course material - fidelity bond and crime coverage...

HB Litigation Conferences Presents

Fidelity Bond and Crime Coverage Conference Thursday, December 3, 2009 Location: 599 Lexington Avenue, 22nd Floor, New York, NY 10022 Conference Chairs: Matthew Schlesinger, Esq., Reed Smith LLP, Washington, DCJohn McDonald, Esq., Meagher & Geer, P.L.L.P., Minneapolis

7:45 Continental Breakfast and Morning Registration

8:20 Welcome and Opening Remarks

8:30 Nature of Fidelity Bonds and Crime Coverage Policies •Whopurchasesthiscoverageandwhy?•Whatiscoveredundertypicalpolicies-differentformsfordifferenttypesofcompanies-Employeedishonesty,onpremises,forgery/alterationandmortgagefraud,servicingcontractorfraud,electroniccrimes•UnderstandingthedifferencebetweenthiscoveragetypeandD&O,E&OandCGLpolicies•Keyconditionsforclaims:discoveryandnotice,proofofloss,timelinessofsuit,limitsofliabilityandpriorinsuranceMatthew Schlesinger, Esq., Reed Smith LLP, Washington, DC Robert Briganti, Belle Mead Claims Service, Inc., Hillsborough, NJ Robert Olausen, Manager-Specialty Commercial Lines, Insurance Services Office, Inc. (ISO), Jersey City, NJ John McDonald, Meagher & Geer, P.L.L.P., Minneapolis

9:45 Key Issues with Employee Dishonesty and Employee Theft •Manifestintent•Whatisalossandwhatisnotaloss?•Directloss•Collusion•Improperpersonalgain Robert Konop, Esq., Hinshaw & Culbertson LLP, Chicago Wayne Everson, Esq., Claim Attorney, OneBeacon Professional Insurance, Minnetonka, MN

10:15 Morning Break

10:30 Emerging Coverage Disputes and Common Exclusions •Exclusions:losses,potentialincome,prior/subsequentactivity,damagesforwhichtheinsuredisliable,warehousereceipts,tradingandnegligenceexclusions•Rulesofconstruction•Commondisputedissuessuchascausation,loanexclusion,intent,policyholdernegligence,reliance,discoveryandvaluationclausesLisa Cirando, Esq., Orrick, Herrington & Sutcliffe LLP, New York William Bogaert, Esq., Wilson Elser Moskowitz Edelman & Dicker LLP, Boston

11:30 Unique Issues with Special Cases •Computerandfundstransferfraud•Inventorylosses•LoanlossesKerry Evensen, Esq., Assistant Vice President – Claims, OneBeacon Insurance, Minnetonka, MN Eric Emmette, Principal, Tripoli Risk Management, LLC, Minneapolis, MN John McDonald, Meagher & Geer, P.L.L.P., Minneapolis, MN

12:15 Networking Luncheon

1:15 Ponzi Schemes and Coverage-Related Issues •AreMadoff-relatedlossescovered?Whyorwhynot?•Typesofponzi-schemelossesthatmighttriggerfidelitybondcoverageKevin Mattessich, Esq., Cozen O’Connor, New York William Passannante, Esq., Anderson Kill & Olick, P.C., New York

2:15 The Market for Crime and Fidelity Coverage-The Insurer and Broker’s Perspective •Markettrends,domesticandforeign•Abilityofpolicyholderstonegotiatepriceandlanguage•Newcoverageavailability•ReinsuranceSteven Balmer, Product Manager-Crime Bond & Financial Products, Travelers, Philadelphia Patricia Logan, Vice President, Regional Manager, Berkley Asset Protection Underwriting Managers, LLC, New York

3:15 Afternoon Break

3:30 Forensics, Determining the Amount of the Loss and Damages •Whenandhowtouseforensicaccountantsonabondclaim•Thebenefitsandpotentialpitfallsofretainingaforensicaccountantfrombothinsurerandinsuredstandpoint•Determiningthelossamount-commonaccountingissuesregardingquantificationandvendorrelatedandtradinglosses•TheinherentaccountingissuesraisedinSectionIIIregardingexclusions-specificallypotentialincomeandpriorandsubsequentactivity•Possiblesetoffs&disputedissues•DeterminingcausationwithforensicaccountingVincent D’Amelio, Navigant Consulting, New York James Reynolds, Reynolds Financial Services Group, LLC, Summit, NJ

4:15 Claims Processing Guidelines for Insureds and Insurers •Claimsinvestigation,presentationandresolution•Burdensofproof•Privilege/workproductconcerns•Cooperation–whenisenough,enough?•Avoidingbreakdownsincommunication•Litigationstrategies Duane Sigelko, Esq., Reed Smith LLP, Chicago Joel Wiegert, Esq., Meagher & Geer, P.L.L.P., Minneapolis John Tomaine, Esq., Vice President-Fidelity Claims, Chubb & Sons, Warren, NJ John Morrissey, Esq., Senior Vice President-Legal and Claims Practice Group, Aon Financial Services Group A Division of Aon Risk Services, Inc., New York

5:15 Networking Reception

HB Litigation Conferences Presents Fidelity Bond and Crime Coverage

December 3, 2009

Chair and Faculty Biographies Chairs John McDonald is a partner in the Minneapolis office of Meagher & Geer, P.L.L.P., where he devotes a significant amount of his practice to trial work including, insurance and reinsurance coverage claims including fidelity bond claims, financial institution bonds, crime polices, directors and officers, fiduciary policies. He is a member of the American Board of Trial Advocates. Mr. McDonald is AV rated by Martindale-Hubbell, he was selected for inclusion in the Minnesota issue of Leading American Attorneys and appears in The Best Lawyers in America, every year since 2003. He appears on Minnesota Law & Politics' Super Lawyer list every year since 2000 to the present. He has been selected as one of the top 100 lawyers in Minnesota and one of the top 40 employment lawyers in Minnesota for the past nine years. He also serves on the firm’s Management Committee. The Honorable Minnesota Governor Tim Pawlenty appointed Mr. McDonald to the Judicial Selection Committee in March 2008 and to the Metropolitan Airports Commission in January 2009. Mr. McDonald received his BA from the University of St. Thomas and his JD from Creighton University. He is admitted to practice in all courts in Minnesota and Wisconsin, The United States Supreme Court, several federal circuit courts and the Mille Lacs Band of Chippewa Indian District of Nay Ah Shing. Matthew Schlesinger is a partner at Reed Smith in Washington, D.C. Mr. Schlesinger has extensive experience representing policyholders nationwide in insurance coverage disputes with their insurance carriers, and counseling clients on insurance-related issues. He has obtained insurance recoveries and counseled clients in a wide variety of unique and challenging cases involving fidelity, directors' and officers' liability, first-party property damage and business interruption, environmental and asbestos liability, HIV-infected blood, intellectual property, power interruption, construction, professional disability, and other issues. His clients include Fortune 100 and 500 companies and others. In addition, Mr. Schlesinger has experience utilizing mediation to successfully resolve insurance coverage disputes, as well as serving as lead counsel in large, complex, multi-party, multi-claim litigation. Some of his successes include: prevailing on behalf of a policyholder in a four week bad faith/punitive damages trial involving business interruption and property damage coverage for explosions at two manufacturing facilities; winning summary judgment and an award of attorney's fees in a hotly contested directors' and officers' liability matter; successfully resolving first-party property and business interruption claims involving a hacker attack and extensive water and mold damage to a hotel; and obtaining favorable settlements with multiple insurers in an intensely litigated environmental case involving hundreds of sites. Mr. Schlesinger lectures and writes frequently on insurance coverage issues, and has co-chaired numerous Mealey's (now HB) insurance coverage conferences. He is also co-chair of the Membership Subcommittee of the Insurance Coverage Litigation Committee of the American Bar Association. He is admitted to practice in the D.C. and Maryland Bars, and in the U.S. District Courts for the Districts of Columbia and Maryland. Mr. Schlesinger earned his JD from Northwestern University School of Law (1989), serving as Note and Comment Editor of the Northwestern Journal of International Law and Business. He received his BA cum laude from American University (1985).

Faculty Steven Balmer is a Product Manager for Crime Bond & Financial Products at Travelers Insurance Group in Philadelphia. Mr. Balmer has been with Travelers since 2000. Prior to his current position, Mr. Balmer was with Reliance Surety Company for 24 years, which included 15 years as Chief Underwriting Officer for Fidelity / Crime. His Surety & Fidelity Association of America Memberships include: Fidelity and Public Official Advisory Committee (Past Chairman); and Forms Drafting Committees for: Financial Institution Bond / Form 24, Computer Crime and Crime Protection Policies. He is a member of the ISO Crime and Financial Institution Advisory Panels, and is co-author with Edward Gallagher of A Complete Guide to the ERISA Bonding Requirement. Mr. Balmer is a frequent panel speaker for American Bar Association / Tort and Insurance Practice Section, Fidelity Law Association. He graduated from Penn State University with a BS in Business Administration. William Bogaert is a partner in the Boston office of the national law firm Wilson, Elser, Moskowitz, Edelman & Dicker, LLP. As a trial lawyer, Mr. Bogaert brings 24 years of experience to a practice that has concentrated in the investigation and defense of claims made against financial institution bonds and commercial crime policies as well as the representation of non-medical professionals and their insurers, and the representation of life and disability insurers. He has been responsible for a number of the most important court decisions interpreting fidelity policies in Massachusetts. He is also a frequent author and speaker on issues presented by claims made against fidelity bonds, and he has assisted clients in drafting fidelity and related coverages for financial institutions and commercial entities. Mr. Bogaert is a Vice Chair of the Fidelity and Surety Law Committee of the American Bar Association: Tort and Insurance Practice Section. Selected by his peers as a Massachusetts and New England SuperLawyer each year from 2004 through 2009, Mr. Bogaert also has an AV Rating from Martindale-Hubbell. Robert Briganti is President of Belle Mead Claims Service, Inc., which provides fidelity claim investigation services, policy drafting, and litigation support services including expert testimony. Mr. Briganti’s previous positions include National Manager of Fidelity Claims for the Chubb Group of Insurance Companies and Manager of Fidelity Claims for Continental Guaranty & Credit Corporation. He is a graduate of Indiana University (A.B.) and Western New England School of Law (J.D.), and is admitted to practice in Massachusetts. Mr. Briganti served as Editor of the Newsletter of the Fidelity & Surety law Committee of the American Bar Association and is an Advisor Emeritus of the Fidelity Law Association. Lisa Cirando is of counsel in the New York office of Orrick, Herrington & Sutcliffe LLP, where she is a member of the Litigation Division. Her complex civil litigation practice concentrates on the representation of corporate policyholders in insurance coverage disputes. Before joining Orrick, Ms. Cirando was special counsel with Heller Ehrman LLP. In insurance matters, Ms. Cirando represents policyholders exclusively. She litigates complex coverage claims and provides effective non-litigation solutions to coverage disputes involving virtually every type of insurance policy. She also counsels clients in areas of risk management. She has recovered hundreds of millions of dollars in insurance proceeds and has developed favorable precedent for policyholders. In addition, Ms. Cirando has experience in litigating claims against insolvent insurers and advising policyholders in bankruptcy. Ms. Cirando crafts and implements innovative strategies that serve the diverse needs of her policyholder clients located throughout the world, including Fortune 500 companies as well as small- and middle-market companies in the financial services, real estate and construction, high technology,

manufacturing, shipping, media and entertainment, apparel, textile, retail, food and beverage, industrial, energy and telecommunications industries. Ms. Cirando holds a BA from Colgate University (1990) and JD from Fordham University School of Law (1996). Vince D'Amelio, a Managing Director in the Investigations practice at Navigant Consulting, is a forensic accountant with over 20 years experience. He has conducted numerous investigations in the context of employee dishonesty. He has assisted his clients in preparing and supporting proofs of claim for submission to insurance carriers. He has testified as an expert witness in a fidelity claim litigation that led to a verdict in favor of his client. Prior to being a consultant he served as the first Director of Forensic Accounting in AIG’s Fidelity Claim Department where he had responsibility for all forensic accounting matters pertaining to fidelity claims. Early in his career Mr. D’Amelio performed criminal investigations as a Senior Financial Investigator in the New York County District Attorney’s Office Financial Crimes Bureau. He is currently working on numerous matters related to the Madoff and other Ponzi scandals as well as issues relating to the credit crisis and mortgage lending. Mr. D’Amelio is a CPA and holds a BA in Accounting from Queens College. Eric Emmette has over 20 years of experience in the insurance industry. He has worked for ten years in various underwriting positions primarily in the professional lines area (Crime, Directors’ & Officers’, Errors’ & Omissions, Employment Practices, etc.) at one of the largest insurers in the world. Over the past 12 years he has been on the risk management (i.e., insurance buying) side for large organizations, including the past five years as the principal at Tripoli Risk Management. Tripoli offers risk management solutions to a range of clients including outsourced risk management, audits of insurance programs, reviews of policies and procedures, assessments of broker/agent services, contract analysis, and forms reviews. Mr. Emmettee received his BA from Macalester College and MBA from Boston College. In addition, he also has a number of professional insurance designations including a Chartered Property Casualty Underwriter and Associate in Risk Management. Kerry Evensen is an Assistant Vice President for Specialty Claims at OneBeacon Insurance. In this capacity, she manages the Financial Services Claims, Management Liability Claims and Employment Practices Claims. Ms. Evensen’s prior experience includes: Assistant Vice President for the Errors and Omissions Claim Department at the St. Paul Companies, where she managed the Claim professionals throughout the country who handled the Financial Institution, Legal Malpractice, Director and Officer Liability, EPLI Claims and Miscellaneous E&O claims. She also handled and managed outside litigation and coverage actions in these areas of practice. Prior to joining the St. Paul Companies, Ms. Evensen was in private practice for eight years at a large insurance defense law firm in Minneapolis, Minnesota. While in private practice, she litigated and tried many cases in state and federal court on behalf of insurance companies and their insureds. Ms. Evensen received her JD degree with honors from the William Mitchell College of Law (1990) and her undergraduate degree from the University of Minnesota-Duluth (1986). Wayne Everson is a claim attorney with OneBeacon Professional Insurance in the Professional Liability and Financial Institution Specialty Claims group. He is a graduate of the University of Minnesota (1970) and Drake University Law School (1975), and is a licensed attorney in Minnesota. He has been involved in Fidelity and Surety underwriting and claims since 1970 both as a corporate representative and an independent consultant and has been a presenter on Fidelity, Surety and Professional Liability (D&O) topics in a number of forums including Minnesota CLE programs, American Bar Association Fidelity and Surety Committee, Surety Claims Institute and American and State Banker’s Association programs.

Robert Konop is a partner with Hinshaw & Culbertson LLP in its Chicago office. Mr. Konop focuses his practice on Fidelity and Surety, Directors and Officers, and Property and Casualty insurance. Prior to joining Hinshaw & Culbertson LLP in 2005, Mr. Konop was in-house counsel for CUNA Mutual Group for 28 years, with his most recent position being Vice-President, Associate General Counsel. Mr. Konop has extensive experience with insurance coverage issues, including providing coverage investigations and policy drafting. He has authored or co-authored articles on fidelity insurance issues and has spoken on insurance and financial institution issues to numerous groups around the country. Mr. Konop received his BS degree in Nuclear Engineering from the University of Wisconsin in 1969 and his JD degree in 1973 also from the University of Wisconsin. He worked as a civilian Nuclear Engineer for the United States Department of the Navy from 1969 – 1971. Mr. Konop is admitted to practice in Wisconsin and Illinois and is a member of the Fidelity and Surety Law Committee of the Tort and Insurance Practice Section of the American Bar Association. Patricia Logan is a Vice President, Regional Manager in Berkley Asset Protection Underwriting Managers (“BAPU”) practice. Her responsibilities include producing and underwriting fidelity and related coverage lines for commercial organizations, financial service firms and financial institutions. Prior to joining Berkley Asset Protection in July 2009, Ms. Logan was a Managing Director and served as a Senior Client Advisor, the National Fidelity Product leader, and the team leader of the Fidelity Center of Excellence (COE) in Marsh NY’s Financial & Professional Services (“FINPRO”) practice. Her responsibilities include managing, training and providing product content to FINPRO colleagues and servicing and providing advice to clients on FINPRO coverage lines, with a primary focus on fidelity products for financial institutions, financial service firms, and commercial organizations. Additionally, Ms. Logan served as a national resource within FINPRO for Kidnap & Ransom insurance. Prior to joining Marsh in August 1995 she was an underwriter/manager in the Financial Services Division of the Aetna Property and Casualty Insurance Company’s’ New York City branch. In this role, Ms. Logan was involved in underwriting many of the major financial institution, commercial fidelity, Excess SIPC and fiduciary liability programs that Aetna led or participated on. Ms. Logan holds a BS in Business Management from St. Francis College, Brooklyn, New York Kevin Mattessich joined the New York office of Cozen O’Connor in October 2000 and practices with the Global Insurance Group. He focuses his practice on insurance law and commercial litigation. Prior to joining Cozen O’Connor, Mr. Mattessich was the managing partner of the New York office of an international firm. In addition, he served as a federal prosecutor with the U.S. Department of Justice in Washington, D.C., and as a member of the Fraud Section of the Criminal Division in a special unit investigating healthcare and insurance fraud. Mr. Mattessich has represented foreign and domestic professional indemnity and general liability insurers and reinsurers in cases throughout the world. His experience includes matters involving insider trading, money laundering, foreign corporation bribes, derivatives trading, securities offerings, telecommunications fraud and insurance fraud within multi-national financial institutions, brokerage houses and other corporations. He has assisted insurers in establishing insurance programs and in underwriting specialized risks, and has also drafted financial institution and commercial bonds and liability policies relating to professional services, directors and officers, trustees and fiduciaries, employment practices, kidnap and ransom, fidelity and electronic risks. He has advised both cedents and reinsurers with respect to the administration of treaty and facultative risks, including programs involving complex financial institution claims. Mr. Mattessich has spoken on such issues as white

collar fraud and insurance at FBI training seminars, the U.S. Attorney General’s Advocacy Institute and at various privately sponsored seminars. Also, he has been called to testify before the U.S. Senate Judiciary Committee concerning health care/insurance fraud issues. Mr. Mattessich was a contributing author to @RISK (Reactions 2002) and is a member of the Professional Liability Underwriting Society and vice chair of the Professionals’ Officers’ and Directors’ Liability Committee of the tort trial and insurance practice section of the American Bar Association. Mr. Mattessich received his BA cum laude from Boston College (1982) and his law degree from Catholic University of America Law School (1985). He is admitted to practice in New York and New Jersey. John Morrissey is a Senior Vice President in the Legal and Claims Practice Group at Aon Financial Services Group. Robert Olausen is a Manager in the Insurance Services, Inc. (ISO) Specialty Commercial Lines Division. He is responsible for various lines of business including Crime and Fidelity, Financial Institutions, Kidnap and Ransom and Internet Liability. Prior to joining ISO in 1997, Mr. Olausen served as Director of the Fidelity Department at the Surety and Fidelity Association of America. Mr. Olausen earned his bachelor’s degree from Upsala College in East Orange, NJ (1979). He did post graduate work at the College of Insurance (St. John’s University) in New York, and holds the Professional Certificate in Bonding. Mr. Olausen served on the Insurance Institute of America’s Associate in Fidelity and Surety Bonding (AFSB) Program Advisory Committee. He also services on the Executive Committee of the Fidelity Law Association and is a member of the Professional Liability Underwriting Society. William Passannante is co-chair of the Insurance Recovery Group and a member of the executive committee at Anderson Kill & Olick. Mr. Passannante has appeared in cases throughout the country and has been recognized by Chambers USA 2006: America’s Leading Lawyers for Business as “a tremendous tactician and an incredible trial lawyer.” In 2007 and 2008, Chambers USA once again ranked Mr. Passannante a leading lawyer in Insurance: Dispute Resolution. Chambers USA 2008 ranked Anderson Kill’s Insurance Recovery Group No. 1 in New York for Insurance: Dispute Resolution. In 2009, Mr. Passannante was selected by his peers to Best Lawyers in America. He has also been rated "AV" by Martindale Hubbell. Mr. Passannante is a leading lawyer for policyholders in the area of insurance coverage. He has represented policyholders in litigation and trial in major precedent-setting cases. He has represented The Glidden Company, The Trustees of Princeton University, HLTH Corporation/WebMD, Picker International, Weyerhaeuser Company, Occidental Chemical Company, Imperial Chemical Industries, The Lefrak Organization, Quest Diagnostics, Automatic Data Processing, Fleming Companies, Inc., and others. Prior to joining Anderson Kill, Mr. Passannante was a Financial, Industrial, and Econometric Consultant with Standard and Poor's/Data Resources, Inc. Mr. Passannante was a drafter of the precedent-setting Weyerhaeuser case in the Supreme Court of the State of Washington which held that no overt threat against a policyholder is required to trigger insurance policies. Mr. Passannante co-chaired the program "Current Issues in D&O and Professional Liability Insurance" sponsored by the ABCNY and the ABA. He testified before the New York State Legislature regarding the insurance industry response to the victims of the terrorist attack on September 11, 2001. Mr. Passannante is an editor of the recent book, The Policyholder Advisor, and has published widely including in Risk Management, The (ABA) Brief, Corporate Counsel Magazine, Policyholder Advisor, Copyright World, Healthcare Financial Management, Insurance Litigation Reporter, and Mealey's Insurance. Mr. Passannante holds a BA from Oberlin College and a JD from Fordham University.

James Reynolds is founder and managing partner of The Reynolds Group. Mr. Reynolds has extensive experience in mortgage banking and related financial services. He has worked closely with owners, investors and senior managers of mortgage banking firms and financial institutions in evaluating, developing and implementing enhancements involving risk mitigation, cost controls and profit maximization. Prior to forming The Reynolds Financial Services Group, LLC, Mr. Reynolds owned and operated a mortgage banking firm which originated non-conforming, agency (Fannie Mae & Freddie Mac), government (HUD), ALT-A, and sub-prime residential loans on a nationwide basis. In addition, as president of a mortgage banking subsidiary of a publicly owned bank holding company, he established several profitable nationwide business units including: loan servicing, loan production, document custodian, and warehouse lending. Mr. Reynolds also established a due diligence and quality control group whose clients included the FDIC, FHLB, commercial banks, thrifts, investment banks and insurance companies. Mr. Reynolds holds an AB in government and an MBA in finance and marketing from Harvard University. Duane Sigelko joined Reed Smith when the firm combined with Sachnoff & Weaver in 2007. Mr. Sigelko is a senior member of the firm's Insurance Coverage Group. He has been heavily involved for more than twenty years in both negotiating the terms and conditions of D&O, E&O, Media, E-Commerce, Commercial Crime, Fidelity and similar policies and successfully resolving disputes under these policies. Overall, Mr. Sigelko has helped recover hundreds of millions of dollars in insurance proceeds and he has helped to design and negotiate insurance coverage programs for corporations, investment funds, partnerships, foundations and not-for-profit entities throughout the United States and internationally. Mr. Sigelko has authored and contributed to numerous articles and given presentations on insurance coverage issues at prominent conferences and courses throughout the United States. He holds a BA from the University of Detroit (1978) and a JD cum laude from Northwestern University School of Law (1986). John Tomaine is Vice President, Fidelity Claims at Chubb & Son. He advises company personnel in the handling of fidelity claims. The claims include those submitted under Financial Institution Bonds and Commercial Crime Policies. He also assists underwriters of fidelity insurance in product development. He began his career with The Hartford Insurance Group. Mr. Tomaine holds an MA degree from Seton Hall University, a JD degree from Western New England College School of Law and a BA degree from Moravian College. Joel Wiegert is a partner at Meagher & Geer, P.L.L.P. in Minneapolis, where the majority of his practice is in insurance coverage and defense. Mr. Wiegert handles an extensive variety of first- and third-party commercial insurance coverage disputes ranging from advising clients regarding basic coverage issues to complex coverage litigation. Areas of coverage expertise and litigation experience include commercial crime, financial institution bonds, commercial general liability, commercial property, surety, professional liability, errors and omissions, Directors and Officers, environmental, reinsurance, and subrogation. Mr. Wiegert has been recognized as a Rising Star by Minnesota Law & Politics magazine (2003, 2006-2008). In his spare time, he enjoys doing anything outdoors, and in the summer you will find him boating, following the Twins, or playing baseball with his sons. Mr. Wiegert holds a BA from Concordia College (1997) and a JD with high honors, Order of the Coif, from Drake University Law School (2000).

Nature of Fidelity Bonds and Crime Coverage Polices

Matthew J. Schlesinger Reed Smith LLP [email protected]

John McDonald Meagher & [email protected]

Fidelity Bond and Crime Coverage Conference

December 3, 2009

PracticPractical Considerations

Time-Sensitive Limitations.

Discovery – as of the time knowledge of a loss or potential loss of type covered by the Bond is acquired.

Notice – typically within 30-90 days of discovery.

Proof of Loss – typically within 6 months of discovery.

Suit Limitations – typically within 2 years of discovery.


Notice.

Driven by “discovery” – knowledge of a loss or potential loss of type covered by the Bond.

Discovery ought to be by General Counsel or Risk Manager’s office, not a mere employee – check your bond.

Be aware of incident disclosures to regulators.

Typically need to give notice within 30 days (can be modified for losses unlikely to exceed the deductible).

Need not be elaborate – in fact, is likely to be very bare bones.


Loss Mitigation.

Don’t necessarily need to initiate a recovery action.

But, cannot do anything to prejudice the rights of the insurer.

Seek insurer consent before reaching settlements or waiving claims.

Analyze coverage early.

Understand how loss may be covered and coverage defenses insurer may raise.

Should be done by coverage counsel.

The analysis may affect how you characterize the loss to the insurer.


The Proof of Loss.

No standard form.

Insurers may indicate the types of information they’d like to see.

It’s your story – Exhibit A in any litigation.

So, explain the loss and how it occurred in manner that demonstrates is covered.

Its not a legal brief – but coverage can be shown by how the loss/fraud is described.

Insurer may want you to designate an insuring agreement under which you seek coverage, but leave yourself options.

Extensions of time in which to submit are fairly routine.


Claim Resolution.

Manage expectations internally.

Be prepared to argue why loss is covered.

Includes the amount.

When determining whether to accept a less than full value settlement, understand insurer’s potential weaknesses.

Will a litigated decision in your favor create “bad law” for insurer?

Don’t take “no” for an answer.

Acknowledging the ClaimAcknowledging the Claim

Basic response mechanisms that exist in any claim (analyze facts and coverage provided, investigation, decision).

Additional inquiry – is there other insurance?

Identify relevant dates of loss and effective coverage dates.

Review underwriting file.

Ask the insured.

7


Initial communication with the insured:

Identify relevant coverage(s).

