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Citation: 28 Tort & Ins. L.J. 69 1992-1993

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SUBROGATION: THE DUTIES AND OBLIGATIONS OF

THE INSURED AND RIGHTS OF THE INSURER REVISITED
Gregory R. Veal

I. INTRODUCTION

Subrogation is the fidelity insurer's primary means of salvage. This topic has been
addressed ably in the past' and continues to draw the attention of courts and authors.
Because the subject deals with allocating risks and competing for scarce sources of
recovery, the cases tend to turn on their specific facts. Because subrogation is a child
of equity, the courts have reserved for themselves a broad discretion to reach "equitable" results in light of those various facts. The resulting lack of judicial consensus
should be no surprise.
This article revisits subrogation by reviewing a number of the more recent decisions
shaping the right. Most of these decisions do not deal particularly with fidelity insurance, but the cases that are on point demonstrate that the courts adopt determinative
principles from numerous contexts, all of which are instructive.

II. GENERAL PRINCIPLES

Subrogation is an equitable remedy that seeks to impose ultimate responsibility for

a wrong or loss on the party who, in equity, ought to bear it.2 This transfer of
1. See, e.g., Hlafcsak, The Nature and Extent of Subrogation Rights of Fidelity Insurers Against Officers
and Directors of Financial Institutions, 47 U. PiTt. L. REV. 727 (1986); Brown and Goode, Conflicts
of Interest in Subrogation Actions, 22 TORT & INS. L.J. 16 (1986); Schroeder, Handling the Complex
Fidelity or Financial Institutions Bond Claim: The Liability of the Insured's Officers and Directors and
Their D&O Carrier,21 TORT & INS. L.J. 269 (1986); Murray and Nocera, Sureties' Remedies to Recover
Fidelity Loss, 51 INS. COUNS. J. 566 (1984); Rizk, Bank Directors' Liability to Fidelity Insurers: How
"'Bad" Is Bad Faith?, 19 THE FORuM 481 (1984); Knox, Recovery from Principal,Banks, Co-conspirators, Other Carriersand Officers and Directors (ABA National Institute
1983); Wisner and Leo, Subrogation Rights of Surety on a Fidelity Bond Against Officers and Directors of Insured Corporation, 18 THE
FORuMt 320 (1983); and Knox, Subrogation Rights in Fidelity Cases, 12 THE FORUM 348 (1976).
2. Knox, Subrogation Rights in Fidelity Cases, 12 THE FORUM 348, 350-54 (1976).

Gregory R. Veal practicesfidelity, surety, and construction law in Atlanta, Georgia. This
article is adaptedfrom Mr. Veal's presentationto the TIPS Fidelity and Surety Law Committee
at the 1991 ABA Annual Meeting.

70

Tort & Insurance Law Journal, Volume XXVIII, Number 1, Fall 1992

responsibility is accomplished by the fiction that the paying party (subrogee) steps
into the shoes of the party who suffered the loss (subrogor) for purposes of enforcing
the latter's rights against the ultimately responsible entity.'
Subrogation may arise from contract (conventional) or by operation of law (legal
or equitable), and the distinction may or may not make a difference, depending on
the facts and the jurisdiction. 4 Insurers rely on subrogation for reimbursement because
the courts almost uniformly have refused to apply the doctrine of equitable indemnity. By that doctrine, equity recognizes an implied promise of repayment from the
ultimately responsible party to any payor who is secondarily liable.'
While the insurer by subrogation steps into the shoes of the insured, that substitute
position is implied by the type and amount of claim paid.' For example, the insurer's
right of subrogation has been held ineffective to take the insured's right to recover
punitive damages from a wrongdoer because the insured covered only the actual
damages caused by the wrongdoer. 7 The insurer/subrogee also faces its insured's
period of limitations for suit, which begins to run upon the insured's discovery of
the wrongdoing.'
A number of other equitable principles qualify the insurer's right to reimbursement. Because the insurer steps into the insured's shoes, the insurer can assert no
claims greater than or different from the insured's rights. The insured's actions may
prejudice its claims and thereby prejudice the insurer/subrogee's ability to assert those
claims.3 The insurer, before being subrogated, usually must pay the insured, who
must have recovered the loss in full before the insurer may be reimbursed.'"
The most restrictive principle is the doctrine of "superior equities": an insurer may
not be allowed to recover from any party whose equities are equal or superior to the
insurer's.'' In comparing the relative positions of the subrogee and the subrogation
3. Federal Savings & Loan Ins. Corp. v. Aetna Cas. & Sur. Co., 696 F. Supp. 1190 (E.D. Tenn.
1988) (savings and loan blanket bond insurer may assert a claim in subrogation against officers and
directors, to the extent of bond coverage, if S&L could have asserted a claim).
4. See infra section IV.
5. See In re Eastern Marine, Inc., 104 B.R. 421 (Bankr. N.D. Fla. 1989) (distinguishing legal/
equitable subrogation, which is not a security interest under the Uniform Commercial Code, and contractual/conventional subrogation, which must be perfected under the UCC); First Hays Banshares, Inc.
v. Kansas Bankers Sur. Co., 769 P.2d 1184 (Kan. 1989) (equitable indemnity not available as a remedy
for bankers blanket bond insurer).
6. Southern Ry. Co. v. Malone Freight Lines, Inc., 330 S.E.2d 371 (Ga. App. 1985).
7. Colorado Farm Bureau Mut. Ins. Co. v. CAT Continental, Inc., 649 F. Supp. 49 (D. Colo.
1986).
8. Fidelity & Deposit Co. v. Smith, 730 F.2d 1026 (5th Cit. 1984) (Louisiana). While few courts
expressly recognize the distinctions between a contract surety and an insurer, the cases do reflect the
practical differences. Unlike a fidelity insurer, the contract surety has equitable indemnity rights and
usually an agreement of indemnity creating extensive additional rights. Upon payment of a claim, a
contract surety steps into the shoes of several parties and acquires priorities unavailable to the insurer.
In re Eastern Marine, Inc., 104 B.R. 421 (Bankr. N.D. Fla. 1989). In the subrogation context, the
interchangeable use of the terms "surety" and "insurer" requires careful reading of some court decisions.
9. See Security Nat'l Bank v. Continental Cas. Ins. Co., 586 F. Supp. 139 (D. Kan. 1982); infra
section VI.
10. Infra section VII.
11. Infra section VIII.

Duties and Obligations of the Insured and Rights of the Insurer

71

defendant, the court decides who ultimately should bear the loss. Sometimes called
"balancing the equities," the doctrine draws upon the court's concept of fairness and,
where apposite, the perceived intent of the parties. For example, an insured pays a
premium to transfer its risk and, therefore, always has equities superior to those of

the insurer. The wrongdoer, being culpable and the ultimate cause of the loss, always
loses to the superior equities of the insurer.
Difficulties may arise, however, when weighing the equities of third parties whose
conduct contributed to or permitted the loss. Directors and officers of the insured,
accountants, attorneys, banks, and others may be involved in the circumstances
surrounding the loss, with greater or lesser degrees of responsibility. When the insurer
sues one of these third parties, the courts still look for the party who, in good conscience,
ultimately ought to bear the loss. The doctrine of superior equities therefore affects,
expressly or tacitly, virtually every case of subrogation against entities other than the
wrongdoer. 12
Each of these underlying equitable principles must be considered in evaluating the
rights and obligations of insurer and insured in subrogation cases. From the fidelity
insurer's viewpoint, though, the terms of the fidelity bond logically precede any
examination of these important principles.
III. BOND LANGUAGE
Most fidelity coverages arise from standard forms, primarily the blanket bonds. With
the exception of public officials bonds, these blanket bonds expressly address the
insurer's right to receive recoveries in certain circumstances. On questions of salvage
rights, the form blanket bonds fall into three groups.
First, the Commercial Blanket Bond and Blanket Position Bond both provide that
the insured shall be reimbursed fully from any net recoveries against third parties.
Thereafter, the insurer is entitled to reimbursement from any remaining net recoveries. " The bond language contemplates that either the insurer or the insured might
accomplish the recovery of salvage, although the bond is silent concerning subrogation
or assignment of rights.
Second, the Blanket Crime Policy and the Comprehensive Dishonesty, Disappearance, and Destruction Policy contain an additional, nearly identical provision for

12. Infra section V.

13. Section 8 of the Cdinmercial Blanket Bond and the Blanket Position Bond (in force since 1980)
is entitled "Recoveries" and reads as follows:
If the Insured shall sustain any loss covered by this Bond which exceeds the amount of indemnity
provided by this Bond, the Insured shall be entitled to all recoveries (except from suretyship, insurance, reinsurance, security or indemnity taken by or for the benefit of the Underwriter) by whomsoever
made, on account of such loss under this Bond until fully reimbursed, less the actual cost of effecting
the same; and any remainder shall be applied to the reimbursement of the Underwriter.

