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The Fidelity

Law Journal

published by

The Fidelity Law Association

Volume XIX, November 2013

Editor-in-Chief Michael Keeley

Associate Editors Jeremy T. Brown

Adam P. Friedman Jeffrey S. Price

Scott L. Schmookler

Cite as XIX Fid. L.J. ___ (2013)

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THE FIDELITY LAW ASSOCIATION

President Michael Retelle, CUMIS

Vice President Vacant

Secretary Dolores Parr, Zurich

Treasurer Robert Olausen, Insurance Services Office, Inc.

Executive Committee Timothy Markey, CNA Tracey Santor, Travelers Mark Struthers, CUMIS

Michael V. Branley, The Hartford

Advisors Michael Davisson, Sedgwick, Detert, Moran & Arnold CharCretia V. Di Bartolo, Hinshaw & Culbertson LLP

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

Bernard L. Balkin, Gilliland & Hayes, PC Robert Briganti, Belle Mead Claims Service, Inc.

Michael Keeley, Strasburger & Price, LLP Harvey C. Koch, Montgomery Barnett, LLP

Armen Shahinian, Wolff & Samson PC

The Fidelity Law Journal is published annually. Additional copies may be purchased by writing to: The Fidelity Law Association, c/o Wolff & Samson PC, One Boland Drive, West Orange, New Jersey 07052. The opinions and views expressed in the articles in this Journal are solely of the authors and do not necessarily reflect the views of the Fidelity Law Association or its members, nor of the authors’ firms or companies. Publication should not be deemed an endorsement by the Fidelity Law Association or its members, or the authors’ firms or companies, of any views or positions contained herein. The articles herein are for general informational purposes only. None of the information in the articles constitutes legal advice, nor is it intended to create any attorney-client relationship between the reader and any of the authors. The reader should not act or rely upon the information in this Journal concerning the meaning, interpretation, or effect of any particular contractual language or the resolution of any particular demand, claim, or suit without seeking the advice of your own attorney.

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

Copyright © 2013 Fidelity Law Association. All rights reserved. Printed in the USA. For additional information concerning the Fidelity Law Association or the Journal, please visit our website at http://www.fidelitylaw.org.

Information which is copyrighted by and proprietary to Insurance Services Office, Inc. (“ISO Material”) is included in this publication. Use of the ISO Material is limited to ISO Participating Insurers and their Authorized Representatives. Use by ISO Participating Insurers is limited to use in those jurisdictions for which the insurer has an appropriate participation with ISO. Use of the ISO Material by Authorized Representatives is limited to use solely on behalf of one or more ISO Participating Insurers.

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CharCretia V. Di Bartolo is a partner with Hinshaw & Culbertson LLP in Boston, Massachusetts. John J. Tomaine is the sole member of John J. Tomaine LLC in Mountainside, New Jersey. 53

INDIRECT LENDING: IT’S NOT PERSONAL, IT’S JUST BUSINESS

CharCretia V. Di Bartolo John J. Tomaine

“That which ordinary men are fit for, I am qualified in, and the best of me is diligence.”

King Lear William Shakespeare

I. INTRODUCTION

With the 2007-08 recession fading, automobile buyers have returned to the market1 and automobile sales and thus automobile loans are on the rise.2 With this increase comes a renewed concern regarding indirect loans, or loans which do not originate with the lender, and the attendant risks to financial institutions involved with such programs.

1 Bill Vlasic, March Auto Sales Increased 3.4% for Highest Total Since

2007, N.Y. TIMES, Apr. 2, 2013, http://www.nytimes.com/2013/04/03/business/ car-sales-keep-up-their-streak.html (based on sales of 1.45 million vehicles in March 2013, the best monthly performance since 2007, car executives and analysts predict sales for entire year at more than 15 million vehicles); see also David Mielach, At Auto Show, Car Makers Put Recession in Rear-View Mirrors, BUS. NEWS DAILY, Apr. 3, 2013, http://www.businessnewsdaily.com/4270-recession-auto-industry-retool.html.

2 Michelle A. Samaad, Credit Union Auto Loans Reach Two Post-Recession Milestones, CREDIT UNION TIMES, Sept. 17, 2012, http://www.cutimes .com/2012/09/17/credit-union-auto-loans-reach-two-post-recession-m (annual growth for credit union auto lending activity reached 5% and new vehicle portfolio growth turned positive on a year-over-year basis for first time in almost five years).

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54 Fidelity Law Journal, Vol. XIX, November 2013

While these programs can provide significant revenue to the financial institutions that offer them, strict lending guidelines and diligence in implementation and monitoring are necessary to achieve success and prevent fraud. This article will provide some background about indirect lending and the parties typically involved in these programs, and will discuss potential coverage issues that may arise under a fidelity bond as well as the few court opinions addressing the topic.

II. THE RISKS AND REWARDS OF INDIRECT LENDING

In general, “indirect lending” means financing arranged through a dealer or other third-party vendor rather than directly through a financial institution. The dealer initially makes the loan and then immediately sells the loan to a bank, credit union, or other finance company that has approved the buyer’s credit before the loan is made.3 Arrangements between the dealer and lender often pre-exist the borrower’s contact with the dealer so that the dealer can quickly obtain approval of the loan and better service the customer. In theory, everyone wins; the buyer gets the car or mobile home, the dealer makes the sale, and the credit union gains a member. The existence of the intermediary between the lender and the borrower, however, creates the opportunity for fraud, particularly where dealers shop the borrower to several lenders, often with strict time pressures on the lenders to accept the loan or pass.

Edison Fund v. Cogent Investment Strategies Fund, Ltd.4 offers a glimpse of the risks involved in the business of indirect lending. At issue in Edison Fund were alleged misrepresentations by fund managers surrounding the quality of investments in a portfolio of sub-prime automobile finance loans where credit unions were the lenders. The investors sought significant damages from the fund managers, alleging that the managers failed to advise or address the risks attendant to these types of loans.

3 What is the Difference Between Dealer-Arranged and Bank

Financing?, CONSUMER FINANCIAL Protection BUREAU (June 11, 2013), http://www.consumerfinance.gov/askcfpb/759/what-difference-between-dealer-arranged-and-bank-financing.html.

4 551 F. Supp. 2d 210 (S.D.N.Y. 2008).

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Indirect Lending: It’s Not Personal, It’s Just Business 55

The court’s opinion refers to certain communications by the National Credit Union Administration5 which identified causes for concern about indirect lending.6 NCUA issued a letter in September 2004 to federally-insured credit unions, in which it addressed the “alternative lending arrangements” of “sub-prime lending, indirect lending and outsourced lending relationships.”7 The letter described indirect lending as “an arrangement where a credit union contracts with a merchant to originate loans at the point of sale (e.g., an auto dealer)”8 and provided a brief description of the transformative effect indirect lending can make. “An indirect lending program can lead to rapid growth, changing the structure and risk profile of a credit union’s balance sheet quickly.”9 The NCUA went on to prescribe actions credit unions should take in the face of these effects.

According to the NCUA, a credit union should periodically review its approved dealers to ensure that they meet certain standards, such as reputation, experience, and financial condition.10 Periodic review of approved dealers will ensure that the dealer is not using excessive sales pressure on the borrower to increase its sales volume, which could result in lower credit quality for the loans presented to the credit union. Ongoing review and monitoring of individual dealer loan statistics ensures the dealer’s compliance with credit union credit criteria.11

Written contracts should be in place addressing, at minimum, dealer compensation, credit criteria, documentation standards, and dealer reserves. A dealer reserve account is controlled by the credit union and provides for charging back nonperforming loans to the dealer under

5 Hereinafter NCUA. 6 Id. at 219. The NCUA regulates federally-chartered and federally-

insured credit unions. Federal Credit Union Act, 12 U.S.C. §§ 1751-1795k. 7 Letter from National Credit Union Administration to Credit Unions,

Letter No. 04-CU-13 (Sept. 2004), http://www.ncua.gov/Resources/Documents/ LCU2004-13.pdf.

