ST. PAUL FIRE AND MARINE INSURANCE COMPANY vs. BOSTON HOUSING AUTHORITY.

CUTTER, J. The plaintiff company (the insurer) on February 20, 1985, filed a complaint seeking a declaration of its rights and its obligations (if any) to the Boston Housing Authority (BHA) under two public employees' blanket bonds (the bonds) in circumstances outlined in the complaint. BHA filed an answer and counterclaims. Responses were received to requests by both the insurer and BHA for admission of facts.

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BHA, on April 2, 1986, filed a motion, supported by an affidavit, for partial summary judgment. [Note 1] The insurer, on June 10, 1986, filed a motion for total summary judgment for it, supported by affidavits. The motion judge denied BHA's motion and on June 30, 1986, allowed (with a short memorandum) the insurer's motion. BHA has appealed.

A. Background Facts

The facts summarized in part A of this opinion we treat as essentially undisputed. [Note 2]

1. From November 28, 1978, through November 28, 1981, BHA was the insured under two public employees' blanket fidelity bonds issued by the insurer. On September 17, 1981, the insurer's bond manager sent to Geraldine Scotti, "Insurance Officer" for BHA, a renewal application for the fidelity bonds and a letter stating, among other things, "The policy you have now is continuous and will stay in effect. The renewal application is needed to compute the renewal premium."

2. The completed renewal application contained the following sequence of questions and answers: [Q] "Audits: By whom? [A] C.P.A. [box checked] . . . BIANNUAL [sic] AUDIT REQUIRED[,] ARTHUR YOUNG & CO. MOST RECENT AUDITOR . . . . [Q] When was last audit made? [A] 3/31 1980 . . . . [Q] Will bank statements be reconciled monthly by someone not authorized to deposit or withdraw? [A] Yes. [box checked]. [Q] Who will reconcile? [A] Finance-Accounting Dept." The last two questions and answers give rise to the present controversy. BHA returned the completed application, signed by Miss Scotti, on October 30, 1981.

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3. BHA first employed James Deas (known to it as Andrew Adams) in April, 1982, as a temporary employee in its finance and accounting department. In September, 1982, BHA hired him as supervisor of the payroll area, a permanent position. He remained in that position until September 21, 1984.

4. As payroll supervisor, Deas was custodian of manual payroll checks and was authorized to issue payroll checks (using a facsimile signature) in amounts less than $1,000. Deas was specifically assigned to reconcile certain accounts (not including the payroll account) and was authorized to reconcile any account other than the payroll account.

5. James Kalil, an employee of BHA's accounting staff, was responsible for seeing that reconciliations were done when and as required, and that each account was reconciled by an accountant not responsible for the records of the account. During Kalil's employment, there were at least twenty-five accounts to be reconciled on a monthly basis. The payroll account was the most complex account.

6. During Deas's two-year tenure as payroll supervisor, no other accountant reconciled the payroll account. Deas, during this period, was embezzling money by writing checks to himself on the manual payroll stock of checks and endorsing and depositing them to his personal bank account. Other BHA employees attempted on several occasions to obtain from Deas the materials needed for an independent reconciliation of the payroll account. Deas, however, always had an excuse which was accepted.

7. BHA had at least the following knowledge that accounting functions were not being segregated. BHA's independent outside auditor, in its management letter evaluation (for BHA's use) for the two-year period ending March 31, 1982, noted (in referring to cash disbursements) that the individual responsible for check sequence, who had access to blank checks, also performed the bank reconcilation. The BHA response was that, prior to the audit, the objective assignment of bank reconciliations was recognized as desirable and such assignments had been made. [Note 3]

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8. Beginning in October, 1981, Sarah Stratman was BHA's director of finance and accounting. For about two years, Mrs. Stratman was aware that Kalil was not enforcing the segregation-of-duties policy. In September, 1982, Mrs. Stratman distributed to all program accountants in the finance and accounting department a memorandum assigning the responsibilities for bank reconciliations of a number of specific accounts. Mrs. Stratman frequently reminded Kalil of his responsibility regarding bank statement reconciliations.

