Inventory Shortages Exclusion

 

April 2009

 

Exclusion Applies to Fidelity, Theft Coverages

Summary: Theft claims upon shortage of an insured's physical property as determined by an inventory computation presents difficult problems. Depending on the insured's business, the shortage may be of merchandise, finished goods, raw materials, parts, tools, supplies – any personal property that goes in or out of the employer's premises in such quantities that it must be accounted for by inventory and that can be readily disposed of by a dishonest person. The base of the problem is establishing the cause of shortage without depending solely on the use of inventory or profit and loss computations. The reason for this is that inventory shortages may have many explanations—theft by dishonest employees or others, but also loss by breakage or over-measuring. With some types of property, there may actually be no physical shortage—just honest errors in inventory, record keeping, or deliveries. And, to say that one confirmed incident of theft is the cause of all shortages established by inventory computation may not reflect the true situation. Following is a discussion of the differing interpretations of the inventory shortages exclusion. All the court cases cited are valid; none have been overturned.

 

 

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Policy Provisions

 

Loss that is evident only upon inventory or profit and loss computations is excluded under the following insuring agreements of the commercial crime policy: A.1., employee theft; and A.6 computer fraud. The same exclusion applies to the following insuring agreements of the government crime policy: A.1, employee theft, per loss; A.2., employee theft, per employee; and A.7., computer fraud. The exclusion is identical in all five insuring agreements: excluded is loss “or that part of any loss, the proof of which as to its existence or amount is dependent upon (1) An inventory computation; or (2) A profit and loss computation.”

 

The inventory shortages exclusion came into use in the 1950s and was designed to protect the insurer from claims based on mistaken or falsified computations in claims involving employee fidelity policies. Prior to the creation of the 1986 crime program, only employee fidelity policies contained such a clause.

 

For this reason, the first part of this exclusion had an additional provision that stated: “provided, however, that this paragraph shall not apply to loss of money, securities or other property which the insured can prove, through evidence wholly apart from such computations, is sustained by the insured through any fraudulent or dishonest act or acts committed by any one or more of the employees.” This provision was deleted by some insurers, beginning in the late 1970s and early 1980s, in the belief that its omission would strengthen the basic exclusion.

 

The exception to the exclusion in the current policies reads as follows: “However, where you establish wholly apart from such computations that you have sustained a loss, then you may offer your inventory records and actual physical count of inventory in support of the amount of loss claimed.”

 

Most of the cases discussed below involve policies that included this language, although the courts generally did not point specifically to this language to support their decisions.

 

Court Decisions

 

The following cases illustrate the application of the inventory shortages exclusion. Since prior to the creation of the 1986 crime program only employee fidelity policies contained such a clause, the cases discussed all involve employee theft; however, the principles involved may be applied to the exclusion as contained in other theft coverage forms.

 

Until the late 1960s, the legal trend was to apply the inventory computation exclusion strictly, permitting the use of inventory computation only to corroborate other direct evidence of both the loss and the amount of loss. Some courts continue to apply this rule. The reason for this position is the belief that inventory computations are not reliable evidence, either as to the fact of a loss or as to the amount. Many courts have modified this rule so that inventory computations are allowed if the fact of loss has been established by other evidence – even if only circumstantial, and the inventory computation is being introduced merely to prove the amount of loss. In determining whether the exclusion applies, the courts have grappled with the meaning of inventory computation, as illustrated by some of the cases that follow.

 

Strict Interpretation

 

Several of the conservative decisions discussed below considered whether records of item-by-item inventory comparisons (pre-loss to post-loss) came within the meaning of inventory computations, and held that they did. Other courts have held that such records are inherently unreliable and thus fall outside the meaning of inventory computation so that there is coverage for the insured's loss.

 

An example of the strict application of the rule is the Mississippi Supreme Court case of Gotcher Engineering & Manufacturing Co., Inc. v. United States Fidelity and Guaranty Co., 193 So. 2d 115 (1966). The insured manufactured and sold agricultural machinery, equipment, and supplies and maintained a warehouse for storing these items. Two brothers—who had exclusive control of the warehouse where the insured's products were kept—admitted to taking and selling one item. Thereupon, as a result of an inventory computation, other shortages were discovered. The insured argued that the theft of the one item created a probable and reasonable conclusion that the rest of the shortage resulted from misappropriation by these employees. However, the court declined the insured's argument on the basis of the policy provision applying to loss “the proof of which…is dependent upon an inventory computation or profit and loss computation derived from an item-by-item inventory.”

