The Ontario Court of Appeal overturned the finding of the trial judge who erred in holding that the insured was not in breach of its obligation to disclose all material facts relevant to determining the risk inherent in its new cheque issuing process, even in the absence of specific questions from the insurer. The Court also stated that when determining the scope of the duty to disclose, there must be an objective element to the insurer’s awareness of the risk.

W.H. Stuart Mutuals Ltd. v. London Guarantee Insurance Co., [2004] O.J. No. 5156, Ontario Court of Appeal

The insurer appealed a trial judge’s ruling that the insured plaintiff was entitled to indemnification in the amount of approximately $266,000 pursuant to a financial institution bond. The fidelity insurance bond covered losses including theft by employees carried out by means of electronic transfer of funds and computer accounting schemes. A long time employee of the insured misappropriated approximately $266,000 by producing computer generated cheques and effecting the electronic transfer of funds to separate accounts. The insured denied coverage on the basis that the insured had made material misrepresentations in its application for renewal and that it had failed to disclose the true nature of its cheque issuing process. Specially, it alleged that the following material misrepresentations had been made: that the cheques were signed by the principals of the company only and that cheque signing machines were not used.

The trial judge held that the insured had not made any misrepresentations and therefore concluded that the insured had complied with its general obligations of disclosure because subjectively, it did not understand the risks associated with the computerized chequing system it had implemented.

The representations were first made in the insured’s initial application for coverage in 1997 which was completed by one of the two principals of the insured company. They were also repeated in a renewal application submitted in 2000. Specifically, the insured stated on the renewal application that there was no counter-signing of cheques in its computerized chequing system and that all outbound cheques were signed by principals. The insured testified that by this she meant that the cheques were signed manually by either her or her husband (the only principals of the company). In addition, the insured wrote “N/A” in response to the question: “if cheque-signing machines are used, describe control over signature plates.”

The Court of Appeal found that at the time the application was completed in 1997, the insured must have realized the matter of internal controls was important to the insurer. In 1998 and 1999, the policy was renewed on the basis of short-form applications in which the insured confirmed there had been no change in internal controls. In 2000, the response to the question regarding counter-signing of cheques, was left blank. The insurer pursued the matter and the insured ultimately confirmed that “all outbound cheques are signed by the principals”.

While the representation that all cheques were signed by the principals was true when it was made in 1997, it was not true at the time the response was given in relation to the application to renew beginning in 1998. Beginning at that time, the insured changed its cheque issuing procedure and had adopted a computerized cheque generating system which merely recreated a computerized facsimile of the principals signature. However, in 2000, by writing the letter it did confirming that all cheques were “signed by principals,” the insured represented to the insurer that it had controls in place which at least involved the participation of principals in the cheque issuing process and that nothing had changed since 1997 when the insured first volunteered the information. This was a material misrepresentation. It was the lack of such controls that contributed to the fraud in question with respect to which the loss was claimed.

The Court of Appeal therefore found that the trial judge erred in failing to hold that the insured was in breach of its general obligation to disclose all material risks within its knowledge relevant to determining the nature and extent of the risk, even in the absence of specific questions from the insurer. While the Court of Appeal did not disagree with the trial judge’s view that this duty to disclose must relate to facts or risks of which the plaintiff is aware, the trial judge turned this test into a completely subjective one, which cannot be the case. There must be an objective element to the insurer’s awareness of the risk. The existence of the new system should have been disclosed to the insurer.

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