A federal district court in Wisconsin recently ruled that losses a mortgage lender incurred as a result of having to repurchase loans that were issued through the dishonest acts of an employee and went into default were not covered by the mortgage lender’s fidelity bond. In Universal Mortgage Corp. v. Wurttembergische Versigherung, 2010 WL 3060655 (E.D. Wis. 2010), Universal Mortgage Corporation (Universal), a mortgage lender, filed an action against its fidelity bond to recover losses it attributed to dishonest acts by one of its loan managers. (Fidelity bonds are indemnity contracts that guarantee reimbursement for losses sustained by the insured resulting from the dishonesty of the insured’s employees). The fidelity bond covered certain financial losses sustained by Universal which were “directly caused by: (a) dishonest acts by any employee . . . whether committed alone or in collusion with others, which dishonest acts were committed by the employee with the manifest intent to obtain and resulted in the receipt of improper personal financial gain for said employee, or for the persons acting in collusion with said employee . . ..”
Universal sold its mortgage loans to investors and required its loans to meet the standards of the Federal National Mortgage Association (FNMA). Universal warranted to investors that its mortgage loans met the standards. If an investor later discovered that a particular loan failed to comply with the FNMA standards, Universal was obligated to repurchase the loan. One FNMA standard was the requirement that borrowers taking out purchase money mortgages made down payments equal to a specified percentage of the purchase price. One of Universal’s employees, a loan manager, allegedly entered into a conspiracy with representatives of a mortgage brokerage company whereby the Universal employee accepted mortgage loan applications with down payment assistance that violated FNMA standards. In return for his help, the Universal employee allegedly received personal payments from the mortgage brokerage company. The non-compliant mortgages were sold to investors and many later went into default. When it was discovered that the mortgages did not meet FNMA standards, Universal was obligated to repurchase the loans pursuant to its contracts with investors. After repurchasing the loans, Universal sought to recover over $833,000 under the fidelity bond.
The court held that Universal’s losses were not covered by the fidelity bond. First, the losses were not “directly caused by” its employee’s acts. The court noted that there were competing interpretations of loss “directly caused by” employee dishonesty. Some courts allow proximate causation to satisfy the standard such that the employee’s acts need not be the “sole” or “immediate” cause of the loss, while others hold that “direct means direct.” See e.g., Vons Companies, Inc. v. Federal Ins. Co., 212 F.3rd 489, 492-93 (9th Cir. 2000). However, relying on Tri City National Bank v. Federal Ins. Co., 674 N.W.2d 617 (Wis. Ct. App. 2003), where the Wisconsin Court of Appeals rejected the contention that “direct” is synonymous with “proximately” or “proximate cause” for purposes of coverage under a fidelity bond, the court held that Universal’s losses were not “directly caused by” employee dishonesty. The court noted that Universal was seeking liability coverage for its contractual obligation to repurchase loans from third-party investors (not covered) rather than fidelity coverage for losses directly caused by its employee’s actions (covered):
Universal issued mortgage loans that did not comply with the FNMA standards. However, the dispersal of loan proceeds to non-qualifying borrowers did not inflict loss upon Universal. Indeed, no loss could be inflicted until the mortgages went into default. * * * However, Universal sold its mortgage loan to investors before any default occurred and suffered no direct financial harm when the loans later defaulted. The only parties adversely affected at the time the non-FNMA-compliant mortgages went into default were the investors who purchased the mortgages. Universal first suffered loss when it was required to repurchase the non-compliant loans. * * * Thus, Universal first suffered a loss when the buy-back provisions in its contracts were enforced and not earlier when it dispersed loan proceeds, or when it sold the mortgages to investors, or when the borrowers initially defaulted. The losses Universal incurred by repurchasing the non-conforming mortgages were not the immediate result of [its employee’s] approval of unqualified borrowers. Instead, the costs were the immediate result of Universal’s contractual obligations to repurchase. If Universal was not subject to buy-back provisions in its contracts with investors, it would not be financially affected by the default of the borrowers because Universal no longer owned the mortgages. * * * Thus, the losses Universal claims for the required repurchase were “directly caused by” its contractual obligations and not by employee dishonesty.
Second, the court ruled that Universal’s claimed losses did not represent “direct financial loss” within the meaning of the fidelity bond and, thus, were not covered. On this issue, the court relied in part on the federal district court’s opinion in Direct Mortgage Corp. v. National Union Fire Ins. Co., 625 F. Supp.2d 1171 (D. Utah 2008), where the court held the loss plaintiff mortgage company incurred in having to repurchase fraudulently-obtained mortgages was not direct because the “loss was contingent on the occurrence of a series of events that were not inevitable, and such a contingency takes the loss outside the scope of the Fidelity Bond.” Id. at 1177-78. The plaintiff mortgage company argued that it suffered a direct loss at the time the loans were issued and sold to third-parties, and not after its buy-back obligations were enforced, because it was “on the hook” for violation of the warranty as soon as the loans were issued and sold. Id. at 1178. However, the court rejected this argument stating: “although [the plaintiff] was potentially ‘on the hook’ as soon as the loans were sold, its loss was theoretical at that point.” According to the federal district court, the losses Universal suffered were likewise not “direct losses” because:
First, they were contingent upon borrowers defaulting on the mortgages. Default is not the inevitable result of issuing mortgages to individuals who do not meet FNMA standards. If the borrowers had paid or continued to make their payments in a timely manner, no loss would have resulted. Therefore, no party experienced “loss” until the loans went into default. Second, the repurchase costs were contingent upon enforcement of contractual repurchase obligations. If investors had not uncovered the mortgage irregularities and enforced the buy-back provision, Universal would not have experienced any loss. These intervening events had to transpire before Universal felt any financial injury related to [its employee’s] approval of unqualified borrowers.
Finally, the court concluded that Universal’s claimed losses were not covered by reason of an exclusion for losses resulting from “having repurchased or having been required to repurchase a Real Estate Loan from an Investor.” The damages that Universal asserted were for the immediate consequence of having to repurchase non-conforming mortgages from the parties to whom they were sold. Therefore, the terms of the fidelity bond excluded coverage of Universal’s losses.
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Good thing the court ruled that this incident was not covered by a fidelity bond. With all the abuses and negligent procedures the banks have exhibited, the insurance industry would go broke if they had to pay off on the myriad of similar instances.
Guy C. Hatfield CPCU