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More Federal Decisions Highlight Need to Invoke Original Document Defense in Financial Institution Bond Cases

Posted on July 22, 2014 by Ludwig & Robinson PLLC

As reported in our September 2013 Newsletter, recent federal decisions in Michigan serve as instructive reminders of the need for insurers in Financial Institution Bond (FIB) cases to timely explore the availability of, and invoke, the original document requirement defense under Insuring Agreement (D) or (E). In Bank of Ann Arbor v. Everest Nat’l Ins. Co., 2013 U.S. Dist. LEXIS 24999 (E.D. Mich. Feb. 23, 2013), the district court granted summary judgment in favor of coverage, and then denied reconsideration in Bank of Ann Arbor v. Everest Nat’l Ins. Co., 2013 U.S. Dist. LEXIS 65762 (E.D. Mich. May 8, 2013), where the insurer had not timely raised the defense.

In that case, the Michigan bank received a faxed wire transfer request from an individual purporting to be its customer, requesting that $196,000 be wired from the customer’s home equity line to a bank in South Korea. The request contained the customer’s signature and account information. The bank further verified the request by calling the phone number on file (modified the week before by letter purportedly emailed from the customer), and wired the funds to Seoul. Two days later the bank received a second request for a $98,000 wire, this time processed by an employee who knew the customer, questioned why he would wire funds to South Korea, and called him on his actual phone number, uncovering the scam. The bank re-credited the account and submitted a claim for coverage under its FIB, which the insurer denied.

On cross-motions for summary judgment, the court overruled the insurer’s two grounds for denying coverage. The court found the forged wire request was a covered “Withdrawal Order” under Insuring Agreement (D) and an Unauthorized Signature Rider, and that the loan-loss exclusion of the Bond did not apply where the loss was not the result of a loan, the customer having neither received the funds nor agreed to repay the debt. Though both Agreement (D) and the Rider expressly required a “Written Original” for coverage, which the faxed transfer request clearly did satisfy, that requirement was not raised by the insurer until after summary judgment, and the court declined to consider the new argument on reconsideration in the exercise of its discretion pursuant to Federal Rule 59(e).

This Spring three more federal decisions were handed down which further underscore the importance of timely raising the original document requirement in FIB cases under Insuring Agreements (D) and (E).

1. In April, the Sixth Circuit affirmed the result in Bank of Ann Arbor, holding the district court did not abuse its discretion in refusing to entertain the insurer’s original document defense, raised for the first time on motion for reconsideration after summary judgment had been granted. Bank of Ann Arbor v. Everest Nat’l Ins. Co., 2014 U.S. App. LEXIS 7820 (6th Cir. Apr. 23, 2014). Additionally, the appeals court held that under Michigan law, when an insurer denies coverage on stated grounds, it generally waives or is estopped from raising new defenses. Here the insurer’s declination letter stated only two grounds for denying coverage, and did not raise the original document requirement. Although not addressed in either opinion, the insurer also did not raise the related “physical possession” requirement of the Bond, which provided further grounds for denial of coverage.

Bank of Ann Arbor serves as a cautionary tale of the importance for insurers to closely evaluate the potential applicability of the original document defense (and related physical possession defense) at the earliest stages of not only the litigation, but the claim itself.

2. In contrast, in May the District Court for the Southern District of Alabama granted summary judgment to the insurer which did timely raise the original document defense in relation to certificated securities alleged to be counterfeit. Bank of Brewton v. The Travelers Companies, Inc., 2014 U.S. Dist. LEXIS 69567 (S.D. Ala. May 21, 2014).

In that case the bank, in exchange for a series of loans consolidated and renewed beginning in 2005, obtained assignment of several stock certificates from its customer. Comparing the certificates in 2009, the bank realized one was not an original but a color copy. The customer provided a replacement certificate, and the bank renewed certain loans totaling $1.5 million. Then in 2010, the bank discovered the customer had actually pledged the prior original certificate to another bank, rendering the replacement certificate null and void, as representing the same shares as the pledged original certificate.