8 Id. at 2. 9 Id. 10 Id. 11 Id.

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certain conditions.12 Credit unions were encouraged to be active and discerning in an ongoing effort to mitigate risk as a balance against the rapid acquisition of new business and customers derived from sources external to them.13

The Edison Fund decision also references additional guidance provided by the NCUA in the form of a Risk Alert.14 The Risk Alert noted that there had been a “sharp increase” in, among other things, indirect lending since 2004 and an accompanying increased concern on the part of the NCUA that effective controls over that activity had not been instituted.15

Similarly, in 1994, the now defunct Office of Thrift Supervision16 provided background and guidance regarding the risks and required safety considerations for financial institutions involved with indirect lending programs. In its Examination Handbook, the OTS noted that indirect loans are initially granted to purchasers of retail products by the seller. The institution then purchases the loans from the seller on either a recourse or nonrecourse basis.17 The difference turns on the lender’s desire to require the dealer to repurchase the loan or to compensate the lender for nonpayment of loans. An agreement to acquire loans on a recourse or nonrecourse basis depends upon the degree of certainty on the part of the lender concerning such matters as

12 Id. 13 Id. 14 Edison Fund, 551 F. Supp. 2d at 219. 15 NCUA Risk Alert, No. 05-RISK-01 (June 2005), http://www.ncua.

gov/Resources/Documents/Risk/RSK2005-01.pdf. 16 Hereinafter OTS. The OTS was established under the Financial

Institutions Reform and Recovery and Enforcement Act of 1989, 12 U.S.C. § 1811, in the aftermath of the savings and loan crisis of the 1980s to regulate state and federal savings and loan holding companies. Robert Cooper, The Office of Thrift Supervision, 59 FORDHAM L. REV. S363, S365 (1991). In 2010, the Dodd-Frank Act abolished the OTS and transferred its powers to the Office of Controller of the Currency, the Federal Deposit Insurance Corporation, and the Federal Reserve, with the latter acquiring authority over savings and loan holding companies. See 12 U.S.C. §§ 5412, 5413.

17 OFFICE OF THRIFT SUPERVISION, EXAMINATION HANDBOOK 216.4

(1994), http://www.occ.gov/static/news-issuances/ots/exam-handbook/ots-exam-handbook-216.pdf.

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the dealer’s reliability, the dealer’s profitability as the result of participating in an indirect lending program, and the dealer’s established record of adhering to the lender’s underwriting requirements.18

The OTS provided specific guidance regarding approving a dealer for indirect lending:

Thrifts should do business with dealers only after formal approval by board of directors. Dealer approval should be based on careful analysis of the dealership and should include review of at least the following documents:

Dealer Loan Application. The application should show the locations of all of the sales and storage lots operated by the dealer as well as the dealer’s primary business address. It should name all manufacturers supplying the dealer and include a general description of the type and process ranges of units the dealer sells . . . . The applications should also state whether the dealer is willing to sign repurchase agreements in favor of the institution. Terms of a manufacturer’s or supplier’s buy-back or repurchase agreement should be provided. The application should name all persons having a proprietary interest in the dealership and state the amount of that interest in terms of percentage of the whole.

Balance Sheet. A current balance sheet of the dealership, certified to be true and accurate, and signed by the dealer should be reviewed. A statement dated not earlier than the last business day of the preceding month is considered current. Financial statements of any guarantors should be reviewed.

Profit and Loss Statement. A profit and loss statement for the last fiscal year, supplemented by a similar statement for the months since the close of that year should be reviewed. To ensure that a dealer maintains high financial standards, current balance sheets and

18 See id.

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profit and loss statements should be obtained at least every month. These monthly statements should be reviewed by senior officers.

Credit Report. Written credit reports on the dealer and principals from a recognized credit reporting agency should be reviewed.

On-Site Review of Dealer Operations. An officer should prepare a written report of sales and inventory areas and the accounting system.

The purpose of the board’s reviewing the above items is to ensure that thrifts limit their relationships to dealers who show sufficient financial strength to maintain a viable dealer operation, as well as sound business ethics, integrity, and common sense. This will be reflected in the quality of the assets originated through individual dealers.19

The integrity and financial soundness of the dealer in the dealer-lender relationship is critical. The absence of either one may pose risks for the lender. Santander Consumer USA, Inc. v. Manheim Automotive Financial Services, Inc.20 provides an example of this interplay. Although the decision involved only a procedural issue, the underlying facts are instructive. In Santander, the plaintiff engaged in indirect lending with automobile dealerships and relied on the dealers to sell cars to their customers on credit. The dealers subsequently sold their rights to receive payment from the sales to the plaintiff.21 Two of the dealers purchased their vehicles under a floor-plan arrangement with the defendant, pursuant to which the defendant held possession of the certificates of title to vehicles pending repayment of the loan as to each vehicle.22 The dealers were contractually obligated to note the plaintiff’s security interest on the certificates of title before conveying title to the purchasers. When the dealers defaulted on their loans to the defendant,

19 Id. at 216.6 (emphasis added). 20 652 F. Supp. 2d 805 (W.D. Tex. 2009). 21 Id. at 807. 22 See id.

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the latter refused to release the titles to the vehicles covered by the loans in default. The plaintiff resorted to filing a declaratory judgment action seeking a determination that it had a priority interest in the vehicles.23 A program of continuous monitoring of the dealers’ financial condition may have assisted in averting such an incident.

Another exposure to lenders engaging in indirect lending may arise from their use of third-party vendors to provide various services, such as originating and servicing the loans. The risk that a third-party vendor may engage in fraud against a lender is known as a “transaction risk.”24 While the third-party vendor may bring expertise and capacity to assist the lender to achieve its indirect lending goals, the arrangement lessens the lender’s direct control over that aspect of its business. This means that the lender’s oversight of indirect lending must exist at a higher level than if the delegated processes were kept in-house. The FDIC maintains that there are four elements to governing third-party relationships:

1. Risk Assessment—The process of assessing risks and options for controlling third-party arrangements.

2. Due Diligence in Selecting a Third Party—The process of selecting a qualified entity to implement the activity or program.

3. Contract Structuring and Review—The process of ensuring that the specific expectations and obligations of both the institution and the third party are outlined in a written contract prior to entering into the arrangement—a contract should act as a map to the relationship and define its structure.

4. Oversight—The process of reviewing the operational and financial performance of third-party activities over those products and services performed

23 Id. at 808. 24 FEDERAL DEPOSIT INSURANCE CORPORATION, COMPLIANCE

EXAMINATION MANUAL VII-4.3 (2013), http://www.fdic.gov/regulations/ compliance/manual/pdf/VII-4.1.pdf.

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through third-party arrangements on an ongoing basis, to ensure that the third party meets and can continue to meet the terms of the contractual arrangement.25

The Federal Credit Union Act invests credit union boards with the responsibility to determine interest rates, the security required and maximum amount of a loan,26 and to establish lending policies.27 It would be an abrogation of that responsibility to allocate that responsibility to a third party.28 The reason credit unions enter into arrangements with third parties to perform functions related to indirect lending is that the credit union may lack the experience, staffing, and equipment to undertake the function.29 However, the credit union must then acquire the skill and acumen to monitor and control the third party’s conduct to mitigate the risk attendant to all such arrangements.30

A particular type of third-party vendor to which credit unions may resort is a Credit Union Service Organization.31 The Federal Credit Union Act defines a CUSO as “any organization as determined by the Board, which is established to serve the needs of its member credit unions, and whose business relates to the daily operation of the credit unions they serve.”32 A credit union may invest up to “1 per centum of the total paid in and unimpaired capital and surplus of the credit union with the approval of the Board”.33 The relationship between federal credit unions and CUSO is governed by the Code of Federal

25 Id. at VII-4.4. 26 12 U.S.C. § 1761(b)(8). 27 12 U.S.C. § 1761(b)(20). 28 NCUA Risk Alert, supra note 15, at 4. 29 Supervisory Letter from National Credit Union Administration,

Supervisory Letter No. 07-01 at 8 (Oct. 2007), http://www.ncua.gov/Resources/ Documents/LCU2007-13enc.pdf.

30 See id. 31 Hereinafter CUSO. Letter from National Credit Union

Administration, Letter No. 10-CU-15 (Aug. 2010), http://www.ncua.gov/ Resources/Documents/CU-2010-15.pdf.

32 12 U.S.C. § 1757(5)(D). 33 12 U.S.C. § 1757(4). The “Board” is the NCUA Board.

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Regulation.34 There may be concurrent jurisdiction regarding the regulation of CUSO and federally insured, state chartered credit unions.35

Indirect lending prevails because of the prospects for gain for the parties involved—the dealer, the purchaser, and the lender. Among the cohort of buyers who borrow to consummate the agreement with a dealer, there is a tendency to believe that banks have higher standards when it comes to offering credit, but do so at lower rates.36 But instead of running the risk of being rejected by a bank, the buyer will resort to obtaining credit from the dealer for the purchase.37 Buyers then allocate more time seeking out a dealer rather than a lender “where they can arrange the credit contract while they shop.”38 With indirect lending, the lender incurs less cost in screening since it is presumed the higher-risk borrowers will gravitate to the dealer, while concurrently expanding its customer base.39 For credit unions engaged in indirect lending, enlargement of their customer base is assured by the requirement that they may only lend to members.40

The Consumer Financial Protection Bureau41 was created under the Dodd-Frank Act for the purpose of protecting consumers when engaging in financial transactions.42 The CFPB described indirect lending in the context of automobile financing where:

the dealer usually collects the basic information regarding the applicant and uses an automated system to forward that information to several prospective indirect auto lenders. After evaluating the applicant, indirect auto lenders may choose not to become involved in the

34 12 C.F.R § 712. 35 12 C.F.R. § 712(d)(3) and (e). 36 Michael E. Staten, Otis W. Gilley & John Umbeck, Information

Costs and the Organization of Credit Markets: A Theory of Indirect Lending, 28 ECONOMIC INQUIRY 508, 520 (1990).

