the fidelity law journal · the fidelity law journal ... fraudulent, or criminal acts.8 as ......

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The Fidelity

Law Journal

published by

The Fidelity Law Association

December 2011

Editors-in-Chief Michael Keeley

Martha L. Perkins

Associate Editor J. Will Eidson

Cite as XVII Fid. L.J., 2d ed., ___ (2011)

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THE FIDELITY LAW ASSOCIATION

President Tracey Santor, Travelers

Vice President Michael Retelle, CUMIS

Secretary Dolores Parr, Zurich

Treasurer Robert Olausen, Insurance Services Office, Inc.

Executive Committee Lawrence R. Fish, The Hartford

Ronald G. Mund, Travelers Joseph Szary, Chubb

Advisors Samuel J. Arena, Jr., Stradley, Ronon, Stevens & Young, LLP

Michael Davisson, Sedgwick, Detert, Moran & Arnold Michael Keeley, Strasburger & Price, LLP

Martha L. Perkins, Whiteford, Taylor & Preston, LLP

Advisors Emeritus Bernard L. Balkin, Gilliland & Hayes, PC

Robert Briganti, Belle Mead Claims Service, Inc. Harvey C. Koch, Montgomery Barnett, LLP

Armen Shahinian, Wolff & Samson PC

FLA Journal Editors-in-Chief Michael Keeley, Strasburger & Price, LLP

Martha L. Perkins, Whiteford, Taylor & Preston, LLP

The Fidelity Law Journal is published annually. Additional copies may be purchased by writing to: The Fidelity Law Association, c/o Wolff & Samson PC, One Boland Drive, West Orange, New Jersey 07052.

The opinions and views expressed in the articles in this Journal are solely of the authors and do not necessarily reflect the views of the Fidelity Law Association or its members, nor of the authors’ firms or companies. Publication should not be deemed an endorsement by the Fidelity Law Association or its members, or the authors’ firms or companies, of any views or positions contained herein. The articles herein are for general informational purposes only. None of the information in the articles constitutes legal advice, nor is it intended to create any attorney-client relationship between the reader and any of the authors. The reader should not act or rely upon the information in this Journal concerning the meaning, interpretation, or effect of any particular contractual language or the resolution of any particular demand, claim, or suit without seeking the advice of your own attorney.

The information in this Journal does not amend, or otherwise affect, the terms, conditions or coverages of any insurance policy or bond issued by any of the authors’ companies or any other insurance company. The information in this Journal is not a representation that coverage does or does not exist for any particular claim or loss under any such policy or bond. Coverage depends upon the facts and circumstances involved in the claim or loss, all applicable policy or bond provisions, and any applicable law.

Copyright © 2011 Fidelity Law Association. All rights reserved. Printed in the USA. For additional information concerning the Fidelity Law Association or the Journal, please visit our website at http://www.fidelitylaw.org.

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Michael Keeley is a partner and J. Will Eidson is an associate with Strasburger & Price, LLP in Dallas, Texas. Michele Fenice is Assistant Vice President with ACE North American in New York, New York. 203

INSURING AGREEMENT (E)—REVISITED

Michael Keeley Michele L. Fenice

J. Will Eidson

I. INTRODUCTION

The Financial Institution Bond has been available to banks in some form since the early 1900s. As with all forms of insurance, fidelity bonds create a risk-sharing arrangement between insurers and insureds. A fidelity bond is not, however, a form of credit insurance that insures a bank against bad business deals. Rather, fidelity bonds are designed to insure banks and other insureds from losses they cannot control by following sound business practices, such as losses from employee theft, counterfeit securities, or forged or altered loan documents with intrinsic value.

Insuring Agreement (E) was added to the standard form bond for the first time in 1946 to address certain loan losses. Despite its lengthy seventy-year life, insurers and insureds continue to disagree over the precise reach of coverage, such as the types of documents that are covered, just how “direct” a loss must be to be covered, and who must have possession of the original covered documents, and when. As a result, courts have often misconstrued the requirements of Insuring Agreement (E), construing it broadly in favor of coverage. In response, the Surety and Fidelity Association of America1 has responded to these cases by periodically revising the language of Insuring Agreement (E) to clarify its narrow coverage. Yet, dispute remains about the precise meaning and requirements of Insuring Agreement (E).

1 Hereinafter SFAA. The SFAA was formerly known as the Surety

Association of America.

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204 Fidelity Law Journal, Vol. XVII, 2d ed., December 2011

Insuring Agreement (E) is clear and unambiguous. Any disagreement over its meaning should have been resolved long ago. Those cases that continue to construe coverage broadly either misapply tort concepts of causation where none belong, incorrectly perceive the bond as credit insurance, misunderstand the intent of the bond, or simply are result-oriented. The purpose of this article is to discuss what the authors believe to be the clear construction of Insuring Agreement (E); that is providing narrow coverage for losses incurred by a bank when it relies in good faith upon the original of certain forged, altered, counterfeit, lost or stolen loan documents having intrinsic value. In doing so, this article briefly reviews Insuring Agreement (E)’s evolution and analyzes five commonly misunderstood issues: 1) the mutually exclusive coverage of Insuring Agreement (E) and Insuring Agreement (D); 2) the type of documents that are covered under Insuring Agreement (E); 3) Insuring Agreement (E)’s “direct” causation requirement; 4) Insuring Agreement (E)’s good faith requirement; and 5) Insuring Agreement (E)’s requirement that the insured have actually relied upon the faith of an original covered document. While some of these issues have been addressed by the most recent revisions to the standard form SFAA bond in 2004 and 2011,2 most insurers continue to utilize the 1986 Bond, or proprietary forms similar to it, as opposed to the newer 2004 Bond, or the 2011 Bond, which was only finalized in May 2011. As a result, these issues continue to be of critical importance in handling claims under Insuring Agreement (E).

II. HISTORY OF INSURING AGREEMENT (E)

The SFAA drafted the first American Bankers Blanket Bond in 1916.3 By 1941, the bond had undergone several revisions, and was

2 See Financial Institution Bond, Standard Form No. 24 (revised Apr.

2004) [hereinafter 2004 Bond], reprinted in STANDARD FORMS OF THE SURETY ASS’N OF AMERICA [hereinafter STANDARD FORMS]; Financial Institution Bond, Standard Form No. 24 (revised May 2011) [hereinafter the 2011 Bond], reprinted in STANDARD FORMS.

3 Edward G. Gallagher, A Concise History of Standard Form No. 24, 1986 Edition, in ANNOTATED FINANCIAL INSTITUTION BOND 5 (Michael Keeley ed., 2d ed. 2004).

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Insuring Agreement (E)—Revisited 205

termed the “Bankers Blanket Bond, Standard Form No. 24.”4 Each revision to the bond has been made with input from the American Bankers Association and other trade groups.5 In the 1986 revision, the bond was renamed the “Financial Institution Bond, Standard Form No. 24.”6 The standard form bond now contains six Insuring Agreements,7 which cover an insured financial institution against loss arising from specified dishonest, fraudulent, or criminal acts.8

As the Financial Institution Bond has evolved through the years, each of its Insuring Agreements has also undergone its own revisions.9 Insuring Agreement (E) is no exception. The first version of Insuring Agreement (E) became available some time in the late 1920s or 1930s as a rider to the standard form bond.10 It was not until 1946, five years after the Bankers Blanket Bond, Standard Form No. 24, was first unveiled,11 that Insuring Agreement (E) was introduced as part of the standard form bond.12 Insuring Agreement (E) was subsequently revised in 1951, 1969, 1980, 1986, and 2004.13 These versions of Insuring Agreement (E) look markedly different than the most recent version adopted in 2004, or the 1986 version, which is the most commonly seen form in practice.

4 First Nat’l Bank v. Cincinnati Ins. Co., 485 F.3d 971, 975 (7th Cir.

2007) (citing Peter J. Broeman, An Overview of the Financial Institution Bond, Standard Form No. 24, 100 BANKING L.J. 439, 439-40 (1993)); Gallagher, supra note 3, at 5.

5 Gallagher, supra note 3, at 5. 6 Id.; Financial Institution Bond, Standard Form No. 24 (revised Jan.

1986) [hereinafter 1986 Bond], reprinted in STANDARD FORMS. 7 See, e.g., Id. at Insuring Agreements (A)-(F). 8 Broeman, supra note 4, at 440. 9 Gallagher, supra note 3, at 1 (stating that “[n]ew editions were

published in 1946, 1954, 1969, 1980, and 1986”). 10 Robin V. Weldy, History of the Bankers Blanket Bond and the

Financial Institution Bond Standard Form No. 24 with Comments on the Drafting Process, in Second SUPPLEMENT: ANNOTATED BANKERS BLANKET BOND 5 (Harvey C. Koch ed., 1988).

11 Financial Institution Bond, Standard Form No. 24 (revised Apr. 1941).

12 Financial Institution Bond, Standard Form No. 24 (revised Mar. 1946) [hereinafter 1946 Bond].

13 Weldy, supra note 10 at 3

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The original Insuring Agreement (E) in 1946 provided:

SECURITIES INSURING CLAUSE

(E) Any loss sustained by the Insured through having, in good faith and in the course of business, whether for its own account or for the account of others, in any representative, fiduciary, agency or any other capacity, either gratuitously or otherwise, purchased or otherwise acquired, accepted or received, or sold or delivered, or guaranteed in writing or witnessed any signatures upon, or given any value, extended any credit or assumed any liability, on the faith of, or otherwise acted upon any securities, documents, or other written instruments which prove to have been counterfeited or forged as to the name of any maker, drawer, issuer, endorser, assignor, transfer agent or registrar, acceptor, surety or guarantor, or raised or otherwise altered or lost or stolen, EXCLUDING, HOWEVER, any loss through accepting, cashing or paying forged or altered checks, drafts, or money orders, or any of the said instruments bearing forged endorsements, acceptances or certifications, or through the establishment of any credit to any customer or the giving of any value on the faith of such checks, drafts or orders, or through transferring, paying or delivering any funds or Property or establishing any credit or giving any value on the faith of any written instructions or advices, directed to the Insured, authorizing or acknowledging the transfer, payment, delivery or receipt of funds or Property, which instructions or advices purport to have been signed or endorsed by any customer of the Insured or by any banking institution but which instructions or advices either bear the forged signature or endorsement or have been altered

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without the knowledge and consent of such customer or banking institution.14

The first major revision to the original Insuring Agreement (E) was in 1969. Unlike the current version of Insuring Agreement (E), which specifies the documents covered, the 1969 version applied broadly to “securities, documents or other written instruments.”15 The 1969 Bond defined “securities, documents or other written instructions” to mean:16

(a) original (including original counterparts) negotiable or non-negotiable agreements in writing, other than as set forth in (b) and (c) below, having value which value is in the ordinary course of business, transferable by delivery of such agreement with any necessary endorsement or assignment;

(b) a carbon copy of a bill of lading provided that the signature on such carbon copy of such bill of lading is an original signature or is a carbon copy impression of a signature, or

(c) original corporate, partnership or personal guarantees.17

Further, unlike the 1986 Bond, the 1969 Bond did not define any of the documents, such as “guarantees,” which were included in the definition of “securities, documents or other written instruments.” Because the 1969 Bond failed to narrowly define the covered documents, courts construed the language broadly.18 As a result, in 1980, the SFAA,

14 1946 Bond, Losses Covered by Bond (E) 15 Financial Institution Bond, Standard Form No. 24 (revised Apr.

1969) [hereinafter 1969 Bond], reprinted in STANDARD FORM. 16 Before the revision in 1969, the bond contained no definition of

“securities, documents, or other written instruments.” 17 1969 Bond, Insuring Agreement (E)(b)(2)(a)-(c). 18 See, e.g., Union Inv. Co. v. Fid. & Deposit Co. of Md., 549 F.2d

1107, 1111 (6th Cir. 1977) (holding that a certificate of mortgage insurance constituted a security, document, or other written instrument); Home Sav. & Loan Ass’n v. Fid. & Deposit Co. of Md., 742 F.2d 831, 833 (4th Cir. 1984)

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in consultation with the American Bankers Association, again revised Insuring Agreement (E) in order to narrow the number of documents that could qualify for coverage.19 In the 1980 revisions, the SFAA sought to limit its coverage by enumerating and defining the specific documents that came within its purview.20

The 1980 Bond was revised to apply to the following categories of original documents:

(a) Security, (b) Document of Title, (c) deed, mortgage or other instrument conveying tile

to, or creating or discharging a lien upon, real property,

(d) Certificate of Origin of Title, (e) Evidence of Debt, (f) corporate, partnership or personal Guarantee, or (g) Security Agreement.21

The 1980 Bond also defined most of these categories of documents.

In 1986, the SFAA again revised the standard form bond. Very few changes were made to Insuring Agreement (E)’s application to certain categories of documents, but it did add two additional categories of documents:

(h) Instruction to a Federal Reserve Bank of the United States, or

(holding that a certificate of title falls within the definition of “securities, documents or other written instruments”).

19 See Edgar L. Neel, Financial Institution and Fidelity Coverage for Loan Losses, 21 TORT & INS. L.J. 590, 614 (1986).

20 See First Union Corp. v. U.S. Fid. & Guar. Co., 730 A.2d 278, 282 (Md. Ct. App. 1999) (discussing revisions to Insuring Agreement (E), and stating that the “history of Standard Form 24 demonstrates, the bond does not provide broad coverage for losses resulting from forgeries”).

21 Financial Institution Bond, Standard Form No. 24, Insuring Agreement (E)(1)(a)-(g) (revised July 1980) [hereinafter 1980 Bond], reprinted in STANDARD FORMS.,

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(i) Statement of Uncertificated Security of any Federal

Reserve Bank of the United States22

Additionally, the 1986 Bond modified the “Security” category to include only a “Certificated Security.”23 The definition of a Security and Certificated Security are virtually the same and, as a result, this modification had little or no effect on Insuring Agreement (E)’s coverage.

Insuring Agreement (E) of the 1986 Bond provides coverage for:

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 Original:

(a) Certificated Security, (b) Document of Title, (c) Deed, mortgage or other instrument

conveying title to, or creating or discharging a lien upon, real property,

(d) Certificate of Origin or Title, (e) Evidence of Debt, (f) Corporate, partnership or personal

Guarantee, or (g) Security Agreement; (h) Instruction to a Federal Reserve Bank of the

United States, or (i) Statement of Uncertificated Security of any

Federal Reserve Bank of the United States which

22 1986 Bond, Insuring Agreement (E)(1)(h)-(i). 23 1986 Bond, Insuring Agreement (E)(1)(a).

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(i) bears a signature of any maker, drawer, issuer, endorser, assignor, lessee, transfer agent, registrar, acceptor, surety, guarantor, or of any person signing in any other capacity which is a Forgery, or

(ii) is altered, or (iii) is lost or stolen;

(2) guaranteed in writing or witnessed any signature upon any transfer, assignment, bill of sale, power of attorney, Guarantee, endorsement or any items listed in (a) through (h) above; or

(3) acquired, sold or delivered, or given value, extended credit or assumed liability, on the faith of any item listed in (a) through (d) above which is a Counterfeit.

Actual physical possession of the items listed in (a) through (i) above by the Insured, its correspondent bank or other authorized representative, is a condition precedent to the Insured’s having relied on the faith of such items.

