Category: Financial Institution Bond Blog

No coverage for Bank under financial institution bond’s fraudulent telephonic voice instructions insuring clause for loss from wiring funds to imposter of Bank customer where customer didn’t qualify as “Customer” as defined under bond

April 18th, 2013 — 4:26pm

by Christopher J. Graham and Joseph P. Kelly

First National Bank of Northern California v. St. Paul Mercury Insurance Company, (N.D. Cal., January 3, 2013):

Bank customer’s signature card for deposit account stated “With respect to wire transfers or other transfers of funds not governed by the Electronic Funds Transfer Act, [the account holder agrees] to enter into and comply with [Bank’s] wire transfer (if applicable) agreement and to comply with [Bank’s] security procedures.” Customer signed the signature card, but never signed the Wire Transfer Agreement and the security procedures were never provided to customer, but were on file at Bank.

Bank received a phone call from someone purporting to be customer, requesting a wire transfer of $412,876.18 to a bank in Bangkok. Bank’s employee asked for the date and amount of customer’s last deposit and the branch location of that account as verification. One day later there was another phone wire transfer request for $98,876.13, to a bank in Shanghai. Bank completed this transfer, asking for and receiving the same verification information as the first call.

Those transfers were part of a sophisticated international wire fraud scheme.

Bank’s Financial Institution Bond, subject to its terms, provided coverage for “loss directly from: . . . having in good faith . . . transferred funds on deposit in a Customer’s account in reliance upon a fraudulent telephonic voice instruction” transmitted to [Bank] ‘which purports to be from . . . [among others] an individual person who is a Customer of’ [Bank].

“Customer” was defined under the Fraudulent Instructions Insuring Clause as “an entity or natural person” that

(i) has a Written agreement with the Insured authorizing the Insured to rely on telephonic voice or Telefacsimile Device instructions to make transfers;

(ii) has provided the Insured with the names of persons authorized to initiate such transfers; and

(iii) with whom the Insured has established an instruction verification procedure other than voice recognition.

Bank timely filed a claim under the Bond, Insurer denied coverage, and Bank sued Insurer for breach of contract. Both sides moved for summary judgment and the Court granted summary judgment to Insurer.

Issue #1: Was the signature card the Bank’s customer signed a “Written agreement” so that the customer could qualify as a “Customer” under the bond’s telephonic voice instructions insuring clause? No.

Under California law:

A contract may validly include provisions of a document not physically part of the basic contract, so long as any incorporation by reference is “clear and unequivocal” and is “called to the attention of the other party” and the other party consents, and the terms of the incorporated document are “known or easily available to the contracting parties.”

But here the signature card was not accompanied by any copy of the Security Procedures, the wire transfer agreement, or even any document that detailed their terms. As such, the signature card was “nothing more than an agreement to agree, which is not enforceable under California law.”

Issue #2: Did the signature card provide Bank with “the names of persons authorized to initiate such transfers so that customer could qualify as a “Customer” under the bond’s telephonic voice instructions insuring clause? No.

The words “voice”, “verbal”, and “telephonic” did not appear on the Signature Card, and no term appeared to even mention wire transfers.

Issue #3: Did Bank establish an “instruction verification procedure other than voice recognition” with customer so that customer could qualify as a “Customer” under the bond’s telephonic voice instructions insuring clause? No.

Bank never gave Customer a copy of the Security Procedures which Bank purported to establish such a procedure.

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Bank, as required under Insuring Agreement E of financial institution bond, had “actual physical possession” of fake guarantees from Borrower, even though Borrower rather than Bank possessed guarantees, because Borrower was Bank’s “authorized representative” within the meaning of Insuring Agreement E

April 18th, 2013 — 4:22pm

by Christopher J. Graham and Joseph P. Kelly

BancInsure, Inc. v. Highland Bank, Civil No. 11-2497 (D. Minn. Dec. 4, 2012):

Borrower entered into an agreement with First Premier (a lease financing company). First Premier requested a loan from Highland Bank (Bank) to finance the purchase of the equipment to be leased in exchange for an assignment of the lease payments to Bank, and Bank agreed to lend the funds. First Premier sent various financial documents to Bank under their agreement, including certified copies of what purported to be the borrower’s guaranties. After approximately 30 months, borrower ceased making its payments. Bank learned upon investigation that the leased equipment did not actually exist, the illusory equipment was in fact pledged to multiple lenders, and the guaranty supposedly provided by one of the borrower’s principals was fake. Bank eventually charged off $2,011,618.30 due to the defaulted loan.