37 Id. at 517. 38 See id. 39 Staten, et al., supra note 36, at 527. 40 12 U.S.C. § 1757(5). 41 Hereinafter CFPB. 42 12 U.S.C. § 5511 (a), (b).

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transaction or they may choose to provide the dealer with a risk-based “buy rate” that establishes a minimum interest rate at which the lender is willing to purchase the retail installment contract executed by the consumer for the purchase of the automobile. 43

The dealer and the lender may agree that the dealer will be permitted to mark up the interest that is charged to the buyer/borrower above the “buy rate.” The amount of mark-up may be used to fund the dealer’s reserve account.44

There are various factors that account for the risks to lenders that engage in indirect lending. In the distance between the lender and the origination of the loan, including the functioning of a third party on behalf of the lender, is the space wherein the opportunity lies for fraud to occur. The presumed target of the fraud will be the lender, the party advancing the money to fund the underlying transaction.45 In return for being provided with an easier way toward growing its business come the additional burdens of acquiring the skills and expending the effort to prevent loss.

III. COVERAGE ISSUES

Given the varying levels of oversight that can exist in an indirect lending program, coverage claims involving these programs are factually intense and require significant investigation into how the programs are run and how the insured and its employees are involved in underwriting and review of the loans. A program in which a financial institution simply sets a risk-based “buy-rate” without further guidelines and

43 Bulletin, Consumer Financial Protection Bureau, Indirect Auto

Lending and Compliance with the Equal Credit Opportunity Act, Bulletin No. 2013-02 (Mar. 21, 2013), http://files.consumerfinance.gov/f/201303_cfpb_ march_-Auto-Finance-Bulletin.pdf.

44 See id. 45 Dealers also are subject to fraud from within by their own

salespeople or a credit manager in an indirect lending scenario. Cases discussing such fraud, and the coverage claims generated by those schemes, are discussed in Section III.B., infra.

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employee involvement in screening and approving loans presents issues for coverage because the insured likely will be unable to show the requisite direct connection between the loss and the insured’s own policies or employees. The amount that insureds stand to lose when one of these programs goes badly, as demonstrated by the cases discussed below, can be significant. Insureds, therefore, are likely to press forward with a claim, even in the face of significant factual hurdles.

The following sections will discuss issues that may arise in a claim involving an indirect lending loss and the few published fidelity cases that have involved these programs. In addition, because indirect lending is, in the end, simply another type of loan program, the final section will discuss some general issues that arise in coverage claims involving loans and how those generic issues may be affected by the idiosyncrasies of an indirect lending program.

A. Faithful Performance Insuring Agreement

1. The Insuring Agreement and Relevant Definitions and Exclusions

Generally, faithful performance coverage in credit union bonds is intended to provide coverage for a specific peril, that is, to cover losses directly resulting from a credit union employee’s conscious disregard of an established and enforced lending policy. One example46 of this coverage provides: “We will pay you for your loss of covered property resulting directly from a named employee’s failure to faithfully perform his/her trust.”47 The bond defines “failure to faithfully perform his/her trust” as

46 Unlike other fidelity coverages, such as the standard form Financial

Institution Bond (Standard Form No. 24), there is no standardized industry form for faithful performance coverage. Rather, the carriers that write this coverage do so using their own proprietary forms, which are approved by the NCUA. The NCUA maintains a list of pre-approved forms on its website at http://www.ncua. gov/Resources/CUs/Pages/CU-Bonds-aspx.

47 This coverage form was at issue in Michigan First Credit Union v. CUMIS Society, Inc., 641 F.3d 240 (6th Cir. 2011), discussed infra at Section III.A.(2).

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acting in conscious disregard of your established and enforced share, deposit or lending policies.

Failure to faithfully perform his/her trust does not mean:

a. Negligence, mistakes or oversights; or

b. Acts or omissions resulting from inadequate training; or

c. Unintentional violation of laws or regulations; or

d. Unintentional violation of your polices or procedures; or

e. Acts or omissions known to, acquiesced in or ratified by your Board of Directors; or

f. Acts of an “employee” for which you could have made claim under Employee Or Director Dishonesty Coverage.48

As the following cases will demonstrate, whether an employee’s conduct crosses the line from negligence to intentional disregard of corporate policies in the context of an indirect lending program is not always easy to discern.

2. Relevant Cases

There are a limited number of reported and unreported cases that deal directly with coverage issues in indirect lending scenarios. Given that auto lending is a significant part of the credit union portfolio,49 and that indirect auto financing is a popular means of lending to these

48 Id. 49 Nationally, auto loans account for 29% of credit union loans

outstanding, representing $166 billion in the third quarter of 2011. Successful Indirect Auto Lending Progress Builds on Credit Union Strengths in Relationship and Portfolio Management, CREDIT UNION DIRECT CORPORATION 1 (2012), https://www.cuany.org/access_files/ CUDL_white_paper_2012.pdf.

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consumers,50 it should come as no surprise that the most significant coverage cases involve indirect lending programs for automobile loans run through credit unions.

The following cases are instructive on several levels. They demonstrate the significant potential losses that can be incurred by insureds, and potentially their fidelity carriers, from an indirect lending program gone awry. They also highlight the intense factual nature of these claims and the need to explore in great detail the lender’s underwriting and monitoring of the loans in question. Both cases turn on the fact finder’s review of the lender’s policy regarding acceptance and monitoring of loans received from dealers as well as the collateral backing the loans and training of the employees charged with such monitoring.

a. Michigan First Credit Union v. CUMIS Insurance Society, Inc.

In Michigan First Credit Union v. CUMIS Insurance Society, Inc.,51 Michigan First Credit Union52 sued its fidelity insurer, CUMIS Insurance Society, asserting that CUMIS wrongfully denied its fidelity bond claim. The Sixth Circuit upheld a jury verdict in favor of MFCU that awarded significant damages.53 The primary issue at trial concerned whether credit union employees had acted in conscious disregard of an established and enforced lending policy specifically relating to the indirect lending program such that coverage was proper under the faithful performance insuring agreement.

MFCU presented evidence at trial regarding its indirect lending program, which allowed applicants to apply for loans at automobile dealerships. Once indirect loan applications were completed, the third-

50 As of the third quarter of 2011, indirect auto loans accounted for

43% of credit union auto loans outstanding compared to 37% for the same quarter in 2007. Id.

51 641 F.3d 240 (6th Cir. 2011). 52 Hereinafter MFCU. 53 The jury rendered a verdict in the amount of $5,050,000. The district

court then added $2,730,415 in interest for a total judgment of almost $8,000,000. Id. at 245.

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party administrator compiled the applications and automatically approved low-risk loans. Higher risk applications were forwarded to MFCU for further review.54 Two employees were responsible for review of indirect loan applications and were instructed to follow MFCU’s lending policy. This policy directed staff to make lending decisions based upon eight key factors: (1) intent to pay; (2) capacity to pay; (3) total debt; (4) escalating debt; (5) job stability; (6) assets; (7) security; and (8) any other relevant risk indicator.55 According to the lending policy, “management” was responsible for the monitoring of the indirect lending program to ensure policy compliance. MFCU allocated this responsibility to a vice president of lending, who was required to provide monthly reports to the board. This vice president, however, failed to monitor the indirect lending program.56

A quarterly internal audit discovered an indirect loan that the auditor felt violated MFCU’s lending policy, and he listed that loan as an “exception” in a report submitted to MFCU’s supervisory committee.57 At the vice president’s insistence, however, this loan was removed from the report. During the same time period, a vice president of finance became concerned about the percentage of high-risk loans being approved by the indirect lending program. These concerns were discussed with the CEO, who in turn discussed the issue with the vice president of lending. The vice president of lending told the CEO that he was monitoring the program and that everything “looked good.”58

A further internal audit was conducted and, at a meeting to discuss the results, the vice president of lending admitted that he had not been monitoring the indirect lending program.59 After a full audit, MFCU learned that the indirect lending program had approved hundreds of loan applications in violation of the lending policy, resulting in numerous defaulted loans. Upon learning of the substantial losses stemming from the indirect lending program, MFCU filed a claim with

54 Id. at 244. 55 Id. 56 Id. 57 Id. 58 Id. at 245. 59 Id.

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CUMIS.60 MFCU alleged that it suffered financial harm as a result of the vice president’s and several staff members’ conscious disregard of the lending policy, and that, as a result, its loss was covered. CUMIS denied the claim and suit followed.61

On appeal, the Sixth Circuit considered whether the faithful performance coverage applied to the loss. CUMIS argued that the loss was not covered by the faithful performance insuring agreement because the lending program was not “established,” “enforced,” or “consciously disregarded.”62 It also argued that the loss was not covered because MFCU “acquiesced” in the policy violations at issue. The Sixth Circuit rejected these arguments.