Advise of relevant burdens and duties.

Request additional information.

Identify known or possible claim deficiencies.

Reserve rights.

8


And, if issues presented that raise possibility of other coverage,

Ascertain identity of all other carriers.

Demand the insured provide notice to all other carriers.

Provide notice directly to all other carriers.

9

Notice to other carriersNotice to other carriers

Avoid possible late notice defenses.

Foreclose any remote possibility of a “selective tender” argument.

Protect potential equitable contribution claims

Synergize the investigation.

Identify relevant policy language/significant differences; share information and facts, etc.

Defamation concerns.

Meeting the insuredMeeting the insured

Timing should be discussed between the co- insurers.

Insured has obligation to cooperate with each insurer, which could require it to attend separate meetings.

Preliminary meetings should be joint.

Eases burden on insured.

Fosters cooperation.

11

Preparing for RecoveriesPreparing for Recoveries

Should be considered immediately.

Mutually-benefits insured and insurer.

12

Proof of LossProof of Loss

Disregard efficiencies of multiple insurers– each insurer should insist on separate Proof.

Information is “sworn” to, so it should not be a generalized document – presents first opportunity to address any requirements peculiar to the insurer’s coverage.

13


Requirement to provide Proof of Loss runs directly between each insurer and insured through the Bond/Policy; i.e., insured can not argue undue burden.

However, multiple Proofs of Loss could potentially affect a “prejudice” argument in response to untimely filing.

14

Investigating the ClaimInvestigating the Claim

Insurers do not “investigate” the claim, they evaluate it.

The evaluation may be coordinated between co- insurers and their counsel.

No affirmative obligation to “investigate” if the evidence does not suggest coverage.

15

Evaluating the ClaimEvaluating the Claim

Insurer’s obligation:

Diligent

Prompt

Thorough

Co-insurers provide opportunity to maximize efficiency of evaluation and minimize burden on insured.

16


Requests for Information

Reasonable requests are almost always necessary.

Duplicative requests can be burdensome.

Opportunity to synergize the process and coordinate the scope of documentation needed in a single request among the co-insurers.

17


Requests for Information

Work-product should not prevent production.

Substance of the product—not the person who produces it—that determines whether the information should be produced.

Cooperation clause provides backbone to demanding full disclosure.

Duty to cooperate runs directly to each insurer.

18


Interviews

Co-insurers have contractual right to interview.

If insured has control over an individual, he or she is subject to an EUO or interview.

19


Interviews

Although each insurer could claim a right to independently interview, practicality favors joint interview.

Eases burden on insured and interviewee as well.

20


Interviews

Differing issues and objectives can usually be negotiated among the co-insurers ahead of time.

If not, consideration to separate interviews may be warranted, despite the impracticality of the situation.

21

The Coverage DeterminationThe Coverage Determination

Existence of a co-insurer is irrelevant

Each insurer must make its own independent determination as to coverage.

Facts and coverage are unique to each insurer.

Co-insurer’s decision can not affect coverage analysis.

May be helpful to discuss analysis among co- insurers to ensure all facts addressed.

22

The Coverage DeterminationThe Coverage Determination

Reasonable insurers can, and do, differ

Duty of good faith and fair dealing requires objective analysis.

Inherently based on facts and law at the time of the decision.

23

Nature of Fidelity Bonds and Crime Coverage Polices

Matthew J. Schlesinger Reed Smith LLP [email protected]

John McDonaldJohn McDonald Meagher & GeerMeagher & [email protected]@meagher.com

Fidelity Bond and Crime Coverage Conference

December 3, 2009

HB Litigation ConferencesDecember 3, 2009

Robert Briganti, Belle Mead Claims ServiceRobert Olausen, Insurance Services Office, Inc.

The Business Cost Of Crime

The Hidden Cost Of Crime

Who Purchases Coverage?

Commercial & Government Entities

Financial Institutions

Fraud cost American businesses approximately $994 billion in 2008

U.S. organizations lose 7 percent of annual revenue to fraud

Smaller companies (fewer than 100 employees) suffer a greater percentage of fraud

Increased internal cost = increased cost of products/services sold

Loss of productivity

Decreased earnings

Cost to present claim — internal and external

Effect on morale

Adverse risk experience

Governmental agencies

Financial institutions

Commercial entities

Fewer than 1 in 3 private companies purchase crime insurance

Why?

ERISA

Public official/employee statutes

Other federal and state laws/regulations

Coverage written in the form of:

Package policies

Stand-alone policies Discovery or loss sustained

Coverages

Fidelity

Employee Dishonesty

Employee Theft

Coverages continued

Forgery Or Alteration

Inside The Premises – Theft Of Money And Securities

Coverages continued

Inside The Premises – Robbery Or Safe Burglary Of Other Property

Outside The Premises

Coverages continued

Computer Fraud

Funds Transfer Fraud

Money Orders And Counterfeit Money

Coverages

Employee Theft

“Per loss” or “per employee”

The remaining insuring agreements essentially the same as the commercial forms

Major industry classes

Commercial banks and savings institutions

Securities brokers and dealers

Insurance companies

Finance companies

Credit unions

Investment companies

Mortgage bankers

Heavily regulated

For many institutions, employee coverage is required

Separate forms designed for operations of each industry class but the form for commercial banks and savings institutions serves as the template

Coverages

Fidelity

On Premises

In Transit

Coverages continued

Forgery Or Alteration

Securities

Counterfeit Money

Computer Fraud

Coverages continued

Voice Initiated Transfer Fraud

Telefacsimile Transfer Fraud

Automated Teller Machines (ATMs)

Attended v. Unattended

Coverages continued

Fraudulent Mortgages

Stop Payment Or Refusal To Pay

Cash Letter

Coverages continued

Audit And Claims Expense

Servicing Contractor

Extortion

Agents

HB Litigation Conferences Fidelity Bond & Crime Coverage

Conference

December 3, 2009 – New York, New YorkWayne Everson, Esq., OneBeacon Insurance

Robert Konop, Esq., Hinshaw & Culbertson LLP

Key Issues With Employee Dishonesty and Employee Theft

Direct lossWhat is a loss and what is not a lossManifest intent vs. theftCollusion Financial benefit


Financial Institution Bond Form 24 (1986)

A. Loss resulting directly from dishonest or fraudulent acts committed by an Employee acting alone or in collusion with others.Such dishonest or fraudulent acts must be committed by the Employee with the manifest intent.

a) to cause the Insured to sustain such loss; andb) to obtain financial benefit for the Employee or another person or entity.

However, if some or all of the Insured’s loss results directly or indirectly from Loans, that portion of the loss is not covered unless the Employee was in collusion with one or more parties to the transactions and has received, in connection therewith, a financial benefit with a value of at least $2,500.As used throughout this Insuring Agreement, financial benefit does not include any employee benefits earned in the normal course of employment, including: salaries, commissions, fees, bonuses, promotions, awards, profit sharing or pensions.


Commercial Crime Policy

1. Employee TheftWe will pay for loss of or damage to “money”, “securities” and “other property” resulting directly from “theft” committed by an “employee”, whether identified or not, acting alone or in collusion with other persons.For the purposes of this Insuring Agreement, “theft” shall also include forgery.


Direct Loss

“Direct means Direct”contract principlesno third party liability

“Proximate Cause” tort principles “direct” means “proximate”

“But For” tort principlesminority of cases


What is a loss?

actual vs. theoretical

depletion of assets

money has left the building

Computation of loss

Timing

potential income

forensic accounting

recoveries


Manifest Intent

Theft compared“Unlawful taking of ‘money’…to the deprivation of the

insured”

Three approachesspecific intentactual state of mind


Manifest Intent objective natural consequences of action

substantial certaintyconsider all circumstances

Future of intentactive and conscious purpose “intent”


Collusion

loan losses

termination or cancellation condition “…not in collusion with such person…”

active vs. passive


Financial Benefit

does not include:employee benefit earned

in the normal course of employment Majority – “normal course” includes enhanced benefit

as a result of dishonesty Minority – “normal course” does not include enhanced

benefits


Read the policyWhat law applies?Apply the law to the facts and policy

Wayne Everson, Esq. [email protected]

612-702-8374

Robert Konop, Esq. [email protected]

312-704-3879

KEY ISSUES WITH EMPLOYEE DISHONESTY AND EMPLOYEE THEFT COVERAGE

Robert M. Konop, Esq., Hinshaw & Culbertson LLP, Chicago, IL Daniel L. Morriss, Esq., Hinshaw & Culbertson LLP, Chicago, IL

___________________________________________________________________________

INTRODUCTION

This paper will address the most frequently litigated and often commented upon coverage requirements of the Employee Dishonesty Insuring Agreement of fidelity bonds. Although the requirements may be stated slightly differently depending on the bond form, they include:

Direct Loss Manifest Intent Loss Collusion Financial Benefit or Improper Gain

The purpose of this paper is to introduce the reader to the issues that arise when dealing with these requirements. For further references, please contact either of the above authors.

THE “DIRECT LOSS” REQUIREMENT1

In the majority of standard form Financial Institution Bonds, coverage begins with the phrase “Loss resulting directly from,” a relevant coverage clause. This phrase has become known as the “direct loss” coverage requirement. The purpose behind the requirement is to ensure proof that (1) the insured sustained a loss – measurable economic harm; and (2) the insured has shown, assuming all other coverage requirements are met, a direct loss – meaning a direct and immediate connection between the covered act and the claimed economic harm.

I. The Purpose and Development of a Financial Institution Bond – The Reason for the “Direct Loss” Coverage Requirement

Understanding the importance and meaning of the “direct loss” coverage requirement

appropriately begins with a review of the purpose and historical development of fidelity – or financial institution – bonds. The most common scenario presenting the direct loss issue after an insured suffers a loss as a result of a dishonest employee.

To begin, an important distinction to recognize concerning a fidelity bond is that it is not a liability policy. Aetna Cas. & Sur. Co. v. Kidder, Peabody & Co., Inc., 676 N.Y.S.2d 559 (N.Y. App. Div. 1998), appeal denied 711 N.E.2d 643 (1999). “The difference turns on what is defined as the risk.” Id. at 565. Whereas “[i]nsurance covers the liability of the insureds to a 1 The authors wish to acknowledge the contribution of Russell Ponessa, Partner with the Minneapolis office

of Hinshaw & Culbertson LLP to this section of the paper.

6504186v2 1080 2866

third-party,…fidelity bonding covers the loss of property owned by the insured or held by the insureds, as a consequence of employee dishonesty.” Id. This distinction between a fidelity bond and a liability insurance policy is well recognized in the law. See, e.g., First Mountain Mortg. Corp. v. Citizens Ins. Co., 2008 4604689, *3 (Mich. App. Ct. Oct. 9, 2008) (“employee dishonesty policies are not liability policies.”); Fireman’s Fund Ins. Co. v. Puget Sound Escrow Closers, Inc., 979 P.2d 872, 876 (Wash. App. Ct. 1999) (“a fidelity bond indemnifies only against proven losses suffered by the insured; it does not indemnify the insured against liability.”).

What was originally called a Banker’s Blanket Bond was revised in 1980, and again in 1986, and is now generally known as a Financial Institution Bond. See Wildau, Evolving Law of Third Party Claims Under Fidelity Bonds: When is Third Party Recovery Allowed, 25 Tort & Ins. L.J. 92, 93-94 (1989). The post-1980 versions of the financial institution bond contain several relevant important coverage revisions. Id. The pre-1980 revision, however, restricted the bond’s language to provide coverage only for “[l]oss resulting directly from dishonest or fraudulent acts” of employees. Id. at 94.

The inclusion of the language “loss resulting directly from” in place of the language “loss through a fraudulent or dishonest act” was deliberate. The drafters of the language, the Surety Association of America (in coordination with the American Bankers Association) wanted to make it clear that Insuring Agreement A only covered first party losses the insured sustained as a result of the dishonesty of its employees – that is, the drafters wanted to make it clear that the bond was not providing liability insurance to the insured to cover its liability to third parties. See Duncan L. Clore, Financial Institution Bonds 23-24 (2d ed. 1998). The drafters felt compelled to change the language and provide clarity because certain courts had misinterpreted fidelity bonds as covering an insured’s liability to third parties arising out of the fraud or dishonesty of the insured’s employees. See Kidder, 676 N.Y.S.2d at 565. Another key change was also made at that time to the standard form fidelity bond that is relevant here – the exclusion for “indirect of consequential loss of any nature” was added. Wildau, 25 Tort & Ins. L.J. at 117.

These changes to the financial institution bond were intended to ensure that the coverage language would not be construed by courts as providing indemnity for the insured’s liability to third parties. Lynch Props., Inc. v. Potomac Inc. Co., 140 F.3d 622, 627 (5th Cir. 1998). After the “resulting directly from” language was put into the financial institution bonds, many courts have confronted the issue of whether coverage is provided for an insured’s liability to third parties. In the vast majority of those decisions, the courts have held that a fidelity bond with the “loss resulting directly from” coverage language did not cover the insured’ liability to third parties arising out of the dishonest or fraudulent conduct of its employees.

II. The “Direct Loss” Coverage Requirement Is Unambiguous With a Plain and Ordinary Meaning Which Precludes Coverage for Losses from Third Party Liabilities.

The majority of courts that have considered the “direct loss” coverage language have

found it to be “unambiguous” with a “plain and ordinary” meaning which precludes coverage for damages from third party liabilities. For instance, in Direct Mortgage Corp. v. Nat’l Union Fire Ins. Co. of Pittsburgh, P.A., the Utah Supreme Court made its first pronouncement concerning

2 6504186v2 1080 2866

“direct loss” and fidelity coverage under Utah law. 625 F.Supp.2d 1171 (D. Utah 2008). In Direct Mortgage, an employee of an insured wholesale lending company falsified documents to enable otherwise unqualified loan applicants to obtain mortgages. Id. at 1173. The mortgages were then sold by the lending company to third party financial institutions including CitiMortgage, Countrywide Home Loans, GMAC Mortgage, and Washington Mutual. Id. When the fraud was discovered, the financial institutions demanded that the lending company buy back the fraudulent mortgages. Id. After doing so, the lending company sought coverage for the payments it made to the financial institutions from its insurer – National Union – under its employee dishonesty coverage. Id.

National Union denied the claim on the basis that coverage did not extend to an insured’s third party liabilities. Id. The U.S. District Court of Utah reviewed the history of fidelity bonds and noted the split among jurisdictions as to whether “direct loss” coverage should be reviewed under a proximate cause analysis or what has been referred to as the “direct means direct” approach. Id. 1174-75. The Court ultimately adopted the “direct means direct approach,” reasoning that the plain language of the fidelity bond demonstrates that it is not a liability insurance policy and the insured’s alleged losses were too contingent to be direct Id. at 1175-78. The Court explained:

the cause of [the lender’s] actual financial loss was third parties’ enforcement of the warranty and buy-back provisions. The losses were not immediate or readily ascertainable at the time of [the employee’s] actions. And if the third parties never discovered the fraud or if they chose not to enforce the clauses, [the lender] would not have suffered the loss it now claims.

Id. at 1178. In a footnote, the Court further stated that, “[t]he law is relatively clear that fidelity bonds do not create third party beneficiaries and that such individuals who suffer loss may not maintain direct claims against the insurance company.” Id. at 1178, n.9. Accordingly, the Court dismissed the claim against the insurer. Id. at 1178-79.

Many other courts are in accord with the Direct Mortgage decision in holding that the plain and ordinary meaning of the bond language at issue does not cover third party liability losses arising from the conduct of a dishonest employee. In First Mountain Mort. Corp. v. Citizens Ins. Co., the Michigan Appellate Court considered whether an insurer was liable to its insured after the insured was found liable to a third-party for non-economic damages caused by the fraud of its employees in connection with a mortgage for purchase of a house. 2008 WL 4604689 *1 (Mich. App. Oct. 9, 2008). The Court held that the policy was not a third-party liability policy and did not cover employers for the tortious acts committed by their employees against third-parties. Id. at *3. The Court explained, “[e]mployee dishonesty policies insure against the risk of property loss through employee dishonesty and, while the policies may cover the loss of third-party property possessed by an insured, they are not liability policies and do not protect employers against tortious acts that their employees commit against third parties.” Id.

In a decision from Minnesota concerning a “standard fidelity provision”, the Court in Cargill, Inc. v. Nat’l Union Fire Ins. Co., et al., held:

3 6504186v2 1080 2866

[T]he provision unambiguously covers only [the insured’s] direct losses, not claims arising form a third party’s direct losses, and requires that the insured’s loss – and not the third party’s claim – be directly caused by employee theft in order for coverage to become available. ‘That the insureds may be liable to a third-party for loss of money resulting from employee [theft] does not transform a policy covering the insureds against a direct loss into one indemnifying against liability.

2004 WL 51671 *10 (Minn. App. Jan. 13, 2004) (quoting Aetna Cas. & Sur. Co. v. Kidder, Peabody & Co., Inc., 676 N.Y.S.2d 559, 564 (N.Y. App. Div. 1998), appeal denied 711 N.E.2d 643 (1999)).

Similarly, in an Illinois decision, the Court in RBC Mortg. Co. v. Nat’l Union Fire Ins. Co. of Pittsburgh, stated that the phrase “loss directly from” for purposes of fidelity bond coverage means that an insured’s consequential losses resulting from third party liabilities are not covered. 812 N.E.2d 728, 737 (Ill. App. 2004). The Court explained:

A “direct loss” must be afforded its plain and ordinary meaning. (citation omitted). To equate “loss resulting directly from” with “loss proximately caused by” requires a strained reading of “direct loss” which is much narrower concept than “proximately caused loss.” This is because a proximate cause “need not be the sole cause nor the last or nearest cause. It is sufficient if it concurs with some other cause acting at the same time, which, in combination with it, causes the injury.” (citation omitted).

Id. at 736-37.

Wisconsin courts are also in agreement. For example, in Tri-City National Bank v. Federal Insurance Co., the Wisconsin Appellate Court applied the plain and ordinary meaning of a fidelity bond to hold that the plaintiff’s losses from third party settlements were outside the fidelity bond’s coverage. 674 N.W.2d 617 (Wis. Ct. App. 2003). The Court explained:

Tri-City’s losses – the settlements with the mortgage companies – are not the direct result of the employee’s dishonesty; the employees were dishonest by permitting financially inappropriate people to obtain mortgages from other entities, not the employer bank. Thus, the bank initially lost nothing as a result of their dishonesty. It was only after the unsuitable mortgagees defaulted on their loans and the mortgage company sued Tri-City that ‘losses’ resulted.

Id. at 626.

III. The Proximate Cause Approach to the Direct Loss Requirement

Some courts have interpreted the “direct loss” coverage requirement in a way as to allow a more liberal “proximate cause” standard. A careful reading of those decisions demonstrates they are often attributable to a mistaken reliance on inapplicable precedent (pre-1980 “any loss” fidelity bond and casualty insurance coverage cases) or from an improper borrowing of tort law principles (i.e. the tort law in many states equates “direct cause” with “proximate cause”). Other

4 6504186v2 1080 2866

decisions seem to misidentify the actual loss at issue, while others can only be explained as result oriented.

In Graybar Electric Co., Inc. v. Federal Ins. Co., the Eastern District Court of Missouri stated that fidelity policies reviewed under Missouri law would be subject to “a proximate cause analysis to determine if a loss was a direct result of an action.” 2007 WL 1365327 *5 (E.D. Mo. May 9, 2007). Graybar concerned losses arising from an alleged marketing and distribution agreement between the insured – a distributor of electronic and telecommunication products – and a third party distributor of office supplies. Id. at *2-3. The office supplier alleged that one of the insured’s employees entered into an agreement to jointly market and sell their products. Id. at *3. After upgrading its infrastructure and raising capital for the partnership, the insured represented that the alleged agreement was fraudulently entered into and refused to perform under the agreement. Id. Underlying litigation resulted in the insured paying the office supplier $1,775,000.00. Id. The insured then submitted this claim to its fidelity insurer for payment. Id. at *4. Coverage was extended to some, but not all of the losses and suit was filed to recover the remainder. Id.

The Court noted that, under Missouri law, “‘direct is a synonym of proximate.’” Id. at *6 (citing John Drennon & Sons Co. v. New Hampshire Ins. Co., 637 S.W.2d 339, 341 (Mo. Ct. App. 1982)). Finding no exclusionary language in the fidelity policy, the Court denied motions for summary judgment and held that “any losses that are proximately caused by the forgery are covered.” Id. at *7.

In Frontline Processing Corp. v. American Economy Ins. Co., the Montana Supreme Court applied a proximate cause analysis to determine the extent of losses under a fidelity policy. 149 P.3d 906, 335 Mont. 192 (Mont. 2006). In Frontline, an insured credit card processing company’s employee responsible for paying the insured’s taxes forged checks and failed to pay the company’s payroll and corporate income taxes. Id. at 908. The insured hired several companies to investigate the extent of its losses, including companies for forensic computer examinations, forensic handwriting analysis and financial analysts. Id. The insured then submitted the costs of these companies and the costs, penalties, interest, and fees assessed by the Internal Revenue Service resulting from the unpaid taxes to its insured for payment under an employee dishonesty policy. Id.

Under the proximate cause standard, the Court held that all of these costs were incurred by the insured as a consequential loss from an employee’s theft rather than third party losses. Id. at 910. The Court reasoned, “[the insured’s] claims are not the result of lawsuits by or settlements made to third parties. Rather,…they arise from costs incurred to investigate the extent of [the employee’s] dishonest conduct and to mitigate and remedy the discovered damage.” Id.

Similarly, in Auto Lenders Acceptance Corp. v. Gentilini Ford, the New Jersey Supreme Court reversed what was a favorable decision of the appellate division on meaning of direct loss. 854 A.2d 378, 181 N.J. 245 (N.J. 2004); see also 816 A.2d 1068, 358 N.J. Super 28 (N.J. App. Ct. 2003). The Supreme Court held that traditional principles of proximate cause should be used in determining whether an insured sustained a direct loss under employee dishonesty coverage. The facts involved a dishonest employee of the insured automobile dealer who falsified loan

5 6504186v2 1080 2866

applications for the buyers of vehicles, causing a third party lender to advance credit. The fraud was discovered, and the dealer had to make good on the loans under its agreement with the lender. The dealer’s employee dishonesty policy covered a “direct loss of” business property, money, and securities caused by employee dishonesty.

The appellate division decided the case based on the nature of the loss. It viewed the dealer’s having to pay the lender as having to satisfy a claim made by a third party – not a direct loss of the dealer’s own property. The supreme court, however, ignored the nature of the loss, and instead looked at how it occurred. It then held that if the dealer’s loss was “proximately” caused by employee dishonesty, it was “directly” caused by that dishonesty.

IV. The “But For” or “Cause-In-Fact” Approach to the Direct Loss Requirement

One final approach courts have considered in direct loss analysis, include the “but for” or “cause-in-fact” approach. In First National Bank v. Lustig, an insured bank’s employee made misrepresentations in connection with loans issued based on fraudulent reports. 961 F.2d 1162 (5th Cir. 1992). The insurer argued that losses resulted from the decline in the general real estate market. Id. at 1167. In considering whether such alleged losses were direct, the U.S. Court of Appeals for the Fifth Circuit applied Louisiana law to state that “[a] loss is directly caused by the dishonest or fraudulent act within the meaning of the Bond where the bank can demonstrate that it would not have made the loan in the absence of the fraud.” Id. at 1167-68. The Court further explained:

The [sureties] would have us read the requirement that the loss be directly caused by the dishonest or fraudulent act narrowly. Such a reading would, however, all but eliminate coverage for loans made because of dishonest or fraudulent acts. There will always be some intervening cause for the failure of these loans to be repaid; otherwise the bank would suffer no loss.

Id. at 1168. Accordingly, the Court held that “the decline in the real estate market did not preclude a finding of causation under the Bond.” Id. at 1167.

In conclusion, courts have generally taken two approaches to defining “direct loss.” The majority of courts have defined “direct loss” as unambiguous, and therefore, have precluded coverage for damages resulting from such things as third party liabilities because “direct means direct.” However, a minority of courts have allowed the more broad “proximate cause” definition of “direct loss.” Courts adopting this standard seem to mistakenly rely on inapplicable precedent regarding cases pre-1980, or on an improper borrowing of concepts from tort law. Finally, a few courts have applied a “but for” approach to direct loss. It is important to understand the jurisdictional split on this issue before proceeding in any litigation.

THE “MANIFEST INTENT” REQUIREMENT

Under the law, the definition of “intent” differs pending on the legal context. For example, under criminal law, crimes can be committed with either “general” or “specific intent.” General intent is represented by acts done by a defendant for which they know the result would be “practically certain or substantially certain to occur.” Duncan L. Clore, Financial Institution Bond, 57 (3d Ed. 2008). Specific intent is demonstrated where a “defendant actually intend[s] or

6 6504186v2 1080 2866

desire[s] the results of his actions.” Id. at 58. Under the model penal code, specific intent is more akin to “purposeful” conduct whereby a party acts with a “conscious desire” for a particular result. Id. at 59. Acts done “knowingly” is akin to general intent whereby a person acts with awareness “that a result is practically certain to follow from his conduct.” Id. (quoting U.S. v. Bailey, 444 U.S. 394, 404 (1980)). Finally, tort law constructions of intent are based on the concept that an “actor desires to cause the consequences of his act, or that he believes that the consequences are substantially certain to result from it.” Id. at 61 (quoting Restatement (Second) of Torts § 8A(1977). These different interpretations of the term “intent” have also crossed over into different courts analysis of what “manifest intent” means under fidelity policies.

In order for coverage to apply under the employee dishonesty coverage of many fidelity policies today, one requirement an insured must prove is that their employee acted with a “manifest intent” to both cause the insured to sustain a loss and obtain a financial benefit for himself or another. For example, the Crime Protection Policy of the Surety Association of America, March 2000 edition, includes the following coverage provision:

1. Employee Dishonesty

We will pay for loss of, and loss from damage to, money, securities and other property resulting directly from dishonest acts committed by an employee, whether identified or not, acting alone or in collusion with other persons, and with the manifest intent to:

a. cause you to sustain a loss; and also

b. obtain financial benefit (other than employee benefits earned in the normal course of employment, including: salaries, commission, fees, bonuses, promotions, awards, profit sharing or pensions) for:

(1) the employee; or

(2) any person or organization intended by the employee to receive that benefit.

Before 1976, a showing of “manifest intent” was not required in Commercial Crime or Financial Institution Bond policies. Exemplified in the Bankers Blanket Bond Form 24, revised in 1969, the bond provided coverage for:

loss through any dishonest or fraudulent act of any of the employees, committed anywhere and where committed alone or in collusion with others, including loss, although any such act of any of the employees, of the Property held by the Insured for any purpose or in any capacity and whether so held fortuitously or not and whether or not the Insured is liable therefore.