Bank filed a claim with BancInsure (Insurer), who wrote a Financial Institution Bond for Bank for the entire amount of the loss.

In pertinent part, Insuring Agreement E provides coverage for:

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.

Insurer denied coverage, alleging that Bank did not have actual physical possession of the document, which was a condition precedent to coverage under Insuring Agreement E. Insurer then filed for a declaratory judgment of non-coverage against Bank. Bank moved for summary judgment that First Premier was its “authorized representative” within the meaning of Insuring Agreement E, and the Court resolved the issue as follows:

Issue: Was First Premier Bank’s “authorized representative” within the meaning of Insuring Agreement E so as to satisfy the “actual physical possession” requirement of the Insuring Agreement? Yes.

Bank argued that First Premier was its “authorized representative” as the loan originator under the Insuring agreement, meaning that since First Premier had the original of the guaranty, Bank’s loss would be covered under the Bond. The Court held that there are three elements to an inquiry into whether one party was another party’s agent: did the principal consent to the agency, did the agent actually act on behalf of the principal, and did the principal exercise control over the agent.

Employees of Bank testified that they considered First Premier their agent, and that Bank permitted First Premier to retain the original guaranty. It was also standard industry practice to have a lease financing company like First Premier retain original guaranties. Given these facts, the Court held that Bank consented to First Premier’s agency.

Because First Premier actually held the original guaranties, collected and remitted loan payments, paid sales and use tax, provided additional financial documentation, updated insurance, inspected collateral and acted as the primary contact with the borrower, the Court held that First Premier acted on behalf of Bank.

The Court also held that Bank exercised control over First Premier, because Bank held the funds at its discretion in the lending transaction. Bank could have refused to fund the loan if the location of the original guaranty documents was not acceptable; therefore they controlled First Premier’s actions.

Given that the three elements of the test were met, the Court held that First Premier was Bank’s authorized agent, but refused to rule on the issue of whether the loss was covered by the Bond, as that issue was not presented for summary judgment.

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Summary judgment denied for bond insurer when undisputed material facts failed to prove material misrepresentation in financial institution bond application or that bank failed to comply with bond’s notice and proof of loss requirements

April 18th, 2013 — 4:18pm

by Christopher J. Graham and Joseph P. Kelly

FDIC v. Denson, Civil Action No. 3:11CV498TSL-MTP (S.D. Miss., November 7, 2012):

Fraudster Denson was a teller employed by Bank. On November 14, 2006, a dual, verified count at a branch revealed a $209,500 shortage in the branch vault and a $172,104.49 shortage in the teller cash dispenser. These losses were traced to Fraudster, who eventually pled guilty to falsifying bank records. Bank made a claim under Insuring agreement A (Fidelity) of a Financial Institution Bond issued by Progressive.

The Bank provided the following answers in its Bond application: “Cash controls: a) Are all currency shipments prepared, received, and counted under dual control? Yes b) Are the main and reserve cash vaults in each location maintained under dual control? Yes c) Maximum cash held in main vault of any location $750,000.” It also affirmed in the application “that reasonable efforts have been made to obtain sufficient information from each and every individual or entity proposed for this insurance to facilitate the proper and accurate completion of this Application.” The Bond provided: “The insured represents that the information furnished in the application for this bond is complete and correct. Such application constitutes part of this bond” and “Any intentional misrepresentation, omission, concealment or incorrect statement of a material fact, in the application or otherwise, shall be grounds for rescission of this bond.”

The Bond’s discovery provision provided:

This Bond applies to loss first discovered by the Insured during the Bond Period. Discovery occurs when the Insured first becomes aware of facts which would cause a reasonable person to assume that a loss of a type covered by this bond has been or will be incurred, regardless of when the act or acts causing or contributing to such loss occurred, even though the exact amount or details of the loss may not then be known. … This bond terminates as an entirety upon occurrence of any of the following: This bond terminates as to any Employee (a) as soon as any Insured, or any director or officer of an Insured who is not in collusion with such person, learns of any dishonest or fraudulent act committed by such person at any time, whether in the employment of the Insured or otherwise, whether or not of the type covered under Insuring Agreement (A), against the Insured or any other person or entity, without prejudice to the loss of any Property then in transit in the custody of such person…

Termination of this bond as to any Insured terminates liability for any loss sustained by such Insured which is discovered after the effective date of such termination. Termination of this bond as to any Employee terminates liability for any loss caused by a fraudulent or dishonest act committed by such person after the date of such termination.

