Washington Court Finds Coverage for Fraudulently Originated Loans Repurchased by Now-Defunct Bank

A Washington federal court has denied an insurer’s motion for summary judgment regarding coverage under a fidelity bond issued to a now-defunct bank for losses incurred in connection with fraudulently originated loans the bank purchased, resold, and ultimately repurchased pursuant to contractual obligation. The court held that the loan originators were “Employees” under the policy, and the bank’s immediate, initial loss in the amount it paid for the faulty loans was a direct result of the loan originators’ fraud. Federal Deposit Ins. Corp. v. Arch Ins. Co., 2017 WL 5289547 (W.D. Wash. Nov. 13, 2017).

The insured bank contracted with third parties to originate mortgage loans, which the bank then agreed to purchase. The bank ultimately learned that it had purchased a number of loans based on fraudulent misrepresentations by the loan originators. The bank had resold most of these loans to other lenders but was contractually obligated to repurchase the loans once they were discovered to have been based on fraudulent statements.

The FDIC, as receiver for the bank, sought coverage for the losses from these fraudulent loans from the bank’s insurer under the fidelity bond portion of a financial institution blended policy, which provides coverage for “Loss resulting directly from dishonest or fraudulent acts committed by an Employee” and defines employee to include individuals who originate mortgage loans purchased by the insured bank. The insurer argued that the originators were not “Employees” because they were not originating loans purchased by the bank at the time the policy was issued. Further, the insurer argued that the claimed losses suffered by the bank did not directly result from their fraudulent acts but rather from the bank’s contractual obligation to repurchase faulty loans.

In denying the insurer’s motion, the court held the policy’s definition of “Employee” was not limited to current employees. Further, the court held that the bank suffered an immediate, initial loss the moment it purchased the fraudulent loans that directly resulted from the loan originators’ fraud and that loss does not become indirect just because subsequent attempts to mitigate the loss, such as by reselling the faulty loans, were ultimately unsuccessful.