However, these earlier bonds did not contain a specific definition of dishonest or fraudulent acts and thus forced litigants to look to the courts to provide an appropriate definition.

7 6504186v2 1080 2866

Early court cases interpreting the dishonesty language defined dishonesty as “a want of integrity,”2 or which is “manifestly unfair to the employer,”3 and in later cases “recklessness.”4 Eventually, the courts interpreted this coverage without any reference to the intent of the employee to harm the employer. This broad interpretation of dishonesty led to a finding of coverage for claims that were never intended to be covered by the insurers.

Therefore, in response to the courts’ broad interpretation, the Employee Dishonest coverage was first modified by rider and then eventually by modification of the Financial Institution Bond in the 1980 revision of Standard Form Number 24 to include the manifest intent requirements. The language was later adopted by various Commercial Crime policies in 1986. The purpose of the revision was to restrict coverage to only those claims where an employee intended to cause a loss to the employer and a financial benefit to himself and others.

I. Three Interpretations of “Manifest Intent”

In interpreting the manifest intent language, the courts have taken essentially three approaches which can best be characterized as, “the Specific Intent test or Subjective test,” the “Objective test” and the “Substantial Certainty test.”

A. Specific Intent or Subjective Test

Courts applying the Specific Intent or Subjective Test focus on the true or actual intent of the employee, and whether the employee specifically intended to cause the employer a loss. Oriental Financial Group v. Federal Insurance Co., is a case illustrative of this approach. 309 F.Supp.2d 216, 220 (D. Puerto Rico 2004). In Oriental, an insured bank brought a claim to recover under a fidelity bond after an employee fraudulently and dishonestly manipulated bank accounts, ledgers and mortgage loans. In making a “subjective evaluation of [the employee’s] motivation,” the U.S. District Court for Puerto Rico examined deposition statements taken by the employee to determine whether he intended to cause the bank a loss. Id. at 221. Although the employee stated that he never intended to cause a loss to the bank, the Court stated that such statements alone were insufficient to prove that the requisite intent did not exist. Id. Rather, “[t]he employee’s intent to cause a loss to [the insured] may be substantiated via circumstantial evidence and ‘a claim by an employee that he intended no loss to the bank is not conclusive.’” Id. (citing FDIC v. United Pacific Ins. Co., 20 F.3d 1070, 1078 (10th Cir. 1994)).

Another example is the case of General Analytics Corporation v. CNA Ins. Co., an employee altered purchase orders to indicate that a customer had ordered one brand of parts, when in fact he had ordered a different brand. 86 F.3d 51 (4th Cir. 1996). The employer suffered a loss when the customer would not accept delivery of the altered brand of parts. Id. at 52-53. The question before the U.S. Court of Appeals for the Fourth Circuit was whether the employee, when altering the purchase orders, had a manifest intent to cause the loss suffered by the employer. Id. at 53. The Court held that in order to establish manifest intent, the employee had to have acted with a specific intent. Id. at 54. In order to determine that specific intent, the

2 United States Fidelity & Guaranty Co. v. Bank of Thorsby, 46 F.2d 950, 951 (5th Cir. 1931). 3 London & Lancashire Indemnity Co. of America v. Peoples Nat. Bank Trust Co., 59 F.2d 149, 157 (7th Cir. 1932). 4 Home Indem. Co. v. Reynolds & Co., 187 N.E.2d 274, 277 (Ill. Ct. App. 1963).

8 6504186v2 1080 2866

Court stated that it was necessary to analyze both the words and conduct of the actor, as well as all the surrounding circumstances, in order to determine the employee’s true purpose. Id. The Court then gave the following example to illustrate its point:

Thus, for example, the mere fact that a person discharges a firearm, killing a bystander, does not establish that the person holding the firearm shot the bystander with the intent to kill him. On the other hand, evidence that the person had just quarreled with the bystander (motive), that the person said, after shooting the bystander, ‘he deserved it’ (subjective expression), and that the person was seen aiming the firearm at the bystander (conduct) tends to establish the person’s intent to kill the bystander.

Id. Until resolution of such issues, summary judgment was precluded. Id.

B. Objective Test

The Objective test looks to the natural consequences of an employee’s actions, and presumes that the employee intended those consequences. In the recent case of Oriental Financial Group, Inc. v. Federal Ins. Co., an insured financial holding company filed losses under a fidelity policy after some of its employees were alleged to have committed dishonest or fraudulent acts in connection with reconciling various banking accounts. 598 F.Supp.2d 199, 203 (D. P.R. 2008). The insured’s fidelity policy only required a showing of intent, rather than “manifest” intent and was stated as follows:

The underwriter agrees to indemnify the Insured for loss resulting solely or directly from one or more dishonest acts by an Employee, whether committed alone or in collusion with others, which acts are committed with intent: (1) to cause the Insured to sustain such loss, or (2) to obtain financial benefit for the Employee.

Id. at 202 (emphasis added).

In considering whether the intent standard was satisfied, the U.S. District Court for Puerto Rico stated the proof required “that the employees acted with intent to cause the bank to sustain such loss, or to obtain financial benefit to themselves.” Id. at 214. The insured argued that the employee’s acts were intentional because they did not comport with professional regulations required of all accounting employees and because the employees testified that they intentionally committed the acts with the understanding that it was possible that the bank would suffer losses resulting from non-reconciled accounts. Id.

Although the Court ultimately held that the insured’s inability to prove the existence of a loss also precluded their ability to demonstrate intent, the Court reasoned that intent could otherwise be shown if a person “desires to cause the consequence of his acts or knows that the result is the natural and probable consequence of his actions.” Id. at 215. Accordingly, “even if a person does not desire to cause the consequences of his actions, if he knows that his actions will naturally or probably cause said consequences, then he is deemed to have acted with intent to cause them.” Id.

9 6504186v2 1080 2866

In Bancinsure, Inc. v. BNC Nat’l Bank, N.A. an insured bank’s loan officer extended several loans and lines of credit to a third party production company that obtained such loans through inaccurate financial documentation. 263 F.3d 766 (8th Cir. 2001). The employee’s husband also formed a company with the owner of the production company and later the employee and her husband bought out the owner’s interest. Id. at 769. After many of the loans and lines of credit were never repaid and were insufficiently secured, the bank submitted a loss claim to its fidelity insurer. Id.

In subsequent litigation over payment of the loss, the U.S. Court of Appeals for the Eighth Circuit considered whether the employee had the requisite manifest intent to cause a loss to the bank. Id. In its analysis, the Court affirmed the district court’s application of the following jury instruction defining “manifest intent” under North Dakota law:

You may consider any statement made or act done or omitted by a party whose intent is in issue, and all of the facts and circumstances which indicate his state of mind. You may consider it reasonable to draw the inference and find that a person intends the natural and probable consequences of acts knowingly done or knowingly omitted.

Id. at 770-71. The Court concluded that the jury’s finding of manifest intent to cause the bank a loss was supported because the employee “involved herself in such a way as to secure her own rights [regarding her company’s interests] at the expense of the bank’s security” by extending loans to the production company to in order to receive benefits to her company from the owner.

Other courts, such as those in Auto Lenders Acceptance Corp. v. Gentilini Ford, Inc., 854 A.2d 378 (N.J. 2004) and Transamerica Ins. Co. v. FDIC, 465 N.W.2d 713 (Minn. Ct. App. 1991) rev’d on other grounds, 489 N.W.2d 224 (Minn. 1992), have also held that a person is deemed to have intended the natural consequences of his actions. The test does not look to the actual intent of the actor, but focuses primarily on the results of his actions. Therefore, an employee may be acting with the best of intentions, but if he engages in reckless conduct, the natural consequence of which is a loss to the employer, the Objective test would find that he acted with a manifest intent to cause the loss.

C. Substantial Certainty Test

Courts adopting this approach may look to evidence of the specific intent of the actor, but such intent is not controlling. A court also looks at all of the circumstances surrounding the loss to determine whether or not the loss to the employer was substantially certain to result from the actions of the employee. Accordingly, this approach can produce differing results depending on how the court weighs evidence of actual intent.

In Phillip R. Seaver Title Co., Inc. v. Great Amer. Ins. Co., an insured title company’s escrow closing agent responsible for receiving client money and placing it into appropriate escrow accounts began embezzling money for personal use. 2008 WL 4427582, *1 (E.D. Mich. Sept. 30, 2008). To cover up the scheme, the agent transferred money between accounts to cover shortfalls in other accounts. Id. After discovering the scheme, the title company replenished funds from the escrow accounts affected and submitted a claim to its insurer under a Crime

10 6504186v2 1080 2866

Protection Policy that covered loses for employee dishonesty. Id. The insurer denied coverage for claims relating to money the title company paid into its escrow account. Id.

The U.S. District Court for the Eastern District of Michigan first held that the losses for replenishing client accounts were direct, rather than third party losses because the title company’s “overall funds were directly impacted” by the dishonest employee’s acts. Id. at *3. Thereafter, the Court considered whether the employee acted with the requisite intent, stating “the concept of ‘manifest intent’ does not necessarily require that the employee actively wish for or desire a particular result, it does require more than a mere probability.” Id. at *4 (quoting F.D.I.C. v. St. Paul Fire & Marine Ins. Co., 942 F.2d 1032, 1035 (6th Cir. 1991)) (internal quotations omitted). “Manifest intent exists when a particular result is ‘substantially certain’ to follow from conduct.” Id. (quoting Peoples Bank & Trust Co. of Madison County v. Aetna Cas. & Sur. Co., 113 F.3d 629, 635 (6th Cir. 1997)) (internal quotations omitted). Accordingly, the Court stated that it would not “delve into [the employee’s] mind to determine whether she intended to harm [the title company],” but concluded “as a matter of law, based on [the employee’s] conduct, there was substantial certainty [the title company] would face a financial loss as a result of her embezzlement.” Id. at *5.

Similarly, the U.S. Court of Appeals for the Tenth Circuit, in FDIC v. United Pacific, stated:

Manifest intent does not require that the employee actively wish for or desired a particular result; rather, manifest intent exists when a particular result is substantially certain to follow from the employee’s conduct. Manifest intent to cause loss may be inferred from an employee’s reckless conduct and other circumstantial evidence. Direct evidence of the employee’s intent is not required, and a claim by an employee that he intended no loss to the bank is not conclusive.

20 F.3d 1070, 1078 (10th Cir. 1994).

II. The Future of Manifest Intent

The Oriental reading of manifest intent comports with the latest revision of the Surety Association of America Financial Institution Bond Form 24, which has replaced “manifest intent” with the terms “active and conscious purpose.” In adopting this language, the Surety Association stated its reasoning as follows:

The change was made in light of the fact that some judicial decisions misinterpreted the meaning of ‘manifest intent.’ In those cases[,] courts applied a tort concept of intent and found that the employee intended the natural and probable consequences of his acts or intended a result substantially certain to occur. The drafters of the language intended a stricter meeting of a conscious object to cause the result. ‘Active and conscious purpose’ is meant to restore that standard.

Letter from Robert J. Duke, Director – Underwriting of the Surety Association of America dated December 24, 2003 to Alabama Commissioner of Insurance.

11 6504186v2 1080 2866

Whether or not this wording will be adopted by more carriers is yet to be seen. Competitive issues will certainly play a role in the ultimate decision.

Overall, courts have taken three different approaches in interpreting “manifest intent” which include: the “Specific Intent or Subjective test,” the “Objective test,” and the “Substantial certainty test. Because of these different interpretations, the Surety Association of America Financial Institution Bond Form 24 has replaced “manifest intent” with the terms “active and conscious purpose” in order to reiterate the policies true objectives. Only time will tell if this new language will be adopted by insurers and thus will help the courts interpret the policy as the drafters intended.

THE LOSS REQUIREMENT

When determining whether a loss occurred under a typical fidelity institution bond the threshold question presented is was there an actual loss. Bradford Carver, Handling Fidelity Bond Claims 364 (Michael Keely and Sean Duffy eds., ABA Publishing (2d ed. 2005)). Addressing the first question, most financial institution bonds do not define the word “loss” and thereby leave it to the courts to do so. Id. at 365. In Cincinnati Insurance Co. v. Star Financial Bank, the U.S. Court of Appeals for the Seventh Circuit defined “loss” as an “actual present loss, as distinguished from a theoretical or bookkeeping loss.” 35 F.3d 1186, 1191 (7th Cir. 1994). This definition of loss was recently applied in Oriental Financial Group, Inc. v. Federal Insurance Co., Inc., where employees of an insured financial holding company fraudulently reconciled customer bank accounts. 598 F.Supp.2d 199, 203. This allegedly prevented the insured from reconciling accounts to the extent of creating a $3.4 million loss. Id. at 208. The U.S. District Court for Puerto Rico stated:

Loss under a fidelity bond refers to actual loss, as distinguished from a theoretical or bookkeeping loss. A recoverable loss is a direct loss, or the actual depletion of funds, i.e. cash, caused by the employee’s dishonest acts. Bookkeeping or theoretical losses, not accompanied by actual withdrawals of cash or other such pecuniary loss, are not recoverable losses.

Id. at 209. The Court further stated that loss could be proved through circumstantial evidence as the insured did “not need to prove its loss with mathematical precision or certainty, or to identify the specific items that make up the loss.” Id.

The insured alleged that it suffered losses by its inability “to realize its assets because it could not obtain the supporting documentation to properly reconcile the accounts.” Id. The Court stated that such might represent loss if it was proved that “more likely than not, [the insured] would have realized assets upon complete reconciliation of the pending transactions.” Id. Because the transactions that made up the unreconciled amounts could not be identified, the Court held that no actionable loss occurred under the insured’s fidelity bond because it was unable to prove that “money left the bank or that it could not realize assets it otherwise would have.” Id. at 210. Further, the Court explained that “[e]ven if there was a write-off, the evidence show[ed] that more likely than not, the write-off was an accounting adjustment not based on actual loss.” Id.

12 6504186v2 1080 2866

In Fireman’s Fund Insurance Co. v. Special Olympics International, Inc., an insured charity filed a claim under its fidelity policy after its employee conducted an unauthorized fund-raising scheme to raise over $1 million that was used by the employee for personal expenses. 249 F.Supp.2d 19, 23 (D. Mass. 2003). The employee deposited the donations in a bank account fraudulently opened using the insured’s name and other business documentation. Id. The insured argued that its “loss” was comprised of the contributions fraudulently obtained through use of the its name as the employee’s misconduct was allegedly “tantamount to his taking checks from [the charity’s] mailbox, from its authorized accounts, or from its petty cash supply.”. Id. at 27-28. The U.S. District Court for Massachusetts disagreed, stating that “donations,’ made without [the insured’s] knowledge and deposited into an account over which [the insured] had no knowledge or control, were not consummated gifts,…[and thus], were not included in [the insured’s] assets.” Id. at 28. The Court concluded that the donors, rather than the insured, were the parties to have suffered a loss of tangible assets from the fraudulent scheme. Id. at 29.

Other instances where courts have found losses to occur are, First State Bank of Monticello v. Ohio Casualty Insurance Co., the U.S. Court of Appeals for the Seventh Circuit which applied Illinois law to find that a loss occurred when dishonest employee “repeatedly exchanged bad checks for the [insured bank’s] money orders,” resulting in dishonor of the insured’s attempt to cash the checks. 555 F.3d 564, 569 (7th Cir. 2008). Similarly, in FDIC v. United Pacific Insurance Co., the U.S. Court of Appeals for the Tenth Circuit applied Utah law to rule an insured bank suffered losses when acts of its dishonest employee actually caused it to disburse a $4.5 million loan that could not be recovered. 20 F.3d 1070, 1080 (10th Cir. 1994); see also Amer. Trust & Sav. Bank v. U.S. Fidelity & Guar. Co., 418 N.W.2d 853, 855 (Iowa 1988) (“‘loss’…refer[s] to the actual depletion of bank funds caused by the employee’s dishonest acts and not the eventual personal liability of the employee to the bank.”).

These cases underscore the point that a loss will not be deemed to occur unless the answer is “yes” to the colloquial question, “has any money left the doors of the insured?” Carver, 365. Bookkeeping and other indirect or theoretical losses normally do not qualify as loss. In determining the ultimate amount of loss other issues such as the method of computation of loss and how recoveries are to be applied also come into play. Carver, 367-369. These issues are more fully addressed by Bradford R. Carver in Handling Fidelity Bond Claims referenced above.

THE COLLUSION REQUIREMENT

Often, disputes concerning the requirement of collusion under fidelity policies arise out of a situation where another employee has knowledge of a dishonesty employee’s conduct, but remains silent. Michael Keely, Lisa A. Block, Loan Loss Coverage Under Financial Institution Bonds 59 (Gilbert J. Schroeder and John J. Tomain, eds. ABA Publishing (2007)). In such instances, courts have considered whether the silent employee is colluding with the dishonest employee for purposes of coverage under a loan loss. Id. This area of the law, however, has not been the subject of a significant amount of litigation over the years.

In Adair State Bank v. American Casualty Company of Reading Pennsylvania, the chairman of an insured bank’s board of directors engaged in a check-kiting scheme by writing checks that would normally overdraft his account but for his practice of writing checks from

13 6504186v2 1080 2866

another overdrawn account at a separate bank to cover up the insufficient balance the chairman had on his account with the insured bank. 949 F.2d 1067, 1069-70 (10th Cir. 1991), overruled on other grounds, Stauth v. Nat’l Union Fire Ins. Co., 236 F.3d 1260 (10th Cir. 2001). Three of the insured bank’s officers knew of the chairman’s scheme, but did not disclose the fraudulent transactions for various reasons. Id. Two of the officers – a vice president and a secretary/cashier of the insured bank – were cousins of the chairman, one of which remained silent due to worry about “relatives inside and outside of the bank and about the effect on the family name if her cousin were exposed.” Id. The third officer to discover the scheme was the president of the insured bank and also a half-brother of the chairman. Id. at 1070. The president confronted the chairman about the scheme, but in return was threatened with financial ruin and loss of income and livelihood should he disclose the fraudulent transactions. Id. The chairman’s scheme was later discovered during an FDIC examination. Id. at 1071.

The insured’s fidelity bond covered “loss resulting directly from dishonest or fraudulent acts of an Employee committed alone or in collusion with others.” Id. at 1072. During litigation over a coverage dispute, both the insured and insurer agreed that fraudulent or dishonest acts were committed by the chairman with the requisite manifest intent to cause the bank a loss and to obtain a financial benefit. Id. A remaining issue was whether the chairman’s acts were committed in “collusion” with the officers. Id. The president honored checks written by the chairman while knowing there was insufficient funds in his account and attempted to borrow money to place in the chairman’s account to hide the scheme during the FDIC investigation. Id. at 1073. The vice president, responsible for internal control of the insured bank, submitted reports to the board of directors that hid the chairman’s actions and even attempted to sell her shares in the insured bank before the chairman’s actions were discovered. Id. at 1073-74. The secretary had no conversations with the chairman about the scheme, but was still responsible for submitting reports to the board of directors that neglected to report the chairman’s actions.

Because the policy did not define the term, the U.S. District Court applied a plain and ordinary definition of “collusion” from Black’s Law Dictionary to make a finding of collusion. Id. at 1075. The Court held:

An agreement between two or more persons to defraud a person of his rights by the forms of law, or to obtain an object forbidden by law. It implies the existence of fraud of some kind, the employment of fraudulent means, or of lawful means for the accomplishment of an unlawful purpose….A secret combination, conspiracy, or concert of action between two or more persons for fraudulent or deceitful purpose.

Id. (quoting Black’s Law Dictionary 240 (5th ed. 1979)). On appeal, the U.S. Court of Appeals for the Tenth Circuit only addressed whether the District Court’s ruling that the secretary was in collusion with the chairman was correct. Id. The Court affirmed the ruling and, by its silence as to the other officers, implicitly agreed that the dictionary definition and application of collusion was correct as to the remaining officers. Id. at 1075-76.

Similarly, in FDIC v. Aetna Casualty & Surety Co., 947 F.2d 196, 210 (6th Cir. 1991), the U.S. Court of Appeals for the Sixth Circuit affirmed the following jury instruction defining “collusion” over the insurer’s argument that the instruction equated silence with collusion when

14 6504186v2 1080 2866

it stated: “In determining whether a director or officer was in collusion with [the dishonest employee], you may consider the silence of that person or his or her failure to report the dishonesty to the Board of Directors or regulatory authorities as evidence of collusion.” The U.S. District Court for Tennessee explained that “[t]he instruction does not equate silence with collusion; it simply states the logical conclusion that silence may be considered as evidence of such collusion.” Id. The Sixth Circuit considered this rationale sound because the district court’s charge further stated that “someone who colludes with another is one who enables, participates with or otherwise aids and abets his dishonest act by action or inaction.” Id.

In many cases, the insured argues that collusion in presumed to have occurred between, for example, a loan officer of a bank and a borrower. This is not always the case, as it was demonstrated in Standard Chartered Bank v. Milus, 826 F.Supp. 310, 311 (D. Ariz. 1990). In this case, an insured bank’s vice president and chief credit officer gave two illiquid borrowers undercollateralized loans for millions of dollars. Id. The loans were intended to keep the borrowers from defaulting with the bank since the borrows ran a business that the vice president owned shares in through a stock option plan. Id. The term “collusion” was not defined in the bank’s fidelity policy, but the Court stated that it was agreed “that the term collusion is synonymous with the term conspiracy as it is used in the criminal context.” Id. at 312. The insured argued that collusion was present in the transaction because the approval of the bank loans were under such “egregious circumstances” that the borrowers must have known they were being approved for the vice president’s own purposes. Id. at 312.

The U.S. District Court for Arizona disagreed, stating that “[t]he fact that the loans were allegedly supported by worthless collateral does not support an inference that [the borrowers] knew of or intended to promote [the vice president’s] scheme, because there is no allegation that [the borrowers] engaged in activity knowingly designed to encourage the unauthorized lending of funds.” Id. at 313 (emphasis in original). The Court further explained that the “gist of conspiracy” is “intent…given effect by overt act.” Id. (quoting Direct Sales v. U.S., 319 U.S. 703 (1943)) (internal quotations omitted). Without evidence of “clear and unequivocal” knowledge, “allegations of conspiracy [would be] made by piling inference upon inference.” Id.; see also Progressive Casualty Ins. Co. v. First Bank, 828 F.Supp. 473 (S.D. Tex. 1993) (insured’s allegation that dishonest employee violated bank policies in loans given to personal friends not enough to establish collusion without satisfying bond’s requirement that “there must be collusion, at least inferable, from the banker’s personal secret gain.”).

Overall, these cases demonstrate that mere silence alone will not be enough to implicate an otherwise honest employee’s conduct with a dishonest employee’s conduct for purposes of establishing “collusion” under a fidelity bond. Evidence to implicate the other employees as colluding with a dishonest employee needs to include facts suggesting active participation in the fraudulent scheme or affirmative neglect in correcting known errors that assist the dishonest employee in further perpetrating fraud.

THE FINANCIAL BENEFIT OR IMPROPER GAIN REQUIREMENT

The Employee Dishonesty Insuring Agreement requires that for coverage to apply the employee must not only have a manifest intent to cause a loss to the insured, but also a manifest intent to obtain a financial benefit for himself or for another person or organization to whom the

15 6504186v2 1080 2866

benefit is intended. The coverage grant parenthetically excepts from the term “financial benefit,” “employee salaries, commissions, fees, bonuses, promotions, awards, profit sharing and pensions or other employee benefits earned in the normal course of employment.” The question arises whether or not fraudulently obtained employee benefits are also excluded by the parenthetical language. The majority of courts have found that employee benefits, whether or not obtained by fraud, are excluded from the financial benefit requirement.

In Mortgage Associates, Inc. v. Fidelity & Deposit Co. of Maryland, the California Appellate Court provided an extensive discussion of the importance of the “financial benefit” requirement under fidelity bonds. 129 Cal. Rptr. 2d 365 (Cal. Ct. App. 2002). The Court stated:

The financial benefit requirement protects the insurer from claims where the employee’s motivation is either undeterminable or intangible. The employee must, instead, have acted dishonestly with the intent or motivation to receive financial gain for himself or for some third party. It is this additional financial motivation which implicates coverage under the employee dishonesty coverage provisions. Not only does the financial benefit requirement limit coverage to that intended under the policy or bond, it also helps to focus coverage on truly dishonest conduct and not conduct which is merely improper, negligent, or incompetent. An employee [who] causes his employer to incur a loss without receipt of any financial benefit rarely acts with the intent or malice which is implicit in the employee dishonesty coverage.

Id. at 379 (citing Armentrout & Price, Financial Benefit Requirement 4 (unpublished paper presented at 2002 Annual Midwinter Meeting of the Fidelity & Surety Law Committee of the ABA, New York, New York, January 2002).

Recently, in Palm Hills Properties, L.L.C. v. Continental Ins. Co., an insured property company’s employee, who was responsible for showing and renting various apartments, began misrepresenting the status of apartment rentals in order to collect bonuses in addition to her salary and commissions. 2008 WL 4303817 (M.D. La. July 23, 2008). After the company filed a loss claim under its fidelity policy, the U.S. District Court for the Middle District of Louisiana considered whether the employee demonstrated a manifest intent to obtain a financial benefit. Id. at *4. The insured’s policy, precluded “employee benefits earned in the normal course of employment, including: salaries, commissions, bonuses, promotions, awards, profit sharing or pensions.” Id. Accordingly, the Court held that the “plain language of the policy clearly exclude[d]” coverage for the alleged financial benefits resulting from the employee’s salary and bonuses. Id.

In perhaps an exceptional case, the U.S. District Court of Colorado in F.D.I.C. v. St. Paul Companies, denied summary judgment to an insurer which argued that bonuses resulting from fraud were precluded “financial benefits” under a fidelity policy. 634 F.Supp.2d 1213 (D. Col. 2008). The case involved an insured bank and third party that entered into a marketing and processing agreement whereby the third party sold travel memberships and offered its customers a bank-issued credit card to make their initial travel charges. Although the third party agreed to purchase the bank’s delinquent accounts, it began to re-age such accounts to make them appear

16 6504186v2 1080 2866

current. Id. at 1217. After discovering the scheme, certain bank employees began participating in the scheme and collecting bonuses therefrom. Id.

Under the insured’s Fidelity Insuring Agreement, “financial benefit” did not include “any employee benefits earned in the normal course of employment, including: salaries, commissions, fees, bonuses, promotions, awards, profit sharing or pensions.” Id. at 1221. The bank argued that the employees received financial benefits from the third party in addition to the bonuses. Id. Additionally they argued that the bonuses were derivative of embezzlement rather than the normal course of employment. Id. Moreover, the bank stated that the agreement covered financial benefits obtained for other persons such as the third party. Id. After taking note of testimony that the employees’ relationships with the third party was “very valuable,” the Court held that an issue of fact existed as to whether or not the employees obtained a financial benefit other than the bonuses. Id. at 1222.