 

A few years later, the Nebraska Supreme Court also strictly applied the exclusion in the case of Paramount Paper Products Co., Inc. v. Aetna Casualty & Surety Co., 157 N.W.2d 763 (1968). The insured was a printing business involved primarily in the printing of labels of different sizes and types. It used expensive types of paper and tape. Company officials became aware that discrepancies existed between the amount of paper purchased and the amount used. Through the surveillance of an undercover detective, the company determined that two employees were stealing. These employees were arrested and convicted of two thefts of stock. All of the stock involved in these thefts was recovered. Then the company tried to determine the amount of other loss that could be attributable to employee theft. The post-loss inventory was taken on a unit basis and compared to an inventory taken seven months earlier, although the earlier unit inventory was not available at the time of trial. An accountant testifying for the company stated that figures he used were compiled by the use of raw-material usage figures that he got from the insured's books, and the same was true for material-usage figures. There was testimony as to the inexactness of such figures, and the fact that the printing operation involved considerable waste of paper in the normal course of business. Furthermore, the pressmen got the paper they needed from the stockroom without any checks on the amount taken.

 

The court conceded that a unit-basis inventory and accounting system can be reasonably accurate, but that the insured in this case did not use a strict unit basis inventory. Partially used rolls of paper were inventoried by means of measurement and estimation. The inventory figures were then converted to a dollar figure, and this dollar figure was compared to the dollar value of goods that had been sold. In concluding that these computations fell within the meaning of inventory computations, the court stated: “The plain meaning of the language used definitely indicates that proof, other than that arrived at by means of an inventory or profit and loss computation, is required not only as to the fact of a loss, but also as to the amount of such loss although such computations are not forbidden as corroborative evidence…[i]t will be noted that the exclusionary clause does not bar recovery based upon an inventory, but only upon an 'inventory computation or profit and loss computation'…[a]n inventory made upon a unit or physical basis comprises simply a list of merchandise or materials on hand and there is no computation or computing in regard thereto, it is simply an enumeration…[o]n the other hand, an inventory taken and reduced to a dollars and cents basis does involve the act of computing and is a computation.”

 

The court concluded that proof of the loss could be supported by an inventory made upon a unit basis; but could not be proven by inventories that involve computations to convert them to some other basis, or comparisons of an earlier inventory with a later one where it is necessary to compute and allow for sales, purchases, and waste in the interim. The court also concluded that the insured was seeking to prove all the loss solely by an inventory computation of employee dishonesty; the only direct proof of loss related to those items that had already been recovered from the two employees who had been caught stealing. This conservative position was again reaffirmed in another Nebraska Supreme Court case, Jones v. Employers Mutual Casualty Co., 432 N.W.2d 535 (1988).

 

Another case in which the exclusion was upheld is Prager and Bear, Inc. v. Federal Insurance Co., 136 Cal. Rptr. 340 (1977). In this California Appeals Court decision, the insurer was judged not liable under an employee fidelity bond for the loss of textile goods from the insured's warehouse. Following a regular inventory count, the insured noticed a large discrepancy between its inventory records and the results of the actual count. Despite the installation of security measures to prevent or detect break-ins to the premises, a subsequent inventory also revealed a large discrepancy. On the basis of the shortage the insured made a claim to the insurer, and was denied coverage due to the inventory computation exclusion.

 

Two years later, the insured discovered additional losses and was able to obtain a confession from the warehouse manager that he and another warehouse employee had conspired to steal the insured's property. The insured presented a claim to the insurer for these losses, and the claim was paid.

 

The insured then brought action to recover for the earlier losses. However, the court held that the earlier losses were not connected to the losses for which the insured was paid, and that, apart from inventory computations (involving the comparison of physical counts of inventory), there was no proof of employee dishonesty in the earlier losses (the warehouse manager and some employees were different persons during the two periods in which loss occurred).

 