First, the Sixth Circuit held that the evidence presented at trial established that the lending policy was adopted by the MFCU board on February 20, 2001, and was still in effect at the time the relevant policy violations occurred.63 The court noted that there was significant evidence in the record to demonstrate that MFCU’s employees were required to apply the “key factors” in making all lending decisions. The court noted that the language of the policy itself indicated that consideration of these “key factors” was mandatory, and that testimony elicited at trial indicated that consideration of these factors was required.64

The court also rejected CUMIS’s argument that the lending policy was not “enforced.” 65 Again, the court noted that the evidence at trial indicated that the vice president of lending was specifically tasked with monitoring the indirect lending program to ensure lending policy compliance and that the staff were similarly required to ensure that indirect loans were made “in accordance with established policies and procedures.”66 The court also looked to training provided to employees and enforcement through quarterly audits. Notably, despite the fact that

60 Id. 61 Id. 62 Id. at 246-47. 63 Id. at 246. 64 Id. 65 Id. at 247. 66 Id.

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the quarterly audit failed to uncover the policy violations at issue, the court found significant that an audit was even performed, demonstrating that MFCU actively enforced the lending policy in the indirect lending program. Remarkably, the court said that it did not matter as to whether the enforcement actually worked; what mattered was simply that there was a mechanism in place. The “language of the faithful-performance clause does not require a certain level of enforcement, or perfect enforcement, for MFCU to be entitled to coverage. Indeed, if MFCU were required to have perfect enforcement mechanisms, no covered losses would ever occur.”67 The court also looked to whether the lending policy was successfully enforced in the direct lending program and, finding that it was, held that this also factored into the finding that an enforcement mechanism was in place for the indirect program, despite the significant differences between the two types of programs.68

The court also disagreed with CUMIS’s position that there was insufficient evidence to support the jury’s finding that the employees had “consciously disregarded” the lending policy.69 Despite the lack of evidence of subjective intent by the employees, the court looked to evidence from MFCU’s expert that certain loans were “clearly outside of the [policy] . . . [that they] would never be approved probably in any credit union.”70 Such flagrant lending errors, according to the court, could not have been made without consciously disregarding the lending policy.71

Finally, the court rejected CUMIS’s argument that the evidence did not support the jury’s finding that MFCU did not “acquiesce” to the underlying policy violation.72 The court held that CUMIS adduced no evidence indicating that the board knew that the violations at issue were occurring. Without such evidence, the record supported the jury’s finding that MFCU did not acquiesce to the violations that ultimately caused this loss.

67 Id. (emphasis in original). 68 Id. 69 Id. 70 Id. at 247-48. 71 Id. at 248. 72 Id.

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b. Greater Minnesota Credit Union v. Federal Insurance Co.

In a recent unpublished decision, Greater Minnesota Credit Union v. Federal Insurance Co.,73 the court considered whether a loss involving a credit union’s “floor plan” loan program was covered under a fidelity bond’s faithful performance coverage. The court denied the motion of the insurer, Federal Insurance Company, for summary judgment, finding numerous issues of material fact regarding the nature and extent of the insured’s directing lending policies.

In GMCU, the Greater Minnesota Credit Union (GMCU) offered floor plan loans to its members.74 These loans allowed automobile dealers to purchase inventory which then served as collateral for the loan. As the automobiles were sold, the amount of the loan was reduced. In 2003, GMCU made a floor plan loan to Trent’s of Princeton, LLC.75 The loan had a one-year maturity and was renewed or extended annually. To protect its security interest, GMCU inspected the vehicles monthly, as provided in its written Business Loan Policy.76

GMCU’s president testified that its employees were trained to conduct monthly inspections (1) by physically inspecting and identifying the vehicles’ VIN numbers; (2) by inquiring about any missing vehicles; and (3) by sending the completed inspection form to the GMCU commercial loan department.77 This method of conducting an inspection was not put in written form or made part of GMCU’s written business loan policy. A GMCU employee, DiAnne Bean, was trained to follow this unwritten inspection policy. For a period of time, she would visually inspect the automobiles on the lot at Trent’s every month. She approved numerous financing loans to GMCU members who purchased vehicles from Trent’s, including some buyers who did not meet GMCU’s lending criteria. At some point, while she was responsible for the Trent’s floor plan loan, Bean stopped following GMCU’s unwritten inspection procedure. She claimed that she was told by GMCU’s commercial loan

73 Civil No. 10-2345 ADM/LIV (D. Minn. Sept. 15, 2011). 74 GMCU, slip op. at 1-2. 75 Id. at 2. 76 Id. 77 Id. at 3.

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officer that she could merely “spot check” a few vehicles on each visit. She began simply spot checking but continued to report to GMCU that she had checked every vehicle. Had she continued to check the VINs of each automobile, she would have discovered that many of the cars listed on Trent’s inventory had been sold and had not been replaced with new collateral.78

When Trent’s defaulted on the floor plan loan, GMCU discovered that cars listed as collateral for its loan had been sold. As a consequence, GMCU sustained a loss in excess of $500,000.00.79 Unable to recover from Trent’s, GMCU sought coverage under the faithful performance coverage of its fidelity bond. Federal denied the claim, asserting that the exclusions within the faithful performance coverage for “negligence, mistakes or oversights,” “acts or omissions resulting directly from inadequate training” or “unintentional violation of the insured’s policies or procedures” barred coverage.80

Federal moved for summary judgment, and the court considered whether GMCU had an “established and enforced . . . lending policy.”81 In finding that a question of material fact existed as to whether GMCU’s vehicle inspection policy was “established,” the court found significant that neither case law nor treatise equate “established” or “policy” with a written or board-adopted policy. The court held that the plain meaning of the terms did not preclude an “established lending policy” from being an unwritten plan or a set of guidelines that were chosen from among alternatives to guide lending decisions and that had been used for an extended period. Although the precise requirements for conducting the inspection were not written, Bean testified that she was trained to follow a particular practice instituted by GMCU and that she followed that practice.82

In arguing that there could be no dispute that the policy was not “in force,” Federal cited to Michigan First, arguing that, in that case, training employees to follow the policy, appointing an employee to

78 Id. at 3-4. 79 Id. 80 Id. at 4. 81 Id. at 5-6. 82 Id. at 8.

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monitor compliance with the policy, and periodically auditing loans to reveal non-compliance evidenced that a policy was in force.83 The lack of similar safeguards clearly indicated, according to Federal, that no policy was “in force” at GMCU. The court disagreed, finding that the term “in force” was ambiguous, and noting that it could mean disciplining an employee for failure to comply with the relevant provision of the policy, as Federal proposed, or setting up procedures to ensure that the policy was followed, such as training. The court stated that the undisputed evidence showed that GMCU had procedures in place to monitor compliance with its policy and that Bean submitted the monthly inspection report to the department stating that she had complied. The court noted that there was, at the very least, a question of fact as to whether the inspection policy was “in force” given these facts.84

Federal also argued that GMCU failed to show “conscious” disregard of the policy and suggested that a subjective standard of intent should be applied.85 The court held that “conscious disregard” requires “at a minimum, that an employee must actually be aware of an established and enforced lending policy, and must deliberately choose not to follow that policy.”86 Again, the court held that GMCU produced evidence, including Bean’s own admissions and the inventory report she filed, reflecting that she had deliberately deviated from the procedure she had originally tried to follow.87 Thus, a question of fact on this issue also precluded summary judgment.