The FIB provided coverage under Insuring Agreement (E) for an extension of credit “on the faith of any item listed in (a)(i) through (a)(iv) above [including a “Certificated Security”], which is a Counterfeit.” The Bond defined “Counterfeit” as meaning “an imitation which is intended to deceive and to be taken as an original.” Addressing those provisions of the Bond, the court upheld the insurer’s denial of coverage upon the bank’s initial claim that the color copy of the original certificate constituted a counterfeit, on grounds that the bank knew the certificate was a copy and not an original, and thus not counterfeit. The court further held that the bank suffered no loss resulting directly from having relied upon that certificate as a genuine original document, knowing it to be a copy when the loans were renewed.

Addressing the bank’s belated alternative argument that the replacement certificate constituted a counterfeit within the meaning of the Bond, the court noted that a document “must be a fake version of an existing, genuine document,” and “must possess sufficient similarity to to the original to render it plausible that it is the genuine original of that which it imitates.” 2014 U.S. Dist. LEXIS 69567, *10. Finding the prior original certificate was a genuine document, the court held the replacement certificate, while quite similar, bore obvious differences beginning with the certificate number itself, and thus could not purport to be a counterfeit imitation as a matter of law.

The bank filed a notice of appeal of the district court’s grant of summary judgment denying coverage, on June 2nd.

3. Earlier this year a district court in Utah addressed whether electronic transmissions are covered “originals” under a modified version of the standard Form 24 FIB that omitted the form’s definition of “Original.” Transportation Alliance Bank, Inc. v. BancInsure, Inc., 2014 U.S. Dist. LEXIS 22187 (D. Utah Feb. 21, 2014).

The case involved a factoring fraud perpetuated on Transportation Alliance Bank (TAB) by Arrow Trucking, Inc. TAB, pursuant to an Accounts Receivable Purchase and Security Agreement, purchased Arrow’s accounts receivable at discount with the right to the full receivables when paid, also guaranteed and secured by Arrow’s accounts and assets. Pursuant to the Agreement, Arrow periodically provided TAB with electronic account statements, which Arrow electronically altered to falsely reflect higher receivables, inducing TAB to advance more cash than Arrow was entitled to receive, leading to a loss of $11.5 million. TAB submitted a FIB claim to BankInsure, Inc., which denied coverage for failure to satisfy the five discrete conditions to coverage under Insuring Agreement (E).

Addressing the first condition, the court found the electronic account statements were covered documents, whether as “Evidence of Debt,” or as a “Security Agreement” when combined with the A/R Purchase and Security Agreement. Next, addressing the condition that each covered document be an “original,” the court noted the Bond omitted the Form 24 definition (“Original…does not include…electronic transmissions even if received and printed”), under which there would have been no coverage. Finding that omission to be deliberate, and citing case law and Utah’s Uniform Electronic Transactions Act, the court held that, in the absence of a contrary definition, electronic transmissions “are a way of life and are just as original as a printed, hard copy of document…” Further, the court found that Arrow’s electronic overwrites were covered “alterations,” and that TAB had “physical possession” of the electronic data in its computers within the meaning of the Bond. The “physical possession” requirement, however, is meant to be read in conjunction with the “original” requirement and to provide the insured the opportunity to examine the “original” document and discover obvious defects. That purpose is not served in the case of electronic documents. Lastly, the court held the loss “resulted directly from” TAB having made over-advances upon Arrow’s alterations of its accounts receivable.

The case is an object lesson, particularly in today’s banking world where electronic documents are widely treated as originals, to ensure the standard form definition of “original” or its equivalent is included in the Bond.

For further information, contact Robert Ludwig at rludwig@ludwigrobinson.com or 202-289-7603, or Salvatore Scanio at sscanio@ludwigrobinson.com or 202-289-7605.

Posted in BANKING & FINANCE, CORPORATE, INSURANCE, LITIGATION | Tagged Bank Fraud, Counterfeit Securities, Cybercrime, Declination Letter, EFT Fraud, Electronic Funds Transfer (EFT), Electronic Transmission, Financial Institution Bond (FIB), Insurance Coverage, Original Documents, Robert Ludwig, Salvatore Scanio, Waived Defenses, Wire Transfer Fraud | Leave a comment

Eighth Circuit Upholds Ruling and Allows Attorneys’ Fees in Favor of Bank in Malware Wire Case Where Customer Refused Security Procedures

Posted on July 22, 2014 by Ludwig & Robinson PLLC

In a recent malware case arising from a large fraudulent wire transfer, the Eighth Circuit Court of Appeals upheld the district court’s grant of summary judgment to the bank. Choice Escrow and Land Title, LLC v. BankcorpSouth Bank, 2014 U.S. App. LEXIS 10817 (8^th Cir. June 11, 2014).

