Warehouse Lending Losses Due to Forged Promissory ... - DRI Today

Fidelity and SuretyAre Financial InstitutionBonds Susceptible?By Daniel E. Tranenand Stefan R. DandellesWarehouse LendingLosses Due to ForgedPromissory NotesWhen confronted withthese claims, courtsshould determine thatno coverage attachesbecause the forgeryis not the directcause of the loss.Most warehouse lending losses from fraud are largelosses suffered by sophisticated banks. Warehouse lendingtypically involves a substantial, revolving line ofcredit given to a mortgage lender, which uses that creditto fund a portfolio of loans to variousresidential home buyers for short periodsof time. If a mortgage lender wishesto perpetrate fraud using its warehouselender, there are many opportunities to doso since almost no underwriting is performedby warehouse lenders on the loansthey finance. Instead, warehouse lendersprotect themselves by performing due diligenceon their mortgage lenders in thehope that theses mortgage lenders’ intentionsare honorable, and by taking possessionof the original promissory notessigned by residential home buyers aroundthe time the loans are funded as collateralfor this interim financing. Currently, dueto reduced lending resulting from the subprimelending crisis and poor economy,bank warehouse lending departments aremore at risk from fraud than ever as theyattempt to find mortgage lenders that canuse credit lines.Over the past few years, several highprofilefrauds have been perpetrated onbanks involved in warehouse lending. Twocases dealing with coverage disputes underfinancial institution bonds arising fromsuch frauds were litigated in courts in theSixth Circuit. Although the frauds werefactually similar, the trial courts, and ultimatelythe Court of Appeals for the SixthCircuit, came to very different conclusionsregarding the coverage obligations of thefidelity bond insurers based on a perceiveddifference in the underlying transactions.This article analyzes coverage for warehouselending losses associated with forgedpromissory notes through the prism ofthese two Sixth Circuit decisions. Applyingthe language in the 2004 version of theFinancial Institution Bond, Standard FormNo. 24 and considering the backgroundand purpose of the bond, courts shoulddetermine that no coverage attaches forwarehouse lending losses associated withforged promissory notes used as collateralbecause the unenforceable “promise,”not the forgery, is the “direct” cause of an Daniel E. Tranen and Stefan R. Dandelles are partners in the Chicago office of Wilson Elser MoskowitzEdelman & Dicker LLP. Mr. Tranen’s practice areas include insurance coverage, professional liability, andlife, health, and ERISA litigation, as well as fidelity bond matters. Mr. Dandelles’s practice areas includedirectors’ and officers’ liability, financial institutions, commercial crime, and fidelity bonds. Both authors aremembers of DRI and its Fidelity and Surety Committee.36 n For The Defense n March 2009© 2009 DRI. All rights reserved.

warehouse lender’s loss when a warehouselender relies on forged promissory notes toextend credit to a mortgage lender for putativereal estate transactions.The Fraud Risks to WarehouseLenders from Mortgage LendersWarehouse lenders provide a kind of “bridgefinancing” that allows mortgage lenders,which are not otherwise backed by a financialinstitution, to extend credit to residentialhome buyers for real estate purchases. Inthese transactions, a warehouse lender doesnot have a direct relationship with a homebuyer. Instead, a home buyer’s relationshipis with a mortgage lender. In exchange for amortgage lender’s funding of the home purchase,a home buyer signs a promissory notepromising to repay the loan, and a mortgageon the property as security for the loan. Themortgage lender uses this promissory noteand the mortgage, which it assigns, as collateralfor the credit extension it receivesfrom its warehouse lender.A warehouse lender typically funds thisextension of credit to a home buyer when ahome buyer closes on the purchase of thehome. If the funding is “wet,” a warehouselender will generally part with its fundsprior to execution of the promissory note bythe home buyer, although it will not receivethe original promissory note until somelater point in time. In other words, fundingis released prior to or simultaneous withcreation of the promissory note.If the funding is “dry,” the originalpromissory note and mortgage assignmentdocuments are signed and transferred to awarehouse lender prior to the closing