by Christopher Graham and Joseph Kelly

The factoring business: You’re an industrial bank. Your business is buying accounts receivable. You buy them at a discount. You expect customers to collect them and turn over the full proceeds or make up the difference. You profit by being paid the full face amount of those discounted receivables. Customers benefit by receiving immediate cash. They also grant you a security interest in their assets to secure repayment. This way of financing business operations is “factoring.”

You have a factoring agreement with a trucking company. You agree to purchase all of company’s receivables. Your agreement is an Accounts Receivable Purchase and Security Agreement.

Purchases are on a rolling basis. Company reports sales periodically. You pay company, discounting the receivable amounts. Company guarantees payment, securing its guarantee with collateral including a large reserve account and all other assets. It grants you a security interest in those assets. And as required under the agreement, it provides electronic account statements on a rolling basis showing its obligation. Those statements naturally are sent electronically. Company hits send on its computer directing electronic transmission to your computer. You start your computer, and there it is! The wonders of the internet. No mail. No hard copy transmittal.

The factoring fraud: One day someone at company wants even more cash. But there’s a problem. Company is not generating enough sales to get the desired the cash. So someone electronically inflates receivables in the electronic account statements to whatever is needed to get that cash. It’s amazing what you can do with a few strategic key strokes and devilish ingenuity.

Company electronically transmits inflated electronic account statements; you provide the cash. Happy days are here again! This occurs repeatedly. And before you know it, we’re talking real money. When the scheme is discovered, there’s nowhere near enough receivables or other assets to repay you. Your loss is over $11.5 million!

The financial institution bond claim and suit: What to do? Didn’t we buy a financial institution bond? Sure did. Isn’t it different from the standard Form 24 Surety Association of America bond? Sure is. Isn’t it broader coverage for altered and forged, counterfeit, and lost and stolen documents of a type described in the bond’s insuring agreement E, Securities coverage? You think so. Let’s make a claim. And so you do. But insurer says pound sand. So you sue. And once again a court must decide a fascinating issue of insurance contract law.

Decision in a nutshell: Who wins? The insured bank, says the court in Transportation Alliance Bank, Inc. v. Bancinsure, Inc.*, Case No. 1:11CV148-DAK-EJF (D. Utah Feb. 21, 2014).

Why? Per this court, the undisputed material facts show bank suffered a loss within insuring agreement E, of this bond’s “broader”-than-Form-24 Securities coverage. This was a “Loss resulting directly from the Insured [bank] having, in good faith, for its own account or for the account of others,

(1) acquired, sold or delivered, given value, extended credit or assumed liability on the faith of any original . . .

(e) Evidence of Debt, . . . [and] (g) Security Agreement, . . . which (ii) is altered . . . .”

“Loss resulting directly”: How was this “Loss resulting directly” from those covered acts concerning an alteration of those covered documents? According to the court:

[Bank’s] loss from [trucking company’s] factoring fraud was the amount it over-advanced to [company] based on the fraudulent alteration of the amount of the various accounts receivable. [Bank’s] loss resulted directly from [its] having made the over-advances. [Bank] made the over-advances because and only because [company] fraudulently altered its accounts receivable. If [company] had not made the alterations, [bank] would not have over-advanced and would not have suffered the losses. This interpretation and explanation of the phrase “resulting directly from” is reasonable and follows from the ordinary meaning of the words, as the phrase is not a defined term in the Bond.

Original Evidence of Debt: But how were the over-advances extended “on the faith of any original . . . Evidence of Debt”? Per the court, the bank over-advanced on the faith of a combination of the A/R Purchase and Security Agreement and electronic account statements. That combination qualified as an “original” Evidence of Debt. Under the bond, “Evidence of Debt means an instrument . . . executed by a customer of the Insured [bank] and held by the Insured [bank] which in the regular course of business is treated as evidencing the customer’s debt to the Insured.” As the court explained, the electronic account statements are “instruments” “executed by a customer of the Insured,” namely, the trucking company customer; “held by [the] Insured” bank; and “in the regular course of business . . . treated as evidencing the customer’s debt to the Insured [bank].”

Instruments: If not hard copy, how did the account statements qualify as “instruments” as required for an Evidence of Debt? As the court explained: “The electronic account statements qualify as “instruments” for the same reasons they qualify as originals . . . .”

“Originals”: Regarding why they qualify as “originals” (and thus instruments):

[I]n the absence of a definition to the contrary [(there was no definition)], electronic transmissions are a way of life and are just as original as a printed, hard copy document that contains the same information. Indeed, by omitting Form 24 defined terms like “Original” and “Written,” [insurer] allowed for coverage based on electronic information, alterations, and transmissions. The electronic account statements [company] fraudulently altered and then transmitted to [bank] under the terms of the A/R Purchase and Security Agreement (itself a hard copy document) are reasonably considered to be originals for purposes of determining coverage under the Bond.

