by Christopher Graham and Joseph Kelly

Remember 2003, 2004, 2005, and even part of 2006. Easy money from real estate investing. Prices always rise. It will never end. Use leverage. You’ll make a ton of money.

You gotta love it! And two brothers can’t get enough. So they scheme to use the same properties again and again to secure multiple bank loans. And they dupe their bankers.

One brother is a lawyer. How convenient! The brothers set up multiple companies to borrow. Brother lawyer issues title certificates showing properties with clean title. As far as the bankers know, no other bank has a lien. The properties look sufficient to secure the loans! For the brothers, there are no worries. Property values will rise. They’ll be worth more than enough to pay all loans. Money, money, money! Greed is good! The bankers never will know the difference.

But then the market collapses. The brothers present more “lien-free” properties to more banks for more loans. They need money to pay-off and keep current old loans. Round and round we go, where the Ponzi scheme stops nobody knows! But it does stop. And when it does, there’s over $80 million in loans from almost 50 banks to nearly 30 shell companies and over $20 million in losses. And the brothers wind up in a Federal pen. Yikes!

One bank provides non-lawyer brother a line of credit, just over $100,000. It’s secured by a first lien on real estate, so the bank thought. Brother lawyer provides a title certificate saying so. But the property is security for two prior loans from two other banks. Borrowing brother defaults. He has no money. His brother doesn’t either. And after considering the two prior liens, the property is no repayment source.

So someone at the bank says, “Don’t we have insurance?” And someone thinks, “Oh, yeah. There’s this thing called a financial institution bond. The scheming lawyer, he gave us a title certificate; we relied on it to make the loan; it showed clean title when there really were two prior bank liens. Let’s ask them to pay.” And so they do. But the insurer has other ideas. So the bank sues.

Who wins? Insurer based on the undisputed facts and as a matter of law, says the court in Copiah Bank, N.A. v. Federal Ins. Co., et al Case No. 3:12-cv-27-FKB (S.D. Miss. Jan. 15, 2014).

Why?

Well says the court, the bond’s employee dishonesty coverage doesn’t apply, despite what bank says. Bank argued it had “Loss resulting directly from dishonest acts of any Employee, committed alone or in collusion with others, except with a director or trustee of the [bank] who is not an Employee, which arise totally or partially from: . . . (2) any Loan . . . .” It also argued “loss was directly caused by dishonest acts of [an] Employee which result[ed] in improper personal financial gain to such Employee and which were committed with the intent to cause [bank] to sustain such loss.” Bank argued brother lawyer qualified as an Employee because he supposedly was “an attorney retained by the [bank] . . . while . . . performing legal services for the [bank].”

That the undisputed material facts showed brother attorney wasn’t bank’s “Employee” was enough to grant insurer a summary judgment: “the only legal service provided by [brother attorney] in relation to the subject loan and the only source of ‘Dishonesty’ on which the Bank bases its claim is [brother attorney’s] April 2, 2009 title certificate, and the Bank has presented no evidence that it ever asked [brother attorney] to prepare that title certificate.”

Bank officer’s deposition testimony explaining how brother attorney was retained by bank while performing legal services for bank didn’t raise a fact issue requiring trial. As the court explained: “Although [bank officer] testified that, after he received the title certificate, he asked [brother attorney] to file the deed of trust and prepare another title certificate and that he considered this to constitute a ‘verbal agreement’ between [attorney] and the Bank, such an agreement would, at most, be an agreement that [attorney] provide those services.” “But, it is the April 2, 2009 title certificate, not the non-existent title certificate [bank officer] requested, that is the ‘dishonest act’ on which the Bank’s claim under the bond is based.”

Insurer relied on Moultrie National Bank v. Travelers Indemnity Co., 275 F.2d 903 (5th Cir. 1960), where the court held “as matter of law” that “a construction of the bond which would . . . bring [the attorney who issued the title certificate] within the definition of `an attorney retained by the bank’ is supported by neither reason nor authority. . .”

Bank relied on Federal Insurance Company v. United Community Banks, Inc., 2010 WL 3842359 (N.D. Ga. Sept. 27, 2010), where a court distinguished Moultrie and found an attorney was an “Employee” under a similar bond issued by the same insurer.

Moultrie was more like this case; the Georgia case didn’t apply. Unlike attorney in the Georgia case, brother attorney didn’t prepare or approve a settlement statement, serve as trustee on bank’s deed of trust, receive or disburse loan proceeds, or have closing documents for the loan. He also didn’t perform any closing for the loan. Bank in its notice to insurer, moreover, referred to him as “attorney” and/or “representative” for the other fraudster brother, not for bank.

The court also rejected bank’s argument that the bond’s “On Premises” coverage applied. Bank argued it had a “Loss of Property resulting directly from: . . . false pretenses, or common law or statutory larceny, committed by a natural person while on the premises of the [bank], while the Property is lodged or deposited at premises located anywhere.” But for this coverage, there was an exclusion for “loss resulting from the complete or partial non-payment of or default on any Loan whether such Loan was procured in good faith or through trick, artifice, fraud or false pretenses . . . .” Loan meant “all extensions of credit by [bank] and all transactions creating a creditor or lesser relationship in favor of [bank], including all purchase and repurchase agreements, and all transactions by which [bank] assumes an existing creditor or lessor relationship.” The line of credit thus was a “Loan,” notwithstanding bank’s contrary argument.

And the court rejected bank’s argument that the bond’s “Extended Forgery” coverage applied. Bank argued this was “Loss resulting directly from [bank] having, in good faith, for its own account or the account of others .. . extended credit . . . in reliance on . . . [a (3) “Certificate of Origin or Title”] which is a Counterfeit Original.” (bracketed material in original). But “Certificate of Origin or Title” meant a “document issued by a manufacturer of personal property or a governmental agency evidencing the ownership of the personal property and by which ownership is transferred.” Emphasis added). And “Counterfeit Original” meant “an imitation of an actual valid original which is intended to deceive and be taken as the original.” So “Certificate of Origin or Title” didn’t include real property. And bank failed to present evidence or argument showing the real property certificate of title was a “Counterfeit Original.”

Fidelity insurers decided years ago they didn’t wish to insure the risk of loss from loans involving borrower fraud. Financial institutions are in the business of underwriting loans and thus best positioned to manage their lending risks. Premiums for a broad loan loss insurance product would be prohibitive. The industry instead generally provides limited loan loss coverage. Standard form bonds include a loan loss exclusion, with exceptions for certain Employee Dishonesty, Forgery or Alteration, and Securities as detailed in insuring agreements A, D, and E. For the limited loan loss coverage under financial institution bonds, there have been numerous disputes about risks within the scope. And over the years the insurance and banking industry have modified the coverage periodically to further define the insured risk. We can expect suits and modifications to continue.

Tags: Mississippi, financial institution bond, employee dishonesty, on premises, extended forgery, loan loss exclusion, Employee