TRYING TO FIT A SQUARE PEG INTO A ROUNDHOLE, PART 2: THE SCOPE AND LIMITS OF

INSURING AGREEMENT (E) IN CONNECTION WITHELECTRONIC CRIME CLAIMS

TWENTY SEVENTH ANNUALNORTHEAST SURETY AND FIDELITY

CLAIMS CONFERENCESEPTEMBER 22nd - 23rd, 2016

PRESENTED BY:

MICHAEL KEELEYStrasburger & Price, LLP

901 Main Street, Suite 4400Dallas, Texas 75202

CARLA C. CRAPSTERStrasburger & Price, LLP

901 Main Street, Suite 4400Dallas, Texas 75202

DANIEL J. RYANOneBeacon Financial Services

601 Carlson Parkway, Suite 600Minnetonka, Minnesota 55305

TRYING TO FIT A SQUARE PEG INTO A ROUND HOLE, PART 2: THE SCOPE AND LIMITS OF INSURING AGREEMENT (E) IN CONNECTION WITH ELECTRONIC

CRIME CLAIMS

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 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 revised the language of Insuring Agreement (E) to clarify its narrow coverage. But disputes remain about the precise meaning and requirements of Insuring Agreement (E).

Over roughly the last decade, one particular dispute regarding Insuring Agreement (E) has arisen frequently. Insureds seek coverage for losses they incur after they transfer funds to a fraudster on the faith of fake or forged documents that are either e-mailed or faxed to the insured. This type of loss is not covered, as the insured does not rely on the original when it receives a fax or e-mail. But insureds nonetheless attempt to sidestep this requirement. Fortunately, most of these attempts have been unsuccessful.

This paper will examine the history of Insuring Agreement (E) and the types of cases that arise under it most often; it will also pay particular attention to the recent body of cases addressing claims for coverage when the insured receives a fraudulent request by fax or e-mail. The authors conclude that Insuring Agreement (E) is clear and unambiguous in providing narrow coverage for losses incurred by a bank when it relies in good faith on the actual original of certain forged, altered, counterfeit, lost, or stolen loan documents having intrinsic value.

II. History of Insuring Agreement (E)

The SFAA drafted the first American Bankers Blanket Bond in 1916.2 By 1941, the bond had undergone several revisions, and was termed the “Bankers Blanket Bond, Standard Form No. 24.”3 Each revision to the bond has been made with input from the American

1 Hereinafter SFAA. The SFAA was formerly known as the Surety Association of America. 2 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). 3 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 2, at 5.

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Bankers Association and other trade groups.4 In the 1986 revision, the bond was renamed the “Financial Institution Bond, Standard Form No. 24.”5 This name has stuck through the 2004 and 2011 revisions to the bond. The 2011 Standard Form No. 24 is the most recent form. It contains six Insuring Agreements, which cover an insured financial institution against loss arising from specified dishonest, fraudulent, or criminal acts.6

As the standard-form Financial Institution Bond has evolved through the years, each of its Insuring Agreements has also undergone its own revisions.7 Insuring Agreement (E) is no exception. The first version of Insuring Agreement (E) became available sometime in the late 1920s or 1930s as a rider to the standard-form bond.8 It was not until 1946, five years after the Bankers Blanket Bond was first unveiled,9 that Insuring Agreement (E) was introduced as part of the standard-form bond.10 Insuring Agreement (E) was subsequently revised in 1951, 1969, 1980, 1986, 2004, and 2011.11 The early versions of Insuring Agreement (E) look markedly different than the most recent version adopted in 2011.

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.”12 The 1969 Bond also 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.13 As a result, in 1980, the SFAA, 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.14 In the 1980 revisions, the SFAA sought to limit its coverage by enumerating and defining the specific documents that came within its purview.15

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

4 Gallagher, supra note 2, at 5. 5 Id.; Financial Institution Bond, Standard Form No. 24 (revised Jan. 1986) [hereinafter 1986 Bond], reprinted in STANDARD FORMS. 6 Financial Institution Bond, Standard Form No. 24 (revised May 2011) [hereinafter 2011 Bond], reprinted in ANNOTATED FINANCIAL INSTITUTION BOND 741 (Michael Keeley, ed., 3rd ed. 2013). 7 Gallagher, supra note 2, at 1 (stating that “[n]ew editions were published in 1946, 1954, 1969, 1980, and 1986”). 8 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). 9 Financial Institution Bond, Standard Form No. 24 (revised Apr. 1941). 10 Financial Institution Bond, Standard Form No. 24 (revised Mar. 1946) [hereinafter 1946 Bond]. 11 Weldy, supra note 8 at 3; ANNOTATED FINANCIAL INSTITUTION BOND 713 (Michael Keeley, ed., 3rd ed. 2013) (appendix of revisions to Standard Form No. 24). 12 Financial Institution Bond, Standard Form No. 24 (revised Apr. 1969) [hereinafter 1969 Bond], reprinted in STANDARD FORM. 13 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) (holding that a certificate of title falls within the definition of “securities, documents or other written instruments”). 14 See Edgar L. Neel, Financial Institution and Fidelity Coverage for Loan Losses, 21 TORT & INS. L.J. 590, 614 (1986). 15 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, as the “history of Standard Form 24 demonstrates, the bond does not provide broad coverage for losses resulting from forgeries”).

