In an interesting recent decision, a court rejected two defenses a Financial Institution Bond insurer asserted in denying coverage for a bank’s losses arising from a $3.6 million loan extended in reliance on documents that proved to have been forged. District Court of Arizona Judge G. Murray Snow, applying Arizona law, rejected the bond insurer’s arguments that the loss did not trigger one of the bond’s insuring agreements and that the notice prejudice rule did not apply to the bond’s coverage. The court’s January 4, 2019 decision can be found here. The Hunton Andrews Kurth law firm’s February 5, 2019 post about the decision on its Insurance Recovery Blog can be found here.
In 2012, Metro Bank loaned $3.6 million to Global Medical, in order for Global Medical to purchase two medical equipment companies, JCare Medical and A&A Medical. A condition of the loan was that Global Medical would not make any additional payments to other creditors during the first four years of the repayment plan. Metro Bank obtained Standby Creditor’s Agreements (SC Agreements) from the principals of JCare Medical and of A&A Medical that the principals (referred to in the subsequent judicial opinion as “creditors”) would refuse any payment from Global Medical during the first four years of the repayment plan. The SC Agreements also required the creditors to pay to Metro Bank any payments made to them by Global Medical.
In 2014, Metro Bank exercised its rights of receivership under its loan agreement with Global Medical. After the receivership was in place, Metro Bank discovered a number of problems with Global Medical’s loan application and also discovered that the SC Agreements had been forged. In March 2016, Metro Bank provided its bond insurer with a claim resulting from the SC Agreements. In April 2016, Metro Bank provided the insurer with a proof of loss.
The Bond Insurance
During the period 2013 to 2017, the bond insurer had issued Metro Bank two successive Financial Institution Bonds, one for the period 2013-2014 and one for the period 2014-2017. When Metro Bank submitted its loss in connection with the Global Medical loan to the bond insurer, Metro Bank had requested that the insurer consider the loss under both of the two bonds.
Both of the bonds are “loss discovered” bonds, meaning that they apply to losses that are first discovered during the Bond period. The bonds also required that Metro Bank notify the bond insurer of any discovered loss within thirty days, and to provide proof of loss within six months.
Insurance Agreement (E) of the bond provides coverage for a “Loss resulting directly from [Metro Bank] having, in good faith, for its own account or for the account of others, … acquired sold or delivered or given value, extended credit or assumed liability on the faith of, and Written, Original … personal Guarantee… or Security Agreement.”
Under the bond, a “Guarantee” is defined as a “[w]ritten undertaking obligating the signer to pay the debt of another, to the Insured … if the debt is not paid in accordance with its terms.”
The January 4, 2019 Decision
In his January 4, 2019 Order, Judge G. Murray Snow granted Metro Bank’s motion for partial summary judgment on two issues: (1) whether the SC Agreements are covered by the bond as “Guarantees,” and if so, (2) whether the notice-prejudice rule applies to the bonds.
In ruling that the SC Agreements are “Guarantees,” Judge Snow noted that under the terms of the loan agreement, if Global Medical made any payments to the creditors in the first four years of the loan repayment period, that would violate the loan agreement. And if that happened, the creditors were obligated under the SC Agreements to pay to Metro Bank any funds that the creditors received from Global Medical. Judge Snow said “because the purported agreements between the bank and the creditors obligated them to pay the bank any amounts paid to the creditors by Global Medical that violated the terms of its agreement … those SC Agreements meet the terms of a ‘Guarantee’ under the Bond.”
In addressing the notice of claim issue, Judge Snow first noted that Metro Bank conceded that if the “trier of fact” were to conclude that Metro Bank discovered its loss on the Global Medical loan during the 2013-2013 bond period, there would be no coverage, because the bank had not provided notice of the loss prior to the end of the policy period for that bond. If it is determined that the loss was discovered during the policy period of the 2014-2017 bond, then the question arises whether the notice prejudice rule applies under the bond where notice was “potentially given within the Bond period, but not within the 30 days that the Bond prescribes.”
Arizona recognizes the notice prejudice rule but there is case law authority that the notice prejudice rule does not apply to claims made policies. The logic of the cases declining to extend the notice prejudice rule to claims made policies is that doing so would convert the claims made policies to occurrence policies. However, Judge Snow noted, the bond is neither a claim made policy or an occurrence policy, because coverage applies to loss “first discovered” during the policy period. Because, Judge Snow said, discovery triggers the coverage of the Bond to the loss, the rationale for not extending the notice-prejudice rule to claims-made policies does not apply in this context,” since it “merely requires that [the insurer] provide coverage to claims that are discovered and reported within the policy period if it has not been prejudiced by a late notice.”
The question in this case of the applicability of the “Guaranty” Insuring Agreement is an interesting illustration of the way that complicated coverage questions can arise. I will leave to others with more detailed knowledge of Financial Institution Bonds to assess the merits of Judge Snow’s analysis.
The more interesting question for me is Judge Snow’s analysis of the notice prejudice issue. The judge is of course correct that the bond is not a “claims made” policy in the strict sense that a claims made policy applies only to claims that are first made during the policy period; the bond’s coverage is triggered, if at all, if a loss is discovered during the policy period, not with relation to whether or not a claim is made during the policy period.
There is a larger question worth considering whenever this kinds of late notice issues come up, and that is whether there should ever be exceptions made to the notice prejudice rule, even, for example, with respect to claims made policies. Creating an exception to the notice prejudice rule in effect says that if notice is late, coverage is entirely forfeit even if the late notice did not prejudice the insurer in any way. This exception, to my mind, turns the notice provisions into a trap for the policyholder and an escape clause for the insurer. Substantive rights – indeed, the very commitments that form the basis of the insuring contract – are made subordinate to empty procedural form.
The notice prejudice rule represents a pragmatic recognition that a simple process error should not effect a forfeiture of valuable substantive rights, and least in the absence of a showing that the process error caused the other party some prejudice. Unfortunately, many jurisdictions do not recognize the notice prejudice rule, and even in jurisdictions that do recognize the notice prejudice rule, there are some jurisdictions (such as Arizona) holding that the notice prejudice rule does not apply to claims made policies.
In light of the hodge-podge of different rules in different jurisdictions about the notice prejudice rule and whether or not it applies to claims made policies, it may be advisable, as I have previously discussed in prior posts, to seek (where available) the addition of policy language along these lines:
If the Insured fails to provide notice of such Claim to the Insurer as required under this Section, the Insurer shall not be entitled to deny coverage for the Claim based solely upon late notice unless the Insurer can demonstrate that its interests were materially prejudiced by reason of such late notice.
The inclusion of this language will ameliorate the hardships that can arise when the late provision of notice results in coverage preclusion. The inclusion of this language would certainly eliminate the dispute about whether or not the notice prejudice rule applies in the context of claims-made policies.
All of that said, as Judge Snow found here, there are good reasons on which to argue that the notice prejudice rule does apply to late notice issues under a “loss discovered” Financial Institutions Bond. As the Hunton Andrew Kurth law firm noted in its blog post about the decision (to which I linked above), “the opinion should provide a useful precedent for financial institutions to cite when confronting similar arguments by insurers in the future.