Because of the state of the evidence, the court ruled that the insured “was not entitled to prove the fact or amount of such (earlier) losses by inventory computations.” The court stated: “No matter how construed, it is clear that under the requirements of [the inventory shortages exclusion] there must be some evidence that the losses for which coverage is sought were caused by employee dishonesty before the court can consider any evidence of the method by which the extent of such losses has been determined. Here [the insured] presented evidence that its perpetual unit-type inventory was audited annually…Notwithstanding the reliability of such inventory computation methods, however, the trial court found that such evidence failed to prove that the losses which it disclosed were necessarily caused by any act or acts of employee dishonesty. As has been pointed out…the trial court was correct in its conclusion.” The insurer was relieved of further liability. A more recent case, HCA, Inc. v. American Protection Ins. Co. 174 S.W.3d, (2005) declined to follow both Paramount Paper Products Co., Inc. v. Aetna Casualty & Surety Co. and Jones v. Employers Mutual. The case involved a health care provider that owned numerous hospitals and surgical facilities. When linens were discovered missing during an inventory that occurred during the insured's tenure as cleaning contractor, HCA brought suit against the all-risk policy for the losses. The trial court granted the insurer summary judgment, and HCA filed an appeal. The appeals court held that a genuine issue of material fact existed as to whether the provider had evidence besides inventory calculations to establish the inventory loss. Couch on Insurance explains that the reason for the exclusion is that it prohibits coverage where disappearance of property or loss or shortage of property is disclosed on taking inventory. Inventories are not a reliable way to establish a loss. The court, therefore, determined that the plaintiff's claim was excluded from coverage because the loss was disclosed on taking inventory.

 

Strings & Things in Memphis, Inc. v. State Auto Insurance Companies, 920 S.W.2d 652 (1995), concurred and stated that an inventory computation does not prove a loss because the loss is arrived at by using an inventory figure which adds purchases to a beginning inventory and subtracts the cost of goods sold. The court reasoned that proof of loss by subtracting an actual inventory from a computed inventory does not satisfy the need for independent evidence of loss.

 

Liberal Interpretation

 

An example of a more liberal approach is provided by the case of Ace Wire & Cable Co., Inc. v. Aetna Casualty & Surety Co., 457 N.E.2d 761 (1983). This New York Court of Appeals case involved records of unit-basis inventories that the court found to be a highly reliable method of determining the amount of loss. Records were available that detailed the actual physical count of individual units before and after the loss.

 

The insured manufactured and sold wire cable products, and used a warehouse for storage that was under the control of a manager and protected by an alarm system. The insured's secretary kept detailed records of all wire and cable stored in the warehouse. When wire or cable was received, entries were made on stock records cards showing the total received, the manufacturer or supplier, and the date of delivery. Each reel was separately listed with a note concerning the exact footage. No reel was removed from the warehouse without the secretary's permission and when it was removed it was deleted from the stock record card. The insured conducted a physical stock inspection once a year. On one of these annual inspections it was determined that 116 reels of wire were missing. None had been authorized for removal. Certain facts about the missing reels indicated that the person who took them had inside knowledge of the business and of certain machinery. Before the loss was discovered, the warehouse manager quit without explanation or notice.

 

Because the court found these records reliable in nature, it determined that a comparison of inventory records kept on a unit basis with a physical count of items on hand is not an inventory computation for purposes of applying the exclusion. The court concluded that the exclusion should be read to exclude “proof of the fact or amount of loss through a generalized estimate, calculated, for example, from sales records and average markup, of what the dollar value of inventory on hand should be. It does not, however, preclude proof of the fact or amount of loss through inventory records (whether perpetual or periodically made) detailing the actual physical count of individually identifiable units such as are described by the facts of this case.” The court supported its finding by citing several other cases, including Popeo v. Liberty Mutual Insurance Co., 343 N.E.2d 417 (1976).

 

In the Popeo case, the Supreme Court of Massachusetts said that the application of the exclusion “seems clearest where inventories consisting of a variety of items are kept on a dollar basis and proof of the loss, its amount and its cause is dependent on a showing of a dollar shortage. 'Inventory computation' in such a case arrives at an inventory figure by adding purchases to a beginning inventory and subtracting an actual amount for the costs of goods sold…[p]roof of loss by subtracting an actual inventory from such a computed inventory does not satisfy the clause unless there is independent evidence…[o]nce there is independent proof of loss sustained through dishonest acts of employees, inventory computations are admissible as corroborative evidence.” The court noted that there are conflicting court decisions concerning whether, where employee dishonesty has been independently established, inventory computations alone can be used to prove the extent of the loss. The court noted, without adopting the rule itself, that some courts had held that unit-type inventory records do not fall within the meaning of “inventory computations.” In this case, the court upheld the use of inventory computations to corroborate other indirect evidence of both the existence and the amount of the loss.

 

As stated by the court in Popeo, the trend in court decisions is to allow the introduction of inventory computations to corroborate the loss and to show the amount of the loss when there is independent evidence, even if only circumstantial, of employee dishonesty or theft.

 

For example, in American Fire and Casualty Co. v. Burchfield, 232 So. 2d 606 (1970), uncontradicted evidence of theft by four employees and the fact that the full amount of loss could never be proved by independent evidence were sufficient to persuade the Alabama supreme court to allow the use of inventory evidence to establish the full amount of loss.