The bank received a $440,000 wire request purportedly from the customer, an escrow company, for transfer to a beneficiary’s account in the Republic of Cyprus. The request, received over the Internet using the customer’s login and password, was authenticated via a secure ID token downloaded on the customer’s computer to show it had been initiated from its registered IP address. The customer, a common malware target as an escrow company, had been attacked and its purported request was unauthorized.

Significantly, in establishing online banking services, the customer had declined the use of “Dual Control,” as offered by the bank, requiring two users using separate logins and passwords to process wire transfers, as well as daily limits on wire transfer activity. Subsequently, the customer inquired whether foreign wire transfers could be blocked to avoid fraudulent wires. The bank advised that it was unable to stop just foreign wires, recommending again dual control which the customer still declined.

On appeal as in the district court, the customer argued that the security procedures offered were not commercially reasonable because none involved transactional analysis whereby wire transfers are subject to individual fraud review. The Eighth Circuit disagreed, affirming thatit would be impracticable for the bank to review every outgoing wire and that there was no genuine question of fact whether the bank was required to use transactional analysis as a matter of reasonable commercial procedures. The Eighth Circuit concluded that the security procedures offered were commercially reasonable for that customer, observing:

[T]his appears to be a case where “an informed customer refuses a security procedure that is commercially reasonable and suitable for that customer and insists on using a higher-risk procedure because it is more convenient or cheaper[,]” in which case “the customer has voluntarily assumed the risk of failure of the procedure and cannot shift the loss to the bank.”

Id. at *26-27 (quoting UCC § 4A-203 cmt. 4).

Turning to whether the bank had proved it accepted the payment order in good faith under UCC § 4A-202(b), the Eighth Circuit described the good faith test as follows:

[W]hile there may be some evidentiary overlap between the commercial reasonableness of a bank’s security procedures and its compliance with reasonable commercial standards of fair dealing, we do not believe that the two inquiries are coextensive. While the commercial reasonableness inquiry concerns the adequacy of a bank’s security procedures, the objective good faith inquiry concerns a bank’s acceptance of payment orders in accordance with those security procedures. In other words, technical compliance with a security procedure is not enough under Article 4A; instead . . . the bank must abide by its procedures in a way that reflects the parties’ reasonable expectations as to how those procedures will operate.

[T]he focus of our good faith inquiry is on the aspects of wire transfer that are left to the bank’s discretion. . . .Where, as here, a bank’s security procedures do not depend on the judgment or discretion of its employees, the scope of the good-faith inquiry under Article 4A is correspondingly narrow. . . . [T]o establish that it acted in good faith, [the bank] must establish that its employees accepted and executed the . . . payment order in a way that comported with [the customer’s] reasonable expectations, as established by reasonable commercial standards of fair dealing.

Id. at *29-31. The court concluded that the bank met its burden because: (1) the customer was aware that the only time the bank’s employees saw the payment order was after the wire had cleared its security procedures, (2) the customer was also aware that the employees’ role was to route payment orders, not to check for irregularities, (3) the “payment order was not so unusual that it should have raised eyebrows,” as the amount was not unusual for the customer, and (4) the bank was under no obligation to review the memo line of the payment order. Id. at *32-33. The Eighth Circuit contrasted this case with Experi-Metal, Inc. v. Comerica Bank, 2011 U.S. Dist. LEXIS 62677 (E.D. Mich. June 13, 2011), where the district court found a lack of good faith by the bank in allowing, inter alia, $5 million in overdrafts from an account that had a zero balance.