A mechanically reproduced facsimile signature is treated the same as a handwritten signature.24

The most recent revision to the standard form bond in 2004 removed the two categories mentioned above. According to the SFAA, these two categories were removed because they “do not represent ownership or convey an interest in something of value.”25 The 2004

24 1986 Bond, Insuring Agreement (E). 25 Letter from Robert J. Duke, The Surety Association of America, to

the Alabama Commissioner of Insurance (December 24, 2003), reprinted in FINANCIAL INSTITUTION BONDS 975, 977 (Duncan Clore, ed., 3d ed. 2008) [hereinafter 2003 Duke Letter].

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Bond also added an additional document: “Certificates of Deposit.”26 The 2004 Bond now provides coverage to the following groups of documents.

(a) Certificated Security; (b) Document of Title; (c) Deed, mortgage or other instrument conveying title

to, or creating or discharging a lien on, real property; (d) Certificate of Origin or Title; (e) Certificate of Deposit; (f) Evidence of Debt; (g) Corporate, partnership or personal Guarantee; and (h) Security Agreement.27

III.

INSURING AGREEMENT (D) AND (E) PROVIDE MUTUALLY EXCLUSIVE COVERAGE

At the outset, it is important to understand that Insuring Agreement (E) provides coverage distinct from that provided in Insuring Agreement (D), which also provides coverage for certain forgeries and alterations. This conclusion is clear from the language of the two Insuring Agreements. Yet, insureds and some courts28 maintain otherwise. There is no reasonable support for doing so.

The two Insuring Agreements exist for different reasons and insure different types of losses. Insuring Agreement (D) provides coverage for loss a bank sustains in its ordinary processing and payment functions as a financial institution.29 In other words, if a check is presented to an insured bank, and the bank pays the check, but the signature turns out to be forged and the bank must absorb the loss because it cannot collect from the maker, coverage for such a forgery

26 This addition to Insuring Agreement (E) will be addressed in more

detail below. 27 2004 Bond, Insuring Agreement (E). 28 See e.g., Merchs. Bank & Trust Co. v. Cincinnati Ins. Co.,

No. 1:06cv561, 2008 U.S. Dist. LEXIS 20151, at *9-10 (S.D. Ohio Mar. 14, 2008).

29 2003 Duke Letter, supra note 25.

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loss would be considered under Insuring Agreement (D). In contrast, the purpose of Insuring Agreement (E) is to protect a bank in the course of its business activities where it is extending credit based upon the receipt of collateral documents.30 Where the documentation of the collateral turns out to be forged, and the bank sustains a loss because it has no collateral (as opposed to the collateral itself being worthless) to liquidate to repay the debt, Insuring Agreement (E) would address such a loss.

In Liberty National Bank & Trust Co. v. National Surety Corp.,31 a bank lost $798,715.83 when it purchased promissory notes secured by automobile chattel mortgages and automobile leasing agreements. The signatures on both of these documents were forged. The insured sought coverage under both Insuring Agreement (D) and Insuring Agreement (E). The insurer paid the claim under Insuring Agreement (E), which provided coverage of $500,000, but denied the claim under Insuring Agreement (D), which had $1,500,000 of coverage.32 On appeal, the Sixth Circuit Court of Appeals noted that the agreements and leases were categorized as “securities” that were subject to purchase. With respect to Insuring Agreement (D), the court stated that loss under that insuring agreement must result from the insured paying funds on the faith of “instructions or advices directed to the insured and authorizing or acknowledging the transfer, payment, delivery or receipt of funds or Property, which did not occur.”33 The Sixth Circuit further noted the distinction between Insuring Agreements (D) and (E) by stating:

We note at the outset that Clause (D) is entitled ‘Forgery or Alteration’ and deals principally with cases resulting from forgery of commercial paper of the nature of checks or drafts; and that Clause (E) is entitled ‘Securities’ and deals principally with losses resulting from the purchase or extension of credit on the faith of

30 Liberty Nat’l Bank & Trust Co. v. Nat’l Sur. Corp., 330 F.2d 697,

699-70 (6th Cir. 1964). 31 Id. at 669 32 Id. 33 Id.

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‘any securities, documents, or other written instruments.34

More recently, in First National Bank v. Progressive Casualty Insurance Co.,35 the Tenth Circuit reached the same conclusion. In First Bank the bank argued that it made no sense “for the bond to include an Insuring Agreement (E) on forgeries and alterations when there is already and Insuring Agreement (D) on forgeries and alterations.”36 The court disagreed, reasoning: “The answer from the paling language of the bond is that Insuring Agreement (D) and Insuring Agreement (E) cover different types of forgeries and alterations.”37

That Insuring Agreements (D) and (E) provide mutually exclusive coverage is also clear from the history of the two Insuring Agreements. Insuring Agreement (E) of the 1969 Bond expressly excluded:

Loss through FORGERY OR ALTERATION of, on or in any checks, drafts, acceptances, withdrawal orders or receipts for the withdrawal of funds or Property, certificates of deposit, letters of credit, warrants, money orders or orders upon public treasuries; and excluding, further, loss specified in subdivisions (1) and (2) of Insuring Agreement (D) as printed in this bond, whether or not any amount of insurance is applicable under this bond to Insuring Agreement (D).38

The purpose of this express exclusion was to make clear that Insuring Agreements (D) and (E) provided different coverages.39 In

34 Id. at 699-70. 35 415 F. App’x 867, 869 (10th Cir. 2011) (noting that under the “plain

language of the Bond” it is clear that “Insuring Agreement (D) and Insuring Agreement (E) cover different types of forgeries and alteration”).

36 Id. at 870. 37 Id. 38 1969 Bond, Insuring Agreement (E)(b)(2). 39 Statement of Change, Bankers Blanket Bond (1980), reprinted in

FINANCIAL INSTITUTION BONDS 1003, Appendix (Duncan Clore, ed., 3d ed. 2008) [hereinafter 1980 Statement of Change].

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1980, however, this exclusionary language was removed.40 According to The Statement of Change, Bankers Blanket Bond, Revised to July 1980, “[t]he exclusionary language relating to Insuring Agreement (D) [was] removed because the two Agreements now cover different instruments.”41 In other words, the SFAA believed that, as a result of the revision they had made to Insuring Agreement (E), as well as to Insuring Agreement (D), the exclusion no longer was necessary to make it clear that the two Insuring Agreements were mutually exclusive.

IV. COVERAGE REQUIREMENTS UNDER

INSURING AGREEMENT (e)

Insuring Agreement (E) provides coverage for certain forged, altered, counterfeit, lost or stolen documents under certain circumstances. Most articles discussing this Insuring Agreement focus on the nature of the loss, whether involving forged, altered or other documents. This article focuses on the other requirements of coverage, which are as or more important, but which have less attention and thus are more misunderstood.

A. The Covered Document Requirement

Insuring Agreement (E) provides coverage for a limited number of loan related documents. Although seemingly straight forward, not all insureds, or courts agree. Thus, this section of the article addresses the types of documents potentially covered by Insuring Agreement (E).

1. Insuring Agreement (E)’s Current Application to Covered Documents

The 1986 version of Insuring Agreement (E) provides potential coverage for loss from an original document that falls under one of nine enumerated categories. In contrast, the 2004 Bond extends coverage to only eight categories. The 2004 Bond added one new category, but removed two others that the drafters concluded did “not represent

40 See 1980 Bond. 41 1980 Statement of Change, supra note 39.

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ownership or convey an interest in something of value.”42 The definitions of the covered documents under the 2004 Bond are left largely unchanged. But, the word “Written” was “inserted into a number of definitions to assure that coverage under the basic Form 24 [was] not provided for electronic transactions.”43 To this end, the 2004 Bond included the following new definition of “Written”: “Written means expressed through letters or marks placed upon paper and visible to the eye.”44

Although the standard form bond provides definitions for most of the enumerated writings, issues occasionally arise over whether a specific document falls within a certain category. In 1980, when Insuring Agreement (E) was first revised to make specific reference to each category of covered documents, the drafters of the bond relied on definitions from the Uniform Commercial Code (“UCC”).45 Thus, the UCC, and cases interpreting it, are helpful in understanding what documents are covered under Insuring Agreement (E). Throughout the bond’s revisions, these definitions have remained relatively unchanged, with one notable and important exception being the definition of “Negotiable Instrument.”

a. “Certificated Security”

Certificated Security was added as a covered document in 1986. It is defined as:

a share, participation or other interest in property of, or an enterprise of, the issuer or an obligation of the issuer, which is:

(1) represented by an instrument issued in bearer or registered form;

42 2003 Duke Letter, supra note 25. 43 Id. 44 Id.; 2004 Bond, Definitions, § 1(v). 45 Hereinafter the UCC.

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(2) of a type commonly dealt in on securities exchanges or markets or commonly recognized in any area in which it is issued or dealt in as a medium for investment; and

(3) either one of a class or series by its terms divisible into a class or series of shares, participations, interests or obligations.46

Before 1986, prior versions of the bond used the term “securities,” and did not use the term “certificated securities.” Indeed, when the bond was revised in 1980, it incorporated the UCC’s definition of “securities.”47 This version of the bond defined “securities” very similarly, as:

[A]n instrument which:

(1) is issued in bearer or registered form;

(2) is of a type commonly dealt in upon securities exchanges or markets or commonly recognized in any area in which it is issued or dealt in as a medium for investment; and

(3) is either one of a class or series by its terms is divisible into a class or series of instruments, and

(4) evidences a share, participation or other interest in property or in an enterprise or evidences an obligation of the issuer.48

Since the bond initially incorporated many of its documents’ definitions from the UCC, the UCC remains helpful in understanding what types of document are covered under the standard form bond. The UCC has further defined the requirements of a Certificated Security. For instance, the UCC statutes in certain states define “bearer form” to mean

46 1986 Bond, Definitions, Section 1(d). 47 Empire State Bank v. St. Paul Fire & Marine Ins. Co., 441 N.W.2d

811, 813 (Minn. Ct. App. 1989). 48 1986 Bond, Definitions, § 1(d).

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“a form in which the security is payable to the bearer of the security certificate according to its terms but not by reason of an endorsement.”49

Another requirement for a document to constitute a “Certificated Security” is that it be “of a type commonly dealt in on securities exchanges or markets or commonly recognized in any area in which it is issued or dealt in as a medium for investment.”50 In the context of Article 8 of the UCC, courts have recognized that “whether or not there is a market for the particular instrument is not the controlling factor, if the instrument is ‘of a type commonly dealt in upon securities exchanges or markets.’”51

Several cases have also considered whether a specific document constitutes a “security” or “certificated security.” For example, in Empire State Bank v. St. Paul Fire & Marine Insurance Co.,52 the court considered whether a certificate of participation, which allowed a party to participate in another’s loan, constituted a security. The court held that, because the certificate of participation was nontransferable, and was not issued in bearer form, it did not fall under the definition of Security.53 Another court has held that a lease does not constitute a Certificated Security as a matter of law because it was not represented by an instrument issued in bearer or registered form, and it is not the type of document commonly dealt in on securities exchanges or markets or commonly recognized or dealt in as a medium for investment.54 More recently, in Brady National Bank v. Gulf Insurance Co.,55 both parties agreed that certificates of deposit constituted “certificated securities” for

49 See, e.g., MINN. STAT. § 336.8-102(2) (2011). 50 1986 Bond, Definitions, § 1(d). 51 In re Domestic Fuel Corp., 70 B.R. 455, 462 (Bankr. S.D.N.Y. 1987)

(quoting Practice Commentary accompanying Section 8-102); see also Baker v. Gotz, 387 F. Supp. 1381, 1390 (D. Del. 1975) (same).

52 441 N.W.2d at 813. 53 Id. at 813-14; see also Corporacion Venezolana de Fomento v.

Vintero Sales Corp., 452 F. Supp. 1108, 1118 (S.D.N.Y. 1978) (holding that under Article 8 of the UCC, certificates of participation are not securities).

54 Pine Bluff Nat’l Bank v. St. Paul Mercury Ins. Co., 346 F. Supp. 2d 1020, 1026-27 (E.D. Ark. 2004).

55 94 F. App’x 197, 201 (5th Cir. 2004). Note that under the 2004 Bond, this point would not have been an issue because “Certificate of Deposit” is now an expressly enumerated document under Insuring Agreement (E).

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purposes of a contractual provision almost identical to Insuring Agreement (E). These cases show that when considering whether a document constitutes a certificated security, or a security under older versions of the bond, courts adhere strictly to the plain definition of the document contained in the bond.

b. “Document of Title”

The 1986 Bond defines Document of Title as:

[A] bill of lading, dock warrant, dock receipt, warehouse receipt or order for the delivery of goods, and also any other document which in the regular course of business or financing is treated as adequately evidencing that the person in possession of it is entitled to receive, hold and dispose of the document and the goods it covers and must purport to be issued by or addressed to a bailee and purport to cover goods in the bailee’s possession which are either identified or are fungible portions of an identified mass.56

Similar to the definition of Certificated Security, Document of Title borrows its meaning heavily from the UCC, which specifically identifies the “classic” document of title.57 When determining whether a specific document constitutes a Document of Title, courts have applied the ordinary and plain meaning of its definition. For instance, in Pine Bluff National Bank v. St. Paul Mercury Insurance Co.,58 the court considered whether a copy machine lease constituted a Document of Title. In doing so the court noted that:

The form of lease at issue here is not a bill of lading, dock warrant, dock receipt, warehouse receipt, or order for the delivery of goods; nor is it a document that in the regular course of business or financing is treated as

56 1986 Bond, Definitions, § 1(f). 57 See Millennium Partners, L.P. v. Colmar Storage, LLC, 494 F.3d

1293, 1300 (11th Cir. 2007) (citing FLA. STAT. ANN. § 671.201(15) (West 2007)).

58 346 F. Supp. 2d at 1027.

