STEAL-A-DEAL, OTHER PEOPLES' MONEY, - Forcon International

SEVENTEENTH ANNUAL
SOUTHERN SURETY AND FIDELITY CLAIMS
CONFERENCE
St. Pete Beach, Florida
th th
MAY 4 - 5 , 2006
“CAPITALIZED INTEREST AS POTENTIAL INCOME UNDER
THE FIB: DON’T ROLL OVER ON ROLLED OVER INTEREST.”
PRESENTED BY:
STEPHEN M. KRANZ
SR. PROFESSIONAL E&O CLAIM ATTORNEY
ST. PAUL TRAVELERS
GREGORY R. VEAL, ESQ.
BOVIS, KYLE & BURCH, LLC
53 Perimeter Center East
Third Floor
Atlanta, Georgia 30346-2298
770-391-9100

CAPITALIZED INTEREST AS POTENTIAL INCOME UNDER THE FIB: DON’T
ROLL OVER ON ROLLED OVER INTEREST
INTRODUCTION
Several kinds of interest can raise issues under Standard Form 24, the Financial
Institution Bond. Insureds’ claims can include interest income not realized due to loss of
money, interest earned by a wrongdoer or others on money or property embezzled from the
insured, interest on interest owed, pre-judgment interest on claims from the date of loss or the
date of demand under the FIB, and capitalized or “rolled-over” interest. This paper focuses on
this last type of interest claim: interest that, in the bank’s view, becomes a part of the principal
loss because it was rolled over into a subsequent loan.
Imagine a scheme in which a bank employee creates a fraudulent note purporting to
loan $100,000 for one year at 5% to a real or fictitious person. The employee takes the
money, and the bank has incurred a loss because no borrower actually exists to repay the
amount stolen. The note on the bank’s books is a worthless piece of paper but appears to
represent the value of a valid loan transaction, including the accrual of interest owed to the
bank. When the “note” comes due, the dishonest bank employee simply rolls the note over
into a new note for another year and avoids being caught when the bank tries to collect the
$105,000 now appearing to be due. The new note, however, must have a face value of
$105,000 to cover both the principal (which actually was stolen) and the “interest” that is just
as fictitious as the loan and borrower.
If the scheme unravels at this point, the insured bank may claim that its loss is the
$105,000 represented by the fraudulent rollover note. The insurer will point to Exclusion S of
the FIB, which excludes “potential income, including but not limited to interest and dividends,
not realized by the Insured.” Since $5,000 of the claim results from rolling the apparently
accrued interest into a new, fraudulent note, the potential-income exclusion is asserted to bar
recovery of that portion of the claim. The bank has not lost the $5,000, only the $100,000
stolen by its employee.
The insurer focuses on the bank’s out-of-pocket loss, while the bank simply prints out
an accounting of the loss based on its books, reflecting principal and interest accrued. The
FIB does not define the term “loss,” and the courts, unfortunately, are split. Does the FIB
cover or exclude rolled over interest?
THE CASE FOR COVERAGE OF ROLLED OVER INTEREST
The leading and first case holding that rolled-over interest is covered by the FIB and not
excluded as potential income was Bank of Huntingdon v. Smothers, 626 S.W.2d 267 (Tenn.
App. 1981). Troy Smothers, described in the opinion as an officer and “trusted employee,” had
been stealing from the bank for 16 years by creating fictitious notes and forging the names of
bank customers on those notes. He would present a note to a teller and receive the cash
value. Since no customer actually borrowed any amount from the bank, this scheme was
nothing more than embezzlement covered up on the bank’s books by fraudulent notes. The
court in fact describes the thefts by using the word “embezzled.”
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The amount Smothers received from a note, however, was not 100% of the face
amount of the note, because the bank’s policy was to withhold the interest from the “loan” on
the front end. For instance, on a $100,000 note at 5% for one year, the bank would deliver to
the borrower only $95,000 and retain the $5,000 that would be earned as interest over the
term. The bank made its profit when the borrower repaid the face amount of the note, which
included $5,000 that the bank earned for loaning its $95,000 for a year. When a note came
due, Smothers would create another fictitious note. Some of the subsequent notes paid
interest only, some paid a prior note in full, and some notes generated more cash.