The court also cited a dictionary definition of original as its “plain meaning”: “Dictionaries define ‘original’ as ‘not secondary, derivative, or imitative,” or “being the first instance or source from which a copy, reproduction, or translation can be made.'” It also stated: “The ordinary meaning of the term ‘original’ includes electronic originals—particularly in today’s banking world where most people do most or all of their banking online, and electronic copies are widely considered originals.”

Regarding the definition of “Original” in Form 24, the court stated:

Form 24, unlike the Bond in this case, does define the term “Original” (with a capital O) in section 1(q) of the Conditions and Limitations of F&SA: “Original means the first rendering or archetype and does not include photocopies or electronic transmissions even if received and printed.” Had [insurer] included this definition of “Original” in the Bond, the electronic account statements that [bank] received would not be considered “originals.” The omission of the F&SA Form 24 definition of “original” in this Bond, which would have excluded electronic documents if applied, must be assumed to be deliberate. The Form 24 defined term and requirement that the documents be “Written” also was omitted from the Bond.

In concluding electronic statements were originals, the court also noted decisions “recognize[ing] that electronic documents cannot be distinguished from hard copies” and Utah’s Uniform Electronic Transactions Act (“UETA”), applicable to “‘transactions between parties each of which has agreed to conduct transactions by electronic means,’ with the parties’ intent to be determined by ‘the context and surrounding circumstances.'” Regarding the UETA, the court explained:

[Company] and [bank] intended to transact through electronic means when [company] gave [bank] access to its computer system. UETA therefore provides that “[a] record . . . may not be denied legal effect or enforceability solely because it is in electronic form.” . . . UETA also authoritatively states that an electronic document is equivalent to an original document for retention and presentation purposes. . . . Not only does UETA demonstrate that the banking world widely recognizes the reality and enforceability of electronic transmissions, but in the last decade several other federal acts have granted legal validity to electronic documents.

“Executed”: But then if not signed, how did those account statement “instruments” qualify as “executed” as also required for an Evidence of Debt? According to the court:

They were executed in the only way electronic data can be executed—electronic transmission at the command of the sender, [trucking company], which was a customer of [bank], the Insured. [Bank] treated the electronic account statements, and in particular the fraudulently altered amounts, as evidencing [company’s] debt to [bank].

Further:

[T]he Evidence of Debt definition requires that the instrument be “executed,” not that it be signed. “Execution” is a broader concept than “signed.” “As Black’s Law Dictionary indicates, there is more than one meaning for the term `execute.'” . . . Again, an electronic transmission is executed or done or performed when the sender transmits or “gives” the electronic document by hitting the send button and directing it to the intended recipient.

Alterations: But the A/R and Security Agreement wasn’t altered. So how was the Evidence of Debt, the combination of the A/R and Security Agreement and account statements “altered”? Well, as the court explained:

While the term “alter” is not defined by the Bond, the electronic change that [company] made reasonably constitutes an alteration under the ordinary meaning of the term. . . . The alteration occurred by simple key strokes in which [company] overwrote the correct account receivable data with false data, which it sent to [bank]. Indeed, electronically altering an amount such as $1,000 by placing a 2 in front of the 1 to make it $21,000 is no different substantively from taking a pen and writing in a 2 on a hard copy document. See, e.g., Metro Fed. Credit Union v. Fed. Ins. Co., 607 F. Supp. 2d 870, 881 (N. D. Ill. 2009). The alterations occurred in the only way an electronic alteration could occur — by using key strokes to overwrite or change the account data.

Original Security Agreement: How were over-advances extended “on the faith of any original . . . Security Agreement” that was “altered”? Per the court, the bank over-advanced on the faith of a combination of the A/R Purchase and Security Agreement and altered electronic account statements. The reasons why the court considered the statements “altered” and “original” are stated above. As for why the court considered the combination of the A/R Purchase and Security Agreement and altered statements a “Security Agreement” as defined under the bond:

Under the Bond, “Security Agreement means an agreement which creates an interest in personal property or fixtures and which secures payment or performance of an obligation.” . . . [Company’s] debt to [bank] was repayment of the full amount of the stated receivable either by collection, application of the reserve, or otherwise. The chief security for [company’s] repayment obligation was the reserve account, as set forth in the A/R Purchase and Security Agreement, but the Security Agreement also included [company’s] various other assets. Therefore, the A/R Purchase and Security Agreement created an interest for [bank] in that reserve account, which secured [company’s] payment or performance of an obligation. This satisfies the definition of Security Agreement.