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adequately evidencing that the person in possession of it is entitled to receive, hold, and dispose of the document and the goods it covers. Each lease at issue here was first held by [the borrower], but the lease was not evidence that [the borrower] was entitled to receive, hold and dispose of the copy machine covered by such lease. So long as the lease was in effect, and so long as the lessee was not in default, [the borrower] was not entitled to hold, receive, and dispose of the copy machine. Furthermore, [the borrower] delivered the leases to the Bank. However, possession of such a lease by the Bank was not evidence that the Bank was entitled to receive, hold, and dispose of the copy machines at issue. So long as the lease fulfilled its obligations under the lease, and so long as the lease was in effect, the lessee was entitled to hold the copy machines, not [the borrower], and not the Bank. As a matter of law, the form of lease is not a Document of Title within the meaning of the Bond.59

In reaching its conclusion that the lease was not a Document of Title, the court based its analysis strictly on a plain reading of the definition of Document of Title, and noted that the lease in question was not one of the specifically enumerated types of Documents of Title, and that it did not otherwise fall within the plain definition.60

Because there is a dearth of case law discussing what falls within the purview of Document of Title, cases under the UCC are instructive. In Bank of New York v. Amoco Oil Co.,61 the court addressed the issue of whether “holding certificates” constituted “Documents of Title” under § 1-201(15) of the UCC.62 The holding certificate at issue provided: (1) an entity was holding platinum for the account or order of the precious metal company; (2) the platinum was free of all liens and encumbrances; and (3) the platinum was to be released on surrender of the holding certificate, if properly endorsed. To determine whether holding certificates were Documents of Title, the court first looked at whether the

59 Id. 60 Id. at 1027-28. 61 831 F. Supp. 254 (S.D.N.Y. 1993). 62 Id. at 261-62.

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holding certificates were treated as “adequately evidencing that the person in possession of” the holding certificate was entitled to receive and dispose of the platinum.63 The court also looked to both the intent of the parties and industry standards to determine whether a holding certificate is treated as adequately evidencing that a person is entitled to receive and dispose of goods. The court concluded the holding certificate met the first criteria because, consistent with industry standards, the bank treated the holding certificates as evidence it was entitled to receive and dispose of the platinum.64 Next, the court addressed whether the holding certificates purported to be issued by, or addressed to, a bailee and purported to cover the goods in the bailee’s possession. The entity holding the platinum maintained it was not a bailee as defined under UCC § 7-102(1)(a) because the holding certificates neither “acknowledg[ed] possession of the goods [nor] contract[ed] to deliver them.”65 It further argued the only contractual obligation imposed was its lease of the platinum from a trading company. The court rejected this argument because the holding certificates expressly provided for the release of the platinum to a specific person upon presentation of a properly endorsed holding certificate. Further, the court noted even if the holder was not a bailee, the holding certificates could still be Documents of Title because § 1-201(15) only required that the holder of the platinum purport to be a bailee.66 The court held that by including language in the holding certificate requiring the seller to surrender and deliver the platinum upon presentation of a properly endorsed holding certificate, the seller had purported to be a bailee.67 The court also rejected the seller’s argument that the lease between it and the trading company prevented the holding certificates from being Documents of Title. The court concluded that the holding certificates did not indicate the nature of the underlying transaction, but only provided that the seller would surrender and deliver the platinum upon presentation of a properly endorsed holding certificate.68 Thus, the court held the holding certificates were Documents of Title because the bank treated the holding certificates as adequately evidencing its right to

63 Id. at 261. 64 Id. 65 Id. 66 Id. at 262 67 Id. 68 Id. at 264

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possess and dispose of the platinum, the holding certificates purported to be issued by or addressed to a bailee, and the holding certificates purported to cover the platinum.69 The United States District Court for the Southern District of New York’s analysis in this case is instructive of how a court may analyze the issue of whether a particular document falls within the bond’s definition of Document of Title.

c. “Deed, Mortgage or Other Instrument Conveying Title To, or Creating or Discharging a Lien Upon, Real Property”

Unlike the previous two categories of documents, the 1986 Bond does not define this category of documents, and there is little case law addressing this category of documents in the fidelity bond context. However, the intent appears straightforward, applying coverage to documents creating legal title or creating or discharging a lien.

Black’s Law Dictionary defines “deed” as “[a] written instrument by which land is conveyed” or that “conveys some interest in property.”70 Also, it defines “mortgage” as “[a] conveyance of title to property that is given as security[.]”71 Thus, both a “deed” and “mortgage” are defined as conveying title or interest in property. Accordingly, in order for a document to fall within this category of covered documents, the documents must convey some interest in real property, or create or discharge a lien. If the document at issue does not do one of these three things, then under the plain meaning of the bond, it cannot fall under this category, and should not be included in coverage under Insuring Agreement (E).

Despite the apparent clarity of this category of documents, insureds occasionally attempt to be creative in arguing what documents are covered. For example, the authors are familiar with a case in which an insured argued that a real estate contract falls under this category because equitable title, under some states’ laws, is transferred at the time

69 Id. 70 BLACK’S LAW DICTIONARY 444 (7th ed. 1999). 71 Id. at 1031.

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of the execution of the real estate contract.72 A traditional real estate contract, however, would not fall within this category because it does not covey title, create a lien, or discharge a lien. Moreover, most real estate contracts contemplate the execution of an additional document, namely a deed or mortgage, that does convey title. If real estate contracts did convey title by themselves, then there would never be any reason to conduct a “closing,” where title is actually conveyed once a deed or mortgage is executed.

In First Federal Savings Bank of Newton, Kansas v. Continental Casualty Co.,73 the court considered whether construction cost statements, a subcontractor agreement, subcontractor invoices, and checks to subcontractors, which were all provided to the insured by a borrower, were documents “creating . . . a lien upon real property.” The insured argued that under Colorado law, the performance of work, which was evidenced by the documents, created a lien on the property.74 The court in its analysis cited § 38-22-101(1) of the Colorado Revised Statutes, which provides, in relevant part:

Every person who supplies machinery, tools, or equipment in the prosecution of the work, and mechanics, materialmen, contractors, subcontractors, builders, and all persons of every class performing labor upon or furnishing directly to the owner or persons furnishing labor materials to be used in construction, . . . shall have a lien upon the property upon which they have supplied machinery, tools, or equipment or rendered service or bestowed labor . . . .75

The court rejected this argument, and noted that these documents alone did not create a lien but, at best, evidenced work done that would potentially support a lien or evidence the fact that a lien existed.76

72 See, e.g., Bd. of Comm’rs of Madison Co. v. Midwest Assocs., Inc.,

245 N.E.2d 853, 858 (Ind. Ct. App. 1969). 73 768 F. Supp. 1449, 1455 (D. Kan. 1991). 74 Id. 75 Id. (citing Colo. Rev. Stat. Ann. § 38-22-101(1) (West 1991). 76 Id.

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d. “Certificate of Origin or Title”

The 1986 Bond defines Certificate of Origin or Title as “a document issued by a manufacturer of personal property or a governmental agency evidencing the ownership of the personal property and by which ownership is transferred.”77 In FDIC v. Fidelity & Deposit Co. of Maryland,78 the FDIC attempted to argue that a city ordinance constituted a “certificate or origin or title.” The insurer argued that the city ordinance was not a document “by which ownership is transferred,” and it was not issued by a “governmental agency.”79 The court found that the ordinance’s express language requiring prior approval by the Council of the City coupled with the fact that the parties executed an assignment of contractual rights, indicated that the ordinance was not in fact a document “by which ownership is transferred.”80 The court also noted that because of the inclusion of “forgery” and “counterfeit” in Insuring Agreement (E), a “certificate or origin of title” could include one issued by a governmental agency that was a forgery or counterfeit.81 Thus, even if a document is forged or counterfeited, it can still conceivably satisfy the “issued by a governmental agency” requirement.

e. “Certificate of Deposit”

The most recent revision to the bond in 2004 added Certificates of Deposit as a covered document under Insuring Agreement (E).82 A Certificate of Deposit has been a specifically covered document under Insuring Agreement (D) since its inception in 1936. However, before the latest revision, Certificates of Deposit was not a covered document under Insuring Agreement (E). Thus, on the face of the 2004 Bond, there appears to be an overlap in coverage under Insuring Agreements (D) and (E). This was not the intent of the bond’s drafters and, in fact, is not the case.83 While it is true that a Certificate of Deposit may fall under either

77 1986 Bond, Definitions, Sections 1(c). 78 827 F. Supp. 385, 394 (M.D. La. 1993). 79 Id. at 395. 80 Id. at 396 81 Id. at 395-96. 82 2004 Bond, Insuring Agreement (E)(1)(e). 83 Notes, SFAA Drafting Subcommittee, July 1, 2002, available on file

with the SFAA [hereinafter 2002 Notes].

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Insuring Agreement (D) or (E), the coverage afforded under both insuring agreements is different. Indeed, with respect to Insuring Agreement (D), a Certificate of Deposit may serve as an instruction to a bank to pay. And under Insuring Agreement (E), it may serve as a security and serve to collateralize a loan. In drafting the 2004 Bond, the SFAA recognized this distinction, and the two possible uses of Certificates of Deposit. Specifically, the Notes from the Drafting Subcommittee for the 2004 Bond note the distinction:

Staff will insert Certificate of Deposit to the list of items in Insuring Agreement D.84 The addition will address a scenario whereby a perpetrator presents a forged CD to the bank and transfers the funds to his account.

Still will insert Certificate of Deposit to the list of items in Insuring Agreement E. The addition of CDs to the list addresses a scenario in which a loan is made on the basis of a forged CD.85

The 1986 Bond defines Certificate of Deposit as “an acknowledgment in writing by a financial institution of receipt of Money with an engagement to repay it.”86 Because of its recent introduction into the bond, there is no case law discussing its application under Insuring Agreement (E). However, as stated above, in the introduction to this sub-section, the UCC is instructive. The UCC defines a “Certificate of Deposit” as a promissory note where the maker is a bank.87

f. “Evidence of Debt”

The 1986 Bond defines “Evidence of Debt” as “an instrument, including a Negotiable Instrument, executed by a customer of the Insured and held by the Insured which in the regular course of business is treated

84 To the extent this statement implies that Certificate of Deposit is

being added to Insuring Agreement (D) as a covered document for the first time is, the sentence is wrong. As stated above, Certificates of Deposit have been covered under Insuring Agreement (D) since its incorporation into the bond.

85 2002 Notes, supra note 83. 86 1986 Bond, Definitions, § 1(b), 87 U.C.C. § 3-104 (1992).

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as evidencing the customer’s debt to the Insured.”88 The 2004 Bond added the phrase “or purportedly executed” to the definition of Evidence of Debt.89 This addition forecloses an insured’s argument that a forged instrument that is not actually signed by a customer is not an Evidence of Debt.90

The most-often cited case addressing “evidence of debt” is Merchants National Bank of Winona v. Transamerica Insurance Co.91 In Merchants, a construction company applied for several commercial loans from Merchants National Bank. As a condition of issuing the loans, the bank required the construction company to present it with fully executed construction contracts.92 Between 1980 and 1981, the construction company’s principal owner assigned two forged construction contracts to the bank. The construction company eventually defaulted on the loans, and the bank filed a claim with its insurer requesting indemnification for its losses under its Financial Institution Bond.93 The insurer denied the claim on the ground that the bond did not provide coverage for forged construction contracts. Subsequently, the bank filed suit and alleged that the forged construction contracts were “evidences of debt” under Insuring Agreement (E).94 This argument was rejected. The Court of Appeals of Minnesota recognized that “‘[e]vidence of debt’ refers to primary indicia of debt, such as promissory notes or other instruments that reflect a customer’s debt to the bank,” and that the forged construction contracts did not evidence the construction company’s debt to the bank and, as a result, were not an Evidence of Debt.95 Other cases interpreting Evidence of Debt have reached similar results.96 For

88 1986 Bond, Definitions, §1(h). 89 2004 Bond, Definitions, § 1(i). 90 Robert J. Duke, A Brief History of the Financial Institution Bond, in

FINANCIAL INSTITUTION BONDS 26 (Duncan L. Clore ed., 3d ed. 2008). 91 408 N.W.2d 651, 653 (Minn. Ct. App. 1987). 92 Id. at 652. 93 Id. 94 Id. 95 Id. 96 See, e.g., O’Brien’s Irish Pub, Inc. v. Gerlew Holdings, Inc., 332

S.E.2d 920 (Ga. Ct. App. 1985); First Union Corp. v. U.S. Fid. & Guar. Co., 730 A.2d 278, 282 (Md. Ct. App. 1999) (citing Portland Fed. Emps. Credit Union v. Cumis Ins. Soc’y, Inc., 894 F.2d 1101 (9th Cir. 1990)); Suburban Nat’l Bank v. Transamerica Ins. Co., 438 N.W.2d 119 (Minn. Ct. App. 1989).

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instance, in First Union Corp. v. United States Fidelity & Guaranty Co.,97 the Maryland Court of Appeals held that forged incumbency certificates, which merely showed that a certain individual was a high-ranking individual with the borrower, was not a primary indicia of debt, and hence not an evidence of debt.

(i) Promissory Notes Fall Under Insuring Agreement (E), not Insuring Agreement (D)

An important issue that has arisen in the last decade with the increase in fraudulent mortgage and warehouse lending claims, is whether a claim involving a forged promissory note falls under Insuring Agreement (D) or Insuring Agreement (E). Insuring Agreement (D) applies to Negotiable Instruments, except an Evidence of Debt.98 Insureds often argue that a promissory note is a Negotiable Instrument, but it is not an Evidence of Debt because the person signing the note was not a “Customer” of the insured bank, and thus Insuring Agreement (D), and not Insuring Agreement (E), is applicable. This is incorrect on both points. First, while a promissory note typically is a negotiable instrument under the broad definition of the term in the UCC,99 the Financial Institution Bond defines Negotiable Instrument narrowly to limit the term to checks and other items that fall under only Insuring Agreement (D), but which do not include promissory notes. Further, a promissory note is the quintessential Evidence of Debt.

(ii) A Promissory Note is Not a Negotiable Instrument as Defined by the Bond

Unlike the majority of the other definitions of the covered documents in Insuring Agreement (E), the definition of “Negotiable Instrument” is not identical to the definition contained in the UCC. In fact, the definition is narrower than the UCC’s definition. The UCC defines a “negotiable instrument” as:

97 First Union Corp., 730 A.2d at 282. 98 1986 Bond, Insuring Agreement (D)(1). 99 U.C.C. § 3-104 (1990).

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an unconditional promise or order to pay a fixed amount of money, with or without interest or other charges described in the promise or order, if it:

(1) is payable to bearer or to order at the time it is issued or first comes into possession of a holder;

(2) is payable on demand or a definite time; and

(3) does not state any other undertaking or instruction by the person promising or ordering payment to do any act in addition to the payment of money, but the promise or order may contain:

i. an undertaking or power to give, maintain, or protect collateral to secure payment,

ii. an authorization or power to the holder to confess judgment or realize on or dispose of collateral, or

iii. waiver of the benefit of any law intended for the advantage or protection of an obligor.100

The definition under the bond, however, is narrower, as follows:

[A]ny writing: (1) signed by the maker or drawer; and (2) containing any unconditional promise or order to pay a sum certain in Money and no other promise, order, obligation or power given by the maker or drawer; and (3) is payable on demand or at a definite time; and (4) is payable to order or bearer.101

The bond’s definition is clear and unambiguous. It has been carefully drafted to be narrower than the definition under the UCC. Given the SFAA’s reliance upon UCC definitions for most of the other documents in Insuring Agreement (E), there can be no doubt that the

100 Id. at § 3-104 (a). 101 1986 Bond, Definitions, § 1(o).

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SFAA intentionally narrowed the definition of Negotiable Instrument to apply to “items”, such as checks or drafts, under Insuring Agreement (D). Thus, the definition of Negotiable Instrument under the UCC is of no use in construing the bond.

The two most significant differences between the two definitions is that the bond provides that a Negotiable Instrument must contain an “unconditional promise or order to pay,” but “no other promise, order, obligation or power given by the maker or drawer . . . .” And, the order to pay must be “in money.” Most modern promissory notes contain numerous additional promises or obligations, and they permit payment by other than only “Money.”

(aa) Limit on Promises, Orders, and Obligations

The bond’s restriction against other promises is in stark contrast to that contained in the UCC, which allow an unconditional promise to pay and no other promise, order, obligation, or power “except as authorized by this Article.” The “except as authorized” language refers to additional promises, orders, obligations, or powers permitted under Section 3-105, without affecting the concept of “negotiability” under the UCC, including the following: (1) an allowance that an instrument “refers to or states that it arises out of a separate agreement or refers to a separate agreement for rights as to prepayment or acceleration.,” and (2) an allowance that an instrument “states that it is secured, whether by mortgage, reservation or title or otherwise.”102

The additional promises contemplated by the UCC are commonly found in most modern promissory notes. For example, most modern promissory notes include provisions allowing the holder to accelerate the note. They also typically include provisions regarding the payment of taxes and insurance. And, most modern notes incorporate mortgages or deeds of trust, which are replete with addition promises and obligations. Thus, most modern promissory notes are negotiable instruments under the UCC, but they are not Negotiable Instruments under the bond.