9. No extra precautions were taken as a result of Mrs. Stratman's knowledge of the lack of enforcement of the segregation-of-duties policy. Had BHA removed reconciliation supervision from Kalil's area of responsibility, it would have lost a ground for termination of Kalil's services for BHA (apparently then under consideration). Eventually Kalil was discharged for cause.

10. On September 21, 1984, a Boston bank called Mrs. Stratman about multiple payroll checks being deposited in Deas's (Andrew Adams's) personal account with that bank. Deas was later arrested for embezzling over $350,000 from BHA. BHA recovered $50,000 from an insurer and $14,144.22 from Deas's assets. The total loss was determined to be $355,343.69.

11. About September 24, 1984, BHA notified the insurer of its claim on the bonds. It estimated the loss at $365,000 at that time. The insurer denied coverage.

12. An affidavit of an underwriter for the insurer stated that failure to segregate accounting functions significantly increases the risk of fidelity losses. The increase of risk, of course, was illustrated by the circumstances of Deas's embezzlement. B. Effect of G. L. c. 175, Section 186.

This case requires consideration of the effect to be given to G. L. c. 175, Section 186, which reads: "No oral or written misrepresentation or warranty made in the negotiation of a policy of

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insurance by the insured or in his behalf shall be deemed material or defeat or avoid the policy or prevent its attaching unless such misrepresentation or warranty is made with actual intent to deceive, or unless the matter misrepresented or made a warranty increased the risk of loss" (emphasis supplied). There is no significant contention by the insurer that BHA in its application (see part A, 2, supra) gave "with actual intent to deceive" its answers to the questions about the reconciliation of bank statements monthly, although there is a slight suggestion of such a contention in its brief. [Note 4] It does not seem to be contended that the language of the bonds was sufficiently explicit to make the accuracy of the representations a "condition precedent" to any liability of the insurer upon the bonds. Cf. Charles, Henry & Crowley Co. v. Home Ins. Co., 349 Mass. 723, 726-727 (1965). In that decision, the Supreme Judicial Court (at 727) distinguished Goldstein v. Royal Indem. Co., 297 Mass. 55 (1937), as "not . . . applicable" to the facts then before the court because it regarded the explicit language (in the case before it) of "the representations as a condition precedent to recovery," thus making G. L. c. 175, Section 186, "not applicable to the policy." The less explicit and definite representations in the present case, however, we think, are governed by Section 186, and, if they were violated by BHA, the effect of the representations must be evaluated by whether the violations increased the risk of loss.

As Judge Keeton, [Note 5] said in Shapiro v. American Home Assur. Co., 584 F. Supp. 1245, 1249 (D. Mass. 1984), of Section 186, "The Massachusetts statute is declaratory of longstanding common law principles defining the . . . [sort] of false representations that can serve to avoid an insurance policy." In Pahigian v. Manufacturers' Life Ins. Co., 349 Mass. 78, 85 (1965), it was said, "Misrepresentations by the insured . . . which increase

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the risk of loss will, if proved, enable the . . . [insurer] to avoid the policy," citing Section 186. That a representation is promissory in character does not appear to affect the situation under Section 186.

Promissory representations have been treated as constituting warranties, violations of which may affect the risk of loss and provide a defense to the insurer, as in the Goldstein case, 297 Mass. at 57-58. [Note 6] For a case prior to the enactment of the first predecessor of Section 186, see, e.g., Houghton v. Manufacturers' Mut. Fire Ins. Co., 8 Met. 114, 123-126 (1844). It may well be that, prior to the enactment of what is now Section 186, promissory representations would not be enforced unless they constituted warranties. See generally the following treatises (which may not take into account completely the effect of Section 186): 9 Appleman, Insurance Law & Practice, Section 5292, at 239-40 (rev. ed. 1981); 9 Couch, Insurance 2d, Section 37B:407-408 (rev. ed. 1985). See also 7 Couch, Insurance 2d, Sections 35:100-104 (rev. ed. 1985). As to the general effect of Section 186 and its predecessor statutes, see Everson v. General Acc., Fire & Life Assur. Corp., 202

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Mass. 169, 171-174 (1909). Compare Elder v. Federal Ins. Co., 213 Mass. 389, 391 (1913, where a predecessor of Section 186 was held not applicable).

