policies. The insurer claimed that the director's knowledge of his own fraudulent scheme was imputed to the bank, rendering the fidelity policies void ab initio. The insurer argued, among other things, that the director was acting in the bank's interests in obtaining the policies, and thus his knowledge would be imputed to the bank. 67 Rejecting the insurer's position, the court found that both the director's defalcations and his concealment thereof on the policy applications were not in the bank's interest and also found that the bonds were obtained at the request of the bank's board of directors and the applications were signed by another officer of the bank who had no involvement in the director's fraud. 68 On these findings, the court refused to impute the director's knowledge to the bank.

The minority position, in cases of dishonest officers procuring fidelity bonds, is that while an officer's prior misconduct or fraudulent application for insurance may be adverse to the corporation's interest, the act of procuring fidelity coverage is in the corporation's interest, and thus the dishonest officer's knowledge is entirely imputed to the corporation, including the knowledge of his prior defalcations. An early example of this view is Gordon v. Continental Casualty Co.,69 decided in 1935. In Gordon, the Pennsylvania Supreme Court addressed the case of the president of a bank who fraudulently represented on an application for fidelity coverage that the bank was unaware of any reason to believe that any corporate officers or directors were dishonest or otherwise unworthy of the trust invested in them, and that the bank was unaware of any covered losses in the five years prior to the application. At the time, the president had embezzled $26,000 from the bank. 70 The court held that while the president was acting adversely to the bank's interest in his fraudulent misrepresentation, obtaining the fidelity coverage was in the bank's interest as evidenced by the fact that the board of directors instructed him to obtain the insurance. Therefore, the court held, the president's knowledge of his own misdeeds was imputed to the bank. 71

More recently, in the Payroll Express case,72 the United States Trustee overseeing the corporate bankruptcy contended that the CEO's knowledge of employee fraud at the time that he executed the application for insurance should not be attributed to PEC because of the protections afforded the corporate form.73 The Trustee argued that the CEO was acting adversely to PEC's interest and on his own behalf, presumably because of the embezzlement in which he took part. The court disagreed, finding that the CEO was acting in PEC's interest in obtaining the fidelity policy. 74 The court held that the insured, PEC, could not take advantage of the benefits of the fidelity policy, e.g., coverage for the embezzlement committed by the CEO and other employees, and simultaneously disavow the CEO's actions in applying for the policy.

The court also imputed the officer's knowledge to the corporation in Tri-State Armored Services, Inc. v. Subranni (In re Tri-State Armored Services, Inc).75 There, the insurer sought to rescind fidelity insurance on the grounds that answers to several questions in applications for coverage were untrue. The insured's former president and majority shareholder had long engaged in dishonest and fraudulent activities, including regular diversion of corporate funds for his own use. Employees and other officers of the insured were well aware of, and in some cases participated in, these defalcations and even after the dishonest officer resigned, they continued to consult him in most matters. Eventually the insured filed for bankruptcy.

The insurer asserted that the insured made material misrepresentations regarding its losses each time that it submitted an application for renewal of the policy.76 The insured claimed that it could not be charged with the knowledge of its officers. The court rejected this contention, holding


that the corporation is affected with constructive knowledge, regardless of its actual knowledge, of all material facts of which its officer or agent receives notice or acquires knowledge while acting in the course of his employment and within the scope of his authority, and the corporation is charged with such knowledge even though the officer or agent does not in fact communicate his knowledge to the corporation.77


This knowledge includes knowledge of fraud by officers of the corporation. In addition, the court held that "an agent’s misrepresentations bind the principal if the agent was authorized to represent the principal in obtaining the contract” 78 and that "[if] the court is satisfied that the officer or employee making the innocent, or negligent or willful misrepresentations on behalf of the insured had the actual, implied, or apparent authority to do so, the misrepresentations will be imputed to the insured."79