Other courts have been more clear regarding the financial benefit requirement. For example, in Performance Autoplex II Limited v. Midcontinent Casualty Co., an employee of an auto dealer obtained an unauthorized pay increase for herself and another person. The insured sought coverage under the policy arguing that the pay increase was not “earned” and was not obtained “in the normal course of employment,” and, therefore, the exclusionary language would not apply. 322 F.3d 847 (5th Cir. 2003). The Court disagreed with the insured’s argument and found no coverage, stating:

Looking at the plain language of a policy, the interpretation of rejecting coverage makes sense. If ‘in the normal course of employment’ means ‘not obtained through employee dishonesty’ the policy language excluding salaries would become mere surplusage. That is, the language excluding salaries presumes that there are acts of employee dishonesty that result in increased employee benefits that the insured and insurer agreed to exclude from coverage.

Id. at 858; see also First Bank of Marietta v. Hartford Underwriters Mutual Ins. Co., 997 F.Supp. 934 (S.D. Ohio 1998) (court denying alleged financial benefits obtained by a dishonest employee consisting of “enhancement in the eyes of the local community and enhancement in the eyes of [the insured].”); Municipal Securities, Inc. v. Ins. Co. of North America, 829 F.2d 7, 9-10 (6th Cir.1987) (No financial benefit was found in where a securities dealer made trades beyond the insured’s inventory limit and committed other intentional reporting errors in order to obtain unearned commissions because they were obtained in the normal course of employment regardless of the fraudulent circumstances.).

There are a minority of cases holding to the contrary, including Cincinnati Ins. Co. v. Tuscaloosa County Parking and Transit Auth., 827 S.2d 765 (Ala. 2002) and Klyn v. Travelers Indemnity Co., 709 N.Y.S.2d 780 (N.Y. App. Div. 2000) holding that unauthorized salary increases due to employee dishonesty would be covered losses, as they are not employee benefits earned in the normal course of employment.

To summarize, for coverage under most Employee Dishonesty Insuring Agreements, the employee must not only have a manifest intent to cause a loss to the insured, but also a manifest intent to obtain a financial benefit to himself or to another person or organization to whom the

17 6504186v2 1080 2866

18 6504186v2 1080 2866

benefit is intended. The majority of courts have found that employee benefits, whether or not obtained by fraud, are excluded from the financial benefit requirement. The court in Performance Autoplex II Limited most succinctly summed up the majority opinion, when they held, “[i]f ‘in the normal course of employment’ means ‘not obtained through employee dishonesty’ the policy language excluding salaries would become surplusage.” 322 F.3d at 858. Despite the majority position, a minority of courts have held that an unauthorized salary increase due to an employee’s dishonesty would be covered.

The overall conclusion that can be drawn from the foregoing discussion of the issues arising under the Employee Dishonesty Insuring Agreement, is that the analysis is dependent on the law of the appropriate jurisdiction. Therefore, it is imperative that one consider the varying results that can derive depending on the law of the jurisdiction which is being applied.

HB LITIGATION CONFERENCES

FIDELITY BOND AND CRIME COVERAGE CONFERENCE Thursday, December 3, 2009

EMERGING COVERAGE DISPUTES

William Bogaert, Esq.Wilson Elser Moskowitz Edelman & Dicker LLP260 Franklin Street - 14th FloorBoston, MA 02110-3112tel 617-422-5391fax [email protected]

Lisa M. Cirando, Esq.Orrick, Herrington & Sutcliffe LLP666 Fifth AvenueNew York, NY 10103-0001 tel 212.506.5157fax [email protected]

2

Caesar: Let me have men about me that are fat,

Sleek-headed men and such as sleep a-nights.

Yond Cassius has a lean and hungry look,

He thinks too much; such men are dangerous.

Julius Caesar Act 1, Scene 2, 190-195

4

CAUSATION

When a warehouse lender receives promissory notes with forged signatures on underlying fraudulent transactions, will Insuring Agreements D or E provide coverage?

5

CAUSATION


YES

Union Planters Bank, N.A. v. Continental Cas. Co., 478 F.3d 759 (6th Cir. 2007)

6

CAUSATION


YES

Union Planters Bank, N.A. v. Continental Cas. Co., 478 F.3d 759 (6th Cir. 2007)

NO

Flagstar Bank, F.S.B. v. Federal Ins. Co., 260 Fed. Appx. 820, 2008 WL 162946 (6th Cir. 2008)

7

INSURING AGREEMENTS (D) (E)

FORGERY OR ALTERATION

(D) Loss resulting directly from the Insured having, in good faith, paid or transferred any Property in reliance on any Written, Original

(1) Negotiable Instrument (except an Evidence of Debt) . . .

which (a) bears a handwritten signature of any maker, drawer or endorser which is a Forgery; or (b) is altered but only to the extent the Forgery or alteration causes the loss.

SECURITIES

(E) 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 or given value, extended credit or assumed liability, on the faith of, any Written, Original . . .

(c) Deed, mortgage or other instrument conveying title to, or creating or discharging a lien upon, real property . . .

which (i) bears a handwritten signature of any maker, drawer, issuer, endorser, assignor, lessee, transfer agent, registrar acceptor, surety, guarantor, or of any other person whose signature is material to the validity or enforceability of the security, which is a Forgery, or (ii) is altered, or (iii) is lost or stolen.

8

NEGLIGENCE

It is well settled that negligence of the policyholder does not bar recovery absent a clear and specific contractual limitation or circumstance.

“Neither negligence nor inattention, nor any failure to discover what by diligence might have been discovered, nothing, in fact, short of actual discovery by the bank of dishonesty or a positive breach of an imperative condition, will defeat claims for loss caused by that dishonesty, unless it is otherwise provided in the contract.” USF&G v. Comm. Nat’l Bank, 62 F.2d 718, 719-20 (5th Cir. 1933)

9

Can you introduce negligence to prove causation?

“Solely or directly” causation language

Oriental Financial Group, Inc. v. Fed. Ins. Co., 598 F. Supp. 2d 199, 212 (D.P.R. 2008)

10

THIRD PARTY CLAIMS

Claims based upon the policyholder’s liability for damages caused by perpetration of fraud on a third party

OR

Claims based upon misappropriation of third party property while in the possession, custody or control of the policyholder

11

QUESTIONS?

Oh what a tangled web we weave

When first we practice to deceive.

--Sir Walter Scott (Marmion, 1808)

Unique Issues In Special Cases: Computer Funds Transfer Fraud,

Loan Loss, and Inventory Loss

John J. McDonald, Esq. Kerry M. Evensen, Esq.Meagher & Geer, PLLP Assistant Vice President - Claims33 South 6th Street, Suite 4400 OneBeacon Insurance CompanyMinneapolis, MN 55402 601 Carlson Parkway, Suite 700612-338-0661 Minnetonka, MN [email protected] 651-210-0172www.meagher.com [email protected]

www.onebeacon.com

Eric E. EmmetteTripoli Risk Management, LLCP.O. Box 21573St. Paul, MN [email protected]

Computer Fraud and Funds Transfer Fraud

o Today’s world is electronico Business and banking

no exception

o Computer enables “invisible” criminal

o Average computer crime losses doubled from 2006 to 2007

o Insurance industry “response”:

o Computer Fraud Coverage

o Funds Transfer Fraud Coverage

Computer Fraud Coverage

o ISO Form Fo “Computer Fraud” defined as:

o “theft” of property following and directly related to the use of any computer to fraudulently cause a transfer of that property from inside the “premises” or “banking premises” to a person (other than a “messenger”) outside those “premises” or to a place outside those “premises.”


o Generally intended to protect from third- party’s use of a computer to “hack” into insured’s computer system and cause a transfer of funds from the insured’s (or its bank’s) premises.


o ISO Form Fo Standard exclusions:

o Inventory Shortageso Traditional exclusion, precluding loss for which

the proof is dependent on an inventory profit and loss computation.

o Acts of Employees, Directors, Trustees or Representatives

o No coverage for dishonest or criminal acts of “inside” party, whether alone or in collusion with others, or while performing services for the insured or otherwise.

o Potential gap –

o Fidelity insuring agreement will normally pick up loss caused by employee, but if the individual is not an employee, yet still an “inside” party under the Computer Fraud Coverage, no coverage will be available.

o Example: Bank hires non-employee third-party to process credit-card payments to vendors for charges made on cards. In this arrangement, third-party is given access to bank’s computer system to issue payments to the vendors.

o However, third-party processor uses access to computer system to issue fraudulent payments to himself.

o Here, the processor is not an employee, but is still an “inside” party who is authorized to access the bank’s computer system.

o Endorsements usually fill this gap.


o Market has created many insurer-specific forms as wello Allows niche endorsements designed for

specific businesses

o Focus remains on third-party theft of assets through the use of a computer


o Insurer-specific forms:o Exclusion for giving or surrendering covered

property in any purchase or exchange, whether legitimate or fraudulent.o Reinforces coverage is available for traditional

theft, not swindle.o Not limited to salesperson error.


o Insurer-specific forms:o No coverage for loss resulting directly or

indirectly from input of “Electronic Data” by someone authorized to enter the insured’s computer system.

o What is “Electronic Data”?


“Electronic Data” generally includes facts or information converted to a form that the computer system uses in performing its function.

o It is the data – not the programo No coverage for incorrect data inputo Does not preclude coverage for altering

program


o Insurer-specific forms:o Coverage limited to “covered property”

o Most often moneyo Not intangible property or confidential informationo “Electronic data” and “computer programs” fall

within scope of exclusion

Funds Transfer Fraud Coverage

o “Funds Transfer Fraud”1) an electronic, etc., instruction fraudulently

transmitted to a Financial Institution directing such institution to debit the insured’s Transfer Account and pay money from the Transfer Account. The instruction purports to come from the insured, but is fraudulently transmitted by someone else, without the insured’s knowledge or consent.


o “Funds Transfer Fraud”2) fraudulent written instructions (other than one

covered under I.A.B) to Financial Institution directing it to debit a Transfer Account and pay money from such by use of an electronic funds transfer system at specified intervals or under specified conditions.Written instruction purports to come from insured, but fraudulently issued, Forged, or altered by someone else without insured’s knowledge or consent.


o “Funds Transfer Fraud”Or3) an electronic, etc. or written instruction

initially received by insured which purports to have been transmitted by Employee, but fraudulently transmitted by someone else without insured’s or Employee’s consent.


o What is a “Transfer Account”?o ISO Form: an account maintained by the

insured at a financial institution from which insured can initiate the transfer, payment or delivery of funds through electronic or telephonic instructions directly through an electronic funds transfer system, or by written instructions establishing the conditions under which the transfer is to be initiated by the financial institution through an electronic funds transfer system.


o Broad definition of “Transfer Account” seems to leave little room for excluding any standard account in today’s business world.

o Other forms define as an account from which the insured “can initiate the transfer, payment or delivery of Money or Securities.”


o Provides coverage for losses caused by fraudulent written, telephonic or teletype instructions.o Mirroring the way business was transacted

before computers.

o Computer Fraud and Funds Transfer Fraud Coverages intended to be mutually exclusive

o Computer Fraud excludes loss resulting from “fraudulent instruction” directing payment or transfer from “transfer account”

o Funds Transfer Fraud excludes loss resulting from use of any computer to cause transfer

o As Computer Fraud does not cover loss from “transfer account,” essential too Identify the method used in the loss;o Determine the type of account from which the

loss was sustained, which requireso Specifying the means by which the transfer can

be made. (I.e, can the transfer be made through an electronic funds transfer system)?

o Other differences:

o Computer Fraud = “Money, Securities, and Other Property”

o Other Property would include inventoryo Other Property must be tangible

o Funds Transfer Fraud = “Money or Securities,” or “Funds” only

o Practical application; content of a transfer account limited to funds, money, or securities.

Common issues

o What is a computer?o Sometimes not defined, and rarely addressed

in case law.o A court has ruled that the use of facsimile

machine stretched meaning of “computer” too far, as it is commonly understood.

o Look at definitions of “computer” in computer crime statutes

o Telephone voice mailbox; automated telephone systemo Mere use of telephone insufficient – must manipulate

computer technology.

Common issues

o What extent must the theft involve a computer such to directly relate to use of a computer?o Direct means direct.o Passive instrument in facilitating the loss

should not be enough.

Scenario 1

Prepaid Gift Cards ‘R Uso To cash in on the growing popularity and

convenience of gift cards, Prepaid Gift Cards ‘R Us (PGC) set up a distribution network whereby its customers would send a fax of a post dated check and a bank guarantee to receive gift cards.

o PCG received a fax from one of its dealers ordering $2 million worth of gift cards. Later PCG met with a known employee of that dealer who delivered the original post-dated check and bank guarantee in exchange for the gift cards.

o A few days after the exchange, the dealer denied authorizing the transaction and the now former employee was never heard of again.

Scenario 1

o In this scenario, the thief used:o a facsimile machine;o to fraudulently transfer covered Property;o from the insured’s Premises where they conduct

business;o directly caused by Computer Theft.

o Claim submitted on PCG’s Crime Policy for Computer Fraud.

o Covered?

Scenario 1

o Denied: No coverage under PCG’s Crime Policy:o Were the gift cards covered “Property”?o Did the loss occur on the insured’s Premises or its

Banking Premises?o Did the facsimile transmission “fraudulently cause

a transfer” of the gift cards as required by the Computer Fraud definition?

o Exclusion for giving or surrendering covered property in any purchase or exchange, whether legitimate or fraudulent.

Scenario 1 Case Law

o Brightpoint, Inc. v. Zurich American Ins. Co.o Phone cards were not transferred from inside

the “premises”o Loss did not flow immediately from use of

computer, so no direct cause.

o Cases very limited regarding Computer Fraud

Scenario 2

First National Banko A customer of First National has an agreement with

the bank permitting its Treasurer to initiate wire transfers by computer using secured login and password information.

o Computer hacker breaks into the customer’s computer system and steals the Treasurer’s login and password for wire transfers.

o Hacker uses login and password to initiate wire transfer of $1 million from the bank’s customer account to hacker’s offshore account.

Scenario 2

o In this scenario, the hacker:o used a computer;o to fraudulently transfer money;o from inside First National’s banking premises;o to a place outside those premises.

o Hacker’s use of a computer directly caused the loss to the customer – there were no intervening actions between the use of the computer and the loss to the customer.

o Claim submitted on First National’s F.I. Bondo Covered?

Scenario 2

o Denied: No coverage under First National’s Bond:o The Treasurer’s login and password were

authorized to enter into the insured’s computer system.

o U.C.C. Section 4A-202(b)o Electronic Funds Transfer Act (“EFTA”) 15 U.S.C.

§1693.o Coverage would likely fall under First National’s

customer’s Crime Policy, if their coverage included Computer Fraud.

Scenario 2 Case Law

o Funds Transfer Fraud Coverageo Northside Bank v. American Cas. Co.

o “obvious intent of the insurance policy”:o Protect insured from someone breaking into

the electronic funds transfer system and pretending to be an authorized person, or

o Protect insured from someone altering the electronic instructions to divert monies from the rightful recipient.

Scenario 3

OffMad Securitieso OffMad agreed to provide custodial services for its

customer State Penn Securities (SPS). o In order to facilitate transactions, OffMad provided

SPS with access to its computer system. Due to a series of transactions, one of SPS’s clients had ordered SPS not to engage in any trading. OffMad was not informed of this change in status.

o SPS later instructed OffMad to liquidate the client’s portfolio through instructions sent by computer, fax and voice by persons authorized by SPS.

Scenario 3

o In this scenario, OffMad suffered a loss as a result of o Fraudulent instructions via voice, fax and

computer.o Claim submitted on OffMad’s Financial

Institution Bond for Computer Fraud.o Covered?

Scenario 3

o Denied: No coverage under OffMad’s F.I. Bond:o Facsimile Transfer Instructions were sent by an

authorized person of SPS.o Fraud was committed by an authorized person of

the Insured.

o Potential coverage could exist under Customer Voice Initiated Transfers if it is determined that SPS had exceeded their authority in the custodial agreement. Coverage may not be limited to imposters or hackers.

Scenario 3 Case Law

o Funds Transfer Fraud Coverageo Morgan Stanley Dean Witter & Co v. Chubb Group

o Actions of authorized representative and input of electronic data precluded coverage under “Computer Systems” and “Facsimile Transfer Instructions” coverages.

o Coverage available under “Customer Voice Initiated Transfers” coverage.

o Was not limited to “imposters or hackers”o Also important to determine where the transfer of

property occurred. If transfer occurred outside of insured’s or insured’s bank’s premises, then the claim likely is not covered.

o Limited case law is encouraging…o Courts have been unwilling to interpret the

language out of contexto Look to the intent of the coverageo Thus far, unambiguous.

o As new schemes develop, will no doubt test scope of coverage, and give rise to modifications.

Loan Loss Exclusion

o The Financial Institution Bond is not meant to “bail out” a bank that makes a bad loan.o Insurer has no influence over loan decisionso Banks can be willing to relax standards or take

on bigger risks in order to accommodate a long time customer or to obtain new business.

Loan Loss Exclusion

o How do the insured bank and the insurer balance the bank’s business risk with the insurable risk under the Bond?

The Loan Loss Exclusion.

Loan Loss Exclusion

o Standard Form 24 (2004 ed.), Exclusion (e) provides that Bond does not cover:o Loss resulting directly or indirectly from the complete or

partial non-payment 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 or 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).

Loan Loss Exclusion

o Standard Form 24 (2004 ed.) defines “Loan” as:o 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.

Loan Loss Exclusion

o Standard Form 24o Three exceptions – exclusion does not apply

when loss is otherwise covered under:o Insuring Agreement A – loss resulting from

dishonest acts of employee.o Insuring Agreement D – loss involving forged

or altered instruments.o Insuring Agreement E – loss involving forged,

altered, lost, stolen or counterfeit securities.

Loan Loss Exclusion

o When a loss involves Insuring Agreement (A), (D) or (E), the application of the exclusion takes a back seat.

o The primary issue in these cases is whether the Insuring Agreement applies.o If any of these insuring agreements apply, the

exclusion need not be addressed.

Loan Loss Exclusion

o Several courts have found the Loan Loss Exclusion to be clear and unambiguous in its scope and application:

o The Bond is not intended to “protect the bank when it simply makes a bad business deal.”

Republic Nat’l Bank of Miami v. Fid. & Dep. Co. of Md., 894 F.2d 1255, 1263 (11th Cir. 1990).

Loan Loss Exclusion

o The Loan Loss Exclusion “clearly allocates the risk of entering into a bad credit transaction on the insured rather than the insurer.”Flagstar Bank v. Fed. Ins. Co., 2006 WL 3343765 at * 13(E.D. Mich. Nov. 17, 2006).

o “The rationale underlying this exclusion is to deny coverage for poor loan underwriting.”First Union Corp. v. U.S. Fid. & Guar. Co., 730 A.2d 278, 281 (Md. Ct. Spec. App. 1999).

What is a Loan?

o What types of transactions constitute a “Loan” that may be precluded by the Loan Loss Exclusion?

o “Loan” defined as “all extensions of credit”; “all transactions creating a creditor relationship”; and “all transactions by which the Insured assumes an existing creditor relationship”. o Not limited to situations in which a customer

applies for a loan and is approved by the bank’s management.

Loan Loss Exclusion Scenario

Slippery Sliding Savings & Loano In order to speed up her day at work, an accounting

clerk Employee of Slippery Sliding Savings & Loan (SS S&L) honored $1 million in customer overdrafts. She was not in collusion with the customers and did not receive a financial benefit.

o The next day SS S&L found that a customer who had a $500,000 line of credit kept borrowing from it even though the bank intended to close the line.

o Then an ATM owner and customer of SS S&L disappeared with $5 million in cash.

Loan Loss Exclusion Scenario

o In this scenario, SS S&L suffered multiple losses:o due to the accounting clerk honoring NSF checks;o to a customer fraudulently advancing funds where

bank did not intend to continue creditor/lender relationship;

o from a customer of the bank disappearing with $5 million in cash.

o The Claims were submitted on SS S&L’s Financial Institution Bond.

o Covered?

Loan Loss Exclusion Case Law

o Denied: No coverage for any of the claims under the F.I. Bond:

o Clerk’s honoring of NSF check constituted a loan because it created a debtor-creditor relationship between bank and customero Before the exclusion could be applied, trial court

required to determine if Ins. Agreement (A) (employee dishonesty) provided coverage.

o Remember – It is important to first see if any exceptions apply.

o Nat’l Bank of Andover v. Kan. Bankers Sur. Co., 2008 WL 939545 (Kan. Ct. App. April 4, 2008)


o Denied: No coverage for any of the claims under the F.I. Bond:o The Loan Loss Exclusion would apply to the customer

who continued to advance funds from their line of credit.o No “meeting of minds” between bank and customer

needed. A loan exists any time a bank expects the customer to repay money.

o Court determined that bank “assumed” a creditor relationship with the customer.

First New Eng. Fed. Credit Union v. Cuna Mutual Group, 2005 WL 1154762 (Conn. Super. April 21, 2005).


o Denied: No coverage for any of the claims under the F.I. Bond:

o The ATM customer’s disappearance with the cash would be considered a loan to that customer.

o Court considered bank’s relationship with ATM owner an “extension of credit.”Humboldt Bank v. Gulf Ins. Co., 323 F. Supp. 2d 1027 (N.D. Cal 2004).

Unique Issues In Special Cases: Computer Funds Transfer Fraud,

Loan Loss, and Inventory Loss

John J. McDonald, Esq. Kerry M. Evensen, Esq.Meagher & Geer, PLLP Assistant Vice President - Claims33 South 6th Street, Suite 4400 OneBeacon Insurance CompanyMinneapolis, MN 55402 601 Carlson Parkway, Suite 700612-338-0661 Minnetonka, MN [email protected] 651-210-0172www.meagher.com [email protected]

www.onebeacon.com

Eric E. EmmetteTripoli Risk Management, LLCP.O. Box 21573St. Paul, MN [email protected]

Unique Issues With Special Cases: Computer and Funds Transfer Fraud, Inventory Losses, and Loan Losses

John J. McDonald, Jr., Esq.

Daniel L. Payne, Esq. Kerry M. Evensen, Esq.

Mr. Eric Emmette

I. Computer and Funds Transfer Fraud1

Over the past few decades, the use of computers and other electronic technology in business has become more and more prevalent to the point now where it appears to be an absolute necessity. Today, a business cannot compete without the ability to conduct transactions electronically, and to provide that same convenience to its customers. Face-to-face transactions have long given way to a click of the mouse and instant credits or debits to the customer’s account that can be viewed in real-time. But the necessary convenience also gives rise to new risks. Although the risk of on-premises fraud will always exist, from the defalcator’s perspective the possibility of achieving the same goal without having to be seen is proving to carry with it an allure difficult to resist. Further, the prospect of being able to swindle much larger amounts by simply entering instructions from a computer carries an obvious incentive as well. Although one is by no means completely invisible behind a computer screen, the concept is certainly proving to be empowering and providing many otherwise innocuous individuals with the confidence to act in ways they likely would never endeavor to undertake were they required to personally appear before their victim.

In light of the substantial increase in electronic transactions, it goes without saying that computer-related fraud is a growing concern to even the smallest businesses and banks. Computer crimes present real risks and the stakes are high to any business when, ultimately, a thief can access its entire portfolio with the touch of buttons. The threats of theft are far greater than the “on premises robbery.” With the right knowledge and equipment, a “hacker” can make off with millions in an instant without having to be anywhere near the premises of the business or bank, and still be somewhat confident that he or she will have sufficient time to make a “get-away” before the theft is even discovered. Having anticipated and seen these sophisticated risks for many years, the insurance industry has long offered protection two inter-related additions to the crime coverage: the Computer Fraud and Funds Transfer Fraud Insuring Agreements.

A. THE COMPUTER FRAUD COVERAGE INSURING AGREEMENT The ISO Computer Fraud Coverage Form (Form F) in the commercial crime coverage

has been around for nearly two decades. First appearing in 1983, the coverage has gone through a number of revisions to it current form. The coverage provided is as follows:

1 For a more detailed discussion of these types of coverages please see John J. McDonald, Jr., Joel T. Wiegert &

Jason W. Glasgow, Computer Fraud and Funds Transfer Fraud Coverages, XIV Fid. L.J. 109 (2008).

A. Coverage – We will pay for loss of and loss from damage to Covered Property

resulting directly from the Covered Cause of Loss. 1. Covered Property: “Money,” “Securities” and “Property Other Than

Money and Securities.”

2. Covered Cause of Loss: “Computer Fraud.”2

The additional definitions place the coverage into context, and most notably, “computer fraud” is itself defined as follows:

“Computer Fraud” means “theft” of property following and directly related to the use of any computer to fraudulently cause a transfer of that property from inside the “premises” or “banking premises” to a person (other than a “messenger”) outside those “premises” or to a place outside those “premises.”3

Generally speaking, this insuring agreement is intended to protect an insured where a defalcator uses a computer to fraudulently and improperly gain access to an insured’s internal computer system by circumventing the insured’s computer security procedures, directly causing a loss. In other words, the coverage applies in situations where when a third-party uses a computer to “hack” into an insured’s computer system and cause funds to be transferred from the insured’s (or its bank’s) premises. Some combination of fraudulent key strokes and/or mouse clicks would need to directly cause the insured’s loss of funds. However, the specific insuring agreements, definitions, and exclusions utilized by a particular carrier would need to be analyzed in any situation where an insured is seeking coverage.

The standard coverage includes two additional exclusions to the Crime General

Provisions: Acts of Employees, Directors, Trustees or Representatives; and Inventory Shortages. The Inventory Shortages exclusion is similar to the traditional exclusion that precludes a loss for which the proof of such is dependent on an inventory or profit and loss computation, which will be discussed in more detail later in this article. The more pertinent of these exclusions is the first, which precludes coverage for loss resulting directly from any dishonest or criminal acts committed by what could be referred to as an “inside” party, such as an employee, director, trustee, or authorized representative of the insured, whether acting alone or in collusion with other persons, or while performing services for the insured or otherwise.

The exclusion is broad, precluding coverage regardless of the employee’s intent, and regardless of when the employee acts. By precluding losses involving “inside” parties the exclusion makes clear that coverage is intended to protect against third-party access.