72

Tort & Insurance Law Journal, Volume XXVIII, Number 1, Fall 1992

allocating recoveries first to the insured and then to the insurer.' 4 In addition, these
bonds expressly provide for conventional subrogation and require that the insured
"do nothing after loss to prejudice such rights." 5 Because the bond language requires
contractual subrogation in the event of "any payment," the insurer might assume
that subrogation is enforceable pro tanto for the amount paid. As discussed in Section
VI infra, that expectation may be frustrated unless the insured first has recovered
100 percent of its loss.
None of the bonds in these first two categories addresses the impact of a deductible
amount on the allocation of recoveries. While the recoveries clauses refer to allocation
of amounts in excess of the bond or policy limits, insurers and most insureds understand that the deductible amount is a risk retained always by the insured. Nevertheless, as noted above, most courts require that the insured be fully reimbursed
6
before the insurer may participate in recoveries to any extent at all.'
The third category for subrogation purposes includes the 1980 versions of the
Bankers Blanket Bond and the current (1986) Financial Institutions Bond. Both
bonds contain a Section 7 entitled "Assignment-Subrogation-Recovery-Cooperation,"
7
and the five subparts in both bonds contain virtually identical language.'

14. The "Recoveries" section of these bonds is section 10, which reads as follows:
If the Insured shall sustain any loss covered by this Policy which exceeds the applicable amount of
insurance hereunder, the Insured shall be entitled to all recoveries (except from suretyship, insurance,
reinsurance, security or indemnity taken by or for the benefit of the Company) by whomsoever made,
on account of such loss under this Policy until fully reimbursed, less the actual cost of effecting the
same; and any remainder shall be applied to the reimbursement of the Company.
15. Section 14 of the bonds, entitled "Subrogation," reads as follows:
In the event of any payment under this Policy, the Company shall be subrogated to all the Insured's
rights of recovery therefor against any person or organization and the Insured shall execute and deliver
instruments and papers and do whatever else is necessary to secure such rights. The Insured shall do
nothing after loss to prejudice such rights.
16. See Oss v. United States Auto. Ass'n, 807 F. 2d 457, 460 (5th Cit. 1987) (in Texas, even a
contractual subrogation clause cannot deny the insured's priority to recoveries); Ray v. Donohew, 352
S.E.2d 729, 737-38 (W. Va. 1986) (full reimbursement to insured is a prerequisite to subrogation).
See also ABA, THE COMMERCIAL BLANKET BOND ANNOTATED S 8 (Tort and Insurance Practice Section
1985).
17. The language of section 7 of both bonds, with the exception of the definition of "excess loss"
contained in subsection (c), is identical, as reflected in the Financial institutions Bond:
(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.
(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 of Aggregate Limit of Liability,
secondly to the Underwriter as reimbursement of amounts paid in settlement of the Insured's claim,
and thirdly, to the Insured in satisfaction of any Deductible Amount. Recovery on account of loss of
securities as set forth in the second paragraph of Section 6 or recovery from reinsurance and/or
indemnity of the Underwriter shall not be deemed a recovery as used herein.
(d) Upon the Underwriter's request and at reasonable times and places designated by the Under-

Duties and Obligations of the Insured and Rights of the Insurer

73

Subsection (a) gives the insurer the right to take by assignment, to the extent of
a loss payment, all of the insured's rights and causes of action concerning any third
party. In some jurisdictions, that universe of assigned rights far exceeds the scope of
equitable subrogation, which may include only parties who caused the loss, benefitted
from the wrongdoing, or acted in bad faith (see section VII below).
Subsection (b) likewise attempts to encompass all of the insured's rights against
any third parties within the scope of the conventional subrogation established by the
bond.
Subsection (c) specifically allocates recoveries (net of collection expenses) first, to
the insured's excess loss; second, to the insurer; and third, to the deductible. Even
this express allocation, however, may be unenforceable in jurisdictions that require
full recovery by the insured before the right to subrogation accrues (see section VII
below).
Subsections (d) and (e) require the insured's cooperation with the insurer's attempts
to obtain salvage recoveries. Subsection (e) also requires that the insured "do nothing
after discovery of loss to prejudice rights or causes of action" as the insurer has taken
by assignment or subrogation. "
The "other insurance" provision of the bond forms also bears mention concerning
the fidelity insurer's salvage rights. Some jurisdictions, faced with one insurer seeking
to enforce by subrogation the rights of the insured against another insurer, look to
the policy language to determine which insurer ultimately should be responsible. The
bond forms in each of the three categories contain provisions attempting to make
the fidelity insurer excess to other insurance to which the insured has recourse.' 9
Whether these detailed bond provisions will have the desired effect depends on the
jurisdiction. Other insurance policy language has made a difference, as illustrated by
Dome Petroleum Ltd. v. Employers Mutual Liability InsuranceCo.,2" where contractual
subrogation language permitted the subrogee to reach the subrogor's E&O insurer.
writer, the Insured shall
(1) submit to examination by the Underwriter and subscribe to the same under oath; and
(2) produce for the Underwriter's examination all pertinent records; and
(3) cooperate with the Underwriter in all matters pertaining to the loss.
(e) 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.
In the 1980 Bankers Blanket Bond, S 7(c) differed by requiring application of recoveries first to the
insured's "loss in excess of the amount paid under this Bond," as opposed to the Financial Institutions
Bond description 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."
18. SeeABA, BANKERS AND OTHER FINANCIAL INSTITUTIONS BLANKET BOND (ABA National
Institute 1979); ABA, THE ANNOTATED BANKERS BLANKET BOND S 7 (Tort and Insurance Practice
Section 1983 Supp.).
19. Commercial Blanket Bond S II (bond excess to any overlapping coverage); Comprehensive
Dishonesty, Disappearance, and Destruction Policy S 13 (with some restrictions, 3-D Bond excess to
any coverages recoverable that would be recoverable in the absence of the 3-D Bond); 1980 Bankers
Blanket Bond and 1986 Financial Institutions Bond S 9 (specifies that the other insurance need not be
the insured's).
20. 767 F.2d 43, 47 (3d Cit. 1985) (grant of summary judgment to subrogor's E&O insurer reversed;
absent contract provision, no right of subrogation would have existed).

74

Tort & Insurance Law Journal, Volume XXVIII, Number 1, Fall 1992
IV. CONVENTIONAL SUBROGATION/ASSIGNMENT

The jurisdictions split over whether conventional/contract subrogation is different in