Finally, the Eighth Circuit addressed the bank’s counterclaim for attorney’s fees based on an indemnification provision in the customer agreement. The district court had found that the indemnification provision conflicted with Article 4A, and dismissed the counterclaim. The Eighth Circuit reversed:

[The bank’s] counterclaim seeks attorney’s fees, not damages stemming from the fraudulent payment order, and Article 4A contains no provision allocating attorney’s fees between the bank and its customer in the event of litigation. Although awarding attorney’s fees to a bank under an indemnification agreement might reduce a customer’s overall recovery against that bank, it would do so for reasons extrinsic to Article 4A’s attempts to balance the risk of loss due to a fraudulent payment order. We thus conclude that the portion of the indemnification provision relating to attorney’s fees is not inconsistent with Article 4A and that [the bank] may seek attorney’s fees from [the customer] under this provision.

Id. at *38-39. Plainly, a bank’s ability to obtain attorney’s fees upon prevailing in customer claims under Article 4A may become a significant factor in the resolution of such claims.

Choice Escrow represents another decision illustrating the importance of bank customer agreements in allocating losses for unauthorized electronic funds transfers. See Salvatore Scanio and Robert W. Ludwig, Surging, Swift and Liable? Cybercrime and Electronic Payments Fraud Involving Commercial Bank: Who Bears the Loss?, 16 J. of Internet L. 3 (April 2013).

For further information, contact Salvatore Scanio at sscanio@ludwigrobinson.com or 202-289-7605, or Robert Ludwig at rludwig@ludwigrobinson.com or 202-289-7603.

Posted in BANKING & FINANCE, CORPORATE, LITIGATION | Tagged Account Takeover, Attorney’s Fees, Bank Customer Contract, Cybercrime, Deposit Account Agreement, EFT Fraud, Electronic Funds Transfer (EFT), Malware, Online Banking, Robert Ludwig, Salvatore Scanio, Security Procedures, UCC Article 4A, Wire Transfer Fraud | Leave a comment

L&R Obtains Summary Judgment for PNC Bank in Maryland $5 Million Banking Suit

Posted on June 17, 2014 by Ludwig & Robinson PLLC

In March 2014, L&R obtained summary judgment in Maryland state court for client PNC Bank, N.A., dismissing the rest of a suit arising out of a $9 million distressed real estate investment scheme. Ivanhoe Investment Partners, LP, et al. v. The PNC Financial Services Group, Inc., et al. This action was the last of a series of civil suits filed in Maryland, Connecticut and New York arising from the latest financial fraud by Michael Howard Clott, who 25 years ago, as head of First American Mortgage Co. (FAMCO) during the S&L crisis, pled guilty to “one of the largest [frauds] brought to prosecution in the federal system in” Maryland. E.F. Hutton Mortg. Corp. v. Equitable Bank, 678 F. Supp. 567, 570 (D. Md. 1988). At sentencing for a subsequent financial crime, the judge reportedly proclaimed that Clott could not be stopped “short of isolating him from all contact with humanity, like putting him on a desert island,” and even then “[h]e’d fleece the pigeons that landed there.”

In 2009, while facing charges in New York, Clott induced investors from Greenwich and Philadelphia to invest $9 million in a purported “no-risk” deal, to simultaneously buy and sell bulk portfolios of foreclosed properties from banks, as “show money” deposited in a title company’s accounts at PNC Bank. The investors, after filing prior actions against the title company and others, brought suit against PNC asserting claims of knowing participation in breach of fiduciary duty, negligence, breach of implied contract, breach of contract for intended third-party beneficiaries, negligent misrepresentation, conversion, banking malpractice, and wrongful involvement in litigation.

In December 2013, the trial court dismissed eight of ten counts against the bank, permitting plaintiffs’ two negligence claims to proceed pursuant to Chicago Title Ins. Co. v. Allfirst Bank, 394 Md. 270 (2006). On summary judgment in March 2014, the court dismissed the remaining claims, finding the bank owed no duty to the investors under Chicago Title, had not acted with actual knowledge of any breach or in bad faith, and that the action was further barred by contributory negligence and the statute of limitations.

The court observed that “as a general rule, banks don’t owe duties to non-account holders.” Under the exception in Chicago Title, however, a duty may exist where there is “some type of intimate nexus that is established and based upon the facts of [the] case.” Here, based upon the facts in the record, plaintiffs did not fall within the exception, particularly as there was “no evidence that the defendant, PNC, was aware of the plaintiff’s reliance on any of their actions.”