Of those three types of fictitious notes, only one caused a real out-of-pocket loss to the
bank—the notes for which Smothers received money. Otherwise, he was merely concealing
his thefts with fraudulent paper. The insurer, relying on the bank’s incomplete records of which
notes had been paid or rolled, paid to the bank $250,000 estimated to have been stolen out of
the total $468,495.75 claimed. The insurer’s expert accountant testified that the balance of the
190 unpaid “notes” actually accounted for principal and interest on “previously forged fictitious
notes” which were just paper transactions on the bank’s books. The three-judge panel of the
Tennessee Court of Appeals did not see it the same way.
The court first considered Smothers’ liability to the bank. Instead of calling his actions
theft or embezzlement, as the court had earlier in its opinion, the court switched to couching
those actions in terms of borrowing. “In effect, Smothers made unauthorized loans of bank
funds to himself. . . The law will treat those notes as signed by Smothers for the simple reason
that they were signed by Smothers and funds were obtained for his ultimate credit in one name
or the other.” Id. at 270. Describing what Smothers did as loans is like a thief’s denial by
claiming that he just “borrowed” the item stolen. While the law may employ the fiction that the
fraudulent note is enforceable against Smothers as a loan because he signed the name on
that paper, theft still is the essence of the transaction. Smothers did not sign his own name, he
never intended to repay the amount stolen, and imputing a loan is unnecessary to holding him
responsible for his embezzlement.
The court then compounded its legal fiction by pretending that, when a note was rolled
over into a new note, funds actually changed hands. “If a new note is created to pay off an old
note, such old note is paid off out of the general funds of the bank.” Id. Those were not the
facts established in the record of the case, however: the evidence showed that Smothers
merely covered up his earlier thefts by placing new, fictitious notes in the bank’s records to
explain why no new funds came into the bank to repay the earlier notes. The court might have
noted the fallacy of its reasoning if it had focused on what really happened instead of going
abstract. “It matters not a whit whether this is accomplished by an account transfer by the
bank or by actually handing out “greenbacks” by one hand and receiving them back with the
other. The result is the same. The payment of the old note is realized.” Id.
The opinion offers two suggestions as to why the court fell into this false logic. The
insurer’s expert had testified that Smothers embezzled money to repay prior notes, instead of
insisting that no money changed hands when Smothers placed new notes in the records to
cover old thefts. Also, the insurer’s counsel reportedly argued that “new funds were used to
pay old interest due on old notes.” Id. Such an argument invites the court to think of the new
notes as representing “greenbacks” instead of fraudulent, and therefore void, paper.
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Having incorrectly analyzed the basis for Smothers’ liability to the bank, and having
equated that liability to the bank’s loss, the court needed only a short step to conclude that the
insurer likewise must pay the bank’s loss. What to do with the potential-income exclusion,
though? The court made the following statement:
We hold that “Potential income, . . . not realized by the Insured” as stated in
the exclusionary clause of the policy is that which the bank hopes to receive
from the unrepaid money loaned, taken, embezzled or stolen from its
general fund.
Id. Unfortunately, the court applied this correct statement to its previous fallacious conclusion
that rollover notes represented money loaned from the bank’s general fund. What was left to
consider was only the “interest” accruing on the outstanding notes. The trial court had
calculated the loss as the face amount of the notes outstanding, minus interest not yet earned
when the proof of loss was submitted, plus past-due interest accrued on notes previously due.
The court of appeals panel disagreed with that calculation. The panel deducted from the
insured loss the up-front interest that the bank had deemed earned and the past-due interest
as of the date of the proof of loss.
One argument by the bank was rejected by the court. The bank sought to keep its
award of accrued interest by arguing that it had “realized” the interest on its books so that the
exclusion of “potential income not realized by the Insured” would not apply. The bank referred
the court to bank accounting principles and IRS treatment of booked interest as income. The
court disagreed. In frustratingly correct words, the court said the right things despite having
reached the wrong result on the big dollars:
Id. at 271.
There is no reason, however, to believe that the insurer had Internal
Revenue concepts in mind in drafting the exclusionary clause and the
bank’s treatment of unreceived interest as “realized” for its purposes does
not govern the meaning of the insuror’s language. The plain meaning of the
words “potential” and “realized” leads us to conclude that the insurer meant
to exclude unreceived income so that the bank would recover only that
which it lost, not the income it hoped to receive from the lost amount. . . . To
read the clause as appellee would have us read it makes the clause
virtually meaningless. Such a reading excludes only unearned income,
which would not be included in a loss in the first place. Given its plain
meaning, the clause excludes earned but unreceived income, which would
be included in a broad definition of loss, absent the exclusionary clause.