B. Employee Theft and Employee Dishonesty Coverage

Where a financial institution bond is involved, Insuring Agreement (A), entitled “Fidelity”, may be at issue, as this insuring agreement is one of the relevant exceptions in certain bond forms to the loan loss exclusion, the financial institution bond’s key language in the evaluation of a claim arising out of a loan. Typical exclusion language states that the bond does not cover:

83 Id. 84 Id. at 8-9. 85 Id. at 9. 86 Id. at 10. 87 Id.

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loss resulting directly or indirectly from the complete or partial nonpayment of, or default upon, any Loan or transaction involving the Insured as a lender or borrower, or extension of credit, including but not limited to the purchase, discounting or other acquisition of false or genuine accounts, invoices, notes, agreements or Evidences of Debt, whether such Loan, transaction or extension was procured in good faith or through trick, artifice, fraud or false pretenses, except when covered under insuring Agreements (A), (E) or (G).88

Unless the claim is covered under one of the insuring agreements stated in the exclusion, the loss is excluded. In this quoted exclusion, the exceptions are for losses covered under the Fidelity (A), Securities (E), and Fraudulent Mortgages (G) insuring agreements.89 Similarly, where a commercial crime policy issued, employee dishonesty or employee theft coverage may be involved.

1. The Insuring Agreements

Coverage for employee-related loss may be provided in commercial fidelity policies under a number of different, but similar, coverages. For example, the standard form ISO Commercial Crime Policy provides coverage for “employee theft” as follows:

88 Financial Institution Bond, Standard Form No. 24, § 2(e), reprinted

in FINANCIAL INSTITUTION BONDS 983 (Duncan L. Clore, ed., 3d ed. 2008). Earlier versions of this exclusion also included the “Forgery or Alteration” Insuring Agreement (Insuring Agreement (D)). Jean E.K. Pern, Jeffrey M. Paskert and James A. Black, Jr., The Loan Loss Exclusion: Assuring That Credit and Business Risks Remain With the Financial Institution, in FINANCIAL

INSTITUTION BONDS 443, 446. 89 Id. Insuring Agreements (D) and (E) cover only certain enumerated

risks involving forged or altered documents which are relied upon by the lender when loaning money. See Scott L. Schmookler, Insuring Agreement D, in FINANCIAL INSTITUTION BONDS, supra note 88, at 313; Peter C. Haley & Dolores Parr, Coverage Under Insuring Agreement (E) of the Financial Institution Bond, in FINANCIAL INSTITUTION BONDS, supra note 88, at 385. General issues involving these two insuring agreements will be discussed below in Section III.C.

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We will pay for loss of or damage to “money”, “securities” and “other property” resulting directly from “theft” committed by an “employee”, whether identified or not, acting alone or in collusion with other persons.90

In contrast, the Financial Institution Bond provides coverage for “Fidelity” as follows:

Loss resulting directly from dishonest or fraudulent acts committed by an Employee acting alone or in collusion with others.

Such dishonest or fraudulent acts must be committed by the Employee with the manifest intent:

(a) to cause the Insured to sustain such loss; and

(b) to obtain financial benefit for the Employee or another or entity.

However, if some or all of the Insured’s loss results directly or indirectly from Loans, that portion of the loss is not covered unless the Employee was in collusion with one or more parties to the transactions and has received, in connection therewith, a financial benefit with a value of at least $2500.91

90 Commercial Crime Policy (Discovery Form), Form No. CR 00 22 07

02 (ISO Properties 2001), reprinted in COMMERCIAL CRIME POLICY 691 (Randall I. Marmor & John Tomaine eds., 2d ed. 2005). A commercial crime policy may provide coverage for “employee dishonesty” rather than “employee theft.” Such coverage includes elements similar to that for “Fidelity” under the Financial Institution Bond (see Financial Institution Bond, supra note 85), including manifest intent to cause a loss to the insured and financial benefit to the employee other than standard employee benefits such as salary, wages or commissions. See Crime Protection Policy, Form No. SP 00 01 03 00 (Surety Association of America 1999), reprinted in COMMERCIAL CRIME POLICY 677.

91 Financial Institution Bond, Standard Form No. 24 (rev. 1986), reprinted in FINANCIAL INSTITUTION BONDS, supra note 88, at 596.

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The primary defined term of relevance to these coverages of course is “employee.” Although the specific definition may vary, particularly through the use of endorsements, most policies will include a requirement that the insured have the “right to govern and direct” the employee.92 Most policies also exclude from the definition agents, independent contractors, and representatives “of the same general character.”93

2. Is an “Employee” Involved in the Scheme?

An obvious common requirement in an employee dishonesty, employee theft, or faithful performance claim is the involvement of an “employee” of the insured. Because indirect lending programs vary in level of involvement or review by the insured and its employees, an employee’s involvement in the fraud may not be self-evident. The insured may attempt to create an employer/employee relationship or characterize the party directly involved in the loss in such a way as to qualify as an “Employee,” as the term is defined in the policy. Although not involving an indirect lending program, Suffolk Federal Credit Union v. CUMIS Insurance Society, Inc.94 involved such an effort and is instructive.

In Suffolk Federal, a credit union brought an action against its fidelity carrier (CUMIS), alleging that the carrier breached the terms of the party’s bond by refusing to indemnify the credit union for losses arising from a fraud committed by a credit union’s loan servers. Suffolk and CU National Mortgage, LLC entered into a “mortgage services agreement” whereby CU National agreed to perform various services in connection with Suffolk’s residential mortgage business.95 For approximately five years, Michael McGrath, CU National’s president and chief executive officer, directed a fraudulent scheme in which he and others at CU National sold 189 of Suffolk’s mortgage loans to the Federal National Mortgage Association (“Fannie Mae”), without Suffolk’s knowledge or authorization, and then pocketed the proceeds.

92 ANNOTATED COMMERCIAL CRIME POLICY 181 (Cole S. Kain & Lana

M. Glovach eds., 2d ed. 2006). 93 Id. 94 910 F. Supp. 2d 446 (E.D.N.Y. 2012). 95 Id. at 450.

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McGrath committed the fraud by first selecting a loan that Suffolk had not authorized CU National to sell.96 He or one of his employees would prepare the documentation to assign the loan to U.S. Mortgage, an automated loan seller to Fannie Mae. McGrath or an employee would sign their own name on the documentation but falsely represent that they were a Suffolk AVP or employee. After completing the assignment to U.S. Mortgage, McGrath or his employee would then draft similar documentation to assign the loan to Fannie Mae. Instead of forwarding the proceeds to Suffolk, McGrath would keep the money.97 CU National continued to service Suffolk loans to conceal the fraud and falsely reported financial information to Suffolk to conceal the fraud.98

Upon discovery of the scheme, Suffolk asserted a claim under the employee dishonest coverage of its fidelity bond,99 contending that CU National was a “servicing contractor” included within the definition of “employee.” Agreeing with CUMIS, which had denied the claim, the court held that the bond’s including of servicing contractors within its definition of “employee” was limited to where serving contractors were performing the three traditional loan servicing functions listed in the bond: collecting and recording payments on real estate mortgage or home improvement loans, establishing tax or insurance escrow accounts, and managing real property.100 The court declined to ignore the plain and ordinary meaning of the bond’s “only while performing” language, as it was “clearly designed to addressed those situations where a third party vendor performs both traditional loan servicing functions and non-servicing functions so as to limit coverage to only those fraudulent acts committed by the vendor in its loan servicing role.”101 Because selling loans fell outside of a traditional loan servicing function, as specifically enumerated in the bond’s definition of “servicing contractor,” the court

96 Id. at 451. 97 Id. 98 Id. 99 Id. 100 Id. at 457. 101 Id.; see also N.E. Credit Union v. CUMIS Ins. Soc’y, Inc., Civil No.

09-cv-88-SM, slip op. at 7 (D.N.H. May 24, 2010) (attorney not an “employee” when performing duties as an escrow agent which did not require legal training, experience or licensure).

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declined to find coverage under the employee dishonesty insuring agreement.

In the indirect lending context, the bond’s or policy’s definition of “employee,” and any relevant endorsements that may expand or limit the standard definition, must be considered to determine whether any of the players in the scheme might fall within the bond’s or policy’s coverage. In addition, the traditional characterizations of an employee, including control and direct payment of salary or wages,102 must also be considered.

3. Does the Conduct Alleged Constitute “Theft”?

An area of potential concern for fidelity carriers involves claims by an insured originator of loans where the originator agrees to buy back or repurchase loans that were sold to a financial institution or credit union. In this scenario, the originator incurs a loss due to a contract provision requiring buy back or repurchase of non-conforming loans that were fraudulently altered by an employee to comply with lending guidelines. Under the standard definition,103 the scenario likely would not be covered because it would not be considered a “taking”; instead, the loss is more in the nature of an indirect or third party loss, and thus not covered.

In Pine Belt Automotive, Inc. v. Royal Indemnity Co.,104 the court considered the meaning of “taking” in the context of an indirect lending scheme. In Pine Belt, an automotive dealership, Pine Belt Automotive, entered into a Dealer Agreement with First Atlantic Federal Credit Union under which First Atlantic was to extend loans to Pine Belt’s customers

102 The standard commercial crime policy defines “employee,” in part,

as a person over whom the insured has the right to “direct and control while performing legal services . . . .” Commercial Crime Policy (Discovery Form), supra note 90, at 693.