2. The Sole Representative Doctrine

In cases where an agent or employee is acting adversely to the interests of the corporation, the wrongdoer's knowledge is not ordinarily imputed to the corporation.80 Where the agent is the sole representative of the corporation, however, this rule may not apply. Under that exception, when the dishonest agent is the sole representative of the principal with respect to the transaction, then the principal is chargeable with the dishonest agent's knowledge of all things relevant to that transaction, including his misrepresentations. In In re Fuzion Technologies Group, Inc.,81 the court explained the sole actor doctrine and its rationale as follows:


[I]f an agent is the sole representative of a principal, then that agent's fraudulent conduct is imputable to the principal regardless of whether the agent's conduct was adverse to the principal's interests. The rationale for this rule is that the sole agent has no one to whom he can impart his knowledge, or from whom he can conceal it, and that the corporation must bear the responsibility for allowing an agent to act without accountability. 82

 

In Post v. Maryland Casualty Co,83 the Washington Court of Appeals applied the sole representative exception to the case of an owner and president of two corporations who obtained on behalf of the corporations fidelity bonding as protection against fraud, embezzlement, and other dishonesty of the corporations' employees, including the president. The president held almost all of the corporations' stock except for qualifying shares held by the other directors.84 The bond contained a stipulation that the corporations had no knowledge of any acts of fraud or dishonesty committed by any employees. When the bonds were issued, the president had already committed various acts of fraud and mismanagement and, by the time he was replaced by a receiver, had embezzled over $25,000 from the corporations. 85 The Post court recognized the "general rule" that knowledge of an agent is attributable to the principal and an "exception" to the rule when the agent acts adversely to the interests of the principal. 86 The court, however, also recognized, "a qualification to the exception," that when "'the agent, though engaged in perpetrating an independent fraudulent act on his own account, is the only representative of the principal, his knowledge is imputed to the principal. . . .' 87 The court held, as would the later decision in In Re Payroll Express Corp., that a corporation cannot simultaneously seek the benefit of the contract and ignore the fraud perpetrated in obtaining the policy.88 As the officer was the sole representative of the corporations, his knowledge of his own fraud and deceit was imputed to the corporations, and the court held the bonds void ab initio.89


IV. SURETY BONDS

 

Unlike fidelity insurance, the surety bond creates a three-party relationship.90 The party which typically applies for the bond, the principal, is not the party which benefits from its issuance, the obligee. Because the principal deals directly with the surety, the obligee would usually have no reason to know when the principal induces the surety to issue the bond by fraud. Allowing the surety to rescind a bond on the basis of the principal's fraud, of which the obligee has no knowledge, would violate the obligee's separate interest in the protection afforded by the bond.

Common law rules governing rescission do not neatly apply in such a context. When the surety is induced to issue the bond as a result of the obligee's affirmative misrepresentation of facts material to the surety's risk, there is no difficulty in refusing to allow the obligee to benefit by its wrongdoing. The thorny issue arises when the obligee has knowledge of facts which would affect the surety's decision whether to issue the bond and the obligee remains silent. Under common law principles, nondisclosure of a fact affecting the surety's risk might well support rescission.91 Whether the obligee has an obligation to disclose facts material to the surety's risk must be evaluated in light of the surety's responsibility for investigating its undertaking through queries of its principal and other means. The issue is to identify those situations in which the obligee has a duty to disclose and may have breached that duty.

A. The Parameters of the Defense in the Suretyship Context

1. Fraudulent Inducement or Misrepresentation by the Obligee as a Basis for Rescission

An obligee does not stand in a fiduciary relationship to the surety.92 Nevertheless, "[i]n all suretyship relations, the creditor/obligee owes the surety a duty of continuous good faith and fair dealing,” 93 and, as with contracts generally, a suretyship contract induced by the obligee fraud is subject to rescission.94

The word "fraud" encompasses at least several, if not a multitude of, sins. Under general contract law, an affirmative statement of fact which is known to be false and is communicated with an intent to deceive, will clearly support rescission.95 Even an innocent misrepresentation, if made as to a material fact and justifiably relied upon, will render a contract voidable.96

Applying those principles to the suretyship context, section 12(1) of the Restatement (Third) of Suretyship and Guaranty 97 provides:


§12 When Secondary Obligation Is Voidable Due to Misrepresentation

(1) If the secondary obligor's98 assent to the secondary obligation is induced by a fraudulent or material misrepresentation by the obligee upon which the secondary obligor is justified in relying, the secondary obligation is voidable by the secondary obligor.99


More simply, if the surety's issuance of its bond is based upon an affirmative misrepresentation which is either fraudulent or material by the obligee and on which the surety is justified in relying, the bond is voidable by the surety.100

2. Fraudulent Inducement or Misrepresentation by the Principal or a Third Party as a Basis for Rescission

While discovery of an affirmative misrepresentation by the obligee may allow a surety to rescind and void its bond, fraud by the principal or a third party alone generally will not be a defense to a claim by the obligee. Absent the obligee's knowledge of, or participation in, the principal's or third party's fraud or misrepresentation, the surety's obligation cannot be rescinded. Rather, the surety will have a cause of action against only the principal or third party for damages resulting from such fraud or misrepresentation. 101

Thus, section 12(2) of the Restatement of Suretyship provides as follows:


(1) If the secondary obligor's assent to the secondary obligation is induced by a fraudulent or material misrepresentation by either the principal obligor or a thitd person upon which the secondary obligor is justified in relying, the secondary obligation is voidable by the secondary obligor unless the obligee, in good faith and without reason to know of the misrepresentation, gives value or relies materially on the secondary obligation.102


Section 119 of the Restatement of Security, upon which section 12(2) of the Restatement of Suretyship is based, provides as follows:


§119 Fraud or Duress on Surety by Principal

Where the surety by fraud or duress of the principal has been induced to become bound to the creditor [obligee], the fraud or duress is not a defense against the creditor [obligee], if, without knowledge of the fraud, he has extended credit to the principal on the security of the surety's promise or relying on the promise, has changed his position in respect of the principal.103


Hence, if the surety has been fraudulently induced by the principal or a third party to issue a bond, and the obligee had no knowledge of the fraud and proceeded to enter into a contract with the principal in reliance upon the surety's bond, the surety has no defense to the obligee's claim. If, on the other hand, the obligee knew of the principal's fraud and failed to disclose it, the surety may, under certain circumstances, be discharged in full.

These principles were applied recently in In re Commercial Money Center, Inc., Equipment Lease Litigation,104 a case which shows that differentiating between the obligee and the principal is not necessarily a simple task. In that case, sureties issued bonds in connection with transactions between a number of investor hanks and Commercial Money Center ("CMC"), which purportedly leased equipment and vehicles to numerous lessees in exchange for lease payments. CMC then pooled the leases and sold them (or their anticipated income streams) to the banks. The surety issued "bonds"105 guaranteeing that the lease payments would be paid by the lessees and/or by CMC, which, as servicer or subservicer of the lease pools, was responsible for receiving the payments and delivering them to the banks. The banks and the sureties agreed that most of CMC's leasing business was a sham in that many of the leases never existed, were never consummated, were forged, or were sham transactions with CMC-affiliated entities. Those parties also agreed that CMC operated a "Ponzi scheme" in which early investors were paid using money generated by new investors. The sureties alleged that they were induced to issue the bonds by CMC's misrepresentations as to its financial condition, the leasing program, lease default rates, lease recoveries, and related matters. Eventually, the banks ceased receiving lease payments, and CMC filed for bankruptcy.106

The surety 107 denied the banks' claims and, when sued, sought a declaration that its bond obligations were invalid and unenforceable by reason of CMC's fraud. The banks moved for partial judgment on the pleadings under Fed. R. Civ. P. 12(c). They invoked the "basic principle of surety law that 'fraud or misrepresentation practiced by the principal alone on the surety, without any knowledge or participation on the part of the creditor or obligee, in inducing the surety to enter into the suretyship contract will not affect the liability of the surety.'108 In response, the surety argued that because the bonds named CMC as the "First Named Insured," CMC was the obligee and that its fraud did void the bonds and the general rule did not apply.109 The court rejected the surety's argument because it was clear from the face of the documents that the ultimate flow of proceeds of the bonded transactions was to the banks, not CMC, and that therefore the banks were intended to be the party to whom the surety owed its obligations.110 As a result, the general rule applied, and CMC's fraud did not relieve the surety of its obligation to the banks.111

3. The Obligee's Failure to Disclose as a Basis for Rescission

In the construction surety context, the case of an obligee making an affirmative misrepresentation to a surety which induces the surety to issue a bid, performance, or payment bond rarely arises. This is, in large part, because, in the construction context, both the obligee and the surety usually deal directly with the principal and not with each other. Thus, the more common situation is that in which the obligee possesses, but fails to inform the surety of, facts which bear upon the risk to be undertaken by the surety.

