Whether a policyholder’s losses are “direct” or “indirect” can be coverage-determinative. Most financial institution bonds exclude “indirect” or “consequential” losses. A recent decision in Fed. Deposit Ins. Corp. v. Arch Ins. Co., No. CV C14-0545RSL, 2017 WL 5289547 (W.D. Wash. Nov. 13, 2017) addressed the issue of “direct” versus “indirect” losses in a dispute under a financial institution bond issued by Arch Insurance Company (Arch) to Washington Mutual Bank (WaMu). The court held that WaMu’s losses resulting from its purchase of fraudulent loans were “direct” losses, and that WaMu’s sale and contractual obligation to repurchase the fraudulent loans did not convert its losses from direct to indirect.

In the early 2000s, WaMu purchased a number of real property mortgage loans originated by third-party companies. One of those companies was CIP Mortgage Corporation (CIP). After noticing irregularities with some of the loans, WaMu notified CIP of the issues, and CIP purportedly undertook remedial measures, including firing the loan processor. WaMu later discovered that CIP’s 2003 net worth was less than 1/10th of what it had been a year before, due in large part to a significant distribution to shareholders. WaMu later suspended its business with CIP.

Three years later, WaMu was notified by a defendant in a criminal matter that it had been the victim of fraud perpetuated by CIP, and upon investigation, WaMu concluded that it had purchased approximately 124 fraudulent mortgage loans totaling $53,344,641.16. CIP had “prepared fraudulent paperwork, including loan applications, mortgages, notes and title insurance, to make it look like a third party was borrowing money that was secured by real property owned or controlled by CIP’s CEO.” The CEO and others involved in the fraud fronted just enough money to get through settlement, then sold the loans to WaMu and kept the proceeds for themselves without ever recording the mortgages, paying taxes or purchasing insurance. Monthly payments were made on the loans so that they appeared legitimate. WaMu had sold the loans to CitiMortgage, but was contractually obligated to repurchase the loans when the material representations and warranties WaMu made about the loans proved false.

WaMu notified its carriers of the loss. The financial institution bond required the insurers to indemnify WaMu for “[l]oss directly resulting from the dishonest or fraudulent acts committed by an Employee” with the intent to cause WaMu loss and obtain a financial benefit for themselves. The bond included an exclusion for “indirect or consequential loss of any nature.” After the carriers denied coverage and WaMu collapsed in 2008, the FDIC filed suit against Arch. Arch filed for summary judgment, arguing in part that WaMu’s losses were not “directly” caused by CIP’s fraud, but instead resulted from WaMu’s contractual obligations to repurchase the fraudulent loans.

Arch’s argument did not convince the court. The court began its analysis of the issue by noting that the bond failed to define the phrase “directly resulting.” However, the court found that “a common sense understanding of the policy and the relationship between the entities involved” showed that WaMu suffered a loss the moment it delivered funds to CIP [] and received worthless paperwork in return. Thus, the loss was “direct.” The court further explained that while WaMu “may have been able to reduce its losses over time when the scammers made payments and/or WaMu sold the loans to third parties, […] it nevertheless suffered an initial loss in the amount it paid for the fraudulent loans directly resulting from the loan originators’ fraud.” Further, the court noted that “Arch cites no policy language that would support the proposition that a direct loss of the type the policy was intended to cover becomes indirect simply because, at a later time, attempts at mitigation were unsuccessful.” Accordingly, the court denied Arch’s motion for summary judgment.

The “direct” versus “indirect” loss distinction arises in many cases. Because many policies and bonds do not define either type of loss, carriers frequently contend, as Arch did here, that resulting financial loss is merely an “indirect” result of fraudulent conduct. The court’s opinion finding otherwise provides a useful roadmap for those seeking coverage under similarly worded policies. The opinion likewise lends clarity to what has proven to be a vague and poorly worded policy.

You can read the court’s opinion here.