103 The standard commercial crime policy defines “theft” as the “unlawful taking of ‘money’, ‘securities’ or ‘other property’ to the deprivation of the insured.” Commercial Crime Policy (Discovery Form), supra note 90, at 694.

104 Civil Action No. 06-5995 (JAP), 2008 WL 4682582 (D.N.J. Oct. 21, 2008), aff’d, 400 Fed. Appx. 621 (3d Cir. 2010).

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to facilitate automobile purchases.105 William Thomson, Pine Belt’s credit manager, was the primary liaison between Pine Belt and First Atlantic. Thomson convinced his superiors to make the initial loan payments to First Atlantic on behalf of Pine Belt customers, arguing that this method would help Pine Belt customers with bad credit ratings to secure loans.106

Thomson allegedly used the scheme to embezzle approximately $800,000 through the conversion of money orders.107 Thomson also falsified credit applications and reports to support the loans.108 He misrepresented the creditworthiness of some customers, thereby inducing First Atlantic to issue loans to customers who would not ordinarily have met its credit standards. When Thomson’s scheme was discovered after several auto loans went into default, First Atlantic demanded that Pine Belt reimburse it for losses on twenty-seven defaulted auto loans, which Pine Belt ultimately did, sustaining a loss of $471,684.96.109

In determining that the loss incurred by Pine Belt in reimbursing First Atlantic did not constitute a “taking,” the court considered the case of Williams Electronic Games, Inc. v. Barry110 to be instructive. In Barry, the court determined that a loss involving an employee’s bribery scheme was not a “taking” within the policy’s definition.111 The Pine Belt court noted that bribery was not considered by the Barry court to be a “taking” because nothing was “taken” from the insured, even if the insured was required to pay the victim of the bribery scheme the gross profits made pursuant to the scheme.112 Similarly, in Pine Belt, the court held that Pine Belt’s loss resulted from its contractual obligation to buy back bad loans from First Atlantic. Because its loss was in the nature of

105 Id. at *2. 106 Id. 107 Id. at *3. This aspect of the scheme will be discussed infra. in

Section III.B.(4), which discusses number of occurrences. 108 Id. 109 Id. 110 No. 97 C 3743, 2000 WL 106672 (N.D. Ill. Jan. 13, 2000). 111 In Barry, the insured’s salesman bribed a purchasing agent to

purchase component parts from the insured at inflated prices. 2000 WL 106672, at *1.

112 Pine Belt, 2008 WL 4682582, at *6.

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compensation of a third party for the third party’s loss, the court held that Pine Belt had failed to prove a “taking” of property belonging to the insured and, thus, no “theft” within the scope of the policy’s insuring agreement.113

4. Number of Occurrences

Any indirect lending scheme of significance will undoubtedly include multiple loans and, potentially, multiple employees involved in the scheme. Most fidelity bonds and policies include language providing that a scheme constitutes only one “occurrence” or “loss,” regardless of the number of loans involved.114 Depending on the size of the loss, the limits of liability for the coverage, or the amount of the deductible, an insured may want to argue that each loan represents a separate occurrence. Several cases involving indirect lending schemes address this issue.

In Pine Belt, the court considered the issue of how many occurrences resulted from the fraud. As part of the fraudulent scheme, the insured’s credit manager, Thomson, requested checks corresponding to the initial payment from Pine Belt’s accounting departments made payable to Commerce Bank. He would then exchange the checks for blank money orders, which he converted to his own use instead of

113 Id.; see also Direct Mortg. Corp. v. Nat’l Union Fire Ins. Co. of

Pittsburgh, Pa., 625 F. Supp. 2d 1171 (D. Utah 2008) (insured wholesale lending company sought coverage under its fidelity bond for liability to third-party financial institution that had unknowingly purchased fraudulently-obtained mortgages from the insured and then demanded a buy back; court denied coverage, holding that a fidelity bond is intended to provide indemnification for direct loss suffered by insured at hands of dishonest employee and is not intended to be a liability policy).

114 The standard commercial crime policy, which provides for a single loss limitation per “occurrence,” defines “occurrence,” as it respects employee theft coverage, as follows: “‘Occurrence’ means all loss caused by, or involving, one or more ‘employees’, whether the result of a single act or a series of acts.” Commercial Crime Policy (Discovery Form), supra note 90, at 694. In contrast, the Financial Institution Bond defines “Single Loss” as all covered loss resulting from “all acts or omissions . . . caused by any person (whether an Employee or not) or in which such person is implicated . . . .” Financial Institution Bond, supra note 91, at 605.

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forwarding them to the lender, First Atlantic.115 Over the course of several policy periods, Thomson converted approximately $785,000 in money orders.116 The insured submitted a claim for the entire amount of the embezzlement, despite the policy’s $100,000 per occurrence limit. The insurer argued that the losses resulting from the conversion of money orders by Pine Belt’s credit manager were all part of the same, ongoing embezzlement scheme and thus constituted only a single occurrence. The district court agreed, granting the insurer’s motion for summary judgment.117

The policy defined “occurrence” as “all loss caused by, or involving, one or more ‘employees’ whether the result of a single act or series of acts.”118 Noting that, in the Third Circuit, “the general rule is that an occurrence is determined by the cause or causes of the resulting injury,”119 the district court reasoned that it needed to determine whether “there was but one proximate, uninterrupted, and continuing cause which resulted in all of the injuries and damages.”120 The court ultimately agreed with the carrier and held that there was only one “occurrence,” finding that the injury sustained from the conversion of multiple money orders stemmed from a “common cause—the ongoing embezzlement by Thomson.”121

In its decision, the Pine Belt court noted, and declined to follow, a case from the New Jersey Supreme Court, Auto Lenders Acceptance Corp. v. Gentilini Ford, Inc.122 Gentilini Ford also involved an indirect lending program for automobile sales. In Gentilini, an automobile

115 Pine Belt, 2008 WL 4682582, at *6. 116 From October 2003 through June 1, 2004, Thomson converted

approximately $550,000 of money orders and from June 1, 2004, through June 1, 2005, Thomson converted an additional $235,580. Pine Belt, 2008 WL 4682582, at *3 n.1.

117 The Third Circuit affirmed the District Court’s rulings in an unpublished decision, citing to the reasons stated in the District Court’s decision. 400 Fed. Appx. 621 (3d Cir. 2010).

118 2008 WL 4682582, at *5. 119 Appalachian Ins. Co. v. Liberty Mut. Ins. Co., 676 F.2d 56, 61 (3d

Cir. 1982). 120 Pine Belt, 2008 WL 4682582, at *5. 121 Id. 122 854 A.2d 378 (2004).

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dealership, Gentilini Ford entered into a retail-paper “Dealer Agreement” with PNC Bank under the terms of which PNC provided financing for installment sales contracts executed by Gentilini with its customers.123 By a separate agreement between PNC and Auto Lenders Acceptance Corp., Auto Lenders had the option to finance any contract rejected by PNC. PNC tended to accept the lower-risk applicants, leaving the higher-risk (though still creditworthy) applicants for Auto Lenders.124

For each application, Gentilini would enter into an installment sales contract with the purchaser, taking a cash deposit after accepting the customer’s note.125 The accepting lender advanced cash in the amount of the customer’s note to Gentilini and would then take an assignment of Gentilini’s rights under the customer’s sales contract, including a security interest in the financed vehicle, any service contracts for the vehicle, and the right to any insurance proceeds subsequently paid for damage to the vehicle.126 An investigation conducted by Auto Lenders revealed that a Gentilini employee had engaged in a number of credit-application frauds to secure loans for customers otherwise not creditworthy, including falsifying driver’s license information and customer salaries (via falsified pay stubs).127

Auto Lenders sought to have Gentilini repurchase all outstanding installment contracts totaling $831,932.90.128 Gentilini ultimately sued its insurance carriers, asserting that employee dishonesty coverage applied to the claim. The employee dishonesty coverage was included as part of an add-on Master-Pak endorsement and provided limits of $5,000 per occurrence.129 The trial court determined that the Gentilini employee had defrauded Auto Lenders on twenty-seven occasions, resulting in

123 Id. at 381. 124 Id. 125 Id. 126 Id. 127 Id. at 382 128 Id. 129 Id. at 382-83. The policy defined “occurrence” as “all loss or

damage: (1) caused by one or more persons; or (2) involving a single act or series of related acts.” Id.