“Actual physical possession”: But isn’t coverage under insuring agreement E also conditioned upon the insured bank or authorized representative having actual physical possession of an altered original Evidence of Debt or Security Agreement? Sure is. But this court found that “condition precedent” satisfied as well. It was undisputed that bank physically possessed the signed original security agreement. As for the electronic account statements, the court explained:

The court finds that [bank] had actual physical possession of both the Evidence of Debt and the Security Agreement in the form of electronic data. There is no difference between possessing a hard copy of an Evidence of Debt or Security Agreement and possessing the same data in its original electronic form on a secure server, to be viewed on a computer screen, and which was transmitted electronically instead of through the mail.

Tags: Financial Institution Bond, Insuring Agreement E, Securities, Evidence of Debt, Security Agreement, direct loss, causation, “Loss resulting directly from,” original, actual physical possession, electronic account statement, factoring, Form 24, Surety Association

by Christopher Graham and Joseph Kelly

Your company sells financial institution bonds and commercial crime policies. You sell standard industry forms or policies based on them. So your customers must commence legal proceedings against your company within two years of “discovery” of loss. Or your customers must sue your company within two years of a final judgment or settlement from certain legal proceedings brought to determine their liabilities for loss, claim, or damage which, if established, would constitute collectible loss under the bond or policy. You thereby shortened the limitations period for claims against your company. Or at least you have unless a statute or other controlling law prohibits you from doing so. Standard forms explicitly address contrary controlling law by automatically amending the contract to comply with that law.

Due to uncertainty about whether a South Dakota statute prohibits a bond’s standard-shortened contractual limitations period, a Federal District Court recently certified the following question to the South Dakota Supreme Court: “SCDL 53-9-6 prohibits parties from contractually limiting the statute of limitations except in the case of a ‘surety contract.’ Is the Policy a ‘surety contract?'” First Dakota National Bank v. Bancinsure, Inc., Case No. CIV 12-4061-KES (D. S.D. Dec. 31, 2013).

If the court concludes the bond isn’t a surety contract, the six-year South Dakota limitations period for breach of contract claims will apply to the insured’s suit and for all breach of contract suits against financial institution bond insurers in this state, notwithstanding a shorter limitations period in the bond. Similar issues may exist in other states. Stay tuned to this blog for the decision, especially if you do business in this state.

Tags: Financial institution bond, commercial crime policy. Notice/Proof–Legal proceedings against underwriter, contractual limitations period, surety

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

by Christopher Graham and Joseph Kelly

First Bank of Delaware, Inc. v. Fidelity and Deposit Company of Maryland, Case No. N11C-08-221 (Del. Super. Ct. Oct. 30, 2013

According to this Court, this was a case of an exclusion swallowing a coverage grant–so coverage was “illusory” and the exclusion shouldn’t apply. As explained below, the coverage in essence was for loss from certain unauthorized data use; and the exclusion applied to fraudulent data use. So this was problematic.

First Bank of Delaware contracted with Visa and Mastercard to provide debit card transaction services. First Bank processed those transactions using Data Access Systems’s (“DAS”) computers.

DAS’s servers were hacked resulting in millions of dollars in unauthorized customer withdrawals. Visa and Mastercard as a result imposed certain assessments on First Bank which First Bank paid.

First Bank then sought coverage for the assessments from Fidelity and Deposit Company of Maryland under a D&O SelectPlus Insurance Policy. Fidelity denied coverage, and First Bank sued.

Electronic Risk Coverage

First Bank sought coverage under the policy’s “Electronic Risk Liability” insuring agreement, which provided:

The Insurer will pay on behalf of the Insured all loss resulting from any electronic risk claim first made against the Insured during the policy period or the extended reporting period, if applicable, (1) for an electronic publishing wrongful act or (2) that arises out of a loss event.

“Electronic Risk Claim” meant “a written demand for monetary damages or nonmonetary relief.”

“Loss Event” included “any unauthorized use of, or unauthorized access to electronic data or software with a computer system.”

“Computer System” included “related communications networks including the internet, used by the Company or used to transact business on behalf of the Company.”

