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Legal consequences of undisclosed commissions

Everyone knows by now (28 Oct 2004) that New York attorney general Eliot Spitzer has been shining his investigative spotlight on the practice of insurers paying commissions to brokers of which the brokers' clients are unaware ("undisclosed" or "secret" commissions).  These payments are said to range from 5 percent to 7.5 percent of the premium and are above the regular commissions of 15-20 percent of which clients are usually aware.

Jeffrey Greenberg, chairman of Marsh, claimed that the practice was long-standing, and that so-called "placement service agreements" are common in the insurance industry. Mr. Greenberg is right; there were rumors of such arrangements between brokers and commercial reinsurers when I worked with Marsh to buy reinsurance for the American Club.  The Council of Insurance Agents and Brokers ("CIAB"), in an April 2004 press release, says that placement service agreements are generally disclosed to clients, and that it has been on record as in favor of disclosure for years.  However, in October 2004, following the criminal prosecution of two AIG executives, Marsh and AIG indicated that their companies would discontinue the practices about which Attorney General Spitzer had complained.

Mr. Greenberg is now gone from Marsh.  As a fellow former Marsh employee, I wish him well and hope he finds another job in less time than it took me.  (I also hope that we don't have another 9/11 before he finds a job.)

Customary or not, whenever undisclosed commissions have been brought to their attention, insureds and regulators have generally taken a dim view of them. The problem is that an insurance broker is supposed to be the loyal agent of the insured, and should not be receiving compensation from sources of which its client is unaware. Undisclosed commissions raise the specter of bribery, or at least suggestions of divided loyalties, and it may not be possible to draw a bright line between customary practices such as placement service agreements paid to brokers who place substantial amounts of business, and more shadowy behavior that looks suspiciously like a bribe.

In 1998, the issue of undisclosed commissions came to the attention of the New York State Insurance Department, who issued a circular on the subject. The Department must not have found any basis for prohibiting the practice, because it said only that the undisclosed receipt of additional compensation is sufficient to create the perception that brokers are conflicted in their loyalties and that such conduct may constitute a violation of Section 2110 [of the Insurance Law] as a dishonest or untrustworthy practice. To my knowledge, the Insurance Department has not said anything about undisclosed commissions since 1998.  According to The Economist, AIG asked the Insurance Department for its views on contingent commissions two years ago but never received a response.

It is not possible to put politics aside in such discussions; the Insurance Department is staffed with career professionals, but the top people report to Gov. Pataki, a Republican who is not known for making waves within the business community. Attorney General Spitzer is a Democrat who is making his reputation as an enforcer of ethical standards for business.

In April 2004, I wrote that "Mr. Greenberg may soon find his customary arrangements subjected to uncomfortable scrutiny."  Now that the world has an inkling of the way Mr. Greenberg's company did business, the underwriters at the Standard Club should probably be keeping their heads down.

The P&I market is not unfamiliar with secret commissions, including some that look more like bribes that Mr. Greenberg's placement service agreements. An underwriter I know once refused to allocate a portion of his marketing budget to a New York marine broker, and lost a prestigious account as a result.

An aspect of P&I broker Peter Smart's operations came to light several years ago in a reported decision that has received little attention. Steamship Mutual sued Cove Shipping for unpaid calls in a U.S. district court. Cove had no real defense, but it raised an interesting argument about secret commissions (deemed to be a "civil bribe" under English law) paid by Steamship to Peter Smart Associates after the insurance had been placed. Steamship ultimately prevailed on its claim for unpaid premiums, because the court refused to rescind the insurance contracts, but the amount of the alleged bribe was set off against the premiums owed.

The following is the discussion of English law by Judge Alex T. Howard, who had the assistance of expert testimony from Sir Michael Kerr, among others. Steamship Mutual Underwriting Assn (Bermuda) Ltd. v. Cove Shipping, Inc., 36 F. Supp.2d 940, 945-946, 1998 AMC 2985 (S.D. Al. 1998), aff'd, 180 F.3d 274 (11th Cir. 1999).