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twenty-seven occurrences.130 After a reversal by the Appellate Division, the New Jersey Supreme Court itself reversed, upholding the trial decision on number of occurrences, holding that each of the employee’s twenty-seven acts of fraud was a separate occurrence.131

In reaching its decision on the occurrence issue, the court, like the Pine Belt court, looked to the cause of the loss. However, the Gentilini court focused on the unique qualities of the purchasers and the terms of their sale, rather than on the method of the embezzlement, to conclude that each act of fraud was a separate occurrence: “the similarity of the acts do not transform them into one continuous event subject to a single recovery under the policy.”132 Accordingly, the court held that Gentilini was entitled to recover up to $5000 for each fraudulently induced sale.133

Gentilini and Pine Belt offer an interesting contrast on the occurrence issue given that both involve fraud at the point of sale in an indirect lending program for automobile loans. The Gentilini court apparently was interested in maximizing recovery for the insured given the low per occurrence limit of liability in the policy. The majority of courts have not followed Gentilini’s rationale and instead interpret an embezzlement scheme carried out by a single employee as one occurrence because it constitutes a series of acts, each one following the other.134 Thus, for a claim involving indirect lending in most

130 The interim appellate court determined that the claim was not

covered because the employee had no “manifest intent” to cause a loss to the insured and because the insured failed to incur a direct loss. On further appellate review, the New Jersey Supreme Court held that a question of fact existed on the issue of intent but upheld the trial court’s decision on the occurrence issue. Id. at 383-84.

131 Id. at 384-85. 132 Id. 133 Id. at 396-97. 134 See Glaser v. Hartford Cas. Ins. Co., 364 F. Supp. 2d 529, 535-37

(D. Md. 2005) (under almost identical definition of “occurrence,” a single occurrence arose when an employee committed a series of dishonest acts, despite the employee’s use of different means to defraud at different times); Wausau Bus. Ins. Co. v. U.S. Motels Mgmt., Inc., 341 F. Supp. 2d 1180, 1183-84 (D. Colo. 2004) (rejected company’s attempt to distinguish the employee’s various means of embezzlement because occurrence was defined by cause and

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jurisdictions, the insured likely will not succeed in proving that scheme involves multiple occurrences or losses.

5. Does the Employee Intend to Cause a Loss to the Employer?

The employee’s intent to cause the employer to sustain a loss through a fraudulent indirect lending program is a required element of an employee dishonesty claim.135 However, depending on the jurisdiction and the scheme itself, the employee’s intent is not always readily apparent. In other words, simply because the employer ultimately incurs a loss does not mean that such was the employee’s plan. The employee could have intended to benefit the employer by generating additional business or commissions through his improper lending activities.

Such lack of clarity regarding the employee’s intent caused the Gentilini court to determine that a question of fact existed regarding the employee’s intent and that summary judgment should not have been granted for either party. A review of the court’s reasoning provides some insight into the complexity of the issue and the evidence that may be required to prove intent in an indirect lending case.

all the loss was caused by the employee’s dishonesty); Bethany Christian Church v. Preferred Risk Mut. Ins. Co., 942 F. Supp. 330, 333-35 (S.D. Tex. 1996); Diamond Transp. Sys., Inc. v. Travelers Indem. Co., 817 F. Supp. 710, 712 (N.D. Ill. 1993); Emps. Mut. Cas. Co. v. DGG & CAR, Inc., 183 P.3d 513, 515-16 (Ariz. 2008); Reliance Ins. Co. v. Treasure Coast Travel Agency, Inc., 660 So.2d 1136, 1137 (Fla. Dist. Ct. App. 1995); Piles Chevrolet Pontiac Buick, Inc. v. Auto Owners Ins. Co, Nos. 2011-CA-002317-MR, 2011-CA-002340-MR, 2013 WL 2120319 (Ky. Ct. App. May 17, 2013) (bookkeeper for car dealership purchased multiple cars from dealership and ensured that checks written to purchase were not cashed; the court held that the continuing embezzlement scheme was one occurrence); see generally Scott D. Baron & Andrew S. Kent, A Dishonest Employee: A Single Cause of Loss or a Man of a Thousand Occurrences? An Analysis of Single Loss Limitations in Modern Crime Policies in the Wake of Auto Lenders Acceptance Corporation v. Gentilini Ford, Inc., 11 FID. L.J. 33 (2005).

135 For a general discussion of the manifest intent element of an employee dishonesty claim, see generally Toni Scott Reed, Employee Theft vs. Manifest Intent: The Changing Landscape of Commercial Crime Coverage, 36 TORT & INS. L.J. 43 (Fall 2000).

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For example, the carrier argued that it was “plain and obvious” that the employee intended not to harm his employer but to benefit both his employer and himself, noting that the employer “‘presumably’ profited from the sale of the cars and assignment of its installment contracts to” the lender.136 The court noted, however, that the employee’s fabrication of the credit applications ultimately harmed the employer because it burdened the employer with the risk of default on the twenty-seven installment sales contracts and deprived it of possession of the vehicles.137 Because the applicants with whom the employee was dealing posed a heightened risk of default, the court reasoned that a jury could infer from the employee’s conduct and the surrounding circumstances that he intended his employer to suffer a loss from potential defaults.138

On the other hand, the court also noted that a jury could infer from the employee’s conduct that he did not act with conscious purpose to harm his employer because the losses were not substantially certain to follow. The employee’s scheme depended on the lender accepting the applications with falsified information, and the longer he could perpetrate the fraud on the lender, the more sales and the more commissions he could generate.139 “Because the losses Gentilini ultimately sustained depended on Auto Lenders uncovering Carpenter’s fraud, a jury could conclude that Carpenter did not intend Gentilini to suffer a loss because that result would be counterproductive to Carpenter’s rational goal of maximizing his commissions.”140 Ultimately, the Gentilini court determined that both the carrier and the insured were speculating as to the employee’s intent and left it to the jury to decide the issue.

Gentilini shows us that, in a case involving an indirect lending scheme, the intent of the employee, whether to cause his employer a loss or to deprive the employer of its property, is likely factual intensive and may not always be inferred simply from the outcome of the scheme itself.

136 Gentilini, 854 A.2d at 394. 137 Id. at 394-95. 138 Id. 139 Id. at 395. 140 Id.

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C. Claims Based on Conduct of Non-Employees

Because indirect lending is simply another type of loan program, fidelity insurers should expect that a claim involving indirect lending that does not include fraud or dishonesty by the insured’s employee could implicate other insuring agreements that insureds turn to when they experience a lending loss, such as Insuring Agreement (D), Forgery or Alteration, or Insuring Agreement (E), Securities.141 As exceptions to the loan loss exclusion, insureds often attempt to find coverage under these insuring agreements when a loan loss occurs.

Fidelity bonds are not, however, a form of credit insurance. 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.”142 Accordingly, care must be taken when reviewing a claim involving these insuring agreements in the context of indirect lending to ensure that the loss directly arises from the covered cause of loss, that is, forged documents or collateral, rather than bad business practices. Given the nature of indirect lending, where the lender often approves the borrower on the basis of the application from the dealer with documentation submitted only after approval, the requirements of these insuring agreements, particularly the physical possession of collateral documents and good faith reliance components of Insuring Agreement (E), likely present issues for the insured. Recent cases involving these requirements and how they could surface in an indirect lending loss scenario are discussed below.

North Shore Bank, FSB v. Progressive Casualty Insurance Co.,143 a recent decision from the Seventh Circuit, illustrates the potential issues under Insuring Agreement (E) regarding the type of documents

141 Much has been written on the very specific requirements of these

insuring agreements and the limited nature of the coverage provided therein. See, e.g., Schmookler, supra note 89, at 313; Haley & Parr, supra note 89, at 385. These insuring agreements exist for different reasons and for different types of losses. Michael Keeley, Michele L. Fenice & J. Will Eidson, Insuring Agreement (E)—Revisited, 17 Fid. L.J., 2d ed., 203, 211-12 (2011).