onthe home buyer’s purchase transaction, andtherefore, a warehouse lender’s possessionof the original promissory note becomes afactor in the warehouse lender’s agreementto release funds to the mortgage lender sothat it can fund the home buyer’s loan. Typically,warehouse lenders prefer “dry” closingsbecause they are most protected whenthey have actual possession of the promissorynote prior to releasing funds. As notedbelow, dry funding may also be critical tocoverage under the Financial InstitutionBond, Standard Form No. 24.A warehouse lender usually receives paymenton its line of credit when the mortgagelender sells the loans on the secondarymarket or to a specific third-party investor.The time lag between the warehouselender’s financing of a loan and repaymentby the mortgage lender is typically between30 and 90 days. Once a loan is sold and awarehouse lender is repaid by the mortgagelender (with interest and fees), additionalcredit becomes available on the warehouseline of credit so that the mortgage lendercan make additional loans. In this way,the collateral—the promissory notes—for credit being extended by a warehouselender is constantly rotating as loans aresold and new loans are made.Because a warehouse lender only providesinterim financing, it is not particularlyconcerned with the overall viabilityof a loan or the ability of the residentialhome buyer to repay the loan. A warehouselender is concerned with the mortgagelender’s ability to sell the loan to a thirdpartyinvestor or with the secondary market.Once a mortgage lender demonstratesan ability to sell a loan during this interimtime period of less than 90 days, a warehouselender becomes comfortable withthe mortgage lender. Indeed, a consistentrecord by a mortgage lender of successfullyselling mortgages and repaying its warehouselender will often induce the warehouselender to extend greater amounts ofcredit to that mortgage lender so that it canfund additional loans.There are many ways for mortgage lenders,usually in conjunction with fake titlecompanies and even fake investors, todefraud warehouse lenders. The fraud usuallyinvolves false or fabricated promissorynotes containing forged signatures, sincepromissory notes are the collateral thatwarehouse lenders typically must receive torelease funds to a mortgage lender to fund areal estate purchase transaction. Fraud successinvolving a forged promissory note isusually unaffected by whether funding was“wet” or “dry,” since the promissory note,whether an “original” or just a “copy” doesnot represent a valid promise by an actualpurported home buyer to pay.Relevant Provisions under theFinancial Institution Bond,Standard Form No. 24Two coverage provisions usually come intoplay when a warehouse lender suffers lossfrom fraud associated with its reliance onforged promissory notes. Insuring AgreementD, which deals with forgery or alteration,covers, in pertinent part, loss resultingdirectly from a bank’s reliance on a negotiableinstrument, certificate of deposit orother similar document (but not an evidenceof debt) that bears a signature of amaker that is forged or altered, but onlyto the extent that the forgery or alterationcauses the loss. Insuring Agreement E,The forgeries did causethe loss because, accordingto the court, the promissorynotes would have had valuebut for the fact that theywere forged by Greatstone.deals with securities, and covers, in pertinentpart, loss resulting directly from abank’s reliance on a security, deed, evidenceof debt or similar document thatbears the signature of a maker and that iseither a forgery, an alteration, lost or stolen.Both coverage under Insuring AgreementsD and E require actual, physical possessionof the item by a bank as a conditionprecedent to coverage under the 2004 versionof the financial institution bond. In the1986 version, only coverage under InsuringAgreement E required a bank to possessthe document. This fact is significantbecause, as noted above, sometimes loansare funded by a warehouse lender, eventhough the warehouse lender does not havepossession of the original documents ascollateral, which, as also mentioned above,is known as “wet” funding.The Union Planters Fraud andCoverage DeterminationIn late 1999, Union Planters Bank extendeda $10 million line of credit to GreatstoneMortgage for the purpose of funding mortgageadvances to residential home buyers.Union Planters Bank N.A. v. ContinentalCas. Co., 478 F.3d 759, 761 (6th Cir. 2007);see also Union Planters Bank N.A. v. ContinentalCas. Co., No. 02-2321-MA (W.D.For The Defense n March 2009 n 37