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(a) 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 of Title, (e) Evidence of Debt, (f) corporate, partnership or personal Guarantee, or (g) Security Agreement.16

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

In 1986, the SFAA again revised the standard-form bond. The SFAA modified the “Security” category to include only a “Certificated Security.”17 The definition of a Security and Certificated Security are virtually the same, however, and as a result, this modification had little or no effect on Insuring Agreement (E)’s coverage. The SFAA also added two additional categories of documents:

(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 States18

In 2004, the SFAA deleted these two new categories because, according to the SFAA,

they “do not represent ownership or convey an interest in something of value.”19 The 2004 Bond also added an additional document: “Certificates of Deposit.”20 The 2004 Bond provided coverage for 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;

16 Financial Institution Bond, Standard Form No. 24, Insuring Agreement (E)(1)(a)-(g) (revised July 1980) [hereinafter 1980 Bond], reprinted in STANDARD FORMS. 17 1986 Bond, Insuring Agreement (E)(1)(a). 18 1986 Bond, Insuring Agreement (E)(1)(h)-(i). 19 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]. 20 Financial Institution Bond, Standard Form No. 24 (revised Apr. 2004) [hereinafter 2004 Bond], reprinted in ANNOTATED FINANCIAL INSTITUTION BOND 771 (Michael Keeley, ed., 3rd ed. 2013). This addition to Insuring Agreement (E) will be addressed in more detail below.

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(g) Corporate, partnership or personal Guarantee; and

(h) Security Agreement.21

The changes by the SFAA in 2011 were similarly limited. No new categories of documents were added to the list. The current version of Insuring Agreement (E), in the 2011 Standard Form No. 24, is quoted below, with the new language highlighted in bold:

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 Written, 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) Certificate of Deposit, (f) Evidence of Debt, (g) Corporate, partnership or personal Guarantee, or (h) Security Agreement

which (i) bears a handwritten signature which is material to the validity or enforceability of the security, which is a Forgery, or (ii) is altered, but only to the extent the Forgery or alteration causes the loss 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 (e) above which is a Counterfeit, but only to the extent the Counterfeit causes the loss.

Actual physical possession of the items listed in (a) through (h) 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 reproduction of a handwritten signature is treated the same as the handwritten signature. An electronic or digital signature is not treated as a reproduction of a handwritten signature.

The new language, highlighted in bold, is not discussed in the SFAA Electronic Filing Letter for the Bond, but its significance is both clear and important. It is now beyond argument that the forgery or alteration must have actually been the cause of the loss. Coverage does not apply if the insured merely relies on a document that contains a forgery if the forgery has nothing to do

21 2004 Bond, Insuring Agreement (E).

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with the insured’s loss. The impact of this small addition to Insuring Agreement (E) is discussed in detail below.

III. The Significance of the Amendments to the 2011 Bond

As noted above, the SFAA amended the Bond in 2011 to make clear that it must be the forgery or alteration to a document that causes the loss, or else Insuring Agreement (E) does not apply. A recent Seventh Circuit case underscored the importance of this clarification: without it, the “worthless-collateral rule” is arguably in jeopardy. The judicial doctrine known as the worthless-collateral rule generally provides that if an insured extends credit on the faith of collateral that bears a forgery, but the collateral was inherently worthless and would have been even if it had borne a valid signature, coverage for forgery cannot apply because the loss does not result directly from the forgery but from the worthlessness. The Seventh Circuit departed from this rule, however, in FDIC v. RLI Insurance Co.22 There, the insured bank made a loan on the faith of leases of computer equipment, but it turned out that the equipment did not exist, and the lessee’s signatures on the leases were forged. The FDIC, as receiver for the bank, sought coverage under a version of Insuring Agreement (E) that did not include the new language added by the 2011 amendment. The insurer argued that the loss resulted not from the forgeries but from the underlying fact that there never was any computer equipment to lease. In other words, the insurer argued that the court should apply the worthless-collateral rule. But the court refused. It stated, “The bond does not say that the loss must have resulted directly from a forgery; it says that the loss must have resulted directly from reliance upon a security agreement that contained a forgery.”23

This conclusion was not correct—the inclusion of the word “directly” should have made clear that the loss had to result from the forgery itself or the alteration itself, rather than the reliance on a document that merely contained a forgery or alteration. This should also be clear by the very nature of a Financial Institution Bond. Historically, such Bonds protected banks from the types of losses they could not thoroughly guard against themselves, such as the risk that a signature that appeared valid was a forgery.24 But these bonds did not protect against losses resulting from a bank’s credit decisions, which encompass ensuring that the collateral pledged actually exists. These types of decisions are squarely in a bank’s wheelhouse, and any fallout from failing to adequately protect against those risks should fall on the bank itself.25 Though this should have been clear before, and many courts agreed that it was, the SFAA has now removed any doubt on this issue and addressed precisely the concern that FDIC v. RLI Insurance raised. As of 2011, Standard Form No. 24 makes explicitly clear that it must be the forgery or alteration that causes the loss.

IV. Coverage Requirements Under Insuring Agreement (E)

Insuring Agreement (E) provides coverage for losses resulting from extending credit on the faith of certain forged, altered, counterfeit, lost, or stolen documents. Of course, there are a number of specific requirements that must be satisfied for coverage to apply. This section will explore each of those important requirements.

22 784 F.3d 1104 (7th Cir. 2015) 23 Id. at 1109. 24 Forcht Bank, N.A. v. Bancinsure, Inc., 514 F. App’x 586 (6th Cir. 2013). 25 Id.; KW Bancshares, Inc. v. Syndicates of Underwriters at Lloyds, 965 F. Supp. 1047, 1053-55 (W.D. Tenn. 1997).

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A. The Insured Must Have Relied on the Right Type of Document

Insuring Agreement (E) covers loss resulting from extending credit on certain loan-related documents. The threshold question in any Insuring Agreement (E) case is usually whether the insured’s loss resulted from reliance on one of the specified documents. One might be tempted to think that deciding whether a document fits within one of the proper categories would be straightforward, but courts do not always agree on this issue. This section addresses the types of documents potentially covered by Insuring Agreement (E).

Although the standard-form bond defines 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”).26 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.”

1. “Certificated Security”

Certificated Security was added as a covered document in 1986. It is defined in the 2011 Standard Form No. 24 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 a Written instrument issued in bearer or registered form;

(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.27

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.”28 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

26 Hereinafter the UCC. 27 2011 Bond. 28 Empire State Bank v. St. Paul Fire & Marine Ins. Co., 441 N.W.2d 811, 813 (Minn. Ct. App. 1989).