effect from legal/equitable subrogation. The question at issue is whether equitable
principles apply to subrogation by contract as they do to equitable subrogation. For
example, can the insurer and its insured by contract change priorities between themselves or change the responsibility of third parties? While the underlying theory is
different, assignment or "sale" of rights gives rise to the same question: are rights
taken by assignment from an insured any different from rights taken by equitable
subrogation?
These questions come into play when the insurer settles a claim. Either after negotiation or by policy requirement, an assignment or acknowledgement of contractual
subrogation may become part of the settlement documentation. The parties by agreement may attempt to allow sharing of recoveries or otherwise permit reimbursement
of the insurer before the insured has recovered its loss in full. The parties also may
intend, by contractual provision, to avoid other equity restrictions, such as the general
requirement that the insurer have equities superior to those of the subrogation defendant. Whether these expectations will be fulfilled is another question.
A number of jurisdictions apply equitable principles to restrict the insurer's rights
taken by conventional subrogation or by assignment. In Home Indemnity Co. v. Shaffer," the S&L blanket bond insurer took an assignment of all of its insured's rights,
then claimed against the allegedly negligent officers and directors of the savings and
loan. The district court granted summary judgment against the insurer and, in a case
of first impression in both Ohio and the Sixth Circuit, the court of appeals affirmed.
Both courts determined that the assignment added nothing to the limited right of
equitable subrogation, under which mere negligence on the part of the officers and
directors was insufficient to swing the balance of equities in favor of the assignee/
insurer.
22
In Oss v. United Services Automobile Association, the insurer attempted by the
subrogation clause in its policy "to reverse the priority of rights between insured and
insurer to any recovery from a third party." The Fifth Circuit Court of Appeals
rejected that attempt and held that, at least in Texas, subrogation clauses can "confirm,
but not expand, the equitable subrogation rights of insurers"; the court based its
3
ruling on the need to protect "the expectations of insureds. '' The Texas appellate
courts have split on the treatment of contractual subrogation clauses since the Fifth
4
Circuit's decision in Oss.'
21. 860 F.2d 186 (6th Cir. 1988).
22. 807 F.2d 457, 460 (5th Cir. 1987).
23. Id. The court cited G. PALMER, LAW OF RESTITUTION 23.14, at 434 and note 13 (1978), for
the proposition that giving an insurer a right to salvage recoveries ahead of the insured would be
"inherently deceptive" and "would qualify the basic promise to pay."
24. See Fleetwood v. Med Ctr. Bank, 786 S.W.2d 550, 554 (Tex. Civ. App. 1990) (equitable
principles apply even though the insurer's rights arise by conventional subrogation, due to the prejudice
resulting if such principles were not applied). But seeLexington Ins. Co. v.Gray, 775 S.W.2d 679
(Tex. Civ. App. 1989) (reaching the opposite conclusion and holding that the doctrine of superior
equities does not apply to conventional subrogation in Texas).

Duties and Obligations of the Insured and Rights of the Insurer

75

The Nebraska Supreme Court addressed these issues in Employers Reinsurance

Corp. v. Santee Public School District No. C-5. 25 An injured employee of an uninsured
school district recovered from the errors and omissions insurer for the insurance
company whose agent failed to procure coverage. The E&O insurer took an assignment of the employee's cause of action against the school district. The insurer then
succeeded in convincing the trial court to strike the school district's affirmative defense
that equity barred the insurer's claim, whether based on subrogation or assignment.
The Nebraska supreme court reversed, in a convoluted analysis, reaching the result
that "an insurer cannot defeat the law of subrogation by taking an assignment against
its insured.'"'6

Not all jurisdictions agree with this restrictive view of the insurer's contractual
ability to enhance the possibility of recovering against third parties. In FederalInsurance Co. v. Arthur Andersen & Co.,2' the New York trial court had granted summary
judgment to an allegedly negligent accountant, who had been sued for failure to
discover employee dishonesty, in a subrogation action by the fidelity insurer. Although
the intermediate appellate court affirmed, the New York court of appeals reversed
and held that neither the "full recovery" doctrine nor the "superior equities" defense
defeated the insurer's claim.
A prior settlement between the insured employer and the accountant expressly had
preserved the insurer's subrogation rights. Also, the insurer documented its subsequent settlement with the insured by references to its
conventional subrogation rights
and by the taking of an assignment. These agreements avoided the normal restrictions
imposed by equitable subrogation.

In Sargeant v. InternationalUnion of OperatingEngineers, Local Union 478 Health

Benefits and Insurance Fund,29 an employee benefits plan sought to enforce a reimbursement agreement to recover part of the proceeds of a settlement by the insured
with a third-party tortfeasor. The federal district court held, under Connecticut law,
that equitable principles do not qualify the reimbursement agreement, which was
construed as identical to a conventional subrogation situatiqn. The court did not

25. 438 N.W.2d 124 (Neb. 1989).

26. Id. at 130 (citing Meyers v. Bank of America Nat'l
Trust & Savings Ass'n, 77 P.2d 1084 (Calif.
1938) (assignee must be able to satisfy equitable requirements as well)). Seealso
Arvada Hardwood
Floor Co. v. James, 638 P.2d 828, 830 (Colo. App. 1981) (assignment "merely reinforced [insurer's)
preexisting subrogation right."). SeeDixie Nat'l Bank v. Employers Commercial Union Ins. Co., 463
So. 2d 1147 (Fla. 1985) (in answer to certified questions from Eleventh Circuit, Florida Supreme Court
held neither conventional subrogation nor assignment adds anything to equitable subrogation. Fidelity
insurer on bankers blanket bond could not establish superior equities against negligent directors and
their D&O insurer, summary judgment properly granted against fidelity insurer); American Nat'l Bank
& Trust Co. v. Weyerhaeuser Co., 692 F.2d 455 (7th Cit. 1982) (under Illinois law, assignment of
rights after payment by insurer of no effect because equitable subrogation already had conveyed those
rights).
27. 552 N.E.2d 870 (N.Y. App. 1990).
28. Id. Seealso Travelers Ins. Co. v. Dickey, 799 P.2d 625 (Okla. 1990) (citing Federal Ins. Co.,
the court allowed conventional subrogee to pursue merely negligent third party).
29. 746 F. Supp. 241, 245-47 (D. Conn. 1990).

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Tort & Insurance Law Journal, Volume XXVIII, Number 1, Fall 1992

require clear and express language overriding the equitable principle of "full recovery," specifically rejecting a previous Minnesota decision to the contrary. -"
One of the clearest statements of this approach is contained in Lexington Insurance
Co. v. Gray.3I There, a Texas appellate court held that the doctrine of superior equities does not apply to conventional subrogation in Texas, with its "unusually 'hospitable' treatment . . . historically" of the right of subrogation. 32 The insurer had paid
the insured mortgagee and had taken an assignment of all rights, including a guaranty
agreement running from a third party. The court held that the assignment, required
by a standard mortgage clause in the insurance policy, did not equate to conventional
subrogation but should receive the same treatment. Consequently, the insurer was
permitted to enforce the guaranty agreement without establishing that its equitable
3
position was superior to that of the guarantor.1
Likewise, in PPGIndustries, Inc. v. ContinentalHeller Corp., 34 the Arizona Court
of Appeals held that conventional subrogation and assignment are free of the limits
that equity imposes on legal subrogation. 5 A subcontractor's employee sued the
contractor for negligently causing injury; the contractor filed a third-party complaint
against the subcontractor for failing to procure the required liability insurance. The
employee settled with the contractor's insurer, the contractor obtained a verdict against
the subcontractor, and the contractor's insurer sought to be subrogated to that verdict.
Because the insurance policy provided that the insurer would be subrogated to all of
the contractor's rights, the court held that the subcontractor could not raise its lack
3
of direct fault as a defense.

30. Westendorf by Westendorf v. Stasson, 330 N.W.2d 699, 703-04 (Minn. 1983) (absent clear
and express language, equitable principles apply to conventional subrogation).
31. 775 S.W.2d 679 (Tex. Civ. App. 1989).
32. Id. at 684.
33. But see Fleetwood v. Med Cir. Bank, 786 S.W.2d 550, 554 (Tex. Civ. App. 1990) (reaching
opposite conclusion).
34. 603 P.2d 108 (Ariz. App. 1979).
35. The court relied upon Liberty Mut. Ins. Co. v. Thunderbird Bank, 555 P.2d 333 (Ariz. 1976),
where a fidelity insurer was permitted to enforce its assignment and conventional subrogation rights in
uing a third-party bank without satisfying additional equitable requirements.
36. See Clark v. Greater Anchorage, Inc., 780 P.2d 1031, 1036 (Alaska 1989). PPG Industries, in
distinguishing between equitable and conventional subrogation, noted that it followed the law in Georgia, First Nat'l Bank of Atlanta v. American Sur. Co., 30 S.E.2d 402 (Ga. App. 1944) (cited regarding
"confusion and conflict in the decisions of the various state and federal courts"), and rejected California's
view as stated in Meyers v. Bank of America Nat'l Trust & Savings Ass'n, 77 P.2d 1084 (Calif. 1938)
(even assignee must satisfy the requirements of equitable subrogation).
See also International Underwriters/Brokers, Inc. v. Liao, 548 So. 2d 163 (Ala. 1989), where the
insurer's subrogation rights were reduced from a total of $75,000 to $7,500 because the subrogation
clause did not expressly vary the equitable principle of full recovery to the insured. The court noted
that the policy could override equitable principles in Alabama, which followed Minnesota, Tennessee,
Maine, Wisconsin, and Utah.
See also Garrity v. Rural Mut. Ins. Co., 253 N.W.2d 512, 515-16 (Wis. 1977), where the court
ruled against an insurer whose assignment contained no express language restricting the application of
equitable principles that would otherwise govern the insurer's rights. The court stated:
The assignment adds nothing to the rights vested in the surety by the doctrine of subrogation [citing
COUCH ON INS. 2d S 61.105, at 297)....
The difference between an assignment and an equitable right to a cause of action is that the express