102 U.C.C. § 3-105(a)(3), (5).

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An example of a case holding that a promissory note is not a negotiable instrument, even under the UCC, is Resolution Trust Corp. v. 1601 Partners, Ltd..103 RTC filed suit against a partnership on a promissory note. The partnership asserted that the note was not a negotiable instrument due to the incorporation of a deed of trust. The note in that case stated: “The terms, agreements and conditions of the [deed of trust] are by reference made a part of this instrument.”104 In discussing whether the note was conditional, the court explained as follows:

Section 3.105(b) of the UCC provides that a promise is not unconditional if the instrument “states that it is subject to or governed by any other agreement. Here, the note states that “the terms, agreements and conditions of [the deed of trust] are by reference made a part of this instrument.” Courts hold that when an instrument incorporates by reference the terms of another document, the instrument becomes “subject to or governed by” another agreement for purposes of section 3.105(b) and the promise contained within the instrument, therefore, is rendered conditional.

Mere reference to a note being secured by a mortgage, of course, is commercial practice, and does not affect the negotiability of the note. The language within the note executed by 1601 Partners, however, exceeds the outer bounds of “mere reference,” as it explicitly purports to incorporate the terms of the Deed of Trust. Accordingly, the note is not a negotiable instrument under Texas law.105

(bb) The “In Money” Restriction

The bond’s definition of Negotiable Instrument also requires payment of “a sum certain in Money[.]” The term “Money” as defined in the bond is understood to be, and has been interpreted as, currency

103 796 F. Supp. 238 (N.D. Tex. 1992). 104 Id. at 240. 105 Id. (internal citations omitted).

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only, and does not include checks, money orders, or other forms of payments.106 In Fillion v. The David Silvers Co., the court analyzed the issue of whether a tender of amounts owed on a mortgage by means of a letter of credit was legally sufficient. The court cited cases holding that, where money is called for as payment, it is not valid to tender a sum by check or money order, and thus payment by a letter of credit also would not be permitted.107 The court held:

Tender of whatever sum is owed on the mortgage debt is a condition precedent to the mortgagor’s recovery of title from a mortgagee who is in possession and claims title under a void foreclosure sale.

It is apparent that a necessary prerequisite to the Silvers’ recovery of title in this action is tender of whatever amount is owed on the note. The question is whether such a tender was made. The Silvers are not entitled to judgment for title to the house if such tender was not made.

One of the grounds on which Fillion objected to the letter of credit as purported tender of payment of all sums due under the note and deed of trust was that a legal tender cannot validly be made through the medium of a letter of credit.

“A tender is an unconditional offer by a debtor or obligor to pay another, in current coin of the realm, a sum on a specified debt or obligation.” It consists of the actual production of funds and offer to pay the debt involved. “The tenderer must relinquish possession of it for a sufficient time and under such circumstances as to

106 Fillion v. The David Silvers Co., 709 S.W.2d 240, 246-7 (Tex.

App.—Houston [14th Dist.] 1986, writ ref’d n.r.e.) (bank properly refused to accept tender of payment of loan where note required payment to be “in money” but tender was not in money).

107 Id. (citing Littlejohn v. Johnson, 332 S.W.2d 439 (Tex. Civ. App.—Waco 1960, no writ); Niagara Fire Ins. Co. v. Mitchell, 164 S.W. 919 (Tex. Civ. App.—San Antonio 1914, writ dism’d)).

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enable the person to whom it is tendered, without special effort on his part, to acquire its possession.” In the absence of an agreement to the contrary, tender of payment, when money is called for, is not valid when made by check. Tender by an express money order was not valid tender of a sum due by an insurance company to an insured for unearned premium. The tender must be made in money.

In the instant case, appellees issued a letter of credit as tender of payment. We find that this letter of credit does not represent an unconditional offer by the debtors-appellees to pay appellants in cash money and therefore is not valid tender.108

This limitation in the definition of “Negotiable Instrument” makes sense because, once again, the items covered in Insuring Agreement (D) are items associated with the ordinary payment and processing functions of a bank, such as checks or money orders. Such items are payable “in Money” because they are written instructions to move or transfer currency. This is not the case, however, with a promissory note. Thus, this distinction between the two definitions is important in analyzing whether a promissory note is a Negotiable Instrument under the bond.

(iii) A Promissory Note is an Evidence of Debt

Even if a promissory note satisfies the definition of a Negotiable Instrument under the bond, it nevertheless is excepted from Insuring Agreement (D1) and covered, if at all, solely under Insuring Agreement (E), because promissory notes are Evidences of Debt. The 1986 Bond defines an Evidence of Debt as follows:

(a) Evidence of Debt means a written instrument, including a Negotiable Instrument, executed by a customer of the Insured and held by the Insured

108 Id. at 246-47 (internal citations omitted).

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which in the regular course of business is treated as evidencing the customer’s debt to the Insured.109

Promissory notes have generally been considered to be the quintessential evidence of debt, meaning a document that provides evidence of a debt that is owed.110 The courts considering this term have found that “evidence of debt” refers to a primary indicia of debt, such as promissory notes or other instruments that reflect a debt to a bank.111 In addition, courts have concluded that a “customer” of a bank can be the maker of a note.112

Some creative insureds argue that a promissory note is not an Evidence of Debt in the context of warehouse lending claims. In these claims, a warehouse lender that has funded a mortgage closing as the lending bank for the mortgage company argues that the borrower/home buyer is the customer of the mortgage company, not the customer of the insured warehouse lender, and thus the promissory note is not an Evidence of Debt as to the insured warehouse lender. This clearly is not the intent of the standard form bond, and even if true, would leave the insured without coverage because a promissory note is not a Negotiable Instrument, and thus is not covered under Insuring Agreement (D).

Such an argument is nonsensical, and ignores the reality of warehouse lending. The warehouse lender provides the loan money to the borrow. Indeed, the whole idea of warehouse lending is that the mortgage company does not actually have its own money to lend. As a result, at a minimum, the warehouse lender takes the forged notes as collateral for its loan. In most cases, the notes are actually transferable to the warehouse lender, and in many, if not most, cases, the notes is contemporaneously transferred to the warehouse lender, who then sells

109 1986 Bond, Definitions, § 1(h). 110 Merchs. Nat’l Bank v. Transam. Ins. Co., 408 N.W.2d 651, 653

(Minn. Ct. App. 1987); In re Miller’s Estate, 218 P.2d 966, 967-68 (Or. 1950) (promissory note not a debt but was evidence of a debt).

111 Merchs. Nat’l Bank, 408 N.W.2d at 653; First Union Corp., 730 A.2d at 282.

112 Am. Nat’l Bank v. Stanfill, 252 Cal. Rptr. 861, 866 (Cal. Ct. App. 1988); Swerdloff v. Miami Nat’l Bank, 584 F.2d 54, 58 (5th Cir. 1978) (“In common usage, a customer is one who has business dealing with another.”).

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the note on the secondary market. In any event, it is the borrower who will be repaying the warehouse lender if a note payment is due, not the mortgage company. Thus, the borrower truly is the customers of the warehouse lender.

The UCC is helpful on this issue. The term “customer” generally is defined broadly under the UCC.113 Interpreting § 4-104 of the UCC, one court expressly found that a “customer” of a bank can be the maker of a note.114 Where the name of the account holder is a legal entity, the court considers a number of factors to determine customer status, including the authorized signatories, the circumstances surrounding the accounts opening, what persons control the account, and the beneficial interest of persons associated with the account.115

Also, under the UCC, unauthorized signatures are treated as those of the person who actually signed the instrument, not the person whose name appears on the instrument, for every relevant purpose. The pertinent language in the current version of the UCC reads:

(a) Unless otherwise provided in this Article or Article 4, an unauthorized signature is ineffective except as the signature of the unauthorized signer in favor of a person who in good faith pays the instrument or takes it for value. An unauthorized signature may be ratified for all purposes of this Article.116

113 See generally Williams v. Cullen Ctr. Bank & Trust, 685 S.W.2d

311, 314 (Tex. 1985). 114 Am. Nat’l Bank, 252 Cal. Rptr. at 866. 115 See Lietzman v. Ruidoso State Bank, 827 P.2d 1294, 1299 (N.M.

1992); see also Schoenfelder v. Ariz. Bank, 796 P.2d 881, 889 (Ariz. 1990) (addressing whether officer was customer via corporate account); Kendall Yacht Corp. v. United Cal. Bank, 123 Cal. Rptr. 848, 853 (Cal. Ct. App. 1975) (disregarding corporate entity); Parrett v. Platte Valley State Bank & Trust Co., 459 N.W.2d 371, 378 (Neb. 1990) (same); but see Koger v. E. First Nat’l Bank, 443 So. 2d 141, 142-43 (Fla. Dist. Ct. App. 1983) (refusing to find individual partner liability because partnership was the customer).

116 U.C.C. § 3-403.

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The prior version of the UCC included analogous language at § 3-404. The Official Comments to current § 3-403 include the following explanation of this provision:

“Unauthorized” signature is defined in Section 1-201(43) as one that includes a forgery as well as a signature made by one exceeding actual or apparent authority. . . .

The except clause of the first sentence of subsection (a) states the generally accepted rule that the unauthorized signature, while it is wholly inoperative as that of the person whose name is signed, is effective to impose liability upon the signer or to transfer any rights that the signer may have in the instrument. The signer’s liability is not in damages for breach of warranty of authority, but is full liability on the instrument in the capacity in which the signer signed. It is, however, limited to parties who take or pay the instrument in good faith; and one who knows that the signature is unauthorized cannot recover from the signer on the instrument.117

As a result, an unauthorized signature is, in effect, treated as the signature of the unauthorized signer under an assumed name.118 Thus, because the mortgage company is typically the forger on the promissory notes at issue, the note is signed by a customer of the warehouse lender as the mortgage company is clearly the warehouse lender’s customer.

g. “Corporate, Partnership or Personal Guarantee”

Although the 1986 Bond does not define Corporate, Partnership, or Personal, it defines a Guarantee as “a written undertaking obligating the signer to pay the debt of another to the Insured or its assignee or to a financial institution from which the Insured has purchased participation in the debt, if the debt is not paid in accordance with its terms.”119 The

117 Id. at cmts. (1), (2). 118 See U.C.C., Notes & cmts. to art. 3, § 18 at 89 (Tentative Draft No.

1, 1946). 119 1986 Bond, Definitions, § 1(j).

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Guarantee may be made by a corporation, partnership, or an individual. Thus, there is no reason for any misunderstanding concerning this covered document.

h. “Security Agreement”

The 1986 Bond defines a Security Agreement as “an agreement which creates an interest in personal property or fixtures and which secures payment or performance of an obligation.”120 In Merchants National Bank of Winona v. Transamerica, Inc.,121 a bank extended a loan based on the assignment of two construction contracts by the borrower/contractor to the bank. Subsequently, the loans went into default and the bank learned that the assignment language contained forged signatures. The bank then sought coverage under Insuring Agreement (E), and argued that the construction contracts constituted, in addition to an Evidence of Debt, a Security Agreement.122 The Minnesota Court of Appeals rejected this argument, and held that the two construction contracts did not constitute a Security Agreement because they did not “create an interest in personal property or fixtures.”123

In KW Bancshares v. Syndicates of Underwriters at Lloyd’s,124 a bank agreed to loan money to its customer in reliance on a letter from a company purporting to confirm that the customer had earned a substantial bonus. However, the letter was forged, and the customer was not actually entitled to a bonus. After the loan went into default, the bank sought to recover its loss under Insuring Agreement (E). The bank claimed that the letter was a security agreement under the bond.125 The insurer disagreed, arguing that the letter could not qualify for coverage under Insuring Agreement (E) because it did not provide any value or protection to the bank in the event of default.126 The court agreed:

120 1986 Bond, Definitions, § 1(q). 121 408 N.W.2d 651, 654 (Minn. App. Ct. 1987). 122 Id. at 652. 123 Id. at 654. 124 965 F. Supp. 1047 (W.D. Tenn. 1997). 125 Id. at 1054. 126 Id. at 1054-55.

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In this case, plaintiffs have not explained how the Crenshaw letter is an enforceable security agreement or how it could even be reasonably construed as such. In fact, the letter did not have any real value to FSB, which explains why FSB had Whitman and NMC sign the Assignment of Bonus Payment. It was this assignment, which did not bear any forged signatures, that created an interest in Whitman’s alleged bonus in favor of FSB. Consequently, plaintiffs cannot seriously contend that the Crenshaw letter is an original security agreement[.]127

i. Instruction to a Federal Reserve Bank of the United States

The 1986 Bond does not define this category of documents. But, it does define “Instruction” as “a written order to the issuer of an Uncertificated Security requesting that the transfer, pledge, or release from pledge of the Uncertificated Security specified be registered.”128 This category of document, along with the definition of Instruction, was first introduced in the 1986 Bond.129

Only a few cases have interpreted Instruction. For instance, in Universal Bank v. Northland Insurance Co.,130 the Ninth Circuit Court of Appeals held that under a fiduciary bond, neither a purchase agreement nor an escrow instruction constituted an Instruction. By way of further example, in KW Bancshares, Inc. v. Syndicates of Underwriters at Lloyd’s,131 the United States District Court for the Western District of Tennessee held that a forged letter from a comptroller of a mortgage company which advised the insured-bank that an executive seeking a loan was entitled to an annual bonus, was not an Instruction because the letter did not direct the insured to do anything.

127 Id. at 1055. 128 1986 Bond, Definitions, § 1(k). 129 Statement of Change, Financial Institution Bond, Standard Form

No. 24, Revised to Jan. 1986, reprinted in FINANCIAL INSTITUTION BONDS 975 (Duncan Clore, ed., 3d ed. 2008).

130 8 F. App’x 784, 786 (9th Cir. 2001). 131 KW Bancshares, 965 F. Supp. at1052.

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This category of documents was removed as a covered category under Insuring Agreement (E) in the 2004 Bond because, “[u]nlike the other enumerated items, [this item did] not represent ownership or convey an interest in something of value.”132 Additionally, the drafters of the 2004 Bond noted that “[d]iscussions with the banking industry [indicate] that banks do not rely on” this type of document.133

j. Statement of Uncertificated Security of any Federal Reserve Bank of the United States

Similar to an Instruction to a Federal Reserve Bank of the United States, this category of documents was first introduced into the standard form bond in 1986. The 1986 Bond defines “Statement of Uncertificated Security” as:

[A] written statement of the issuer of an Uncertificated Security containing:

(1) A description of the Issue of which the Uncertificated Security is a part;

(2) the number of shares or units:

(a) transferred to the registered owner; (b) pledged by the registered owner to the

registered pledgee; (c) released from pledge by the registered

pledgee; (d) registered in the name of the registered

owner on the date of the statement; or (e) subject to pledge on the date of the

statement;

(3) the name and address of the registered owner and registered pledgee;

132 2003 Duke Letter, supra note 25. 133 Id.