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(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.29

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 “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.”30

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.”31 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.’”32

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.,33 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.34 Another court has held that a lease does not constitute a Certificated Security as a matter of law because it is 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.35 In Brady National Bank v. Gulf Insurance Co.,36 both parties agreed that certificates of deposit constituted “certificated securities” for 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.

2. “Document of Title”

The 1986 Bond defined Document of Title as:

29 1986 Bond, Definitions, § 1(d). 30 See, e.g., MINN. STAT. § 336.8-102(2) (2011). 31 1986 Bond, Definitions, § 1(d). 32 In re Domestic Fuel Corp., 70 B.R. 455, 462 (Bankr. S.D.N.Y. 1987); see also Baker v. Gotz, 387 F. Supp. 1381, 1390 (D. Del. 1975). 33 441 N.W.2d at 813. 34 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). 35 Pine Bluff Nat’l Bank v. St. Paul Mercury Ins. Co., 346 F. Supp. 2d 1020, 1026-27 (E.D. Ark. 2004). 36 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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[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.37

The 2011 Standard Form No. 24 changes this definition only by adding the word “Written” before the list of documents (beginning with “bill of lading”), making clear that electronic forms of these documents are not acceptable.38

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.,39 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 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.40

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 did not otherwise fall within the plain definition.41

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.,42 the court addressed the issue of whether “holding certificates” constituted “Documents

37 1986 Bond, Definitions, § 1(f). 38 See infra Section IV.8, discussing the significance of the word “Written.” 39 346 F. Supp. 2d at 1027. 40 Id. 41 Id. at 1027-28. 42 831 F. Supp. 254 (S.D.N.Y. 1993).

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of Title” under § 1-201(15) of the UCC.43 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 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.44 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.45 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.”46 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.47 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.48 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 provided only that the seller would surrender and deliver the platinum upon presentation of a properly endorsed holding certificate.49 Thus, the court held the holding certificates were Documents of Title because the bank treated the holding certificates as adequately evidencing its right to 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.50 The 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.

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

Unlike the previous two categories of documents, none of the terms in this category are defined, and there is little case law addressing this category of documents in the fidelity bond

43 Id. at 261-62. 44 Id. at 261. 45 Id. 46 Id. 47 Id. at 262 48 Id. 49 Id. at 264 50 Id.

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context. But 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.”51 Also, it defines “mortgage” as “[a] conveyance of title to property that is given as security[.]”52 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, one insured has argued that a real estate contract falls under this category because equitable title, under some states’ laws, is transferred at the time of the execution of the real estate contract.53 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.,54 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.55 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.56

4. “Certificate of Origin or Title”

The 1986 Bond defined 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.”57 The 2011 Bond includes almost this exact same definition; the current definition varies only in that it adds the word “Written” before the word “document.”58 There is little case law on this category of documents, but one interesting case is FDIC v. Fidelity & Deposit Co. of Maryland,59 in which the FDIC attempted to argue that a city ordinance constituted a “certificate or origin or title.” The insurer argued

51 BLACK’S LAW DICTIONARY 444 (7th ed. 1999). 52 Id. at 1031. 53 See, e.g., Bd. of Comm’rs of Madison Co. v. Midwest Assocs., Inc., 245 N.E.2d 853, 858 (Ind. Ct. App. 1969). 54 768 F. Supp. 1449, 1455 (D. Kan. 1991). 55 Id. 56 Id. 57 1986 Bond, Definitions, Section 1(c). 58 2011 Bond, Definitions Section 1(b). The import of the word “Written” in the Bond is discussed below in Section IV.B. 59 827 F. Supp. 385, 394 (M.D. La. 1993).

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that the city ordinance was not a document “by which ownership is transferred,” and it was not issued by a “governmental agency.”60 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.”61 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.62 Thus, even if a document is forged or counterfeited, it can still conceivably satisfy the “issued by a governmental agency” requirement.

5. “Certificate of Deposit”

The revision to the bond in 2004 added Certificates of Deposit as a covered document under Insuring Agreement (E).63 The 2011 version—the latest version— still includes this category.64 A Certificate of Deposit has been a specifically covered document under Insuring Agreement (D) since its inception in 1936. Before the 2004 revision, however, a Certificate of Deposit was not a covered document under Insuring Agreement (E). Thus, on the face of the 2004 and 2011 Bonds, 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.65 While it is true that a Certificate of Deposit may fall under either 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.66 The addition will address a scenario whereby a perpetrator presents a forged CD to the bank and transfers the funds to his account.

Staff 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.67

The 1986 Bond defined Certificate of Deposit as “an acknowledgment in writing by a financial institution of receipt of Money with an engagement to repay it.”68 Because of its relatively recent introduction into the bond, there is no case law discussing its application under Insuring Agreement (E). But, as stated above in the introduction to this sub-section, the

60 Id. at 395. 61 Id. at 396 62 Id. at 395-96. 63 2004 Bond, Insuring Agreement (E)(1)(e). 64 2011 Bond, Insuring Agreement (E)(1)(e). 65 Notes, SFAA Drafting Subcommittee, July 1, 2002, available on file with the SFAA [hereinafter 2002 Notes]. 66 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, the sentence is wrong. As stated above, Certificates of Deposit have been covered under Insuring Agreement (D) since its incorporation into the bond. 67 2002 Notes, supra note 65. 68 1986 Bond, Definitions, Section 1(b),

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UCC is instructive. The UCC defines a “Certificate of Deposit” as a promissory note where the maker is a bank.69

6. “Evidence of Debt”

The 1986 Bond defined “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 as evidencing the customer’s debt to the Insured.”70 The 2004 Bond added the phrase “or purportedly executed” to the definition of Evidence of Debt.71 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.72 The 2004 Bond also added the word “Written,” requiring that an instrument qualifying as an Evidence of Debt must be on actual paper, continuing the theme of not including electronic documents.73

The most-often cited case addressing “evidence of debt” is Merchants National Bank of Winona v. Transamerica Insurance Co.74 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.75 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.76 The insurer denied the claim on the ground that the bond did not cover forged construction contracts. Subsequently, the bank filed suit and alleged that the forged construction contracts were “evidences of debt” under Insuring Agreement (E).77 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.78 Other cases interpreting Evidence of Debt have reached similar results.79 For instance, in First Union Corp. v. United States Fidelity & Guaranty Co.,80 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.