142 Id. 143 674 F.3d 884 (7th Cir. 2012).

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covered by the insuring agreement that might arise in the context of an indirect loan, the manner in which a dealer’s wrongful conduct can pervert the lending process, and how penetrating a financial institution’s loss prevention procedures must be to avoid a loss. In North Shore, the bank made a claim on its financial institution bond arising from a loan to purchase a motor home. The purchaser sought a loan in the amount of $404,881 to finance the purported purchase of a motor home from a dealership. The borrower eventually defaulted on the loan. In the process of attempting to repossess the motor home, the bank discovered that the certificate of origin for the motor home presented to the bank to support the loan had been fabricated by the borrower. The motor home that supposedly secured the loan did not exist.144

The bank asserted a claim under Insuring Agreement (E), arguing that the certificate of origin furnished by the borrower, a covered item, was a “Counterfeit,” a covered peril.145 The court affirmed the lower court’s decision granting summary judgment to the insurer, noting that the definition of “Counterfeit” in the bond required that the item which is the subject of the claim be a “Written imitation of an actual, valid Original which is intended to be taken as the Original.”146 The court held that there could not be an “Original” of the certificate of origin because the manufacturer never issued one, not having ever manufactured the motor home purportedly the subject of the loan.147

Although it was not a basis for its decision, the North Shore court also discussed the bond’s requirement that the bank act in “good faith” on the basis of the covered document in extending credit. The parties disputed whether the procedures followed by the bank to confirm the collateral satisfied the bond’s requirements.148 In the context of that issue, the court discussed the due diligence that the bank undertook concerning the borrower and the dealership prior to granting the loan. In addition to reviewing the borrower’s financial records, an employee of the plaintiff traveled to the dealership to examine the motor home,

144 Id. at 885-86. 145 Id. at 886. 146 Id. at 887. 147 Id. at 888. 148 Id. at 886.

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photographed it and compared the Vehicle Identification Number149 on the faked certificate of original from the borrower with the one on the vehicle presented to it, observing that they matched.150 Unfortunately for the bank, the motor home presented for inspection was a fake. The court queried, without deciding, whether the bank should have compared the features of the older model presented with the one purchased or compared the certificate of origin presented with an authentic one from the manufacturer. The bank also did not verify the VIN directly with the manufacturer.

North Shore involved a direct lending situation where the bank was actually involved in verifying the collateral. The additional efforts discussed by the court to comply with the good-faith requirements in the bond could present issues for an insured in an indirect lending scenario, where the bank or credit union makes the decision to lend to the borrower before it obtains documentation, such as a certificate of origin. If the bank’s efforts in North Shore were insufficient to support an Insuring Agreement (E) claim, an even higher hurdle may be faced by a lender in an indirect lending situation.

In re Russell,151 although not a case involving a financial institution bond, also illustrates how a loss may be caused to a financial institution engaged in indirect lending by collusive activity between a borrower and employee of a dealer where the bank relies on representations in the application, rather than in a covered item. The case involved a determination of the dischargeabilty of the borrower-debtor’s obligation to a credit union from which she borrowed money for the purchase of a pick-up truck. At trial, the debtor admitted to conspiring with a salesperson at the dealership to structure the purchase and loan process in such a manner as to conceal the fact that the borrower-debtor was buying the truck for her father. The borrower testified that she expected her father to repay the loan, but the father’s credit history stood as an impediment to his qualification for the loan.152 As part of its indirect lending program, the credit union required the dealer to submit the former’s credit application executed by the

149 Hereinafter VIN. 150 Id. 151 463 B.R. 464 (Bankr. W.D. Mich. 2012). 152 Id. at 465.

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borrower. The application contained the following provision: “You are applying for individual credit in your own name and are relying on your own income or assets and not the income or assets of another person as the basis for payment of the credit requested.”153

Eventually, the borrower-debtor defaulted on the loan and sought protection under the Bankruptcy Code.154 On the facts of the case, any loss to the credit union arose from the collusion between the sales person and the borrower, neither an employee of the credit union, as well as the borrower’s fraud in her application for the loan, not a covered document under Insuring Agreement (E).155

Another issue that can arise in an Insuring Agreement (E) claim involves the existence of an “authorized representative” of the insured and whether such “authorized representative’s” possession of the covered documents allows the insured to argue that it has met the “actual physical possession” requirement of the insuring agreement.156 Whether a party is an “authorized representative” of the insured may become an issue in an indirect lending scenario, where the financial institution establishes a relationship with a third party, such as a CUSO, to assist it in originating, approving or servicing the loan. The financial institution may contend that it had “actual physical possession” of covered documents at the time the loan was granted because the third party actually had such possession.

In BancInsure, Inc. v. Highland Bank,157 the court elaborated on the requirements necessary to establish the element of “authorized representative”, an undefined term in the bond involved in this Insuring

153 Id. at 466. 154 Id. at 465. 155 Id. 156 Insuring Agreement (E) requires that the insured lender establish

that is acted “on the faith of” allegedly defective documents. It also provides that “[a]ctual physical possession of the items listed in (a) through (i) above by the Insured, its correspondence bank or other authorized representative, is a condition precedent to the Insured’s having relied on such items.” Haley & Parr, supra note 89, at 413.

157 Civil No. 11-2397 (SRN/JSM), 2012 WL 6217375 (D. Minn. Dec. 4, 2012).

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Agreement (E) claim. In BancInsure, the insured bank sought coverage for losses from its financing of a lease arrangement between its borrower and a vendor of semiconductor equipment. The insurer argued that the bank did not have “physical possession” of the guarantees from the vendors’ principals when it extended credit, and that therefore the claim under Insuring Agreement (E) failed as a matter of law.158 The court considered whether the borrower could be considered the “authorized representative” of the bank, and held that it is mandatory that an agency relationship exist between the insured, as principal, and the person alleged to be the “authorized representative,” the agent.159 An agency relationship may be established by a course of dealing between the parties, regardless of the intent of the parties to establish such a relationship.160 The court went on to hold that an agency relationship existed between the bank and the lessor because there was an “intentional relationship involving several assignment agreement transactions and the agreement that [the lessor] maintain the original documents.”161Accordingly, the court granted the bank’s motion for partial summary judgment on the issue.162

In the context of indirect lending, where a bank or credit union has an established relationship with the dealer or a third-party vendor like a CUSO, the financial institution may argue that physical possession of the covered documents by the dealer or third-party vendor provides the necessary link to establish reliance by the bank. A thorough investigation of the relationship between the bank and the third party, including the length of the relationship and any documents describing

158 Id. at *6. 159 Id. at *4. 160 Id. 161 Id. at *7. 162 Id. at *8. In a subsequent decision, BancInsure, Inc. v. Highland

Bank, No. 11-cv-2497, 2013 U.S. Dist. LEXIS 135299 (D. Minn. Sept. 23, 2013), the court granted a motion for summary judgment filed by the insurer and denied the insured’s cross motion, holding that there was no loss resulting directly from a forged guaranty because the guarantor was insolvent at the time the loan was made. Thus, the loss resulted directly from the worthlessness of the collateral and not from any forgery. The court also found that the insured did not rely on the guaranty in extending credit because it was never the beneficiary of the guarantee.

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their relative responsibilities in the transaction, is required to flesh out this issue.

IV. CONCLUSION

Financial institutions are well aware that there are various risks generally inherent in lending. These risks are particularly pronounced in indirect lending for several reasons. In the indirect lending scenario, the lender does not directly underwrite the risk presented by the requested loan, and is one step removed from the borrower, who secures the financing at the point of purchase. Therefore, the lender has less involvement in reviewing the qualifications of the borrower, and either must trust the intermediary car dealer who brings the borrower to the lender or must set standards for the dealer to follow and monitor compliance regularly. In addition, the subjects of the loans are typically up-market durable consumer goods which depreciate in value fairly quickly. Thus, the collateral for the loans may not support the unpaid portion of the loans at the time of a default. The volume of loans also can be substantial, particularly in a hot market, like car sales at the present time. So, when a loss does occur, the size of the loss can be significant while the salvage value of the collateral may be insufficient to cover the loss.

In addition, in contrast to a traditional lending scenario, there are necessarily three parties to an indirect loan: the buyer/borrower, the seller/intermediary and the lender. Each one is acting out of a heightened sense of self-interest in order to accomplish their respective goals in the transaction. Buyers, who may not be the most creditworthy, want to get the best deal they can from both the dealer and the financial institution in the purchase of an item that is likely to begin depreciating as soon as they take possession. Dealers want to attract more customers by providing an easier path to credit. Lenders see an opportunity to expand their business and customer base exponentially with a comparative reduction in effort. These interests all compete to make indirect lending a riskier, although potentially profitable, venture for lenders.

These risks transfer to the fidelity insurer when the insured suffers a loss and submits a claim, and are apparent in the few coverage

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cases described above that have involved indirect lending. The same diligence required of lenders in this type of lending is also necessary for the fidelity insurer faced with a claim of loss arising from indirect lending. Thorough investigation and scrutiny of the facts involved in each claim, particularly the policies and procedures of the lending institution in dealing with third-party intermediaries and whether such procedures are enforced, as well as an understanding of the relationships between the parties involved in these loans, are required in considering coverage for such claims.

As a general proposition, fidelity insurers do not intend to provide coverage for losses arising out of the extension of credit. This intention is manifested by the inclusion of the loan loss exclusion in the bond. A review of the exclusion and the insuring agreements that are excepted from it is required early in the claim-handling process. Whether the loan exclusion will apply in an indirect lending claim depends on whether the claim meets the requirements of one of the insuring agreements noted among the exceptions.

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