Bank sued Progressive for failing to pay the claim. FDIC became plaintiff after Bank failed and FDIC was appointed its receiver. The Court, applying Mississippi law, denied Progressive’s motion for summary judgment and addressed these issues:

Issue #1: Did undisputed material facts establish, as Progressive argued, that the Bank made a material misrepresentation in answering “Yes” when asked in the Bond application by Progressive: “Are the main and reserve cash vaults in each location maintained under dual control?” No.

It was undisputed that the Bank had a dual control policy. But Progressive argued the undisputed material facts proved the Bank was ignoring that policy when the application answer was provided. Progressive claimed that dual cash counts were not being done for at least six weeks before the application answer. It cited two tally sheets dated February 2006 which had Fraudster’s initials plus the forged initials of another teller. So, per Progressive, answering that the Bank had a dual control policy was a false statement. But the Court held that there was a genuine issue of material fact on this issue. It emphasized that that Progressive’s investigator, after almost a year’s investigation, thought the Bank’s answers were accurate, and that there was not enough information in the record to decide whether the Bank had made “reasonable efforts” to ensure the dual control policy was in force, or even if those reasonable efforts would have discovered the fraud.

Issue #2: Did the undisputed material facts establish that after Bank personnel discovered in March 2006 that cash was missing from the vault, Bank failed to comply with the Bond’s notice and proof of loss provisions? No.

It was undisputed that on March 23, 2006, Sheila Craig, teller operations officer for the Bank, appeared at the Highway 16 Branch unannounced for the purpose of auditing vault cash. Craig’s audit found a shortage of approximately $30,000. When Craig inquired of Denson regarding the shortage, Denson explained that the amount of the shortage in the vault had been overloaded into the teller cash dispenser, and she showed Craig a cash out ticket she had prepared but not yet run that was in the same amount as the shortage from the vault. Craig accepted Denson’s explanation and made no further investigation.

Progressive argued that a reasonable person in Craig’s position would not have accepted Denson’s story and made an investigation that would have revealed Denson’s lies. Bank therefore had discovered a loss on March 23, which was not timely reported, and per the terms of the Bond coverage for Denson’s actions terminated on that date. The Court disagreed, citing U.S. Supreme Court precedent that “although an insured `may have had suspicions of irregularities; he may have had suspicions of fraud, but he was not bound to act until he had acquired knowledge of some specific fraudulent or dishonest act which might involve the defendant in liability for the misconduct.'”) (quoting American Sur. Co. of New York v. Pauly, 170 U.S. 133, 145, 18 S. Ct. 552, 42 L. Ed. 977 (1898).”

The Court held that under the circumstances, a reasonable jury could find either way on the issue, so summary judgment must be denied.

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Investors in failed lender have no right to recover investment loss under lender’s bond’s Dishonesty Insuring Clause even after lender’s bankruptcy trustee’s assignment of rights under that bond to investors; investors’ loss is not “direct loss” under bond’s terms

April 18th, 2013 — 4:17pm

By Christopher J. Graham and Joseph P. Kelly

Abady v. Certain Underwriters At Lloyd’s of London, Col. Court of Appeals No. 11CA1870, (3rd Div. October 11, 2012):

Commercial Capital, Inc. (CCI) provided short-term financing for commercial construction developers that could not secure credit from traditional lenders. CCI raised capital by borrowing from investors. It guaranteed investors that it had a $5 million bond securing them against loss of principal and also annual rates of return of between 18% and 25%. CCI’s owner also personally guaranteed payment of CCI’s debt to the investors. CCI defaulted, the owner refused to honor his guaranty, and CCI filed bankruptcy. The investors received relief from the automatic bankruptcy stay, and the bankruptcy trustee assigned them CCI’s rights under CCI’s Mortgage Bankers Bond, underwritten by Lloyd’s.