The court found, based upon the record evidence, that PNC had not acted with actual knowledge of any breach of fiduciary duty by the fiduciaries or in bad faith. The court rejected plaintiffs’ argument that the bank was chargeable with knowledge of alleged suspicious account activity and obligated to investigate, finding that PNC did not act in a commercially unjustified manner under the circumstances.

The court also ruled that plaintiffs’ action was barred by contributory negligence and the statute of limitations, finding as a matter of law that plaintiffs were both contributorily negligent and on inquiry notice well before December 2009, more than three years before suit was filed. The court made extensive findings based on undisputed facts and admissions developed in discovery that the investors could not simply rely on Clott, but rather ignored repeated red flags and failed to investigate, illustrated particularly by the primary investor request that the investment manager obtain bank statements on plaintiffs’ purported account, who failed to do so.

The case is currently on appeal to the Maryland Court of Special Appeals.

For further information, contact Robert Ludwig at rludwig@ludwigrobinson.com or 202-289-7603 or Salvatore Scanio at sscanio@ludwigrobinson.com or 202-289-7605.

Posted in BANKING & FINANCE, LITIGATION | Tagged Bank Liability, Contributory Negligence, Deposit Fraud, Fiduciary Duty, Investment Fraud, James Tompert, Ponzi Scheme, Robert Ludwig, Salvatore Scanio, Statute of Limitations | Leave a comment

New York Court of Appeals Approves Reduction of UCC One-Year Notice Period for Reporting Check Fraud to Fourteen Days

Posted on June 6, 2014 by Ludwig & Robinson PLLC

Under UCC § 4-406(f), a customer must discover and report any unauthorized signature or alteration on a check to its bank within one year after a statement or check is made available to the customer. Absent timely notice, the customer’s claim against its bank is precluded regardless of bank negligence. A bank by contract may vary the provisions of UCC Article 4 but “cannot disclaim” its “responsibility for its lack of good faith or failure to exercise ordinary care or limit the measure of damages for the lack of failure.” Rev. UCC § 4-103(a). As an additional limitation, the parties may only “determine by agreement the standards by which the bank’s responsibility is to be measured if those standards are not manifestly unreasonable.” Id.

In Clemente Bros. Contracting Corp. v. Aprile Hafner-Milazzo, 2014 N.Y. LEXIS 1003 (N.Y. May 8, 2014), the New York Court of Appeals recently addressed whether a customer agreement reducing the UCC’s one-year notice period to 14 days was enforceable. (Although New York has not adopted Revised UCC Article 4 (1990), the provisions applicable here are substantially similar.) In a split 5-2 decision, the court held that a bank may cut-down the one-year notice by agreement as long as the modification is not manifestly unreasonable. Specifically, the court held that the 14-day period was enforceable in cases where the customer is “a corporate entity that either is financially sophisticated or has the resources to acquire professional guidance.” Id. at *17. In this case, the court noted that the customer had numerous employees, regularly moved hundreds of thousands of dollars in and out of its accounts, had the resources to make an informed decision about opening an account at its bank and to monitor its accounts once a month within 14 days of each statement, and critically, had executed a corporate resolution containing the 14-day notice provision. Id. at *16-17. In dicta, the court observed that a 14-day period could be manifestly unreasonable for unsophisticated customers, small family businesses, or consumers, in which cases a 30- or 60-day period may be appropriate. Id. at *17.

One other court has upheld a 14-day notice period, Borowski v. Firstar Bank Milwaukee, N.A., 579 N.W.2d 247, 251 (Wis. App. 1998), though commentators have suggested such a short period is manifestly unreasonable because it can serve effectively to enable a bank to escape liability as an outright disclaimer. Several other courts, however, have enforced 60-day notice periods. See, e.g., Peters v. Riggs Nat’l Bank, N.A., 942 A.2d 1163, 1168 (D.C. 2008); National Title Ins. Corp. Agency v. First Union Nat’l Bank, 559 S.E.2d 668, 672 (Va. 2002); American Airlines Employees FCU v. Martin, 29 S.W.3d 86, 96 (Tex. 2000).