If the court had applied this language to the rollover interest, the result would have
changed. The bank may have “earned” amounts corresponding to interest, in the sense that
Smothers created fraudulent paper imposing on himself the duty to pay “interest,” but those
amounts are income the bank hopes to receive on the principal amounts actually stolen. If the
potential-income exclusion excludes earned but unreceived income, as the court stated, then
the interest imputed to Smothers’ account falls in that category and should have been
excluded.
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The other principal case against applying the potential-income exclusion to rollover
interest is St. Paul Fire & Marine Insurance Co. v. Branch Bank & Trust Co., 834 F.2d 416 (4 th
Cir. 1987). For 14 years, Thomas Riley, a loan officer, took money from the bank under the
guise of fictitious loans. He even opened fraudulent checking accounts in the names of the
fictitious borrowers in order to deposit the money corresponding to the fictitious notes. When a
fake loan would have come to the bank’s attention because the time for repayment came due,
Riley either renewed the term or created another fake loan. Sometimes he used one
transaction to cover prior principal and interest and also to steal more money. When the
scheme broke down, Riley confessed to 12 outstanding fraudulent notes with total principal
due of $781,500.
As with Bank of Huntingdon, the facts establish a dishonesty loss of the funds taken
from the bank. The covering notes were nothing more than a way to conceal the thefts for a
longer time. The court starts down the wrong path by denominating the loss as loans. St. Paul
determined the amount of the claim representing dollars the bank never lost: dollars taken but
immediately repaid to cover prior “loans.” That total was $534,206.64, and St. Paul paid the
balance of the loss. Both the trial court and the Fourth Circuit Court of Appeals focused on the
bank’s total loss, including loss of use of its funds, notwithstanding the exclusion of potential
income.
The trial court was particularly hard on the exclusion. The judge listened to the bank’s
expert, a professor at a local university, who validated the bank’s “realization” as income of
money stolen from it and then repaid in the form of “interest.” (The insurer’s own expert
confirmed the opinion of the bank’s expert as to what generally accepted accounting principles
provide concerning “realized” income.) St. Paul Fire & Marine Insurance Co. v. Branch Bank &
Trust Co., 643 F. Supp. 648, 651 (E.D.N.C. 1986). Since the bond excluded potential income
not realized, and the parties appeared to agree that the bank properly realized accrued
interest, the judge concluded that the parties never even contemplated a capitalized-interest
dishonesty loss. Finding that the exclusion did not apply, the trial court awarded the bank the
balance of its claim.
The appeals court started by endorsing the holding in Bank of Huntingdon, but it went
further. Even if the outstanding principal reflected in the notes were considered to be interest,
the court stated, that interest must be considered “realized” so that it would not be excluded as
“potential income not realized.” Although the transaction was, in essence, taking money from
one pocket and putting it back in another, the court adopted the experts’ view of accounting
principles to hold that the bank nevertheless realized the income. Realized income is not
excluded, but only through some alchemy can the bank realize income that it also claims it lost
because the income never was received.
The heart of the Fourth Circuit’s decision appears near the end of its opinion. In
response to St. Paul’s argument that the court’s ruling allows BB&T to recover profits, the court
stated,
It is undisputed that had BB&T not made the loans to Riley, it would have
allocated the funds to honest borrowers who would have repaid the
principal with interest. Moreover, BB&T has lost more than the $215,924.96
voluntarily paid by St. Paul, because it was required to pay income tax on
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834 F.2d at 418.
the interest payments and was unable to recover $50,000 of the
outstanding principal due to the policy’s $50,000 deductible. In addition, as
Judge Kiser, one of the panel members, noted from the bench at oral
argument, interest payments cannot be categorized solely as profit,
because the real interest rate is only 3% while the remaining interest
charged represents inflation, not profits.