Fidelity and SuretyTenn. August 23, 2004) (Mays). These fundingadvances were “wet,” meaning that atthe time Union Planters extended the creditto Greatstone to fund the home purchase,Union Planters would only have faxed copiesof the promissory notes, mortgages andmortgage assignment documents. Id. The“original” documents would be deliveredto Union Planters at a later date.The fact that the namedborrowers were actualcustomers… does notmake the transaction thatwas collateralized by theforged promissory noteany more authentic.After successfully demonstrating anability to sell the mortgages on the secondarymarket, Union Planters providedGreatstone with larger lines of credit. Bythe summer of 2001, Greatstone had a $25million line of credit, which it had drawndown, purportedly, to fund loans to residentialhome buyers. Id. at 761. Greatstonesubsequently defaulted on its line of creditand ceased making payments to UnionPlanters. The principals of Greatstone tookthe money and fled to Costa Rica to avoidthe authorities.Union Planters soon discovered that ithad been one of the victims of fraud perpetratedby Greatstone against a numberof banks. The fraud suffered by UnionPlanters in part involved the origination oflegitimate mortgages for which Greatstoneborrowed money on a line of credit fromanother warehouse lender. From informationsupplied by the home buyers withthese legitimate mortgages, Greatstone createdfraudulent mortgages and promissorynotes upon which Greatstone forged the signaturesof these otherwise legitimate buyers.Id. at 762. Next, Greatstone transmittedthe forged mortgage documents to UnionPlanters, which induced Union Planters38 n For The Defense n March 2009to continue to extend credit to Greatstone.The fake mortgage documents containedunique loan numbers that did not reflectan actual extension of credit from Greatstoneto the borrowers; those borrowershad already received mortgage funds fromGreatstone, pursuant to separate loan documents,legitimately signed by those borrowers.See Union Planters,at fn. 5.Union Planters’ primary financial institutionbond insurer denied coverage for itsloss. The insurer made two strong argumentsin favor of its position. First, itargued that because Union Planters didnot have possession of the original promissorynotes when it extended the credit,and provided “wet” funding, Union Plantersdid not “rely” on those original noteswhen it extended the credit, which was oneof the conditions for coverage under thebond. While the court agreed that therewas no reliance on the individual promissorynotes for a particular extension ofcredit, the court rejected the insurer’s argumentbecause Union Planters did rely onits possession of original promissory notesfor one loan to extend credit for futureloans. Because the original collateral wasconstantly rotating, the court found thatUnion Planters did rely on original loandocuments that were in its possession. Id.at 764.Second, the financial institution bondinsurer argued that the loan losses did not“directly result from” the forgeries. Instead,other factors, including Greatstone’s useof duplicate, fraudulent loan documents,actually caused this loss. The court found,however, that the forgeries did cause theloss because, according to the court, thepromissory notes would have had value butfor the fact that they were forged by Greatstone.The court reasoned that the value ofa promissory note lies in the “promise topay.” According to the court, had the notecontained a valid promise to pay, it wouldhave had value. Since the forgery was thedifference between value and lack of value,the Sixth Circuit Court of Appeals held thatthe forgery directly caused Union Planters’loss. Id. at 765.The court found that Union Planters’loss met the conditions for coverage underthe subject financial institution bond, andthe insurer had to indemnify Union Plantersfor these loan losses.The Flagstar Fraud andCoverage DeterminationIn 2003, Flagstar Bank provided a putativemortgage broker operating under thename “Amerifunding” a $20 million line ofcredit. Flagstar Bank FSB v. Federal Ins. Co.,2006 U.S. Dist. LEXIS 83825 3 (E.D. Mich.2006); see also Flagstar Bank FSB v. FederalIns. Co., 2008 U.S. App. LEXIS 1114 (6thCir. 