Duties and Obligations of the Insured and Rights of the Insurer

77

Concerning an insurer's contractual salvage arrangements with its insured, two

other points bear mention. First, settlement with the insured by "loan receipt" has
met with mixed success in the courts. A loan receipt is a device with which the
insurer essentially settles by paying the insured and taking control of, but not title
to, the insured's claims. Rather than being subrogated to any right to recoveries, the
insurer defers repayment of the "loan" unless and until the insured prevails on claims
against third parties.
For instance, in Transport Indemnity Co. v. BB&S, Inc.,37 the Oregon Court of
Appeals enforced an insurer's right of subrogation even though the insurer originally
took a loan receipt upon payment of the insured. (After taking the loan receipt, the
insurer settled on behalf of itself and its insured's joint-tortfeasor co-defendants, then
sought statutory contribution.) The court held that the initial loan receipt arrangement did not prevent later renegotiation to a release and subrogation arrangement.
The principal difference between the two arrangements is that the loan receipt gives
the insurer the right "to control litigation brought in the 'borrower's' name and to be
'repaid' from any recovery," while subrogation gives the insurer "the capacity to bring
in its own name the action the releasor could have brought."' Results in other jurisdictions have been mixed. - 9
The second point concerns whether the insurer or the insured is the real-parry-ininterest for purposes of joinder and, in federal court, diversity. Generally, the federal
courts apply Federal Rule of Civil Procedure 17(a), not state procedural law, in
determining whether the insurer will be joined in the loan receipt context."'
Generally, if the policy establishes conventional subrogation or requires an assignment, the insurer would be prudent to take advantage of those potential enhancements to its rights. In many situations, no practical difference will result. On the
other hand, some courts will enforce the insurer's contractual salvage rights in the
assignment "has the effect of benefiting the insurer by making it unnecessary for it to probe the
existence of the facts justifying subrogation, for it can rely on the express assignment." Id. 61.106.
37. 664 P.2d 1115 (Or. App. 1983), pet. for review denied, 670 P.2d 1034 (Or. 1983).
38. 664 P.2d at 1116 (emphasis in original).
39. Compare Riewe v. Arnesen, 381 N.W.2d (Minn. App. 1986) (loan receipt is a loan and therefor
does not give rise to subrogation rights for the insurer) and State ex rel. Bartlett & Co., Grain v. Kelso,
499 S.W.2d 579 (Mo. Ct. App. 1973) (loan receipt in favor of fidelity insurer accomplished neither
subrogation nor assignment despite sham nature of transaction), with Mut v. Newark Ins. Co., 289 So.
2d 237 (La. App. 1973) (because loan receipt contained highly restricted obligation to repay and policy
contained subrogation clause, loan receipt created conventional subrogation) and Potomac Elec. Power
Co. v. Babcock & Wilcox Co., 54 F.R.D. 486 (D. Md. 1972) (insurer's exclusive control of third-party
action under loan receipt created conventional subrogation and made insurer indispensable party). See
also Annot., Insurance: Validity and Effect of Loan Receipt or Agreement between Insured and Insurer for
a Loan Repayable to Extent of Insured's Recovery from Another, 13 A.L.R.3d 42 (1967).
40. Compare Industrial Chem. & Fiberglass Corp. v. North River Ins. Co., 908 F.2d 825, 832 (1 th
Cit. 1990) (loan receipt held valid and insurer not required to be joined), with Travelers Ins. Co. v.
Riggs, 671 F.2d 810, 812-14 (4th Cir. 1982) (circuit's rule of involuntary joinder at the defendant's
election applied, in lieu of Virginia statute allowing suit in the insured's name even where insurer is
totally subrogated). See also 13 A.L.R.3d 42, SS 18-22, for discussion of "distinctive interpretation or
... unique provision" in Delaware, Missouri, New York, and Pennsylvania regarding Rule 17(a) and
the real-parry-in-interest. See also Armor., Diversity of Citizenship between Subrogee, Subrogor, and Defendant for Purposes of FederalJurisdictionof Action Based on Subrogation, 6 A.L.R.2d 137 (1949).

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face of defenses that would defeat equitable subrogation. Given the opportunity, the
insurer has little or nothing to lose by taking the insured's rights contractually, particularly if the ability to proceed in the insured's name is preserved.

V. DEFENDANTS IN SUBROGATION: PARTICULAR CONSIDERATIONS

An insurer with one eye on the insured's claim should have the other eye on potential
sources of recovery. In general, those sources fall into three categories: the direct cause
of the loss (e.g., the dishonest employee and co-conspirators), insiders without direct
fault (e.g., directors and officers of the insured), and strangers with legal or contractual responsibility (e.g., accountants, banks, guarantors, and other insurers).
Subrogation against the direct cause of the loss is straightforward in theory: he or
she who causes the loss must bear it. In practice, evidence of the dishonest employee's
actions often is lacking or contradictory, so that no clear picture of liability takes
shape. The insured's claim, based on information in the insured's control, may be
much stronger than the insurer's subrogation claim against the accused employee.
Once the insured has recovered under the fidelity policy, cooperation, evidence, and
witnesses can become difficult to obtain.
The insurer may contest the insured's claim, perhaps vigorously, before settling.
The accused employee, as the defendant in subrogation, often will turn the insurer's
previous defensive positions against it. In addition, the employee may seek the protection of the bankruptcy court, where the insurer first must establish that subrogation
applies 4 and then must make out a case of fraud sufficient to avoid discharge of the
employee's debt.
Beyond the question of liability, the dishonest employee often is insolvent. Coconspirators inside or outside the insured's organization would be logical targets in
that case, but the disincentive to pursue an insolvent principal wrongdoer may weaken
the insurer's ability to prove the fault of others. Finally, retaliatory claims (e.g., libel,
slander, interference with contractual relationships) may be an effective deterrent from
prosecuting a gray-area claim in subrogation.
The second category, insiders without direct fault, most frequently consists of officers and directors of the insured. Diligent performance of the duties required of
officers and directors many times could have prevented or greatly mitigated fidelity
losses. Failure to act in a prudent manner may permit or exacerbate the loss and
become a part of the cause.
Directors and officers appear to be targets in subrogation actions more frequently
today than in the past. In part, suits by Federal Deposit Insurance Corp. and Resolution Trust Corp. have focused attention on the responsibilities of directors and
officers of failed banks and S&Ls. Also in part, increased use and scope of director's
and officer's insurance coverage (D&O coverage) indirectly have deepened the pockets
of officers and directors. For whatever reasons, courts have been willing to expand
directors' and officers' liability.
41. Infra section IX.

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79

Until recently, the doctrine of superior equities made successful subrogation against
officers and directors unlikely. To reach those parties, an insurer had to establish
actual knowledge of loss and failure to prevent it, bad faith, or fraud; mere negligence
was insufficient.4 ' Some courts now are willing to consider subrogation against officers
and directors who attempt to or do benefit from wrongdoing and even against those
4
who merely negligently supervise dishonest employees. 3
If the insurer can overcome the superior equities doctrine against directors and
officers, other obstacles remain. If the insured has a contract to indemnify its management, as is permitted and even required in many states, then subrogation against
directors and officers in effect is recovery from the insured-a result that courts
usually will not permit.4 If the insured has D&O coverage for its indemnity obligation, however, subrogation logically should be allowed. Along that line, the fidelity
insurer in subrogation may be able to pursue the D&O carrier in "direct action"
jurisdictions; mere assignment of the insured's rights to D&O coverage rarely helps,
because most policies require that the D&O carrier consent to any settlement. Finally,
the fidelity insurer must consider the potential for a counterclaim or separate bad
faith claim brought by the insured, which after all is controlled by the same directors
45
and officers whom the insurer would be suing.
The third category, strangers with legal or contractual responsibility, includes a
wide range of potential defendants exemplified by financial institutions and accountants. Where a fidelity claim arises from facts involving commercial paper, such as
forged checks, the Uniform Commercial Code (UCC) establishes the insured's right
(to which the insurer succeeds) and the third parties' defenses. For example, a subrogation claim against a drawee bank paying over an unauthorized signature may fail
if the insured should have discovered the dishonesty from prior bank statements but
failed to notify the bank under UCC section 3-406. Those facts would bring into
play the responsibility of the insured's supervising employees and the possibility of
46
an "impairment of subrogation" defense.
Subject to the superior equities restriction, the insurer may pursue the insured's
rights against contractual obligors such as guarantors and other insurers. Privity forms
the link that allows the insurer to assert contract rights previously held by the insured.
An example of a potential defendant without a contractual payment obligation is the
accountant who audited the insured and negligently failed to detect employee dishonesty. Especially where the insurer asks in the application and the insured affirms that