69 U.C.C. § 3-104 (1992). 70 1986 Bond, Definitions, Section1(h). 71 2004 Bond, Definitions, Section 1(i). 72 Robert J. Duke, A Brief History of the Financial Institution Bond, in FINANCIAL INSTITUTION BONDS 26 (Duncan L. Clore ed., 3d ed. 2008). 73 2004 Bond, Definitions Section 1(i). 74 408 N.W.2d 651, 653 (Minn. Ct. App. 1987). 75 Id. at 652. 76 Id. 77 Id. 78 Id. 79 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). 80 First Union Corp., 730 A.2d at 282.

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7. “Corporate, Partnership or Personal Guarantee”

Although the 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.”81 The Guarantee may be made by a corporation, partnership, or an individual. Thus, there is no reason for any misunderstanding concerning this covered document.

8. “Security Agreement”

The Bond defines a Security Agreement as “a Written agreement which creates an interest in personal property or fixtures and which secures payment or performance of an obligation.”82 In Merchants National Bank of Winona v. Transamerica, Inc.,83 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.84 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.”85

In KW Bancshares v. Syndicates of Underwriters at Lloyd’s,86 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. But 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.87 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.88 The court agreed:

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[.]89

81 2011 Bond, Definitions Section 1(k). 82 2011 Bond, Definitions Section 1(s). 83 408 N.W.2d 651, 654 (Minn. App. Ct. 1987). 84 Id. at 652. 85 Id. at 654. 86 965 F. Supp. 1047 (W.D. Tenn. 1997). 87 Id. at 1054. 88 Id. at 1054-55. 89 Id. at 1055.

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9. 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.90 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.

The “bundling” theory first emerged in Omnisource Corp. v. CNA Ins. Co.91 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.92

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.93 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.”94 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 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

90 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). 91 Omnisource Corp., 949 F. Supp. at 687. 92 Id. at 686. 93 Id. at 687. 94 Id. at 686.

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whole.”95 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.96 But “bundling” was correctly rejected by the court in First Union Corp. v. United States Fidelity & Guaranty Co.,97 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.98 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.99 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.”100 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.101 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).

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:

95 Id. at 688. 96 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. 97 730 A.2d at 282-83. 98 Id. at 283. 99 Id. at 280-81. 100 Id. at 282. 101 Id. at 283.

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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.102

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.”103 The 2011 Bond includes this same language.104 Thus, going forward, this issue should be put to rest.

B. The Document Must be “Written” and Must be an “Original”

In 2004, the SFAA added the requirement that the documents the insured relied upon had to be “Written.” This requirement was “inserted into a number of definitions to assure that coverage under the basic Form 24 [was] not provided for electronic transactions.”105 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.”106 This definition is still used in the 2011 Bond.107 By noting that the writing must be on “paper,” the SFAA attempted to eliminate reliance on electronic documents.

The requirement that the document must be an “Original” is also aimed at requiring banks to examine the best possible version of a document that exists, and not an electronic copy of it. The standard-form Financial Institution Bond defines the term “Original” as: “the first rendering or archetype and does not include photocopies or electronic transmissions even if received and printed.”108 This definition very plainly excludes faxes and printed e-mails. Nearly everyone can attest to the fact that copies are rarely as crisp as originals. Just as a print of a painting cannot perfectly replicate the color and brushstrokes of the original artwork, a photocopy of a signature fails to capture the tiny nuances that make each autograph unique. Insuring Agreement (E) merely recognizes this basic fact and requires actual physical possession of Originals because banks need “an opportunity to examine them and, it is … hoped, detect forgeries.”109 Another court has also recognized that it is critical for banks to examine the original version of a document before extending funds in reliance on that document.110 The court stated, “we find it ludicrous that the bank, which certainly would not

102 2004 Bond, Anti-Bundling, Section 9. 103 2003 Duke Letter, supra note 19. 104 2011 Bond, Anti-Bundling, Section 9. 105 SFAA Filing Letter for Financial Institution Bond, Standard Form No. 24 (revised Apr. 2004), reprinted in ANNOTATED FINANCIAL INSTITUTION BOND 789 (Michael Keeley, ed., 3rd ed. 2013). 106 2004 Bond, Definitions Section 1(v). 107 2011 Bond, Definitions Section 1(v). 108 2011 Bond, Definitions Section 1(q). 109 BancInsure Inc. v. Marshall Bank, N.A., 400 F. Supp. 2d 1140, 1143 (D. Minn. 2005). 110 Hamilton Bank v. Ins. Co. of N. Am., 557 A.2d 747 (Pa. App. 1989).

