State Bank of the Lakes v. Kansas Bankers Surety Co., Cross-Appellee

Citations: 328 F.3d 906; 2003 U.S. App. LEXIS 9014; 2003 WL 21056008Docket: 02-2534, 02-2665

Court: Court of Appeals for the Seventh Circuit; May 12, 2003; Federal Appellate Court

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State Bank of the Lakes provided loans to Pistakee Marina, Inc. for over a decade, securing each loan with a Manufacturer's Statement of Origin (MSO), which Pistakee needed to transfer boat titles. The release of MSOs was contingent on loan repayment. In 1997, Pistakee defaulted, revealing that owner William Slater had committed fraud by presenting fake MSOs to multiple lenders, securing loans against the same collateral. Slater was convicted of bank fraud, receiving a 46-month sentence. 

The Bank sought indemnification from Kansas Bankers Surety Co., which had issued a "Crime Bond" covering losses from borrower crimes. The bond specified indemnity for losses resulting from reliance on forged or altered documents, including MSOs categorized as "Certificates of Origin or Title." The Bank maintained possession of the fraudulent documents, satisfying a coverage condition. The bond defined "counterfeit" as a deceptive imitation intended to appear original but did not define "good faith." Slater meticulously crafted his forgeries to closely resemble authentic documents, using identical materials and techniques, including forged signatures, making it difficult for the Bank to detect the fraud at the time of loan disbursement.

Kansas Bankers Surety acknowledged that signed certificates are considered "counterfeit" under the bond's terms, but disputed that unsigned fraudulent Master Service Orders (MSOs) fit this definition, arguing that lending against unsigned documents indicates a lack of "good faith." A lawsuit followed under diversity jurisdiction, leading to Judge Marovich denying the insurer's summary judgment motion due to material disputes requiring a trial. Judge Bucklo subsequently held a bench trial, determining that the unsigned fakes were sufficiently convincing to warrant a $290,000 judgment for the Bank to cover losses from advances against these documents. However, he found the insurer's position neither unreasonable nor vexatious, denying the Bank's requests for penalties and attorneys' fees.

Both parties appealed, agreeing that Illinois law applied. Kansas Bankers Surety argued that unsigned documents cannot be classified as "counterfeit," but the court noted that the definition of "counterfeit" encompasses imitations intended to deceive, regardless of a signature. The court referenced federal law, asserting that a lack of signature does not negate the potential for deception. It concluded that Slater's fraudulent intent was sufficient for the unsigned documents to qualify as "imitations" under the bond's definition. The court also highlighted that the bond's language implies that unsigned documents may still be considered counterfeits.

Additionally, the insurer contended that the Bank did not act in "good faith," equating this term with "due care." The court noted that "good faith" typically connotes a subjective standard, while "due care" is objective, suggesting that conflating the two diminishes the meaning of "good faith." The court implied that an "imitation" can deceive someone exercising ordinary care, regardless of negligence.

In United States v. Turner, the court clarified the standard for what constitutes "counterfeit" in criminal law, emphasizing that for something to be deemed an "imitation," it must be credible enough to deceive a banker, not just a child or an animal. The district court found that the Bank exercised due care in accepting the documents classified as "imitations." This finding can only be overturned on appeal if deemed unreasonable, which was not the case here. The insurer failed to provide evidence that bankers typically reject genuine but unsigned certificates, undermining the argument that the fraudulent documents would not pass scrutiny by loan officers exercising ordinary prudence.

Concerns about moral hazard—where a bank may act carelessly knowing another party will bear the loss—are less significant when coverage is restricted to criminal fraud, as banks face various risks in secured lending. The importance of ensuring that chattel paper accurately references real collateral is reinforced by case law, as seen in several decisions that ruled fake documentation regarding nonexistent assets does not qualify as "counterfeit." The Bank's diligence in confirming inventory related to the certificates was noted.

Furthermore, Kansas Bankers Surety adjusted premiums based on their clients' loss experience, incentivizing the Bank to act responsibly. If the insurer desired more protection against moral hazard, it should have explicitly included that in the contract. The court distinguished between "good faith" and "due care," stating that ambiguities in insurance policies are resolved in favor of policyholders, but this principle did not apply here since the concepts are fundamentally different. The court upheld the insurer's decision to decline payment pending judicial determination of legal questions, which were novel and not previously addressed in appellate decisions. The insurer acted within its legal rights by disagreeing with the Bank over the bond's interpretation, leading to the affirmation of the lower court's decision.