More recently, the market seems to have gone towards an insurer-specific form of coverage with respect to computer fraud. The risk has presented insurers with the opportunity to

2 ISO CR 00 07 (10 90) (Form F). 3 “Premises” itself is defined to mean “the interior of that portion of any building you occupy in conducting your

business.”

address their insured’s needs through niche endorsements that depend on the insured’s particular business. However, the same general concept first found in the ISO form seems to have survived. The focus is on providing protection for the third-party theft of assets through the use of a computer. Although the general concept behind the original coverage remains, the more recent policies have been refined to limit the scope of coverage due to the ever-evolving scope of risk. The limitation has been primarily confined to the exclusions that apply to the coverage grant. For example, most modern policies contain an exclusion precluding coverage for loss due to the giving or surrendering of covered property in any purchase or exchange, whether legitimate or fraudulent.4 Thus there is no coverage for loss of property that the insured gives up in connection with a fraudulent sale, transaction or exchange that involves the computer. Another exclusion that is often relevant in the context of Computer Fraud coverage precludes coverage for loss resulting directly or indirectly from the input of “Electronic Data” by someone having the authority to enter the insured’s computer system. The pertinent issue with respect to this exclusion is understanding the scope of what is identified as “electronic data.” Electronic data generally includes those facts or information converted to a form that the computer system can utilize in performing its function. In other words, it is the data, not the program. As such, the exclusion does not preclude coverage for loss resulting from someone altering the computer program, but it does preclude coverage for loss resulting from someone entering incorrect or fraudulent data that does not allow the computer program to accurately perform its function. Finally, another of the more relevant exclusions (and there can be many others depending on the coverage form utilized) makes clear that the extent of coverage applies only to the loss of covered property—most often money—and does not include intangible property or confidential information. Many policies will specifically identify “electronic data” and “computer programs” as falling within the scope of the exclusion. The intent behind this exclusion is to limit coverage to that which can be readily quantified, as valuating the data or program itself can often be a difficult assessment. The information can usually be replaced for a value much less than the value (and dependence) the insured places on it. Other property coverages may encompass this risk, but the crime coverage does not.

B. THE FUNDS TRANSFER FRAUD INSURING AGREEMENT The Funds Transfer Fraud Coverage is usually written as a direct corollary to the Computer Fraud coverage. Many times it may be added to the crime policy in the same endorsement. However, the two coverages are distinct and protect against separate risks. A typical example of the coverage afforded by the Funds Transfer Fraud coverage in today’s market is as follows:

4 Some policies, however, limit the application of this exclusion to those transactions with a party not in collusion

with an Employee.

Funds Transfer Fraud: We will pay you for your direct loss of Money and Securities contained in your Transfer Account on deposit at a Financial Institution directly caused by Funds Transfer Fraud. “Funds Transfer Fraud” means: 1. an electronic, telegraphic, cable, teletype or telephone instruction fraudulently

transmitted to a Financial Institution directing such institution to debit you Transfer Account and to transfer, pay or deliver Money or Securities from your Transfer Account which instruction purports to have been transmitted by you, but was in fact fraudulently transmitted by someone other than you without your knowledge or consent;

2. a fraudulent written instruction, other than one covered under Insuring

Agreement B., issued to a Financial Institution directing such Financial Institution to debit a Transfer Account and to transfer, pay or deliver Money or Securities from such Transfer Account by use of an electronic funds transfer system at specified intervals or under specified conditions which written instruction purports to have been issued by you but was in fact fraudulently issued, Forged or altered by someone other than you without your knowledge or consent; or

3. an electronic, telegraphic, cable, teletype, telefacsimile, telephone or written

instruction initially received by you which purports to have been transmitted by an Employee, but which was in fact fraudulently transmitted by someone else without your or the Employee’s consent.

While the Computer Fraud Coverage Insuring Agreement and the Funds Transfer Fraud Insuring Agreement are similar, (so much so they have sometimes been combined into one insuring agreement), they obviously differ in the risks they cover. The Funds Transfer Fraud Insuring Agreement was intended to provide coverage to losses caused by fraudulent written, telephonic or teletype instructions, mirroring the way business was transacted before computers became ubiquitous. The policies containing both coverages generally are structured such that the two are mutually exclusive. For example, many will contain an exclusion that the computer fraud insuring agreement does not apply loss resulting from a fraudulent instruction directing a financial institution to transfer, pay or deliver funds form the insured’s transfer account. Similarly, they will also include an exclusion stating funds transfer fraud insuring agreement does not apply to loss resulting from the use of any computer to fraudulently cause a transfer of money, securities or other property.

C. APPLICATION OF THE COMPUTER FRAUD AND FUNDS TRANSFER FRAUD COVERAGES Even though variations of Computer Fraud and Funds Transfer Fraud Coverages have been available for over 20 years, there is a surprisingly low number of reported decisions interpreting these coverages. However, the cases available provide good discussions of the issues relevant to the coverage. With respect to the Computer Fraud Coverage, Brightpoint, Inc.

v. Zurich American Insurance Co.,5 identifies several issues that often come up in the context of that coverage. With regard to the Funds Transfer Fraud Coverage, the limited cases provide insight into the common coverage issues as well. Each are discussed below.

1. The Computer Fraud Insuring Agreement

Brightpoint, Inc. v. Zurich American Insurance Co. involved the theft of nearly $1.5 million through a scam involving prepaid telephone cards.6 The insured sought coverage under a computer fraud insuring agreement arguing that the computer fraud was carried out by a fraudulent facsimile purchase order.

The insured distributed mobile telephone cards, and its customary practice was to receive

a facsimile purchase order from one of its regular phone card dealers.7 Along with the purchase order, the insured would accept a post-dated check from the dealer and would require the dealer to provide a bank guarantee certifying the sufficiency of the funds in the dealer’s account and committing the bank to honor the post-dated check when it was presented on the maturity date. The dealer normally sent copies of the post-dated checks, guaranties, and purchase orders to the insured by facsimile. The insured would then purchase the phone cards from a telecom company and deliver them to the dealer in exchange for the original check, guaranty and purchase order.

On two occasions the insured went through the order process, and eventually met with a

known employee of a dealer, who purported to deliver to the insured an original copy of a post dated-check and bank guarantee in exchange for the $1.5 million worth of prepaid phone cards.8 A few days after the exchange, the dealer met with the insured to advise that it had not authorized issuing the purchase order, denied authorizing the bank to issue the guaranties, and denied authorizing its employee to pick up the cards.9 Ultimately, the phone cards were never recovered and the insured never received payment for the stolen cards. The insured claimed a loss under the Computer Fraud/Wire Transfer insuring agreement, contending that the facsimile constituted the use of a computer. The insurer denied coverage, maintaining a computer was not used to fraudulently cause a transfer of the phone cards.10 On summary judgment the insurer set forth several defenses in support of its coverage denial, some of which are discussed below.

a. “Covered Property”

The insurer argued that the phone cards were not “covered property,” defined by the

policy as “Money”, “Securities” or “Property Other Than Money or Securities.”11 The insurer’s position was based on its argument that the loss resulted only from the economic value attached to the phone cards and not the cards themselves. Therefore, the phone cards could not be considered “tangible” property. The court agreed that to fall under the “Property Other than

5 No. 1:04-CV-2085, 2006 WL 693377 (S.D.Ind. March 10, 2006). 6 See id. at *1. 7 See id. at *2. 8 See id. 9 See id. at *3. 10 See id. However, this defense was not developed in the summary judgment motion. 11 See id.

Money and Securities” category, the property must be “tangible.”12 The court also recognized that the property must have “intrinsic value” and not be any property specifically excluded by the policy.13 However, the court held that the phone cards were tangible because they can be physically transferred.14 In addition, the court held that the cards had an intrinsic value because each had a specific value attached to them.15 Therefore, the court held that the stolen prepaid telephone cards did qualify as “covered property” under the policy.

b. “Premises”

Next the insurer suggested that the theft of the phone cards was not covered under the

policy because the phone cards were not transferred from inside the “premises” or “banking premises,” as required under the policy definition of “Computer Fraud.”16 “Premises” was defined as “the interior of that portion of any building you occupy in conducting your business.”17 However, the insured argued that the definition of “premises” should be interpreted broadly to include any location where one of its employees carries out the company’s interests, including the location where the phone cards were actually exchanged should be covered as a “premises” because they were places the insured’s employees conducted business.18

The court adopted a narrower view of the “premises” concept, limiting its application to

the context of the policy definition and holding that only the places that the insured occupies in conducting its business is included in the definition. Applying the relevant rules of contract interpretation, the court found that the limitation on coverage to property transferred out of the insured’s premises (or its bank’s) would be made meaningless by adopting the insured’s broad interpretation. As a result, because the phone cards were never inside an office building occupied by the insured, the loss did not result from a transfer from “inside the premises or banking premises” as required by the policy.19

c. “Directly Caused by Computer Fraud”

Finally, the insurer focused on the direct loss requirement and contended that the

facsimile transmission did not “fraudulently cause a transfer” of the phone cards, as required under the “Computer Fraud” definition.20 Rather, the insurer argued that the fraudulent facsimile simply alerted the insured to the fact the dealer, or someone purporting to be the dealer, wished to place the order.21 Indeed, based on the insured’s established practices, it would not have exchanged the phone cards simply on the basis of the facsimile itself. It was only after the insured received the physical documents that it would release the cards. Therefore, the insurer

12 See id. 13 See id. 14 See id. at *6. 15 See id. 16 See id. 17 See id. 18 See id. 19 See id. 20 See id. at *7. 21 See id.

argued, the fraud was carried out through the use of unauthorized checks and guaranties, and was not directly or proximately caused by the use of the facsimile machine, much less a computer.22

On the other hand, the insured argued that the policy only required that the theft follow

and be directly related to the use of a computer. Moreover, the insured argued that the policy did not contain a modifier such as “proximate cause”, “predominate cause” or the like.23 As such, the insured argued all that was required by the policy is the use of a computer followed by a theft that is in some way connected to that initial use of the computer.24

The court rejected the insured’s interpretation of the term “directly related” and found

that the insured’s loss did not flow immediately from the use of the facsimile machine.25 Rather, the court held that intervening events or circumstances became the direct, proximate, predominate, and immediate cause of the insured’s loss.26 Consequently, the court held that this was another ground for which the insurer was justified in denying coverage under the Computer Fraud policy.

2. The Funds Transfer Fraud Insuring Agreement

The following two cases raise issues unique to the coverage available under the Funds

Transfer Fraud Coverage Insuring Agreement.

a. Northside Bank v. American Casualty Company of Reading27

In Northside Bank v. Am. Cas. Co. of Reading, the insured opened an account for its client-merchant pursuant to a merchant services agreement.28 Pursuant to the agreement the client-merchant would accept orders for merchandise by debit and credit card payments. Upon receipt of electronically transmitted debit and credit card authorizations from the client-merchant, the insured would then transfer money into the client-merchant’s account. However, it turned out that the client-merchant never actually delivered the purchased merchandise to its customers. When the client-merchant’s customers exercised their rights under federal law to rescind their debit and credit card payments for the undelivered goods, the creditors refused to pay, or charged back the amounts they had paid, to the insured. When the insured similarly attempted to charge back the client-merchant’s account, it discovered that the account had been completely depleted.29

22 See id. A seemingly threshold issue presented in Brightpoint was whether the facsimile machine itself was a

“computer” for purposes of the policy. However, the insurer did not address the issue in the summary judgment motion.

23 See id. 24 See id. 25 See id. 26 See id. 27 No. GD 97-19482, 2001 WL 34090139 (Pa.Com.Pl. Jan. 10, 2001). 28 See id. at *96. 29 See id.

The insured sought coverage under its financial institution bond for what it deemed to be fraudulent electronic fund transfers and computer crimes.30 The insured argued that the loss should be covered because the submission from the client-merchant was an electronic instruction, and the subsequent failure to ship the merchandise should be viewed as a ‘modification’ or ‘alteration’ of the electronic instruction with the intent to deceive.31

Although the insured argued “modified or altered” was ambiguous, the court held that the

insured was trying to “place a square peg in a round hole.”32 The electronic instructions sent from the client-merchant were never modified or altered, but were paid according to the intended instruction. In what is proving to be an encouraging pattern with respect to the decisions involving these coverages, the court, in affirming the denial of coverage under the Bond, found the insured’s claim to be at odds with the “obvious intent of the insurance policy.”33

Viewing the policy as a whole, the court found that the purpose of the Electronic Funds

Transfers and Computer Crime coverages was to protect the insured from someone breaking into the insured’s electronic fund transfer system and pretending to be an authorized representative or altering the electronic instructions to divert monies from the rightful recipient.34 The funds transfer instructions at issue in Northside Bank, whether fraudulent or not, were sent directly from the client-merchant to the bank unaltered. Therefore, the court agreed that this was not the type of risk that was contemplated by the coverage.

b. Morgan Stanley Dean Witter & Co. v. Chubb Group of Ins. Cos.35

Morgan Stanley Dean Witter & Co. v. Chubb Group of Insurance Cos. involved the issue of whether coverage was available under an Electronic and Computer Crime Policy for fraudulent telephone-initiated funds transfers.36 Morgan Stanley sought indemnification for over $21 million it paid to defend and settle a lawsuit which stemmed from the fraudulent actions of one of its customers, London and Bishopsgate International (LBI).

Morgan Stanley had agreed to provide custodial services for property owned or held by LBI. According to the written custodial services agreement between them, Morgan Stanley was to be responsive to instructions from LBI, which could come from several specifically authorized persons. In order to facilitate the instructions, Morgan Stanley provided LBI with computer software allowing access to Morgan Stanley’s computer programs. LBI later entered into an investment management contract with First Tokyo Index Trust Limited (First Tokyo), allowing

30 See id. at *98. 31 See id. at *101. The definition of “fraudulent electronic instruction or advice”—to which both the Electronic

Funds Transfers and Computer Crime coverages referred—involved two subparts: when someone other than a customer defrauded the insured; and when an electronic instruction or advice was “modified or altered with intent to deceive after being sent by another financial institution or automated clearing house or by a customer of the insured.” Id.

32 See id. at *101. 33 See id. 34 See id. at *101-102. 35 Morgan Stanley Dean Witter & Co. v. Chubb Group of Ins. Cos., No. L-2928-01, 2005 WL 3242234 (N.J. Super.

Ct. App. Div. Dec. 2, 2005) 36 See id. at *1.

LBI to manage First Tokyo’s investments. To facilitate the management of First Tokyo’s investments, LBI opened an account with Morgan Stanley, which was subject to the custodial services agreement between the two parties.37

Two years later, the company owning the controlling share of LBI made a public offer to

purchase First Tokyo. Once the offer became unconditional, the purchasing company requested that there be no changes to First Tokyo’s securities portfolio without its consent. As such, First Tokyo ordered LBI to cease all trading on its behalf; however, Morgan Stanley was not informed that LBI was no longer authorized to trade for First Tokyo.38 Despite the lack of authority, LBI later instructed Morgan Stanley to liquidate the bulk of First Tokyo’s portfolio through several transactions, and the sale proceeds were delivered to LBI-affiliated accounts.39 The transactions were accomplished through instructions sent by computer, fax, and voice to Morgan Stanley by persons who were specifically authorized by LBI.40

Morgan Stanley’s crime policy provided coverage for loss as a result of fraudulent

instructions communicated by voice, fax, and computer. After settling the claim First Tokyo made against it, Morgan Stanley argued that its loss was covered by those insuring agreements, covering “computer systems,” “customer voice initiated transfers,” and “facsimile transfer instructions.”41

The court held there was no coverage under fraudulent facsimile transfer instruction

agreement. The facsimile insuring agreement was recognized to limit coverage to situations “where an unauthorized person poses as a customer or other authorized person to issue the fraudulent transfer instructions.”42 As the instructions at issue had been made by persons authorized to act for LBI, they were not “imposters.” Consequently, the failure to satisfy this requirement precluded coverage.

With respect to the “computer systems” insuring agreement, the court held there was no

coverage because any such coverage otherwise available was excluded. The applicable exclusion precluded coverage for “loss by reason of the input of Electronic Data at an authorized electronic terminal…or a Customer Communication System by a customer or other person who had authorized access to the customer’s authentication mechanism.”43 The court held this exclusion also unambiguously excluded coverage for fraud committed by customers or other authorized persons.44 Again, there was no dispute that the fraudulent instructions were made by authorized employees of LBI, but Morgan Stanley tried to argue that LBI was not a customer. Citing the custodial agreement, the court dismissed this argument and held there was no “computer systems” coverage.45

37 See id. 38 See id. 39 See id. at *2. 40 See id. 41 See id. 42 Id. at *3. 43 Id. 44 See id. at *3. 45 See id.

However, the court held the “customer voice initiated transfers” agreement was not as limited as the others. Contrary to the lower court, the appeals court found the voice initiated transfer agreement was not limited to “imposters or hackers.”46 Rather, this agreement covered voice transfer instructions that:

[1] fraudulently purport to have been made by a person authorized and appointed by a Customer to request by telephone the transfer of such funds but which instructions were not made by said Customer or by any officer, director, partner or employee of said Customer or [2] were fraudulently made by an officer, director, partner or employee of said Customer whose duty, responsibility or authority did not permit him to make, initiate, authorize, validate or authenticate customer voice initiated funds transfer instructions.47

The insurers first argued that coverage was limited to the transfer of “funds,” and therefore did not include securities.48 “Funds” was not defined in the policy, and the court held the concept was ambiguous and could be more broadly interpreted to include assets other than money.49 The insurers also contended the agreement, like the other coverages, was limited to “imposter or hacker” coverage. The court interpreted the insurers’ position regarding the scope of the agreement as one conceding ambiguity.50 Nonetheless, the court found there was no ambiguity with respect to the second provision and held the voice initiated transfer agreement covered the losses attributed to the transactions made by telephone because when the LBI employees issued the telephone instructions, they were no longer authorized by First Tokyo to do so.51 Thus, it became a matter of exceeding authority, and therefore, coverage was held to be available under this coverage part.52

D. ISSUES INVOLVED IN RECENT CASES

One of the most basic issues with regard to Computer Fraud coverage is what qualifies as

a “computer.” Most insuring agreements do not include a policy definition for “computer.” As a result, it is not clear how broadly the term “computer” is interpreted. For the most part, this term is unaddressed by courts interpreting coverage under Computer Fraud policies. One exception is Brightpoint, wherein the insured claimed that the fraudulent use of a facsimile machine constituted the use of a computer for purposes of its Computer Fraud policy.53 While the insurer abandoned at summary judgment its argument that the facsimile was not a “computer,” the court’s decision included a footnote disagreeing with the insured’s expert’s position that it did constitute a “computer.” Although it did not explicitly decide the question, the court opined that that the common and ordinary meaning of “computer,” as used and understood in our society and around the world, would be stretched too far by including the use of a facsimile machine.54

46 See id. at *4. 47 Id. 48 See id. 49 See id. 50 See id. at *5. 51 See id. 52 See id. 53 See Brightpoint, Inc., 2006 WL 693377 at *7 n. 5. 54 Id.

Another issue becoming more prevalent in computer fraud claims is that of to what extent

must the use of a computer be involved to trigger coverage? For example, does the use of a computer to create and print fraudulent documents that are submitted to the insured in paper form constitute Computer Fraud? An insured asserted this claim in Milwaukee Area Technical College v. Frontier Adjusters of Milwaukee.55 There, the wrongdoer fashioned fake check ledgers using standard accounting software.56 By submitting the fake check ledgers to the insured, the wrongdoer received reimbursements for payments that were never made. The court, however, did not reach the issue of whether this action constituted computer fraud because coverage was excluded as the fraud was carried out by an authorized representative.57

A similar claim was asserted by an insured in Great Am. Ins. Co. v. AFS/IBEX Fin.

Servs., Inc.58 In that case, the defalcator was an insurance agent who obtained insurance premium finance checks from the insured by submitting premium financing applications from fictitious insureds.59 The agent purportedly used a computer to fill out an application online, enter the information from the fictitious application into the insured’s online processing system, which would generate a premium finance agreement.60 The agent would then print and sign the finance agreement, and fax it and the signed application to the insured. Upon receipt of these documents, the insured would then issue the checks.61

The insurer argued that the losses sustained by the insured did not bear a direct enough

loss to the use of a computer to fall within the coverage available under its policy’s computer fraud provision.62 It asserted that there were several intervening acts before the insured’s loss occurred, including its receipt of the signed applications and finance agreement, its issuing of the finance checks, and the agent’s endorsement and deposit of the checks. The court granted the insurer’s motion for summary judgment related to computer fraud coverage, finding that the insured failed to raise a fact issue as to whether the use of a computer directly caused the transfer of any funds from the insured’s bank.63

The issue of whether an insured suffered a direct loss due to the use of a computer may

also become more prevalent in the Ponzi scheme cases that have recently made headlines. In those cases, insureds who lost money by investing in a Ponzi scheme may assert that the defalcator’s use of a computer to facilitate the scheme, such as by generating false income statements or bogus trading slips, fell within the Computer Fraud insuring agreement of the a commercial crime policy. The insureds in these cases will necessarily need to establish that money or other covered property was fraudulently transferred from inside the insured’s premises or banking premises to a person or place outside those premises. Further, like in the AFS/IBEX

55 752 N.W.2d 396, 372 (Wis. Ct. App. 2008). 56 See id. at 366. 57 Id. at 373. 58 No. 3:07-CV-924-O, 2008 WL 2795205 (N.D. Tex. July 21, 2008). 59 Id. at *2. 60 See Great Am. Ins. Co.’s Br. in Supp. of Mot. for Summ. J., pp. 11-12 (on file with the authors). 61 Id. 62 Great Am. Ins. Co., 2008 WL 2795205 at * 14. 63 Id. (noting that insured did not present any evidence or arguments opposing insurer’s summary judgment motion

with respect to computer fraud provisions).

and Frontier Adjusters cases, the direct loss analysis likely will be one of the most crucial issues. Direct loss means direct, and consequently, the computer must be used to directly cause the insured’s loss, not merely be a passive instrument that happened to be used in facilitating the fraud.

E. CONCLUSION

The Computer Fraud and Funds Transfer Fraud coverages will continue to present issues that one can not even imagine at this point. The schemes are constantly evolving and the coverage responding. Although there is surprisingly little case law on the coverages, it is most certain that that will change in the near future as more and more insureds are suffering losses, as well as larger losses, as a result of computer crimes. Although the vast majority of decisions are unreported, the cases are positive in the that courts’ analyses, particularly with the application of exclusions, has indicated an unwillingness to interpret the language out of context as to what the coverage is intended to provide. Coverage is available for third-party access to computer systems for the purpose of theft. The coverage grant, and the exclusions, make this intent clear and unambiguous. Thus far, the courts have agreed.

II. Loan Loss Exclusion64

For several years, one of the most heavily disputed issues relating to coverages available under a Financial Institution Bond is the extent to which coverage is available for so-called “loan loss” claims. The Financial Institution Bond is not intended to provide a life-line to the insured bank when it makes an ill-advised loan decision. The rationale behind this theory is that after the bond is issued, an insurer has no influence or input related to loan decisions made by a bank’s loan officers and committee. Banks develop relationships with their customers, and in the course of those relationships, often relax certain requirements pertinent to a loan. Banks may also be interested in obtaining new business, and in doing so, decide to take a risk they otherwise would not to accommodate the customer. There simply is no analytical schematic that any bank will follow in determining whether to issue credit or enter into a loan transaction. Each loan requires individual attention and decisions, and the bank is certainly entitled to base its decision on whatever criteria it is comfortable with, and the insurer has no basis to interfere with that process.

The trade-off between the insurer’s involvement and the bank’s autonomy is simple—the loan loss exclusion. That particular exclusion provides the allocation between the business risk maintained by the insured and the insurable risk the insurer agrees to undertake in the bond. The bond will not provide coverage for any loss resulting directly or indirectly from a Loan or other transaction or extension of credit, whether that loss is the result of a legitimate loan gone bad or a thief duping the bank through a fraudulent transaction, unless the loss falls within one of several explicit exceptions. Courts have generally recognized this limitation and allocation of risk by applying the loan loss exclusion where appropriate.

64 For a more detailed discussion of the history and application of the Loan Loss Exclusion please see John J.

McDonald, Jr, Joel T. Wiegert, and Michelle M. Carter, The Loan Loss Exclusion, in LOAN LOSS COVERAGE

UNDER FINANCIAL INSTITUTION BONDS 123 (Gilbert J. Schroeder & John J. Tomaine, eds., 2007).

A. THE FINANCIAL INSTITUTION BOND’S LOAN LOSS EXCLUSION

The first American standard form bond (Standard Form 24) was produced in 1916 by the Surety Association of America (“SAA”) and the American Bankers Association.65 Over the last 90 years, the standard form bond has undergone numerous revisions, including renaming the bond from a Bankers Blanket Bond to a Financial Institution Bond to deter courts from interpreting coverage as broader than intended by the parties.66 The first loan exclusion clause appeared in the Standard Form 24 around 1920.67 The “loan loss” exclusion, as it has come to be known, has been revised numerous times since its original introduction, the most comprehensive revisions to the exclusion taking place in 1969, 1980, and 1986.68

The most recent version of the Standard Form 24, as revised in 2004, contains a loan loss exclusion which provides that the bond does not cover:

(e) loss resulting directly or indirectly from the complete or partial non-payment 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 or 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).69

Moreover, the 2004 version of the Standard Form 24 defines the term “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.”70

One of the more prevalent issues with respect to the loan loss exclusion is the exceptions contained within the exclusion. Every version of the loan loss exclusion has contained three general exceptions: Insuring Agreement (A), covering a loss resulting from the dishonest acts of an employee; Insuring Agreement (D), covering certain activities which involve forged or altered instruments; and Insuring Agreement (E), covering certain transactions involving forged, altered, lost, stolen or counterfeit securities. If any of these exceptions apply, the loan loss exclusion does not.

65 See James A. Knoll & Randy L. Arthur, A Brief History of the Financial Institution Bond, in FINANCIAL

INSTITUTION BONDS 3, 8 (Duncan L. Clore ed. 1992); Peter I. Broeman, An Overview of the Financial Institution Bond, Standard Form 24, 110 BANKING L.J. 439, 444 (1993); Flagstar Bank v. Federal Ins. Co., No. 05-70950, 2006 WL 3343765, *2 (E.D. Mich. Nov. 17, 2006).

66 See Broeman, supra note 65 at 444. 67 See Edgar L. Neel, Financial Institution and Fidelity Coverage for Loan Losses, 21 TORT & INS. L.J. 590, 591

(1986). 68 Id. 69 FINANCIAL INSTITUTION BOND, Standard Form No. 24 (revised April 1, 2004), reprinted in LOAN LOSS

COVERAGE UNDER FINANCIAL INSTITUTION BONDS, supra note 64, Master App’x at 667. 70 Id.

