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COVID-19 has had and will continue to have impacts on virtually every corporation in Canada and globally.
Insurance policies are constantly evolving in response to new and unexpected claims scenarios. In the run-up to every annual policy renewal, there is invariably a wording issue to consider as a result of a novel claim or other development which has happened somewhere in the world. The challenge then is to negotiate a solution which achieves a fair balance of risk between the insurer and the policyholder.
Financial institutions’ (FIs) crime or, as they are known in the US, “bond” insurance policies, are no exception to this rule. The general aim of this type of insurance is to provide cover for a comprehensive range of crime-related exposures, including fidelity, third-party fraud and extortion losses. Crime policies are also highly developed, typically encompassing several insuring clauses aimed at providing the cover which FIs require in the face of an ever-changing risk environment.
In spite of their popularity, there is a surprising lack of English case law on crime policies. This may be a function of the fact that FIs and their insurers often prefer to resolve their insurance disputes behind closed doors, by arbitration, in the relatively rare situation where a negotiated solution is not possible. Whatever the reason, the practical result for FIs and their professional advisers is that, from year to year, they do not obtain the benefit of judicial decisions on the scope of crime policies and how they operate.
In order for FIs to understand how their policies might respond, it is possible to look at some recent US cases in this area. These cases are instructive, not only because they provide examples of crime-related losses which have come before the Courts in the past, but also because they give a sense of the factors which may have a bearing on whether a loss is covered (and this applies just as much to jurisdictions outside the US).
Cheque fraud is often covered under FI crime policies, subject to certain restrictions. While there are a number of variations, at its most basic, cheque fraud involves Bank B encashing a cheque drawn on Bank A, where Bank A has insufficient funds on account for the customer with which to reimburse Bank B. More complex schemes, such as ‘cheque kiting’ involve multiple accounts at different banks, with cheques passed back and forth between them to cover an underlying insufficiency of funds, thereby obtaining unauthorised credit.
In this case, the bank fell victim to a cheque fraud scheme conducted by an individual over a period of months. The unusual feature of this particular scheme was that the fraudster was not a customer of the bank, which raised money orders for his cheques in breach of its rules. When the scheme collapsed, the bank was left holding worthless cheques with a value of around $300,000 from the last three days of the scheme. However, when the bank claimed under the “on-premises” insuring clause of its bond policy, cover was denied on two grounds.
The first ground was that the bank’s losses did not fall under the “on-premises” insuring clause which covered losses “resulting directly from...false pretenses…committed by a person present…on the premises of the insured while the property is lodged or deposited within offices or premises located anywhere.” This was based on a technical argument that on each occasion that a cheque was presented it was a valid and enforceable instrument – it was only when Bank B failed to collect from Bank A that the loss occurred. This analysis was rejected.
The second ground was that the bank’s losses did not result “directly from” the fraudster’s “false pretenses” and were otherwise caught by an exclusion for “loss caused by an Employee”, as a result of the bank’s failure to follow its own rules. This argument was also rejected, the Court finding that the fraudster’s conduct was plainly the direct cause of the bank’s losses, rather than the bank’s failure to follow its own rules.
In one form or another, most crime policies also provide cover for fidelity losses. These are losses which result from the wrongful acts of the FI’s own employees, and normally require the policyholder to demonstrate an intent, on the part of the employee, to make an improper financial gain for himself, or for another person with whom the employee has colluded. As a general rule, the insurer will also only be liable for losses which are “discovered” during the policy period. Depending on the bargaining power of the insured, “discovered” can refer to the first date on which (at its narrowest) a particular senior executive first became aware that a claim under the policy was a realistic possibility or (more broadly) when the insured first acquired corporate knowledge of the underlying problem.
In the Resolution Trust case, there were two issues arising from what the Court referred to as a “kiting scheme” conducted by a mortgage lender, Northwest. The mortgage lender’s operations had been financed by a loan provided by a warehouse lender, City Collateral (CC), and the scheme involved the diversion of CC’s security and loan repayments. When the matter first came to the attention of certain executives at CC, they decided to suppress it in the belief that, if CC’s parent company became aware of the matter, the executives would not be awarded the “golden handcuff” payments which they were expecting to receive. In due course, the matter came to the attention of the parent company but, by this time, the Northwest credit line was in default and CC faced a $7 million loss. The parent company notified its bond insurer who denied coverage.
The first issue was whether the loss had been discovered during or (as the bond insurer contended) after the policy period. The policy provided that discovery occurred “when the Insured becomes aware of facts which would cause a reasonable person to assume that a loss covered by the bond has been or will be incurred, even though the exact amount of or details of loss may not be known”. On this point, the Court decided that this definition should be interpreted widely so that there was a low threshold for discovery and, on the facts of the case, it had been inappropriate to award the insurer summary judgment on the basis that the loss had been discovered after the policy period.