Here, in the most straightforward terms, is the reason insureds and some courts don’t
understand or just don’t like the potential-income exclusion: it excludes potential profits lost by
the insured. When a dishonest employee deprives a bank of money on which it otherwise
could earn interest, the bank actually loses something. That loss is the income the bank
potentially could earn due to the time-value of money. The easiest example is when the bank
loans that money to the “honest borrower” imagined by the Fourth Circuit and theoretically is
repaid with interest. Of course, banks also earn interest on the overnight market, by investing
in stocks and bonds, by purchasing certificates of deposit, and in many other ways not
involving consumer or commercial loans. Take away a bank’s money, and it is deprived of the
opportunity to earn this time-value income.
Likewise, in straightforward terms, the insurer under the FIB has declined to cover that
lost opportunity. The insurer does not deny that a loss has occurred; it simply chooses not to
cover that loss. One reason may be that the lost income is speculative and uncertain. In what
form might the insured have chosen to invest the money had it not been stolen? Would some
other borrower in fact have repaid the loan? Would that borrower, or the company whose
stock was purchased, or some other entity using the bank’s funds, become insolvent prior to
repayment? What term would the bank choose? When did the bank lose the ability to earn
income on the stolen amounts? The insurer is unwilling to give the bank the benefit of the
doubt on quantifying so many possibilities in determining the amount of its actual loss.
Calling the dishonest employee’s thefts “loans” similarly exposes the insurer to
uncertainties that it cannot contemplate. When the employee creates the fictitious note, why
should the insurer’s liability depend on the interest rate chosen by the employee? Why should
one insurer’s loss be governed by the dishonest employee’s decision to create a 10% note
while another’s loss may be calculated at only 3%? If the employee books a fake note for
$200,000 but only draws out $175,000 before being caught, why should that “note” and the
interest accruing on $200,000 dictate what the insurer must pay? Why should an insurer face
more exposure to an insured bank operating on the accrual basis than to a different insured
bank operating on the cash basis?
With rollover interest, though, the question is even clearer: why talk about interest at
all? What occurred in real life was not a loan but an embezzlement hidden by paperwork
designed to look like a loan. If a dishonest employee violates lending policies and makes a
loan that the bank would not allow to a real borrower who is not creditworthy and does not
repay, the bank incurs a loan loss that includes both the principal and the accrued interest. At
least in that case, a bona fide loan existed. Even in that case, though, the interest accrued but
not realized is excluded. Why should fictitious interest on fake loans be included in covered
loss when real interest on real loans is not?
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What if the dishonest employee is in collusion with a real third party and, together, they
trump up a fraudulent transaction documented to look like a loan? The two take the bank’s
funds, and paper in the bank’s files appear to show a valid loan, but the bank’s loan committee
does not know about it, the third party never intends to repay, it is not within the employee’s
authority, and the terms would be unacceptable. When the bank discovers the fraud, does it
merely attempt to enforce the loan made without actual or, in this case, apparent authority, or
does it go after both employee and colluder for fraud? Would the bank accept merely the
principal and interest repayment and let bygones be bygones? The bank will want attorney’s
fees, consequential damages, and even punitive damages if possible. If a third party’s
collusion causes the bank to acknowledge that a real loan never existed, how can it argue that
a unilaterally created fictitious “loan” is real?
Two other cases have reached similar results to Bank of Huntingdon and BB&T. The
district court judge in Interstate Production Credit Ass’n v. Fireman’s Fund Insurance Co., 788
F. Supp. 1530, 1542 (D. Or. 1992) did not offer any reasoning for concluding that “there is no
basis for excluding from the amount of the loss those monies borrowed to pay interest.” The
insured extended a bona fide loan, and made other loans to cover the accrued interest on that
loan, in reliance on the fraudulent application made by John Courtright, who started out as
owner of the borrower and later became an employee of the insured lender. (Courtright’s
failure upon being employed by the insured to disclose his prior fraud entitled the insured to
coverage for all losses incurred after that date.)
Rather than explain its ruling, the court merely quoted the insured’s expert accountant.
The accountant’s opinion was that, regardless of the purpose of the loan, the principal loan
balance was increased when the insured made loans to cover previously accrued interest.
The insured distinguished accrued but unpaid interest, which it admitted was excluded, from
accrued interest “paid” by a later loan. The problem is that the accrued interest was not
actually paid but simply transferred on the books of the insured from the category “accrued
interest” to the category “principal.” The court fell prey to the illogic of thinking money really
changed hands when all that occurred was an accounting entry shifting digits from one ledger
column to another.