Does the obligee have an obligation to disclose such facts to the surety, even if the surety has not made inquiry to the obligee? The answer is, it depends on both the facts and the jurisdiction. Unlike a fidelity bond relationship, where there is "an absolute duty upon the obligee to volunteer disclosure of all facts materially affecting the risk to tlte surety,"112or a relationship of trust and confidence between the parties which, in and of itself, makes concealment fraudulent,113 a prospective obligee of a contract bond has no absolute duty to inform the surety of facts affecting the risk which are known to the obligee.114 The obligee has a duty to speak only under certain circumstances.

B. The "Old" Restatement of Security Section 124(1) and the "New" Restatement of Suretyship Section 12(3)

The most widely accepted formulation of the circumstances which impose a duty upon the prospective obligee to disclose material facts to the surety has been that set forth in section 124(1) of the "old" Restatement of Security, now incorporated into section 12(3) of the "new" Restatement of Suretyship.115


Section 124(1) of the Restatement of Security provided as follows:

§124. Non-Disclosure by Creditor

(1) Where before the surety has undertaken his obligation the creditor knows of facts unknown to the surety that materially increase the risk beyond that which the creditor has reason to believe the surety intends to assume, and the creditor also has reason to believe that these facts are unknown to the surety, failure of the creditor to notify the surety of such facts is a defense to the surety.116


Section 12(3) of the Restatement of Suretyship is based on and derived from section 124(1) of the Restatement of Security and provides as follows:


§12. When Secondary Obligation Is Voidable Due to Misrepresentation

(3) [I]f, before the secondary obligation becomes binding, the obligee:

(a) knows facts unknown to the secondary obligor that materially increase the risk beyond that which the obligee has reason to believe the secondary obligor intends to assume; and

(b) has reason to believe that these facts are unknown to the secondary obligor; and

(c) has a reasonable opportunity to communicate them to the secondary obligor;

the obligee's nondisclosure of these facts to a secondary obligor constitutes a material misrepresentation.117


The Restatement of Suretyship goes a bit further than the Restatement of Security did by identifying the factors to be considered in determining whether the obligee has reason to believe that (i) facts unknown to the secondary obligor materially increase the risk beyond that which the secondary obligor intends to assume and (ii) such facts are unknown to the secondary obligor. Those factors, set out in section 12(4), are the obligee's reasonable beliefs as to


(a) the nature of the secondary obligor's relationship to the principal obligor;

(b) the nature of the secondary obligor's business; and

(c) the secondary obligor's ability to obtain knowledge of such facts independently in the exercise of ordinary care.118


The Restatement of Suretyship §12(3) also provides the following illustration in the appended commentary:


Developer A will enter into a construction contract with contractor only if C procures payment and performance bonds satisfactory to A. B, who has issued bonds for C in the past, agrees to issue the bonds to A. Unknown to B, C has just suffered a series of business reverses leaving C equitably insolvent. A does not disclose this to B. A is aware of this state of facts, knows that it is unknown to B, and that it increases the risk beyond that which B intends to assume; nonetheless, A fails to disclose it to B despite opportunity to do so. A’s nondisclosure is a material misrepresentation. 119


In general terms, an obligee has a duty to speak "[w]here he realizes that the surety is acting or is about to act in reliance upon a mistaken belief about the principal in respect of a matter material to the surety's risk."120