B. PURPOSE AND INTENT OF THE FINANCIAL INSTITUTION BOND AND LOAN LOSS EXCLUSION

1. The Financial Institution Bond is Not Credit Insurance

The evolution of the loan loss exclusion evinces the intent of insurers to avoid becoming guarantors of bad loans made by banks. Lending is the business of banks and a part of its business risk permitting insureds to an interest on the loans made. The modern day Financial Institution Bond is not “credit insurance.”71 It is not intended to “protect the bank when it simply makes a bad business deal.”72 Again, the primary provision in the bond exemplifying this objective is the loan loss exclusion. The exclusion is quite broad, encompassing all extensions and transactions creating a debtor/creditor relationship, in addition to those transactions falling within the scope of the bond’s definition of Loan.

The rationale behind the loan loss exclusion is that making loans is the financial institution’s business and part of its business risk.73 “The Bond’s language attempts to distinguish between risks against which the banks could reasonably protect themselves through, for example, diligence in screening and approving loans, and risks which commercial realities indicate that the banks should not assume.”74 The exclusion “clearly allocates the risk of entering into a bad credit transaction on the insured rather than the insurer.”75 Quite simply, “[t]he rationale underlying this exclusion is to deny coverage for poor loan underwriting.”76

2. Allocating the Business and Insurable Risks Between Insured and Insurer

The insured is certainly entitled to make loan decisions based upon the comfort level it maintains with the borrower. But this is a business practice only the bank can control and demonstrates why it is not an insurable risk. Insureds cannot pass the consequences of their business decisions and practices onto the insurer. That is not the purpose of the bond. The bond is designed to protect banks “against risks of dishonesty, both external and internal, but does not insure good management nor against the risk or loss inherent in the banking operations.”77 “The failure to follow sound business practices and verify authenticity is a business risk taken by banks and not an insured risk covered by the Bond.”78

The primary mechanism for enforcing this distinction actually arises out of the exceptions—the identified Insuring Agreements—and their direct loss requirements. The interplay between the exclusion and stated exceptions vis-à-vis the direct loss requirements distinguishes “between the ‘risk of authentication’ (forgery and counterfeiting) against which the [insured] could not reasonably protect itself and the credit risk” maintained by the insured, such as the risk of not verifying collateral securing a loan.79 There is no coverage for the credit risk

71 Liberty Nat’l Bank v. Aetna Life & Cas. Co., 568 F. Supp. 860, 866 (D.N.J. 1983). 72 Republic Nat’l Bank of Miami v. Fid. & Dep. Co. of Md., 894 F.2d 1255, 1263 (11th Cir. 1990). 73 French Am. Banking Corp. v. Flota Mercante Grancolombiana, 752 F. Supp. 83, 88 n.5 (S.D.N.Y. 1990). 74 Id. 75 Flagstar Bank v. Federal Ins. Co., No. 05-70950, 2006 WL 3343765, at *13 (E.D. Mich. Nov. 17, 2006). 76 First Union Corp. v. United States Fid. & Guar. Co., 730 A.2d 278, 281 (Md. Ct. Spec. App. 1999). 77 Nat’l City Bank of Minneapolis v. St. Paul Fire & Marine Ins. Co., 447 N.W.2d 171, 177 (Minn. 1989)

(citations omitted). 78 Id. 79 See Liberty Nat’l Bank, 568 F. Supp. at 863.

because the insured can “investigate the assertions made therein through credit checks, appraisals, title searches, financial statements and the like.”80

The expectation that banks will protect themselves through their own credit evaluation procedures is not only derived from common sense, as the bank is in the best position to make such judgment calls based upon its market, but also carries a preemptive element with respect to loss management. Indeed, requiring the insurer to underwrite the business risk would bind the carrier to a contract that it did not enter into and “transform the bond into a credit insurance policy.”81

But some restraint is required when distinguishing the insured’s business risk. Placing the loss within the insured’s business risk is not akin to arguing the insured has been negligent in its evaluation and therefore, no coverage is available. “Ample authority supports the conclusion that, in the absence of policy language to the contrary, mere negligence of the insured does not defeat coverage under a fidelity bond.”82

The issue presented is not that the insured was negligent in its credit evaluation procedures, but rather, the insured’s negligence demonstrates why the matter is not an insurable risk to begin with. While every bank, for example, has a loan policy, exceptions are made on a daily basis. Those exceptions are based on the bank personnel’s comfort level and knowledge with respect to the borrower. A bank is certainly entitled to make those decisions, however, it does so at its own risk. A bank simply does not have the luxury to disregard verifying collateral or signatures simply with the hope of getting insurance coverage for such an ill-fated decision. An insurer has no means of underwriting such acts. In light of that, by virtue of the loan loss exclusion, the bond provides that the insurer will not cover losses that arise out of a loan, whether such losses were “procured in good faith or through trick, artifice, fraud or false pretenses.”

3. Loan Loss Exclusion Is “Clear and Unambiguous”

Numerous courts have interpreted and applied the loan loss exclusion. When interpreting the scope of the exclusion, courts have found “there is no dispute as to the meaning.”83 The language of the clause is clear and unambiguous.84

That fraudulent loan losses (absent an exception) are not covered is often a difficult concept for insureds to accept. Arguably, fraud is present in no other area of the financial institution’s business more than that involving loans and other extensions of credit. The lack of coverage for fraudulent loans is particularly tough to swallow for the insured when it reads through the bond and notes various references to coverage for dishonest or fraudulent acts by an employee, false pretenses committed by a person on the insured’s premise, forgery or alteration of negotiable instruments and securities and other coverages to the like. The presence of such language often leads to the insured’s argument that fraud is sufficient to establish coverage.

80 Id.; see also Nat’l City Bank, 447 N.W.2d at 177. 81 KW Bancshares, 965 F. Supp. at 1055; see also Flagstar, 2006 WL 3343765, at *13. 82 RBC Dain Rauscher, Inc. v. Federal Ins. Co., 370 F. Supp. 2d 886, 892 (D. Minn. 2005) (citations omitted).

For a full discussion of the issue, see Alex Hofrichter, Proximate Cause of Fidelity Loss (unpublished paper presented at the Annual Meeting of the Surety Claims Institute, Hershey, Pa., June 26, 1999).

83 Liberty Sav. Bank v. Am. Cas. Co., 754 F. Supp. 559, 561 (S.D. Ohio 1990). 84 Id.; see also, Lyons Fed. Sav. & Loan, 863 F. Supp. at 1448.

The concept of no coverage for fraudulent loans can also be difficult for many courts, and the practitioner must often place emphasis on the underlying rationale of the loan loss exclusion, as well as noting the situations for which the bond is intended to provide coverage. Explaining the application of the bond as a whole often alleviates the apprehension carried by some courts when analyzing a loan loss issue. The loan loss exclusion in particular is not a novel issue. It is a veteran among the exclusions to the bond and has survived the numerous revisions to arrive at its current state. It should not take any insured by surprise.

C. RECENT CASES INVOLVING THE LOAN LOSS EXCLUSION

There are relatively few recent cases that actually rely on the loan loss exclusion to preclude coverage. In the majority of reported decisions, the loan loss exclusion is addressed in the context of Insuring Agreements (A), (D) or (E) claims. When the loss involves Insuring Agreements (A), (D) or (E), the exclusion essentially takes a back seat—the primary issue is whether the Insuring Agreement applies. If it does, the exclusion does not and need not be addressed. It is only when a non-excepted Insuring Agreement is triggered, most commonly Insuring Agreement (B), that the exclusion carries weight.

1. National Bank of Andover v. Kansas Bankers Surety Company

The Court of Appeals of Kansas recently considered whether a bank’s payment of insufficient funds checks on behalf of its customers constituted a “Loan” for the purpose of applying a financial institution bond’s loan loss exclusion. In Nat’l Bank of Andover v. Kan. Bankers Sur. Co.,85 the head accounting clerk for an insured bank honored insufficient funds checks drawn on the accounts of three of the insured’s customers, rather than recording overdrafts in the customers’ account records.86 The clerk did not receive any financial reward for honoring these checks, which totaled over $900,000, nor does it appear that she was working in collusion with any of the customers. Rather, she claimed that she was having problems keeping up with her work, and that she believed those customers ultimately would repay the honored overdrafts.87

At trial, the insurer sought summary judgment on the issue that the loss was excluded by

application of the bond’s loan loss exclusion, asserting that the payment of insufficient funds checks constituted loans.88 The trial court denied this motion, finding that the loan exclusion did not apply to those transactions because “although they were loans, they had not been approved by the bank’s management.”89 At trial, the court refused to permit the insurer to present evidence that the loan exclusion applied, apparently based on its earlier ruling denying summary judgment.

In remanding the case for trial, the court of appeals ruled that the insurer should have

been permitted to present evidence at trial to establish that the loan loss exclusion precluded

85 No. 95,548, 2008 WL 939545 (Kan. Ct. App. April 4, 2008) 86 Id. at *1. 87 Id. 88 Id. at * 5. 89 Id. at *10.

coverage.90 The court noted that the payment of insufficient funds checks created a debtor-creditor relationship between the bank and its customers, and that the bank was entitled to reimbursement for the advances made.91 “The transaction…cannot be characterized as anything other than a consummated extension of credit, i.e., a loan from the bank.”92

The court of appeals did not overturn the trial court’s denial of summary judgment on this

issue because the insurer failed to provide undisputed evidence that Insuring Agreement (A) of the bond did not apply:

For [the insurer] to obtain summary judgment, it must establish through uncontroverted evidence not only that the honoring of insufficient funds checks constituted loans to the customer on whose account the checks were drawn, but also that the provisions of Insuring Agreement (A) do not apply. Insuring Agreement (A) includes the provision that “if some or all of the Insured’s loss results directly from Loans, that portion of the loss is not covered unless the Employee was in collusion with one or more parties to the transactions . . . .” For the purposes of summary judgment, [the insurer] had to demonstrate that [the accounting clerk] did not act in collusion with [the customers]. In its statement of uncontroverted facts, [the insurer] makes no such assertion.93

This finding provides a good example of how the application of the loan exclusion can be dependent on first determining whether coverage may be available under Insuring Agreements (A), (D), or (E).

2. First New England Federal Credit Union v. Cuna Mutual Group

A 2005 decision from a Connecticut state court addressed a financial institution bond’s definition of the term “Loan” in the context of a transaction extending of a line of credit on a home equity consumer revolving loan agreement. First New Eng. Fed. Credit Union v. Cuna Mutual Group94 involved a series of transactions by a borrower on a line of equity previously intended to be paid off and closed.95 Despite the banks’ intent to close the line, the borrower continued to take advances and make payments on the line of credit. A dispute developed and the borrower ultimately declared bankruptcy.96

The insured bank sought coverage under its bond, claiming that the transaction in question was not a loan because the funds were advanced in error. The insured further argued that even if the loss were found to arise out of a loan, the loss would still be covered under the bond because the proceeds were obtained by fraud, deceit, or theft within the meaning of the bond.97

90 Id. 91 Id. at *11. 92 Id. 93 Id. at *6. 94 No. CV03520148, 2005 WL 1154762 (Conn. Super. April 21, 2005). 95 Id. at *1. 96 Id. at *2. 97 Id.

The court began its analysis by noting the case law interpreting and applying the loan loss exclusion:

The cases dealing with the loan exclusion language of insurance policies all virtually identical to that in the present case do not focus on questions of whether the financial institution would have lent money if aware of the lender’s actual situation, or whether there was a meeting of the minds that a loan be made, or even whether the intent was to make a loan. The cases which have confronted this issue are basically in agreement that a loan exists in any situation wherein a bank expects that a customer will repay monies.98

The court followed that reasoning and held the language of the bond was not ambiguous and the immediate cause of the loss was nonpayment.99 The court dismissed the insured’s claim that there was never a creditor/lender relationship established and that no Loan ever existed within the meaning of the policy. To support this, the insured relied on the dictionary definition of the term “loan” and contract law to establish there was no meeting of the minds. Relying on the doctrine of construction for insurance policies, the court held it was bound by the definition provided in the bond.100

The court further noted that although the “plaintiff vehemently denies that any ‘loan’ was ever made, the record show[ed] that plaintiff has characterized itself as a ‘creditor’ in its filings in bankruptcy court, and referred to the funds as a loan in other documents.”101 The court found these statements to be an admission. But even beyond this, the court relied on the language of the bond and case law in reaching its conclusions, finding that the insured, through the computer error, “assumed” a creditor relationship with the borrower. In concluding the loss was not covered, the court focused on the purpose of the exclusion, which is to avoid the risk of writing credit insurance, and noted “common sense” dictates that it would be actuarially unsound for insurers to assume the risk of an “unknown, and perhaps infinite, number of bad debts.”102

3. Humboldt Bank v. Gulf Insurance Company

Humboldt Bank v. Gulf Ins. Co.103 analyzed the applicability of a Financial Institution Bond to losses resulting from the theft of the insured’s cash that was loaned to the owner of automated teller machines pursuant to a contract with the insured bank. In doing so, the court focused on the bond definition of Loan.

In this case, the owner of several ATMs was permitted to use its own armored truck service to transport cash from the insured bank to the machines.104 After the bank experienced a change in ownership, it was determined, not surprisingly, that the current procedure and direct access to the cash by the owner was unacceptable. The owner of the ATMs was then given 120 days notice that the contract to supply the ATM cash was terminated unless he agreed to use a third-party armored truck service. After receiving the notice and before the expiration of the 120 98 Id. 99 Id. at *3. 100. Id. 101. Id. 102 Id. 103 323 F. Supp. 2d 1027 (N.D. Cal. 2004). 104 Id.

days, the owner stole $5.25 million, disappeared, and was later found dead in Florida. An investigation by the FBI recovered approximately $3.7 million of the money, and the insured made a claim under its bond for the remaining $1.3 million.105 The claim was denied on the basis of the loan loss exclusion.

In subsequent suit on the matter, the Northern District of California court, looking at the loan loss exclusion “through the eyes of a reasonable lay person,” concluded that the money given to the owner which formed the basis for the action was “in the nature of a loan” or an “extension of credit.”106 The court dismissed the insured’s claim that a review of its internal accounting and financial reporting procedures demonstrated that it did not view or ever treat the transactions as loans. To circumvent the application of the loan loss exclusion, the insured also argued the transactions could not be considered loans because the insured always maintained, pursuant to the contract, exclusive ownership and control of the subject funds. The court stated, “[w]hile it is true that the [Cash Agreement] grants [the insured] title and control over the money, this element does not preclude the Court from finding that this transaction was ‘in the nature of a loan.’”107

In dismissing the insured’s arguments, the court noted that under the contract to provide cash to the ATM owner, the insured received a fixed rate on the amount of money used in addition to other set fees and charges. The owner was also required to fill out an application requesting the same information and materials requested in traditional loan applications. Upon termination of the agreement, the insured would receive an immediate return on the full amount of advances outstanding or receive interest at a rate of 18% on such amounts.108 The court found it “commonsensical” to conclude that this money was “in the nature of a loan” or an “extension of credit.” The court’s decision is consistent with the intent of the loan loss exclusion:

As one commentator has stated, financial bonds in general allocate the risks of loss between an insurer and the financial institution: It is a compromise between insuring against certain risks and providing that coverage at a reasonable premium. To achieve this, credit risks (a natural result of lending money) stay with the financial institution. The loan exclusion accomplishes this goal by sweeping away all loan losses caused by fraud, no matter how pervasive the fraud, unless the loss falls within one of the narrow exceptions to the loan exclusion.109

The court also recognized that the loan loss exclusion is written broadly to include much more than just a “loan” as defined by banking industry standards.110 Applying the economic substance of the transactions, the court declined to “rewrite the terms of the Bond” and enforced the loan loss exclusion, precluding coverage for Humboldt’s claim.

105 Id. 106 Id. at 1033. 107 Id. 108 Id. 109 Id. 110 Id.

D. CONCLUSION

The courts continue to express a willingness to look to the design of the Financial Institution Bond as a whole and recognize the intent of the loan loss exclusion—preclude coverage under the bond for unfortunate loan decisions. The underwriter has no ability to properly assess the likelihood of such decisions and base a premium thereon. Consequently, the business risk that arises in any credit transaction stays with the insured, and that allocation is made through the loan loss exclusion. The trade-off is simple: less interference by the insurer with respect to the insured’s daily activities in exchange for a lower premium.

III. Inventory Loss Exclusion A common way insured entities will confirm or discover an employee dishonesty act or other fidelity loss is by conducting an inventory analysis or a profit and loss statement.111 These methods are often used to gauge the scope of an insured’s loss when it suspects an employee of theft or dishonesty. In other circumstances, the insured’s use of these procedures in its normal business practices can reveal a shortage in income that could be explained by intentional wrongful acts of the insured’s employees.112 When fidelity losses are revealed or confirmed by inventory count or the preparation of a profit and loss statement, the insured often will based the amount of its claim on these types of analyses. An insured’s reliance on an inventory analysis or a profit and loss statement to support a fidelity claim is problematic to the insurer for several reasons. First, even if there is some other evidence of an otherwise covered claim, the use of these procedures to determine the scope of the loss often is not accurate. There can be several other factors reflecting the amount of “loss” shown in an inventory count or profit and loss statement that would not be covered by a commercial crime or similar fidelity policy, including but not limited to as non-intentional accounting mistakes, market factors, and losses covered under a first-party property or business income insurance policy. Accordingly, commercial crime policies have long excluded or limited coverage for fidelity or commercial crime claims that are based solely or substantially on inventory analysis or profit and loss statements.113 As one court noted, those provisions “reflected a belief that proof of an inventory shortage does not establish either that there has been actual loss of goods or, in case of an actual loss, that it is due to employee dishonesty. The [inventory exclusion] clause is designed to protect the insurer against claims based on erroneous or falsified computations.”114

A. THE LANGUAGE OF INVENTORY LOSS EXCLUSIONS For over 50 years, commercial crime and other similar policies have included exclusions precluding coverage for losses that are substantiated solely by the use of inventory counts or

111 See D.M. Studler & Dolores A. Parr, Inventory Loss Exclusion, in ANNOTATED COMMERCIAL CRIME POLICY

267 (Cole S. Kain & Lana M. Glovach, eds., 2d ed. 2006). 112 Id. 113 Id. at 268-69. 114 Popeo v. Liberty Mut. Ins. Co., 343 N.E.2d 417. 419 (Mass. 1976).

profit and loss statements.115 The most recent versions of these inventory exclusions include language identical or substantially similar to the following, which excludes coverage for:

b. Inventory Shortages: loss, or that part of any loss, the proof of which as to its existence or amount is dependent upon:

(1) An inventory computation; or (2) A profit and loss computation.116

However, some inventory exclusions, such as that contained in ISO’s Commercial Crime Policy (Loss Sustained Form), include a provision that permits an insured to utilize an inventory count only – and not a profit and loss computation – to establish the amount of a covered loss if that insured is able to prove that a covered loss occurred wholly independent of the inventory analysis.117 That exclusion precludes coverage for

b. Inventory Shortages Loss, or that part of any loss, the proof of which as to its existence or amount is dependent upon: (1) An inventory computation; or (2) A profit and loss computation. However, where you establish wholly apart from such computations that you have sustained a loss, then you may offer your inventory records and actual physical count of inventory in support of the amount of loss claimed.118

Insurers utilizing this provision require insureds to compare their inventory records with an actual physical count of the inventory.119 Use of a loss of profit calculation will be unacceptable to establish loss under this provision.120

B. APPLICATION OF THE EXCLUSION Courts have generally enforced the intent of inventory exclusion in those policies, both for the policies that include a provision permitting the use of an inventory calculation to establishing the amount of loss and those that do not.121 In Sec. Ins. Co. of Hartford v.

115 See Studler & Parr, supra note 111, at 269. 116 Employee Dishonesty Coverage Form (Form A, Blanket), CR 00 01 10 90 (Sur. Ass’n of Am. 1997), reprinted

in ANNOTATED COMMERCIAL CRIME POLICY, supra note 111, App’x, at Ex. I. 117 See Studler & Parr, supra note 111, at 270. 118 Commercial Crime Policy, CR 00 23 07 02 (ISO Props., Inc. 2001) (Loss Sustained Form), reprinted in

ANNOTATED COMMERCIAL CRIME POLICY, supra note 111, App’x, at Ex. E. 119 See Ace Wire & Cable Co. v. Aetna Cas. & Sur. Co., 454 NY.S.2d 897, 900 (N.Y. App. Div. 1982). 120 See Studler & Parr, supra note 111, at 271. 121 See, e.g., Blue Stripe, Inc. v. U.S. Fid. & Guar. Co., 360 S.E.2d 140, 141 (N.C. Ct. App. 1987) (applying the

exclusion as written where insured’s evidence showed that loss was “disclosed on taking inventory”); Ernie Von Schledorn, Ltd. v. U.S. Fid. & Guar. Co., No. 00-2775, 2001 WL 942595 at *2 (applying the exclusion to

Wilson,122 an insured restaurant owner submitted a claim under an employee dishonesty endorsement to its business liability policy based for a loss related to cash stolen by the insured’s business manager.123 The insured apparently was able to provide independent evidence of the business manager’s theft, but relied solely upon a profit and loss computation to establish the amount of its claimed loss. The insurer denied coverage based on an inventory exclusion that did not permit use of a physical inventory calculation to establish the amount of loss. The court upheld this denial:

The language of section 2(b) [the inventory exclusion] is clear and unambiguous: a claim footed on alleged employee dishonesty must be supported by more than profit and loss computations . . . . In opposing a motion for summary judgment, the [insured] had the burden to come forward with other evidence of the amount as well as the existence of the alleged loss to raise a genuine issue of material fact for trial on those essential elements of their claim. Their failure to do so – their admitted inability to do so – amply supports the district court’s summary judgment against them on that issue.124

It is important to note that, while courts typically enforce the provisions as written, some are hesitant to apply the exclusion broadly with respect to what constitutes an “inventory computation” or a “profit and loss computation.” In Stings & Things in Memphis, Inc. v. State Auto Ins. Cos.,125 an insured musical instrument seller submitted a claim under its employee dishonest coverage for approximately $30,000 in missing inventory.126 In support of its loss, the insured submitted invoices, packing lists, sales receipts and other documents showing that it had purchased and financed the missing instruments and equipment, but that they had not been sold in the ordinary course of business. It also testified that a visual inspection of its inventory indicated that certain items were missing. The insurer denied coverage relying on the inventory loss exclusion, asserting that the documentation submitted by the insured constituted an “inventory computation.”127 The Court disagreed with the insurer, finding that the evidence provided by the insured did not constitute an “inventory computation”:

The language in the policy in this case refers to an “inventory computation,” which denotes some type of mathematical calculation. Considering the language used, we feel that … the policy exclusion [does] not apply[] to a physical count of individually identifiable units of inventory. When dealing with individual identifiable units, there is no computation involved; the unit is simply present and accounted for, or it is missing. We think it is significant that the policy language

preclude coverage where the only evidence supporting the loss was inventory computations and a telephone conversation transcript that was inadmissible hearsay the could not be used to support the claim); but see Movie Distrs. Liquidating Trust v. Reliance Ins. Co., 595 A.2d 1302, 1307-08 (Pa. Super. Ct. 1991)

122 800 F. 2d 232 (10th Cir. 1986). 123 Id. at 233. 124 Id. at 233-34 (citing Lumbermens Mut. Cas. Co. v. Renaurt-Bailey-Cheely Lumber and Supply Co., 387 F.2d

423, 425 (5th Cir. 1968); Paramount Paper Products Co. v. Aetna Cas. & Sur. Co., 157 N.W.2d 763, 768 (Neb. 1968)).

125 920 S.W.2d 652 (Tenn. Ct. App. 1995). 126 Id. at 654. 127 Id. at 656.

excludes loss based on an inventory computation rather than on an enumeration of missing items.128

Other courts have taken similar positions regarding what does or does not constitute an “inventory computation” or a “profit and loss computation.”129

C. RECENT DECISIONS INVOLVING THE INVENTORY LOSS EXCLUSION

Although the inventory loss exclusion is an issue that insureds and insurers alike need to be aware, there are no notable recent decisions interpreting this provision in commercial crime or employee dishonesty claims. There are, however, recent cases involving a similar exclusion that can be found in first-party commercial property policies. That exclusion precludes coverage for tangible property that is missing, where the only evidence of the loss or damage is a shortage disclosed on taking inventory, or other instances where there is no physical evidence to show what happened to the property.130 The application of an inventory exclusion was a major issue in HCA, Inc. v. Am. Protection Ins. Co.131 There, an insured hospital system (HCA) sought coverage under a first-party property policy for the loss of several million dollars worth of linen stock that purportedly was caused by the negligence or intentional misconduct of the hospital’s linen management company (FDR).132 Approximately two and a half years after HCA first began using FDR, the hospital system conducted a physical inventory of linen stocks at each of its medical facilities. Based on this inventory, HCA determined that it had suffered a loss of linen stock valued at between $8 million and $12 million. After conducting this analysis, HCA submitted claims to different insurers under various “all-risk” property policies the carriers issued.133 The carriers denied coverage for several reasons, including the application of an inventory exclusion, which in relevant part precluded coverage for “loss or shortage disclosed on taking inventory, except this exclusion does not prohibit proving the amount of any loss otherwise provable by inventory.”134 The trial court granted summary judgment to the carriers, finding that the inventory exclusion precluded coverage.135 On appeal, the Tennessee Court of Appeals reversed the summary judgment ruling. After an exhaustive discussion of case law relating to similar inventory exclusions, the court found that there was a factual dispute as to whether the inventory exclusion applied.136 The court determined that HCA had presented evidence that it was aware that it had suffered substantial losses of its linen stock under FDR’s 128 Id. at 657. 129 See, e.g., Fid. & Dep. Co. of Md. v. S. Util., Inc., 726 F.2d 692, 695 (11th Cir. 1984) (finding that purchase

orders, invoices for good delivered incorrectly or not delivered, monthly statements, cancelled checks, building plans, job specifications, bid estimates, and expert and lay testimony supporting loss was evidence “independent of any inventory or profit and loss computation.”).