While the New York decision provides authority for varying the UCC’s one-year notice provision to as little as 14 days for many commercial customers, the case is also a reminder that a one-size-fits-all approach may not be appropriate, with longer reporting periods potentially required for other types of customers. Indeed, in 2001 the Uniform Law Commissioners circulated a draft amendment to section 4-406 that would have made any shortening of the one-year period to less than 90 days unenforceable against a consumer.

For further information, contact Salvatore Scanio at sscanio@ludwigrobinson.com or 202-289-7605, or Robert Ludwig at rludwig@ludwigrobinson.com or 202-289-7603.

Posted in BANKING & FINANCE, CORPORATE, LITIGATION | Tagged Bank Customer Contract, Check Fraud, Deposit Account Agreement, Robert Ludwig, Salvatore Scanio | Leave a comment

The Future of Payments Fraud/Counterfeit Cashier’s Checks

Posted on March 26, 2014 by Ludwig & Robinson PLLC

Sal Scanio spoke at BAI’s Payments Connect 2014 conference, The Future of Payments Fraud, in Las Vegas on March 11, 2014, as part of a panel titled, Counterfeit
Cashier’s Checks: Avoiding Both Fraud and Revenue Losses.

In recent years, financial criminals have moved upstream to find victims, often by scamming established bank customers into accepting counterfeit cashier’s checks. As a recent FBI bulletin illustrates, one common scheme is directed at law firms, in which a fraudster assumes the identity of a foreign entity seeking to retain a law firm to collect a large debt. Shortly after the law firm issues a demand letter, the firm receives a facially valid cashier’s check in payment of the debt. Per the “client’s” instructions, the firm deposits the cashier’s check in its account and then promptly wires out the funds overseas, without allowing the check to clear. The cashier’s check is returned as counterfeit and charged back to the law firm’s account, potentially resulting in an overdrawn account.

While banks have charge-back rights under deposit agreements with their customers as
well as the UCC (including breach-of-warranty claims for indorsement liability), customers often raise non-UCC common law claims in an effort to shift liability for the loss to the bank. Such claims, typically plead equitable estoppel or negligent misrepresentation
based on allegations that the bank said the “check had cleared” or “funds were available,” the bank did not place a Reg. CC hold for any amount over $5,000, or the bank permitted uncollected funds to be transmitted by an international wire transfer. Although the UCC’s provisions often displace common law claims, some courts have held otherwise, particularly in cases where a bank had communications with its customer about the check-collection process, finding they are not specifically covered by the UCC. In virtually all cases, customers argue that banks have superior knowledge of banking operations and greater access to information and thus the depositary should bear the risk of loss.

In order to avoid exposure for fraudulent cashier’s checks, banks may consider various measures, including:

Placing Reg. CC holds on cashier’s checks over $5,000
Reviewing the bank’s written disclosures on cashiers’ checks regarding check clearance and funds availability
Instructing staff on communicating with customers on cashiers’ checks regarding check clearance and funds availability (and documenting those communications where appropriate)
Include a question on the wire transfer request whether the funds are being sent to a person introduced over the internet
Implementing appropriate outgoing wire transfer verification procedures, including alerts for wires based on recent deposits

For further information, contact Salvatore Scanio at sscanio@ludwigrobinson.com or 202-289-7605, or Robert Ludwig at rludwig@ludwigrobinson.com or 202-289-7603.

Posted in BANKING & FINANCE, CORPORATE, INSURANCE, LITIGATION | Tagged Check Fraud, Counterfeit Cashier's Checks, Robert Ludwig, Salvatore Scanio | Leave a comment

More Federal Decisions Highlight Need to Invoke Original Document Defense in Financial Institution Bond Cases

Eighth Circuit Upholds Ruling and Allows Attorneys’ Fees in Favor of Bank in Malware Wire Case Where Customer Refused Security Procedures

L&R Obtains Summary Judgment for PNC Bank in Maryland $5 Million Banking Suit

New York Court of Appeals Approves Reduction of UCC One-Year Notice Period for Reporting Check Fraud to Fourteen Days

The Future of Payments Fraud/Counterfeit Cashier’s Checks

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