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(4) a notation of any liens and restrictions of the issuer and any adverse claims to which the Uncertificated Security is or may be subject or a statement that there are non of those liens, restrictions or adverse claims; and

(5) the date:

(a) the transfer of the shares of units to the new registered owner of the shares or units was registered;

(b) the pledge of the registered pledgee was registered, or

(c) of the statement, if it is a periodic or annual statement.134

No courts have construed this category of documents. Similarly, no case has interpreted the meaning of an Uncertificated Security, which the 1986 Bond defines as:

[A] share, participation or other interest in property of or an enterprise of the issuer or an obligation of the issuer, which is:

(1) not represented by an instrument and the transfer of which is registered upon books maintained for that purpose by or on behalf of the issuer;

(2) of a type commonly dealt in on securities exchanges or markets; and

(3) either one of a class or series or by its terms divisible into a class or series of shares, participations, interests or obligations.135

134 1986 Bond, Definitions, Section 1(r). 135 1986 Bond, Definitions, Section 1(t).

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However, it is clear that this category refers to book-entry securities for which no certificate is issued. Most bonds, for example, such as Treasury Bills, are Uncertificated Securities.

The 2004 Bond removed this category from the list of enumerated covered documents. According to Robert Duke, writing on behalf of the SFAA to the Commissioner of Insurance for the State of Alabama, this category was removed because it did not represent ownership or convey an interest in something of value.136 More specifically, Mr. Duke noted that “[t]he Statement is only the issuer’s representation of any interests in an uncertificated security at a single point in time,” and it “does not specify that it must come directly from the issuer of the security.”137 Also, the drafters of the 2004 Bond recognized that relying on a Statement that did not come directly from the issuer was bad banking practice, and such Statements were not relied upon in the banking industry.138

2. The “Bundling” Theory

The “bundling” theory is a creative effort developed by some insureds to manufacture coverage under Insuring Agreement (E), and to avoid its clear requirement that only certain enumerated documents are covered.139 Under a “bundling theory,” a forged document that does not fall under one of Insuring Agreement (E)’s categories is “bundled,” or considered together with, a non-forged document that does fall under one of Insuring Agreement (E)’s listed categories. For example, a forged power of attorney, which is not a covered document, is bundled with a non-forged evidence of debt, a covered document, to arguably trigger coverage. This argument strains credulity.

136 2003 Duke Letter, supra note 25. 137 Id. 138 Id. 139 See, e.g., Omnisource Corp. v. CNA Ins. Co., 949 F. Supp. 681

(N.D. Ind. 1996); Cmty. State Bank of Galva v. Hartford Ins. Co., 542 N.E.2d 1317, 1319 (Ill. App. Ct. 1989); First Integrity Bank, N.A. v. Ohio Cas. Ins. Co., No. 05-2761, 2006 U.S. Dist. LEXIS 30426, at *12 (D. Minn. May 15, 2006).

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The “bundling” theory first emerged in Omnisource Corp. v. CNA Ins. Co.140 In Omnisource Corp., Insuring Agreement (E) was not at issue. Rather, a provision more similar to Insuring Agreement (D) was involved. It provided:

We will pay for loss involving Covered Instruments resulting directly from the Covered Causes of Loss.

1. Covered Instruments:

Checks, drafts, promissory notes, or similar written promises, orders, or directions to pay a sum certain in “money” that are:

a. Made or drawn by or drawn upon you;

b. Made or drawn by one acting as your agent;

or that are purported to have been so made or drawn.141

The court in Omnisource Corp. considered whether the presentation of a sight draft along with the supporting documents that were required by a letter of credit, which obliged the insured bank to pay the face amount of the sight draft, was an order or direction to pay a sum certain in money. Under the terms of the letter of credit, each document was necessary to oblige the bank to honor the sight draft.142 The insurer argued that the sight draft and supporting documents did not constitute a “covered instrument” for two reasons: (1) they did not constitute “checks, drafts, promissory notes, or similar written promises, orders or directions to pay a sum certain in ‘money’”; and (2) they were not “made or drawn by or drawn upon [the insured], nor “made or drawn by one acting as [the insured’s] agent,” nor were they “purported to have been so made or drawn.”143 The insurer also admitted that, standing alone, the sight draft, which was not forged, was a covered document. The insured argued that the sight draft and supporting documents should be construed

140 Omnisource Corp., 949 F. Supp. at 687. 141 Id. at 686. 142 Id. at 687. 143 Id. at 686.

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together. The court agreed, and held that “because the sight draft would have been useless without the supporting documents, the letter of credit transaction supports ‘bundling’ these documents to construe them as a whole.”144 Under those circumstances, the court held that forgeries on the supporting documents, but not the sight draft itself, was sufficient for coverage under an insuring clause covering loss from forgery.

This case was wrongly decided, and is contrary to the clear requirement of Insuring Agreement (E) that a covered instrument be forged or altered. Indeed, were an insured allowed to “bundle” a non-enumerated forged or altered document with an enumerated document that was not forged or altered, the Financial Institution Bond’s listing of the categories of covered documents would be meaningless. Furthermore, Omnisource Corp. is distinguishable because, under the insuring agreement at issue, the supporting documents were bundled only with the sight draft so that they could constitute an order or direction to pay, a covered instrument. The sight draft, alone, was insufficient to cause the insured to pay any sum of money. Thus, the supporting documents were necessary, and part and parcel, of an order or direction.

After the opinion in Omnisource Corp. was issued, at least two other cases have applied a “bundling” theory.145 One of these cases was First Integrity Bank, N.A. v. The Ohio Casualty Ins. Co.,146 and it also did not involve Insuring Agreement (E). Rather, First Integrity Bank, N.A. involved Insuring Agreement (D).147 Moreover, this case was decided upon a motion to dismiss and it had little to no discussion regarding bundling. With no discussion, the court “determined that the wire transfer and the check may be construed as one act for the purposes of this motion [to dismiss].”148 The remainder of the court’s opinion was based on this assumption. For instance, the court stated that “[a]ssuming that the wire transfer and the check were related, it is possible that the check could have been ‘altered’ by a telephonic wire transfer request.”149

144 Id. at 688. 145 See Cmty. State Bank of Galva, 542 N.E.2d at 1319; First Integrity

Bank, N.A., 2006 U.S. Dist. LEXIS 30426, at *12. 146 2006 U.S. Dist. LEXIS 30426, at *12. 147 Id. 148 Id. at *10. 149 Id. at *12.

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The court then found the contract ambiguous and required a jury to construe its meaning.150 Also, the court provides no discussion as to why the wire transfer alone would not trigger Insuring Agreement (D).

The only other case to apply a “bundling” theory was the Appellate Court of Illinois, Third Division, in Community State Bank of Galva v. Hartford Insurance Co.151 Unlike the other two cases that applied a “bundling” theory, Community State Bank of Galva involved Insuring Agreement (E).152 In this case, Hartford issued a bond to the Bank of Galva.153 The bank claimed that a customer delivered to it a power of attorney purportedly executed by Peter. S. Craig, appointing the customer as Mr. Craig’s agent, and then executed a promissory note as the agent for Mr. Craig.154 The bank argued that together these documents constituted an evidence of debt, a covered document under Insuring Agreement (E).155 Hartford argued that Insuring Agreement (E) did not apply because the bank relied solely on the power of attorney, which is not a specifically enumerated document under Insuring Agreement (E).156 The court, however, concluded that the power of attorney and the promissory note, which was also forged, and was executed in the same transaction as the power of attorney, should be construed as a single instrument.157 Although the court construed the power of attorney and the promissory note as a single instrument, both documents were forged, and a promissory note may be a covered document under Insuring Agreement (E).158 Thus, it is arguable that the court in Community State Bank of Galva did not apply a bundling theory to trigger Insuring Clause (E). Although the bank in that case relied on only a power of attorney in extending credit, the Illinois Court of

150 Id. 151 542 N.E.2d 1317, 1319. 152 Id. 153 Id. at 1318. 154 Id. 155 Id at 1319. 156 Id. 157 Id. at 1320 (citing Bogdan v. Ausema, 179 N.E.2d 401 (Ill. App. Ct.

1962); Feldman v. Cipolla, 129 N.E.2d 774 (Ill. App. Ct. 1955)). 158 Whether a promissory note falls under the definition of Evidence of

Debt, and is therefore a covered instrument under Insuring Agreement (E) is discussed above, in subsection f(i).

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Appeals held that Insuring Agreement (E) provided coverage because the bank “was also legally relying on the [forged] executed promissory note as consideration for making the loan.”159 Thus, in this case the forged promissory note, possibly an enumerated document in Insuring Clause (E), was a required part of the transaction.

“Bundling” was correctly rejected by the court in First Union Corp. v. United States Fidelity & Guaranty Co.,160 because “in determining whether a forged document qualifies for coverage under Insuring Agreement (E), the object of the court’s inquiry should be on the contents of the forged document,” not on arguably related documents.161 In First Union, the insured argued that an “evidence of debt” consists of multiple documents, and that forged incumbency certificates were to be considered as part of the evidence of debt.162 The Maryland Court of Appeals rejected this argument, and held that the incumbency certificates did not evidence any debt of the borrower to the bank; rather, they “simply represent that Edward Reiners is a high-ranking official of Philip Morris authorized to act of behalf of the company.”163 Not only did the court refuse to construe the incumbency certificates as an evidence of debt, but it refused to “bundle” the certificates with any document evidencing the loan. In refusing to apply the bundling theory, the Maryland Court of Appeals noted that “in determining whether a forged document qualifies for coverage under Insuring Agreement (E), the object of the court’s inquiry should be on the contents of the forged document,” not on arguably related documents.164 Thus, according to this court, and the clear language of Insuring Agreement (E), the forged document must be one of the enumerated documents in Insuring Agreement (E).

The First Union court also distinguished, and declined to follow, Omnisource Corp., partly because Omnisource Corp. did not involve Insuring Clause (E): “Omnisource, however, did not involve a Standard Form 24 Financial Institution Bond. In fact, the policy at issue in that

159 Cmty. State Bank of Galva, 542 N.E.2d at 1320. 160 730 A.2d at 282-83. 161 Id. at 283. 162 Id. at 280-81. 163 Id. at 282. 164 Id. at 283.

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case did not contain any provision even remotely similar to section (E)(1)(e) of the bond in this case.”165 The First Union court also distinguished Community State Bank of Galva by noting that “the promissory note [at issue in Bank of Galva] was executed pursuant to the forged power of attorney, and therefore, the court properly considered them in its determination of the case.”166 It should be noted that no court has, to the authors’ knowledge, applied Insuring Clause (E) when an enumerated document was not forged.

To counteract the emergence of the “bundling” theory, the drafters of the 2004 Bond specifically addressed the viability of the bundling theory, and included express language rejecting its use under Insuring Agreements (D) and (E). Specifically, Section 9 of the 2004 Bond provides:

ANTI-BUNDLING

Section 9. If any Insuring Agreement requires that an enumerated type of document be altered or counterfeit, or contain a signature which is a Forgery or obtained through trick, artifice, fraud or false pretenses, the alteration or counterfeit or signature must be on or of the enumerated document itself not on or of some other document submitted with, accompanying or incorporated by reference into the enumerated document.167

According to the SFAA, Section 9 was included in the 2004 Bond to address “[t]he mistaken decision in Omnisource Corp. v. CNA Transcontinental Ins. Co., 949 F. Supp. 681 (N.D. Ind. 1996), [which] led a number of Insureds erroneously to believe that coverage can be claimed based on forgery to a document not covered by the bond if the forged document is ‘bundled’ with a covered document.”168 However, because most of the bonds in use currently do not have this provision, insurers must still contend with Omnisource Corp. and its progeny when making coverage decisions under Insuring Agreement (E).

165 Id. 166 Id. at 282. 167 2004 Bond, Anti-Bundling, § 9. 168 2003 Duke Letter, supra note 25.

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B. “Resulting Directly From”—Insuring Agreement (E)’s Causation Requirement

In order for a loss to be covered by Insuring Agreement (E), it must have been caused “directly” by the qualifying event. In other words, the loss must follow as a direct or immediate result of the forged, altered, or counterfeit document. Although the majority of courts have recognized that Insuring Agreement (E)’s “resulting directly from” language creates a more exacting standard than that of the proximate cause test, enough outlying cases exists to merit discussion in this article.169 Previously, Insuring Agreement (E), like the other insuring agreements in the Financial Institution Bond, required merely a “loss through” a covered event or transaction.170 The “resulting directly from” language was added to Insuring Agreement (E) in 1980 “in response to the erroneous application of tort concepts of causation by some courts[.]”171 The 1986 Bond was modified for the same reason. This was noted by the Seventh Circuit:

The 1986 version of the bond specifically modified the bond to require, in the case of some coverages, a loss ‘resulting directly from’ the covered peril. This was a response to certain court interpretations that applied tort

169 See, e.g., Flagstar Bank v. Fed. Ins. Co., 260 F. App’x 820, 824 (6th

Cir. 2008) (holding that “the language ‘resulting directly’ establishes a causation standard more stringent than the ‘proximate cause’ standard”); see also RBC Mortg. Co. v. Nat’l Union Fire Ins. Co. of Pittsburgh, 812 N.E.2d 728, 736 (Ill. App. 2004) (“adopting the reasoning from the majority of other jurisdictions, the proximate cause analysis simply is too broad to capture accurately the intent behind the phrase ‘loss resulting directly from’”); United Sec. Bank v. Fid. & Deposit Co. of Md., No. 96-16331, 1997 U.S. App. LEXIS 33718 (9th Cir. 1997); Merchs. Bank & Trust Co. v. Cincinnati Ins. Co., No. 1:06cv561, 2008 WL 728332 (S.D. Ohio Mar. 14, 2008); see also Vons Cos., Inc. v. Fed. Ins. Co., 212 F.3d 489 (9th Cir. 2000) (construing a fidelity policy).

170 First State Bank of Monticello v. Ohio Cas. Ins. Co., 555 F.3d 564, 570 (7th Cir. 2009) (citing Bradford R. Carver, Loss and Causation, in HANDLING FIDELITY BOND CLAIMS 363, 379 (2d ed. Michael Keeley & Sean Duffy eds., 2005)).

171 Beach Cmty. Bank v. St. Paul Mercury Ins. Co., 635 F.3d 1190, 1194 (11th Cir. 2011).

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concepts of causation to the bond’s loss-causation requirements.172

Tort-causation standards, like proximate cause, but for cause, substantial factor causation, and intervening cause, are inappropriate in a contractual setting such as when dealing with a Financial Institution Bond. This also was aptly noted by the same Seventh Circuit Court of Appeals:

This approach is misdirected; tort-causation concepts like proximate cause, ‘substantial factor’ causation, and intervening cause are inappropriate here. In particular, the concept of proximate cause is problematic in [the financial institution bond] context; proximate cause is a shifting standard that draws the line of causation ‘because of convenience, of public policy, of a rough sense of justice . . . . It is practical politics.’173

The court continued:

Insurance-coverage cases are not concerned with the philosophical social-duty underpinnings of tort law. The action sounds in contract, and our task is to interpret the parties’ agreement.

. . . .

Accordingly, contract—not tort—principals apply to the determination of loss causation [.]

In contrast, insurance-coverage cases are not concerned with the “philosophical social-duty underpinnings of tort law.”174 Thus, the Financial Institution Bond should be interpreted according to its plain

172 First State Bank of Monticello, 555 F.3d at 570 (citing Carver, supra

note 170). 173 Id. (quoting Palsgraf v. Long Island R.R., 162 N.E. 99, 103 (N.Y.

1928) (Andrews, J., dissenting)). 174 Id.

