Recovering for Derivatives Trading Losses under Financial Institution and Crime Bonds

Article excerpt

With the increase in losses from the use of derivatives, it can be expected that insures will claim under various types of bonds

While the 1995 collapse of Barings PLC focused the media's and public's attention on another massive loss sustained from trading in "derivatives," the insurance industry has braced itself for a new round of claims by financial institutions and investors that have incurred these losses and other liabilities.(1) One type of insurance that may be the subject of claims is the fidelity bond. But there are coverage issues that arise in claims involving derivatives-trading losses.

A "derivative" generally is defined as a financial agreement whose value depends on, or is "derived from," the performance of an underlying financial asset such as a bond, currency, or an index of securities.(2) The term is commonly used to describe a broad range of instruments such as futures, options on securities, options on futures, forward contracts, structured notes, swap agreements, and mortgage pool participations. While some derivative instruments are traded on exchanges or through organized markets, as is the case with futures and options on futures, over-the-counter derivatives, such as swaps and structured notes, are individually negotiated between the parties. An entity or individual usually invests in a derivative to reduce risk, known as hedging," or as an alternative to investing in more traditional securities.(3)

Employee Dishonesty Insuring

Agreements

Generally speaking, there are two types of fidelity bonds available in the commercial insurance market: (1) the financial institution bond and (2) the commercial crime bond. The financial institution bond covers banks, brokerage houses, investment banks, and savings and loan associations. The commercial crime bond is usually purchased by corporations or other business entities.

Although fidelity bonds, whether issued to financial institutions or corporations, provide coverage to the insured entity for losses caused by such perils as forgery, certain counterfeited documents, "on-premises" losses, or damage to property, the main insuring agreement provides coverage for losses caused by "dishonest and fraudulent acts" or, as in the case with some commercial crime bonds, "theft," committed by "employees" of the insured entity.(4)

Since the mid-1970s, most financial institution bonds have contained an employee dishonesty insuring agreement covering:

Loss resulting directly from dishonest or fraudulent acts of an employee committed alone or in collusion with others.

Dishonest or fraudulent acts as used in this insuring agreement shall mean only dishonest or fraudulent acts committed by such employee with the manifest intent

(a) to cause the insured to sustain such loss, and

(b) to obtain financial benefit for the employee or for any other person or organization intended by the employee to receive such benefit, other than salaries, commissions, fees, bonuses, promotions, awards, profit sharing, pensions or other employee benefits earned in the normal course of employment.(5)

Under this language, the insured entity generally must show four main elements in order to demonstrate a covered claim. First, the insured show that it has sustained a "loss." Fidelity bonds are not liability policies; they are generally considered to be indemnity policies that reimburse only the insured's out-of-pocket loss.1 Second, the insured must show that the loss was caused by dishonest or fraudulent acts committed by an "employee" of the insured.1 Third, the employee's dishonest or fraudulent acts must have been committed with a "manifest intent" to cause the insured to sustain a loss.1 Fourth, the employee's dishonest or fraudulent acts must have been committed with the "manifest intent" to obtain an improper benefit for the employee or, under some bonds, a third party.(9)

The commercial crime bond often contains similar language. …