Is the Owner-Manager of your Vendor your “Employee?”

Expansion of Coverage: North Carolina Crime Coverage Part:  Embezzlement

Is the Owner-Manager of your Vendor your “Employee?”

            On November 14, 2014, the Eastern District of North Carolina entered summary judgment in favor of an insured seeking coverage for embezzlement for actions by owners of a vendor. Colony Tire Corp. v. Fed. Ins. Co., No. 2:15 CV 27, 2016 WL 6683590 (Nov. 14, 2016 E.D.N.C.)

            The insured was seeking coverage under a claims-made policy for theft that occurred between 2002 to 2014.  The embezzlement losses were approximately $492,350.00.  The insurer denied coverage claiming that Colony, the insured, could not establish that the loss was caused by an “Employee” under the Policy.

            The money was stolen from Colony through its payroll and tax vendor, Employee-Services.Net (“ESN”).  Through the contract between ESN and Colony, ESN was allowed to withdraw funds from a designated bank account to pay Colony’s payroll and taxes.  Owners/Managers/Principals of ESN, James Staz and William Staz (collectively “the Stazes”) pled guilty to embezzling over $14 million from ESN’s many clients, including Colony.

            Essentially, the Stazes would withdraw money from Colony’s account, claiming that the money would be used to pay payroll taxes.  In reality, the taxes would go unpaid, and the money would fund the Stazes’ extravagant lifestyle, which included alcohol, strip clubs, jewelry, a luxury car, and a luxury home “with a lavish three-tiered pool, a cascading waterfall, wet bar, and dining area.”

            The critical issue for the court was whether the Stazes were “Employees” under the policy.  In the policy, the definition of Employees included “contractual independent contractor.”  In the definition, “contractual independent contractor” had to be a natural person.  Thus, from the outset, ESN, as a business entity, could not be a “contractual independent contractor.”  Further, to qualify as a contractual independent contractor, there had to be a written contract between Colony on one hand, and on the other hand either (a) the natural person or (b) an entity “acting on behalf of” the natural person.

            The written contract was between Colony and ESN.  The Stazes were not a part of the contract.  Thus, to qualify as “contractual independent contractors,” the court had to determine whether ESN was an entity “acting on behalf of” the Stazes pursuant to part (b) of the definition.

            The court interpreted the phrase “acting on behalf of” broadly due to its ambiguity.  Thus, not only did the phrase mean to act within the scope of a formal agency relationship, the Court also construed the phrase to mean actions in the general interest of or in the general benefit of the natural person.  Given this broad definition of “acting on behalf of,” the Court determined that ESN acted on behalf of the Stazes when it contracted with Colony.  Thus, the Stazes were Employees as defined by the policy.  Because they were Employees, there was coverage for the loss and directed the insurer to pay the loss.  The Court then directed the insured to prepare additional briefings on potential costs, attorney’s fees, and interest that it sought through its prayer for relief.    

            An important portion of the analysis, in our opinion, was the Court’s use of the Federal indictment for the Stazes.  Using the facts of the indictment, the Court concluded that ESN’s purpose was to facilitate the Stazes’ embezzlement scheme.  No one, other than the Stazes, benefited from ESN’s existence.  Further, the Court emphasized that ESN was a tool used by the Stazes for their criminal actions:  “the Stazes “through [ESN] defrauded ESN clients.” Id. at *5 (emphasis in original).  While not explicitly done in this case, such findings could support a veil piercing theory under North Carolina law, which would yield similar results through equitable means. 

            Given the results of this case, it would not be surprising to see a re-write of the “contractual independent contractor” provision in the future.  However, litigators could also distinguish this case on the basis of the facts.  The facts in the indictment supported showing that the Stazes used ESN for their exclusive, personal benefit.  One could potentially argue that similar facts, establishing this high-bar, close to a veil-piercing standard, would need to be found in order to meet the burden of “acting on behalf of” language.  This would be distinguished from actions by a "lone wolf" employee at a vendor who steals funds without benefiting the owners. 

Five Important Lessons on North Carolina Insurance Law from Recent Federal District Court Decision

A recent decision by United States District Court Judge Richard L. Voorhees in Charlotte, North Carolina, serves as a reminder of five rules followed by the North Carolina courts when determining an insurance company’s duty to defend. See New NGC, Inc. v. ACE American Insurance Co., et. al, 3:10-CV-00022-RLV-DSC, 2015 WL 2259172 (W.D.N.C. May 13, 2015) (“Memorandum and Order”).

In New NGC, the policyholder was one of the largest drywall manufacturers in the country. It became a defendant in a number of individual actions and class actions around the country, which all generally claimed that New NGC’s products were defective, causing both property damage within buildings where the drywall was installed, as well as bodily injury to individuals complaining of respiratory illness and allergy-like symptoms.

The first major takeaway from this opinion is, not only is the North Carolina Court of Appeals’ 1991 decision in West American Insurance Co., v. Tufco Flooring East, Inc., 409 S.E.2d 692 (N.C. App. 1991) of questionable precedential value, but the attempt by the policyholder to argue that the pollution does not apply when the pollution arises out of the policyholders’ central business activity only applies, if at all, if the court determines that the pollution exclusion is ambiguous. [Tufco] was unusual in that the court found that the exclusion was ambiguous because of the “interrelationship between the completed operations coverage and the pollution exclusion clause.” Id at 697.

Second, this case is important because it explains that an insurance company may not focus exclusively on the allegations of the putative class representative in evaluating its duty to defend. Focusing solely on the named Plaintiff would “completely ignore the general notice pleadings standard of the Federal Rules of Civil Procedure as well as the underlying purposes of class action.” Memorandum and Order at 23.

In our next post, we will address three additional points of insurance law, as explained by Judge Voorhees.