The investors sued in Colorado state court, alleging various claims against CCI and two claims against Lloyd’s: one as assignee of the bond and the other to garnish Lloyd’s bond as CCI’s judgment creditor. Both claims were based on the bond’s “Dishonesty Insuring Clause” under which Lloyd’s agreed, subject to the bond’s terms, conditions, and exceptions to pay:

Direct financial loss sustained by the Assured at any time and discovered by the Assured during the Bond Period by reason of and directly caused by [a] Theft of Money, Securities and other Property by any Employee of the Assured, whether committed alone or in collusion with others, or [b] any other dishonest acts by any Employee of the Assured, whether committed alone or in collusion with others, committed by said Employees with the manifest intent to obtain Improper Personal Financial Gain for said Employee, or for any other person or entity intended by the Employee to receive such Improper Personal Financial Gain.

Lloyd’s moved for summary judgment, and the trial court held: (1) the bond is a fidelity bond and not a surety bond; (2) the bond terms were unambiguous; (3) the plain language of the bond protects only CCI; (4) the bankruptcy trustee’s assignment of CCI’s rights to investors did not convert the investors’ third-party claims into first-party insurance claims; and, therefore, (5) investors’ claims were not recoverable under the bond. The investors appealed.

Issue #1: Can the investors collect under the Bond for damages that CCI could not itself collect? No.

“An assignee has no greater rights than his or her assignor. Pierce v. Ackerman, 488 P.2d 1118, 1120 (Colo. App. 1971) (not published pursuant to C.A.R. 35(f)). Therefore, investors’ third-party claims — to the amounts, plus interest, that they invested in CCI — have not become first-party losses merely because investors now stand in CCI’s shoes as first-party claimants. Rather, investors may only recover those losses that CCI could have recovered for itself.”

Issue #2: Are the losses asserted by the investors recoverable as “direct losses” under the terms of the Bond? No.

As “direct financial loss” is not defined in the Bond, the court looks to the plain and ordinary meaning of the term. The Court adopted Black’s definition of “direct” as “free from extraneous influence; [or] immediate.” The court noted that: “A liability policy protects the insured against claims brought by third parties who have been injured by the insured’s conduct. . . . In contrasting liability insurance with a fidelity bond, it is helpful to note that in the liability context, the insured’s loss is indirect; it is a third party who directly suffers the loss. City of Burlington v. Western Sur. Co., 599 N.W.2d 469, 472 (Iowa 1999)(emphasis added) (citing 1 Eric Mills Holmes & Mark S. Rhodes, Holmes’s Appleman on Insurance § 3.3, at 349 (2d ed. 1996)); see also Qwest Communications Int’l, Inc. v. QBE Corporate Ltd., 829 F. Supp. 2d 1037, 1040 (D. Colo. 2011) (“Commercial crime policies are not intended to be liability policies.”).”

The court chose not to follow bond cases holding that “direct financial loss” included losses from an insured’s liability to third parties, including F.D.I.C. v. United Pacific Ins. Co., 20 F.3d 1070, 1079 (10th Cir. 1994), Continental Savings Ass’n v. U.S. Fidelity & Guarantee Co., 762 F.2d 1239, 1243 (5th Cir. 1985), and RBC Dain Rauscher Inc. v. F.D.I.C., 370 F. Supp. 2d 886, 890 (D. Minn. 2005). The court also distinguished Massachusetts Mutual Life Insurance Co. v. Certain Underwriters at Lloyd’s of London, 2010 WL 2929552 (Del. Ch. No. 4791-VCL, July 23, 2010)(unpublished opinion), which denied a bonding company’s motion to dismiss an insured mutual fund’s complaint alleging coverage under the fidelity insuring agreement for indemnity and defense costs arising from mutual fund investor claims. The investors’ claims in that case were premised on allegations that the mutual funds deposited funds with the notorious Bernie Madoff to manage as an investment advisor (which qualified as an Employee under the bond), the funds remained property of the mutual funds while possessed by Madoff, and the funds were misappropriated by Madoff for his own benefit.

Given the meaning of “direct” and that CCI bought a fidelity bond, not a liability policy, the Court held that “direct financial loss” unambiguously refers to the immediate loss of CCI’s property, not harm to investors. The investors therefore could not recover the losses under the Bond.

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