Section 124(1) "is merely a special application in suretyship of the rule of Contracts that fraud creates a defense"121 for nondisclosure by the obligee under the circumstances of the rule that "constitute fraud on the surety."122 When applicable, section 124(1) provides a complete defense to the surety, because it has been held to require the rescission of the bond and the discharge of the surety's obligations thereunder.123 It is also important to remember that under section 124(1), "it is not necessary that the concealment or the failure to disclose facts material to the surety be willfully done by the creditor, or that the creditor have the intent to deceive."124

Although section 12(3) of the Restatement of Sureryship and its predecessor, section 124(1) of the Restatement of Security, appear somewhat sweeping, the commentary to those sections imposes important limitations, "It [duty to disclose] does not place any burden on the creditor to investigate for the surety's benefit. It does not require the creditor to take any unusual steps to assure himself that the surety is acquainted with facts which he may assume are known to both of them."125 Perhaps the most important limitation on the usefulness of these sections arises as a result of the very reason for the existence of the rule. Essentially, a prospective obligee has a duty to make disclosure to the surety when the obligee has reason to foresee that the surety is about to act under a mistaken belief as to the risk. By its very nature, however, suretyship involves an assumption of risk, and that fact circumscribes the existence and extent of the obligee’s duty. Thus, the commentary to Restatement of Security §124(1) expresses the limitation as follows:


Every surety by the nature of his obligation undertakes risks which are the inevitable concomitants of the transactions involved. Circumstances of the transactions vary the risks which will be regarded as normal and contemplated by the surety. While no surety takes the risk of material concealment, what will be deemed material concealment in respect of one surety may not be regarded so in respect of another.126


As with its predecessor, the comments to the new Restatement of Suretyship §12(3) also stress the limitations of the obligee's duty:


It should be noted that this subsection places no burden on the obligee to investigate for the benefit of the secondary obligor. Nor does it require the obligee to take any particular steps to ascertain whether the secondary obligor is acquainted with facts that the obligee may reasonably believe are known to both of them.127


If a fact known to the obligee relates to a risk which is regarded as normal and contemplated by the surety, then it is unlikely that the obligee will be held to an obligation to disclose that fact in the absence of a direct inquiry by the surety.128 The case law is replete with statements that an obligee may reasonably assume that the surety will acquire from the principal or otherwise all information which it considers relevant to its risk and, indeed, that the surety has an obligation to conduct its own investigation of facts bearing upon the risk which it contemplates. 129

The Restatement Rule has been adopted or otherwise referred to in connection with a contract surety's nondisclosure defense by courts in at least the following states: Alaska, 130 Arizona, 131 California, 132 Colorado,133 Georgia,134 Idaho,135 Illinois,136 Indiana,137 Maine,138 Michigan,139 Montana,140 New Jersey,141Oregon,142 Wisconsin,143 and Washington.144 The Restatement Rule has also been adopted by the Fifth Circuit to discharge sureties from their bond obligations under federal law.145 North Carolina has applied the rule in Williston on Contracts,146 which is substantially similar to the Restatement Rule as to a surety's nondisclosure defense. 147

C. New York, The Restatement Rule Plus

Until the Second Circuit decision in Rachman Bag Co. v. Liberty Mutual Insurance Co.,148 there was some ambivalence among courts in New York as to the legal principles governing a surety's nondisclosure defense. In State v. Peerless Insurance Co., 149 an Appellate Division decision upheld by the N.Y. Court of Appeals, the court refused to adopt Restatement of Security section 124(2), which imposed a duty upon the obligee, arising after the issuance of the bond, to disclose facts justifying termination of the bond under circumstances comparable to those set out in section 124(1). There, the surety issued a bond to the State of New York to secure a wholesale cigarette dealer's financial obligations, including payment of cigarette taxes. Although the dealer's repeated failures to make timely payment demonstrated its deteriorating financial condition, the state continued to permit the dealer to incur additional liability for taxes without informing the surety of the dealer's defaults. Holding that section 124(2), under which the surety was arguably entitled to a discharge, did not set forth the law of New York and that the state had no duty to keep the surety informed about the principal's financial condition or its prior defaults unless the surety made direct inquiry to it,150 the court affirmed summary judgment against the surety.