2008). Amerifunding used that line ofcredit purportedly to extend credit to homebuyers purchasing residential real estate.Id. In fact, there were no home purchases,no home buyers, and no real estate transactionsassociated with these loans. Id. at 4.The purported home buyers were real individualswho had applied for jobs at Amerifunding.Id. at 20. Amerifunding usedcopies of their driver’s licenses and otherpersonal information obtained with theputative job applications to make it appearto Flagstar that legitimate home purchaseswere taking place. Id. at 22.With that information, Amerifundingcreated promissory notes, which includedforged signatures using the names of theseindividuals. Upon receiving the originalsof these promissory notes, Flagstar wouldfund the loans by unwittingly providingthe money for fictitious home purchases toa fictitious closing agent. In reality, thesefunds went to the principals of Amerifunding.Id.Amerifunding had identified a specificinvestor from which Flagstar received paymentfor the loans it extended to Amerifundingfor these fictitious home buyers.This “investor,” TDF Funding, was alsofictitious and was operated by the principalsof Amerifunding. Flagstar’s beliefthat these loans were being purchased byTDF Funding was instrumental in its decisionto extend credit to Amerifunding. Id.at 22–23.Ultimately, Flagstar did not discoverthe fraud as a result of an Amerifundingdefault, as occurred in the Union Planterscase. Instead, an enterprising processoremployed by Flagstar discovered the fraudwhen her suspicions caused her to contacta putative home buyer, who denied participatingin a home purchase with Amerifunding.Id. at 10.Flagstar sought coverage for its lossesfrom its financial institution bond insurers.They denied coverage because Flagstar’s

loss did not directly result from the forgerieson the promissory notes. Instead, the insurersargued, and the Sixth Circuit Courtof Appeals agreed, that the collateral—the promissory notes—had no value, andwould have had no value, even if they hadnot been forged, since the underlying transactionswere wholly fictitious. Flagstar, 2008U.S. App. LEXIS 1114 at 11. Therefore, Flagstar’sloss was not caused by the forgeries,but by the fraudulent scheme itself.Are the Flagstar and UnionPlanters CircumstancesMaterially Distinguishable?Factually, the fraud schemes involved inFlagstar and Union Planters are similar.Both schemes involved the creation ofpromissory notes by mortgage brokers withforged signatures of real people. In bothcases, the promissory notes did not evidencepromises to pay by purported homebuyers based on a legitimate home purchasetransaction, but instead were createdto deceive the warehouse lender so that itwould extend credit to the mortgage lender.In both cases, the warehouse lender reliedon the legitimacy of forged promissorynotes in making a decision to extend creditto the mortgage broker. In each instance,the warehouse lender obtained the originalpromissory notes as collateral from themortgage lender as part of the agreement tofund the putative transactions. In the Flagstarcase, the transaction never occurred.In the Union Planters case, a home purchasetransaction did at one point occur,but the money provided by the insuredwarehouse lender was obtained via fraudand was not used to fund the transaction,and instead, went directly into the mortgagelender’s pocket.The Union Planters court distinguishedits factual circumstances from the Flagstarfacts as follows:But the collateral the bank received in[the Flagstar case] was entirely fictitious:the named borrowers were never customersof the mortgage lender; no permanentlender ever purchased any ofthe mortgage loans; and even if the loanshad borne legitimate signatures, theystill would have been worthless. Here, bycontrast, the named borrowers were customersof Greatstone; permanent lenderspurchased some of the loans; andif the loans had borne legitimate signatures,they would have had value.Union Planters, 478 F.3d at 765.However, these distinctions are eithersuperficial or incorrect.The first two distinctions identifiedby the Union Planters court, while true,do not appear to be critical distinctions.The fact that the named borrowers wereactual customers of Greatstone does notmake the transaction that was collateralizedby the forged promissory note anymore authentic. Indeed, at most, this factprovided Greatstone with evidence to convinceUnion Planters that the forged promissorynotes were associated with authentictransactions. In fact, the money released byUnion Planters was not used by the homebuyers to purchase real estate.The second distinguishing point, that, insome cases, legitimate investors purchasedlegitimate loans from Greatstone, againonly made the fraud more convincing, andtherefore, easier to hide from