42. Rizk, Bank Directors' Liability to Fidelity Insurers: How "Bad" Is Bad Faith?, 11 THE FORUM
481 (1984) (the author argues that the equities should balance in favor of the subrogee/insurer where
the director or officer is guilty of reckless disregard; that standard was expressly rejected in Employers
Ins. of Wausau v. Doonan, 712 F. Supp. 1368 (C.D. Ill. 1989)).
43. Infra section VIII.
44. See National Union Fire Ins. Co. v. Continental Ill. Corp., 658 F. Supp. 775 (N.D. Ill. 1987).
45. Schroeder, Handling the Complex Fidelity or FinancialInstitutions Bond Claim: The Liability of
the Insured's Officers and Directors and Their D&O Carrier,21 TORT & INS. L.J. 269, 290 (1986)
46. See supra, this section and infra section VI. See also Knox, Recovery from Principal, Banks, CoConspirators, Other Carriers and Officers and Directors (ABA National Institute 1983).

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its operations are audited, the insurer may be a "reasonably foreseeable" potential
plaintiff relying on the audit.
If a jurisdiction has not balanced the equities unequivocally in favor of accountants,
the surety can increase its chances of recovery by requiring in the policy that the
insured notify its auditor of the existence of the fidelity bond and instruct the auditor
to send a copy of any audit reports to the fidelity insurer. Also, the surety should
investigate the involvement of the insured's accountant and the results of any audit.
Where the underwriting file reflects reliance by the insurer on the accountant's work,
a negligent audit is more likely to be considered a contributing cause to the insurer's
claim payment and, thus, a basis for subrogation action. Further, if in its application
the insured makes misrepresentations, either about or taken from its accountants, the
insurer may have grounds for rescission, of the policy instead of payment and
subrogation.47
Many of these considerations also apply to other third parties. Attorneys providing
opinion letters can find themselves in a position analogous to that of the accountant.
Securities brokers who trade for an employee without authorization may face claims
like those against banks (with the added complexity of federal regulations). The
nature of the third party will play a primary role in the insurer's decisions about
whether and how to pursue subrogation claims.

VI. IMPAIRMENT OF SUBROGATION BY INSURED

Impairment of subrogation by the insured's action or inaction probably occurs most
often through ignorance. Failing to recognize the insurer's conditional rights to salvage,
the insured makes decisions that can impair or preclude recovery against third parties.
The insurer, seeking to step into the insured's shoes after payment under the bond,
may find that the laces already have been tied together.
The insured may allow a dishonest employee to receive salary, bonuses earned,
vacation pay, pension distributions, or other sums due without exercising the right
of offset. Failure to press criminal charges where warranted could allow a wrongdoer
to avoid a prompt investigation and later to deny the crime entirely. Settling with
the wrongdoer without the insurer's consent probably is the most common form of
impairment, but choosing not to pursue a civil action or a claim in bankruptcy (or
missing the deadline for objecting to discharge due to fraud) are just as detrimental.
Depending on the circumstances, the insured's impairment of subrogation may
give the insurer certain remedies. Whether or not the fidelity bond contains an express
prohibition, the insured may not impair the insurer's subrogation rights without risk
of losing the coverage. For instance, in Security National Bank v. Continental Casualty Insurance Co.," the insured discharged its bankers blanket bond insurer by releasing the wrongdoers (debtors in bankruptcy) without reserving the insurer's rights or
47. Smirz, Liability of Accountants to the Financial Institutions Bond Surety (ABA TIPS MidWinter Meeting 1988).
48. 586 F. Supp. 139, 146-48 (D. Kan. 1982).

Duties and Obligations of the Insured and Rights of the Insurer

81

obtaining the insurer's consent. Without discussion, the federal district court indicated
that, under Kansas law, such a discharge might occur even if an insured did reserve
the insurer's rights and even if the release caused no demonstrable prejudice to the
insurer. Presumably, that indication simply recognized Kansas' strict protection of
the insurer's right to consent before the insured interferes with subrogation rights.49
Additional remedies may be available if the insurer has paid in settlement of the
insured's claim without knowledge that the insured already has impaired subrogation
by releasing claims against a third party. The insurer may be permitted to proceed
against the third parry without regard to the release (if the third parry knew of the
insurer's rights at the time of settling with the insured) or may be allowed to recover
reimbursement directly from the insured.
In Conservatorship of Edwards," the surety for a predecessor conservator paid in
settlement with the successor conservator and was joined as a subrogee in the successor's action against certain banks. Without notice to the surety, the successor settled
with and released the banks. The California Court of Appeals addressed the following
question of first impression:
[Wlhat are the rights of the surety where an insured, without the consent of the surety
which is also a party to the insured's actions against the tortfeasors, has settled with
third-party tortfeasors for an amount which when added to the sum paid by the surety
will not compensate the insured for its entire loss[?]"

The court decided that the surety is not barred as to any tortfeasor with knowledge
of the surety's subrogation interest and that the surety may recover from its insured
if the tortfeasor did not have knowledge that the settlement prejudiced the surety's
rights.52 In reaching this result, the court referred by analogy to subrogation rights
created under California's workers compensation statute. Obviously, insureds must
take care to preserve their insurer's subrogation rights or risk losing the traditional
equitable protections."
An insurer may waive its rights to insist that the insured preserve subrogation
interests. The most common form of waiver is denial of coverage. In First Hays
Banshares, Inc. v. Kansas Bankers Surety Co.,54 the bankers blanket bond insurer
denied coverage of the loss caused by a director of the insured. The insured then
49. But see Blue Cross & Blue Shield United v. Fireman's Fund Ins. Co., 411 N.W.2d 133 (Wis.
1987) (because Wisconsin law splits the cause of action between an insured and its insurer/subrogee,
the insured's release of a tortfeasor has no effect on the insurer's portion of the cause of action). See
Annot., Rights and Remedies of Insurer Paying Loss As Against Insured Who Has Released or Settled
with the Third Person Responsible for Loss, 51 A.L.R.2d 697 (1957).
50. 244 Cal. Rptr. 330 (Ct. App. 1988).
51. Id. at 330, 335.
52. Id. at 335-36.
53. To overcome those from equitable protections, the insurer may be required by some jurisdictions
to establish prejudice flowing from the insured's conduct. In particular, some states require that the
insurer must at least allege and possibly prove that a released claim would have been enforceable against
the third party. See, e.g., Washington Fire & Marine Ins. Co. v. Williamson, 100 So. 2d 852 (Miss.
1958).
54. 769 P.2d 1184 (Kan. 1989).