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and ordinary meaning.175 This was artfully stated by then Judge Cardozo nearly a century ago:

General definitions of a proximate cause give little aid. Our guide is the reasonable expectation and purpose of the ordinary business man when making an ordinary business contract. It is his intention, expressed or fairly to be inferred, that counts. There are times when the law permits us to go far back in tracing events to causes. The inquiry for us is how far the parties to this contract intended us to go[.] . . . The question is not what men ought to think of as a cause. The question is what they do think of as a cause.176

A brief summary of the differences between the concepts of tort causation and contractual liability for damages may be helpful in understanding why the phrase “resulting directly from” requires stronger, more immediate proof of causation than that provided for under tort law.

1. Tort Causation

Tort causation involves two elements: cause-in-fact, also referred to as the “but for” or “sine qua non” test, and legal cause, also referred to as “proximate cause” or the “substantial factor” test.177

a. Cause in Fact

The cause in fact or “but-for” test of causation, carried to its logical extreme, has been likened to the expansive chain of causation that Winston Churchill constructed in his history of the First World War:178

175 Id. (citing RBC Mortg. Co. v. Nat’l Union Fire Ins. Co., 812 N.E.2d

728, 736-37 (Ill. App. Ct. 2004)). 176 Bird v. St. Paul Fire & Marine Ins. Co., 120 N.E. 86, 87 (N.Y.

1918). 177 See John w. Hinchey, Loss and Causation, in ANNOTATED BANKERS

BLANKET BOND, FIRST SUPPLEMENT, at 5-6 (Frank L. Skillern, Jr. ed. 1983). 178 Peter C. Haley, The Power of Defined Terms and Causation

Theories Under Insuring Agreement (E) of the Financial Institution Bond, 31 TORT & INS. L.J. 609 (1996).

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[Churchill] began by referring to the fact that in 1920 King Alexander of Greece died by blood poisoning, having been bitten by a pet monkey. This event was followed by a plebiscite, then a new king, and finally a bloody war with the Turks. Churchill wrote, “A quarter of a million persons died of that monkey’s bite.”179

Fidelity insurers would shudder to think that this type of Churchillian, “but-for” causation would apply to their policies. Yet, “inventive” insureds have made exactly this type of argument.180 For example, in Continental Corp. v. Aetna Casualty & Surety Co.,181 the insured argued that losses resulting from acts of its employees committed after being fired were nevertheless covered acts of employee dishonesty, because the losses could not have occurred, under the circumstances of this case, but for the fact that the wrongdoers had once been employees.182 The Seventh Circuit, in reversing the trial court’s finding of coverage, observed, “[o]nly through the most tortuous causal chain could actions of [the ex-employee committed while employed elsewhere] be deemed even marginally relevant to [the insured’s] losses[.]”183 As Continental Corp. illustrates, “but-for” causation would render meaningless the requirement that the loss “result directly from” a covered risk, and allow for coverage even for causes that indirectly lead to losses.

b. Legal or Proximate Cause

The “legal cause” element of tort causation requires a plaintiff to prove that the defendant’s conduct was the proximate cause of the harm suffered.184 While cause in fact relates to the chain of events culminating

179 Id. at 630. 180 See Cont’l Corp. v. Aetna Cas. & Sur. Co., 892 F.2d 540, 546-48

(7th Cir. 1989). 181 Id. at 548. 182 Id. 183 Id. at 548-49. 184 Dan B. Dobbs, THE LAW OF TORTS 405 (West. Group 2000).

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in a loss, the proximate cause concept ostensibly narrows the scope of a tortfeasor’s legal responsibility by requiring something more.185

Proximate cause in this context means that the loss was caused in a direct sequence by the allegedly covered action, unbroken by any independent cause, without which the loss would not have occurred.186 Courts that have applied this standard to Financial Institution Bond claims, such as the Kentucky district court did in FDIC v. Reliance Insurance Corp.,187 consider it to be an “established rule of insurance law” that where the peril specifically insured against sets other causes in motion that, in an unbroken sequence and connection between the act and the final loss, produces the result for which recovery is sought, the insured peril is regarded as the proximate cause of the entire loss.188 As noted by the court in Auto Lenders Acceptance Corp. v. Gentilini Ford, Inc.,189 this rule is also known as the “Appleman’s Rule,” based on certain statements in a chapter on fire insurance in John Alan Appleman’s Insurance Law and Practice, concerning the issue of when it can be said that property has been damaged as a result of fire.190 Appleman’s generalization about the coverage afforded by fire insurance makes no mention of the specific policy language being construed, and instead bases its analysis on “the reasonable expectation of an ordinary business man in making an ordinary [fire insurance] contract.”191

185 Id. at 407. 186 Hanson PLC v. Nat’l Union Fire Ins. Co.,794 P.2d 66, 73 (Wash. Ct.

App. 1990). 187 716 F. Supp. 1001, 1004 (E.D. Ky. 1989). 188 Id. at 1004 (quoting Goodyear Rubber and Supply, Inc. v. Great

Am. Ins. Co., 545 F.2d 95, 96 (9th Cir. 1976). See also Mid-America Bank v. Am. Cas. Co., 745 F. Supp. 1480, 1485 (D. Minn. 1990) (If a loss is caused by an act which played a substantial part in bringing about the loss and the loss is a reasonably probable consequence of the act, then the act is the proximate cause of the loss.).

189 816 A.2d 1069 (N.J. Super. Ct. 2003), overruled on other grounds by Rothschild Inv. Corp. v. Travelers Cas. & Sur. Co. of Am., No. 05 C 3041, 2006 U.S. Dist. LEXIS 30033 (N.D. Ill. May 4, 2006).

190 John Alan Appleman & Jean Appleman, 5 INS. LAW. & PRAC. § 3083, at 307-308 (1970).

191 Id.

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The Appleman or tort law causation standard allows for multiple causes, especially along a chain of events across time. “Proximate consequences need not be close in point of time or distance in order to make the defendant liable in tort for the damage caused; they may be remote both in time and distance but still be included in any recovery against the defendant.”192 Very importantly, “proximate cause . . . is not about causation at all but about the significance of the defendant’s conduct or the appropriate scope of liability, an issue that entails heavy elements of moral and policy judgment about the very particular facts of the case.”193 Again, while appropriate in measuring the affect of a tortfeasor’s conduct, proximate cause has no legitimate use in the law of contracts.

The court in FDIC v. Reliance Insurance Corp.,194 was partially correct; the concept of proximate causation is an established rule of insurance law, under certain circumstances and types of policies. Consequently, if the drafters of the Financial Institution Bond had wanted to use a proximate cause standard in each of the bond’s Insuring Agreements and exclusions, they could have done so, especially given the propensity of courts to read that standard into prior versions of the bond. But they did not. Instead, they replaced the pre-1980 language of the bond, which stated the causation requirement in the far more general terms of insuring “loss through” a covered act, with the very specific requirement of “resulting directly from.” Under rules of contract interpretation, case law relying on generalized principles of insurance and tort law derived from completely different insurance policies and risks, as well as inapplicable public policy considerations, should not be allowed to supersede the intentionally chosen, actual language in the Financial Institution Bond requiring “direct” causation.195

2. Contract Causation

When a contract like the Financial Institution Bond forms the basis of the parties’ relationship, the moral and policy judgments of tort

192 22 Am. Jur. 2d Damages § 477. 193 Dobbs, supra note 184, at 408. 194 716 F. Supp. at 1004. 195 See First State Bank of Monticello v. Ohio Cas. Ins. Co.¸ 555 F.3d

564, 570 (7th Cir. 2009).

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law are irrelevant. Rather, principles of contract interpretation determine the scope of the parties’ liability for damages based upon their stated intentions.196 Contract damages simply flow from the intention of the parties at the time their agreement was made.197 As is simply stated in Comment (a) to § 346, Restatement (Second) of Contracts, the parties to a contract may by agreement “vary the rules” concerning their liability for damages.198

Additionally, the doctrine of foreseeable consequences limits the scope of a party’s liability for contractual damages.199 “Damages are not recoverable for loss that the party in breach did not have reason to foresee as a probable result of the breach when the contract was made.”200 Thus, “the requirement of foreseeability is a more severe limitation of liability than is the requirement of substantial or ‘proximate’ cause in the case of an action in tort[.]”201 Williston provides an example:

Where a seller wrongfully fails to deliver promised goods, the buyer’s damage from the inability to use them for a special profitable purpose it had in mind is a proximate consequence of the breach, but not one that is usual or one that the seller would reasonably expect. The law of torts and contracts differ in this respect. For a tort, the defendant becomes liable for all proximate consequences, while for breach of contract the defendant is liable only for consequences that were reasonably

196 Spearman Indus., Inc. v. St. Paul Fire & Marine Ins. Co., 138 F.

Supp. 2d 1088, 1101 (N.D. Ill. 2001). 197 22 AM. JUR. 2d Damages § 451; see also Hofstee v. Dow, 36 P.3d

1073, 1076 (Wash. Ct. App. 2001) (explaining that contract damages arise from expectations created by agreement).

198 Restatement (Second) of Contracts § 346, cmt. (a) (1979). 199 See Vanderbeek v. Vernon Corp., 50 P.3d 866, 782-73 (Colo. 2002)

(discussing foreseeability as element of contract measure of damages). 200 Restatement (Second) of Contracts § 351 (1) (1981). 201 RESTATEMENT (SECOND) OF CONTRACTS § 351, cmt. (a) (1981); see

also Inchaustegui v. 666 5th Ave. Ltd. P’ship, 706 N.Y.S.2d 396, 400 (N.Y. App. Div. 2000) (stating that “[w]hile tort damages are expansive, focusing on the full spectrum of the harm caused by the tortfeasor, damages for a breach of contract are restrictive”).

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foreseeable, at the time the contract was made, as likely to result if the contract were broken.202

In addition to considering foreseeability, courts limit the availability of contract damages by looking to the parties’ intentions at the time that they entered into the agreement. To ascertain the intention of the parties, courts look to “the language of the contract in light of the facts, including the nature and purposes of the contract.”203 Ultimately, “[d]amages which are not foreign to the purpose of the contract . . . should be awarded.”204

Applying these principles of contract law, it is proper to construe the “resulting directly from” causation language of the Financial Institution Bond more narrowly than would be required under a proximate cause or other tort standard.205 The causation language of the Financial Institution Bond should be interpreted to conform with the purpose of the Financial Institution Bond, namely, to indemnify for losses resulting directly or immediately,206 without any intervening cause,207 from a covered risk that the insured itself208 sustains.

C. Despite Revisions to the Bond’s Causation Requirement, Some Courts Continue to Apply Tort-Causation Standards

Despite the clear differences between tort causation and contract causation, some courts continue to struggle when interpreting the bond’s “resulting directly from” language, and apply a tort-based causation

202 Samuel Williston, 24 Treatise on the Law of Contracts § 64.13 (4th ed. 1990).

203 22 AM. JUR. 2d Damages § 460. 204 Id. See also Williston, supra note 202 at § 64.13 (4th ed. 1990). 205 See United Sec. Bank v. Fid. & Deposit Co. of Md., No. 96-16331,

1997 U.S. App. LEXIS 27965 at *3 (9th Cir. Sept. 16, 1997) (concluding that “‘direct loss’ [under a fidelity bond] is much narrower than proximately caused loss”).

206 See., e.g., Lynch Prop., Inc. v. Potomac Ins. Co., 962 F. Supp. 956, 961-62 (N.D. Tex. 1996).

207 See, e.g., Auto Lenders Acceptance Corp. v. Gentilini Ford, Inc., 816 A.2d 1068, 1072-73 (N.J. Sup. Ct. App. Div. 2003).

208 Firemans Fund Ins. Co. v Special Olympics Int’l, Inc., 249 F. Supp. 2d 19, 28 (D. Mass. 2003).

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standard. For example, in Jefferson Bank v. Progressive Casualty Insurance Co.,209 the Third Circuit applied a proximate cause standard. There, the insured-bank agreed to loan Shapiro money, with Shapiro’s real property serving as collateral for the loan.210 At closing, Shapiro brought his own notary public, Stevenson, to witness his signature. Shapiro represented to the insured bank that Stevenson was an agent of the title insurance company who issued the title commitment.211 At the closing, Stevenson acknowledged and notarized the mortgage. Subsequently, Shapiro defaulted on his loan, and the bank learned that Stevenson was not an agent of the title company, nor a notary.212 The bank also learned that the title commitment was a counterfeit. The mortgage had also gone unrecorded, despite Stevenson’s promise to record it. Because Shapiro’s collateral was worthless, the bank submitted a claim on its fidelity bond.213

The district court construed “resulting directly from” in Insuring Agreement E strictly, concluding that the phrase means that the loss must be “directly caused by the forged signature.”214 The Third Circuit noted that, “[a]lthough the precise contours of the causation standard applied by the district court are unclear, it appears that it required the plaintiff not only to prove proximate cause, but also some additional closeness in space and time between the loss and the cause of the loss.”215 On appeal, the Third Circuit began its analysis by noting that “the phrase ‘resulting directly from’ in the policy suggests a stricter standard of causation that mere ‘proximate cause.’”216 The Third Circuit declined, however, to adopt a stricter standard. Rather, it turned to Pennsylvania tort law, which governed the bond, and concluded:

Under Pennsylvania tort law, a cause is proximate if it is merely a ‘substantial cause’ of the harm. Arguably the words ‘resulting directly from’ suggest a requirement

209 965 F.2d 1274 (3d Cir. 1992). 210 Id. at 1275. 211 Id. at 1275-76. 212 Id. 213 Id. at 1276. 214 Id. at 1280. 215 Id. 216 Id. at 1281.

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beyond that the cause be substantial, for the words imply that the loss must flow ‘immediately,’ either in time or space, from the forged signature. An analysis of Pennsylvania law persuades us, however, that conventional proximate cause is indeed the correct standard and that requiring ‘immediacy’ is inappropriate.217

The Third Circuit noted that it reached this conclusion for two reasons. First, the court turned to how other opinions under Pennsylvania law had interpreted “direct cause of a loss” as meaning proximate cause.218 Second, the Third Circuit noted that “direct cause” or “immediate cause” is “a nebulous and largely indeterminate concept, and one that does not enjoy favor under Pennsylvania law.”219 Moreover, it noted that “Pennsylvania, consistent with general notions of proximate causation, requires that plaintiffs in negligence cases show substantiality, rather than immediacy, in order to demonstrate proximate cause.”220 The court’s reasoning was misplaced. Indeed, the court applied accepted-tort standards when requested to interpret a phrase contained in a contract. Instead, the court should have applied accepted contract construction, and not tort standards. In short, the Third Circuit chose to ignore the parties’ agreed-upon language in favor of Pennsylvania’s tort standard.

The United States District Court for the Northern District of Florida has recently held that Insuring Agreement (E)’s “resulting directly from” language imposes a “but for” standard.221 There, the insured bank made a loan to a real-estate developer.222 At closing, the

217 Id. (internal citations omitted). 218 Id. (citing Marks v. Lumbermen’s Ins. Co., 49 A.2d 855, 857 (Pa.

Super. Ct. 1946) (equating “direct loss by windstorm” with “proximately caused by windstorm”); Lorio v. Aetna Ins. Co., 232 So. 2d 490, 494 (La. 1970); Lipshultz v. Gen. Ins., 96 N.W.2d 880 (Minn. 1959)).

219 Id. 220 Id. 221 Beach Cmty. Bank v. St. Paul Mercury Ins. Co., No. 5:09-cv-106,

slip op. at 5 (N.D. Fla. Feb. 26, 2010), vacated and remanded in 635 F.3d 1190, 1194 (11th Cir. 2011).