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honor a photocopy of a check of nominal value, has the audacity to contend that it is reasonable to lend $1.4 million based upon mere photocopies of duplicate bills of lading.”111

Fortunately, most courts agree that the word “Original” in the context of fidelity bonds excludes reproductions of any type, including faxes.112 As the Eighth Circuit summed it up: “It simply makes no sense to require possession of the original documents, and then state that a facsimile copy has the same effect as the original.”113

Though the definition of “Original” is clear and most courts agree, insureds nonetheless sometimes try to skirt the requirement for reliance on an original. In one recent case, the insured came dangerously close to succeeding. In Bank of Ann Arbor v. Everest National Insurance Company, the Eastern District of Michigan held that an insurer had to cover a loss that a bank incurred when it wired funds based on a forged wire-transfer instruction that was sent by fax.114 In the summary-judgment briefing, the insurer did not make the argument that the bank had relied on a fax, as opposed to an original. The court awarded summary judgment in favor of the insured. But the opinion granting summary judgment to the insured stated, in reciting the facts, that the wire-transfer instruction had been received by facsimile. And the opinion also noted that the bond required reliance on an “Original.”115 Thus, although the opinion did not analyze the issue, it could have been read for the proposition that a fax satisfied the requirement for an “Original.” In a motion for reconsideration, the argument that a fax is not an “Original” was raised.116 The court refused to entertain the argument, however, reasoning that it should have been raised earlier.117 On appeal, the Sixth Circuit also refused to consider the issue of whether a fax was an “Original,” because it had not been properly preserved.118 But fortunately, the Sixth Circuit included language that will bar insureds from relying on the Eastern District of Michigan’s opinion for the proposition that a fax qualifies as an “Original.” The court stated: “the lower court did not rest its holding on the fact that a fax was an Original within the meaning of the Bond.”119 Thus, although the overall result of Bank of Ann Arbor is incorrect, it at least does not undermine the bond’s clear definition of “Original.”

Some bonds do not include the clear definitions of “Written” and “Original” that appear in Standard Form No. 24. As one recent case demonstrated, the absence of a good definition

111 Id. at 751. Of course, today, as most people know, banks are accepting photocopies of checks for deposit. Many large banks now allow customers to make deposits by snapping a photo of a check. But there is often a limit to the amount the customer may deposit via this method. And more importantly, the court’s point remains the same even today: “Originals” are still important in the banking world. And banks that insist on “Originals” for key transactions should certainly require the “Originals” of documents that are relied on in deciding whether to extend bank funds. 112 See, e.g., Marshall Bank, N.A., 453 F.3d at 1076 (faxed copies are not originals); Valley Cmty. Bank v. Progressive Cas. Ins. Co., 854 F. Supp. 2d 697, 706-707 (N.D. Cal. 2012) (electronic PDF versions of account statements are not originals); Highland Bank v. BancInsure, Inc., No. 10-4107 (SRN/AJB), 2012 U.S. Dist. LEXIS 119940, at *7-12 (D. Minn. Aug. 24, 2012) (e-mail copies of guarantees are not originals); Hamilton Bank, 557 A.2d 747 (photocopies of forged bills of lading are not originals). 113 Marshall Bank, 453 F.3d at 1076. 114 Case No. 12-11251, 2013 U.S. Dist. LEXIS 24999 (E.D. Mich. Feb. 25, 2013). 115 Id. at *1, 7. 116 Bank of Ann Arbor v. Everest Nat'l Ins. Co., Case No. 12-11251, 2013 U.S. Dist. LEXIS 65762 (E.D. Mich. May 8, 2013). 117 Id. at *6. 118 Bank of Ann Arbor v. Everest Nat'l Ins. Co., 563 F. App’x 473, 477 (6th Cir. 2014). 119 Id. at 477.

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can have disastrous results.120 In Transportation Alliance Bank, the insured purchased accounts receivable from a third party. The purchase agreement required the third party to provide “electronic account statements” to the insured evidencing the amount of the accounts receivable it was selling. Unbeknownst to the insured, the third party was electronically altering the electronic accounts statements to reflect a higher receivable than actually existed.121 In other words, the insured was being tricked into advancing more cash to the third party than it was actually entitled to receive. The insured was never able to recover the extra amounts it was paying to the third party, and it turned to its insurer for coverage of the loss. The bond provided coverage for loss resulting from the extension of credit on the faith of any original evidence of debt, and required actual physical possession of the instrument relied on. Neither “written” nor “original” was capitalized, and neither was defined. The insurer argued that the electronic accounts receivables were not originals because they were electronic and not in hard copy; it contended that they were the equivalent of photocopies, which are not originals.

The court did not agree. It held that the absence of a definition of “original” was significant. It cited the typical definition of “Original” that appears in standard-form bonds, and stated that, if the insurer had “included this definition of ‘Original’ in the Bond, the electronic account statements … would not be considered ‘originals.’”122 But because this definition was absent, the court refused to draw a distinction between a hard copy and the electronic version of the accounts receivable. It stated: “Indeed, by omitting Form 24 defined terms like ‘Original’ and ‘Written,’ BancInsure allowed for coverage based on electronic information, alterations, and transmissions.”123 The court cited a number of cases (outside the insurance context) in which electronic documents have been treated as equivalent to hard copies. These cases persuaded the court to conclude:

In the absence of a definition to the contrary, electronic transmissions are a way of life and are just as original as a printed, hard copy document that contains the same information. Indeed by omitting [the standard definition of “Original,” the insurer] allowed for coverage based on electronic information, alterations, and transmissions.124

Transportation Alliance Bank’s holding on this point should not be of great concern, since the bond at issue did not include the usual definitions of “Written” and “Original,” and the opinion makes clear that the absence of these definitions was outcome determinative. But the result of the case does not reflect the insurer’s true intent. There is, after all, little purpose in requiring reliance on an original and actual physical possession of that original if the insured can rely on documents it receives electronically. The insurer surely did not have electronic invoices in mind when it drafted the bond.

The case highlights the ever-growing problem that fidelity insurers face: bond language often contemplates paper transactions even though electronic transactions are fast becoming the norm. But the facts of Transportation Alliance Bank demonstrate why insurers may be unwilling to jump feet first into rewriting the bond to cover loss resulting from reliance on

120 Transp. Alliance Bank, Inc. v. Bancinsure, Inc., No. 1:11CV148-DAK-EJF, 2014 U.S. Dist. LEXIS 22187 (D. Utah Feb. 21, 2014). 121 Id. at *9-10. 122 Id. at *22-23. 123 Id. at *26. 124 Id. at *25-26.