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settled with and released that director. In the insured's action on the bond, the insurer
raised the release of the wrongdoer as a bar to coverage. The Kansas Supreme Court
rejected this defense and held that the insurer's denial of coverage allowed the insured
to settle with third parties without prejudice to the rights of the insurer, despite the
express language in section 7(e) of the Bankers Blanket Bond (1980 version)."
Where the insurer otherwise might be entitled to participate in recoveries by the
insured, denial of coverage may sacrifice that right. In FederalSavings & Loan Insurance Corp. v. Transamerica Insurance Co., 5" denial of coverage by the S&L blanket
bond insurer destroyed the insurer's right to have a partial recovery by FSLIC allocated fairly to both covered an uncovered portions of the loss. The federal district
court in California distinguished a California state court decision 57 in which an allocation of recoveries to covered and pre-policy losses was required due to a settlement
without notice to the insurer.
Finally, an insurer may waive its right of subrogation simply by failing to exercise
its rights in a manner deemed timely by the courts. In Bank of Danielsville v.
Seagraves,' a bank employee took $8,000 from her cash drawer and left two $4,000
promissory notes, which the bank would not accept without a co-signature. Upon
discovery, she was fired and a fidelity claim submitted, including notification of the
existence of the two notes. The insurer paid the loss and took an assignment of the
bank's rights to bring an action against the employee, but the insurer did not take
assignment or possession of the notes. The employee then filed suit against the bank
for libel and slander, and the bank and the employee reached an accord and satisfaction of all claims and counterclaims.
Three years after taking assignment of the bank's causes of action, the insurer took
an assignment of and sued on the two promissory notes. The Georgia Court of
Appeals held that the bank's assignment of the notes conveyed no value, due to the
previous settlement with the employee. Likewise, equitable subrogation failed to
provide the insurer with a remedy. With knowledge of the notes and with the right
to take them, the insurer allowed the employee to believe that the bank could include
those notes in the settlement. Consequently, the insurer's inaction led to a complete
loss of all right to recover from the dishonest employee.' 9

VII. FULL RECOVERY REQUIREMENT AND THIRD-PARTY PRACTICE

One of the equitable principles qualifying the insurer's right of subrogation is the
requirement that the insured recover 100 percent of its loss before the insurer is
entitled to any recovery. The covered amount does not determine: if the insured's
55. See also H.S. Equities, Inc. v. Hartford Acc. & Indem. Co., 661 F.2d 264 (2d Cir. 1981) (denial
of coverage barred insurer's defense of impairment of subrogation).
56. 661 F. Supp. 246, 252-53 (C.D. Cal. 1987).
57. Graydon-Murphy Oldsmobile v. Ohio Cas. Ins. Co., 93 Cal. Rptr. 684 (Ct. App. 1971).
58. 305 S.E.2d 790 (Ga. App. 1983).
59. Id. Seealso Annot., Waiver by Insurance Company of Right to Subrogation, 16 A.L.R.2d 1269
(1951).

Duties and Obligations of the Insured and Rights of the Insurer

83

loss exceeds the policy limits-most jurisdictions require that the insured first recover
its excess loss before the insurer begins to recover its outlay.'1 Until the insured has
been made whole, generally no right of subrogation vests in the insurer with the
exception of a third-party plaintiffs standing to pursue its contingent claim.
Although sometimes called the "full payment" requirement, actually the only
condition is that the subrogor/insured be fully reimbursed from all sources, including
the subrogee/insurer. " The priority for reimbursement of the deductible is an open
question, although one presumably settled between insurer and insured in the scheme
of the policy itself. The concept of the deductible as the insured's retained risk contradicts the insured's claim for reimbursement of the deductible until after the insurer
recovers its claims payment.
The rule that the insured must recover in full has been qualified in some jurisdictions. For example, in Blue Cross and Blue Shield United v. Fireman's Fund Insurance Co.f" the trial court had dismissed the insurer's subrogation claim against a
third-party torrfeasor's liability insurer because the subrogee had failed to allege that
the insured had recovered in full. The Wisconsin Court of Appeals reversed, and the
Wisconsin Supreme Court affirmed in light of a recent Wisconsin decision, 63 holding
that "equity under the circumstances," not "full recovery," is the rule in Wisconsin.
The Wisconsin Supreme Court noted two circumstances that supported equitable
subrogation even though the insured had not recovered its loss in full. First, the
subrogee/insurer was not seeking to recover any sums from the insured, and the
third-party tortfeasor's liability insurer had no equitable standing to complain that
the subrogor/insured had not been made whole. Second, the insured already had
released any claims against the defendant in the subrogation action, so the subrogee/
insurer's claim would not have the effect of diminishing funds available to reimburse
the insured.14 Other courts also have recognized that pro tanto subrogation may be
appropriate in claims against third parties in the absence of prejudice to the insured/
subrogor6 5
In the absence of a full recovery, and particularly where the insured still seeks to

60. See,e.g., Oss v. United Servs. Auto. Ass'n, 807 F.2d 457 (5th Cir. 1987).
61. Ray v. Donohew, 352 S.E.2d 729, 737-38 (W. Va. 1986). Seealso Oss v. United Servs. Auto.
Ass'n, 807 F.2d 457, 460 (5th Cir. 1987) (insurer receives no participation in insured's recovery of
salvage unless all sources of recovery, including insurance, exceed loss plus collection costs).
62. 411 N.W.2d 133 (Wisc. 1987).
63. Vogt v. Schroeder, 383 N.W.2d 876 (Wis. 1986).
64. The court distinguished Rimes v. State Farm Mut. Auto. Ins. Co., 316 N.W.2d 348 (Wis.
1982), where recovery directly against the insured was denied in the absence of a full recovery by the
insured, and Garrity v. Rural Mut. Ins. Co., 253 N.W.2d 512 (Wis. 1977), where the insurer was
competing with the insured for recoveries from the same third party.
Also, a subrogated insurer in Wisconsin takes a part of the cause of action belonging to the insured,
and the state employs a statutory scheme for joinder of the insured in the insurer's subrogation action,
to protect the interests of both.
65. DeFoe v. Great Southern Nat'l Bank, 511 So. 2d 912, 917 (Miss. 1987) (direction to lower
court on remand that pro tanto subrogation is allowable if no prejudice to creditors' rights); State ex rel.
Paden v. Carrel, 597 S.W.2d 167, 177 (Mo. Ct. App. 1979).

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recover from the insurer, the insurer often will attempt to address its contingent
subrogation rights by a third-party complaint. Some courts have rejected that attempt.("
Taking less of a hard-line approach, some courts have held that a third-party
complaint asserting a contingent subrogation claim may be permitted upon a
"balancing of policy considerations," even though such an action may not be considered a matter of right. In Cleveland-Cliffs Iron Co. v. First State Insurance Co., 67 the
Michigan Court of Appeals held that those policy considerations to be balanced include
"Iprobability of delay, .
motion ....

similarity

. complications of the trial, .

of evidence ....

. . timeliness of the
possibility of prejudice to the plaintiff,

[and] ... possibility of prejudice to third-party defendant."6

Most courts, however, appear to be permitting third-party impleader on contingent
subrogation claims as a matter of right, in accordance with Federal Rule of Civil
Procedure 14(a) and its analogs in the state courts. InJ&B Schoenfeld, Fur Merchants,
Inc. v. Albany Insurance Co.,69 the New York trial court was not permitted to condition summary judgment for the insured on an assignment of rights to the insurer
prior to payment, either under equitable principles or under policy language requiring
an assignment. The appellate court held that third-party impleader is the insurer's
only right as a potential subrogee prior to payment."

VIII. SUPERIOR EQUITIES DEFENSE

The concept of "balancing the equities," or of determining whether the subrogee/
insurer has interests superior in equity to those of the defendant in subrogation,
continues to receive mixed treatment in the courts. Perhaps one of the more extreme
situations in which the equities "balanced" against the insurer was National Union
Fire Insurance Co. v. Continental Illinois Corp.7 After the insurer paid the loss to
innocent insureds, it sought recovery in subrogation from the fraudulent wrongdoer
who, although defined as an "insured" for some purposes under the policy, did not
fall within the coverage at issue. The federal district court in Illinois held that the
wrongdoer's status as "insured" nevertheless defeated the insurer's subrogation claim.
The same theory in a different context allowed the Idaho Supreme Court to reject
a subrogation claim by a landlord's fire insurer against the tenant who caused the
66. See Village of Crainville v. Argonaut Ins. Co., 410 N.E.2d 5 (Ill. 1980) (contingent or anticipatory third-party claim not permitted).
67. 307 N.W.2d 78, 82 (Mich. App. 1981).
68. Id. See also Foley Machinery Co. v. Amland Contractors, Inc., 506 A.2d 1263, 1267 (N.J.
Super. 1986) (payment by insurer not an absolute condition precedent to subrogation action against
tortfeasor).
69. 492 N.Y.S.2d 38 (A.D. 1985).
70. ld. Also permitting third-party impleader as a matter of right are Federal Saving & Loan Ins.
Corp. v. Aetna Cas. & Sur. Co., 696 F. Supp. 1190 (E.D. Tenn. 1988) (S&L Blanket Bond insurer,
equitable subrogation claim permitted); Guiberson v. Hartford Cas. Co., 704 P.2d 68, 71-72 (Mont.
1985); General Acc. Ins. Co. v. Fidelity & Deposit Co., 598 F. Supp. 1223 (E.D. Pa. 1984). See also
Security State Bank v. Commercial Standard Title Ins. Co., 605 S.W.2d 673 (Tex. Civ. App. 1980).
71. 658 F. Supp. 775, 780-81 (N.D. Ill. 1987).

