Warehouse Lending Losses Not Covered Under A Financial Institution Bond
December, 2006
In a case of first impression, Clausen Miller attorneys Scott L. Schmookler and Gilbert J. Schroeder achieved a significant victory when the United States District Court for the Eastern District of Michigan held that a $20 million warehouse lending loss was not covered, as a matter of law, under a financial institution bond. Flagstar Bank, FSB v. Federal Ins. Co., 2006 WL 3343765 (E.D. Mich. 2006).
Facts
Flagstar issued a warehouse line of credit to Amerifunding and Twentieth Century Mortgage (collectively “Principals”), independent mortgage brokers. Under the warehousing agreements, Flagstar agreed to advance money to the Principals, so they could fund real estate loans. The Principals were thereafter supposed to sell the loans to a pre-arranged investor, and use the proceeds of that sale to repay Flagstar.
Flagstar alleged that in 2003, the Principals submitted forged loan documents to induce Flagstar to advance money to fund fictitious real estate transactions. Because the collateral securing these advances (the underlying real estate loans) were fictitious, and therefore worthless, and the Principals were insolvent, Flagstar was unable to recoup its advances and sought recovery under a financial institution bond issued by Federal Insurance Company.
Analysis
A financial institution bond “is not a form of credit insurance.” Liberty Nat’l Bank v. Aetna, 568 F. Supp. 850, 866 (D. N.J. 1983). It does not “protect [an insured] when it simply makes a bad business deal.” Republic Nat’l Bank v. Fid. & Guar. Co., 894 F.2d 1255, 1263 (11th Cir. 1990). On the contrary, “[t]he failure to follow sound business practices and verify the authenticity is a business risk taken by [the insured] and not an insured risk covered by the Bond.” Nat’l City Bank v. St. Paul, 447 N.W.2d 171, 177 (Minn. 1989).
To this end, financial institution bonds only cover losses “resulting directly from” a covered impairment on a covered instrument. Strictly interpreting this requirement, courts have held that a loan loss is not covered unless the insured sustained an economic loss as a direct result of the impairment, typically a forgery. To do so, the insured must prove that absent the forgery, the impaired documents would have had monetary value. KW Bankshares v. Synd. of Underwriters, 965 F. Supp. 1047 (W.D. Tenn. 1997); French v. Flota Mercante, 752 F. Supp. 83 (S.D.N.Y. 1990); Reliance v. Capital, 685 F. Supp. 148 (N.D. Tex. 1988), aff’d, 912 F.2d 756 (5th Cir. 1990).
The bond imposes this requirement because of the distinction “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.” Liberty, 568 F. Supp. at 863. The latter is not covered (even if the claim involves a forgery) because while “[a] bank cannot protect against counterfeit and forged documents,” it “can, on the other hand, investigate the assertions made therein through credit checks, appraisals, title searches, financial statements and the like.” Id.
Liberty illustrates the point. In that case, the plaintiff made two loans, secured by two certificates of deposit. When the plaintiff discovered that the certificates of deposit were forged, it sought indemnity under its financial institution bond. Affirming judgment for the insurer, the district court held that although the CDs were qualifying documents, and were forged, the claim was nonetheless not covered under Insuring Agreement D because the loss “was not caused by whatever unauthorized execution, alteration or completion did occur.” Id.
The loss was caused by the fact that the statements contained in the document were not true. The assets represented thereby did not exist. If the documents were authentic and their signatures genuine and authorized, the loss nonetheless would have occurred. The failure of the security was not because they were counterfeit or forged, but solely because the assets represented thereby were non?existent. (Id.)
KW Bankshares reached the same conclusion. In that case, the insured approved a loan based upon a forged letter from the borrower’s employer, purportedly confirming the borrower’s entitlement to a substantial bonus. The court held that although the letter was forged, the claim was not covered because the insured would have sustained the same loss even if the letter was authentic.
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 plaintiff’s 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, plaintiff’s 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.
965 F. Supp. at 1054; Georgia Bank v. Cincinnati Ins., 2000 WL 1210709 (Ga. App., Aug. 28, 2000) (although bank approved loan based on forged document, claim not covered because “[e]ven if the signature on the confirmation was authentic, the bank would have suffered the loss, because the assets did not exist”).
Although no court had previously applied this analysis to a warehouse lending loss, the United States District Court for the Eastern District of Michigan did so here, holding that Flagstar’s loss was not covered under a financial institution bond because it was undisputed that Flagstar’s collateral was fictitious.
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. See 9A COUCH ON INSURANCE § 132.47 (1995) (stating the “purpose of the exclusion is to avoid the risk of writing credit insurance.”). 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 Bankshares 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. . . .
The district court, therefore, granted summary judgment in favor of Federal.
In reaching its decision, the district court recognized that an insured can protect itself against the risk of extending credit against fictitious collateral. As such, the court reasoned that holding an insurer liable for losses resulting from an insured’s failure to confirm the existence of its collateral would effectively rewrite the terms of a financial institution bond.
Like the courts in Liberty Nat’l, Georgia Bank, and KW Bankshares, the Court refuses to rewrite the parties’ agreement and convert the bond into a form of credit insurance. This is because an insured such as Flagstar can protect itself against credit risks throughits normal credit evaluation procedures. As the court in Liberty Nat’l noted, financial institutions have the means and experience to evaluate their debtors’ ability to repay loans and to appraise
collateral. . . . [I]n the present case, Flagstar could have easily verified the existence of the underlying mortgage transactions that were the basis of its collateral by investigating whether the mortgages were actually recorded, investigating the creditworthiness of the underlying borrowers,or maintaining strict control over the title company to which it entrusted the funds prior to closing the transactions.
Learning Point:
When analyzing loan loss claims under a financial institution bond, it is important to investigate whether the insured extended credit against fictitious collateral. Such losses are not covered under a financial institution bond, even if the insured can demonstrate that it was induced to approve the loan based upon a covered impairment on a covered instrument, because the insured would have sustained the same loss even if the documents had been legitimately executed.
Back to CM Report of Recent Decisions (2006v4) 2006 Volume 4 Table of Contents