In considering summary judgment cross-motions, the Court found First Bank established that: Visa and Mastercard’s assessments were loss resulting from an electronic risk claim, namely, by Visa and MasterCard; against the Insured, namely, First Bank; during the policy period; and that arises out of a loss event, namely, unauthorized access to electronic data with a computer system, DAS’s computers. Fidelity argued the unauthorized access on DAS’s computers wasn’t with a “computer system” used to transact bsuiness on First Bank’s behalf. The Court disagreed, explaining that the DAS computers were used to transact business on behalf of First Bank because First Bank earned fees from debit card transactions conducted on DAS’s computers.

So First Bank’s loss was within the scope of the insuring agreement.

Fraud Exclusion

The Court’s analysis then shifted to Exclusion M which excludes coverage under the “Electronic Risk Liability” insuring agreement for any claim against First Bank “based upon or attributable to or arising from the actual or purported fraudulent use by any person or entity of any data or in any credit, debit, charge, access, convenience, customer identification or other card, including, but not limited to the card number.”

The Court found that First Bank’s loss fell within the scope of the exclusion because “the fraudulent use of data and subsequent Visa and MasterCard assessments are meaningfully linked in a way that qualifies as ‘arising from’ under Exclusion M.”

Illusory Coverage

But then First Bank argued that Exclusion M rendered the Electronic Risk Liability’ coverage part illusory.

The Court agreed stating:

…[W]hen the burden shifts back to First Bank to prove that Exclusion M should not be applied, the Court considers that a grant of coverage should not be swallowed by an exclusion. The principle that a grant of coverage should not be rendered illusory protects the reasonable expectations of the purchaser.

and

The Court finds that applying Exclusion M would swallow the coverage granted…for “any unauthorized use of, or unauthorized access to electronic data…with a computer system.” It is theoretically possible that an example of non-fraudulent unauthorized use of data exists. However, in the context of this Policy, all unauthorized use could be, to some extent, fraudulent. The abstract possibility of some coverage surviving the fraud exclusion is not sufficient to persuade the Court to apply an exclusion that is almost entirely irreconcilable with the Loss Event coverage. The Court finds that First Bank met its burden to prove that an exception prevents the application of Exclusion M.

Tags: D&O, illusory coverage, electronic risk liability, bank, fraud

by Christopher Graham and Joseph Kelly

BancInsure, Inc v. Highland Bank (D. Minn. Sep. 23, 2013)

BancInsure sought a declaratory judgment against its insured, Highland Bank, that the Bank’s loss is not covered under the Financial Institution Bond BancInsure issued to the Bank.

In 2005, Equipment Acquisition Resources (“EAR”) and First Premier Capital, LLC entered into an equipment lease under which First Premier would provide manufacturing equipment to EAR. First Premier secured personal guarantees from EAR’s principals as a condition precedent to the lease.

In 2006, First Premier went to the Bank on EAR’s behalf seeking to borrow $3 million to finance the lease. First Premier and the Bank entered into a “Collateral Assignment of Lease Payments and Equipment” agreement under which First Premier assigned to the Bank “rental payments due or to become due under the Lease” and all of First Premier’s “rights, title and interest in and to the personal property subject to the Lease.”

Before entering into the agreement with First Premier, the Bank: didn’t contact EAR or its principals; didn’t conduct a background check on EAR’s principals — despite First Premier informing the Bank about one of the principal’s prior conviction for lease fraud; and didn’t inspect the equipment or otherwise determine its liquidation value.

After 20 months or so, EAR stopped making payments. The Bank then learned that the leased equipment didn’t exist and that the non-existent equipment was pledged to multiple lenders. The Bank also learned that the guaranty of one of EAR’s principals was likely forged.

In January 2010, Highland Bank sued First Premier for default under their agreement. The Bank won but was unable to collect on its judgment. The Bank subsequently submitted a Proof of Loss to Bancinsure under the FIB seeking coverage, in pertinent part, under Insuring Agreement E which provided:

Loss resulting directly from the Insured having, in good faith, for its own account or for the account of others, (1) acquired, sold or delivered, given value, extended credit or assumed liability on the faith of any original … (f) Corporate, partnership or personal Guarantee, [which] … (i) bears a signature of any maker, drawer, issuer, endorser, assignor, lessee, transfer agent, registrar, acceptor, surety, guarantor, or of any person signing in any other capacity which is a Forgery, … (2) guaranteed in writing or witnessed any signature upon any transfer, assignment, bill of sale, power of attorney, Guarantee, endorsement or any items listed in (1)(a) through (h) above. This includes loss resulting directly from a registered transfer agent accepting or instructions concerning transfer of securities by means of a medallion seal, stamp, or other equipment apparatus which identifies the Insured as guarantor, as used in connection with a Signature Guarantee Program, but such use or alleged use of said medallion seal, stamp, or other equipment apparatus was committed without the knowledge or consent of the Insured, and the Insured is legally liable for such loss, (3) acquired, sold, or delivered, given value, extended credit or assumed liability on the faith of any item listed in (1)(a) through (d) above which is a Counterfeit. Actual physical possession of the items listed in (1)(a) through (i) above by the Insured, its correspondent bank or other authorized representative is a condition precedent to the Insured’s having relied on the faith of such items. A mechanically reproduced facsimile signature is treated the same as a handwritten signature.

