Loan Loss Coverage Under Insuring Agreement (A)1
CHAPTER I
loan loss coverage under
insuring Agreement (A)
Michael Keeley, Strasburger & Price, LLP
Lisa A. Block, CNA Insurance Company
A.Introduction
The title of this book—Loan Loss Coverage Under Financial Institution Bonds—is perhaps a bit misleading. Fidelity insurers concluded long ago that a financial institution’s risk of loss from its primary business—making loans—was not a risk that should, or affordably could, be insured. Instead, because banks are in the business of making loans, banks should bear any risk associated with such loans.[1] Indeed, it generally has been recognized that if insurers were to provide coverage for what in essence would be “credit insurance,” the premiums would be unaffordable.[2] As a result, standard form Financial Institution Bonds have included loan exclusions since the Surety and Fidelity Association of America[3] first adopted Standard Form Bankers Blanket Bond No. 8 in 1920.[4]
The basis for the distinction in covered risks is that the Financial Institution Bond is intended to be a risk sharing arrangement. Banks can reasonably protect themselves against losses from loans by, for example, following reasonable underwriting procedures. Thus, banks must bear the risk that a loan will not be repaid. On the other hand, banks are not nearly as prepared to avoid the risk of loss through employee dishonesty, counterfeit securities, or forged or altered documents.
While bankers and some courts have struggled with the fact that loan losses generally are not covered by Financial Institution Bonds, the industry has stood its ground and continually updated various provisions of the standard form policies in order to make it clear that Financial Institution Bonds do not insure against credit risks, regardless of a borrower’s fraudulent intent.[5] The limited exceptions to the loan exclusion are if the bank’s losses otherwise is covered by Insuring Agreements (A), (D), or (E). The latter two insuring agreements provide coverage for losses directly caused by forgery or alteration to certain financial instruments, or by counterfeits of such instruments. Insuring Agreement (A) is the heart and sole of fidelity insurance, providing coverage for losses—including those involving loans—directly caused by the dishonesty of an employee who acted with the actual conscious purpose, or specific or manifest intent, to cause the bank a loss and to obtain a financial benefit for himself. In essence, coverage for loan losses under Insuring Agreement (A) is for embezzlement by a bank employee who decides to cover-up his or her embezzlement by combining it with a loan.
Although insurers have been willing to provide coverage for loan losses caused by employee dishonesty, coverage has always been intended to be narrow, limited to embezzlement and embezzlement-type acts.[6] Unfortunately, over the years Financial Institution Bonds have been construed by courts to cover a much broader range of losses from loans than intended by the industry. In order to counteract such decisions, the industry modified the standard form bond by adding the manifest intent requirement, first with the use of a rider in 1976,[7] and then by revision to the standard form Bankers Blanket Bond in 1980,[8] requiring proof that the employee acted with the manifest intent to cause the insured to sustain a loss. The 1980 standard form Bankers Blanket Bond also included a requirement that the employee act with the intent to obtain a financial benefit for either herself or any other person or organization.[9] And, in 1986 the standard form Financial Institution Bond was revised again, this time to preclude coverage under Insuring Agreement (A) for a loss resulting directly from a loan unless the employee acted in collusion with one or more parties to the transactions and received a financial benefit with a value of at least $2500.[10]
The purpose of this Chapter is to discuss those instances in which modern fidelity policies provide coverage for losses involving loans. The Chapter will begin first with a review of the history of employee dishonesty coverage, particularly involving loan losses. This Chapter will then examine the various important provisions of fidelity bonds that must be examined in analyzing a loss involving loans. It will then carefully analyze what has been the firestorm of controversy involving employee dishonesty losses for the last thirty years—the manifest intent requirement of the bond—as well as other provisions of the bond important in analyzing coverage for loan losses, including the collusion and financial benefit requirements. It then will examine the newest language of Insuring Agreement (A)—the active and conscious purpose requirement being utilized in SFAA forms and the specific intent requirement used in ISO forms, together with other widely used language in certain proprietary forms. This Chapter will also include a discussion of the more important cases involving loan losses.
B.History
1.Origins of Modern Employee Dishonesty Coverage
Modern fidelity coverage had its origins in the latter part of the nineteenth century.[11] These early fidelity bonds indemnified against loss “through” the fraud or dishonesty of either an employee identified by name or by a specific job designation. The first “blanket bond” was underwritten by Lloyd’s of London in 1908.[12] The word “blanket” was used to signify that a uniform dollar amount of coverage applied to each insuring agreement, rather than to mean that blanket coverage was being provided.