222 Id. at 1.

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developer provided the bank with a guaranty purportedly signed by his wife. The wife’s signature turned out to be a forgery. However, the wife turned out to have insufficient assets to cover the loss. The court noted that the insured bank had to show it “would have been able to collect on the loan but for the forged signature” on its customer’s guarantee.223 Nevertheless, despite the apparent application of a “but for” standard, the court held that the insured bank did not meet Insuring Agreement (E)’s causation requirement because its loss was not caused by the forgery, but by the fact that the collateral had become worthless.224 Specifically, the court noted:

To hold that the banker’s bond in this case covers Plaintiff’s loss would reach such an absurd result. If [Insuring] Clause (E) applied to the facts presented, it would create a situation where bankers would hope for forgeries because forgeries would take all the economic risk out of the guarantee. Indeed, it is likely that Plaintiff was relieved when it discovered the ‘fortuitous’ forged guarantee because Plaintiff would otherwise not have been able to collect on the loan because [the wife] had insufficient assets to cover the loan amount. The presence of a forgery in a bank transaction should not be a cause for relief. [Insuring] Clause (E) is a safeguard for bankers who, using their best business practices, made a loan and were unable to collect on it—not because the guarantee proved worthless, but because what otherwise would have been a valuable guarantee directly caused its loss[.]225

Thus, although the court purported to apply a “but for” standard, its result is in keeping with a true “direct means direct” reading of Insuring Agreement (E)’s causation requirement. On appeal of this

223 Id. at 5. 224 Id. at 7.. 225 Id. at 6-7

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decision, the Eleventh Circuit also refused to apply a tort-causation standard.226 Indeed, the Eleventh Circuit noted:

The ‘resulting directly’ language in the bond was adopted in response to the erroneous application of tort concepts of causation by some courts to earlier versions of the bond. Tort-causation concepts like proximate cause, ‘substantial factor’ causation, and intervening cause are inappropriate for interpreting a financial institution bond, which is instead governed by contract law.227

This was the correct result, and the one intended under Insuring Agreement (E).

The Seventh Circuit also recently applied the correct contract construction of causation in First State Bank of Monticello v. Ohio Casualty Insurance Co.228 There, in interpreting the phrase “resulting directly from” in the context of an Insuring Agreement (B) claim, the court expressly applied contract causation principles, and noted that “direct means direct.”229

Similarly, courts have generally held that there must be a relationship, for instance, between the forged document and the non-payment of the loan supported by the forged document. Thus, when the direct cause of a loss is the absence of any underlying legitimate transaction or assets, rather than the presence of a forgery on the relevant document, the loss is not covered.230 Put simply, under a Financial

226 Beach Cmty. Bank v. St. Paul Mercury Ins. Co., 635 F.3d 1190, 1194 (11th Cir. 2011).

227 Id. at 1195 (internal citations and quotations omitted). 228 555 F.3d 564, 570 (7th Cir. 2009). 229 Id. at 571. 230 See, e.g., Flagstar Bank, FSB v. Fed. Ins. Co., 260 F. App’x 820,

822-24 (6th Cir. 2008) (no coverage based upon forged promissory notes secured by non-existent real estate transactions); KW Bancshares, Inc. v. Syndicates of Underwriters at Lloyds, 965 F. Supp. 1047, 1053-55 (W.D. Tenn. 1997) (no coverage based upon a letter containing a forged signature and falsely stating the customer had earned a bonus; the loss was caused by the statements not being true, not by the forgery); French Am. Banking Corp. v. Flota Mercante

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Institution Bond, the bank assumes the risk of its collateral being worthless or non-existent because a loss under those circumstances is not caused by the presence of a forged signature on the documents allegedly relied upon.

As explained by the court in Liberty National Bank v. Aetna Life Ins. & Cas. Co.,231 Financial Institution Bonds do not provide coverage when a loss is caused by worthless collateral because such bonds do not provide credit insurance and the risk of loss resulting from worthless collateral is a risk that can only fairly be borne by the bank, not by the insurer:

The Bond distinguishes between the ‘risk of authentication’ (forgery and counterfeiting) against which the Bank could not reasonably protect itself and the credit risk posed by worthless collateral. Thus, Insuring Agreements D and E protect against risks of authentication and genuineness. Section 2(e) excludes

Grancolombiana, 752 F. Supp. 83, 90-91 (S.D.N.Y. 1990) (no coverage for a bank’s loss stemming from allegedly forged bills of lading accepted by the bank as security for extending a line of credit to a customer; “[e]ven if the signatures had been identifiable and genuine, the bills still represented non-existent or previously completed transactions and (the bank) would have still suffered losses identical to those they now face”); Reliance Ins. Co. v. Capital Bancshares, Inc., 685 F. Supp. 148, 151-52 (N.D. Tex. 1988), aff’d, 912 F.2d 756 (5th Cir. 1990) (no coverage based upon forged stock certificates that had not been issued by the corporation and thus had no value; the banks’ losses resulted from the customer’s fraudulent scheme and not from the forgeries); Liberty Nat’l Bank v. Aetna Life & Cas. Co., 568 F. Supp. 860, 863, 865-66 (D.N.J. 1983) (no coverage based upon forged CDs when the CDs were purportedly issued by a non-existent bank and thus had no value); Georgia Bank & Trust v. Cincinnati Ins. Co., 538 S.E.2d 764, 765-66 (Ga. Ct. App. 2000) (no coverage based upon account confirmation letters containing forgeries; the loss resulted from the false statements in the letters and lack of assets in the accounts); see also FDIC v. Firemen’s Ins. Co. of Newark, 109 F.3d 1084, 1087-88 (5th Cir. 1997) (no coverage for a loss relating to a defective mortgage because the signature in question, even if obtained fraudulently, did not cause the mortgage to be defective).

231 568 F. Supp. at 866.

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credit risks. It is well-settled that the standard bankers bond is not a form of credit insurance. . . . Given this division of risks within the Bond, the court concludes that the parties intended that the Bank would assume the risk of the collateral being worthless.232

Similarly, in KW Bancshares, Inc. v. Syndicates of Underwriters at Lloyds,233 the court noted that a Financial Institution Bond “is clearly not a credit insurance policy,” and adopted the reasoning of Liberty National:

In this case, plaintiff’s loss did not result directly from having made [the loan] on the faith of the Crenshaw letter. Here, as in Liberty National and French American Banking, the plaintiffs’ loss was caused by the fact that the statements contained in the Crenshaw letter were not true—[the customer] was not entitled to an annual bonus[.] . . . Even if Crenshaw’s signature on the . . . letter had been genuine, the plaintiffs’ loss would have occurred nonetheless because the alleged security, the Crenshaw letter, was worthless. It was worthless not because it was forged, but because [the customer] was not entitled to a bonus[.]234

Similarly, in Flagstar Bank, FSB v. Federal Insurance Co.,235 the district court held that it is not enough for a bank merely to show that it would not have made the loan but for the forgery:

The relevant issue here is whether Flagstar has shown, ‘assuming all other coverage requirements have been met, a direct loss, that is a direct connection between the established facts and its claimed economic harm.’ Determining causation under financial institution bonds is policy driven, and ‘all cases on point hold that an

232 Id. (internal citations omitted). 233 965 F. Supp. at 1047, 1054. 234 Id. (internal citations omitted). 235 No. 05-70950, 2006 U.S. Dist. LEXIS 83825 (E.D. Mich. Nov. 17,

2006).

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Insured must prove more than causation in fact. It is not enough to show that ‘but for’ an act of covered forgery, for example, the insured would not have sustained ‘Loss.’ Rather, ‘in the parlance of securities litigation, the insured must show both ‘transaction causation’ and ‘loss causation.’ Therefore, Flagstar must show more than the fact the forgeries caused it to enter into the transactions with Amerifunding; it must also show that these forgeries directly caused its loss.236

Noting that “Flagstar’s loss did not result directly from the forgery, even if the forgery may have caused Flagstar to enter into the transaction,”237 the court held that the risk of loss from worthless collateral is not covered by a financial institution bond:

The Court finds that this result is consistent with the allocation of risks provided by the financial institution bond. The Bond at issue in the present case is based on the standard form bond at issue in Liberty Nat’l, Georgia Bank, and KW Bancshares. As in those cases, Flagstar’s Bond clearly allocates the risk of entering into a bad credit transaction on the insured rather than the insurer as evidenced by the loan loss exclusion. Maintenance of this distinction requires that the Bond not be construed in such a way as to provide coverage for credit risks such as the risk that collateral for a loan turns out to be worthless. As the courts in Liberty Nat’l and KW Bancshares recognized, to hold that a loss caused by the failure of collateral, which is a credit risk, is covered by the bond, would convert the bond into a form of credit insurance. As a further result, such a holding would force the insurer into an agreement which it did not enter. ‘To hold the loss . . . [is] covered by the bond because a technical forgery had been committed would

236 Id. at *24. 237 Id. at *35.

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unfairly allocate the risks of the transaction in favor of’ Flagstar[.]238

D. The Good-Faith Requirement

Insuring Agreement (E) also imposes a requirement on insureds that they act in “good faith.” This requirement is separate and apart from the element that the insured rely on the faith of the document itself, a requirement that is addressed below.239 This is a sometimes overlooked, but yet powerful requirement for coverage. It mandates that, for there to be coverage, the insured must have acted in good faith. In the context of allocation of risk, this requirement makes perfect sense. While insurers are willing to cover losses otherwise covered by Insuring Agreement (E), they are willing to do so only if the insured took normal, business-like steps to ensure it was acting in a reasonable business fashion—in other words, in good faith. If it did not do so, then it cannot fairly be expected for there to be coverage for losses that might have been prevented by acting in good faith. Otherwise, the bond would be turned into credit insurance. Indeed, as the Minnesota Supreme Court has noted:

The Bankers Blanket Bond is designed to ‘protect [a bank] against risks of dishonesty, both external and internal, but does not insure good management nor against the risk of loss inherent in the banking operations.’

. . . .

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.”240

238 Id. at *35-37, aff’d 260 F. App’x 820 (6th Cir. 2008) (internal

citation omitted). 239 U.S. Nat’l Bank v. Reliance Ins. Co., 501 A.2d 283, 284-85 (Penn.

1985). 240 Nat’l City Bank of Minn. v. St. Paul & Marine Ins. Co., 447 N.W.2d

171, 177 (Minn. 1989) (internal citations omitted).

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While the Minnesota Supreme Court made this statement in its analysis of whether counterfeit coverage existed under Insuring Agreement (E), and not in the context of the good-faith requirement, it nevertheless is instructive. Indeed, it is well-settled that the standard form bond is not a form of credit insurance.241

This view is in keeping with the definition of “good faith” in Black’s Law Dictionary, which defines “good faith” as follows:

A state of mind consisting in (1) honesty in belief or purpose, (2) faithfulness to one’s duty or obligation, (3) observance of reasonable commercial standards of fair dealing in given trade or business, or (4) absence of intent to defraud or to seek unconscionable advantage.242

Thus, in order for an insured to act in good faith, it must observe reasonable commercial standards of fair dealing in trade or business. This is in keeping with the good-faith requirement, which is to ensure that a fidelity bond does not become credit-risk insurance.

In a similar vein, it has often been said that financial institutions should bear the risk of loss for losses that they could have prevented through reasonable investigation or verification procedures.243 One commentator has observed:

Even if a customer presents a good imitation of a stock certificate, the financial institution has the opportunity to verify whether the customer actually owns the shares of stock represented by that certificate. There should be coverage under Insuring Agreement E only in those cases where the customer owns such shares, because it is

241 See Calcasieu-Marine Nat’l Bank of Lake Charles v. Am. Emp’rs

Ins. Co., 533 F.2d 290, 299 (5th Cir. 1976); see also Beach Cmty. Bank v. St. Paul Mercury Ins. Co., 635 F.3d 1190, 1197 (11th Cir. 2011) (recognizing that a fidelity bond is not a policy of credit insurance and does not protect a bank when it simply makes a bad business deal).

242 BLACK’S LAW DICTIONARY 713 (8th ed. 2004) (emphasis added). 243 See Liberty Nat’l Bank v. Aetna Life & Cas. Co., 568 F. Supp. 860,

865-67 (D.N.J. 1983).

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only in those cases where the customer owns such shares, that the financial institution cannot prevent a loss through reasonable investigation and verification procedures.244

In National City Bank v. St. Paul Fire & Marine Insurance. Co.,245 the court explained:

The basic rationale behind the definition of ‘counterfeit’ is to require that an insurance company cover only non-business losses or insured risks, with a bank responsible for ordinary business losses. . . . If a bank . . . chooses not to follow sound business practices and fails to investigate, verify, examine, or even possess securities before remitting loan proceeds, it cannot successfully claim this is an insured risk, and not an ordinary business loss.246

The leading case on what constitutes “good faith” is Marsh Investment Corp. v. Langford.247 There, a bank consolidated its customer’s debts in exchange for the customer’s execution of a note, which was secured by a mortgaged property owned by Marsh.248 The bank knew that the customer was not affiliated with Marsh and required the unanimous consent of Marsh’s shareholders as well as a corporate resolution by Marsh that the customer had the authority to encumber its property. The customer’s own attorney prepared the documents and held them in trust.249 The customer’s attorney also prepared an opinion letter, which outlined the terms of the documents. In this letter, the attorney made the following disclaimer: I make no representation or warranty, or give any opinion, that these people are in fact shareholders of Marsh . . . .”250 At trial, a representative for the bank testified that the disclaimer

244 Mark W. Bean, Insurance Agreement E - An Analysis Of Recent

Cases Interpreting What Is A Counterfeit Or Forgery, 17 (1991). 245 447 N.W.2d at 174. 246 Id. at 179. 247 554 F. Supp. 800 (E.D. La. 1982). 248 Id. at 801. 249 Id. 250 Id. at 801-02.

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“concerned [the bank] and made [it] suspicious.”251 The bank, however, did not investigate further and it subsequently learned that the documents were forgeries. The trial court ruled that the bank’s failure to investigate further constituted a failure to act in good faith, as required under Insuring Agreement (E). In doing so, the trial court noted: “what if a person or entity chooses to remain ignorant, concerning the details of a transaction, in fear of what a little knowledge will disclose? In other words, is one acting “in good faith” when one practices selective ignorance? I conclude not[.]”252

On appeal, the Fifth Circuit interpreted Insuring Agreement (E)’s use of “good faith” in terms of what does not constitute “bad faith.”253 Although the Fifth Circuit did not reach the issue of how “good faith” should be defined, due to the appellant’s concession that the trial court properly interpreted its meaning, the Fifth Circuit did summarize the trial court’s ruling by stating that “mere ignorance is not bad faith, but . . . if one chooses to remain ignorant . . . in fear of what a little knowledge will disclose . . . such selective ignorance is bad faith.”254 The Fifth Circuit then noted that if “selective ignorance” is the proper test to determine whether the insured acted in good faith, an insured that relies solely on the debtor’s critical representations about his own authority reaches the level of selective ignorance needed to defeat a showing of good faith under Insuring Agreement (E).255

Similarly, in Republic National Bank,256 the Eleventh Circuit noted that an insurer must show that the insured acted fraudulently or

251 Id. at 802. 252 Id. at 805. 253 Marsh Investment Corp. v. Langford, 721 F.2d 1011, 1014 (5th Cir.

1983). 254 Id. at 1014 (citing Marsh Investment Corp. v. Langford, 554 F.