130 See, e.g., Better Environment, Inc. v. ITT Hartford Ins. Group, 96 F. Supp. 2d 162, 164 (N.D.N.Y. 2000); HCA, Inc. v. Am. Protection Ins. Co., 174 S.W.3d 184 (Tenn. Ct. App. 2005). 131 174 S.W.3d 184. 132 Id. at 188. 133 Id. 134 Id. at 187. 135 Id. at 190. 136 Id. at 195-210, 215.

care and had reported these losses to FDR more than a year before it conducted the inventory that preceded its insurance claim.137 While the court acknowledged that the fact finder may not accept the hospital’s “evidence establishing a loss independent of the inventory, or indeed, whether or not the September 1998 inventory quantifies any such loss,” the evidence was sufficient to preclude summary judgment on the issue.138 In Westcom Corp. v. Greater N.Y. Mut. Ins. Co.,139 an insured telecommunications company sought coverage under a first-party property policy for the loss of several digital line interface cards (“DLICs”) from an off-site storage facility.140 While visiting the off-site storage facility one day, an insured’s employee discovered that the padlock securing the unit had a key broken off in the keyhole. At the insured’s request, the owner of the storage facility cut off the padlock, and the insured placed a new padlock on the unit. However, the insured did not check the inside of the unit at this time. Two days later, another employee of the insured visited the storage unit and discovered that none of the DLICs were there. Moreover, no one had physically observed the inside of the storage unit form approximately two months before the discovery of the missing DLICs.141 The insured submitted a claim of loss with its insurer. The insurer denied coverage on the ground that the claimed loss fell within the policy’s exclusion for “[p]roperty that is missing, but there is no physical evidence to show what happened to it, such as shortage disclosed on taking inventory.”142 The court agreed with this denial, acknowledging that while the loss was not disclosed upon taking an inventory, there still was “no evidence at all, much less any ‘physical’ evidence, to show ‘what happened to’ the DLICs.”143 In so finding, the court disagreed with the insured’s claim that the broken off key in the padlock was physical evidence of what happened, because the unit remained secured and there was no evidence that any attempt to gain access to the unit had been successful.144 While these cases do not address inventory exclusions contained in commercial crime or employee dishonesty coverages, they do demonstrate both that courts continue to enforce the intent behind inventory exclusions, but generally will not take a broad view of what constitutes an inventory or profit and loss computation in determining whether there is evidence of a loss wholly independent of such calculations. 7138753.1

137 Id. at 210-213. 138 Id. at 214. 139 839 N.Y.S.2d 19 (N.Y. App. Div. 2007). 140 Id. at 21. 141 Id. 142 Id. 143 Id. at 22. 144 Id.

1

HB Litigation Conference | HB Litigation Conference |

December 3, 2009 December 3, 2009

Fidelity Bond & Crime CoverageFidelity Bond & Crime Coverage

Kevin Mattessich, Esq.Cozen O’Connor, New York (212) 908-1252 [email protected]

William Passannante, Esq. Anderson Kill & Olick, P.C., New York (212) 278-1328 [email protected]

Ponzi Schemes and Coverage-Related Issues --

Fidelity, D&O & E&O Coverage

2

DISCLAIMER

The views expressed by the participants in this program are not those of the participants employers, their clients, or any other organization. The opinions expressed do not constitute legal advice, or risk management advice. The views discussed are for educational purposes only, and provided only for use during this session

http://www.cozen.com/index.asp?d=1

3

I. Fidelity Bond Coverage For Ponzi Schemes

II. D&O and E&O Coverage

OVERVIEW

4

It’s all just one big lie.”

Bernard Madoff –

December 2008

5

THE GREATEST ?THE GREATEST ?

6

Compton pastor accused of embezzling $800,000 in church funds (Los Angeles Times, August 20, 2009)

Hawthorne company's ex-bookkeeper sentenced for embezzlement (LoHud.com, September 15, 2009) ($260,000)Allentown woman caught stealing over $1.6 million from employer (Chicago Tribune, July 27, 2009)

Vektek embezzler, wife sentenced (The Emporia Gazette, September 10, 2009) ($2.6 million)

Garnerville woman pleads guilty to embezzling $700G from New City bank (LoHud.com, August 28, 2009)

Ex-OSSAA official is charged (Tulsa World, August 15, 2009)($457,500)

7

Fraud

8

Fraud“Of the 3,037 respondents. . .905 (30%) reported having

experienced at least one incident of fraud in the last 12 months alone.”

-No apparent link between economic downturn and economic crime.

The Global Economic Crime Survey, PWC (Nov. 2009)

Credit Crunch & Tough Economic Climate Fraud up 22% Average $8.2 million loss Kroll Global Fraud Report

(September 15, 2008)

Treasury & Risk Management

(March 2009) at 10.

9

Ponzi or pyramid schemes – in which later investors’ cash is used to pay huge “returns” to earlier investors – are as old as capitalism itself, and they have taken multiple forms, ranging from the Dutch tulip scandals of the 1600s to the Bernard Madoff investment scam.

The ongoing global economic downturn exposes new Ponzi schemes on almost a weekly basis.

Charles Ponzi, circa 1920 - Double your money in 90 days!

10

When Ponzi schemes inevitably collapse, investors and those responsible for unwinding the fraud will pursue claims against a host of parties.

Such claims may involve fraud actions against the swindlers; negligence actions against various professionals who were to have acted as gatekeepers, advisors and/or fiduciaries; as well as claims against the against “feeder” funds and other financial institutions which ostensibly promised to ensure that investors’ funds were being properly and safely managed.

Those out of pocket will also consider whether their losses may be recoverable under either commercial crime or financial institution policies.

11

PYRAMID SCHEMES Investment pyramid schemes are relatively simple frauds in which the fraudster touts a seemingly fool-proof investment device to would-be investors. Armed with the original pool of investment cash, the fraudster may or may not actually invest some

of the money, but almost always siphons an

enormous portion of the “investment”

cash for personal use. The original “investors”

later receive their promised

“returns,”

but those funds actually come from fresh investments made by later “investors”

and not any actual

success arising from the purported “investment.”

12

INSURED ENTITIES

Insured entities may potentially include:

A.

The Fraudster

B.

Ponzi-Fund and Related Entities

C.

Fraudster’s Family

D.

“Feeder”

Funds

E.

“Funds of Funds”

13

INSURED ENTITIES (cont’d)

F.

Investment Managers / Advisors

G.

Investment Fund Accountants

H.

Lawyers

I. Earlier-Paid Investors Including individual investors, funds and others such as not for profits.

14

FINANCIAL INSTITUTION AND COMMERCIAL CRIME POLICIES

Financial institution and commercial crime bonds are first-party policies designed to reimburse the policyholder for losses suffered as a result of an employee’s dishonest conduct and other itemized perils.

Typically covered perils include losses resulting from:

A. Employee dishonesty;B. Forgery of negotiable instruments;C. The “theft, disappearance or destruction”

of money, securities or property either inside or away from the insured’s premises; wire fraud; and,

D.

Computer fraud.“Defined Risk”, “First Party”

policies.

15

Fidelity CoverageA typical “fidelity”

or “employee dishonesty”

insuring agreement in an FI or commercial crime policy provides:

We will pay for loss or damage to “money”, “securities”

and “other property”

resulting directly from dishonesty acts committed by an “employee”, whether identified or not, acting alone or in collusion with other persons, with the manifest intent to:

a.

Cause you to sustain loss; and also

b.

Obtain financial benefit (other than employee benefits earned in

the normal course of employment, including: salaries, commissions, fees, bonuses, promotions, awards, profit sharing or pensions for:

(1)

The employer; or

(2)

Any person or organization intended by the employee to receive that benefit.

16

Fidelity Coverage (cont’d)Who is Covered “Employee”

Fidelity coverage extends to losses incurred as a result of the conduct of the policy-holder’s “employee”.

The definition of “employee”

may vary, but typical form policies define “employee”

to mean a natural person in the

policyholder’s service (and most times for a short period, i.e., 30 days, following their departure) who the policyholder compensates directly and has the right to direct and control.

17

Some courts hold that the “principal test of an employer and employee relationship is control.”

In the context of Ponzi schemes, the individual fraudster might qualify as an “employee”

for purposes of the

Ponzi-fund’s own fidelity coverage (if any), subject to other policy limitations.

18

“Feeder”

funds, “funds of funds”

and other third-party funds and professionals presumably did not in any way “direct”

or

“control”

the fraudsters at the helm of a Ponzi-fund –

in fact, many of the emerging allegations suggest to the contrary.

Thus, in most Ponzi scheme situations, it would be unlikely that a “feeder”

fund or other third-party investment fund

could claim coverage under its own fidelity policy because the alleged conduct did not involve a covered “employee.”

19

Some financial institutions may have successfully added certain individual “investment advisors”

or “sub-advisors”

within the definition of a covered “employee”

for fidelity purposes, or sometimes even expressly naming the fraudster or Ponzi-fund as an additional named insured.

This may allow “feeder”

funds or “funds of funds”

– especially those which steeped their entire holdings into a

Ponzi-fund –

to look at their FI coverage to recoup their losses.

20

The Employee Must Act With a “Manifest Intent”

to Cause a Direct Loss

Most commercial crime / fidelity policies require that any direct, first-party loss result from the employee’s “manifest intent”

to cause the insured a loss and to gain a financial

benefit for the employee.

Absent the highly-unusual confession by the fraudster as to his or her intent in the Ponzi-scheme, determining whether the insured’s employee acted with “manifest intent”

requires

a highly-factual analysis.

Policyholders view “intent”

as ascertainable from circumstances.

21

In the past, judicial interpretations have ranged from:

A. An objective test of evaluating the intent (i.e., whether the employee actually wanted to achieve the loss or the natural consequence of his/her actions was to cause a loss), to

B. A purely subjective or “specific intent”

approach (i.e., whether the fraudster’s words and conduct show his intent to cause this particular loss.)

22

It appears, however, that the emerging majority of courts will employ a blended or substantial certainty”

test (i.e., whether the actor’s words or

actions show that a loss was substantially certain to result) to examine the “manifest intent”

issue.

Again, Policyholder and insurance company will often differ.

23

With respect to insurance claims made by Ponzi-funds (including as made through a fund’s trustee or receiver), or where the fraudster or fund is somehow otherwise considered a covered “employee”

under a “feeder”

investment fund’s bond, it will be necessary for the policyholder to show that the fraudster’s actions (and words, if they are available) demonstrate that he knew the conduct was “substantially certain”

to cause a loss.

24

Forgery or Alteration of Negotiable InstrumentsFI and crime policies may contain a “forgery or alteration”

insuring agreement which provides:

a.

We will pay for loss resulting directly from “forgery”

or alteration of checks, drafts, promissory notes, or similar written promises, orders, or directions to pay a sum certain in “money”

that are:

(1)

Made or drawn by or drawn upon you;

(2)

Made or drawn by one acting as your agent; or that are purported

to have been so made or drawn.

b.

If you are sued for refusing to pay any instrument covered in paragraph a. above, on the basis that it has been forged or altered, and you have our written consent to defend against the suit, we will pay for any reasonable legal

expenses that you incur and pay in that defense. The amount that we will pay is in addition to the Limit of Insurance applicable to this Insurance Agreement.

25

The “forgery or alteration”

coverage of an FI bond is limited to situations involving the enumerated negotiable instruments, the key feature

being that a third party has forged or altered the covered documents that were drawn on the Insured as promises, orders or demands to pay a sum

certain.

In contrast, a Ponzi victim has been induced to part with his money on the basis of false promises, and the schemes do not involve payments on forged or altered documents in otherwise legitimate transactions.

26

Wire Computer Fraud Commercial crime policies might also include a “computer fraud”

insuring agreement which provides:

We will pay for loss of or damage to “money,”

“securities” and “other property”

resulting from the use of any computer

to fraudulently cause a transfer of that property from inside the “premises”

or “banking premises”:

a.

To a person (other than a “messenger”) outside those “premises”; or

b.

To a place outside those “premises.”

27

It seems unlikely that any of the emerging Ponzi scheme cases will implicate this coverage part.

First, the Ponzi-funds themselves are not, in any of the current cases, alleged to have “cause[d] a transfer”

of their victims’

investment funds to any person or place outside of the Ponzi-fund. The Ponzi-funds in fact allegedly accepted

(not caused) the transfer of investment funds from

(not “to”) another person or place.

Second, the third-party investment funds (“feeder”

funds, “funds of funds,”

etc.) are not alleged to have fraudulently

cause[d] a transfer,”

but to have negligently

caused their investors’

money to be transferred to the Ponzi-funds.

28

Discovery and Loss-Sustained Coverage

Many commercial crime / fidelity policies operate strictly on a “loss discovered and sustained”

basis.

Losses discovered and/or sustained prior to the inception of coverage are not covered, unless the policy provides otherwise.

29

In the context of Ponzi-fund cases, it is not difficult to imagine facts emerging which suggest the policyholder may have known about the fraud much earlier than it was revealed–i.e., in a prior policy period. These questions usually surface in the initial claims investigation and largely in situations where the insured conducted a lengthy internal investigation long before notifying the insurer of a loss or potential loss.

30

This highly-factual inquiry to pinpoint “discovery”

by a policyholder pits the insured’s “mere suspicions”

(which do

not trigger “discovery”) against an evaluation of whether the facts would cause a reasonable person to assume that a loss occurred or will occur or that would justify a prudent person to charge another with dishonesty or fraud (which does trigger “discovery”

and corresponding notice duties), even if

the details or amount of the loss are not known or quantifiable.

Policyholders may view this inquiry as post-loss underwriting.

31

Commercial crime / fidelity policies, usually contain some form of a “loss sustained during prior insurance”

provision

that allows for recovery of pre-sustained losses suffered as part of a long-running scheme provided

that:

A. The loss was discovered during the bond period (and not prior),

B. The policyholder had prior commercial crime/fidelity coverage in place,

C. There was no lapse in coverage, and

D. The losses would have been covered under the prior commercial crime/fidelity policies.

32

Issues over these features of commercial crime / fidelity insurance seem almost certain to emerge in Ponzi-fund matters because the schemes were usually long-term affairs. Losses claimed against commercial crime / fidelity policies likely will reach back through many policy periods.

33

FI/Commercial Crime Coverage Does Not Typically Apply to Third-Party Liability Actions

Commercial crime policies and fidelity bonds are first-party policies designed to cover the policyholder’s direct losses. They generally do not respond to provide coverage for losses as a result of liability to third parties –

theoretically, that exposure

is left to the province of D&O and E&O insurance.

34

In the context of Ponzi-fund cases, many of the pending and anticipated lawsuits against policyholder financial institutions by former investors or other third-parties who allegedly relied on the policyholder’s work or certifications as to the accuracy of the Ponzi-fund investments would not likely trigger fidelity coverage in the first place. They are third-party liability actions and are not generally subject to FI coverage because they allege, for example, negligence, securities violations, and misrepresentations that cause the third-party investor to suffer damages.

35

Potentially-Applicable Fidelity Policy Exclusions

Acts Committed by The Insured Are Not Recoverable

Fidelity policies typically exclude from coverage any “loss”

resulting from the dishonest acts of the

insured or its partners.

36

Examples of such an exclusion include:

We will not pay for loss as specified below:

1.

Acts Committed by You or Your Partners Loss resulting from any dishonest act

committed by you or any of your partners whether acting alone or in collusion with other persons.

37

Using the Madoff scheme as an illustration, when boiled to its core, it seems possible to argue that Madoff ran BMIS as his “alter ego”

and that the exclusion would apply to Madoff.

Guided by common law principles of the “alter ego”

theory, available information seems to demonstrate that Madoff exercised complete or near-complete domination over BMIS, and Madoff’s

domination of the company was used to

commit the Ponzi fraud against investor victims now suing.

38

Trading Losses Exclusion From Fidelity Coverage

Commercial crime policies also typically exclude the following:

c.

Trading

Loss resulting directly or indirectly from trading, whether in your name or in a genuine or fictitious account.

39

The purpose of this exclusion, as one court put it, is to “exempt from coverage losses caused by market forces, misjudgments of those forces by buyers and sellers of securities, or various errors or omissions in the course of trading.

40

The “trading loss”

exclusion may be most important to insurers faced with claims by third-party “feeder”

funds and the like –

as opposed to any Ponzi-fund fidelity insurer–because excluded “trading losses”

have been defined by the courts to mean losses resulting from “ill-advised, unauthorized, or simply unlucky”

trades, involving no dishonesty on the part of the employee or insured at all.

It is key in this situation to distinguish between the dishonesty of the Ponzi-fund fraudster and the conduct of third-party investment advisors or managers who allegedly misguided their clients’

money into the Ponzi-fund.

The latter is what would most likely be presented as part of a third-party trading entity’s claim under fidelity insurance and would appear, by virtue of how the courts treat the language, to fall within the exclusion from fidelity / commercial crime coverage.

41

It is largely because of this “trading loss”

exclusion, as well as the nature of fidelity / commercial crime coverage as first-party, direct-loss insurance, that the bulk of insurance claims and losses for Ponzi-

fund matters may fall within the realm of D&O and E&O insurance.

42

Notice and Proof of Loss Questions Under Commercial Crime/Fidelity Insurance

— Notice Anything?

— Proof of loss timing

— Suit limitations

43

The typical commercial crime / fidelity policy requires notice of a loss or circumstances “as soon as possible”

after discovery by the insured. Some policies require that, in any event, notice must be given within

a strictly-defined time period, such as 30, 60 or 90 days after discovery of the loss.Discovery, however, is an often-litigated point of contention in many fidelity claims, and may have relevance to Ponzi scheme matters, especially if there arise indications that third-party investment funds had sufficient knowledge of a fraud but simply looked the other way.

When evaluating the timeliness or adequacy of an insured’s notice, especially in a Ponzi-fund matter involving long-running schemes, the claims professional might be well-served to also examine whether the notification period under any

prior

fidelity bonds has in fact expired, as most commercial crime / fidelity policies provide extended reporting or tail periods and there may be an issue concerning an overlap of coverage between current and prior bonds.

44

The Perfect Storm…for Liability Insurance

45

The Perfect Storm… for Liability Insurance

1.

Huge potential losses2.

Continuing “Soft”

Market

3.

Non-Existent (though recovering) Investment Income

4.

Inability of Policyholder to Reduce Recovery

Therefore, enormous

claims pressure

46

1. Individuals1. Directors or Officers of Entities2. Employees/Professionals

2. Investment funds / sub-funds and Investment advisors / sub- advisors1. Related Entities (by endorsement)2. Unnamed Funds – Insured Definitions key

E&O / D&O LIABILITY INSURANCEE&O / D&O LIABILITY INSURANCE

47

1. What is a “Claim”?1. Investigations?2. Subpoena

1. Demand for relief?1. No definition?


48

1. What is a “Wrongful Act”?

1. D&O – Capacity, indemnifable?

2. E&O – Capacity, scope of “Professional Services” – specialized skill.


49

1. What is “Loss”?

1. “Loss”— includes defense costs.1. Advancement

2. Exclusions — Defenses costs adequacy1. Fraud, deliberate dishonesty (finally

adjudicated)2. Personal profit


50

1.Bankruptcy – Priority of payments

1.I v. I issues.

2.Side-A issues.

1.More Common2.Purpose3.Different forms


51

Policyholder Keys To Maximizing Recovery1.

Draft Your Team (Insurance, Finance, Legal)

2.

Identify Your Risks

3.

Mitigate Exposure and Loss

4.

Know All Your Policies

5.

Identify & Meet All Deadlines & Requirements

6.

Create A Formal Information Distribution Chain

7.

Keep An Organized Claim/Investigation File

8.

Lead The Claim Process

52

HB Litigation Conference | HB Litigation Conference |

December 3, 2009 December 3, 2009

Fidelity Bond & Crime CoverageFidelity Bond & Crime Coverage

Kevin Mattessich, Esq.Cozen O’Connor, New York (212) 908-1252 [email protected]

William Passannante, Esq. Anderson Kill & Olick, P.C., New York (212) 278-1328 [email protected]

Ponzi Schemes and Coverage-Related Issues --

Fidelity, D&O & E&O Coverage

11

Crime and Fidelity CoverageCrime and Fidelity Coverage ““Market Trends and IssuesMarket Trends and Issues””

Patricia Logan / Vice PresidentPatricia Logan / Vice PresidentBerkley Asset Protection Underwriting Managers LLCBerkley Asset Protection Underwriting Managers LLC

Steven Balmer / Product ManagerSteven Balmer / Product ManagerTravelers / Bond & Financial ProductsTravelers / Bond & Financial Products

Thursday, December 3, 2009Thursday, December 3, 2009

22


33

Crime and Fidelity / MarketplaceCrime and Fidelity / Marketplace

What is the industry size?What is the industry size?

•• 2008 Direct Written Premium = $1,089,407,7032008 Direct Written Premium = $1,089,407,703

•• 2008 Direct Earned Premium = $1,110,102,3782008 Direct Earned Premium = $1,110,102,378

Source: Source: ©© The Surety & Fidelity Association of America / Top 50 Writers oThe Surety & Fidelity Association of America / Top 50 Writers of Fidelity f Fidelity

44


Who underwrites this business?Who underwrites this business?

•• More than 100 companies underwrite this insurance.More than 100 companies underwrite this insurance.

•• The top 50 companies write 99.6% of the business.The top 50 companies write 99.6% of the business.

•• The top 10 companies write 88.3%The top 10 companies write 88.3%

Source for all data: Surety and Fidelity Association of AmericaSource for all data: Surety and Fidelity Association of America

55

Crime and Fidelity / MarketplaceCrime and Fidelity / Marketplace @ 12/31/08@ 12/31/08

Top 10 WritersTop 10 Writers Direct Written Premium Direct Written Premium Market ShareMarket Share($000)($000) (%)(%)

1.1. Chubb Chubb 242,351 242,351 22.222.22.2. Travelers Travelers 175,663 16.1175,663 16.13.3. ChartisChartis 139,944 139,944 12.812.84.4. Zurich 100,847 Zurich 100,847 9.29.25.5. CunaCuna Mutual Group 87,268 Mutual Group 87,268 8.08.06.6. Great American 68,985 Great American 68,985 6.36.37.7. Hartford 61,781 Hartford 61,781 5.65.68.8. C N A 56,192 C N A 56,192 5.15.19.9. Fairfax Financial Group 17,854 Fairfax Financial Group 17,854 1.61.610.10. Ace Ltd. Group Ace Ltd. Group 14,34414,344 1.31.3Total Top Ten 965,229 Total Top Ten 965,229 88.3 88.3 Total All Other Writers 128,335 Total All Other Writers 128,335 11.711.7Total All Writers 1,093,564 Total All Writers 1,093,564 100.0100.0Source: The Surety and Fidelity Association of AmericaSource: The Surety and Fidelity Association of America

66

Crime and Fidelity / State of the IndustryCrime and Fidelity / State of the Industry Total Fidelity Results Total Fidelity Results (000)(000)

Calendar Yr Calendar Yr Earned PremiumEarned Premium Incurred LossesIncurred Losses Loss RatioLoss Ratio

2002 667,147 605,92002 667,147 605,932 90.8 32 90.8 2003 739,617 269,22003 739,617 269,225 36.425 36.42004 745,025 347,42004 745,025 347,400 46.600 46.62005 737,316 299,32005 737,316 299,396 40.696 40.62006 764,373 264,92006 764,373 264,933 34.733 34.72007 770,628 266,52007 770,628 266,551 34.651 34.62008 2008 758,154758,154 304,596304,596 40.440.4TOTAL 5,182,260 2,358,033 TOTAL 5,182,260 2,358,033 45.545.5

Note: Surety and Fidelity Association of America / Statistical Note: Surety and Fidelity Association of America / Statistical Plan ResultsPlan Results

77

Crime and Fidelity / State of the IndustryCrime and Fidelity / State of the Industry Total Financial Institution Results Total Financial Institution Results (000)(000)


2002 267,752 282,72002 267,752 282,775 105.6 75 105.6 2003 288,123 118,02003 288,123 118,063 41.063 41.02004 305,181 157,12004 305,181 157,113 51.513 51.52005 293,314 156,72005 293,314 156,770 53.470 53.42006 300,925 147,22006 300,925 147,297 48.997 48.92007 297,135 115,82007 297,135 115,857 39.057 39.02008 2008 308,864 308,864 112,868 112,868 38.238.2TOTAL 2,061,294 1,090,743 TOTAL 2,061,294 1,090,743 52.952.9


88

Crime and Fidelity / State of the IndustryCrime and Fidelity / State of the Industry Total Commercial Fidelity Results (000)Total Commercial Fidelity Results (000)


2002 399,395 323,12002 399,395 323,158 81.0 58 81.0 2003 451,494 151,12003 451,494 151,162 33.562 33.52004 439,844 190,22004 439,844 190,287 43.387 43.32005 444,001 142,72005 444,001 142,726 32.226 32.22006 463,448 117,62006 463,448 117,636 25.436 25.42007 473,493 150,62007 473,493 150,694 31.994 31.92008 2008 457,943457,943 191,728191,728 41.941.9TOTAL 2,061,294 1,090,743 TOTAL 2,061,294 1,090,743 52.952.9


99

Crime and Fidelity / Marketplace Crime and Fidelity / Marketplace →→ ResultsResults Profitability Measure Profitability Measure →→ Combined RatioCombined Ratio

Incurred Loss Ratio (Incurred Losses / Earned Premium)Incurred Loss Ratio (Incurred Losses / Earned Premium)+ Incurred Loss Adjustment Expense Ratio+ Incurred Loss Adjustment Expense Ratio

(LAE / Earned Premium)(LAE / Earned Premium)+ Expense Ratio (Expenses / Written Premium)+ Expense Ratio (Expenses / Written Premium)

= Combined Ratio= Combined Ratio

1010

Crime and Fidelity / Marketplace Crime and Fidelity / Marketplace →→ ResultsResults Profitability Measure Profitability Measure →→ Combined RatioCombined Ratio

ExampleExample

45.5 = Loss Ratio 45.5 = Loss Ratio + 5.0 = Loss Adjustment Expense Ratio+ 5.0 = Loss Adjustment Expense Ratio+ 35.0 = Expense Ratio+ 35.0 = Expense Ratio

85.5 = Combined Ratio 85.5 = Combined Ratio

1111

Crime and Fidelity / Marketplace CapacityCrime and Fidelity / Marketplace Capacity 20092009

•• Capacity for individual account Policy Limits fluctuatesCapacity for individual account Policy Limits fluctuates•• Current information indicates policy limits range from Current information indicates policy limits range from

$10,000,000 to $50,000,000.$10,000,000 to $50,000,000.•• A current estimate of total marketplace capacity exceeds A current estimate of total marketplace capacity exceeds

$450,000,000.$450,000,000.•• Some insurers offer different limit amounts depending Some insurers offer different limit amounts depending

on primary and /or excess program placementson primary and /or excess program placements•• Marketplace continues to grow with at least 4 new Marketplace continues to grow with at least 4 new

entrants since 2007. entrants since 2007.