The second issue was whether, for the purpose of the fidelity insuring clause, the City Collateral executives acted with the “manifest intent” to obtain a financial benefit for themselves or a third party which was not a salary, commission, fee, bonus, award or other benefit earned in the normal course of employment – a standard formulation that will be familiar to many FI risk managers. The Court held that the golden handcuff payments (although clearly one-off) fell squarely within the excluded category of benefits that were earned in the normal course of employment. Therefore, the loss was not covered by the crime policy.
In this case, a bank claimed under its fidelity insurance policy when it emerged that an employee had stolen approximately $900,000 from its customers’ brokerage accounts held with a custodian bank. The bank indemnified the customers and the insurer denied cover.
The first issue was whether, for coverage purposes, the stolen money represented “covered property”, in the sense that it was “owned and held by someone else under circumstances which make the insured responsible for the property prior to the occurrence of the loss”. The Court decided that it was, rejecting the insurer’s argument that the terms of the brokerage agreements were such that the bank disclaimed liability for losses due to breach of fiduciary duty or theft.
The second issue was whether the employee’s theft had “directly” caused the bank’s losses, because he had stolen funds from customer accounts and not from the bank itself. This was relevant because the policy covered “loss resulting directly from dishonest or fraudulent acts committed by an Employee”. The Court held that, because the money was “covered property”, and a dishonest employee had stolen it, the employee had “directly” caused the loss. To use the Circuit Judge’s words, it was “as simple as that, and that is true under any definition of ‘directly’.”
The final issue was whether the employee had the sufficient “manifest intent” to cause the bank’s loss. Based on previous US case law this objective requirement was met where a particular result was substantially certain to follow from conduct. In the Court’s view, there could be no doubt that theft from client accounts in these circumstances would be substantially certain to cause losses to the bank.
In general, most crime policies cover losses caused by an FI’s reliance on instruments which are “counterfeit” (meaning, in most cases, a reproduction of an authentic instrument which is intended to deceive) – although cover can be conditional on physical possession of the instrument at the time of reliance.
In this case, the bank’s bond policy provided cover for loss “resulting directly from” the bank having, in good faith, extended credit on the faith of a certificated security which is “Counterfeit”, meaning “an imitation which is intended to deceive and to be taken as an original.” Over a period of years, the bank made and renewed a number of loans to a customer for which the customer pledged various assets as collateral. In 2005, the customer assigned a number of shares in a company to the bank in this way, delivering a stock certificate (Certificate 1). In 2009, further shares in the company were assigned and another stock certificate was delivered (Certificate 2). At this point, Certificates 1 and 2 were compared and Certificate 1 was found to be a copy of the original certificate.
However, the customer was able to persuade the company to issue a replacement certificate (Certificate 3) in respect of the Certificate 1 shares. Later on in 2009, the bank consolidated all of the customer’s outstanding loans secured, in part, by the previous pledged shares in the company. However, it then emerged that the original Certificate 1 had been delivered to a different bank as collateral for another loan, meaning that Certificate 3 was void. When the customer was asked to replace the Certificate 1 shares with other collateral, he immediately filed for bankruptcy.
When the bank claimed under its bond policy for its losses in connection with the 2009 consolidated loans, the insurer contended that Certificate 3 was not “Counterfeit” because it was not an imitation purporting to be an authentic document; rather, it was an authentic document that happened to be void when issued. The Court accepted this analysis: while Certificate 3 was fraudulently procured, and as such valueless, it was an authentic document and thus not “Counterfeit”. As a result, there was no coverage under the Bond Policy.
As we observed at the beginning of this article, examples of previous claims are a valuable resource for any policyholder when attempting to assess the scope of a policy. With input from the policyholder’s broker on the general claims experience, a legal review which draws on cases from across the world in order to stress-test policies, map out exactly what is covered and identify possible enhancements is an important instrument in the toolbox of any insurance risk manager.
These US cases raise the question whether similar losses would be covered under a crime policy issued in London in 2016. While every policy has its own intricacies, reflecting the particular circumstances of the policyholder and what the insurer is prepared to cover, some general observations are nonetheless possible. For example, in a scenario similar to Resolution Trust, the inducement of a one-off golden handcuff payment might well be fatal to a claim for cover under a standard fidelity insuring clause. As for First State Bank of Monticello, the “on-premises” coverage in that case is not, to our knowledge, a common feature of crime policies in the London market, although we would be more optimistic about the prospects of recovering the losses in First Defiance Financial Corporation. Finally, with some caveats, cover is often now available for losses arising from the handling of instruments which are fraudulently obtained. As a result, an FI in a similar position to the claimant in Bank of Brewton might have more luck in the UK. Overall, the US cases illustrate the variety of factual scenarios that may need to be considered when evaluating these policies.
COVID-19 has had and will continue to have impacts on virtually every corporation in Canada and globally.
As business resumes in the workplace and circumstances change, American companies must be ready.