Bancinsure denied coverage because the Bank didn’t have actual physical possession of the guaranty. That same day, Bancinsure filed suit seeking a declaration of no coverage.

The Bank successfully moved for partial summary judgment as to whether First Premier was its “authorized representative” such that the “actual physical possession” requirement of Insuring Agreement E was met.

The Bank and BancInsure subsequently filed competing motions for summary judgment.

Loss “resulting directly from”

BancInsure argued there was no loss “resulting directly from” the Bank’s extension of credit on the faith of the forged guaranty, because irrespective of the forgery, the Bank would’ve suffered a loss.

The Bank argued that there was a loss “resulting directly from” its extension of credit on the faith of the guaranty because the guaranty caused it to enter into the transaction and extend credit where it otherwise wouldn’t have.

The court — citing to Alerus Fin. Nat’l Ass’n v. St. Paul Mercury Ins. Co., No. A11-680 (Minn. Ct. App. Jan 30, 2012) noted that “loan loss is not directly caused by reliance on forgeries constituting or referencing collateral when the collateral is worthless at the time of the loan.” The court then found that the Bank’s loss resulted directly not from the forged guaranty, but from the worthlessness of the collateral and guaranty. There was no equipment and the guarantor had no assets.

Extended credit…on the faith of any original…personal guarantee

The Bank argued that it relied on the faith of the guaranty in extending credit. BancInsure countered that the Bank never had a legal interest in the guaranty (given to First Premier) and that it never examined the original guaranty. The Court agreed with BancInsure because: (1) the guaranty was executed by First Premier and the guarantor and promised repayment to First Premier; (2) the lease was executed between EAR and First Premier without reference to the Bank; (3) the agreement between First Premier and the Bank only transferred First Premier’s interest in the rent due. The court accordingly found that the Bank didn’t extend credit on the faith of the guaranty.

Conclusion

The court granted BancInsure a declaration that there was no coverage under Insuring Agreement E because the loss didn’t directly result from the forged guaranty and the Bank didn’t extend credit on the faith of the forged guaranty.

The court also found that the Bank wasn’t entitled to coverage under the “reasonable expectations” doctrine.

Lastly, the court found that since there’s no coverage, the Bank’s claim for breach of good faith and fair dealing fails.

Tags: Minnesota, Financial Institution Bond, Insuring Agreement E, forgery

by Chris Graham and Joseph Kelly

Piles Chevrolet Pontiac Buick, Inc. v. Auto Owners Ins. Co., Nos. 2011-CA-002317-MR, 2011-CA-002340-MR (Kent. App. May 17, 2013)

Insured’s bookkeeper, along with her husband, defrauded Insured of over $572,000. Bookkeeper wrote unauthorized checks to herself, her husband, and her husband’s business, hid them in a pile of legitimate checks to be signed, and presented the pile of checks to authorized persons for signature. She also purchased vehicles from Insured (a car dealer), and used her knowledge of Insured’s bookkeeping system to make sure their checks for the purchase price of those vehicles were never cashed. In total, bookkeeper engaged in 28 vehicle transactions and 45 unauthorized checks.

The umbrella Policy between Insurer and Insured covered $15,000 for commercial crime caused by employee dishonesty, $10,000 for loss of property caused by forgery or alterations to negotiable instruments, each per occurrence.

“Occurrence” is defined under the Policy as “all loss caused by, or involving one or more `employees’, whether the result of a single act or series of acts.”

Insurer denied coverage for the full amount of loss Insured sustained, and Insured filed suit seeking coverage of the full loss. The key issue at summary judgment was whether bookkeeper’s actions were one occurrence or multiple occurrences under the policy. Trial court held that bookkeeper’s actions were one occurrence, and ordered Insurer to pay $35,000. Both parties appealed but the Court affirmed, resolving the issues before it as follows:

Issue #1: Did the bookkeeper’s fraudulent actions constitute one occurrence of fraud under the Policy? Yes.

The Court noted that the facts clearly established an ongoing scheme by bookkeeper and her husband to defraud Insured and that the Policy clearly defines “occurrence” as “all loss caused by, or involving one or more `employees’, whether the result of an act or series of acts.”