1212

Crime and Fidelity / Marketplace CapacityCrime and Fidelity / Marketplace Capacity 20092009

Insurers noted as active participants in the Crime and Fidelity Insurers noted as active participants in the Crime and Fidelity Marketplace:Marketplace:**

ACE USA HanoverACE USA HanoverAIG / AIG / ChartisChartis HartfordHartfordArch HoustArch Houston Casualty / PIA on Casualty / PIA Axis LibeAxis Liberty Mutualrty MutualBerkley Asset Protection LloydsBerkley Asset Protection LloydsChubb RLIChubb RLIC N A SwissC N A Swiss ReReEverest Re TraveleEverest Re TravelersrsFairfax Financial (Crum & Forster) Zurich / FidelitFairfax Financial (Crum & Forster) Zurich / Fidelity & Deposity & DepositGreat American Great American

* Note: List is * Note: List is not necessarily all inclusive.not necessarily all inclusive.

1313


1414

Crime and Fidelity CoverageCrime and Fidelity Coverage Loss TrendsLoss Trends

•• Frequency / SeverityFrequency / Severity-- Past results do not pinpoint specific frequency and severity isPast results do not pinpoint specific frequency and severity issuessues-- Employees continue to steal from employersEmployees continue to steal from employers-- Anecdotal media reports indicate numerous employee frauds andAnecdotal media reports indicate numerous employee frauds andthefts ranging from 4 to as high as 8 figures.thefts ranging from 4 to as high as 8 figures.

•• Claim DurationClaim Duration-- Crime and Fidelity Claims are typically characterized as short tCrime and Fidelity Claims are typically characterized as short tail claims inail claims in

terms of loss development.terms of loss development.-- 6 6 –– 36 months in length36 months in length

•• Proliferation of Proliferation of PonziPonzi SchemesSchemes-- Bernard Bernard MadoffMadoff-- Allen StanfordAllen Stanford-- Marc DreierMarc Dreier-- WG Trading / Greenwood & WalshWG Trading / Greenwood & Walsh-- Scott RothsteinScott Rothstein

•• Mortgage FraudsMortgage Frauds

1515


Common types of Fidelity LossesCommon types of Fidelity LossesFidelity Fidelity →→

Employee Dishonesty / Employee Theft Employee Dishonesty / Employee Theft

--

Kickback, Bribery (vendor collusion) schemesKickback, Bribery (vendor collusion) schemes--

Inventory (pharmaceuticals, scrap metal)Inventory (pharmaceuticals, scrap metal)

--

Accounts Receivable / PayableAccounts Receivable / Payable--

Fictitious Payroll (ghost employees)Fictitious Payroll (ghost employees)

--

Expense Account manipulationExpense Account manipulation--

Marketing / Sales promotion schemesMarketing / Sales promotion schemes

1616


Other Types of Crime LossesOther Types of Crime LossesNonNon--Fidelity Fidelity

--

ForgeryForgery→→

stolen checks: altered, forged, duplicatedstolen checks: altered, forged, duplicated--

Computer Crime / Electronic Funds Transfer FraudComputer Crime / Electronic Funds Transfer Fraudee--mail virus, malware mail virus, malware →→

stolen bank account codesstolen bank account codes

--

Bank RobberiesBank Robberies--

Fraudulent Loan CollateralFraudulent Loan Collateral

--

Counterfeit Money OrdersCounterfeit Money Orders

1717


Observations:Observations:•• Non Non –– U.S. employees and locationsU.S. employees and locations

(distance, lax controls)(distance, lax controls)•• Multiple locations (difficult to monitor activities)Multiple locations (difficult to monitor activities)•• Obscure Insured subsidiaries (limited supervision) Obscure Insured subsidiaries (limited supervision) •• Lifestyle losses; how fast can the money be spent Lifestyle losses; how fast can the money be spent •• Influence of the economyInfluence of the economy

-- Employee Financial DifficultiesEmployee Financial Difficulties-- Employers Employers →→

More with less; weakened controlsMore with less; weakened controls

-- Influence of corporate ethics Influence of corporate ethics →→

tone set at the toptone set at the top

1818


1919

Crime and Fidelity CoverageCrime and Fidelity Coverage CoverageCoverage IssuesIssues

Financial InstitutionsFinancial Institutions•• Employee DishonestyEmployee Dishonesty

-- Manifest Intent & Personal Gain Manifest Intent & Personal Gain →→

““andand””

vs. vs. ““oror””-- Active and conscious purposeActive and conscious purpose-- Carve back language Carve back language →→

lending and trading activitieslending and trading activitiesNot Not ““bad loanbad loan””

coveragecoverageNot Not ““unauthorized trading coverageunauthorized trading coverage””

→→

rogue traderrogue trader••

General ConditionsGeneral Conditions--

Mergers / Acquisitions Mergers / Acquisitions →→

thresholds for coverage thresholds for coverage -- Automatic Termination provision for regulatory takeoverAutomatic Termination provision for regulatory takeover-- Knowledge of loss / Discovery of Loss Bond triggerKnowledge of loss / Discovery of Loss Bond trigger

Carefully consider all coverage forms and amendmentsCarefully consider all coverage forms and amendments

2020

Crime and Fidelity CoverageCrime and Fidelity Coverage CoverageCoverage IssuesIssues

Commercial / NonCommercial / Non--Profit / Government entitiesProfit / Government entities•• Policy Coverage FormatPolicy Coverage Format

-- Discovery vs. Loss SustainedDiscovery vs. Loss Sustained•• Fidelity CoverageFidelity Coverage

-- Employee Dishonesty vs. Employee TheftEmployee Dishonesty vs. Employee Theft-- Definition of EmployeeDefinition of Employee→→

temp, leased, independent contractortemp, leased, independent contractor-- ERISA ERISA →→

Benefit Plan Benefit Plan InsuredsInsureds, Fiduciaries, Coverage Limit, Fiduciaries, Coverage Limit••

Loss of Client Property Loss of Client Property →→

33rdrd

Party Fidelity coverageParty Fidelity coverage••

General ConditionsGeneral Conditions--

Mergers / Acquisitions Mergers / Acquisitions →→

thresholds for coverage thresholds for coverage -- Automatic Employee Termination Automatic Employee Termination –– threshold for prior dishonestythreshold for prior dishonesty-- Knowledge of loss / Discovery of Loss Bond triggerKnowledge of loss / Discovery of Loss Bond trigger

2121

Crime and Fidelity CoverageCrime and Fidelity Coverage Terms & ConditionsTerms & Conditions

Pricing and Policy Language ConsiderationsPricing and Policy Language Considerations•• Loss Experience Loss Experience –– specific to the accountspecific to the account•• Retention (deductible) / attachment pointRetention (deductible) / attachment point•• Nature of BusinessNature of Business•• Length of relationship between client and InsurerLength of relationship between client and Insurer•• Extent (other Extent (other coveragescoverages) of relationship between client and Insurer ) of relationship between client and Insurer •• Overall profitability of client coverageOverall profitability of client coverage•• Additional premiumAdditional premium•• Loss Trends Loss Trends –– generalgeneral

(e.g. mortgage fraud wording on FI Bonds is a coverage chall(e.g. mortgage fraud wording on FI Bonds is a coverage challenge)enge)•• Legal review of Policy WordingLegal review of Policy Wording

2222

Crime and Fidelity CoverageCrime and Fidelity Coverage Underwriting Issues / What is Important?Underwriting Issues / What is Important?

•• Loss HistoryLoss History•• Financial StabilityFinancial Stability•• Management StabilityManagement Stability•• Corporate PoliciesCorporate Policies•• Audits Audits –– External / InternalExternal / Internal•• Internal Control CharacteristicsInternal Control Characteristics•• Understanding the Risk Understanding the Risk →→

Who is the Insured?Who is the Insured?

••

Terms and Conditions Terms and Conditions →→

Premium, Deductible, ScopePremium, Deductible, Scope••

Managing the Production ProcessManaging the Production Process

2323

Crime and Fidelity CoverageCrime and Fidelity Coverage Risk Management Issues / What is Important?Risk Management Issues / What is Important?

•• Understand Insured Exposures Understand Insured Exposures →→How / Where can employees steal?How / Where can employees steal?

•• Understand what is truly an insurable employee exposureUnderstand what is truly an insurable employee exposure•• Not Insurable Not Insurable →→

Poor Business Practices and Decisions, Poor Business Practices and Decisions, Faulty Business Model,Faulty Business Model,Certain Industry Systemic ExposuresCertain Industry Systemic Exposures

•• Internal Controls Internal Controls →→

Do they exist? Are they enforced?Do they exist? Are they enforced?•• Strong Corporate Ethics Policies? Set the tone at the top.Strong Corporate Ethics Policies? Set the tone at the top.•• Is there a confidential process to report violations?Is there a confidential process to report violations?•• Purchase adequate limits of coverage.Purchase adequate limits of coverage.•• Insist on well written policy language.Insist on well written policy language.•• Get to know the Insurer Get to know the Insurer →→

Who is the underwriter?Who is the underwriter?Who will adjust a clWho will adjust a claim?aim?

Understand the claim proUnderstand the claim process beforehand.cess beforehand.

2424


SummarySummary

•• The Crime / Fidelity Marketplace has been generally profitableThe Crime / Fidelity Marketplace has been generally profitable•• There is no apparent shortage of Crime / Fidelity capacityThere is no apparent shortage of Crime / Fidelity capacity•• Fidelity Coverage has adhered to a time tested indemnity principFidelity Coverage has adhered to a time tested indemnity principlele

Covers direct loss of insured 1Covers direct loss of insured 1stst party, not a 3party, not a 3rdrd party;party;no profit or lost opportunity cost, no liability, no dano profit or lost opportunity cost, no liability, no damagesmages

•• Employees do steal from employersEmployees do steal from employers•• Internal Controls and Corporate Ethics Practices do matterInternal Controls and Corporate Ethics Practices do matter•• Industry has experienced new claims in ancillary crime Industry has experienced new claims in ancillary crime coveragescoverages

(e.g. cybercrime / malware)(e.g. cybercrime / malware)•• Crime and Fidelity results are subject to loss volatility (frequCrime and Fidelity results are subject to loss volatility (frequency ency

and/or severity)and/or severity)•• Terms and Conditions can be negotiable Terms and Conditions can be negotiable

2525


2626


Questions and AnswersQuestions and Answers

Thank YouThank You

Forensic Accounting Issues inForensic Accounting Issues inForensic Accounting Issues in Fidelity Bond Claims

Forensic Accounting Issues in Fidelity Bond Claims

Presented to the Fid lit B d d C i C C f

Navigant Consulting

Fidelity Bond and Crime Coverage ConferenceDecember 3, 2009

Navigant ConsultingVince D’AmelioManaging Director

646.227.4221

When and How to use the Forensic Accountant

Large Dollar Claim

Possibility of Litigation

Industry or subject matter expert Broker Dealer Manufacturing Mortgage lending

Benefits and Pitfalls of the Forensic Accountant

Benefits Thorough and comprehensive investigation Maximized subrogation potential Coordination with Law Enforcement Coordination with Law Enforcement

Pitfalls Over – investigation Internal Control review

Common Accounting Issues

Vendor Losses Were any real services provided? How do you quantify overpayment? Lack of supporting documentation? Lack of supporting documentation?

– What to ask for;– What is available;– Can we rely on anything?

Trading Losses What was the intent?What was the intent? What is authorized or unauthorized? Lack of supporting documentation?

– Can we rely on anything?

Section III Exclusions

Potential Income Unauthorized Trading; Inventory; Vendor Related Claims Vendor Related Claims

Prior and Subsequent Activity What did we know? When did we know it? When did law enforcement know?When did law enforcement know? Did law enforcement restrict us?

“

Mortgage Banking and

Warehouse Lending Fraud Training Seminar”

Presented to theFidelity Bond and Crime Coverage Conference

December 3, 2009

Reynolds Group

57 Union Place, Suite 316, Summit, NJ 07901

908-277-0250

Reynolds Group – Page 2

Discussion Overview

Business Model

3

Mortgage Banking Overview

4

Warehouse Lending Overview

6

Principals of Safety & Soundness

8

Fraud

9

Red Flags

11

Negligence vs. Fraudulent Activity

12


Business ModelRisks

Strategy Structure

Reynolds Group - Page 4

MORTGAGE BANKING OVERVIEW


MORTGAGE BANKER’S RISKS

MORTGAGE BANKER’SOPERATIONAL RISKS

Compliance

Systems

Accounting& Finance

HR

SecondaryMarketing

ServicingLoanOriginations

Processing &Underwriting

Pre-ClosingQA

Closing& Funding

Post-Closing&

Shipping

Branches

1099W-2Retail

Net

Correspondent

Wholesale

Post-ClosingQC

Ops

MSR


WAREHOUSE LENDER OVERVIEW


WAREHOUSE LENDER’S RISKS

WAREHOUSELENDER’S

RISK

MortgageBanker

Risk Collection

CorrespondentRisk

Multiple WHLRisk

AgencyRisk

CPA

Custodian

Collateral

WholesaleTablefunding

Inter CreditorAgreements


PRINCIPLES OF SAFETY & SOUNDNESS

Personnel

Training

Policies & Procedures

Due Diligence

Communications

Financial Review

The Agreement

The Files


FRAUD

Fraud For Profit

Fraud for Housing


WHY FRAUD?

Barriers to Entry

Access to Significant Levels of Cash

Fragmented Structure

Touch Business

“Enablers”

Bad Apples


RED FLAGS


NEGLIGENCEVS

FRAUD


57 Union Place, Suite 316Summit, New Jersey 07901

908-277-0250

www.reynoldsg.com

James E. Reynolds, Managing Partner

[email protected](Cell) 908-377-2622

Richard W. Payne, [email protected]

(Cell) 908-803-1290

Stacy A. Todd, Director of [email protected]

(Cell) 973-735-3724


James E. Reynolds Partner

As founder of The Reynolds Group, has extensive experience in mortgage banking and related financial services.

Prior to forming The Reynolds Group, Jim owned and operated a mortgage banking firm which originated non-conforming, agency (Fannie Mae & Freddie Mac), government (HUD), ALT-A, and sub-prime residential loans on a nationwide basis. In addition, as president of a mortgage banking subsidiary of a publicly owned bank holding company, he established several profitable nationwide business units including: loan servicing, loan production, document custodian, and warehouse lending. Jim also established a due diligence and quality control group whose clients included the FDIC, FHLB, commercial banks, thrifts, investment banks and insurance companies.

Jim holds an AB in government and an MBA in finance from Harvard University.

Fidelity Claim OverviewFidelity Claim Overview

DiscoveryDiscovery

NoticeNotice


InvestigationInvestigation

ResolutionResolution

SubrogationSubrogation

Progression of Fidelity ClaimProgression of Fidelity Claim

First NoticeFirst Notice

Coverage InformationCoverage Information

First Contact with InsuredFirst Contact with Insured

First Meeting with insuredFirst Meeting with insured

1.1. The Insured Organization & Loss Locale StructureThe Insured Organization & Loss Locale Structure2.2. The Discovery ProcessThe Discovery Process3.3. Review Coverage & our Role/InsuredReview Coverage & our Role/Insured’’s Dutys Duty4.4. Obtain a Loss OverviewObtain a Loss Overview

Time Parameters of FraudTime Parameters of Fraud

Perception of QuantumPerception of Quantum

Modus OperandiModus Operandi

Obtain Sample DocumentationObtain Sample Documentation

Progression of Fidelity Progression of Fidelity contcont’’dd

5.5. Introduce Proof of Loss & How/When to File a ClaimIntroduce Proof of Loss & How/When to File a Claim6.6. Employee OverviewEmployee Overview

Review Personnel File Review Personnel File –– Obtain Copies of Relevant Obtain Copies of Relevant MaterialsMaterials

Review DefaulterReview Defaulter’’s Role/Duties, Etc.s Role/Duties, Etc.

7.7. Recovery OverviewRecovery Overview8.8. Criminal or Other PostCriminal or Other Post--Discovery InvestigationDiscovery Investigation

PostPost--MeetingMeeting

Monitoring Ongoing Efforts (Awaiting Proof of Loss)Monitoring Ongoing Efforts (Awaiting Proof of Loss)


Progression of Fidelity Progression of Fidelity contcont’’dd

InvestigationInvestigation Includes Approaching Defaulter, In most cases, with Includes Approaching Defaulter, In most cases, with

InsuredInsured’’s allegations s allegations

SettlementSettlement Take a Position on ClaimTake a Position on Claim If Payment, Secure an Agreement for Subrogation If Payment, Secure an Agreement for Subrogation

PurposesPurposes

Recovery PhaseRecovery Phase

Early Action NecessaryEarly Action Necessary

““ DiscoveryDiscovery”” -- ImportanceImportanceA.A. To identify correct policyTo identify correct policyB.B. Triggers insuredTriggers insured’’s obligationss obligations

1.1. NoticeNotice2.2. Proof of LossProof of Loss3.3. Action under policyAction under policy

C.C. SubrogationSubrogation1.1. Running of Statute of Limitations on actions against Running of Statute of Limitations on actions against

responsible partiesresponsible parties2.2. Arrangement for preserving rights of recoveryArrangement for preserving rights of recovery

D.D. Defenses to claimDefenses to claim1.1. Failure to comply with limitationsFailure to comply with limitations

a)a) Prejudice / no prejudicePrejudice / no prejudice

2.2. Termination of coverageTermination of coverage3.3. Knowledge of prior dishonestyKnowledge of prior dishonesty

Claims Processing Guidelines Claims Processing Guidelines -- Burdens of ProofBurdens of Proof

Universal truths:Universal truths:–– Insured: Burden to establish coverageInsured: Burden to establish coverage–– Insurer: Burden to establish exclusionInsurer: Burden to establish exclusion–– Insured: Burden to establish exceptionInsured: Burden to establish exception


Very practical application.Very practical application.

HHowever, Bond offers some unique owever, Bond offers some unique issues.issues.

Claims Processing Guidelines Claims Processing Guidelines -- Litigation StrategiesLitigation Strategies

Although burdens never shift, insurer Although burdens never shift, insurer may rely on exclusion to deny:may rely on exclusion to deny:–– Perhaps before acknowledging an Perhaps before acknowledging an

insuring agreement applies.insuring agreement applies.


In other words, a primary defense, In other words, a primary defense, rather than secondary one:rather than secondary one:–– Insurer may not wait for insured to Insurer may not wait for insured to

meet its burden, but have ability to meet its burden, but have ability to deny because even if burden met, still deny because even if burden met, still no coverage.no coverage.


While often easier to understand in While often easier to understand in this context, from pure coverage this context, from pure coverage perspective, analysis is out of order.perspective, analysis is out of order.

Other coverage much more Other coverage much more regimented.regimented.–– CGLCGL——Specific steps to establish Specific steps to establish

coverage and less willingness to analyze coverage and less willingness to analyze out of order.out of order.


Bond and Commercial Crime Policy Bond and Commercial Crime Policy are much more fluid.are much more fluid.–– Do not require such an analytical Do not require such an analytical

approach to the process.approach to the process.–– But still maintains the relevant burdens.But still maintains the relevant burdens.


Why are burdens important?Why are burdens important?–– Submission of Proof of Loss:Submission of Proof of Loss:

The Proof is not simply a mechanism The Proof is not simply a mechanism of gathering and producing of gathering and producing information, and then requiring the information, and then requiring the insurer to decide where coverage is.insurer to decide where coverage is.

Often a source of contention but not a Often a source of contention but not a dispute based on semanticsdispute based on semantics..


Insured must prove coverage Insured must prove coverage applies:applies:–– Does not mean insured must identify Does not mean insured must identify

the specific insuring agreement (insurer the specific insuring agreement (insurer generally charged with more relevant generally charged with more relevant knowledge of bond).knowledge of bond).


–– For example, if insured sustains forgery For example, if insured sustains forgery loss and submits claim under Insuring loss and submits claim under Insuring Agreement (A), when no employee Agreement (A), when no employee involved, insurer cannot hide behind the involved, insurer cannot hide behind the error and claim insured did not meet error and claim insured did not meet burden of proof. burden of proof.

–– No No ““head in sandhead in sand”” defense.defense.


However, applies both ways.However, applies both ways. Insurer has no obligation to Insurer has no obligation to

affirmatively exhaust all insuring affirmatively exhaust all insuring agreementsagreements——insurer does not prove insurer does not prove the insuredthe insured’’s claim. s claim. –– Thus, if evidence presented under Thus, if evidence presented under

Clause A does not trigger coverage, and Clause A does not trigger coverage, and nothing suggests potential coverage nothing suggests potential coverage elsewhere, the inquiry ends. elsewhere, the inquiry ends.


–– But if evidence provided that presents But if evidence provided that presents potential coverage under another potential coverage under another agreement, likely an obligation to agreement, likely an obligation to analyze, alert the insured, and invite analyze, alert the insured, and invite additional infoadditional info——primary example: primary example: Insuring Agreements (D) and (E). Insuring Agreements (D) and (E). Both cover forgery, alteration, but as to Both cover forgery, alteration, but as to

different instruments.different instruments.


Rule of Thumb: If insured presents Rule of Thumb: If insured presents facts raising coverage issues in other facts raising coverage issues in other insuring agreements, duty to followinsuring agreements, duty to follow-- up. But no duty to inquire whether up. But no duty to inquire whether facts exist. facts exist.


When to file suit:When to file suit:–– Declaratory Judgment ActionsDeclaratory Judgment Actions——

sometimes are simply inevitable.sometimes are simply inevitable.–– Questions to consider:Questions to consider:

–– Who files? Who files? –– Venue?Venue?

–– State or Federal Court?State or Federal Court?–– What law applies?What law applies?


Role of Discovery:Role of Discovery:–– By most accounts, discovery in a By most accounts, discovery in a

fidelity claim should not be fidelity claim should not be significantsignificant——information produced by information produced by the insured should have already been the insured should have already been provided during claimsprovided during claims--handling handling process. process.


–– If a dispute arose during the claimIf a dispute arose during the claim-- handling process, the Courthandling process, the Court’’s power s power will provide more access to that will provide more access to that information, but still should not affect information, but still should not affect the insured's or insurerthe insured's or insurer’’s production.s production.

–– Power of subpoena will arm the parties Power of subpoena will arm the parties with the ability to demand cooperation with the ability to demand cooperation and response from thirdand response from third--parties. parties.


–– During claim, insurer has little power During claim, insurer has little power to force a thirdto force a third--party to participate.party to participate.

Maybe able to convince cooperation, Maybe able to convince cooperation, but cannot require participation.but cannot require participation.


Examples: Examples: –– Loan Loss CasesLoan Loss Cases——pursuing pursuing

borrowers or collators. borrowers or collators. –– Witnesses to forgeries or other Witnesses to forgeries or other

Insuring Agreement (D)/(E) Insuring Agreement (D)/(E) claims. claims.

–– Working with bankruptcy trustee.Working with bankruptcy trustee.–– Dishonest employees.Dishonest employees.

Yet still may refuse to cooperate Yet still may refuse to cooperate in fear of criminal prosecution.in fear of criminal prosecution.


DepositionsDepositions

–– Usually sworn statements takenUsually sworn statements taken–– Depending on issues, depositions of Depending on issues, depositions of

same personnel may not be necessary same personnel may not be necessary –– Some will be Some will be –– Sworn Statements usually focused on Sworn Statements usually focused on

fact investigation, although statements fact investigation, although statements made by a representative can easily made by a representative can easily bind the insuredbind the insured


–– As such, a 30(b)(6) As such, a 30(b)(6) depodepo may be may be beneficial beyond the Sworn Statement.beneficial beyond the Sworn Statement.

–– Sworn Statements are not adversarial Sworn Statements are not adversarial proceedingsproceedings..

Opposing counsel, if present, is not Opposing counsel, if present, is not entitled to objectentitled to object

Sworn Statement is more Sworn Statement is more ““casualcasual””

May be necessary to followMay be necessary to follow--up on up on issues or additional information may issues or additional information may have come to light.have come to light.


Role of Summary Judgment:Role of Summary Judgment:–– Very straightVery straight--forward approach.forward approach.–– Interpretation of policy is question of Interpretation of policy is question of

law.law.


–– Underlying material facts rarely in Underlying material facts rarely in dispute.dispute.

As such, should be ripe for Summary As such, should be ripe for Summary Judgment.Judgment.

Court should almost always be able Court should almost always be able to apply the facts to the law.to apply the facts to the law.

Especially true as dispute is Especially true as dispute is generally over interpretation of a generally over interpretation of a contract provision, not application of contract provision, not application of the facts. the facts.


Bad Faith Considerations:Bad Faith Considerations:

Objective observation: Bad Faith claims Objective observation: Bad Faith claims largely irrelevant in a fidelitylargely irrelevant in a fidelity--coverage coverage dispute.dispute.

–– Fidelity coverage is an esoteric part of Fidelity coverage is an esoteric part of insurance industry. insurance industry.


–– Very specialized claimsVery specialized claims--handlers.handlers.

Most often attorneysMost often attorneys–– Very seasoned and Very seasoned and

knowledgeable.knowledgeable.


Limited number of carriers provide the Limited number of carriers provide the coverage.coverage.–– Close network, follow all claimsClose network, follow all claims

Coverage is fairly standard among the Coverage is fairly standard among the industryindustry–– Inconsistent positions are not taken Inconsistent positions are not taken

internally, and very seldom on an internally, and very seldom on an industryindustry--wide basis, unless a wide basis, unless a specialized policy form.specialized policy form.

–– Form 24 was negotiated between both Form 24 was negotiated between both industries.industries.


If significant issues are involved, If significant issues are involved, outside counsel is often retainedoutside counsel is often retained

Fact intensive claims that require Fact intensive claims that require attention, and insurers know this.attention, and insurers know this.–– Handlers are not simply managing Handlers are not simply managing

100 claims, pushing automated 100 claims, pushing automated form letters out every 30 days.form letters out every 30 days.

–– Handlers realize fidelity claims are Handlers realize fidelity claims are emotional claims.emotional claims.


Obviously badObviously bad--faith conduct is not faith conduct is not impossibleimpossible..

–– It is improbable.It is improbable.

Certainly not present to the extent Certainly not present to the extent alleged in complaints.alleged in complaints.–– KneeKnee--jerk reaction: Insurance jerk reaction: Insurance

dispute equals standard baddispute equals standard bad--faith faith claim.claim.

Expectation that presence of a Expectation that presence of a badbad--faith claim will bring some faith claim will bring some bargaining power.bargaining power.


Fail to recognize the esoteric nature Fail to recognize the esoteric nature of fidelity coverage.of fidelity coverage.

Inclusion of a badInclusion of a bad--faith claim can faith claim can often have detrimental effect. often have detrimental effect. –– Adds another level of emotion.Adds another level of emotion.–– Detracts from the true coverage Detracts from the true coverage

dispute at issue, which may dispute at issue, which may weaken insuredweaken insured’’s argument or s argument or position. position.


––By and large, no basis for a By and large, no basis for a legitimate claim.legitimate claim.Facts not in dispute, almost Facts not in dispute, almost always a question of policy always a question of policy interpretation.interpretation.

course material - fidelity bond and crime coverage...

Documents