Union Planters.However, those transactions did notdirectly contribute to Union Planters’ loss.The sale of authentic loans to a third-partyinvestor would not legitimize the underlyingtransactions between a mortgagelender and a home buyer, whether authenticor fake.The third distinguishing factor—that,but for the forgeries, the notes would havehad value—seems to be most dispositiveof coverage, at least to the justices on theCourt of Appeals for the Sixth Circuit. Thisdistinction would supply the causal linkbetween the forgery and the loss sufferedby Union Planters. However, as explainedbelow, it should not have been considereda factor distinguishing circumstances inUnion Planters from the circumstances inFlagstar, because the forged promissorynotes in the Union Planters case wouldnot have had value even if those notes didnot contain forgeries, as suggested by thecourt.What Is the Significance of a ForgedSignature on a Promissory Note?A promissory note is an unconditionalpromise to pay. However, the promise isalmost always made “for value given.”While these words do not typically providea defense to the promisor based uponinsufficient consideration, some considerationhas to be given to the promisor inexchange for their unconditional promiseto pay. This is a universal concept. See, e.g.,Sirius LC v. Erickson, 156 P.3d 539 (Idaho2007); The Prudential Preferred Propertiesv. Miller, 859 P.2d 1267 (Wyo. 1993); Gentilev. Bower, 222 S.E.2d 130 (Ga. App. 1996);Williamson v. Guice, 613 So. 2d 797 (La.App. 1993); Rybak v. Dressler, 532 N.E.2dIn all material terms,the Union Planters fraudwas no more deserving ofcoverage under the financialinstitution bond languagethan the Flagstar fraud.1375 (Ill. App. 1988).In the Flagstar case, the transaction wasentirely fictitious. Therefore, even if Amerifundinghad somehow convinced the jobapplicants whose identities were stolen toput legitimate signatures on those promissorynotes, those notes would not have beenenforceable. The job applicants receivedno consideration for those notes. NeitherAmerifunding nor Flagstar, a holder ofthe promissory notes in due course, couldenforce those notes against the job applicantswho might have been duped intosigning them, since a complete lack of considerationis an affirmative defense to theenforcement of a promissory note.What about the home buyers in theUnion Planters case? What if Greatstonehad slipped in an extra promissory noteat closing, secured authentic signatureson two promissory notes and used eachnote as collateral to secure funds on itsline of credit from its warehouse lenders?Could Union Planters have taken theextra note, which the home buyer inadvertentlysigned, but which had an actualsignature, and enforced this promise topay against the home buyer promisor eventhough the home buyer received no considerationin exchange for signing this second,extra promissory note? The answerFor The Defense n March 2009 n 39

Fidelity and Suretyshould still be “no,” for the same reasonsprovided above. The promisor has notreceived “value” in exchange for his or herpromise to pay as recorded on that second,extra promissory note. The note is worthless.Union Planter’s loss would be causedby the fraud perpetrated by the mortgagelender—a fraud that duped both the homebuyer and the warehouse lender. SinceThe bond’s purpose is notto cover those risks that canbe mitigated or avoided bya bank through exercise ofsound business practices.there is no forgery in this example, thisfraud would clearly not be covered undereither Insuring Agreements D or E. Whywould the introduction of a forged promissorynote make any difference?Consider the entire “dry” funding scenario.In such a case, a home buyer signsa promissory note in advance of the homepurchase closing so that the warehouselender can have possession of the originalpromissory note when it releases thefunds to the mortgage broker so that themortgage broker can fund the home purchase.