Defendants (the Cove interests) allege that the commissions paid to PSA by Steamship represent secret commissions to its agent which constitute bribes under English civil law thus allowing Cove to rescind their insurance contracts with Steamship for the period during which the alleged bribes were paid. Under English law:

For the purposes of the civil law a bribe means the payment of a secret commission, which only means (i) that the person making the payment makes it to the agent of the other person with whom he is dealing; (ii) that he makes it to that person knowing that that person is acting as the agent of the other person with whom he is dealing; and (iii) that he fails to disclose to the other person with whom he is dealing that he has made that payment to the person whom he knows to be the other person's agent. Those three are the only elements necessary to constitute the payment of a secret commission or bribe for civil purposes. [P]roof of corruptness or corrupt motive is unnecessary in a civil action. . . . Industries & Gen. Mortgage Co. v. Lewis, 2 All E.R. 573 (K.B. 1949). Moreover, "inasmuch as the amount of the bribes has been quantified, it can be recovered as money had and received. . . . When a [principal] finds out this state of things, he may call upon his agent or the [bribe payer] to disgorge." Hovendon & Sons v. Milhoff, 83 L.T. 41, 42 (C.A. 1900).

The Court also notes that:

any surreptitious dealing between one principal and the agent of the other principal is a fraud on such other principal . . . . [It is] equally clear that the defrauded principal, if he comes in time, is entitled, at his option, to have the contract rescinded, or, of he elects not to have it rescinded, to have such other adequate relief as the Court may think right to give him.

Taylor v. Walker, 1 Lloyd's List L. Rep. 490, 510 (Q.B. 1958) (emphasis added). However, a bribe will not be found to have been made by plaintiff if it is customary in the P&I industry for a P&I club to pay such a commission to an insured's agent. See Baring v. Stanton, 3 Chan. Div. 502 (1872); Great Western Ins. Co. v. Cunliffe, 9 Chan. App. 525 (1874).

The Court finds that the payment of a commission by a P&I club to an insured's agent is not extraordinary in the London P&I market. However, the manner in which the instant commissions were paid was not customary. While the payment itself is not suspect as defendants allege, the retrospective nature of the payment sets it outside the customary commission payment so that plaintiff does not fall within the above-noted exception to the prohibition against paying a secret commission to another's agent. It was not until May of 1989 that PSA approached Steamship regarding the payment of the commission, and the commission that was paid was for the 1988-1989 and 1989-1990 years. The Court finds that the usual practice would be to determine the amount of any commission prior to the establishment or renegotiation of the insurance contract.

Plaintiff placed documents in the broker chain regarding the payment of the commissions which PSA failed to forward to Tilden or Cove. While this is the established method of communication between a P&I club and its insured, the Court holds that this is insufficient in this instance to satisfy the disclosure to the principal required by the English authorities. The Court therefore holds that Steamship did indeed pay what amounts to a civil bribe under English law. Defendants may not rescind the insurance contracts for those policy years, however, because they did not come in time to receive such a remedy. See Taylor, 1 Lloyd's List L. Rep. 490. That is, defendants cannot rescind a contract at this late date which was carried out a decade ago. Both sides have already received the benefits of the contracts, and the Court is unwilling to now undo that which was done so long ago. The Court therefore holds that the amount of the commissions paid, $71,495.10, shall be used to set off the amounts which the Court today finds is owed by defendants to the plaintiff.

The extent to which this analysis applies to insurance commissions in the United States is not clear, because the issue is politically sensitive, and not every "fee payment" is a "bribe", but the foregoing discussion of agency law about surreptitious discussions between one principal and the agent of the other principal applies generally in the United States as well as in England.  In other contexts, such as corporate finance, "aiding and abetting a breach of fiduciary duty" is  actionable under the common law in most states, even if it no longer states a cause of action for securities fraud under the federal laws.

The upshot of this decision is that the payment of a secret commission can have untoward consequences for both the payor and the payee. The insured can void the contract of insurance, "if he comes in time", or force either party to disgorge the amount of the bribe.