The same illogic held sway in First National Bank of Dillonvale v. Progressive Casualty
Insurance Co., 640 N.E.2d 1147, 1149-50 (Ohio App. 1993), abrogated on other grounds by
Bush v. W.C. Cardinal Co., 2003 WL 22332938 (Ohio App. 2003). The scheme in that case
was that bank officer Charles Maleski created fictitious loan documents to generate on the
bank’s books credits he then applied to customers’ real loan accounts. With those loans
apparently paid off, Maleski then was free to convert the customers’ loan payments when they
came in. He also created later fictitious loans to cover the earlier ones when they came due,
and part of the later fictitious loans covered accrued interest.
The court, as did the judge in Interstate Production Credit Ass’n, considered the later
fictitious loans to be real money leaving the bank, even though any such money instantly
returned to “pay” accrued interest, and so concluded that the bank incurred a loss. The court
also distinguished accrued-but-unpaid interest from theoretically paid interest. This concept of
limiting the potential-income exclusion to accrued-but-unpaid interest takes the fiction of a
loan, adds the fiction of accrued interest, piles on the fiction of payment of that accrued
interest, then finds a loss because the payment never actually occurred. Perhaps these courts
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are trying to accomplish through fictions the goal that the Fourth Circuit stated plainly in BB&T:
cover the presumed lost time-value of the bank’s money.
One other case bears mention for its unfavorable treatment of the exclusion. The trial
judge in Mid-America Bank of Chaska v. American Casualty Co. of Reading, PA, 745 F. Supp.
1480 (D. Minn. 1990) found the term “realized” to be ambiguous. The judge could not decide
between the insurer’s meaning—to convert into money—and the bank’s meaning—recognition
on the bank’s books. Neither party had presented any evidence to support its claimed
meaning for the word. As a result, the court submitted the construction of the term to the jury.
THE CASE FOR EXCLUSION OF ROLLED OVER INTEREST
These cases and their reasoning are not the only authorities on the subject. Standing
staunchly opposed is American Trust & Savings Bank v. United States Fidelity & Guaranty Co.,
418 N.W.2d 853 (Iowa 1988). Fred Pape, a senior vice president of the bank, embezzled
funds for 16 years. The way the court described Pape’s scheme shows clarity of analysis from
the outset and foreshadows the result.
Pape would obtain money from the bank by forging notes purporting to be
loan agreements of bank customers. To conceal his embezzlement he
would pay off these notes as they came due, in part with money obtained
from newly forged notes. Over this period of time Pape’s roll-over scheme
involved approximately 496 notes. All but twelve of these had been paid off
by the time his scheme was discovered.
Id. at 854. Pape embezzled, and the paper merely concealed that embezzlement.
The bank claimed the face amount of the 12 notes, $4.3 million, although its own audit
showed that over $2 million of this amount had gone to prior accrued interest on fraudulent
notes. “However, the money Pape obtained from the bank in order to pay interest to the bank
does not represent an actual depletion of bank funds. The ‘total cash out’ of the bank resulting
from Pape’s scheme is actually $2,230,148.36.” Id.
The court determined first that the bond issued by USF&G was a statutory bond
required by Iowa law. For this reason, the bond would be read liberally to satisfy the statutory
requirements but would not be extended beyond the clearly expressed intent of the statute.
Despite this possible problem for the insurer, the court also found that the terms of the
banker’s blanket bond were consistent with the intent of the statute so that no additional
statutory terms were read in and no restrictive bond terms were read out.
The Iowa Supreme Court focused on the bond and statute’s coverage of “losses,” rather
than on the potential-income exclusion. The statute required a bond that indemnified the bank
for losses resulting from embezzlement and forgery until all of the employee’s accounts with
the bank “shall have been fully settled and satisfied.” Id. The bank used this language to
argue that the insurer’s liability on the bond should be co-extensive with that of the employee,
who was liable for the face value of the $4.3 million in notes. This argument is similar to that
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accepted by the court in Bank of Huntingdon. The supreme court in American Trust & Savings
Bank disagreed both with the bank and with the Tennessee Court of Appeals.
Id. at 855-856.