Supp. 800, 805 (E.D. La. 1982) (internal quotation omitted)); see also Cmty. Bank v. Ell, 564 P.2d 685, 691 (Or. 1977) (holding that “if a party fails to make an inquiry for the purpose of remaining ignorant of facts which he believes or fears would disclose a defect in the transaction, he may be found to have acted in bad faith”).

255 Id. 256 See Republic Nat’l Bank of Miami v. Fid. & Deposit Co. of Md.,

894 F.2d 1255, 1264 (11th Cir. 1990).

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with bad faith before it could properly deny coverage under the good faith requirement.

However, courts have differed with respect to their treatment of the good faith requirement. The majority of courts have recognized that mere negligence does not preclude “good faith.”257 For example, the Fifth Circuit held that an insured’s failure to verify the legitimacy of financial statements, without more, did not constitute bad faith.258 Similarly, the Florida Supreme Court noted that insurers assume the risk of negligence by the insured bank and that such risk is reflected in the premiums charged by issuers of financial institution bonds.259

And, in First National Bank of Manitowoc v. Cincinnati Insurance Co.,260 the bank extended a line of credit to a used car dealership based upon receipt of car leases purportedly signed by customers.261 The Seventh Circuit found that the language “in good faith and in the usual course of business” did not create a duty to follow sound banking practices.262 The court explained that while it must interpret the policy as a whole, “to interpret ‘in good faith’ and ‘in the usual course of business’ as together imposing a prerequisite normative standard of banking conduct ignores the independent meaning of each phrase.”263 The court turned to state law negligence standards, and noted that, under Wisconsin law, mere negligence on the part of an insured does not bar the insured from obtaining coverage under a bond unless the negligence

257 See, e.g., Citizens Bank of Or. v. Am. Ins. Co., 289 F. Supp. 211, 214 (D. Or. 1968) (stating that “[u]nder Oregon law, a person may act in good faith and, at the same time, be negligent”); First Nat’l Bank of Crandon v. U.S. Fid. & Guar. Co. of Baltimore, 137 N.W. 742, 745 (Wis. 1912); Beach Cmty. Bank v. St. Paul Mercury Ins. Co., 635 F.3d 1190, 1200 (11th Cir. 2011).

258 First Nat’l Bank of Fort Walton Beach v. U.S. Fid. & Guar. Co., 416 F.2d 52, 57 (5th Cir. 1969).

259 Dixie Nat’l Bank of Dade Cnty. v. Emp’rs Commercial Union Ins. Co. of Am., 463 So. 2d 1147, 1152 (Fla. 1985).

260 485 F.3d 971, 975 (7th Cir. 2007). In Manitowoc, the Seventh Circuit interpreted a fidelity bond that mirrored the 1969 bond. See 1969 Bond, Insuring Agreement (E). Specifically, the bond provided that the insured must act “in good faith and in the course of business.” Id.

261 Id. at 974. 262 Id. at 977-78. 263 Id. at 978.

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amounts to fraud or bad faith.264 The Seventh Circuit also found that the phrase “in the usual course of business” does not impose a particular standard of conduct.265 The court noted that, on its face, the phrase does not suggest a duty of care, but instead suggested a certain category of acts, such as those usually conducted in the banking business.266 Therefore, the court interpreted the phrase to mean acting “upon the kinds of documents that it would normally act upon in its business, such as leases, checks, securities, etc., rather than documents outside that usual course[.]”267

In an effort to determine the requirements Insuring Agreement (E)’s good-faith requirement impose on an insured, courts sometimes turned to other sources for the meaning of “good faith.” For instance, at least one court has relied on the UCC’s definition of “good faith.”268 The UCC defines “good faith” as “honesty in fact in the conduct or transaction concerned.”269 This definition is subjective and has been referred to as “the old white heart and empty head standard.”270 But, such a narrow definition overlooks the risk-sharing arrangement created by a fidelity bond. If a bank could collect for its loss even though it looks the other way or ignores warning signs, insurers would never be willing to insure such risks. Thus, “good faith” must mean something more.

E. The On the Faith of an Original Requirement

Insuring Agreement (E) also requires that the insured have acted 1) ”on the faith of,” an 2) ”original” covered document, 3) in its, or its representative’s “actual physical possession.”

264 Id. 265 Id. 266 Id. 267 Id. at 979 (internal quotations omitted). 268 Stix Friedman & Co., Inc. v. Fid. & Deposit Co. of Md., 563 S.W.2d

517, 522 (Mo. Ct. App. 1978); see also French Am. Banking Corp. v. Flota Mercante Grancolombiana, S.A., 609 F. Supp. 1352, 1359 (S.D.N.Y. 1985) (stating that “good faith” means “honesty in fact in the conduct of transaction concerned”).

269 U.C.C. § 1-201(19). 270 Stix Friedman & Co., 563 S.W.2d at 522; see also J. White & R.

Summers, Uniform Commercial Code § 6-3, at 298 (4th ed. 1995).

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1. “On the Faith of”

The bond does not define the term “on the faith of.” A plain reading of, however, requires some reliance on the document.271 Indeed, where reliance cannot be shown, courts have refused to find coverage for forged documents under Insuring Agreement (E).272 Courts generally do not consider reliance to be synonymous with review or verification, and will not read this heightened burden into the bond where it is not stated.273 However, an insured’s losses that result when it has funded a loan or irrevocably committed to fund a loan before receiving the original documents are not covered under Insuring Agreement (E).274 For instance, in Bank of Bozeman v. Bancinsure, Inc.,275 the Ninth Circuit held that the insured-bank failed to satisfy Insuring Agreement (E)’s reliance requirement because it “failed to examine the original security documents before closing the loan” and, as a result, it could not show that they extended credit “on the faith of” those documents.276 Rather, the court noted, the insured’s reliance amounted to “an act of blind faith, not good faith.”277

2. “Original”

The “original” requirement was first added to the bond in 1980.278 The requirement to have an original has been considered by

271 See First Union Corp. v. U.S. Fid. & Guar. Co., 730 A.2d 278, 283

(Md. Ct. Spec. App. 1999) (noting that “[c]ourts have interpreted the language, ‘on the faith of,’ as signifying reliance”). Cont’l Bank v. Phoenix Ins. Co., 101 Cal. Rptr. 392, 394 (Cal. Ct. App. 1972) (“The phrase, ‘on the faith of,’ clearly signifies something done ‘in reliance upon’”).

272 See, e.g., Republic Nat’l Bank of Miami, 894 F.2d at 1262. 273 Peoples State Bank v. Progressive Cas. Ins. Co., No. 10-0086, 2011

U.S. Dist. LEXIS 75318, at *12 (W.D. La. July 12, 2011). 274 Republic Nat’l Bank of Miami, 894 F.2d at 1262. 275 404 F. App’x 117, 119 (9th Cir. 2010). 276 Id. 277 Id. 278 1980 Statement of Change, supra note 39 (stating that “there is no

reference in the new Insuring Agreement (E) to carbon copies of instruments. The instruments must be original”).

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several courts.279 For instance, in Hamilton National Bank v. Insurance Co. of N. America,280 a Pennsylvania court held that photocopies of covered documents did not satisfy Insuring Agreement (E)’s “original” requirement. Further, in, Reliance Insurance Co. v. Capital Bancshares, Inc.,281 the Fifth Circuit was careful to distinguish the requirements of Agreement (E)(3), dealing with counterfeits where no original is required, from Agreement (E)(1), dealing with forgery where an original is a stated requirement.282 The term “original” is clear and unambiguous, and does not include photocopies or faxes. 283 Thus, it is clear that an insured’s losses from funding a loan or irrevocably committing to fund a loan before receiving the original documents are not covered under Insuring Agreement (E).284

3. “Actual Physical Possession”

The “physical possession” requirement works in tandem with the “on the faith of” requirement because a bank cannot rely on documents it never possessed. The “physical possession” requirement is one that is strictly enforced. For instance, in Republic National Bank of Miami v. Fidelity & Deposit Co. of Maryland,285 the insured entered into a binding contract to finance Columbian Coffee Corporation’s letter of credit on February 3. Thirteen days later, the insured issued its letter of credit, establishing it obligation to honor the letter.286 However, the insured did not receive physical possession of the forged bills of lading, which supported the letter of credit, until February 17. Thus, according to the Eleventh Circuit, by the time the insured received the forged bills of lading, it had already irrevocably committed to the course of action that resulted in its loss.287 And, as a result, the insured “did not have the

279 See, e.g., Hamilton Nat’l Bank v. Ins. Co. of N. Am., 557 A.2d 747, 751 (Pa. Super. Ct. 1989).

280 Id. 281 912 F.2d 756, 758 (5th Cir. 1990). 282 Id. 283 Id.; but see Citizens Banking Corp. v. Gulf Ins. Co., Nos. 03-CV-

74044 & 04-CV-70459, 2005 WL 1983248, at *6 (E.D. Mich. Aug. 10, 2005) (finding that the term “original” in a Rider was ambiguous).

284 Republic Nat’l Bank, 894 F.2d at 1262 (11th Cir. 1990). 285 Id. 286 Id. at 1261. 287 Id. at 1262.

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forged documents in its physical possession at the time it purportedly acted in reliance upon them.”288 In reaching its conclusion that the insured had failed to satisfy Insuring Agreement (E)’s reliance requirement, the Eleventh Circuit noted:

Were we to hold that Republic could recover on a banker’s blanket bond in the instant transaction . . . our decision would allow banks to rely on documents presented by a beneficiary to a letter of credit transaction not because they are worthy of such reliance, but rather because the reliability of such documents is insured. At the least, such a holding would encourage sloppy banking practices[.]289

Although the “physical possession” requirement is strictly enforced, it can be met even if the covered document was not in the insured’s actual possession, as long as it was in the possession of its “correspondent bank or other authorized representative.”290 Specifically, in its final paragraph, Insuring Agreement (E) states that the possession requirement (which is a condition precedent to having relied in good faith) can be satisfied by possession by a correspondent bank or other representative authorized to hold the document if loan participation coverage is included.291

The authorized representative requirement in Insuring Agreement (E) is based upon agency principles.292 In deciding whether a person or entity is acting as the corporate representative of an insured, courts will not look to extrinsic evidence of the standard banking

288 Id. 289 Id. at 1264. 290 1986 Bond, Insuring Agreement (E) (3). 291 Id. 292 See, e.g., Nat’l City Bank of Minn. v. St. Paul Fire & Marine Ins.

Co., 447 N.W.2d 171, 176 (Minn. 1989); Beach Cmty. Bank v. St. Paul Mercury Ins. Co., 635 F.3d 1190, 1199 (11th Cir. 2011) (applying Florida agency law concepts to determination of whether someone was an “authorized representative”).

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practices.293 Thus, there must be some evidence that the insured expressly authorized another to act as its authorized representative.

The issue of whether a person is an “authorized representative” sometimes arises in the context of warehouse lending. Generally, warehouse lending takes one of two forms: “wet” or “dry.”294 “Wet” funding occurs when the lender, before receiving the original loan documents signed by the borrower, funds a loan at or near the time of closing.295 Conversely, “dry” funding occurs when the lender funds the loan only after it receives original, signed loan documents.296 In the context of “dry” funded loans, this issue does not typically arise because such loans are funded only after the warehouse lender has received the signed, original loan documents. In contrast, with “wet” funding, the warehouse lender funds the loans upon its receipt of “copies,” typically faxed, of the loan documents. As a result of this practice with “wet” funding, an insured may argue that the originating mortgage banker or closing agent, one of whom likely had actual physical possession of the alleged forged documents at the time the loan was funded, was the insured’s “authorized representative,” thus satisfying the “actual physical possession” requirement. But this argument is unavailing because it would require a finding that the mortgage banker or closing agent was the agent of the warehouse lender.297 Were a court to so hold, it would render meaningless the distinction between “wet” and “dry” funding in the warehouse lending context. Further, it would be extraordinary for a

293 Bank of Bozeman, 404 F. App’x at 119 (citing McKnight v. Torres,

563 F.3d 890, 893 (9th Cir. 2009)). 294 The terms “wet” and “dry” are in reference to the state of the ink on

the signed loan documents. See Charlie Armstrong, Thomas H. McNeil, & James E. Reynolds, Warehouse Lending Losses Under the Financial Institution Bond, 12 FID. LAW ASS’N J. 6 n. 15 (2006).

295 Id. at 6. 296 Id. 297 Nat’l City Bank v. St. Paul Fire & Marine Ins. Co., 447 N.W.2d

171, 175-76 (Minn. 1989) (discussing proposed definitions of “correspondent bank” and impliedly approving a definition that would not encompass either a mortgage banker or a closing agent).

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court to find that a borrower was the agent of its lender, as the parties ostensibly are involved in an arms-length transaction.298

For example, in Citizens Bank of Oregon v. American Insurance Co.,299 the court addressed the issue in the context of a warehouse agreement. In that case the plaintiff bank had an accommodation agreement with a second bank.300 The second bank worked out the mechanics of the loan at issue in the case, took possession of stock certificates given as collateral, and received the customer’s signed promissory note in its favor.301 The second bank cut a cashier’s check to the customer and forwarded the receipts for the collateral to the plaintiff bank, which credited the second bank’s account in the amount of the loan.302 The collateral turned out to be counterfeit and the plaintiff bank made a claim on its bond. The district court held that the accommodation agreement created an agency relationship between the banks and, under the agreement, the second bank held the collateral for the use and benefit of the plaintiff bank, thus satisfying the “on the faith of” language in Insuring Agreement (E).303 It should be noted, however, that the court’s decision was made based on a version of a Banker’s Blanket Bond that did not require actual physical possession of the collateral relied upon. Indeed, the court held that because the second bank held the securities for the use and benefit of the plaintiff bank, the plaintiff had constructive possession and therefore satisfied the “on the faith of” requirement.304 In addition, principles of agency hold that once the agent breaches a duty to its principal, the person or entity is no longer

298 See Resolution Trust Corp. v. Aetna Cas. & Sur. Co., 831 F. Supp.

610, 618 (N.D. Ill. 1993). 299 289 F. Supp. 211 (D. Or. 1968). 300 Id. at 212. 301 Id. 302 Id. 303 Id. at 213. 304 Id.

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the principal’s agent and has no authority to act on the principal’s behalf.305

V. CONCLUSION

Insuring Agreement (E) has undergone multiple revisions since its incorporation into the fidelity bond in 1946 in order to reverse erroneous court decisions, and to make clearer that coverage under Insuring Agreement (E) is limited. Despite these revisions, courts still misconstrue Insuring Agreement (E) and, at times, ignore its plain language and the drafters’ intent. Most recently, in 2004, the SFAA revised the standard form bond again to make even clearer the proper coverage available under Insuring Agreement (E). Unfortunately, most carriers have not yet adopted this form, and so many issues are left disputed. Since most claims under Insuring Agreement (E) will be under the 1986 Bond, or even earlier versions, it is important to remember the drafters’ intent and the intended coverage of Insuring Agreement (E) when analyzing or litigating an Insuring Agreement (E) claim.

305 See, e.g., Remenchik v. Whittington, 757 S.W.2d 836, 839 (Tex. —

Houston [14th Dist.] 1998) (noting that where an agent binds himself to a course of conduct antagonistic to the interests of his principal, such breach of duty terminated the agency) (citing Cotton v. Rand, 51 S.W. 838, 842 (Tex. 1899)).