Many banks have recently fallen victim to various types of fraud in mortgage loans or warehouse lending relationships. Common scenarios on both individual mortgage loans and warehouse loans have included forged signatures on promissory notes, deeds of trust, mortgages or powers of attorney, fictitious borrowers or nonexistent downpayments or collateral. Whatever fraudulent methodology was employed, the victimized bank must promptly consider whether it has insurance coverage for any resulting loss. The purpose of this article is to describe generally the parameters of coverage for such losses under a typical financial institution bond, which is the most likely source of coverage under the bank’s own insurance policies.
If a bank employee was a party to the fraudulent mortgage scheme, the relevant part of the bond (referred to as an “insuring agreement”) is the “Fidelity” insuring agreement. If a bank employee was not involved, the bank should consider the “Securities” insuring agreement and the “Forgery or Alteration” insuring agreement. In addition, some bonds now also contain an insuring agreement entitled “Fraudulent Mortgages” or “Fraudulently Obtained Signatures—Real Property Mortgages” that must also be considered. Although the language in all four of these insuring agreements has its genesis in standard form policies, carriers have varied the language in those agreements from time to time, so the bank should be sensitive to that possibility. Further, the language in these insuring agreements, and the carriers’ application of the language, can be quite technical—some might say hyper-technical.
The Fidelity Insuring Agreement
If one or more of the bank’s employees was a knowing participant in the fraudulent mortgage scheme, the typical financial institution bond will dictate that the “Fidelity” insuring agreement will be the only source of coverage provided by the bond. This insuring agreement will usually require that the bank’s loss resulted directly from the employee’s engaging in dishonest conduct, either alone or in collusion with one or more other actors, with the intent to cause the bank a loss or to obtain a benefit for a third party or himself. Because the conduct involved a loan, most bonds also require that the employee actually received a financial benefit, other than salary, bonus or the like, in connection with the transactions. In a fraudulent mortgage scheme in which a bank employee is involved, most of the elements of this insuring agreement can be readily satisfied. The challenge for the bank usually will be in gathering sufficient evidence that its employee received the requisite financial benefit in connection with the transactions.
The “Securities” Insuring Agreement
This insuring agreement typically insures the bank from loss resulting directly from it extending credit, in good faith, based on an original “written instrument” that bears a signature that is a “forgery” or bears a “fraudulent alteration.” The bank or its authorized representative must have actual physical possession of the written instrument. Questions that frequently arise under this insuring agreement include:
Is the document a “written instrument?” “Written instruments” include evidence of debt, deeds of trust and mortgages, guarantees and security agreements, but not powers of attorney. An “evidence of debt,” in turn, is an instrument executed by a customer of the bank and held by the bank, which in the regular course of business is treated as evidencing the customer’s debt to the bank. A promissory note will typically fall within that definition if purportedly signed by a customer of the bank.
Is the signature a “forgery?” “Forgery” is a technical, and frequently litigated, concept under the bond. It is typically defined to mean the signing of the name of another person or organization with intent to deceive. It does not mean a signature that consists in whole or in part of one’s own name signed with or without authority for any purpose.
Did the bank act in good faith, or was it on notice of the fraudulent activity?
Did the loss result directly (some bonds say only “result”) from the bank extending credit based on the instrument that contained a forged signature? This question has generated much litigation. For example, if a bank extends a mortgage loan and the promissory note and deed of trust or mortgage contain forged signatures and the property does not exist, the carrier will likely take the position that the loss resulted because the property did not exist rather than because the documents contained forgeries.
Did the bank extend credit based on an original set of documents. If the bank disbursed funds based on faxed documents and received the original documents after funding, the carrier will take the position that there is no coverage.
The “Forgery or Alteration” Insuring Agreement
This insuring agreement is also sometimes called the “Unauthorized Signature or Alteration” insuring agreement. At first blush, this insuring agreement would seem to be a likely source of coverage for various types of mortgage fraud. To the contrary, though, this provision is actually quite narrow and will rarely provide coverage for mortgage fraud. The insuring agreement typically says that it covers loss resulting directly from “forgery,” or alteration of, on or in any “negotiable instrument” (except an “evidence of debt”), “acceptance,” “withdrawal order,” receipt for the withdrawal of “property,” “certificate of deposit” or “letter of credit.” The provision therefore excludes coverage for loss resulting from a forged or altered promissory note. Even if a promissory note qualified under the bond’s very narrow definition of “negotiable instrument” (and it probably does not), a forged promissory note is not covered because it falls within the typical definition of “evidence of debt.” Similarly, loss resulting from a forged or altered deed of trust or mortgage would not be covered because neither is one of the documents listed in the insuring agreement.
The “Fraudulent Mortgages” Insuring Agreement
Some bonds contain a provision insuring against loss resulting from the bank, in good faith and in the usual course of business, accepting a mortgage or deed of trust in connection with a loan when the mortgage or deed of trust is defective because it contains a signature obtained through trick, artifice, fraud or false pretenses. This provision also might cover losses when the signature on the deed conveying or releasing title to the property to the mortgagor under the mortgage or the grantor under a deed of trust was obtained by trick, artifice, fraud or false pretenses. This “fraudulently obtained signatures” insuring agreement consequently will cover some types of mortgage fraud. As a general rule, however, the provision will not cover schemes involving forged promissory notes, deeds of trust or mortgages or schemes involving fictitious borrowers or nonexistent collateral.
Lenders have confronted a myriad of fraudulent mortgage schemes. Unfortunately, not every such scheme falls within the parameters of the typical financial institution bond. Insurers will scrutinize the circumstances of the fraud to assess whether the loss resulted from conduct that falls within the rather technical language of one of these four insuring agreements. Litigation over the “Fidelity,” “Securities” and “Forgery” insuring agreements has been common, particularly where the losses have been substantial. Careful analysis of the facts of the loss and the language of the insuring agreements by the bank can be critical to its successful resolution of an insurance claim for mortgage fraud.