2.Beginnings of Standard Form Policies
In 1916, Standard Form No. 1 was created by SFAA, the Bond and Surety Underwriters Trade Association and the American Bankers Association.[13] By 1941 Standard Form No. 1 had evolved into what is known today as Standard Form No. 24, with further revisions being made in 1946, 1951, 1969, 1980, 1986, and most recently, 2004. Standard Form No. 1 continued to indemnify the insured against loss: “through any dishonest act of any of the Employees wherever committed, and whether committed directly or by collusion with others.”[14]
In subsequent years the words “fraudulent” and “criminal” were added to the fidelity insuring agreement. In fact, the first version of the present Insuring Agreement (A) appeared in 1936 in Standard Form No. 8 as an insuring clause providing coverage for: “Any loss through any dishonest, fraudulent, or criminal act of any of the Employees, including loss of property, through any such act of any of the Employees, wherever any such act may be committed and whether committed directly or by collusion with others.”[15] In the 1986 standard form bond the “loss through” language was changed to “loss resulting directly from,” and the term “dishonest and fraudulent acts,” while not defined, was expressly limited to those types of dishonest and fraudulent acts specifically delineated in Insuring Agreement (A).[16]
3.Adverse Decisions Lead to Sky Rocketing Loss Ratios
From early on, the courts seemed predisposed to construe fidelity bonds in favor of coverage, leading to a broad construction of the term “dishonesty.” Insurers were held liable for losses caused by an employee’s actions that “evinced a want of integrity and an intentional breach of trust ... whether for the benefit of [the employee] or of another”;[17] that were “reckless, willful, and wanton ... [or] manifestly unfair to the employer”;[18] and that were “done in breach of the officer’s duty to the bank and [were] willful omissions.”[19] Remarkably, one court concluded:
[The bond guarantees] openness and fair dealing on the part of the bank’s officers. It is intended to, it does, underwrite that the bank’s officers shall act with common honesty and an eye single to its interests. It guarantees that the bank shall at all times have the benefit of the unbiased, critical, and disinterested judgment of the president in regard to the loans it makes.[20]
As one commentator noted:
The cases seemed to look for a way to find dishonesty or to give the jury instructions on the definition of dishonesty which minimized the element of intent to commit the wrongful act. A snowballing effect resulted, with more claims resulting from the publicity given to the cases unfavorable to the surety industry and those claims bringing about more unfavorable results.[21]
In other words, contrary to the intent of the industry, courts were turning the bond into credit insurance.
By the mid 1970’s adverse court decisions had taken their toll on insurers. The industry’s loss ratio for the eleven year period from 1967 through 1977 ranged from 61.4 percent to 125 percent, with ratios exceeding 100 percent in 1969, 1974, 1976, and 1977.[22] Not surprisingly, a number of insurers were forced to reduce the volume of their business, while others stopped offering fidelity bonds entirely.[23] By the late 1970s a mere dozen or so companies wrote a significant amount of fidelity bond business, while only fifteen years earlier there had been many times more.[24] Such losses and the resulting tightening of the bond market eventually caused the SFAA to react with a series of modifications to the bond.
4.SFAA’s Revisions to Counteract Decisions, Including Rider 6019, and 1980 and 1986 Revisions
Beginning in 1976, the SFAA made available a rider that limited coverage for dishonest acts to those committed by the employee with the “manifest intent” to cause the insured to sustain a loss and to obtain a financial benefit for himself or another person or organization.[25] The rider also replaced the “loss through” language of Insuring Agreement (A) with the narrower phrase, “resulting directly from.”[26] The changes became permanent when the bond was formally revised in 1980.[27]
Although loss ratios decreased after addition of the manifest intent requirement, by the mid 1980s they again were out of hand. At the same time, the country was in the midst of the largest financial institution crisis in history. With the number of claims again increasing and loss ratios of 83.6, 105.4, 140.0, and 69.9 for the years 1982 through 1985,[28] the SFAA again acted to modify the terms of the standard form bond. In 1986 the SFAA added some real teeth to the financial benefit requirement, requiring proof that the employee actually receive a financial benefit of at least $2,500 in connection with a loan, and requiring proof and that the employee acted in collusion with one or more parties to the loan transaction. The title of the bond was changed from Bankers Blanket Bond to Financial Institution Bond in order to counteract those decisions that had relied upon the term “blanket” in holding that coverage under the bond was intended to be very broad.[29]
5.Overview of Decisions Construing “Manifest Intent” Provision
While courts readily accepted the fact that the SFAA added the manifest intent language to the bond in order to limit coverage for dishonesty claims to embezzlement-type acts, there was a great divergence of opinion in the courts as to the precise meaning of the term manifest intent. Early on, some courts concluded that a purely objective standard should be followed in defining the term “manifest intent,” such that an employee could be found to have the manifest intent to cause the insured a loss if the natural consequences of the employee’s actions was a loss.[30] Few recent cases have adopted this standard. Rather, in recent years, debate has centered upon whether an insured must establish that its employee acted with the “specific intent” or “purpose” to cause the insured to sustain a loss, or whether it is adequate to show that the employee knew that a loss was “substantially certain” to follow from the employee’s actions.[31] While the first standard—the specific intent test—is purely a subjective one, the latter standard—the substantial certainty test—employs a fiction to allow a finding of manifest intent regardless of the employee’s actual subjective intent or purpose. To date, the Second, Third, Fourth, and Fifth Circuits have adopted the specific intent test. The Sixth, Seventh, and Tenth Circuits appear to have adopted the substantial certainty test.