In an earlier case, Chemical Bank v, Layne,151 a federal court applied New York law to discharge a surety from his loan guarantee because the creditor bank failed to inform him that stock which it held as collateral for the loan was restricted. Analyzing the same New York cases relied upon in State v. Peerless Insurance Co., the court held that if an obligee has reason to know that the surety is about to undertake an obligation under the mistaken impression of facts material to the risk and the obligee has knowledge of those facts, he has a duty to inform the surety. Although the court made no reference to section 124(1), its holding applied the same underlying principle. In that case, the guarantor made a general inquiry to the bank as to the stock, but the bank did not disclose the restrictions which substantially reduced the value of the stock. Because the restrictions were not readily ascertainable, the guarantor's failure to discover them did not constitute a failure of his duty to investigate. Although the fact that the guarantor made inquiry to the bank was crucial 152 because it put the bank on notice that the guarantor was ignorant of the true facts, the court suggested in dicta that inquiry by the surety was not a necessary prerequisite to the defense if it otherwise appeared that the obligee knew that the surety was mistaken and if the undisclosed fact would not have been discoverable upon reasonable investigation by the surety.153

In Layne, the guarantor argued that it should be relieved of its obligation on the additional grounds that the bank failed to disclose that the borrower's debt included the borrower's guarantee of the debts of third parties and that the bank had released other guarantors of the borrower's debt. The court rejected those grounds because the defendant's guarantee was so broad and vested the bank with such great latitude in dealing with the borrower's debt that the undisclosed transactions must be regarded as included within the risk contemplated by the guarantee. Therefore the guarantor should have inquired as to them, and his failure to do so negated the defense.154 That holding illustrates an important limitation on the surety's defense which also applies under the Restatement Rule. When the undisclosed fact relates to a contemplated risk, a prospective obligee is entitled to assume that a surety, in the discharge of its duty to investigate its risk, will learn of the fact unless the obligee knows of circumstances which make it unlikely that the surety will discover the fact upon a reasonable investigation. In such a case, therefore, unless the surety makes inquiry of the obligee, the obligee, in the words of the Restatement sections 124(1) and 12(3), does not have "reason to believe that these facts are unknown" to the surety.155

Rachman Bag involved an obligee which brought an action against a surety, seeking payment of a loss allegedly covered under a bond issued by the surety. The bond purported to secure a normal business transaction between the principal and the obligee, but, unbeknownst to the surety, the bond actually secured an arrangement whereby the principal would repay through services over $400,000 stolen from the obligee by the principal's president. Upon learning of the true nature of the transaction, the surety refused to honor the bond and sought to be discharged thereunder. The district court granted the surety's motion for summary judgment.

On appeal, the Second Circuit, applying New York law, adopted the same tripart formulation as the Restatement of Security 124(1) and the Restatement of Suretyship §12(3) (then in draft form), which was applied by the district court, but found that "this test lacks an essential fourth element, a duty on the part of the obligee to disclose the relevant information.156 Thus, the court listed the elements of fraudulent concealment as follows:


(1) the obligee must know facts that materially increase the surety's risk, and have reason to believe that surety would be unwilling to assume such a higher risk;

(2) the obligee must have reason to believe that such facts are unknown to the surety;

(3) the obligee must have the opportunity to communicate the relevant information to the surety; and

(4) the obligee must have the duty to disclose the information based upon its relationship to the surety, its responsibility for the surety's misimpression, or other circumstances.157


As to this fourth element, the court noted that the relevant New York case law provides "no definitive test for determining when an obligee's duty to disclose material information arises."158 However, the court pointed out that "New York courts have generally held such a duty to arise when the obligee had either a relationship of trust and confidence with the surety or some degree of responsibility for the surety's misimpression.159 Among the relevant circumstances which New York courts have pointed to in finding this duty of disclosure are:


(1) Where the obligee deals directly with the surety in obtaining the bond;

(2) Where the obligee affirmatively creates a misimpression such that failure to correct it would amount to an affirmarive misrepresentation;

(3) Where the obligee colludes with the principal in creating the deception to the surety;

(4) Where the principal is the obligee's employee or agent; and

(5) Where the obligee has unique access to material information.160


The Second Circuit ultimately reve

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