Issue #2: Was the loss recoverable under the forgery and alteration section of the Policy? Yes.

Insurer unsuccessfully argued that the forgery and alteration coverage language excluding any “loss resulting from any dishonest or criminal act committed by any [Insured] employees . . . whether acting alone or in collusion with other person.” Bookkeeper was not an employee of Insured when she drafted the first 13 fraudulent checks. She was performing work for Insured, but was paid by and was under the control of a third party during that period.

Insurer also unsuccessfully argued that bookkeeper didn’t forge or alter checks, but instead deceived her superiors to sign legitimate checks. As “forgery” was not defined under the Policy, the Court afford the word its plain meaning which under the applicable criminal statute defined a forged instrument as “a written instrument which has been falsely made, completed, or altered.” Court held bookkeeper was essentially altering checks prior to their completion, and thus the checks were forgeries.

by Chris Graham and Joseph Kelly

Seaway Community Bank v. Progressive Casualty Insurance Co., Case No. 11-2575 (6th Cir. Aug. 8, 2013)

A customer of Seaway Community Bank deposited three checks payable to him via a Canadian bank over a span of four months. Seaway cashed the checks – but the checks were fraudulent as the original payee on the checks was deleted and Seaway’s customer’s name was added as payee.

Seaway submitted a proof of loss to Progressive and sought coverage under Insuring Agreement D which provides coverage for:

Loss resulting directly from the Insured [Seaway] having, in good
faith, paid or transferred any Property in reliance on any Written,
Original (1) Negotiable Instrument . . . which . . . is altered, but
only to the extent the alteration causes the loss.

Progressive denied coverage based on Exclusion O which excludes coverage “loss resulting directly or indirectly from payments made or withdrawals from a depositor’s account involving items of deposit which are not finally paid for any reason, including but not limited to Forgery or any other fraud. . .”

The District Court granted summary judgment in favor Seaway and the Sixth Circuit affirmed. The Sixth Circuit outlined the process of check cashing generally and under Michigan law, stating in pertinent part:

• The check-collection process begins when a customer deposits a check for collection in a “depository” bank, defined as “the first bank to which an item is transferred for collection even though it is also the payor bank.”
• Here, Seaway was the depository bank. Seaway paid its customer, and then it sought payment on each check he had deposited by transferring each of them through one or more “intermediary” banks, defined as “any bank to which an item is transferred in the course of collection except the depository or payor bank.”
• Each bank in the collection process “settles” for a check by various means, including by paying cash.
• Giving credit to the prior intermediary bank is the most common method of settlement.
• In other words, each intermediary bank that transfers the check to the next intermediary bank receives a provisional credit from the transferee, with the penultimate intermediary bank in the collection chain receiving its provisional credit from the bank upon which it was drawn, called the “payor” bank, which means “`a bank by which an item is payable as drawn or accepted.'”
• Here, the payor bank for each of the checks was a Canadian bank.
• To revoke a settlement, the payor bank must return the item before its midnight deadline, defined as “midnight on its next banking day following the banking day on which it receives the relevant item or notice or from which the time for taking action commences to run, whichever is later.”
• If the payor bank decides not to finally pay the check—perhaps because it is fraudulent—then these provisional credits are reversed. Whether the payor bank decides to finally pay the check or dishonor it, under Article 4 of the Uniform Commercial Code, the payor bank must take action before midnight on the next banking day following the banking day on which the payor bank receives the check. This is known as the “midnight deadline” rule.
• Under the midnight deadline rule, if the payor bank receives a check and does nothing by midnight on the following banking day, then the bank must pay the check.
• Here, the checks from the Canadian payor bank were “finally paid” as that phrase is defined in the Uniform Commercial Code. Progressive states that the Uniform Commercial Code, and the midnight deadline rule, do not apply to Canadian banks. Therefore, the Canadian payor bank in this case could—and did—decide days after receiving the checks from the collecting bank that it was going to dishonor the checks because they were fraudulent.
• The Canadian bank reversed the provisional credits all the way down the chain to Seaway. Because the fraudulent checks at issue in this case could never be “finally paid,” Progressive argues, they fall under Exclusion (o), which provided that Progressive did not have to pay Seaway for losses incurred on checks not “finally paid.”
• The phrase “finally paid” has a clear meaning within the banking industry: it means when the midnight-deadline rule applies under the Uniform Commercial Code.