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electronic documents. Electronic documents are easily manipulated—more so than paper documents. Reliance on the paper copies of invoices would therefore have been preferable to the electronic statements the insured received. If the third party in the case that was submitting invoices to the insured had paper copies of the invoices, the insured should have insisted on seeing them. And if no physical copies existed, that certainly does not mean that coverage applies. The bond requires that the insured have actual physical possession of a Written Original. If one does not exist, coverage cannot apply to that transaction.

Bonds can be (and are being) written to require different safeguards that would apply to transactions in which pen never touches paper. For example, one recent case interpreted a bond that included coverage for “loss resulting directly from fraudulent instruction through E-mail, Telefacsimile, or Telephonic means … [if] the Insured performed a Callback Verification with respect to such instruction.”125 That bond requires that the insured rely on different safeguards to verify the validity of an instruction received by electronic means: a “Callback Verification.” Bonds like this are becoming more and more prevalent, given that insureds are coming up with other ways (besides carefully examining Written Originals) to protect against forgeries and similar frauds. But Standard Form No. 24 is not there yet. It still contemplates a more formal, and certainly a more physical, transaction than the one at issue in Transportation Alliance Bank.

C. The Types of Acceptable Signatures

In disputes over the term “Original,” even in those cases where the Bond includes the standard definition that clearly excludes photocopies, insurers may face the argument that a photocopy should qualify as an Original because the bond also includes this statement: “A reproduction of a handwritten signature is treated the same as the handwritten signature.” Insureds sometimes contend that if a reproduction of a handwritten signature is treated as a handwritten signature, then a photocopy of a signature will suffice, and the possession of a true, wet-ink Original is unnecessary. This argument is not sound. It assumes that a true Original could never have a reproduced handwritten signature, but that is not the case. An Original could bear a signature made by the type of mechanical arm often used to sign documents in bulk, such as paychecks, or a signature that has been stamped onto the page. Such a document is the first rendering and bears the best possible version of the signature that was available for that document. That is what the Bond requires by including the term “Original”: review of the best available version of a document.

Fortunately, the Eighth Circuit has agreed with this exact reasoning.126 Marshall Bank involved a bond which included the language stating that a “reproduction of a handwritten signature is treated the same as the handwritten signature.”127 The insured relied on this language in arguing that the court “ought to read the bond to treat faxed copies of the guarantees as if they were originals, and accordingly, to hold that its possession of the faxed guarantees satisfied the bond.”128 The court could not be fooled. It reasoned that the sentence providing that a reproduced signature is treated the same as a handwritten signature “speaks to what type of signature is acceptable . . . [but does not] except the bank from maintaining

125 SB1 Federal Credit Union v. Finsecure LLC, 14 F. Supp. 3d 651 (E.D. Pa. Apr. 8, 2014). 126 BancInsure, Inc. v. Marshall Bank, N.A., 453 F.3d 1073, 1076 (8th Cir. 2006). 127 Id. 128 Id.

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actual physical possession of the original.”129 In other words, the standard-form bond permits the Bank to review whatever handwritten signature—reproduced or not—appears on a true Original: the first rendering or archetype of the document. But it does not permit reliance on photocopies, faxes, PDFs, or any other reproduction of the first rendering of the document.

Note that the standard-form bond also includes the following statement about reproduced signatures: “An electronic or digital signature is not treated as a reproduction of a handwritten signature.” This languages makes clear that the common “/s/” followed by the signer’s name does not suffice, nor does a scanned-in signature that is copied and pasted. This is good common sense on the part of the bond drafters. Forging someone’s signature by hand is far more difficult (and therefore less likely to happen) than typing “/s/” into a computer or scanning in someone’s signature and copying it into the document being manipulated. In the future, bond drafters may have to come up with a method of detecting forgeries other than examining original signatures, because electronic signatures are, after all, quickly becoming acceptable.130 But as long as original signatures continue to be valued in the banking world—which is still the case today—requiring reliance on an actual signature and not an electronic signature is the best practice for banks, and the only practice that will lead to coverage under Insuring Agreement (E) of standard-form bonds.

Put simply, even in the lightning pace of today’s culture, true originals remain valuable. The methods of transacting business are surely changing, but they have not yet changed so much that originals are completely outdated. Original signatures are still used in the most important business deals, and banks still frequently rely on them. Insuring Agreement (E) in standard-form fidelity bonds merely recognizes this by requiring Banks to examine actual signatures on actual paper—the best available version of those signatures—before transferring money or property. Banks may certainly choose to conduct business without this safeguard. And insurers are beginning to offer bonds specifically aimed at accommodating these new practices. But the standard-form fidelity bond continues to require that the insured rely on an actual “Original.” Insureds cannot evade that requirement by decrying the bonds as outdated or citing language meant to accommodate mechanically reproduced wet-ink signatures. The bond’s language is clear. And as long as the standard definition of “Written” and “Original” is included in the bond, faxes, e-mails, PDFs, snapshots taken with a camera phone, and photocopies do not make the cut.

D. “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.131 Previously, Insuring Agreement (E), like the other insuring

129 Id. 130 See 15 U.S.C. § 7001(a) (providing that electronic signatures are acceptable in transactions affecting interstate and international commerce). 131 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

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agreements in the Financial Institution Bond, required merely a “loss through” a covered event or transaction.132 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[.]”133 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 concepts of causation to the bond’s loss-causation requirements.134

Tort-causation standards, like proximate causation, but-for causation, and substantial-factor causation are inappropriate in a contractual setting. The Seventh Circuit Court of Appeals agreed:

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.’135

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[.]136

It is for these reasons that the Financial Institution Bond should be interpreted according to its plain and ordinary meaning.137 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

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). 132 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)). 133 Beach Cmty. Bank v. St. Paul Mercury Ins. Co., 635 F.3d 1190, 1194 (11th Cir. 2011). 134 First State Bank of Monticello, 555 F.3d at 570 (citing Carver, supra note 132). 135 Id. (quoting Palsgraf v. Long Island R.R., 162 N.E. 99, 103 (N.Y. 1928) (Andrews, J., dissenting)). 136 Id. 137 Id. (citing RBC Mortg. Co. v. Nat’l Union Fire Ins. Co., 812 N.E.2d 728, 736-37 (Ill. App. Ct. 2004)).