 

Another case applying this liberal interpretation of the exclusionary language is NIB Foods v. Insurance Co. of North America, 234 N.W.2d 725 (1975). Here, a Michigan appeals court held that evidence showing that restaurant bills had not been marked paid, and that the manager had taken money from the cash register without leaving a receipt before his unexplained disappearance, constituted evidence of inventory computations. Thus, inventory records were permitted to show the amount of loss. There is no discussion in the American Fire case or in NIB Foods of the type of inventory records kept or whether they were of a type that could be considered reasonably reliable.

 

Yet another case that used a liberal approach is Hanson v. National Union Fire Insurance Co., 794 P.2d 66 (1990), decided by a Washington court of appeals. The insured, Hygrade, was a national meat processing company. Among its operations was a rendering department where it rendered byproducts that it bought from suppliers into tallow and meat meal. One of its suppliers was Recycling Services. Hygrade paid its suppliers on the basis of the amount of tallow and meat meal rendered from the raw materials. It depended on the supplier to report accurately how much of each category of raw materials each load contained.

 

In 1977, James Laviola took over the management of the rendering department and soon thereafter Recycling began to misstate the proportions of each category of raw materials in each load. The quality of the raw materials also declined. Less tallow was produced as a result, with Hygrade being asked to pay for more tallow than it was actually receiving. Apparently Laviola went along with this scheme because he was afraid that Recycling would take its business elsewhere, making the operation uneconomical to operate, with the result that he would lose his job. In 1982, the comptroller concluded that there was a problem in the rendering department, with a subsequent physical inventory showing that actual inventory levels were less than one-twentieth of the reported levels. A signed confession was obtained from Laviola.

 

The court rejected National Union's argument that Hygrade's damages were speculative, stating that “in an action to recover on a fidelity bond, where it is established with certainty that a loss covered by the bond has occurred, it is not necessary to recovery that the amount of loss be proved with mathematical certainty where that is impossible…It is enough if there is a basis for a reasonable inference as to the extent of the damages sustained.” The court based its opinion that the inventory shortages exclusion did not apply on the fact that inventory computation was only one of four methods used to prove the extent of the loss. In this way, the court seemed to be following the rule that inventory computation may be used only to corroborate independent evidence of the amount of loss. However, the other methods used were arguably less exact than an approximate inventory computation.

 

The first method of proving loss was to compare the records of another rendering company to those of Hygrade for tallow rendered from raw materials supplied by Recycling. The other company had state-of-the-art equipment that allowed it to calculate precisely the tallow yielded. The yields were well below those claimed by Recycling for materials it had supplied to Hygrade. The yield figures derived from other company's records were used to determine Hygrade's net loss figures for each year, resulting in a three-year net loss figure of $1,522,799.

 

The second method of proof was a yield test that was conducted on the last load received from Recycling. The yield was substantially lower than the yields for which Hygrade had been paying. By using this load's yield result to determine the probable actual three-year yield, the net loss was calculated as $2,267,380.

 

The third method was a comparison of the dollar amount paid to suppliers to the amount of tallow and meat meal actually yielded in 1982. The sum paid was based on the amount that should have been yielded based on the yield formulas that Hygrade had developed. This method showed a net loss of $579,806 for 1982. Finally, an inventory computation for 1982 showed a loss of $554,327. The jury awarded the insured a verdict in the amount of $1,528,445.

 

Conclusion

 

This review of cases interpreting the inventory shortages exclusion illustrates that how the exclusion will be interpreted depends upon the jurisdiction in which the case is heard. Three basic interpretations of the exclusion exist. Some courts allow the introduction of inventory computations only as corroborative evidence of both the fact and amount of the loss; there must be direct and independent evidence of employee dishonesty for any portion of any claim to be paid (for examples of this conservative view, see the discussion of the Gotcher and Prager cases). Other courts permit the use of inventory computations to prove the entire amount of the loss where there is some independent evidence, even if only circumstantial, of employee dishonesty (as in the liberal cases of American Fire and NIB Foods). Still other courts hold that unit-basis inventory comparisons are not inventory computations within the meaning of the exclusion, so that such comparisons may be used to prove both the existence of the loss and the amount of the loss without recourse to other evidence (illustrated in Ace Wire). However, despite the strong liberal statement made by the court in Ace Wire, its rule can be seen as a variation of the other liberal rule. There was other circumstantial evidence of employee dishonesty in the case; it is possible that the court would have ruled differently had the only evidence of the occurrence of the loss been a discrepancy between the inventories.

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