We believe that the terms “losses” under the statute and “loss” under the
bond refer to the actual depletion of bank funds caused by the employee’s
dishonest acts and not to the eventual personal liability of the employee to
the bank. Stated otherwise, the covered loss is that which arises at the
time and place that the specified misconduct occurred. . . .
. . . .
When newly forged notes were used to pay interest, the bank suffered no
loss because its assets were not diminished in fact, nor did the phony
interest payments increase the bank’s assets, although its books showed
otherwise. The payment of income tax on the theoretical gain did not result
from the defalcation, rather it was a consequence of Pape’s subsequent
cover-up of the prior embezzlements. Thus, this alleged loss was not a loss
from the specified acts.
In focusing on what the bank lost, the court noted that its conclusion was consistent with
the loan-loss exclusion in the USF&G banker’s blanket bond. If Pape’s transactions had
involved real or legitimate loans, the bond would have excluded those losses. But for his
dishonesty, the bank would have recovered nothing under the bond, so the only recovery could
be for losses caused directly by Pape’s dishonesty. The court found those losses to be limited
to money taken at the time of the dishonesty.
Other than in rejecting Bank of Huntingdon and BB&T, the Iowa supreme court did not
mention the potential-income exclusion. Perhaps it would have felt compelled to read that
exclusion out of the statutory bond as inconsistent with and more restrictive than the statutory
scope. The court did note that, if allowed to recover the full amount of the notes, “the bank
would in fact profit from the dishonest acts of its own employee. Such an interpretation of the
statute and the bond would be unreasonable.” Id. at 856.
American Trust & Savings Bank has been followed and approved by the Eighth Circuit
Court of Appeals in First American State Bank v. Continental Insurance Co., 897 F.2d 319, 329
th
(8 Cir. 1990). That case did not involve wholly fictitious loans or rollover interest, but the
circuit court panel correctly focused on loss as depletion of assets rather than claimed loss
according to banking ledger entries. The bank officer, Robert Clawson, wanted funds for land
speculation but was prevented by regulations from borrowing from his own bank. Instead, he
enlisted the help of two bank customers in creating fraudulent loans as a conduit of the bank’s
money through the customers and back to Clawson, who signed notes to the customers in
return. When Clawson could not repay his notes, the customers got crosswise with the bank
and the scheme came to light.
Because the bank had vicarious liability to the customers for Clawson’s fraud, the bank
settled with those customers, including a restructuring of some of the debts. The result of the
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estructuring was that the bank was unable to collect over $300,000 in accrued interest on one
of the customer’s valid loans. The bank included that amount in its claim, but the court of
appeals affirmed the district court’s summary judgment for the insurer. The bond included a
rider with the standard potential-income exclusion language, and the court found that the
accrued but unrealized interest clearly was excluded from coverage. The court applied the
exclusion even though it also agreed that the bond was a statutory banker’s bond under Iowa
law. Moreover, the court stated that the accrued interest would not have been covered even in
the absence of the exclusion because the interest did not represent a depletion of funds
directly resulting from Clawson’s dishonesty. Id.
In First American State Bank, the insured bank had a legitimate loan, interest legally
accrued of over $300,000, and was held to be justified in settling with the customer so as to
lose the value of that interest. That loss of an asset was caused by a bank employee’s
dishonesty as much as any of the other liability the bank incurred to the customers.
Nevertheless, the court held that no direct loss occurred with respect to that interest, which
also was excluded under the potential-income exclusion. Contrast that holding with the cases
refusing to apply the exclusion: no legitimate loan, no legal interest accrued, no real asset, yet
the courts find both a covered loss and the inapplicability of the exclusion.
The “direct loss” holding of these two cases has additional support. For example, in
1941, the Fifth Circuit considered bank-employee embezzlement concealed by fraudulent
documentation and withheld deposit slips instead of fake loans in Continental Casualty Co. v.
th
First National Bank of Temple, 116 F.2d 885 (5 Cir. 1941). The employees stole money from
customers’ accounts and then covered the thefts with later deposits by other customers. As
the court noted, though, the liability of the bank remained the same, with the loss merely
switched from the old to the new deposits. The court held that loss resulted only from some
action that reduced the available assets in the hands of the bank. Therefore, only the initial
thefts caused a covered loss, even though the bank’s books reflected other dishonest
transactions and later accounts affected. That case was followed over 30 years later in Fidelity
th
& Deposit Co. of MD v. USAFORM Hail Pool, Inc., 463 F.2d 4 (5 Cir. 1972) (transfers from
one account to another within the same corporation are not covered losses under the bond).