In Metropolitan Life Ins. Co. v. Burno, 309 Mass. 7, 11 (1941), Mr. Justice Lummus said that Section 186 "was intended to make a breach of warranty no more onerous for the insured than a false representation. This statute, it has been said, was declaratory as to representations, but changed the law as to warranties." The case cited Barker v. Metropolitan Life Ins. Co., 198 Mass. 375, 383-384 (1908). See also Bolta Rubber Co. v. Lowell Trucking Corp., 304 Mass. 426, 428-429 (1939), cert. denied, 309 U.S. 690 (1940); Vance, Insurance, Sections 72-75, esp. at 418 (3d ed. 1951).

BHA first contends essentially that the insurer cannot avoid the insurance policies unless BHA made a misrepresentation for the future with fraudulent intent. If the answers made in the policy application (with respect to independent monthly reconciliations of bank statements) were representations, the Massachusetts cases at common law required that, so far as they related to the future, they had to be made in good faith and without intent to deceive and also they had to be observed fairly and substantially. [Note 7] We think that the cases so holding dispose of BHA's contention.

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The authorities already cited, not altogether consistent, leave significant uncertainty about the effect of G. L. c. 175, Section 186, in the present situation and about the extent to which only substantial compliance with a promissory representation is required in a case to which Section 186 is applicable. We apply the authorities as we appraise their combined effect.

We hold that the promissory representations (about the reconciliations of bank statements) set out in the application for the two bonds (see par. A, 2, supra) here considered are to be treated as having the general effect of warranties and dealt with in a manner consistent with Section 186. We also hold that BHA was under obligation substantially to comply with the representations made in its behalf by its "Insurance Officer" (acting within the scope of her employment as charged by BHA with responsibility for dealing with insurance matters). See 9 Couch, Insurance, Section 37B:419, and see the analogy (in considering a matter of knowledge and notice) of Judge Keeton's decision in Boston Mutual Life Ins. Co. v. Fireman's Fund Ins. Co., 613 F. Supp. 1090, 1093-1094, 1105 (D. Mass. 1985).

We hold further that, on the facts of record in this case, the violations of the promissory representations, as matter of law, increased the risk of loss (and, indeed, resulted in the loss incurred), as the motion judge correctly ruled. [Note 8] The only possible open question under the cases (see note 7, supra) was

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whether BHA substantially complied with its promissory representations.

Enough facts are undisputed on this record to make it plain that BHA was not in substantial compliance with its representation that bank statements "will be reconciled monthly by someone not authorized to deposit or withdraw." The violations were shown to have continued for a substantial period, and not to have been merely inadvertent, temporary violations. Compare King Brick Mfg. Co. v. Phoenix Ins. Co., 164 Mass. 291, 292-295 (1895). See also the Houghton case, 8 Met. at 123-125. BHA's director of finance and accounting, with broad duties, knew that independent reconciliations by a person other than Deas (of the bank statements of accounts for which Deas had responsibility) were not being conducted for a considerable period. See part A, 8, supra. Although BHA established a policy of complying with the representations, there was abundant indication that BHA's director of finance and accounting knew the policy was not being enforced by employees of BHA having the duty to enforce, and that she tolerated the lack of enforcement, in part, to build up proof of the ineffectiveness of another employee having that duty.

On the record before the motion judge, he could reasonably conclude that the facts did not permit any finding that BHA was in substantial compliance with the representations. See part A, 4-9, supra. The fact that there probably was compliance with BHA's policy as to all but one of the twenty-five accounts to be reconciled independently on a monthly basis, and continued failure to comply only as to the account handled by Deas, BHA's most complex account, cannot be regarded as substantial compliance with BHA's policy or with its promissory representation. We hold that the motion judge properly granted summary judgment for the insurer.

Judgment affirmed.