6.Most Recent Revisions to Standard Form Policies
In 2004 the SFAA, and in 2004 ISO, once again revised Insuring Agreement (A) in an effort to remove any remaining doubt about the limitation of coverage to embezzlement-type acts. The SFAA substituted the term “active and conscious purpose” for the manifest intent language of the bond. Thus, Insuring Agreement (A) of the 2004 SFAA standard form Financial Institution Bond[32] covers: “Loss resulting directly from dishonest or fraudulent acts committed by an Employee, acting alone or in collusion with others, with the active and conscious purpose to cause the Insured to sustain such loss.” Edward Gallagher, General Counsel to the SFAA, explained that this revision was made because some courts “incorrectly equated ‘manifest intent’ with substantially certain to result or with the natural and probable consequences of the act.”[33] According to Gallagher, the SFAA considered using the term “specific intent,” but chose the term “conscious purpose” because it is the Model Penal Code’s highest standard of intent.[34]
Interestingly, ISO decided to utilize the term “specific intent” in its 2004 Financial Institution Crime Policy for Banks and Savings Institutions.[35] In the criminal law, the requirement that the defendant actually intend or desire the results of his actions was known as the concept of “specific intent.”[36] Thus, although using a different term, both the 2004 ISO Policy and the 2004 SFAA Bond were designed to leave no doubt that in order for there to be coverage under Insuring Agreement (A), the dishonest employee must have actually desired to cause the bank to sustain a loss. If not, there can be no coverage under the bond.
C.Overview of Important Bond Provisions
Before discussing certain provisions of the bond in detail, it is important to review the terms of the applicable provisions of the bond, and to discuss certain other provisions briefly.
1.Loan Exclusion[37]
As noted above, insurers have never been willing to provide coverage for fraudulently made loans or other extensions of credit by a bank except under limited circumstances. However, Insuring Agreement (B) of the standard form Financial Institution Bond potentially provides coverage for a bank’s loss from fraudulently made loans. As a result, the standard form bond has included a loan exclusion since 1920.[38] Courts have had little trouble applying the loan exclusion to claims involving standard loans. But not all extensions of credits by banks are in the form of a typical loan. For instance, when a bank allows a customer instant credit on a check that has been deposited but will not clear for a couple of days, it in essence is extending credit or making a loan to that borrower. The loan exclusion would apply to preclude coverage for any loss the bank would sustain in such a situation if the customer’s check did not clear.[39] Similarly, if a bank purchases loans from another entity and eventually suffers a loss on those loans, the bank’s loss would not be covered even though it did not originate the loans.[40]
As with other provisions of the standard form bond, the loan exclusion has undergone revisions over time in order to ensure that it was construed consistently with its broad purpose to exclude coverage for any extension of credit by a bank, regardless of the form. The current version of the loan exclusion seems to have served its purpose in excluding:
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), (D) or (E).
The bond in turn broadly defines the term “Loan,” as follows:
Loan means 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.
For example, in Hudson United Bank v. Progressive Casualty Insurance Co.,[41] the court applied the loan exclusion to exclude coverage for a bank’s loss resulting from an insurance premium finance program. The court explained:
A financial institution bond is essentially an insurance policy that indemnifies the bank for losses caused by dishonest acts. It is not intended to guarantee against bad business operations or judgment or, as in this case, against bad loans made by the insured. . . . . Whatever losses [the bank] may have sustained, those losses obviously resulted directly, or at least indirectly, from loans made by [the bank] under the [premium finance program].[42]
2.Insuring Agreement (A)
The language of Insuring Agreement (A) also has changed over time. Perhaps the most significant revision was the addition of the manifest intent language, first by rider in 1976,[43] and then by a permanent change to the standard form bond in 1980.[44] While a significant amount of case law has developed concerning the requirements of Insuring Agreement (A), the industry continues to be proactive in responding to wrongly decided cases by continuing to clarify insurers’ intentions to limit coverage under Insuring Agreement (A) to only those cases where an insured’s employee acts with the conscious purpose or desire to cause his employer to sustain a loss.