In conclusion, the Sixth Circuit held:

• The Exclusion does not say whether or not checks drawn on Canadian banks are to be exempted from Michigan’s version of the Uniform Commercial Code’s definition of “not finally paid.” Applying the Uniform Commercial Code, the checks were finally paid. Therefore, Exclusion (o) could not apply, and Progressive must indemnify Seaway.

by Christopher J. Graham and Joseph P. Kelly

Emcor Group, Inc. v. Great American Insurance Co., Case No. ELH-12-0142 (D. Md. Mar. 27, 2013):

Insurer wrote three successive one-year commercial crime policies December 1, 2002 and December 1 2005. Insured submitted a claim for a loss resulting from a COO and VP’s fraudulent expense reimbursements running between 1999 and 2005. Each policy contained a “Prior Loss Clause”, which read as follows:

Loss Sustained During Prior Insurance: a. If you, or any predecessor in interest sustained loss during the period of any prior insurance that you or the predecessor in interest could have recovered under that insurance except that the time within which to discover loss had expired, we will pay for it under this insurance, provided: (1) this insurance became effective at the time of cancellation or termination of the prior insurance; and (2) this loss would have been covered by this insurance had it been in effect when the acts or events causing the loss were committed or occurred
Insurer denied the claim, arguing that the Prior Loss Clause applied only to the most recent prior insurance, i.e. the policy written by Insurer covering December 1, 2003 to December 1, 2004, not Insured’s prior policy with another insurance company, which ran from 1999 to 2002. Insured sued and both parties filed motions for summary judgment.

Issue #1: Did the Prior Loss Clause apply to all of the Insured’s previous policies? No.

The Court held the “this insurance” language of the Prior Loss Clause unambiguously referred to the contract immediately prior, not to the Insured’s older policies. The court looked to the Maryland Code’s definition of “insurance” as “a contract to indemnify or to pay or provide a specified or determinable amount or benefit on the occurrence of a determinable contingency.” (Ins. Section 1–101(s)). Because only the 2003–2004 policy terminated when the 2004–2005 policy went into effect, only prior losses incurred during the 2003–2004 policy were covered.

Issue #2: Was Insurer judicially estopped from claiming the Prior Loss Clause applied only to the previous year’s policy because it had settled with another insured under the same policy language and circumstances? No.

A settlement is not a final determination by a court; therefore it does not bind the insurer in the current proceeding.

by Christopher J. Graham and Joseph P. Kelly

Bank of Ann Arbor v. Everest National Insurance Company, Case No. 12-11251 (E.D. Mi. Feb. 25, 2013)

Insured purchased a Financial Institution Bond from Insurer. Insuring Agreement D, subject to the bond’s terms and conditions, provided coverage for:

Loss resulting directly from the Insured having, in good faith, paid or transferred any Property in reliance on any Written Original … (4) Withdrawal Order [or] … (6) instruction or advice purportedly signed by a customer of the Insured … which (a) bears a handwritten signature of any maker, drawer, or endorser which is a Forgery … A reproduction of a handwritten signature is treated the same as the handwritten signature.

The Unauthorized Signature Rider for Agreement D provided:

Accepting, paying or cashing any Written, Original, … Withdrawal Orders that bear Unauthorized Signatures … shall be deemed to be a Forgery” so long as the Bank has “on file the signature of all persons authorized to sign such … Withdrawal Orders.

The opinion didn’t include the bond’s definition of “Forgery.”

Section 2(e) of the Bond excluded:

(e) loss resulting directly or indirectly from the complete or partial nonpayment of, or default upon any Loan or transaction involving the Insured as a lender or borrower, or extension of credit, including the purchase, discounting or other acquisition of false or genuine accounts, invoices, notes, agreements of Evidences of Debt, whether such Loan transaction or extension was procured in good faith or through trick, artifice, fraud, or false pretenses, except when covered under Insuring Agreements (A), (E) or (G).

and the Bond defined “Loan” as:

all extensions of credit by the Insured and all transactions creating a creditor relationship in favor of the Insured and all transactions by which the Insured assumes an existing creditor relationship.

The court summarized the loss as follows:

On October 4, 2011, the Bank received a wire transfer request via facsimile from an individual purporting to be its customer, John Doe. The request was for $196,000. The wire transfer requested that funds from his home equity line of credit be wired to a bank in South Korea. The request contained the customer’s name and handwritten signature, email address, home address, telephone number, and all of the necessary account information.

In order to prevent fraud, the Bank’s established practice is to compare the signature on a request to the signature maintained in the Bank’s file and to confirm the request by telephoning the customer. The Bank followed these procedures upon receiving Doe’s request. It confirmed that the signature on the faxed request was the same as the signature in Doe’s file. Then, the Bank called the telephone number in Doe’s file and verified the request with an individual who identified himself as Doe. After completing the verification procedure, the Bank, in good faith and in reliance on the instructions and signature on the wire transfer request, transferred $196,000 to Korea Exchange Bank in Seoul, South Korea.