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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.138

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.139

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:140

[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.”141

Fidelity insurers would shudder to think that this type of “but-for” causation would apply to their policies. Yet, “inventive” insureds have made exactly this type of argument.142 For example, in Continental Corp. v. Aetna Casualty & Surety Co.,143 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.144 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[.]”145 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 lead—very indirectly—to losses.

138 Bird v. St. Paul Fire & Marine Ins. Co., 120 N.E. 86, 87 (N.Y. 1918). 139 See John w. Hinchey, Loss and Causation, in ANNOTATED BANKERS BLANKET BOND, FIRST SUPPLEMENT, at 5-6 (Frank L. Skillern, Jr. ed. 1983). 140 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). 141 Id. at 630. 142 See Cont’l Corp. v. Aetna Cas. & Sur. Co., 892 F.2d 540, 546-48 (7th Cir. 1989). 143 Id. at 548. 144 Id. 145 Id. at 548-49.

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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.146 While cause in fact relates to the chain of events culminating in a loss, the proximate cause concept ostensibly narrows the scope of a tortfeasor’s legal responsibility by requiring something more.147

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.148 Courts that have applied this standard to Financial Institution Bond claims, such as the Kentucky district court did in FDIC v. Reliance Insurance Corp.,149 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.150 As noted by the court in Auto Lenders Acceptance Corp. v. Gentilini Ford, Inc.,151 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.152 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.”153

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.”154 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.”155 Again, while appropriate in measuring the effect of a tortfeasor’s conduct, proximate cause has no legitimate use in the law of contracts.

The court in FDIC v. Reliance Insurance Corp.,156 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

146 Dan B. Dobbs, THE LAW OF TORTS 405 (West. Group 2000). 147 Id. at 407. 148 Hanson PLC v. Nat’l Union Fire Ins. Co.,794 P.2d 66, 73 (Wash. Ct. App. 1990). 149 716 F. Supp. 1001, 1004 (E.D. Ky. 1989). 150 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) (holding that 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). 151 816 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). 152 John Alan Appleman & Jean Appleman, 5 INS. LAW. & PRAC. § 3083, at 307-308 (1970). 153 Id. 154 22 Am. Jur. 2d Damages § 477. 155 Dobbs, supra note 146, at 408. 156 716 F. Supp. at 1004.

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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.157

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 law are irrelevant. Rather, principles of contract interpretation determine the scope of the parties’ liability for damages based upon their stated intentions.158 Contract damages simply flow from the intention of the parties at the time their agreement was made.159 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.160

Additionally, the doctrine of foreseeable consequences limits the scope of a party’s liability for contractual damages.161 “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.”162 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[.]”163 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 foreseeable, at the time the contract was made, as likely to result if the contract were broken.164

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

157 See First State Bank of Monticello v. Ohio Cas. Ins. Co.¸ 555 F.3d 564, 570 (7th Cir. 2009). 158 Spearman Indus., Inc. v. St. Paul Fire & Marine Ins. Co., 138 F. Supp. 2d 1088, 1101 (N.D. Ill. 2001). 159 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). 160 RESTATEMENT (SECOND) OF CONTRACTS § 346, cmt. (a) (1979). 161 See Vanderbeek v. Vernon Corp., 50 P.3d 866, 782-73 (Colo. 2002) (discussing foreseeability as element of contract measure of damages). 162 RESTATEMENT (SECOND) OF CONTRACTs § 351 (1) (1981). 163 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”). 164 Samuel Williston, 24 TREATISE ON THE LAW OF CONTRACTS § 64.13 (4th ed. 1990).

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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.”165 Ultimately, “[d]amages which are not foreign to the purpose of the contract . . . should be awarded.”166

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.167 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,168 without any intervening cause,169 from a covered risk that the insured itself170 sustains.

E. The Good-Faith Requirement

Insuring Agreement (E) also imposes a requirement on insureds that they act in “good faith.” This requirement is separate from the requirement that the insured rely on the faith of the document itself, a requirement that is addressed below.171 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.”172

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

165 22 AM. JUR. 2d DAMAGES § 460. 166 Id.; see also Williston, supra note 164 at § 64.13 (4th ed. 1990). 167 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”). 168 See., e.g., Lynch Props., Inc. v. Potomac Ins. Co., 962 F. Supp. 956, 961-62 (N.D. Tex. 1996). 169 See, e.g., Auto Lenders Acceptance Corp. v. Gentilini Ford, Inc., 816 A.2d 1068, 1072-73 (N.J. Sup. Ct. App. Div. 2003). 170 Firemans Fund Ins. Co. v Special Olympics Int’l, Inc., 249 F. Supp. 2d 19, 28 (D. Mass. 2003). 171 U.S. Nat’l Bank v. Reliance Ins. Co., 501 A.2d 283, 284-85 (Penn. 1985). 172 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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requirement, it nevertheless is instructive. Indeed, it is well settled that the standard-form bond is not a form of credit insurance.173

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.174

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.175 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 only in those cases where the customer owns such shares, that the financial institution cannot prevent a loss through reasonable investigation and verification procedures.176

In National City Bank v. St. Paul Fire & Marine Insurance. Co.,177 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.178

The leading case on what constitutes “good faith” is Marsh Investment Corp. v. Langford.179 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.180 The

173 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). 174 BLACK’S LAW DICTIONARY 713 (8th ed. 2004) (emphasis added). 175 See Liberty Nat’l Bank v. Aetna Life & Cas. Co., 568 F. Supp. 860, 865-67 (D.N.J. 1983). 176 Mark W. Bean, Insurance Agreement E - An Analysis Of Recent Cases Interpreting What Is A Counterfeit Or Forgery, 17 (1991). 177 447 N.W.2d at 174. 178 Id. at 179. 179 554 F. Supp. 800 (E.D. La. 1982). 180 Id. at 801.