Where the question was whether to account for potential recoveries, the insured bank’s
successor was much in favor of quantifying the loss as what it had out of pocket at the time of
the dishonesty in Federal Deposit Insurance Co. v. United Pacific Insurance Co., 20 F.3d 1070
th
(10 Cir. 1994). Holding for the insured, the Tenth Circuit stated the following:
Language in a fidelity bond to the effect that the insured is covered for
“losses directly resulting from . . .” indicates a direct loss or the actual
depletion of bank funds caused by the employee’s dishonest acts.
[Citations to First American State Bank and American Trust & Savings Bank
omitted.] “[L]ack of any pecuniary loss by the insured from the alleged
wrongful acts constitutes a good defense, since in such case no recovery
can be had.” 13 Couch on Insurance 2d § 46:219 (1982). Bookkeeping or
theoretical losses, not accompanied by actual withdrawals of cash or other
such pecuniary loss is not recoverable.
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Id. at 1080. The court agreed with the insured that potential recoveries do not reduce present
loss, but that reasoning also stands against an insured’s attempt to recover “bookkeeping”
losses not involving a “depletion of bank funds.” That exactly describes a claim for fictitious
interest purportedly accrued on fictitious loans.
On the topic of recoveries, the new version of the FIB provides an alternative reason for
denying a rollover-interest claim. Section 6 now expressly provides that any value the insured
receives, such as interest on fraudulent loans, credits, repayments, or other recoveries
“however denominated,” reduce the amount of the loss. The section also does not differentiate
between recoveries before or after payment by the insurer (the commercial crime policy
speaks only to recoveries after payment). If an insured insists on treating rollover interest as a
real loss not excluded because it was “realized,” then the insured likewise must account for the
recovery of the prior interest when the rollover notes were created. Claiming the face amount
of fictitious notes as the measure of the bank’s loss disregards all of the prior recoveries
represented by prior fictitious notes and overvalues the insured’s loss under new Section 6.
CONCLUSION
The Tennessee Court of Appeals ruled first, albeit incorrectly, primacy certainly carries
influence, and the Fourth Circuit followed. The Iowa Supreme Court ruled later but was not
intimidated, and the Eighth Circuit agreed. The question of what to do with a bank’s claim for
rollover or capitalized interest appears to come down to this: does the court wish to find a way
to cover the bank’s lost use of funds regardless of the exclusion’s language, or will the court
allow the parties to agree between themselves on the scope of the bond’s coverage? So far,
the courts have overlooked the fact that the American Bankers Association played a role in the
drafting of the Financial Institution Bond, so that bankers should not be heard to demand
construing ambiguities against the insurer.
In light of the limited precedents, no one can lay out a roadmap for success in
combating a claim for rollover interest. Keeping the focus on the bank’s money out the door is
a start. Remind the court that the dishonest employee’s documents do not change or affect
the truth that embezzlement caused the loss. Explain the logic of the exclusion in light of the
unknowns, uncertainties, and uncontrolled factors determining just how much potential income
the insured actually did lose. Loss is the key, and the bond covers only what employee
dishonesty took away from the insured, expressly excluding the interest the bank potentially
could have earned on the stolen funds.
Gregory R. Veal
BOVIS, KYLE & BURCH, LLC
Thanks to W. Randal Bryant, Esq. for research assistance. For additional reading, see ANNOTATED FINANCIAL
INSTITUTION BOND 2D (Michael Keeley, ed., ABA 2004), at 405-411; William T. Bogaert & Andrew F. Caplan,
Computing the Amount of Compensable Loss Under the Financial Institution Bond, 33 TORT & INS. L.J. 807 (1998);
David K. Kerr and Jerome M. Joseph, The Potential Income and Principal Other Exclusions, in FINANCIAL
INSTITUTION BONDS 224-225 (Duncan L. Clore, ed. ABA 1995); Benjamin Lentz, Profit and the Potential Income
Exclusion, 19 FORUM 694 (1984); Edgar L. Neel, Financial Institution and Fidelity Coverage for Loan Losses, 21
TORT & INS. L.J. 590 (1986).
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