(The ink used for the signature hashad time to “dry,” hence the term.) What ifthe warehouse lender decides not to fundthe loan and the mortgage lender has noother funding source? Obviously,the promiseby the home purchaser to pay the noteis not enforceable. The promissory note isworthless.What if, during a “dry” funding transaction,a warehouse lender transmits thefunds via the Internet, but Internet piratesintercept the funds, and the funds neverreach the mortgage lender? Again, sincethe home buyer never purchased the homewith the funds—received no value or considerationfor their promise—the promissorynote is not enforceable, and therefore,worthless.What if, during a “dry” funding transaction,a warehouse lender transmits the40 n For The Defense n March 2009funds to the mortgage lender, but an agentor employee of the mortgage lender stealsthe funds? As a result, the home buyercannot purchase the home. The result isno different from either of the first twoscenarios described above for the homebuyer. The promisor, or home buyer, didnot receive value for the promise containedin the promissory note, and therefore, theunconditional promise to pay is unenforceableand worthless. Indeed, the law is clearthat a lender—the holder in due courseof a note signed by a borrower—cannotenforce a note against a borrower if theborrower never received the loan proceeds.Stone v. Behlberg, 728 F. Supp. 1341 (W.D.Mich. 1990); Thomas v. Leja, 468 N.W.2d 58(Mich. Ct. App. 1991); Franck v. Bedenfield,494 N.W.2d 840 (Mich. Ct. App. 1993).As the cases cited directly above eachnote, the protection of borrowers, whopurchase real estate under these circumstances,has been codified into law in theTruth in Lending Act. According to theAct, a borrower can rescind a loan transactionup to three days after consummationof the transaction. 15 U.S.C. §1635 (2008).If a borrower has never received loan proceeds,the loan transaction is never properlyconsummated, and the rescission clockdoes not start to run. Stone, 728 F. Supp. at1345; Thomas, 468 N.W.2d at 58; Franck,494 N.W.2d at 841. As a result, promissorynotes signed by borrowers are unenforceableagainst the borrowers until at leastthree days after borrowers receive considerationfor their promises. Therefore, theUnion Planters court was plainly incorrectwhen it concluded that the promissorynotes would have had value but forthe fact that Greatstone signed the promissorynotes instead of the actual home purchasers,since those home buyers neverreceived loan proceeds from the transactionwith Union Planters. Thus, in all materialterms, the Union Planters fraud wasno more deserving of coverage under thefinancial institution bond language thanthe Flagstar fraud.The district court in Union Planters alsoraised the fact that the promissory notesused by Greatstone were authentic, legitimatepromissory notes, except for the factthat they contained forgeries. The courtsuggested that because Greatstone usedlegitimate promissory note forms andforged the signatures of actual customerson those forms, the notes would have valuehad they been legitimately signed. However,real forms and real customers do notbestow value on promissory notes. It is thepromise to pay made by the person whosigns the promissory note, together withconsideration bestowed on the promisorthereby rendering the note enforceable thatgives the note value. Thus, forgery of anotherwise unenforceable promissory notecannot directly cause a loss sustained by awarehouse lender.Does the Causation StandardMake a Difference?Another distinguishing factor betweenFlagstar and Union Planters was the causationstandard the court used. Both bondscontained “loss directly resulting from”language. The Flagstar court held that thisstandard required more than mere proximatecause. The language used requiredFlagstar to establish that the forged promissorynotes, not some other factor, caused itsloss. Flagstar could not do so because it wasevident that much more than mere forgeddocuments caused it to unwittingly lendmoney to Amerifunding. The entire transactionwas fake. The forgeries were merelya small part of the overall fraud.The Union Planters court, on the otherhand, supposedly relying on Tennessee law,held that the bond’s “loss directly resultingfrom” language equated the proximatecause standard. In fact, the case the SixthCircuit relied on to conclude that the proximate/efficientstandard should be usedinvolved the phrase “arising out of” in aninsurance policy exclusion, as opposed tothe phrase “directly resulting from” in abond insuring clause. See Am. Nat’l Prop.& Gas Co. v. Gray, 803 S.W.2d 693, 695(Tenn. App. 1990). Other jurisdictions doequate “directly resulting from” languagewith a proximate cause standard. See, e.g.,Jefferson Bank v. Progressive Cas. Ins. Co.,965 F.2d 1274 (3d Cir. 1992); Hanson PLCv. National Union Fire Insurance Co., 794P.2d 66 (Wash. App. 1990). Accordingly,it is worthwhile to examine whether theforged signatures on the promissory notesprovided to Union Planters constituted theefficient proximate cause of the loss thatUnion Planters suffered as a result of Greatstone’sactions.