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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.181 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 . . . .”182 At trial, a representative for the bank testified that the disclaimer “concerned [the bank] and made [it] suspicious.”183 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[.]”184

On appeal, the Fifth Circuit interpreted Insuring Agreement (E)’s use of “good faith” in terms of what does not constitute “bad faith.”185 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.”186 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).187

Similarly, in Republic National Bank,188 the Eleventh Circuit noted that an insurer must show that the insured acted fraudulently or with bad faith before it could properly deny coverage under the good faith requirement.

But 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.”189 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.190 Similarly, the Florida Supreme Court

181 Id. 182 Id. at 801-02. 183 Id. at 802. 184 Id. at 805. 185 Marsh Investment Corp. v. Langford, 721 F.2d 1011, 1014 (5th Cir. 1983). 186 Id. (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”). 187 Id. 188 See Republic Nat’l Bank of Miami v. Fid. & Deposit Co. of Md., 894 F.2d 1255, 1264 (11th Cir. 1990). 189 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). 190 First Nat’l Bank of Fort Walton Beach v. U.S. Fid. & Guar. Co., 416 F.2d 52, 57 (5th Cir. 1969).

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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.191

And, in First National Bank of Manitowoc v. Cincinnati Insurance Co.,192 the bank extended a line of credit to a used car dealership based upon receipt of car leases purportedly signed by customers.193 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.194 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.”195 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 amounts to fraud or bad faith.196 The Seventh Circuit also found that the phrase “in the usual course of business” does not impose a particular standard of conduct.197 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.198 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[.]”199

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.”200 The UCC defines “good faith” as “honesty in fact in the conduct or transaction concerned.”201 This definition is subjective and has been referred to as “the old white heart and empty head standard.”202 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.

191 Dixie Nat’l Bank of Dade Cnty. v. Emp’rs Commercial Union Ins. Co. of Am., 463 So. 2d 1147, 1152 (Fla. 1985). 192 485 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. 193 Id. at 974. 194 Id. at 977-78. 195 Id. at 978. 196 Id. 197 Id. 198 Id. 199 Id. at 979 (internal quotations omitted). 200 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”). 201 U.C.C. § 1-201(19). 202 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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F. 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.” The bond does not define the term “on the faith of.” A plain reading, however, requires some reliance on the document.203 Indeed, where reliance cannot be shown, courts have refused to find coverage for forged documents under Insuring Agreement (E).204 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.205 But 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).206 For instance, in Bank of Bozeman v. Bancinsure, Inc.,207 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.208 Rather, the court noted, the insured’s reliance amounted to “an act of blind faith, not good faith.”209

G. “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,210 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.211 But 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.212 And, as a result, the insured “did not have the forged documents in its physical possession at the time it purportedly acted in reliance upon them.”213 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

203 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’”). 204 See, e.g., Republic Nat’l Bank of Miami, 894 F.2d at 1262. 205 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). 206 Republic Nat’l Bank of Miami, 894 F.2d at 1262. 207 404 F. App’x 117, 119 (9th Cir. 2010). 208 Id. 209 Id. 210 Id. 211 Id. at 1261. 212 Id. at 1262. 213 Id.

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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[.]214

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.”215 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.216

The authorized representative requirement in Insuring Agreement (E) is based upon agency principles.217 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 practices.218 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.”219 “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.220 Conversely, “dry” funding occurs when the lender funds the loan only after it receives original, signed loan documents.221 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.222 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 court to find

214 Id. at 1264. 215 1986 Bond, Insuring Agreement (E)(3). 216 Id. 217 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”). 218 Bank of Bozeman, 404 F. App’x at 119 (citing McKnight v. Torres, 563 F.3d 890, 893 (9th Cir. 2009)). 219 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). 220 Id. at 6. 221 Id. 222 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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that a borrower was the agent of its lender, as the parties ostensibly are involved in an arms-length transaction.223

For example, in Citizens Bank of Oregon v. American Insurance Co.,224 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.225 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.226 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.227 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).228 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.229 In addition, principles of agency hold that once the agent breaches a duty to its principal, the person or entity is no longer the principal’s agent and has no authority to act on the principal’s behalf.230

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. In 2004, the SFAA revised the standard-form bond again to make even clearer the proper coverage available under Insuring Agreement (E). Further revisions in 2011 served to clarify several other dangling issues. The 2004 and 2011 versions of the Bond have made strides toward precluding coverage when the insured relies on a purely electronic document. Though this issue is only one of many that arise under Insuring Agreement (E), it has become more prevalent over time, and there is every reason to expect that this trend will continue. Though business practices may eventually change so much that reliance on a true written original will become impractical, that day has not yet arrived. As of today, old-fashioned wet-ink signatures are still required in many transactions, and it behooves banks to review the best available version of those signatures. Moreover, electronic documents are, at least for now, more easily manipulated than a paper document. Until technological advances make it at least as difficult to manipulate online documents as it would be to manipulate a paper document,

223 See Resolution Trust Corp. v. Aetna Cas. & Sur. Co., 831 F. Supp. 610, 618 (N.D. Ill. 1993). 224 289 F. Supp. 211 (D. Or. 1968). 225 Id. at 212. 226 Id. 227 Id. 228 Id. at 213. 229 Id. 230 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)).

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critical transactions will likely still be completed with paper and pen. And the Bond will take that into account by requiring examination of true written originals.