Two days later, the Bank received a second faxed wire transfer request from Doe. The request was for $98,000 and again asked that the funds be transferred from his home equity line of credit account to the same bank in South Korea. This second wire transfer request was received by a Bank employee who coincidentally happened to know Doe personally and questioned why he would want to wire money to South Korea. A review of Doe’s file revealed that on September 30, 2011, the Bank had received an email from an individual identifying himself as Doe inquiring how to change his telephone number on record with the Bank. The Bank had informed the sender that such requests must be in writing. Later that same day, the Bank received another email purportedly from Doe with an attached formal, written request to have his telephone number changed, which was signed by Doe. After comparing the signature on the letter request to the signature in Doe’s file, the Bank changed Doe’s telephone number in its files.

Upon discovering that his contact information had been changed, the Bank immediately contacted Doe at the different, older number and learned that he had not made either wire transfer request. Accordingly, the second request was not honored and the Bank contacted local law enforcement to assist in the investigation. The Bank repaid the $196,000 to Doe’s account.

Insured notified Insurer and requested coverage for the $196,000 under the Bond. Insurer denied coverage claiming the Unauthorized Signature Rider quoted above precluded coverage; and the loan loss exclusion applied.

Insured sued and Bank prevailed on summary judgment.

Issue #1: Did the plain language of Insuring Agreement D cover the loss? Yes.

The loss resulted from a forged original signature that was faxed to the Bank, and it was undisputed that Bank had Customer’s signature on file.

Issue #2: Did Exclusion(e) of the Bond preclude recovery by Insured? No.

Customer did not receive the funds transferred, nor did he agree to repay the related debt: he was in fact unaware of the transfers until he was notified of the fraud by Insured.

The risk at issue was the risk of forgery— a risk that is expressly covered by the FIB. See also People’s State Bank v. American Casualty Co. of Reading, Pa., 818 F. Supp. 1073 (E.D. Mich. 1993) (finding that an identical FIB covered loss relating from a bank employee who fraudulently filled out loans and received the proceeds); Bankinsure, Inc. v. Peoples Bank of the South, 866 F. Supp. 2d 577 (S.D. Miss. 2012) (losses based on forged customer signatures are covered are did not constitute loans).

by Christopher J. Graham and Joseph P. Kelly

Midway Truck Parts, Inc. v. Federated Insurance Co., Case No. 11 CV 9060 (N.D. Ill. Feb. 4, 2013):

Insurer issued Insured a commercial lines insurance policy effective from October 6, 2008 to October 6, 2009. The policy’s Crime and Fidelity Coverage Part, subject to its terms, covered employee thefts discovered after policy cancellation, but only if the discovery was:

No later than 1 year from the date of that cancellation. However, this extended period to “discover” loss terminates immediately upon the effective date of any other insurance obtained by you, whether from us or another insurer, replacing in whole or in part the coverage afforded under this insurance, whether or not such other insurance provides coverage for loss sustained prior to its effective date.

Insured’s policy ended on October 6, 2009, so Insured purchased a policy from another insurer with employee theft coverage valid October 6, 2009 to October 6, 2010. Insured discovered on September 30, 2010 that a former employee had stolen around $1 million from Insured, so Insured notified both Insurer and the issuer of its subsequent policy. Court granted Insurer’s summary judgment motion, resolving the issues as follows:

Issue #1: Is “replacing” in discovery clause unambiguous? Yes

Insurer argued that “replacing” as used in the discovery clause was unambiguous: Insured bought a substitute policy, therefore Insurer’s obligation ended. Insured argued that “replacing” was ambiguous and could be interpreted as only occurring if Insured terminated the policy prior to the scheduled expiration date and purchased substitute coverage covering the same time period the first policy covered.

Applying Illinois law, the Court held that “replacing” was not ambiguous. While “replacing” was not defined in the contract, the plain meaning (according to Webster’s) is “to take the place of: serve as a substitute for or successor of: succeed, supplant.”

Issue #2: Should “replacing” be considered ambiguous because of Insured’s “reasonable expectations”? No.

“Illinois law … disfavors the reasonable expectations doctrine. Smagala v. Owen, 717 N.E.2d 491, 496 (Ill. App. Ct. 1999) (“The reasonable expectations test has been rejected by the courts of this state.”). At best, the reasonable expectations doctrine is used as a tool of construction in assessing the intent of the parties when a contract is ambiguous, which is not the case here. Id. at 497.”