Courts have held that an “efficient proximate”cause is the predominant event thatbrings about another event. Parks RealEstate Purchasing Group v. St. Paul Fire& Marine Ins. Co., 472 F.3d 33, 40 (2d Cir.2006); Pioneer Chrlor Alkalai Co., Inc. v.National Union Fire Insurance Co., 863 F.Supp. 1226, 1231–32 (D. Nev. 1994). TheTennessee case relied on by the UnionPlanters court actually employed a “butfor” standard: would the injuries haveoccurred but for the negligence of the physician.See White v. Methodist Hosp. South,844 S.W.2d 642 (Tenn. App. 1992) (employingthe proximate cause standard set forthin a statute governing a claimant’s burdenin a medical malpractice case).Even applying the less stringent “efficient/proximate”cause standard to thefacts in Union Planters should have yieldedthe same result that was reached in Flagstar.Union Planters’ loss was “predominantly”caused by the fact that it could not enforcethe promissory notes against the home buyersbecause Greatstone submitted illegitimatepromissory notes to Union Planters.These notes were not “illegitimate” becausethey had forged signatures; they were illegitimatebecause the person identified onthem never made the promises indicatedfor value given. As noted above, authenticsignatures would not have made these notesany more legitimate or valuable.The Underlying Purpose ofFinancial Institution BondsThe protections offered by a financial institutionbond are not intended to insure afinancial institution for loan losses or otherlosses preventable by adequate underwritingor due diligence. Coverage under InsuringAgreements D and E in the bond aredesigned to protect an insured from losscaused by presentation of inauthentic documentsto the financial institution. If aperson presents a forged cashier’s check toa bank for payment, there is little a bankcan do to protect itself in the near termwithout sacrificing the convenience offeredby typical banking practices. Courts analyzingcoverage provided under InsuringAgreements D and E make this distinction,noting in particular that these bondsare not meant to protect an insured fromloss caused by false statements containedin documents relied on by banks. See KWBancshares, Inc. v. Underwriters at Lloyd’s,London, 965 F. Supp. 1047, 1054 (W.D.Tenn. 1997) (bank supplied with fabricateddocuments with forged signatures indicatingthat borrower would be receivinga substantial job-related bonus); LibertyNational Bank v. Aetna Life & Cas. Co., 568F. Supp. 860 (D. N.J. 1983) (bank suppliedwith forged certificates of deposit which didnot represent real assets).Is a forged promissory note an inauthenticdocument or a document with falsestatements? The answer is that a forgedpromissory note is probably both—justas in KW Bancshares and Liberty NationalBank. However, the fact that it is not simplyan inauthentic document means that abank has an opportunity to protect itself,and therefore, the purpose of a financialinstitution bond is not triggered merelybecause a false promise also contains aforgery. The bond reflects an allocationof risks, and the bond’s purpose is not tocover those risks that can be mitigatedor avoided by a bank through exercise ofsound business practices.For example, in the Flagstar case, thebank discovered the fraud when a processorfinally called a random “borrower” toconfirm that he was an actual customer ofAmerifunding and had purchased a home.Had the bank made this simple effort earlier,it might have protected itself from itsloss. Flagstar could have performed evena perfunctory check on the third-partyinvestor or the fake title companies usedby Amerifunding to discover that it was thevictim of a fraud.Similarly, had Union Planters asked aboutthe promissory notes Greatstone’s customerssigned, it would have soon discoveredthat the loan numbers on the promissorynotes that Union Planters held were not thesame as the loan numbers on the promissorynotes signed by the actual home buyers.Even if the loan numbers had been thesame, Union Planters had other opportunitiesto protect itself by performing due diligenceon the investors purportedly buyingthe fake notes, the title companies to whichit sent funds, or by requiring Greatstone touse a third-party title companyConclusionIn this time of economic crisis, with mortgageforeclosures at record levels, loanlosses causing financial institutions toshutter their doors, and mortgage fraudschemes seemingly in the news on a dailybasis, a rise in financial institution bondclaims should not be a surprise. InsuringAgreements D and E will certainly becomea focus, as will the need for attention tothe intentionally narrow scope of coveragethey afford. Neither the actual language inthe Financial Institution Bond, StandardForm No. 24, nor the practical purpose ofthe bond support coverage for warehouselenders losses due to credit extensions tomortgage lenders based on forged promissorynotes if such notes are unenforceablenotwithstanding the forgery. There isnothing a financial institution bond underwritercan do to effectively underwrite thefraud risks a lending institution faces inits daily operations. The financial institutionbond is not intended to afford blanketfraud coverage. Nonetheless, insureds willattempt to force the square peg of business,credit or fraud losses into the round hole ofcoverage provided by Insuring AgreementsD and E.For The Defense n March 2009 n 41