Duties and Obligations of the Insured and Rights of the Insurer

85

fire in Safeco Insurance Cos. v. Weisgerber.72 Balancing the equities in the light of
public policy, the court declared that the tenant, although not addressed in the policy
at all, essentially was a co-insured with the landlord and therefore was immune to
subrogation claims.7"
Courts apply the doctrine of superior equities most frequently to protect third
parties not directly responsible for the loss. In Employers Insurance of Wausau v.
Doonan,7 4 a federal district court decided that a fidelity insurer accepts the risk that
its insured's officers and directors may be negligent and allow a loss to occur. Based
on that conclusion, the equities of merely negligent officers and directors were held
superior to those of the insurer.
Continuing its balancing of equities between those same parties, the same district
court later concluded that even gross negligence and reckless disregard are not enough
to swing the balance in favor of the insurer. 75 The court held that the officers and
directors must be guilty of fraud, bad faith, personal benefit from the wrongdoing,
or "actual discovery" of the conduct causing the loss. The court required the insurer
to replead its case to eliminate all counts not meeting that standard.7" In a similar
case, Home Indemnity Co. v. Shaffer,77 both a district court in Ohio and the Sixth
Circuit required that officers and directors of the insurel be guilty of fraud, bad faith,
or an attempt to benefit from the wrongdoer's dishonesty before the equities would
permit recovery by the insurer. In that case, the S&L blanket bond insurer lost on
summary judgment upon conceding that the officers and directors were merely
negligent.
In Federal Savings and Loan Insurance Corp. (FSLIC) v. Aetna Casualty and Surety
Co.," the S&L blanket bond insurer sought legal subrogation against two categories
of defendants: active wrongdoers and negligent employees of the insured. The federal
district court, struggling with the vagueness of the allegations against each employee,
ruled that the insurer could recover in subrogation from active wrongdoers whose
conduct rises to the level of the bond's coverage. 79 In essence, this ruling does not
permit the subrogee to step into the shoes of the subrogor beyond the subrogee's
own scope of liability."'
As to employees other than active wrongdoers, the court ruled that the insurer can
72. 767 P.2d 271 (Idaho 1989).
73. The Illinois Court of Appeals reached an identical result in Anderson for use of American Fam.
Ins. Co. v. Peters, 491 N.E.2d 768 (Il. App. 1986), but the same court overruled that decision as
inconsistent with state policy in Fire Ins. Exch. v. Geekie, 534 N.E.2d 1061, 1062 (Ill. App. 1989)
(absent express agreement to the contrary, if the tenant may be liable to the subrogor/landlord, the
tenant also may be liable to the subrogee/insurer).
74. 664 F. Supp. 1220 (C.D. Il. 1987).
75. Employers Ins. of Wausau v. Doonan, 712 F. Supp. 1368 (C.D. Ill. 1989).
76. 712 F. Supp. at 1369.
77. 860 F.2d 186 (6th Cit. 1988).
78. 696 F. Supp. 1190 (E.D. Tenn. 1988).
79. 696 F. Supp. at 1192-93.
80. The court cited Federal Deposit Ins. Corp. v. Aetna Cas. & Sur. Co., No. 1-85-797, slip op. at
3 (E.D. Tenn. June 6, 1986) (WESTLAW: 1986 WL 21361), where a subrogation claim failed against
merely negligent bank officials because the bankers blanket bond and excess bank employee dishonesty
blanket bond covered only fraud, not negligence..

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recover in subrogation from employees who negligently supervise or fail to detect the
wrongdoer only if those employees benefit from the wrong."' Because the court also
0 2
the court in FSLIC presumably might be persuaded to
expressly followed Doonan,
extend that subrogation liability to negligent employees who actually discover the
conduct causing the loss.1

In a similar case in Florida, the insured bank sued its blanket bond insurer to
recover a loss caused by the bank's dishonest former cashier. 4 The insurer filed a
third-party complaint against the bank's directors and their D&O carrier, based on
conventional subrogation and assignment, but stipulated that the directors had no
actual knowledge of the wrongdoing and were not guilty of fraud or bad faith. A
federal district court balanced the equities in favor of the directors and their insurer,
the Eleventh Circuit certified the question, and the Florida Supreme Court agreed
with the trial court. In balancing the equities, the supreme court held that a fidelity
insurer in Florida assumes the risk that the officers and directors of its insured will
be negligent in allowing losses to occur."'
On the other hand, a number of jurisdictions have been softening the "superior
equities" rule to permit subrogation actions against a broader scope of third parties.
In one example, General Accident Insurance Co. v. Fidelity and Deposit Co. ,06 the
federal district court went so far as to speculate that the "superior equities" analysis
might be "obsolete," at least where the UCC applies. The insured sued its commercial blanket bond carrier for employee dishonesty, and the insurer filed third-party
claims against the banks involved in the collection process. While some of the banks
were accused of fraudulent collusion, others merely had the misfortune to stand in
the collection line. The district court denied all of the banks' motions for summary
judgment and to dismiss and was unwilling to assume that superior equities analysis
still applied to banks in the face of UCC section 3-405. If the "fictitious payee
defense" applies, a bank failing to meet that standard may not be able to establish
superior equities as a matter of law.
A specialized instance of the superior equities doctrine is known as the "compensated surety" defense. A fidelity insurer takes a premium to accept a defined risk,
e.g., employee dishonesty. A third party, although not at fault and receiving no
benefit, also may be liable for the wrongdoing. Because the insurer is compensated,
some courts have held that it cannot demonstrate equities superior to those of the

81. 696 F. Supp. at 1193-95 (citing First Nat'l Bank v. Hansen, 267 N.W.2d 367, 371 (Wis.
1978)).
82. 664 F. Supp. at 1223-24.
83. Doonan, 712 F.Supp. at 1369. Compare Manufacturer's Bank & Trust v. Transamerica Ins. Co.,
568 F. Supp. 790, 792 (E.D. Mo. 1983) (subrogation allowed against negligent bank officials-whether
"active" or supervisory unclear), with Community Fed. Savings & Loan v. Transamerica Ins. Co., 559
F. Supp. 536, 538 (E.D. Mo. 1983) (subrogation allowed against bank official if conduct more responsible for loss than wrongdoer's).
84. Dixie Nat'l Bank v. Employers Comm'l Union Ins. Co., 463 So. 2d 1147 (Fla. 1985).
85. Cf Meyer v. Dempcy, 740 P.2d 383 (Wash. App. 1987) (subrogation not allowed where the
insured's own negligence caused the loss, applying Washington's balancing of equities rule).
86. 598 F. Supp. 1223 (ED. Pa. 1984).

Duties and Obligations of the Insured and Rights of the Insurer

87

"innocent" third party."' Regardless of the words used, the courts usually seek the
entity who ultimately, either through policy or through the parties intent, ought to
bear the loss. With this concept in mind, the insurer should be able to pursue any
third parry who arguably has ultimate responsibility for a covered loss, notwithstanding the insurer's compensated status.
Recently, another court decided that mere negligence may overcome the insurer's
compensated status for purposes of a subrogation claim in Federal Insurance Co. v.
Arthur Andersen & Co.8' The insured's employee embezzled approximately $4 million
by manipulating account records and creating nonexistent receivables. The insured's
auditor for three years failed to discover the fictitious receivables and reflected them
on the insured's balance sheet. The insured and its auditors settled, with the insured
giving a release in exchange for $900,000 in professional services.
The New York trial court dismissed the fidelity insurer's subrogation claim and
was affirmed on appeal. The New York court of appeals reversed both trial and
intermediate appellate courts in holding that neither the "full recovery" doctrine nor
the "superior equities" defense necessarily defeats an insurer's subrogation claim. 9
The court of appeals held that full recovery is not a defense where the insurer sues
the third parry only for what the insurer has paid and does so after the insured has
released the third party. The court also held that the superior equities defense is
merely a specific application of the general rule of equity to dispense justice and, to
the extent applicable, may be overcome by the third party's negligence. In short, a
negligent third party cannot escape responsibility simply because the insured had
fidelity coverage. 9"
In a case of conventional subrogation, where the language allowed the subrogee
to assert claims against "any third party," the Third Circuit under New Jersey law
allowed an indemnitor to reach its indemnitee's E&O insurer in Dome Petroleum Ltd.
v. Employers Mutual Liability Insurance Co.9 ' The subrogee was not limited to claims
against "wrongdoers" and was not required to show superior equities.92 The Third
Circuit directed the district court to decide whether the E&O insurer assumed ultimate contractual responsibility for the loss; on remand, the trial court determined
93
that fact issues precluded summary judgment.
Public policy considerations continue to impact case results. A change in Arizona's
law established an excess carrier's right, by equitable subrogation, to sue the primary
insurer for bad faith refusal to settle the claim in HartfordAccident & Indemnity Co.
87. See Knox, Subrogation Rights in Fidelity Cases, 12 THE FORUM 348, 352 nn.19-29 (1976).
88. 552 N.E.2d 870 (N.Y. App. 1990).
89. The court also noted that the release excluded the fidelity insurer's subrogation rights.
90. 552 N.E.2d at 874-76, cited with approval in Travelers Ins. Co. v. Dickey, 799 P.2d 625
(Okla. 1990) (insurer allowed to pursue negligent roofer for recovery in conventional subrogation after
paying water damage loss). See also Western Sur. Co. v. Loy, 594 P.2d 257 (Kan. App. 1979) (surety
must establish superior equities, but accountant's negligence would be sufficient for surety to prevail).
91. 767 F.2d 43 (3d Cit. 1985).
92. Id. at 45 (citing Hartford Fire Ins. Co. v. Riefolo Constr. Co., Inc., 410 A.2d 658 (N.J. 1980)).
93. Dome Petroleum Ltd. v. Employers Mut. Liab. Ins. Co., 635 F. Supp. 1397 (D.N.J. 1986).
At last report, the case still was in the discovery stage. Dome Petroleum, 131 F.R.D. 63 (D.N.J. 1990).

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Tort & Insurance Law Journal, Volume XXVIII, Number 1, Fall 1992

v. Aetna Casualty & Surety Co.' 4 The supreme court extended the right of subrogation for various policy reasons, including encouraging settlements in good faith by
primary insurers and allocating primary and excess risks as intended by the parties. 95
Finally, as addressed above, the Texas court of appeals appears uncertain about the
96
status of the superior equities defense in the conventional subrogation context.

IX. SUBROGATION IN BANKRUPTCY

As with most other courts on most questions concerning subrogation, the bankruptcy
courts are split on the extent of the right. Unquestionably, co-debtors, guarantors,
and sureties enjoy the right to pursue claims in subrogation under the Bankruptcy
Code' 7 and, with certain exceptions, those entities also take their subrogor's priority. 9
Neither of those Code sections, however, makes reference to insurers, who are left to
assert the applicability of conventional or equitable subrogation in bankruptcy.
In In re Kaiser Steel Corp., 9" one bankruptcy court held that section 509 of the
Code and all of the requirements of equitable subrogation both must be satisfied to
enforce subrogation rights in bankruptcy. On the other hand, the court in In re
Spirtos'" expressly concluded that section 509 is not the exclusive source of subrogation under the Bankruptcy Code.'" The Spirtos court then looked to California's
94. 792 P.2d 749 (Ariz. 1990) (en banc).
95. To reach this result, the supreme court overruled Universal Underwriters Ins. Co. v. Dairyland
Mut. Ins. Co., 433 P.2d 966 (Ariz. 1967), to the extent contrary.
96. Compare Lexington Ins. Co. v. Gray, 775 S.W.2d 679 (Tex. Civ. App.-Austin 1989, no writ)
(doctrine does not apply due to "unusually 'hospitable' treatment ... historically" of the right of subrogation in Texas), with Fleetwood v. Med Ctr. Bank, 786 S.W.2d 550, 554 (Tex. Civ. App.-Austin
1990, writ denied) (equitable principles apply if prejudice would result otherwise).
97. 11 U.S.C. S 509.
98. id. 5 507(d). Section 509, entitled "Claims of Codebtors," reads as follows:
(a) Except as provided in subsection (b) or (c) of this section, an entity that is liable with the debtor
on, or that has secured, a claim of a creditor against the debtor, and that pays such claim, is subrogated
to the rights of such creditor to the extent of such payment.
(b) Such entity is not subrogated to the rights of such creditor to the extent that(1) a claim of such entity for reimbursement or contribution on account of such payment of such
creditor's claim is(A) allowed under section 502 of this title;
(B) disallowed other than under section 502(e) of this title; or
(C) as between the debtor and such entity, such entity received the consideration for the claim
held by such creditor.
(c) The court shall subordinate to the claim of a creditor and for the benefit of such creditor an
allowed claim, by way of subrogation under this section, or for reimbursement or contribution, of an
entity that is liable with the debtor on, or that has secured, such creditor's claim, until such creditor's
claim is paid in full, either through payments under this title or otherwise.
99. 89 B.R. 150, 152 (Bankr. D. Colo. 1988).
100. 103 BR. 240 (Bankr. C.D. Cal. 1989).
101. The court followed In re Massetti, 95 B.R. 360 (Bankr. E.D. Pa. 1989) and In re Previs, 31
BR. 208 (Bankr. W.D. Wash. 1983). Seealso In re Commercial Reprographics, Inc, 95 BR. 174
(Bankr. E.D. Cal. 1988); In re Munzenrieder Corp., 58 B.R. 228 (Bankr. M.D. Fla. 1986), both
applying equitable subrogation without reference to section 509. Cf In re Forester, 529 F.2d 310 (9th
Cit. 1976) (pre-Code authority).

Duties and Obligations of the Insured and Rights of the Insurer

89

general subrogation law and ruled that the insurer could pursue its claim for attorney's fees because, in California, the subrogor had this right.
Insurers have pursued subrogation claims in bankruptcy without any discussion
by the court of the basis for the right. 2 However, as one court recently acknowledged, the existence of legal or equitable subrogation in bankruptcy is an open
question. ,3
X. CONCLUSION
Courts approach subrogation, whether legal or conventional, with the broad discretion
reserved for equitable remedies. Fidelity insurers can take only limited comfort in
bond language addressing assignment, recoveries, and salvage rights. Because thirdparty interests are involved, agreement between insurer and insured may not always
suffice to accomplish the intended result. More often, the insurer and the insured
may operate under inconsistent assumptions about other sources of recovery that may
remain available.
The courts are not always unsympathetic to the insurer seeking to transfer a loss
to the ultimately responsible party. In light of the current high volume of large
fidelity claims, particularly in the banking area, subrogation will continue to receive
the attention of the courts and the insurance industry. Insureds would be well advised
to focus on their duties of cooperation and assistance in dealing with the insurer,
where failure to do so risks the loss of coverage.
Insurers can take steps to protect their subrogation rights. At the outset of a claim,
the fidelity insurer should reinforce to the insured the policy provisions and general
equitable principles relating to subrogation. At the same time, the insurer can warn
the insured not to impair subrogation by forfeiting salvage, allowing the statute of
limitations to run, failing to file claims in bankruptcy and otherwise, and especially
settling without the insurer's consent. On its own part, the insurer must carefully
consider the impact of denying coverage and allowing the insured a free hand in
dealing with third parties.
Once deciding to pay the claim, the insurer should consider whether to utilize a
loan receipt or take an assignment and whether the language of other settlement
documentation can enhance the insurer's position. Finally, the insurer has a right to
and should affirmatively request the insured's cooperation, including information
regarding potentially liable third parties, accountants' audit reports, other available
insurance, and any other pertinent matters. Taking into account developments in the
law of subrogation, fidelity insurers can structure claims payments, settlement, litigation, and the corresponding documentation to avoid sacrificing important salvage
opportunities.
102. See, e.g., In re Dynda, 19 B.R. 817, 818 (Bankr. M.D. Fla 1982) (fire insurer's "posture as a
subrogee of the insured . . . does not affect its right to bring this action," in which the wrongdoer's
willful and malicious act rendered the debt nondischargeable).
103. In re Carley Capital Group, 118 B.R. 982 (Bankr. W.D. Wisc. 1990) (citing In re Spirtos,
supra, on one side of the debate).